Balancing Act - February 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 11 March 2016
Monetary policy experiments have become the norm for central banks, with the latest being the Bank of Japan’s (BoJ) move to negative interest rates on the last day of January. Unfortunately, the subsequent market price action was anything but expected as the Japanese Yen strengthened 7% against the US dollar and the Nikkei equity index fell over 15%. If we consult the ‘central bank playbook’, the expected reaction would be a weaker currency and a stimulus-induced equity rally, so the BoJ are likely to have been disappointed.
What went wrong? We do not pretend to understand the catalyst for all market moves, but our suspicion is the capacity for monetary policy to stimulate economies (and asset prices) has reached its limit. The extremely low level of rates is unable to stimulate any more borrowing and currencies have already devalued so far against the US dollar that it is tough to weaken much further. Moving interest rates into negative territory is unlikely to change this dynamic and may actually have the opposite effect by stifling growth. Does a negative interest rate make you want to rush out and borrow money to invest, or does it make you want to hide it under the mattress as something must be fundamentally broken with the credit system? Our guess is the latter.
If that is the case, central banks may finally have to pass the baton of economic stimulus back to the government in the hope that fiscal policy can kick-start sluggish economies. Investors have been crying out for this for a number of years, but the political morass in many developed world democracies has meant the baton has stayed too long with central banks, forcing them into these monetary experiments.
Recent developments in Japan and China seem promising on this front. China announced an increase in fiscal spending, with details to be released during the National People’s Congress meetings in March and Japan hinted at additions to its supplementary budget package. As with any government rhetoric, the devil will be in the detail, but it is heartening to see some governments willing to take on the economic heavy lifting.
It may once again prove to be hollow rhetoric with fiscal policy continuing to take a back seat. But at the very least if investors are now unwilling to take central bank manipulation at face value and instead require evidence of growth before pushing equity markets higher, it would be a positive development for the longer term stability of markets.
We are still cautious as asset prices are heavily manipulated through central bank action and so remain vulnerable to episodes of dramatic repricing, as seen in January. We remain underweight equities, but if governments start tabling meaningful fiscal reform then we believe it makes sense to increase our allocations to attractively priced assets.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
Japan is no longer on the top of our equity hierarchy
We held Japan equities at the top of our hierarchy for three key reasons, despite the deteriorating price momentum:
- Cheap valuations;
- Continuing delivery on earnings; and
- Policy support from governing bodies.
However, only one of these pillars still stands (cheap valuations); one is gone (earnings); and the other is shaky (policy).
According to our valuation models, Japan equities are still cheap. Momentum remains poor but we had been willing to overlook this given the macro support we believed was provided by solid earnings growth and supportive government and central bank policy. Unfortunately, earnings are no longer delivering.
Chart 1 shows how Japan earnings growth expectations have deteriorated recently (see 2016 line). Declining sales and a strengthening Yen are weighing on earnings. Japanese companies are working hard to increase return on shareholder equity and with plenty of room for margins to expand there is the potential for this to continue. However, at this point it would appear these positives are not enough to offset the growth headwinds facing companies.
Chart 1: Japanese equity earnings expectations
Source: Bloomberg 2016
It is in the domestic growth environment where the headwinds may be getting stronger. The macro support from government and central bank policy is looking a bit shaky. The jury has been out on whether Abenomics could deliver sustainable growth, but we felt comfortable it would remain supportive for risk assets. With the move to negative interest rates, we are now not so sure.
Rather than stimulate credit growth and activity, we are afraid a negative interest rate may have the opposite effect and trigger fear and panic. Japan has had interest rates at zero for nearly 20 years, so why did they suddenly need to go negative? We fear Japanese households will now be more inclined to put money under their mattresses. Combine this deterioration in money velocity with the impact negative interest rates have on the banking sector (see Chart 2), and we are no longer confident the policy settings in Japan are supportive.
Chart 2: Financial sector vs. index performance
Source: Bloomberg 2016
We still score Japan equities a small positive given the cheap valuations and potential to deliver earnings. But given the current headwinds and risks around policy, we are inclined to wait until the outlook is more supportive before moving overweight again.
US equities are now at the bottom of our equity hierarchy
According to our valuation models, US equities are once again registering as expensive and this is the only equity market we monitor that currently has that status. With price and earnings momentum still poor, the combination of an expensive asset with negative momentum leaves US equities at the bottom of our equity hierarchy.
Return on US equity continues to fall. Given the level of margin compression in the last year and degree of financial engineering that has occurred through buybacks, this is not a surprise. But the quantum of the decline is a red flag. Chart 3 shows the US return on equity (ROE) dating back to the 1990s. The shaded green areas highlight strong ROE and the red areas highlight when it is weak. ROE declining into the red has been a harbinger of the last three US recessions. We would not suggest it is a guarantee the US is falling into recession this time, but it does highlight the challenge US companies are facing to deliver quality earnings.
Chart 3: US return on equity
Source: Bloomberg 2016
Earnings growth remains challenged in the US. Momentum across Energy and Materials sectors has been poor for some time, but the more recent deterioration in earnings momentum across the previously strong sectors of Health Care and IT is more troubling. It appears the macro headwinds of a strong US dollar, rising borrowing costs and declining demand across emerging markets are showing up in the earnings of US companies.
The other macro headwind that US companies have to deal with is the current Presidential election race. It appears Hillary Clinton will be the Democratic candidate. The Republican nomination is still uncertain, but Donald Trump’s lead in the polls suggests he is the likely candidate. This is causing considerable consternation within the Republican Party with many powerbrokers doing all they can to ensure he is not successful. Trump is the poster child for the anti-establishment vote, so if the establishment try to pull all the strings to derail him, it will probably just add fuel to the fire. Regardless of the end result, the capacity for meaningful US fiscal reform any time soon would seem a pipe dream.
Chart 4: Odds of Republican nomination
Source: Pivit 2016
US equities have had a negative score in our process since January last year. Valuations, momentum and the macro headwinds have all remained challenging over that time and so we have not adjusted our view. Due to a minor upgrade for emerging market (EM) ex-Asia equities, US equities are now relegated to the foot of our equity hierarchy.
Emerging Market equities are cheap
Our valuation models suggest EM equities are cheap. If we look at the cyclically adjusted earnings yield (Chart 5), it becomes evident there is a significantly higher risk premium available in the emerging regions compared with developed market equities. This is generally the case but the current difference is larger than the historical average, particularly when looking versus US equities.
Chart 5: Cyclically adjusted earnings yield for equities
Source: Bloomberg 2016
This should come as no surprise given EM equities have underperformed their developed market counterparts for five years straight (Chart 6). A turn in the commodity cycle in 2011, a significantly stronger US dollar and the associated tightening of liquidity, as well as various geopolitical flashpoints have all conspired to make EM equities one of the worst performing asset classes over the last five years.
The key question is whether this underperformance will persist. Momentum remains poor across EM markets, although some individual countries look to be improving. Given the degree of adjustment that has already taken place, particularly in the currency markets, it would not be a surprise to see the strength of negative momentum wane. With the strong level of valuation support, an investor at least has some cushion to absorb any further deterioration in the macro outlook.
Chart 6: MCSI Emerging Equity Index vs MSCI World and US S&P500
Source: Bloomberg 2016
And it is in the macro outlook that EM markets may still be challenged. We have highlighted in previous notes the extent of the credit growth that has occurred in EM regions since the crisis in 2008. The deleveraging process has really only just begun and with borrowing costs in USD remaining elevated, the potential for an accident remains high. Combine this with the geopolitical issues that still burden EM countries and the macro outlook remains a problem.
We have moved EM equities off the bottom of the equity hierarchy as the level of adjustment that has already occurred and current valuation support suggest potential returns in the medium term should be attractive. But the macro challenges remain in the short term and so we are reluctant to move them to an overall overweight score at this time.
US investment-grade is our preferred credit
Credit spreads are cheap according to our valuation models, but the absolute level of yields is very low, particularly in Europe and Japan. US investment-grade credit has the added benefit of absolute yields still being relatively attractive at around 3.5% for a moderate duration index. Our modelling suggests that if growth picks up, the gains from spread tightening can offset the expected losses from the interest rate component selling off. In the opposite scenario where spreads widen, at least there is sufficient yield in the interest rate component (around 1.5%) to act as a defensive asset. For these reasons, we have been increasing our allocation to US investment-grade credit.
Chart 7: Credit spreads
Source: Bloomberg 2016
The strong performance of high yield debt since the January sell-off raises the question of whether it is time to start increasing our allocation. Unfortunately, we still believe it is too early for the following key 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 US Financials equity sector (Chart 2) signals a tightening of lending standards going forward; and
- The rationalisation of misallocated capital in the energy sector appears to be ongoing.
Until such time as any or all of these factors stop acting as headwinds, we will maintain our long-standing credit view of preferring high quality over low quality issuers.
We remain underweight sovereign bonds
If an investor buys a bond at a negative interest rate, the only way they can receive a positive return on their investment is if someone is willing to buy it from them at a higher price before it matures.
The ‘greater fool theory’ is defined by Investopedia as ‘the theory that states it is possible to make money by buying securities, whether overvalued or not, and selling them at a profit because there will always be someone (a greater fool) who is willing to pay a higher price”.
It is hard to ignore the similarities.
We also recognise that while central banks continue to purchase billions of dollars worth of bonds every month, the role of greater fool is being well and truly filled. However, this is not a game we are willing to play for two key reasons:
- Central banks may change the rules at any time without warning; and
- A manipulated bond price is open to dramatic repricing at any time.
Markets are currently dominated by fears of deflation, evidenced by the generational lows in long-term inflation expectations shown in Chart 8. With central banks buying billions of dollars of bonds, it is hard to assess how much of this is related to real deflation fears and how much is simply a result of price manipulation.
Chart 8: Long-term inflation expectations – US, Japan, Germany, UK
Source: Bloomberg 2016
It is worth remembering one of the key reasons stated by central banks as to why they embarked on quantitative easing was to raise inflation expectations. A cursory glance at Chart 8 would elicit the simple response that they have failed. It is possible that inflation pressures are actually building but, given the heavy market manipulation, have yet to show up in the bond price.
For example, US inflation is on an upward trajectory (Chart 9). Bond markets could see a period of dramatic repricing if investors start to believe this uptrend might be more permanent.
Chart 9: Long-term US inflation expectations
Source: Bloomberg 2016
Sovereign bonds fulfil the defensive component of a diversified portfolio. We do not believe it makes sense to speculate with this portion of the portfolio and so do not purchase bonds at negative interest rates. That is why cash remains our preferred defensive asset at this time. 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.
We maintain our underweight allocation to commodities
Commodities were given a reprieve this month, recovering from oversold conditions and perhaps stabilising at levels not seen since 1998. It is difficult to say, but cheap energy and base metals are likely to remain vulnerable so long as the supply-demand gap has yet to close. There is some hope for a pick-up on the demand side as China has plans to expand its fiscal budget and credit continues to build, but until further details emerge, historical data is our best guide and it remains quite weak. Supply is still expected to come off later in the year as bankruptcies are likely to accelerate in the second half.
We have long talked about gold as a hedge against policy mistakes, and so far the hedge is working quite well. It is up about 20% from the mid-December lows after the Fed hiked rates followed by policy disappointments both from the BoJ and ECB. As Chart 10 shows, gold is generally inversely correlated to the US dollar, but it managed to begin its rally under dollar strength following the Fed rate hike. The rally accelerated in the early days of February following the BoJ’s shift to negative rates, which brought with it significant Yen strength. Gold has the investment quality of being a store of value, but it comes at a cost – namely, storage. However, with negative rates, cash now also comes at a cost, which could further increase demand for gold at the margin. Still, given the strength of the rally and the price disconnect from recent dollar strength, it is fair to say that gold is due for a correction.
Chart 10: Gold versus US dollar
Source: Bloomberg 2016
The hierarchy remains unchanged, with precious metals remaining at the top despite potential headwinds of returning 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 or increased demand.
US dollar remains our favoured currency, just
It is worth recognising a lot of the expected tightening by the US Federal Reserve is already reflected in the USD exchange rate, with valuations looking expensive on our models. Momentum remains positive but it is waning, particularly against the Yen and Euro. We also believe the macro outlook is more balanced given the tightening in monetary conditions that has already occurred as a result of the stronger USD.
Market attention has been focused on the divergence in monetary policy and as such this has been driving expectations. It is worth recognising that both the Yen and Euro are running large trade surpluses and so once the capital accounts stabilise, the pressure for these currencies will be to appreciate.
We remain (slightly) favourable to the USD given the relative monetary policy trajectories and current apparent relative economic strength. However, the magnitude of currency adjustment to date suggests the balance of risks is more neutral. With investor positioning strongly in favour of the USD, it would not be a surprise to see a period of repricing of policy divergence risks.
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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