Balancing Act - April 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 16 May 2016
On April 24, the first round of elections was held for a new Austrian President. The position is subordinate to the Austrian Chancellor but had still been controlled by the two mainstream parties in Austria for decades. Surprisingly, the two traditionally dominant parties only received 22% of the vote, with the May second round to be contested by two previously minority parties: the right wing Freedom Party (which dominated with one-third of the vote) and a Greens candidate. As the mainstream parties descend into chaos, the poor result has forced the current Austrian Chancellor to resign, given his original support for an open borders policy.
This outcome is symptomatic of the general dissatisfaction felt across Europe regarding the handling of the refugee crisis. Any party that runs on an agenda of putting their country first and closing the borders is seeing a surge in popularity.
However, this is not just a European phenomenon—the anti-establishment vote is gathering momentum globally. Donald Trump has surged to the Republican nomination in the US on the back of a groundswell of disillusioned middle class voters sick of the perceived raw deal they are getting from current government policy. The ‘Brexit’ movement (Britain to exit the EU) is currently neck and neck with the ‘stay’ vote according to opinion polls in the UK as voters grow increasingly concerned about the ramifications of remaining within a fragmented Eurozone. President Rousseff in Brazil is being impeached as her government faces increased scrutiny over corruption.
Voters across the world are showing their discontent at the policies being handed down by their governments. They are taking any opportunity to rail against the current establishment in the hope that change will see an end to negative interest rates, exploding government debt, rising inequality and stagnant wages. Unfortunately, the current leadership vacuum means this process of change may be volatile for a while longer.
We expect geopolitical risk to remain elevated, having an increasing impact on asset price returns. One region of potential stability is Asia, where conventional monetary policy and meaningful fiscal reform are combining to generate more balanced growth outcomes. We remain favourable towards Asian equities firstly because they are cheap, but also because the geopolitical backdrop looks significantly better when compared to other major regions.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
US equities are still at the bottom of our hierarchy
US equities remain expensive according to our research models. With the recent rally in the stock market, momentum has improved but we remain concerned with the earnings outlook. Our primary concern is the dislocation between deteriorating earnings and improving prices.
Equity earnings for companies in the S&P500 index have fallen for four straight quarters, the latest being an 8% decline for Q1 2016 compared with a year earlier. Earnings have struggled for a number of reasons:
- The collapse in oil prices has hurt the Energy and Materials sectors;
- A stronger US dollar has challenged all exporters, particularly Industrials and IT;
- Zero interest rates and a flat yield curve have damaged Financial sector margins;
- Increasing wages, combined with falling prices, have negatively affected margins across most sectors; and
- Rising borrowing costs have challenged weaker balance sheets.
Chart 1 highlights the impact of all these headwinds on company earnings. What can also be seen is the ability of equity prices to shrug off the poor earnings and defy gravity as prices (the red line) are within spitting distance of their all-time high.
Chart 1: S&P500 equity earnings and prices
Source: Bloomberg 2016
It is not unusual for equity markets to ‘look through’ the underlying earnings and price for the future—that is why the equity market is sometimes referred to as forward-looking. But it is highly unusual for it to happen when the market is expensive and near an all-time high. So why are markets willing to accept elevated prices in such a poor earnings environment?
The recent pause in US dollar strength is no doubt helping, but our suspicion is the market is expecting the US Federal Reserve (Fed) to resume adding liquidity to the punchbowl. With Europe and Japan still wholeheartedly easing, the US has been the odd man out. Recent Fed rhetoric suggests that global concerns are dominating policy and as such, the market is assuming easier policy is the logical outcome; and, by extension, easier policy will translate into higher equity markets.
We believe it is worth questioning whether current policy settings are in fact conducive for better earnings growth in equities. Zero interest rates are supposed to spur demand for credit, which translates into increased productive capacity, with growth and jobs the desirable by-product. Unfortunately, this supposed transmission mechanism is broken, with investment in the US actually falling. Chart 2 shows the percentage change in non-residential fixed asset investment in the US since 1980. It is evident that despite all the cheap credit, investment in productive capital has been falling sharply. Companies have been reluctant to spend, instead using the cheap credit to buy back their own shares or purchase existing assets through merger and acquisition.
Chart 2: US fixed asset investment (non-residential)
Source: Bloomberg 2016
Rather than spurring investment demand, monetary policy settings appear to be doing the opposite. So the current dislocation between earnings and market prices would appear to be built more on hope than on reality.
An expensive equity market with poor earnings growth is not an attractive asset. Until such time as either the earnings picture improves or valuations become more reasonable after a price correction, we will remain underweight US equities.
Southern European equities remain unattractive
European equities are not cheap, with the majority of our valuation models suggesting neutral or fair value. Momentum is still poor but we remain concerned for the macro outlook.
The refugee crisis continues to hamper the normal functioning of commerce in Europe. Anecdotes of trucks delayed for hours at borders are common, given the heightened security concerns. Europe’s inability to engineer a coordinated response to the crisis has resulted in a fragmented and potentially protracted solution. All this makes it harder for the economies of Europe to function normally.
Europe was also the first region to experiment with negative interest rates. The results have been far from spectacular, with growth anaemic and lending already losing momentum. Part of the problem is banks’ inability to recapitalise their balance sheets in an environment with little to no risk-free carry. In the past, a key platform for banks returning to healthy balance sheets was a steep yield curve. Unfortunately, this is not possible given that quantitative easing (QE) has had the effect of flattening curves.
Banks appear to be suffering under the current European monetary policy settings. Chart 3 shows the performance of European bank stocks and how they have struggled to take advantage of the cheap liquidity. This is no more evident than in Italy where banks still cannot deliver earnings despite the European Central Bank’s (ECB’s) excessively easy policy.
Chart 3: European financial sector performance
Source: Bloomberg 2016
Debate continues to rage on the efficacy of negative interest rate policies. Apart from the apparent inability to help bank performance, there is little evidence that cheap liquidity has spurred any productive credit growth. One obvious problem is the impact negative rates have on savers—who are unable to generate any income from their savings—and the resultant detraction from consumption. The response from society to such destructive policy is to elect officials not responsible for the current malaise. Hence the rise in popularity of previously fringe parties across Europe, as highlighted in the introduction with the Austrian elections.
Europe continues to face significant macro headwinds. We have long viewed southern European assets as providing unrewarded volatility and this remains the case. Until valuations adjust sufficiently to accommodate the risks, we will remain cautious on southern European equities.
India is our favourite Asian equity market
India has long remained a positive growth story due to reforms and sheer demographic potential. It is now also providing a good entry point given more attractive valuations and an improving earnings outlook as reforms start to pay off.
Last year, we were concerned that valuations had begun to exceed the promise of reform. Prime Minister Modi was politically stymied in pushing through certain important reforms such as land and labour. In addition, the private sector faced the headwind of banks laden with bad debt, unable to assist in boosting private sector growth. Earnings remained weak throughout last year.
However, important fiscal reforms were passed, such as reducing fuel subsidies and wage increases, allowing the government to deliver a much improved and credible budget in March. Chart 4 shows fiscal reform is stretching to infrastructure where road projects are gathering pace. Supply bottlenecks have long been an issue for India so this type of fiscal development is very positive.
Chart 4: Indian infrastructure spending
Source: Goldman Sachs 2016
Modi is also now directly focused on the bank non-performing loan (NPL) issue, seeking to introduce bankruptcy laws to help cleanse bank balance sheets. Along with rate cuts, this should help pave the way for a stronger contribution by the private sector toward growth.
Both reported and forecasted earnings appeared to have bottomed in early 2016, reflecting these positive developments. With valuations no longer expensive and earnings improving, we rank India as our top Asian equity market.
We are still underweight low quality credit
Regular readers of the Balancing Act will be aware that our long-standing credit view has been to be overweight high quality (investment-grade) and underweight low quality (high yield). Following the dramatic sell-off in credit in the first quarter of this year, we reviewed this stance but came away with the same conclusion. We subsequently increased our overweight to US investment-grade credit.
Over the past year, being overweight high quality credit has been the right call as shown in Chart 5. But what is also evident from the chart is that we missed a short-term opportunity to profit from holding low quality credit over the last few months.
Chart 5: Asset class performance
Source: Bloomberg 2016
We have been inclined to maintain our underweight in low quality credit for the following three reasons:
- Our research indicates increased borrowing costs have the most profound effect on the weakest balance sheets, typically in high yield debt;
- The poor performance of the Financials equity sector signals a tightening of lending standards going forward; and
- The rationalisation of misallocated capital in the Energy/Commodity sector appears to be ongoing.
The key risk to our view is an increasingly dovish Fed—borrowing costs come down, banks get support, and the Energy sector earns a respite via a weaker US dollar and higher oil prices. So the risks become substantially more balanced with a dovish US Fed. However, we are still wary of this current credit cycle being long in the tooth. Default rates are rising (see Chart 6), banks are tightening lending standards and with company earnings still deteriorating, the risks for low quality balance sheets remain real.
Chart 6: US credit default rates
Source: Moody’s Investors Service 2016
On the other side of the equation, high quality credit still has some substantial tailwinds:
- In an uncertain world, investors have rewarded visible cash flow;
- No return on cash has forced low risk investors further out the risk curve; and
- Extremely easy monetary policy has created a liquidity glut.
All this risk-averse money has found its way into high quality credit, hence the consistent strong performance. A more dovish Fed only heightens these dynamics. It was a close call, but we have maintained our preference for high quality credit and remain underweight low quality credit.
We remain underweight sovereign bonds
We remain underweight sovereign bonds despite the strong rally so far in 2016. Our preferred defensive asset in our portfolios is still cash. Where we do allocate duration it is to bonds where the cost of that defensive insurance is not prohibitive like US Treasuries, UK Gilts and Australian bonds.
Chart 7: Long-term inflation expectations
Source: Bloomberg 2016
Long-term inflation expectations remain severely depressed (as shown in Chart 7) and yet core inflation in certain economies is ticking up. The importance of this is being masked in bond markets by the persistent buying each month from central banks. We believe sovereign bonds are at risk of a dramatic and sudden repricing and so prefer to stay underweight the asset class.
We raise commodities to neutral
The fundamental picture for commodities remains challenging for at least three reasons:
- The ongoing structural growth slowdown in China;
- Oversupplied markets due to over-investment of the last decade; and
- US dollar strength.
However, as multi-asset investors we need to continually assess whether commodity prices have adjusted enough to adequately reflect these concerns, thereby offering an attractive level to start increasing exposure. This month we lifted our allocation to commodities from underweight to neutral as we believe that might increasingly be the case. Valuation support seems increasingly in place, momentum has turned positive for two out of the four main commodity groups and the macro environment argues for at least a tactically more positive positioning.
On our mean-reversion based valuations models, commodities have appeared cheap for some time and continue to appear so. Fundamental cost-curve based metrics have proven to be poor barometers of value in this cycle as cost curves have been continually pushed lower due to falling input costs from lower energy prices and weaker currencies of commodity producers.
However, as seen in Charts 8 and 9, several commodities bounced off their cost curves earlier this year. That this happened at the same time as energy prices bottomed and EM currencies found some stability may be more than coincidence. Perhaps the cost curve support will stick this time.
Chart 8: Copper cost curve
Source: SG Commodities
Chart 9: Zinc cost curve
Source: SG Commodities
Regular readers will recall that we have been looking to our momentum models for confirmation. This month, our model scores improved to positive for Precious metals and Agriculture. Energy and base metals are still negative on our longer-term momentum measures but if recent strength persists they may tick up soon too.
China growth stabilisation, a more dovish Fed and the pause in US dollar strength all make the macro incrementally more positive for commodities. The main concerns we noted previously remain significant longer-term headwinds, but the macro is at least neutral for the medium term.
If we combine attractive valuations, increasingly supportive momentum and a neutral macro outlook, it is hard to persist with an underweight allocation and hence our upgrade to neutral for commodities. Our hierarchy remains unchanged with Precious Metals and Agriculture preferred over Energy and Base Metals.
Our currency hierarchy remains unchanged
We recently downgraded our long-term positive view on the US dollar in favour of the Yen and Euro. Market attention has been focused on the divergence in monetary policy, which has been driving expectations. Many market forces drive currencies, not just interest rate differentials. Below the surface it is worth recognising that both the Yen and Euro are running large trade surpluses and so as the capital accounts stabilise, the pressure for these currencies will be to appreciate.
We do not expect a sudden US dollar bear market and so it remains in the middle of our hierarchy. The Yen and Euro are not expensive and both are experiencing positive momentum so still deserve to sit above the US dollar.
In house research to understand the key drivers of return:
|Quant models to assess relative value||Quant models to measure asset momentum over the medium term||Analyse macro cycles with tested correlation to asset|
|Example for equity use 5Y CAPE, P/B & ROE||Used to inform valuation model||Monetary policy, fiscal policy, consumer, earnings & liquidity cycles|
|Final decision judgemental|
|Final Score +|
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