Balancing Act - July 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 10 August 2016
“The 35-year bull market in global bonds has come to an end. The rapid growth of populist political movements has increased the urgency for policy makers around the world to embrace reflationary monetary and fiscal policies. The end result will be a drawn out ‘bottoming’ process in global bond yields, before a fiscal stimulus led synchronized global reflation spurs a new secular uptrend in yields. This process could still take several years to play out.” Peter Berezin, BCA Global Strategist, July 2016
We generally refrain from quoting external sources, but found the strength of this statement compelling. Calling an end to a 35-year long bull market is incredibly bold and we are unsure if it will prove to be right or wrong. What we agree with 100% is the reaction function of governments to poor opinion polls—they will do whatever is in their power to turn them around. We expect a raft of populist policies to appease the disaffected masses whose voice had not been given attention until Brexit.
By its very nature this policy will be reflationary, designed to lift the incomes of the majority of middle to lower class workers who have faced stagnant real wages for the past three decades. At this point, it is not possible to gauge how successful such reflationary policy will be in producing sustainable growth, particularly given the deflationary headwinds of demographics, debt piles and excess savings. What is clear is that markets currently place the level of possible success at zero. Defensive trades are more crowded than ever.
In any market we look at, prices are at extreme levels of ‘defensiveness’. Sovereign bond curves are at -0.5% and -0.3% in Swiss and Japanese 10-year bonds, respectively. Investment-grade credit is seeing record low yields across almost all developed markets. In equity markets, defensive sectors have outperformed cyclical sectors by 10% or more depending on the country, with valuations between the sectors at historical extremes. All these signals point to an investor base that expects a future of low growth and low inflation and is positioned accordingly.
Markets are not prepared for inflation expectations to rise. If reflationary fiscal policy is able to turn the dial on future expectations for prices, the rush for the exits on some very crowded defensive trades could see some pretty extreme market movements. We continue with our theme of only investing in defensive assets that provide at least some valuation cushion or yield. That clearly does not include negative yielding sovereigns, such as German Bunds or Japanese government bonds (JGBs). Granted we may miss some short-term performance gains, but we feel that in an environment where the prevailing deflationary forces will be put to the test, these types of assets will not fulfil their defensive role.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
US equities move up the hierarchy
Earlier in the year (February to be precise), US equities found themselves on the bottom of our equity hierarchy. At the time, they were the only expensive equity market in our research and with earnings struggling in the face of a stronger US dollar, rising borrowing costs and weak global growth, we believed returns for US equities would be challenged. That has not turned out to be the case. US equities have delivered a 10% return since that time and have been one of the better performing major equity markets. What did we get wrong?
Firstly, markets were willing to continue to pay a higher multiple for US equities, despite the deteriorating earnings, and so valuations became even more expensive. As Chart 1 shows, US equity returns over the past six months have been driven entirely by multiple expansion (PE change). The US Federal Reserve (Fed) became more dovish following the market dislocations in the first quarter, which explains some of this buoyant sentiment.
Chart 1: US equity returns
Source: Bloomberg 2016
A Fed on hold meant that the US dollar retraced some gains, borrowing costs improved and with the pressure off funding, emerging market (EM) growth saw an uptick. With rates remaining exceptionally low, equities didn’t seem that expensive compared with the stratospheric level of bonds.
The other factor contributing to the strong performance has been the apparent turnaround in US earnings. As Chart 2 shows, a ‘bottoming out’ phase is appearing in US earnings growth. This makes sense given that the headwinds facing companies have reduced with the Fed on hold. The more pressing question is how sustainable is the turnaround? If the slightest move tighter in Fed policy is enough to derail earnings growth, the foundations wouldn’t appear to be solid.
Chart 2: US equity earnings growth
Source: Bloomberg 2016
One factor that continues to concern us is the poor top line growth being generated by companies. Granted there are signs of improvement this quarter, but overall sales remain well below historical averages, even when excluding the Energy sector. This would not be a major concern if margins were expanding, but as Chart 3 shows, margins remain under pressure.
Chart 3: US sales growth & margins
Source: Bloomberg 2016
This margin deterioration does not look like abating any time soon as wage pressures continue to surface in the US. In addition, with the current election cycle focusing on bridging the inequality gap, populist pressure for wage increases will only continue to build.
We have softened our negative view on the US equity market. Last month US equities moved above the UK in our hierarchy and this month they move up another notch above EMEA equities. However, we remain cautious—valuations are expensive, earnings face challenges (particularly given the poor top line growth) and the macro outlook is very cloudy given the current political circus.
Germany remains second in the hierarchy despite deteriorating valuations
We have long viewed European equities as offering unrewarded volatility. They have been susceptible to bouts of policy-driven euphoria before the reality of excessive debt, poor growth and a constraining regulatory environment have driven prices lower. Germany has tended to be the exception to this rule. Strong balance sheets (outside financials), solid employment and favourable policy settings have helped German companies outperform their European counterparts in the last three years, as shown in Chart 4.
Chart 4: European equity performance
Source: Bloomberg 2016
One of the by-products of this outperformance is that German equities are now expensive across our valuation models. This is not automatically a reason to downgrade as long the earnings outlook is not too challenged. German equity earnings have improved recently, albeit in a volatile environment, and so lend some level of support.
However, one big question mark remains across all European markets and that is the performance of the Financial sector, Germany included. Chart 5 shows the European Financial sector performance versus other global markets and one thing stands out—negative rates are tough for banks. Programmes like the TLTRO (targeted long-term refinancing operations) were meant to provide assistance to banks, affording them cheap funding. But with the asset side of their books earning nothing due to negative rates and flat curves, banks are struggling to recapitalise.
Herein lies the quandary. Negative rates are meant to encourage abundant cheap credit, and yet the banks, which are the mechanism for providing it, are in no shape to expand their loan books as they struggle with negative rates. The strategy fails before it even starts.
Chart 5: Global Financials performance
Source: Bloomberg 2016
German equities are expensive but momentum is showing signs of improving. The macro outlook is sound with solid government and household balance sheets and favourable policy settings in the form of low rates and a stable currency. Nevertheless, a major question mark exists around European banks and liquidity is an issue. We are watching for signs of further deterioration in the sector as a catalyst to adjust our view on German equities.
We have expanded our EM equity hierarchy
This month, we have split our EM equity ranking, separating out Latin America and EMEA to acknowledge a divergence in fundamentals and outlook. Note: we had already split out Asia as the circumstances for that region are very different.
Latin America benefits the most from returning commodity price stability. The region also benefits from signs that the political pendulum is swinging back from populism to regimes that favour important reforms. For EMEA, the impact of stabilising commodities is less pronounced and probably outweighed by the deterioration in politics where there is little will or capacity to push forward much-needed reforms.
Latin America is well-known for its commodity exports, but the importance of commodity prices to growth and earnings may be less well appreciated. Chart 6 shows the terms of trade, which is a close reflection of commodity prices, versus earnings. Since 2011, both have been mainly in decline until recently as commodity prices have found support. While the earnings recovery is still nascent, it is important to note that political institutions are also on the mend helping to lift business confidence and therefore investment for higher productivity and stronger growth.
Chart 6: Latin American earnings vs. terms of trade
Source: Bloomberg 2016
Mexico was the first in the region to institute reforms following the GFC and this has led to significant investment and growth. Argentina shifted tack late last year by electing President Macri who has since implemented reforms, starting to reverse decades of extremely poor policies. Cuba is opening up to the US and now Brazil holds promise for a change in leadership and improved policies as well. These developments are encouraging, but we also note significant risks, mainly due to still high debt levels and the challenges that lay ahead in executing painful reforms.
For EMEA, the outlook is bleak. The economies of Turkey and South Africa remain imbalanced, relying on foreigners to fund deficits while political risk is on the rise. In mid-July, a failed coup attempt was followed by a deep crack-down that threatens to undermine the otherwise strong political institutions that Turkey had taken years to build. Prospects for reforms are diminishing. Eastern Europe is more balanced, economically, but populism is returning at the margin, which is hurting business confidence. Russia benefits from returning stability in oil prices, but reforms to diversify the economy beyond oil and gas are lacking.
Asia remains at the top of the EM hierarchy, continuing to benefit from a strong reform agenda, which is now translating into stronger growth and a better earnings outlook. Equities are cheap and momentum looks to be shifting to positive, keeping Asia as our favoured EM equity market. The main risk in Asia is high levels of debt. Last year, the region was plagued with debt deleveraging, mainly in China, which sapped liquidity and squeezed growth. This year, China has struck a better balance between reforms and growth helping to slow painful deleveraging.
We are still underweight low quality credit
Credit remained well bid in the aftermath of June’s Brexit vote, with all sectors and ratings rallying during July. Lower credit quality was the dominant performing theme for the month on expectations of additional central bank stimulus and the continued hunt for yield. The rally in US high yield continued to be driven by Energy and Material companies, whereas other sectors saw more subdued returns (see Chart 7).
Chart 7: US high yield (HY) sector performance
Source: Bloomberg 2016
The collapse in energy prices in 2015 saw at least 67 US oil and gas companies file for bankruptcy, according to consulting firm Gavin/Solmonese, up from 14 the previous year, an increase of almost 380%. This rippled through the US high yield space, pushing the default rate on high yield bonds in the energy sector to an all-time high of 13%. The poor macro outlook and strongly negative momentum led us to remain underweight high yield over this period.
As the oil price rebounded, US high yield moved almost in tandem, a relationship that has held for the past two years. We refrained from increasing our allocation during the rebound as we believed oil had overshot its long-term inflation-adjusted average and that macro headwinds had not abated. After prices had fallen over 60%, oil producers made up for their declining income by increasing production. This has resulted in a glut of inventory, much of which we can see just by looking out of the window of our Singapore office. Iran’s oil exports have tripled since late 2015 as the country eagerly attempts to regain market share, with Saudi Arabia cutting prices in an attempt to retain theirs. Global supply looks likely to be further increased after Nigeria resumes amnesty payments to Delta militants, allowing the country to produce without conflict. Furthermore, with the decreasing impact of Chinese stimulus, combined with the potential consequences of Brexit, demand pressures could also start to wane. The recent fall of over 20% in oil helps lend credence to this view, as it re-entered a bear market in July.
US high yield has now lost its valuation anchor, scoring neutral on our models. As oil prices restart their descent, the macro outlook on the energy sector is again in question. We don’t believe we will revisit the lows seen at the start of the year, but a sustained price at or below USD 40 a barrel leads us to question the viability of many of the companies that helped the sector rally. Troublingly, the relationship between the US high yield energy sector and oil prices appears to be diverging (see Chart 8). Given energy bonds make up 16% of the US High Yield Index, more than any other industry, we continue to be underweight US high yield.
Chart 8: US high yield energy sector vs. oil
Source: Bloomberg 2016
We remain underweight sovereign bonds
The Bank of Japan (BoJ) meeting at the end of July was a disappointment for markets. It maintained interest rates at -0.1% and the only increase in purchases was for exchange-traded funds (ETFs). However, the meeting was not a complete non-event. The BoJ did announce that it would conduct a total review of current policy settings at the September meeting. The subsequent investor reaction can be seen in Chart 9.
Clearly, this is not what an investor would want from a defensive asset. Granted, JGBs are still up so far this year and therefore not a complete disaster, but this type of volatility is not typically associated with government bonds. Given the heavy level of manipulation now associated with the Japanese government bond market, however, investors may come to expect these types of dramatic repricings.
Chart 9: JGB performance
Source: Bloomberg 2016
We cannot help but be intrigued by what a ‘total review of current policy’ means. Is the BoJ blinking on negative rates? The bank moved rates down to -0.1% in January and has subsequently refrained from pushing rates further into negative territory despite growth and inflation disappointing on the low side. It is possible that the negative performance of the financial sector since the introduction of negative rates has given the BoJ pause. Realistically, a central bank admitting fallibility seems highly unlikely.
What is more probable is an extension of the ‘coordination’ between monetary and fiscal policy that is being more openly discussed where the central bank ‘assists’ the government in reaching its funding requirements. This assistance can come in a variety of forms: bond purchases, perpetual issuance and ‘helicopter money’ to name just a few. A delicate balance will need to be achieved between stimulating growth with prudent fiscal policy, but without letting the market think the government has lost all fiscal responsibility through profligate spending.
We continue to believe sovereign bonds are at risk of a dramatic repricing given the degree of current manipulation. The chances of governments enacting populist policy to appease the masses have increased and one of the potential side effects of this is an increase in inflationary pressures. With markets priced for no inflation as far as the eye can see, the impact on bond prices could be sharp and swift. We remain underweight sovereign bonds and where we do allocate, it is to sovereigns with at least some yield cushion should prices suddenly fall.
We maintain our neutral stance in commodities
Commodity prices sold off by about 5% in July, mainly driven by energy (-14%), which seems a normal correction in an otherwise volatile market. Gold prices were up 2.5%, although momentum slowed during the month as real yields stabilised. Agriculture prices were down -7.4%, extending their slide since mid-June. Base metals were up 2.5%, continuing a slow recovery from the January lows.
The sell-off in oil appears to be a natural correction following the outsized gains during the first half of the year. Price discovery takes time, particularly following major dislocations as began in mid-2014. In recent weeks, speculators have pointed to increasing rig counts as a sign of increasing supply that may further drive down prices. Chart 10 compares the rig count to the price of oil and while there has been a small uptick in rig count (partly seasonal), levels remain more than 75% below the peak in 2014. The current price of USD 44 per barrel remains in our estimated range of fair value, with likely support at much lower levels. We keep energy above industrial metals in our commodity hierarchy.
Chart 10: Oil price versus rig count
Source: Bloomberg 2016
Industrial metals continue to be our least preferred exposure across commodities. Momentum has shifted to neutral, although we remain less constructive concerning the fundamentals given the continued large imbalances between supply and demand. Supply takes longer to correct than for energy, while demand has yet to significantly improve. However, we would consider revising this view if demand prospects pick up, such as through the fiscal stimulus that seems to be gathering momentum among policymakers around the world.
Gold remains at the top of the hierarchy for positive momentum and fundamentals that support the current rally. Last month, we believed gold was due for a correction from the spike following Brexit leading to the collapse in real yields. As Chart 11 shows, real yields have stabilised and recovered somewhat, but only to temper the rise in gold prices and not yet to cause a correction. Despite the return of risk appetite, policy risk remains high, still supporting the case for owning gold.
Chart 11: Gold versus real yields
Source: Bloomberg 2016
Agriculture remains second in the hierarchy, but we remain more sanguine than markets are currently pricing given that the shift from ‘el Nino’ to ‘la Nina’ tends to be more supportive of agriculture prices.
No change to the currency hierarchy this month
The Yen is still our favoured currency. Valuations are not yet stretched, momentum is strong and with the markets yet to be convinced on the strength of government policy, current account dynamics continue to favour further appreciation.
The British pound remains at the bottom of the currency hierarchy. The details and scope of policy change following Brexit will be drawn out and cumbersome. In the interim, investors that have been using the pound as a safe haven are looking for alternatives. This pressure on the capital account, combined with a growing current account deficit, leave further pressure to the downside.
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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