Balancing Act - November 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 13 December 2016
Donald Trump has won and the world has changed. A real estate developer cum reality TV star will soon be the leader of the free world. Once again the polls had it alarmingly wrong and, in a similar fallout to Brexit, the knowledgeable elites are railing against the ‘deplorables’ and their small-mindedness. It is hard to know what is more depressing, the predictable response from the ‘elites’, or their complete lack of humility and understanding. Democracy is based on universal suffrage – the individual right to vote, irrespective of sex, race, colour or status. Until such time as the majority feel empowered by government policy, we expect the political landscape to remain volatile. Condescension and snobbery are not the answer.
So what has really changed? The US Republican Party will soon have control of the White House, the Senate and the House of Representatives, making the passage of reforms potentially smoother than the troubled partisan years of the Obama administration. The question then becomes – which reforms will take centre stage? Gleaning what we can from President-elect Trump’s fluid election platform, taxation, infrastructure, immigration and trade would appear to be top of the agenda.
As a real estate developer, the concept of borrowing to build is not foreign to him, so a decent infrastructure spend would seem a definite. As a CEO, President-elect Trump is also well-versed in the benefits of a lower corporate tax rate, so this would appear likely, given it also plays well to the Republican core.
Outside the US, the reaction has been one of concern (unless you are Vladimir Putin), as global leaders wonder how much of Trump’s inflammatory election promises on trade and immigration were more ‘bluff and bluster’, than policy. On this point, it is worth noting that President-elect Trump’s rhetoric post victory has been decidedly less hawkish. What does seem probable is that all future trade deals will be done on a ‘transactional’ basis, avoiding grand bargains like the now scuppered Trans-Pacific Partnership. The number one priority of the US now appears to be no longer exporting a value system to the world, but rather brokering the best deal for itself.
The market reaction to these potential changes has been meaningful. The US dollar has rallied sharply and US Treasury bond prices have fallen, presumably on expectations the tax incentives and increased spending on infrastructure will drive growth and inflation.
The equity market response has been more muted, possibly because moves in the US dollar and bond market place pressure on company margins. Given the already high valuations in the US equity market, investors may need to see actual earnings coming through before pushing markets too much higher.
We remain cautious in our approach to developed market equities. The reforms suggested by US President-elect Trump do provide a platform for potential growth, provided they are delivered. But we remain concerned about the bond market. The current dramatic repricing was overdue, but where does it end? Given bond markets have not reflected fundamentals for some years, it is hard to assess just how much the increase in inflation expectations will impact bond prices. If they keep falling, there is a risk that they will short circuit the nascent earnings recovery, and negatively impact equity markets.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
US equities move higher up the hierarchy, despite headwinds
At the end of November, the S&P 500 Index reached a new all-time high of 2214. US markets were buoyed by the promise of tax cuts and infrastructure spending from the future Trump government.
As has been the case for most of the recent rally in US equities, multiple expansion (light blue bars in chart 1) was the key driver of returns, with the price-to-earnings multiple rising to its highest level since the Tech Bubble.
Chart 1: US Equity Return Decomposition
Source: Bloomberg 2016
So US equities are now more expensive.
As we have discussed before, our process allows us to hold expensive assets, as long as they are supported by momentum, and earnings are improving. Momentum is a tailwind as US equities break to new highs, so we need to confirm the earnings outlook is improving.
Chart 2 shows how both top line (sales) and bottom line (earnings) growth are on the up for US companies, despite the challenges of last year.
Chart 2: US Equity Earnings and Sales
Source: Bloomberg 2016
The risk to this picture is that the challenges of last year resurface. At the start of 2016, we were concerned about the macroeconomic outlook for US equities for the following reasons:
- The cost of capital was increasing after the US Federal Reserve raised interest rates
- A stronger US dollar was pressuring offshore earnings
- Margins were at record highs, but were under pressure as wage growth accelerated.
Our concerns were unfounded, as each of these potential headwinds softened. The US Federal Reserve backed away from further tightening and left interest rates unchanged. This change in stance led to the US dollar weakening for most of the year, with only slight margin compression as the increase in wages remained slow and steady. The removal of these headwinds has allowed US companies to deliver the earnings turnaround we see in chart 2.
Fast forward to now, and some of those concerns appear to be resurfacing. The US Federal Reserve looks certain to increase interest rates at its December meeting. The US dollar has strengthened almost 10% against major currencies in the last two months, while broader inflation measures are starting to pick up, pressuring margins again.
Offsetting these headwinds are the potentially huge macroeconomic tailwinds from the future Trump government – corporate tax cuts and infrastructure spending. If these reforms can stimulate productive growth, they should more than offset the stronger US dollar and increased cost of capital. The risk is in the execution.
We remain neutral on US equities. They appear expensive but momentum is improving, and the macroeconomic outlook is potentially supportive. If President-elect Trump’s reform agenda allows companies to generate earnings growth, then we will look to move overweight. By virtue of the other equity scores deteriorating at the margin, US equities have moved up to second on our equity hierarchy.
Asian equities continue to rank at the top of our hierarchy, with valuations now positive again due to momentum, despite a recent slip in performance. The recent sell-off began after Trump’s election win, with this having less to do with his eventual policy plans for Asia, and more to do with the high velocity bump in bond yields and a stronger US dollar. This repricing removes some of the easier conditions that helped to support Asian equity markets after their harsh start to the year but, so far, appears unlikely to derail the recovery that is now under way.
The recovery began earlier this year through a combination of easing financial conditions, driven by the US Federal Reserve down-shifting its policy tightening plans, and China pivoting to more growth supportive policy, which included a fresh round of stimulus.
As shown in chart 3, Korea and Taiwan’s export growth has returned to normal levels, following the collapse in global demand that began in early 2015.
Chart 3: Korea and Taiwan Exports
Source: Bloomberg 2016
The demand side of the equation appears to remain intact, with continued Chinese stimulus and steady improvements across Asia to Latin America. But it is too early to say that the broader recovery will not be hampered by returning tightness in financial conditions.
In fact, bond rates and the US dollar have been rising since late summer, with President-elect Trump’s win helping both accelerate to levels even higher than when the year began (see chart 4).
Chart 4: US 10-year Yields versus US dollar
Source: Bloomberg 2016
Tighter financial conditions should present two main headwinds for Asia.
First, the pace of interest rate cuts is likely to decline, even halt for some countries, given rising inflation expectations, with higher US bond yields providing less cover to continue cutting rates.
Second, accelerating capital outflows from China should add further pressure to liquidity, not just in China but across Asia.
These headwinds are important to watch as potential sources of increasing risk but could just as easily dissipate as markets stabilise, following their dramatic re-pricing.
Trump is unlikely to impose tariffs and will pragmatically opt to re-negotiate trade deals, which will take time.
In the meantime, increased US fiscal stimulus looks to be net positive for both global demand and Asia.
So along with continued reforms and improving demand, the positive macroeconomic story remains intact, allowing us to keep Asian equities at the top of our hierarchy.
Continue to favour investment grade over high yield
Potential fiscal spending and tax cuts under a Trump presidency would seem to support a better outlook for credit. However the policy prospects and timing are yet to be understood, with the cost of capital already on the rise.
Credit spreads tightened this month, mainly high yield credit due to the sharp rise in treasury yields, but they could easily widen if clarity around President-elect Trump’s policies does not materialise soon to offset this pressure.
His potential fiscal stimulus would benefit US High Yield companies the most, possibly helping them to outperform Investment Grade by more than 2%.
However, with President-elect Trump making some ambitious promises, some are bound to not be delivered. For example, he is planning to increase fiscal spending by 2.5% of GDP. The US is currently not in recession, yet this increase is more than twice the fiscal stimulus ever applied during a recession over the past 50 years (see chart 5).
Chart 5: US Fiscal Response to Recessions
Source: Congressional Budget Office 2016
While we wait for clearer policy outcomes, the fact remains that we are late in the corporate leverage cycle. Corporate debt is at historical highs and rising costs are being driven by higher wages and a steeply rising cost of capital.
Investment grade credit is generally buffered by high cash reserves and long-dated bonds of 20-40 years, but high yield credit remains vulnerable to tighter cash flow and rollover risk.
Until there is some clarity around President-elect Trump’s policies and their implementation, we remain cautious and retain our defensive positioning to credit.
On the demand side, US credit does benefit from ‘yield tourists’ from Europe and Japan, which are investors seeking more attractive yields (relative to home) and a strong US dollar return kicker.
Such demand has been particularly important for high yield credit this year, which has helped to offset US domestic outflows, as shown in chart 6.
The primary risks look to be a shift in policy, which would lift US bond yields higher, and a weaker US dollar.
Chart 6: Cumulative US Investment Grade and US High Yield Flows ($bn)
Source: eVestment 2016
But how will President-elect Trump’s policies affect the rest of the world?
Certainly, his promises for protectionist policies would appear to be negative for emerging markets, but again, the nature and timing of these policies is unknown.
For now, the main headwind is the steep rise in US bond rates and the US dollar. Bond rates and currencies are likely to stabilise after the recent repricing, so we still believe Asia will remain resilient, as the recovery continues across the region.
Global demand for exports is normalising and, importantly, capital spending looks set to improve, as it catches up to recent sales growth (see chart 7).
Chart 7: China Capital Expenditure versus Sales
Source: Bloomberg 2016
From a valuation perspective, Asia appears less attractive than the US, with high yield credit in Asia looking particularly expensive. We continue to favour the US over Asia, with a focus on high quality, low duration credit securities across both regions.
Sovereign bonds suffer a dramatic repricing
Sovereign bond yields spiked in November, as a litany of factors impacted investor expectations.
Chart 8 shows the rout across developed markets, with yields of most bonds back to where they started the year.
President-elect Trump’s win was widely viewed as being responsible for this move, however the following factors may have also contributed to the worst month for sovereign bonds since 2009:
- increasing inflation in most developed markets
- rising wage pressures as the cycle matures
- the European Central Bank’s quantitative easing due to end in March 2017 (although this may be extended at their next meeting)
- output gaps across the world not being as wide as first thought, given the anaemic level of capital expenditure
- bonds being at risk of a repricing, due to being heavily manipulated for several years.
Chart 8: 30-year Sovereign Bond Yields
Source: Bloomberg 2016
So where to from here?
Given bond yields have been detached from underlying fundamentals for a number of years (mainly due to quantitative easing programs), it is hard to assess with any accuracy how much of the recent increase in inflation expectations is actually in bond prices.
We suspect that bonds have entered a ‘normalisation’ phase, where the deflationary forces that drove yields to historic lows are being tempered by the inflationary forces mentioned earlier.
Add to this the shift in fiscal policy that is occurring across the developed world, and it is easy to see why there has been a period of substantial bond volatility.
Chart 9: Inflation Expectations of Major Economies
Source: Bloomberg 2016
We will remain underweight to sovereign bonds until valuations reflect the change in fundamentals or their role as a defensive asset becomes clearer. Cash remains our favoured defensive asset.
We upgrade commodities to overweight
We have upgraded our view on commodities from neutral to overweight.
After several years of commodity price deflation, a turnaround seems to be imminent, given the tailwinds of fiscal stimulus and improved supply/demand fundamentals.
Supply growth has slowed considerably across many parts of the energy, base metal and agricultural commodity sectors, with production cuts succeeding in rebalancing persistent oversupply across many commodities.
The deflation in cost curves seen over the last half decade should be stemmed further, as energy input costs rise next year on the back of the recently-announced OPEC cuts in crude production.
We retain base metals at the bottom of our commodities hierarchy but are taking a more positive view, upgrading the sector from underweight to neutral. This is motivated more by strong Chinese demand than by expectations of increased US infrastructure spending, although that should be a marginal contributor too.
Chart 10 confirms the strength in Chinese economic activity this year, however we disagree with market expectations that this may slow down over the next few quarters.
In fact, we expect Chinese policy to stimulate its economy even further, as a proactive response to the risks of an export slowdown next year.
This increased stimulus is likely to be in commodity-intensive ‘Old China’ sectors like property and infrastructure.
This stimulus will also be magnified if currency depreciation continues to limit the amount of additional monetary easing that the People’s Bank of China is able to put through next year to support economic growth.
Chart 10: China Economic Activity Indicators
Source: Bloomberg 2016
Signs of commodity price inflation can also be seen outside energy and base metals, as shown by rising food price inflation (see chart 11).
Chart 11: Global Food Price Inflation
Source: Bloomberg 2016
Gold and Agriculture remain our favoured commodity exposure.
As discussed in previous updates, we have persisted with this positioning despite momentum deteriorating recently, given these sectors’ attractiveness as a hedge to policy risk and geopolitical uncertainty.
However, the cost of this protection is now rising, with the increase in real yields in the US rising by almost 50 basis points during November.
As such, Agriculture and Precious Metals swap top places on our hierarchy, followed by Energy and Base Metals.
The US dollar is on top of the hierarchy
In the wake of President-elect Trump’s win leading to higher yields, US dollar strength followed quite aggressively.
We previously noted the lift in US dollar momentum, partly due to the impending US Federal Reserve’s rate hike and partly for safety.
Strength in the US dollar tends to be self-reinforcing, as increased demand for it helps to pay down some of the USD 10 trillion of US dollar-denominated debt residing overseas.
This dynamic is back in play, with increased capital outflows in countries like China.
Other currencies were broadly weaker during November as a mirror to the US dollar strength, but the fall in the Japanese Yen was the most dramatic, down over 8% against the US dollar.
One explanation is that the Bank of Japan has committed to holding 10-year yields at 0%, which was tested following the lift in yields. This has effectively initiated unlimited quantitative easing in order to hold this level.
Despite remaining expensive, we have moved the US dollar back to the top of our hierarchy, due to favourable macroeconomic dynamics and momentum.
Correlation between bonds and yields often vary but, for the momentum, higher US yields are supporting higher US dollar demand. As markets attempt to reprice bonds to better reflect fundamentals, this dynamic should continue.
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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