Balancing Act - June 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 13 July 2016
On June 23, the UK voted to leave the EU. Bookmakers had ‘Remain’ as the odds on favourite to win, so the unexpected victory for ‘Leave’ threw markets into turmoil. The British pound fell over 10% versus the US dollar immediately following the result.
The immediate reaction from UK commentators was one of shock and denial, particularly given the vast majority of sitting parliamentarians had declared their desire to remain. There were calls for a second referendum, discussions of the potential for Scotland to veto ‘Brexit’, or given the resignation of Prime Minister David Cameron, for Parliament to simply not pull the trigger on exiting.
Amongst all the wailing and gnashing of teeth, one simple fact seemed to be overlooked: 52% of the UK population had voted to leave. Whether it be from a middle class left behind by austerity policies, a fear of assigning further sovereignty to Brussels, or even the more right-wing anti-immigration sentiment, a majority were willing to risk the widely forecast, damaging economic consequences in order to sever ties with Europe. This is a remarkably strong statement against the current direction of government policies.
And the fault lies not just with UK policy. The inability of European leaders to formulate a united and coherent policy for the immigration crisis seems to have helped feed the fear. Pictures of thousands of refugees backed up at the ‘Calais jungle’ no doubt helped strengthen the anti-immigration sentiment in the UK.
The question now becomes how governments will move forward. Will they live in denial, doubling down on existing policy in the hope things may miraculously change, or will they take this opportunity to listen to the disillusioned majority and actively seek to enact reform that addresses their concerns? The statement from European leaders after the Brexit announcement regarding the desire for different levels of integration within the union is hopefully an indication that the direction is more towards the latter; but only time will tell.
We have been concerned for some time that the disillusioned middle class would eventually rail against the existing establishment and the set of policies they feel are responsible for leaving them behind. Brexit would appear to be more the start than the end of reconciling these differences. This is one of the key reasons we remain underweight risk assets and have instituted tail risk hedges in our portfolios. The ball is now clearly in the policymaker’s court. They have been off their game but we hope to be pleasantly surprised that they can rise to the importance of the occasion.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
Asian equities remain on top of our hierarchy
Equity performance, year to date (YTD), reflects a rotation away from developed markets (DMs) to emerging markets (EMs), as shown in Chart 1. Brexit did little to change this trend, with initial losses in Latin America (LatAm) and Asia being more than offset by subsequent gains. It seems that, so far, prospects for delayed US rate hikes more than offset the negative implications of a Brexit. Of course, EMEA is more exposed to Europe both from a trade and funding perspective, so it is unsurprising that the vote detracted from performance; however, YTD performance remains second-highest behind LatAm. Japan is the worst performing equity market, but the losses are mostly offset by currency gains. Europe is the worst performing market overall, interestingly just behind the UK, even after taking into account a 12.4% loss on the currency. The US is the only developed market delivering positive returns.
Chart 1: Equity returns in US dollars YTD
Source: Bloomberg 2016. LOC—Local currency, FX—Foreign exchange.
We had properly positioned Asia at the top of our equity hierarchy and our relative shifts in the hierarchy have been prudent as well—downgrading both Europe and Japan while upgrading EM ex Asia. However, we may have been caught a little wrong-footed as to the speed and degree of the rotation from DMs to EMs that began early this year.
There have been three primary drivers of EM performance this year:
- The Federal Reserve (Fed) turning dovish, helping to stabilise the US dollar relative to EM currencies;
- A lift in commodities due to the stabilising US dollar, some (albeit small) demand lift from China and some reduction in supply – mainly in energy; and
- Returning confidence in China policy, helping to stem capital outflows.
Returning currency stability has also helped to ease inflationary pressures, which were particularly acute in LatAm and EMEA. As inflation expectations have declined, positive real yields give scope for further easing across EMs (see Chart 2). Faced with negative real rates, DMs can only ease through further unconventional policy, which markets are starting to question.
Chart 2: Global real yields
Source: Bloomberg 2016. *Calculated by first subtracting headline inflation from policy rates and then aggregated using MSCI regional index weights, to approximate real rates for regions.
Despite still attractive valuations and improving momentum, we leave EM ex Asia near the bottom of our equity hierarchy due to ongoing macro headwinds. The commodity picture may have improved at the margin but supply-demand gaps have yet to close, which means that price volatility is likely to continue. Furthermore, debt levels are high and still growing and there is no obvious solution to avoid an increasingly difficult road ahead.
Asia remains at the top of our hierarchy, primarily since it remains very inexpensive and while momentum remains negative, the macro picture is more encouraging than for the rest of the EMs. Earnings are beginning to improve, partly as a function of improving internal growth dynamics but also through the region’s newfound competitiveness given the currency depreciation of last year.
In a world of rising geopolitical risk and instability, Asia remains a beacon of relatively high stability with popular leadership and a visible agenda for promoting growth. While Asia remains exposed to still weak global demand for its exports—potentially worsened by Brexit—significant reforms to date, high savings rates and the tailwind of still low commodity prices offer a clearer path toward achieving alternative sources of growth.
UK is now at the bottom of our hierarchy
Valuations are not cheap, momentum is poor and macro is highly uncertain. Earnings have been struggling and though they may get a boost from a weaker currency, it is too early to suggest a turnaround. Capacity for monetary stimulus is limited given that rates are already very low and fiscal stimulus is also challenged given the lack of political leadership. Consumer confidence is likely to be damaged and liquidity to remain tight, especially given the stress in the EU banking sector and broader EU issues.
However, not all prospects are bleak for the UK. Given the automatic stabiliser of a weaker currency and independence from the bureaucrats in Brussels, the UK has the opportunity to reform and therefore reintegrate its disenfranchised ‘Leave’ voters. It is too early to know what such reforms might look like, but a boost to local manufacturing could help to rebalance the economy in favour of more jobs at home, while serving to narrow the UK’s very wide current account deficit.
Russia could benefit from Brexit
The political turmoil in the EU following Brexit may ultimately benefit Russia in terms of sanctions relief given the economic cost and increasingly murky reasons for maintaining sanctions. Sanctions were introduced in late 2014 in response to the Ukraine crisis, the removal of which has always been contingent on execution of the Minsk Accord. The Minsk Accord is predictably going nowhere, but much of the blame actually resides with Ukraine, so it is difficult to effectively ascribe all blame to Russia in the form of sanctions.
To date, Prime Minister Merkel of Germany has maintained collective support to continue renewing the sanctions, but Brexit is likely to destabilise the already tenuous support. Russia is currently benefiting from higher oil prices and the early stages of an economic recovery, while lifting sanctions would only help to improve the country’s growth outlook. It is possible that improved growth could provide cover to step up reforms to diversify away from Russia’s energy dependence, but prospects for reform remain very limited given Putin’s popularity and little demand for change from the status quo.
We still prefer investment grade over high yield, US over Asia
Credit markets remain buoyant despite Brexit, partly as a function of the search for yield given sovereign yields continue to plummet. Since Brexit, global spreads have widened only moderately, while Asia-ex Japan continues to compress. Rolling six-month returns, as shown in Chart 3, demonstrate the strength of the turnaround early this year where high yield (HY) is now the best performing asset class YTD, mainly driven by the energy sector. However, the performance of US investment grade (IG) is not far behind, with both valuation and momentum shifting from neutral to positive.
Chart 3: Credit market performance
Source: Bloomberg 2016
Our research still favours high quality over low quality credit and we favour the US over Asia. Despite the relief rally in HY, macro fundamentals remain poor given relatively high leverage, deteriorating cash flow and tighter credit conditions as a result of rising non-performing loans (NPLs). The fact that the US is less likely to normalise rates over the near term is positive for easing credit conditions at the margin, but is unlikely to overcome these broader headwinds without a more significant pick-up in economic growth.
In assessing Asia credit, we remain focused on China given the high levels of debt accumulated since the GFC. China walks a fine line, balancing reforms with credit-funded investment to reach its growth targets. Last month, we discussed the significant understatement of China NPLs, with official figures coming in at less than 2% whereas conventional methodologies put the figure closer to 15-20%, amounting to potential dollar losses in the trillions. These would be extraordinary losses, but the question of sustainability comes down to the funding side of bank balance sheets.
China maintains a very high savings rate, which translates into high deposit growth helping to keep bank leverage moderate despite high levels of credit growth. Loan-to-deposit ratios average only 70%, while the top four average about 80%, as shown in Chart 4. Either ratio is deemed within prudent limits, but at the current rate of expansion among larger banks—a favourite channel for financing government stimulus—dangerous levels could be reached within a couple of years.
Chart 4: Loan-to-deposit ratio by bank size
Source: Bloomberg 2016. *Latest data for these banks are from 2014. Remaining are from 2015.
While conventional measures of bank leverage seem tame for the moment, it is important to understand the degree of off-balance sheet leverage, or so-called shadow banking. One way to determine the extent of shadow lending is to view credit expansion as a reflection of money creation in the system. 2015 saw almost RMB 6 trillion in money created, which implies far higher credit growth than official estimates. Regulators have clamped down on these off-balance sheet lending practices, but clearly credit continues to expand at dangerous rates.
While banking leverage continues to build in aggregate, it is important to recognise that funding is still sourced mainly from internal savings, avoiding the external wholesale funding that tends to leave a banking system vulnerable to capital flight. For China, funding risk is likely to be born out of a crisis of depositor confidence which, so far, seems a remote risk, but we also recognise that sentiment can change abruptly.
We are uncomfortable with high levels of debt and credit growth in China and—to a much lesser extent—other parts of the region, but we still favour the risk-return characteristics compared with Japan and Europe where nominal yields are simply too low to compensate for the risk. We continue to keep the US at the top of our credit hierarchy, which is supported by attractive valuations, positive momentum with manageable levels of debt, and credit growth.
We remain underweight sovereign bonds
The rally in sovereign bonds continues to be impressive, while weighing on relative performance given our underweight position. Brexit served to accelerate yield compression to even deeper record lows, driven by increasing concerns for global growth and partly by expectations of even further central bank easing.
Quite surprisingly, risk assets in Asia and the Americas have more than made up for their initial losses following the vote, while there was no corresponding lift to local bond yields. In a world of ever more extraordinary central bank policy, asset prices detaching from fundamentals is perhaps more a rule than an exception. However, we do note that the relative performance of global financials is more in alignment with the less sanguine view of bond markets.
Chart 5 compares 10-year German Bund yields to the performance of European financials relative to the broader equity market. The two series are highly correlated, ratcheting down since late last year, and both plunging following the Brexit result. European banks were never adequately recapitalised like their US counterparts following the GFC and, more recently, negative rates have weighed on earnings. The reaction to Brexit implies even deeper balance sheet risk, with Italian banks currently at the epicentre.
Chart 5: Relative performance of German Bund yields versus European financials
Policymakers never voluntarily let a banking system roll off the edge, but brinksmanship sometimes makes it appear that they are willing to do so. At the moment, Italian banks are the focus, with all sides agreeing that a recapitalisation is required, but differing greatly as to the form that it takes. We assume an agreement will be struck to avert a crisis, helping to lift both financials and sovereign yields. Given this and other deteriorating macro fundamentals, buying into this bond rally would seem especially risky.
By any measure, sovereign bonds are extremely expensive given that yields have never compressed so low in history. Momentum remains positive as yields remain at or near all-time lows, but as we have often discussed, the macro outlook is deteriorating. Although bonds are pricing for deflation, inflation is showing signs of accelerating upward in the short term as the energy shock of last year unwinds and wage pressures continue to build in certain sectors. We remain concerned that this deterioration in underlying fundamentals is being masked by central banks’ persistent buying of duration and other distortions in the market.
We maintain our neutral stance on commodities
As one might expect, broad commodities weakened at the margin for fears of slowing growth related to Brexit, while precious metals soared on rising geopolitical risks. We have long described precious metals, gold in particular, as a hedge against policy mistakes. The UK referendum result, in effect, reflects an accumulation of policy mistakes.
As shown in Chart 6, the UK Policy Uncertainty index spiked following the referendum, lifting with it the price of gold. While gold is up about 20% in GBP terms since the vote, it is still up nearly 8% in US dollar terms despite the US dollar index (DXY) having appreciated 2.8% over the same period.
Chart 6: Gold versus UK policy uncertainty
Source: Bloomberg 2016
The jump in gold is also a reflection of the sudden compression in real yields, as shown in Chart 7. The compression in sovereign yields seems potentially linked with the perception of systemic banking risk, particularly in Europe given the situation in Italy. Currently, it is within policymakers’ capacity to offer a solution which, when it is agreed to, could provide a significant relief rally. This would help to lift real yields, which would likely weigh on gold prices. However, this might be deemed more of a correction than the end of a rally as policy risk continues to remain elevated.
Chart 7: Gold versus real yields
Source: Bloomberg 2016.
Gold is at the top of our commodities hierarchy, followed by agriculture, energy and lastly industrial metals. Energy and industrial metals have been mainly a story of structural oversupply, though energy is much further along in correcting this imbalance. However, with the impact of Chinese stimulus waning, combined with the implications of Brexit, demand pressures could also continue to weigh on this part of the complex. Agriculture has been relatively weak, but the shift from the ‘el Nino’ effect to ‘la Nina’ could be more positive for agricultural prices given the drought impact on North America.
GBP still at the bottom of our hierarchy
Unsurprisingly, the Euro weakened quite significantly following the Brexit vote. This was partly due to anticipated economic weakness, but probably more attributable to the greater risk of an EU break-up, with the UK perhaps being the first domino to fall. Such risk has certainly risen, but it is important to note that the UK never adopted the common currency and therefore it is effectively much easier for it to leave the EU than for the Euro countries. The disincentives to exit from the Euro currency are much higher, making such an outcome more remote. Overall, we maintain the Euro in second position in our hierarchy—external fundamentals, such as its large current account surplus, help to support the currency, especially given US rate hikes appear off the table for now.
While the Yen has remained very strong—particularly following Brexit—we continue to keep it at the top of our currency hierarchy. Usually, a Yen rally is associated with an unwind of the so-called ‘carry trade’, which is reflected in poorly performing high yield currencies, such as the Australian dollar and EM currencies. This effect was less evident this time, at least as reflected in US dollar terms. The Yen remains at the top of the hierarchy for attractive valuations, positive momentum and positive macro—including, in part, a break-down of policy effectiveness that has led to Yen strength. However, the extent of the rally adds pressure to policymakers to react and the landslide victory by Prime Minister Abe in the upper house elections on 10 July could provide adequate ammunition to do so, including recent murmurings of potential ‘helicopter money’ following a secret meeting between previous US Fed Chairman Bernanke and Bank of Japan Governor Kuroda.
The British pound remains at the bottom of the hierarchy. While it had sold off deeply following the referendum vote, macro remains weak as there is further pressure on the Bank of England to ease monetary policy, while the large current account deficit now appears even more daunting.
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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