Balancing Act - December 2015
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 13 January 2016
The US Federal Reserve (Fed) finally increased interest rates in December (by 25 basis points) for the first time in nine and a half years. The move came as a relief to the market insofar as getting it behind us, but there is an air of uneasiness as the Fed proceeds to take the punch bowl away amidst rising stress in credit markets and returning stress across commodities and emerging markets.
The Fed was not the only central bank to cause market unease. Despite the US rate hike, the US dollar actually weakened against the Euro and particularly the Yen as both the European Central Bank (ECB) and Bank of Japan (BOJ) failed to impress, with only mediocre further easing measures. Markets were also displeased with the People’s Bank of China (PBOC) announcing that it would now reference a trade-weighted basket to manage the Renminbi, allowing for accelerated depreciation against the US dollar.
It is increasingly clear that central bankers want asset prices to remain supported so as not to extinguish a still weak economic recovery. In a recent interview, former Fed President Richard Fisher admitted that the Fed “frontloaded a tremendous market rally to create a wealth effect ...The Federal Reserve is a giant weapon that has no ammunition left.” The statement emphasises the importance of markets supporting policy initiatives, and so long as the response remains negative, policy risk is rising.
Central bank policy risk is important to monitor, but it is also important to remain cognisant of the risk to the upside given the depths of the recent sell-off. Monetary policy and increasingly fiscal policy are still accommodative, while money supply is expanding at a healthy clip both in Europe and China. There are fears of an industrial recession, but services are broadly performing satisfactorily and we still see potential for a pick-up in consumption that has typically followed a decline in energy prices on a lagged basis.
Our hierarchies have not changed, maintaining an overall negative score for equities. Japan remains the single positive equity market, but here we note increasing macro headwinds due to the reacceleration of Renminbi depreciation. Outside the US, valuations are increasingly attractive across equities so we are loathe to be excessively bearish, but momentum and macro so far remain sufficiently negative to warrant no change in view. Cash remains our preferred safe asset, and we maintain our risk hedges to buffer against increased volatility.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
US remains near the bottom of the hierarchy
We downgraded the US in early 2015 based on expensive valuations combined with slipping momentum and a deteriorating macroeconomic backdrop – most notably in earnings. This negative view has since become strong consensus, exposing our underweight position to upside risk should companies deliver better top-line growth than markets expect.
For the 12 months ending in September 2015, earnings were down -1.4% but up 2.5% excluding energy. As Chart 1 shows, the fall is both a function of declining top-line growth and compression in profit margins. Clearly, energy forms the epicentre of equity weakness, but dollar strength, weak demand and the rising cost of capital are also weighing on earnings more broadly.
Chart 1: US sales growth versus profit margin
Source: Bloomberg 2015
Negative sentiment seems baked in, but consensus estimates for 2016 are still relatively buoyant, suggesting nearly 9% growth. We have previously noted weak investment as a source of poor top-line growth, with companies instead dedicating cash to buybacks and now accelerating mergers and acquisitions, often used to ‘buy growth’ in the late cycle where organic growth is increasingly scarce.
Still, we look to the US consumer as a source of potential topline surprise, finally spending a portion of higher wages and energy savings on discretionary consumption. Nominal wage growth of 2.5% is less impressive than the 4% levels achieved in the mid-2000s, but on a real basis (net of inflation), wage increases are comparable. Nevertheless, retail sales growth remains uninspiring, so we look to consumer credit to better understand the consumer’s capacity and willingness to spend more.
Chart 2 shows the four main sources of consumer credit that finance discretionary spending. While the consumer clearly deleveraged following the financial crisis, one might be surprised to learn that aggregate debt levels are now 15% above the pre-crisis peak, driven almost completely by student loans and auto loans. This speaks to strong auto sales (a record 17.5 million vehicles in 2015) and perhaps a tuition bubble as argued by venture capitalist Peter Thiel. However, high debt levels could well be weighing on the consumer, driving a preference for saving rather than increasing consumption.
Chart 2: US consumer credit outstanding
Source: Bloomberg 2015
On balance, we remain neutral on the macroeconomics as neither earnings nor sources of top-line growth are yet showing visible signs of upside surprise. Moreover, rising rates coupled with tightening liquidity conditions are raising the costs of capital which, along with higher wages, will continue to weigh on profit margins. Crucially, despite negative momentum, equities remain expensive, only briefly approaching fair value during the summer sell-off. Despite strong consensus, we still rate US equities negative, ranking just above Emerging Markets ex Asia in the hierarchy.
Japan still at the top of the hierarchy
Japan finished the year up 8% in US dollar terms, making it the top performer among developed equity markets. In spite of the Yen going essentially nowhere in 2015, gains were driven by earnings growth with the ‘Third Arrow’ of Abenomics delivering better corporate governance with renewed focus on margin expansion where there is still ample room for further improvement.
Japan was an early mover in the currency wars, managing 30% depreciation on a trade-weighted basis since 2012. Clearly, the export sector was a primary beneficiary and helped to launch the boom in equities. However, as others have joined the game of beggar thy neighbour, the export sector could be tested.
Since the Euro peaked in late 2014, it is down 12% against the Yen, and since the China devaluation in August 2015, the Renminbi is down about 10%. Asian currencies (such as the Korean Won and Taiwan dollar) are following the Renminbi, intensifying competition for Japanese exporters. As shown in Chart 3, the Asia Dollar Index has weakened -4.5% since the August devaluation, while the Yen has strengthened +4.8%. The Yen’s appreciation intensified after the BOJ disappointed markets by failing to increase its quantitative easing (QE) programme.
Chart 3: Japanese Yen versus Asian currencies
Source: Bloomberg 2015
We have noted these macro risks for Japan since China’s initial move to devalue its currency in August and the risk is higher now as the devaluation gathers pace. Nevertheless, we remain positive on Japan’s outlook mainly for the structural reforms that have helped to lift earnings and span much more than the export sector. Valuations remain inexpensive and momentum is neutral, scoring Japan an overall positive while keeping it at the top of the equity hierarchy.
Latin America still at the bottom
Latin America ranks at the bottom of our hierarchy, mainly for the macro-political stresses caused by the headwinds of commodity price declines. Brazil currently faces particularly high economic and political stress. Good intentions to navigate a very painful fiscal adjustment are being met with harsh headwinds of escalating political scandals and possible Presidential impeachment. Mexico sits on the opposite end of the spectrum. Although it is also suffering from falling oil prices, this is more than compensated for by a very strong macroeconomic and political foundation, where significant reforms promise growth dividends into the future.
Terms-of-trade is a helpful lens to understand the relative stress on different economies in the region. Chart 4 compares the change in terms-of-trade from the commodities peak in 2007 to the current situation. Through 2007, terms-of-trade (unsurprisingly) improved across the region as commodities prices climbed, although just barely for Brazil since it was still a net importer of oil at the time. Through 2015, Brazil slipped into negative territory while gains achieved by the rest of Latin America through 2007 have remained largely intact. Latin America remains vulnerable to further commodity adjustments, but it is important to recognise these structural gains that extend beyond simple commodity exposure.
Chart 4: Latin America terms-of-trade
Source: Bloomberg 2015
Valuations are broadly cheap with the exception of Mexico, but the earnings collapse and enormous macroeconomic headwinds offer no visible near-term respite. At some point, there will be a significant buying opportunity, but we are not there yet and, therefore, Latin America remains at the bottom of the equity hierarchy.
We favour low duration and high quality credit
We retain our long-standing preference for high quality credit and low duration. December was a difficult month, particularly in the US high yield space, where fund manager, Third Avenue, was forced to liquidate a USD 790 million junk bond mutual fund due to poor liquidity conditions, rendering it impossible to keep up with redemptions. We have long remained wary of bond mutual funds and exchange-traded funds (ETFs) due to their liquidity mismatch. Since the financial crisis, large inventories of corporate bonds have essentially been pushed from bank balance sheets to bond mutual funds and ETFs, posing a liquidity problem when too many investors head for the exit, as occurred with Third Avenue. It is impossible to say whether this event is a canary in a coalmine, but it certainly warrants additional caution – particularly among riskier credits.
As long as rates stay low, investors will remain hungry for yield but are likely to be increasingly selective as yields are more than offset by capital losses. As can be seen in Chart 5, total returns for US high yield (HY) turned negative in 2015 for the first time since 2008. Interestingly, while credit spreads blew out in 2011, rate compression kept total returns positive, but there was no such offset in 2015. Conversely, investment-grade (IG) delivered negative returns in 2013 purely due to rising rates.
Chart 5: US credit annual total returns
Source: Bloomberg 2015
Energy was the worst performing sector, but even ex Energy, spreads widened for a small negative total return. Credit scores rate inexpensive in our models, but negative momentum and macro fundamentals keep the overall scores negative for high yield. Investment-grade still rates a small positive for attractive valuations, but we remain cautious on negative momentum and potentially deteriorating macro fundamentals. For the moment, monetary conditions remain easy and valuations still compensate for downside risk, in our view.
We remain underweight sovereign bonds
Sovereign bonds remain expensive across developed markets in our valuation models, as elevated volatility weighs against their attractiveness as a defensive asset. Valuation models that rely on mean reversion can sometimes be difficult to defend when such measures continue to push to new extremes. This has been an ongoing theme in sovereign bonds where market prices have been grossly manipulated by central banks. On balance, the risk-reward payoff has become increasingly asymmetric – arguments to the upside simply don’t compensate for the potential bleed if markets go the other way.
For some time, inflation expectations have remained inordinately expensive, at least partly depressed by falling commodity prices (see Chart 6). By definition, depressed commodity prices weigh on inflation, but in order for current low rates of inflation to continue over the duration of a bond, commodity prices need to continue declining at similar rates, which is a very difficult argument to make.
Chart 6: US inflation expectations vs. commodities
Source: Bloomberg 2015
We don’t know where or when commodity prices will bottom, but with current prices at 17-year lows and production likely to decrease in the coming years, it might not be far off. And when this happens, base effects will ultimately lift headline inflation and therefore expectations. Coupled with rising pressures of wage inflation, we see good reason for inflation expectations to mean-revert with downside for sovereign bonds. While we note policy fatigue, central banks can still achieve their goals to lift inflation. ECB Executive Board Member Peter Preat recently reminded markets of this fact, saying “If you print enough money, you always get inflation. Always.”
Real yields are also very expensive for sovereign bonds, but even more difficult to evaluate in recent years given the outsized compression caused by central bank intervention. The tide may be finally turning, which is also negative for sovereign bonds. As Chart 7 shows, real yields have generally been rising – first driven by the ‘taper tantrum’ in 2013 and lifting again since April 2015, defying the ECB and BOJ’s intent to reduce real yields. Momentum, which is directly linked to rising real yields, rolled from neutral to negative this month both for German bunds and Japanese government bonds.
Chart 7: Developed market real yields
Source: Bloomberg 2015
We remain underweight sovereigns based on poor valuations, negative momentum and deteriorating macro conditions. Sovereign bonds typically offer risk protection in a portfolio context, but for these risks and elevated volatility, we still prefer cash as a safe portfolio asset.
We maintain our underweight allocation to commodities
Commodity price declines have been fairly relentless, last month included. Yes, global growth remains weak and supplies excessive, but it is increasingly difficult to argue that the complex is not cheap given the plunge to multiyear lows. Gains from outsized China demand during the 2000s have been more than erased, but a supply adjustment is still required to ease the pressures on price. As Chart 8 demonstrates, in the case of oil, growth in supply has continued to outpace demand, causing inventories to rise. As noted previously, part of this supply dynamic is driven by the break-down in OPEC (Organization of the Petroleum Exporting Countries) and partly through improvements in technology which have kept US production levels high despite declining oil rig counts.
Chart 8: IEA total world oil supply and deman
New investment has effectively halted and the process of restructuring, which is expected to gather pace in 2016, will remove unprofitable supply and help to eventually close the supply-demand gap. While we remain cautious, we will be increasingly constructive with better visibility on the supply adjustment.
The hierarchy remains unchanged, with precious metals remaining at the top of the hierarchy despite headwinds of US dollar strength and rising real yields. Precious metals are an important diversifier, hedging against rising policy risk. Agriculture follows in the hierarchy for relative support attributable to El-Niño that has weighed negatively on crop yields. Energy and Base metals are at the bottom of the hierarchy, awaiting better visibility for a correction in supply.
US dollar remains our favoured currency, just
As we have noted for some time, much of the policy divergence is already priced in, taking into account both anticipated US tightening and continued easing in other countries. The heavy positioning in this regard was clearly evidenced with the US dollar losing ground to the Euro and particularly the Yen in December when both the ECB and BOJ failed to increase easing to the extent expected.
While US dollar momentum has eased relative to the Euro and the Yen, it continues to rally against emerging currencies and those exposed to commodities such as the Canadian and Australian dollars. To date, this trend seems more structural than due to market positioning. Deleveraging across emerging markets and the commodities complex is creating strong demand for the US dollar, which is in decreasing supply due to Fed tightening. In fact, this trend could accelerate due to China shifting its currency benchmark to a trade-weighted basket, rationalising further depreciation against the US dollar and, in the process, dragging down commodity and emerging market currencies with it.
The US dollar is expensive and momentum continues to wane, at least against the Yen and Euro, but for now we continue to keep it (just) at the top of the hierarchy based on monetary trajectories and relative economic strength. Given the extent of the adjustment for both the Euro and the Yen with accompanying attractive valuations, we rate these currencies at neutral. The Australian dollar remains at the bottom of the hierarchy given that macroeconomic headwinds remain high.
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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