Balancing Act - August 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 15 September 2016
Another summer has passed in the northern hemisphere and any Brexit-related jitters appear a distant memory. Global equities have rallied almost 10% since the June lows, with most markets now in positive territory for the year. Volatility is close to post 2008 crisis lows and with most central banks persisting with excessively low or negative interest rates, all appears quiet on the western front.
Nikko AM’s Multi-Asset team is not so sure. We remain concerned that the apparent, central bank-induced stability may be masking growing problems under the surface, maybe even with those same central banks. There is growing disquiet in the broader community that rather than being the solution, monetary policy settings are the cause of many of the current economic woes. Savers earning nothing on their savings, pension funds with skyrocketing liabilities, banks struggling with flat yield curves and shrinking margins (although there may be little sympathy for the latter) are all facing significant challenges as a result of current ultra-low or negative rates.
However, the most vocal disapproval is resulting from the collapse in global productivity. Doubters suggest that ultra-low or negative interest rates don’t encourage activity, but instead are the cause of the misallocation of capital and subsequent collapse in activity. This is a complex debate but one key criticism is the following:
- In a free market, the mechanism for setting interest rates is the result of a bid for capital. Those with access to investment opportunities will compete for the capital, paying an interest rate consistent with their ability to put the capital to productive use. The key mechanism for ensuring capital is sensibly allocated in this free market is the requirement for entrepreneurs to be discerning about their decision – will they make or lose money by using this capital?
- In a world where the interest rate setting mechanism is heavily manipulated lower, capital is freely available to all. There is no level of discernment when making a decision on whether or not to use capital since the cost of capital is well below the rate of return. With no requirement to be discerning, capital is freely misallocated as it flows to both productive and unproductive ends.
By keeping interest rates too low for too long, central banks have been the cheerleaders for capital misallocation and driven productivity lower.
Central bankers have a sensible Keynesian justification for keeping rates low – cheap credit will stimulate investment and demand. But if rates have been low for long enough that the unproductive users have crowded out the productive users, the opportunity to find truly profitable investments becomes harder. A cursory glance at the trend in capital spending across developed markets suggests we may have reached this point.
We tend to think of central bankers as being like swans. Above the surface everything appears serene and calm, but below the surface they are paddling like crazy to keep their heads above water. With multiple central bank meetings coming up in September, we may gain a better insight into the evolution of their thinking over the next few months.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
Japanese equities still face macro headwinds
Japanese equities have been sliding down our equity hierarchy over the course of 2016 as a combination of poor momentum and a challenging macro environment made them less attractive in our research process. On the positive side, valuations are still cheap but the cloudy outlook for earnings and lack of clarity around policy trajectory leave us cautious on Japanese equities.
We are concerned about earnings for two key reasons:
- Positive earnings growth in Japan is closely correlated with Yen weakness. Unfortunately, the Yen has been on a strong appreciating trend in 2016 and earnings have suffered.
- Growth continues to disappoint in Japan, begging the question: How will companies improve their top line?
The cyclical strength in the Yen has been driven in large part by the inability of the Bank of Japan (BoJ) to bring real rates down as inflation keeps disappointing to the low side. However, with US real rates looking to have bottomed in July, some respite may be at hand for the Yen and potentially Japanese earnings growth (see ‘Currency’ section below).
So where will growth in Japan come from? In its simplest form, long-term economic growth can be represented by the following equation: GDP growth = working population growth + productivity growth.
It is well documented that the working population in Japan is declining, so unless immigration suddenly increases, we won’t be getting a boost to GDP from there. Chart 1 shows what has been happening with the productivity side of the equation. There may be arguments about the best way to measure productivity, but what is not up for debate is the clear downward trend of productivity in Japan for the past 15 years. This is not particularly encouraging for our Japanese GDP growth equation.
Chart 1: Japan total factor productivity
Source: Bloomberg 2016
Is this decline in productivity a result of the BoJ keeping interest rates near zero for the past 20 years? Unproductive users crowded out productive users long ago, so the opportunity for a profitable investment is virtually gone. The USD 1.5 trillion of cash on Japanese company balance sheets might support this logic.
The ‘Third Arrow’ of Abenomics was intended to address this slide in productivity, promoting reforms that would help move it to a positive trajectory. Unfortunately, the execution has been painstakingly slow and it appears the government has fallen back on infrastructure as a means of improving labour and capital efficiency. We may be sceptics, but throwing more money into infrastructure in a country with close to the world’s best infrastructure may not result in significant efficiency gains.
Even though they are cheap, we remain cautious on Japanese equities. Momentum is still poor and equity earnings face challenging headwinds in growing their top line. The BoJ is also holding a review of monetary policy in September. Until we see greater clarity on the path and execution of supportive policy, Japanese equities will remain in the middle of our hierarchy.
Italian equities are still near the bottom of our hierarchy
Italian equities have struggled in 2016, down around 20% year to date. Actually, Italian equities have struggled for the best part of the last 20 years as excessive volatility has been combined with little long-term capital gain, as shown in Chart 2.
Chart 2: Italian equity performance
Source: Bloomberg 2016
The poor performance of banks has been, and continues to be, a large contributor to the underperformance. The Financial sector was 50% of the MSCI Italy equity index in 2007. That weight has decreased to 30% now as excessive leverage and poor asset quality have seen bank balance sheets deteriorate significantly.
However, the key driver of the poor performance has been a constant slide in competitiveness. An inflexible and expensive labour force has seen Italian companies continue to lose ground compared with their more efficient northern neighbours. Productivity has subsequently collapsed and this has resulted in company earnings constantly disappointing to the downside. Chart 3 shows how since the 2012 recession, analyst expectations for Italian equity earnings have consistently been downgraded as the hoped-for-recovery has failed to materialise.
Chart 3: Italian equity earnings expectations
Source: Bloomberg 2016
Italian Prime Minister Matteo Renzi is trying to change this untenable situation via constitutional reform. By removing the obstructionist power in the Senate, he hopes to enact labour reforms that will directly address Italian companies’ lack of competitiveness. Success would be a huge positive and Italy will be holding a referendum in late October or November to vote on this reform.
Unfortunately, Renzi has stated he will resign if unsuccessful and so the vote has become a referendum on the government’s popularity rather than reform. This is dangerous in the current climate where a disillusioned middle class are looking for any opportunity to voice their dissatisfaction. A loss will not only signal more political turmoil for Italy but also show the lack of appetite the citizenry have for structural reform over populist policy. We will be watching the outcome closely.
Asian equities remain at the top of our hierarchy
Asian equities continue to rank at the top of our hierarchy and while the region is no longer ‘on sale’ to the extent that it was early this year, valuations remain attractive. Asia is partly riding the wave of inflows to emerging markets that began early in the year when the US Federal Reserve (Fed) signalled a pause in rate normalisation. The US dollar weakened allowing commodities to lift and currencies to stabilise, returning liquidity across all regions that had been deeply squeezed since mid-2014. We believe Asia remains attractive for valuations and various macro tailwinds, which now include better earnings support.
Reforms are slowly navigating Asia toward self-sustaining economic growth, but it still remains dependent on foreign demand for its exports and investment to fill the gaps. As shown in Chart 4, Korean and Taiwanese exports, which had been a significant detractor from growth since early 2015, have stabilised. We are not seeing any significant boost in global demand, but there is room for growth to make up for 18 months of decline.
Chart 4: Korean and Taiwanese exports
Source: Bloomberg 2016
Investment has also stabilised. Despite the recent deceleration in China’s economic leading indicators, policymakers will continue to balance the dual objective of growth and reform. China continues to crack down on shadow banking, which explains some of the slowing as lending declines. China seems to be shifting stimulus funding from banks to the government itself, with the 2016 fiscal deficit expected to increase from 3% to about 8%. This is a big (and somewhat concerning) number, but sovereign debt levels remain low and manageable for now, and such stimulus is likely to be more efficiently deployed given bank lending has been increasingly directed to company life support. Meanwhile, the government continues to consolidate sectors, getting rid of dead wood and excess capacity, so China seems on a better path with near-term growth issues less of a concern.
Asia forward earnings estimates declined 22% from February 2014 to June 2016, as shown in Chart 5. Since June, forward earnings have lifted by about 4%, which is not yet a convincing turn to positive momentum, but there are fundamental reasons to believe that top and bottom lines will continue to improve.
Top line growth is credible for returning stability to exports, but also a fairly sizeable increase in infrastructure investment, most notably in India and Indonesia where fiscal and tax reforms have increased fiscal resources. For the moment, most investment remains on the government side, while the private sector is still hampered by undercapitalised banks. Banks are working their way through non-performing loan issues driven mainly by the commodity bust and, with high savings rates, lending resources will again be replenished to support private sector investment.
Chart 5: Forward MSCI Asia earnings estimates
Source: Bloomberg 2016
The bigger driver of earnings growth over the near term may be margin expansion, driven primarily by the significant decline in rates. Chinese corporate bond yields have declined from a peak of 8% in 2014 to 5.5% currently, amounting to significant savings on interest expense. Rate cuts continue across the region and, provided the hunger for yield remains intact, corporate yields can continue to compress for further savings.
South Korea is expanding margins through better corporate governance, borrowing a page from the Japan playbook. Stock buybacks are up and so are dividends and the return on equity. South Korea has always traded at a discount for ‘chaebol’ (business conglomerate) self-dealing, so if this trend should continue, equity markets could be due for a sizeable re-rating.
Against this positive backdrop, we continue to remain concerned about the high levels of US dollar-denominated debt that could spur another liquidity squeeze should the dollar rally resume. High levels of debt in China and the sustainability of its growth model will always remain a concern and while policymakers have regained confidence to keep the machine turning, one policy mistake could return us to the deep stress experienced in 2015.
We remain underweight low quality credit
The recent rally in high yield and speculative bonds has been described as a ‘hunt for yield’. European and Japanese investors are searching the world for positive yield as their domestic negative rate environments push them further out the risk spectrum. However, their allocation has not been indiscriminate, preferring investment-grade and BB rated issues, while avoiding assets with potential default risk. Speculative-grade credit (below BB) has seen net outflows, with foreign investor inflows being dwarfed by the scale of US domestic selling. These flows perhaps point to a flight to quality as opposed to taking on extra default risk. So if net flows are negative, what is causing the recent rally in low quality credit?
Supply of lower quality credit has decreased substantially from last year, compared with higher quality credit which has seen record issuance. Lower-for-longer rates and a rebound in the oil price saw illiquid lower-quality bonds bid, pushing prices higher. High yield managers, who have been sitting on record high cash positions, were caught off guard. With most managers underperforming their benchmark, they were forced to quickly deploy cash, furthering the rally. High yield fund managers’ cash has been deployed at the fastest rate since 2013.
Chart 6: US high yield managers cash balances
Source: Bloomberg 2016
We believe this rally can only be sustained if flows return to the asset class, which we do not expect to happen any time soon. The recent rally has pushed spreads down to a level that is pricing in the end of the default cycle, which seems optimistic. US oil and gas companies have already seen USD 49 billion of defaults so far this year and Q2 2016 saw the highest default count and volume for US high yield since the recession. This leads us to believe the market is overvalued and potentially fragile. Therefore we continue to favour high quality investment-grade credit where default risk is low and spreads still look attractive.
Chart 7: US high yield defaults
Source: Fitch 2016
Can US assets break the monetary conditions cycle?
US assets have been in a monetary conditions cycle driven predominantly by Fed policy expectations. As expectations for a rate hike increase, monetary conditions tighten as the US dollar rallies and borrowing costs increase. This can be seen in Chart 8 as the Fed tightened in late 2015. US assets, particularly equities, react negatively to the tightening monetary conditions and sell off.
Chart 8: US Monetary Conditions Index
Source: Bloomberg 2016
The Fed, concerned about the falling equity market, backs away from further tightening and policy expectations decrease. The US dollar weakens, borrowing costs fall and monetary conditions ease as has been the case for most of 2016. In this easier environment, the equity market rallies.
Recently, the Fed has been talking about increasing rates again, reflected by that small tightening in monetary conditions in August shown in Chart 8. As we embark on what could be the next upswing of the cycle, it is important to consider if the US economy is strong enough to withstand tightening monetary conditions. If the answer is yes, then interest rates can rise and the bond market will sell off. This is crucial for our sovereign bond hierarchy as placing US Treasuries at the top will no longer make sense if the US economy has reached escape velocity.
At this point we do not think the US will break the current cycle and the tightening in monetary conditions will lead to the next down leg in equities. Apart from the consumer, growth is still struggling and will hamper any attempt to ‘escape’ the cycle. In this environment we still believe it makes sense to keep US Treasuries at the top of the hierarchy, but we are watching closely for signs of accelerating activity.
We remain underweight sovereign bonds overall. Valuations are still stretched and given the high degree of central bank manipulation, bonds are at risk of a dramatic repricing. We prefer cash as the defensive asset in our portfolios since we are not convinced sovereign bonds can rally meaningfully from these levels should growth assets stumble.
We maintain our neutral stance in commodities
Will 2016 be the year of La Nina? That may be the most important question for investors in the commodity asset class at present. As shown in Chart 9, Agriculture has been the worst performing commodity sub-group this year. Much of this underperformance may be due to fading expectations around the arrival of the La Nina climate conditions this year.
Chart 9: Commodity sub-group performance
Source: Bloomberg 2016
La Nina refers to an ocean-atmosphere phenomenon characterised by cooler-than-average ocean temperatures in the equatorial Pacific. These cooler waters can influence climate patterns worldwide. The commodity price impact of La Nina has been variable in the past but commodity analysts from Citi Research estimate that average returns for major grain commodities can be 10–30% higher during La Nina and El Nino crop years. El Nino is the counterpart of La Nina and characterised by a warming of eastern equatorial waters. This was in place over 2014–2016. Usually El Nino events are followed by La Nina ones, which is why expectations were high this year for La Nina to make an appearance. However, so far La Nina has remained elusive.
This has led to disappointing returns for investors in Agriculture commodities. While the effect of both La Nina and El Nino on agriculture yields and supplies varies by region and by crop, the overall impact on agricultural prices is broadly positive as extreme weather of any kind, whether drought or excess rainfall, can be disruptive to agricultural yields. So far 2016 has been just the opposite. El Nino has already departed, while El Nina is yet to arrive and favourable weather and planting conditions have led to record yields for both corn and beans, the two largest components of the GSCI Agriculture Index (see Chart 10).
Chart 10: Corn and soybean yields
Source: Bloomberg 2016
According to the latest El Nino/ENSO diagnostic discussion released in August, La Nina was ‘slightly’ favoured to develop through October. The chances rise a bit later in the Northern Hemisphere autumn and into winter with about a 55–60% chance of a La Nina developing then. If La Nina does arrive over the next few months, we believe we will be rewarded for keeping Agriculture near the top of our hierarchy, second only to Precious Metals. However, if the odds fall further we may have to revise our view.
For now, we retain Precious Metals at the top of our commodity hierarchy and continue to like Energy and Industrial Metals the least. After the strong gains this year, oil prices in the mid-40s may be near their medium-term fair value according to our research. Further upside may also be capped by the potential of a faster supply side response from US Shale than the market is currently expecting. Similarly a meaningful re-rating of Industrial Metals would require further signs of stabilisation and pick up in global and emerging markets growth.
The Yen is no longer our favoured currency
The Yen has been one of the strongest currencies in 2016, outperforming the US dollar by over 15% year to date. A dovish US Fed has been partly to blame, but the inability of Japanese authorities to increase inflation expectations has also driven Yen performance. With inflation consistently disappointing on the low side, real rates in Japan have continued to rise over the year, placing upward pressure on the currency. Chart 11 shows how the real yield differential between the US and Japan is a key driver of the currency cross rate.
Chart 11: US/Japan real yield differential vs. USD/JPY
Source: Bloomberg 2016
This differential is starting to move back in favour of the US dollar. The Fed has been hinting that it will increase rates later this year. As a result, real rates in the US have been moving higher this month. The BoJ is also reviewing its monetary policy settings in September, with a key focus being to reduce real rates in Japan. We expect to see the differential in real rates move higher and support the US dollar going forward.
A by-product of Yen outperformance this year is that our valuation models no longer assess it as cheap. With the BoJ’s upcoming policy review set to focus on providing easier policy, we believe it makes sense to move the Yen off the top of our currency hierarchy.
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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