Balancing Act - September 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 13 October 2016
Since the 2008 financial crisis, markets have become accustomed to central banks calling the shots. Investors eagerly await each central bank meeting in the hope some new form of monetary policy chicanery can help propel markets higher. Given central bankers have openly stated they are trying to push assets higher, this investor Pavlovian response is justified.
And so the eagerness levels were on high alert as September rolled around, with the US Federal Reserve (Fed), European Central Bank (ECB) and the Bank of Japan (BoJ) all on the menu. Unfortunately (or fortunately for those that question central bank omnipotence) there was very little delivered in the form of new magic tricks, although the BoJ did introduce price targeting in an attempt to control the shape of the yield curve.
Despite the relative inaction, the meetings did deliver some interesting insights. Within the Fed, the voting suggested there is meaningful dissent on current policy settings, with a number of governors concerned the low level of rates are causing adverse consequences. As mentioned, the BoJ is now targeting levels on the 10yr bond, in an effort to alleviate the stress negative rates are causing in the banking sector.
And perhaps most instructive was the reluctance displayed by the ECB to commit to more negative rates or an extension of the current quantitative easing(QE) program. Mario Draghi advocated patience, suggesting that negative rates needed time to help generate lending and growth. Unfortunately time is in short supply for the European financial system, where banks are shedding assets and headcount in an attempt to raise their capital levels to acceptable levels. The fact negative rates are the main reason banks are struggling to raise capital seems to be lost on those at the ECB. More time will only make this worse.
Whilst all this central banker navel gazing is going on, the political backdrop is deteriorating. The disaffected masses that feel left behind by current government policy continue to find a voice. Brexit, the improving polling of Trump, the Hungarian referendum to turn back refugees, the rise of ‘nationalist’ parties in Germany and France and the pending Italian referendum are all examples of the populace attempting to rewrite the social contract between the citizens and their government. Political pressure will only intensify for governments to enact populist policy. It does not seem too much of a stretch to suggest the negative rate policy that is severely penalising savers may already be in their sights.
Negative interest rate settings have reached the limit of their effectiveness (assuming they were actually effective at some point) and behind closed doors central bankers already appear to be debating this point. With the potential for political pressure to also question the relevance of negative rates, we are at the point where central banker commitment to their experimental theories will be tested. The potential for a dramatic repricing in sovereign bonds remains acute.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
German equities face political headwinds
German equities have slid down our equity hierarchy. In the past, we had been willing to look beyond the fact they were expensive as we felt the supportive macro environment of a cheap currency and ultra-low rates would be most beneficial to German companies. Unfortunately the financial sector has suffered with rates so low, hampering the availability of credit. Growth is still slow in the region and the political environment continues to deteriorate. These growing risks have shifted the macro outlook from a tailwind to a headwind.
Earnings in Germany have failed to improve as we had hoped. Chart 1 shows the earnings growth for German companies (dark blue line). As you can see, German companies have been unable to take advantage of low funding costs and turn them into meaningful earnings growth.
Chart 1: German equity earnings
Source: Bloomberg 2016
What is holding them back? A contributing factor has been the poor performance of the financial sector (light blue line). The ECB has set short rates at negative and compressed the yield curve with their quantitative easing, eroding the margins and carry for banks. With their usual channel for raising cash gone, banks have to offload assets and shed costs in an effort to raise capital. This can be seen with the recent sale by Deutsche Bank of Abbey Life in the UK and the plan by Commerzbank to cut 10,000 jobs. Rather than negative rates encouraging banks to expand their loan bank, it has had the opposite effect and forced them to shrink their operations.
Another contributing factor has been the deterioration in the political environment. Chancellor Angela Merkel has suffered as a result of her ‘open borders’ policy, with opinion polls showing her popularity continues to fall (Chart 2). This alone is not reason to downgrade our view, as politicians regularly come and go without disturbing markets. Of more concern is that Merkel represented the strongest voice for a united Europe, so if she fails to be re-elected next year, do the risks of a more fragmented Europe increase?
Chart 2: German Chancellor Merkel popularity
Source: Wall Street Journal 2016
Across Europe, elections are showing the increasing popularity of ‘nationalist’ parties. Any party running on a ticket of putting the needs of the country ahead of broader Europe is seeing radical improvement at the polls. Italy is approaching the December referendum with trepidation, as what should have been a vote on constitutional change has become a vote on the popularity of Prime Minister Renzi. The Five Star Movement (nationalist) is waiting in the wings to pick up the pieces if it fails. French politics continues to move to the right as the growing popularity of Marine Le Pen’s National Front, is pushing the larger parties to the right of centre. Pick a European country and the landscape is the same – nationalist policy is trumping (excuse the pun) European policy.
Germans hit the polls next September and if recent state elections are anything to go by, Merkel faces a challenge. The Alternative for Deutschland (AfD), continues to gain ground on the back of strong nationalist policy, particularly around immigration. If Merkel fails to secure re-election next year, the odds of a more fragmented Europe increase considerably.
German equities are expensive and momentum is mixed. The macro outlook has become a headwind as the political environment deteriorates and the financial sector continues to struggle. For these reasons we have moved Germany down our equity hierarchy.
UK equities are still at the foot of the hierarchy
Since Brexit, UK equities have performed well in local currency or GBP terms, up almost 10% since the end of June. One key reason is that investors expect the significantly weaker Pound to help improve UK companies’ earnings growth. But it is this weaker Pound that makes investing in UK equities problematic for non-UK investors such as ourselves. When viewed in common currency or US Dollar (USD) terms, UK equities have performed poorly as shown in Chart 3.
Chart 3: Global equity performance
Source: Bloomberg 2016
The rally has also pushed UK equities into expensive territory as prices get ahead of the expected turnaround in earnings. Forward Price to Earnings for the Financial Times Stock Exchange (FTSE) 100 Index is at over 17x expected earnings, the highest level in the last 10 years.
Aside from being expensive, our other major concern is the macro outlook. The UK economy and markets have behaved very well since the initial Brexit panic - with both surprising to the upside. Whether this is complacency or a genuine resilience in the economy only time will tell and it appears that time is fast closing in. Prime Minister Theresa May announced in a speech at a party conference that Article 50 (the official notification to leave the European Union) will happen no later than March 2017.
This elicited the expected response from across the channel with all manner of European technocrats falling over themselves to demonstrate how much they won’t be helping the UK to make this a smooth transition. Herein lies the challenge for the UK. A more fragmented Europe will be difficult to deal with and is not incentivised to help the UK engineer a ‘soft’ Brexit. The incentive is more to make it as difficult as possible to discourage any other members from making an exit.
The rubber is now hitting the road as Brexit becomes real. The stability of the UK economy and markets belie the growing risks associated with leaving the European Union. With UK equities at expensive levels, we are more inclined to wait until valuations appropriately reflect the underlying risks. For these reasons we are keeping UK equities at the foot of our hierarchy.
LatAm earnings estimates are ambitious given the underlying fundamentals
Fundamentals in Latin America (LatAm) have improved significantly since the dark days of January this year, when unusually tight financial conditions drove commodities to multi-decade lows. The Fed’s signal to slow interest rate normalisation along with China’s announced ’mini stimulus’ induced a justifiable return in risk appetite, which was additionally fuelled by a turn in Brazilian politics promising to bring the country’s fiscal account back from the brink. Still, despite these positive developments, earnings have yet to improve, meaning the turn will need to be strong and timely to keep up with currently high expectations.
The LatAm ‘earnings worm’ in Chart 4 shows just how far forward estimates have diverged from reported earnings (Trailing 12M). These forecasts imply expected growth above reported levels, but ultimately the two should converge by the time the fiscal year earnings is finally reported. Ultimately, earnings need to deliver to keep expectations up or downgrades will follow.
Chart 4: LatAm reported and forward earnings
Source: Bloomberg 2016
The divergence is to be expected at the beginning of a recovery where one-off expenses (e.g. restructuring, write-offs, etc.) that weigh on current reported earnings will eventually be removed, while the outcome of these adjustments produces leaner, more profitable companies. In Brazil, Petrobras is a current example of a strong restructuring story that promises much improved profitability.
Breaking down the earnings forecast, 12-month forward sales is only 7%, which is reasonable given the commodity bounce and early signs of returning economic growth. To reach 12-month forward earnings, profit margins need to improve from the current level of 3.7% to 8.9%, a level last seen in 2013.
Margin expansion can certainly be achieved with the positive developments underway, but the timing may be ambitious. The recovery and promises of fiscal and other reforms will take time, particularly given the still high levels of corporate debt – 120% of GDP at the end of 2015 up from 90% in 2007.
Corporate debt levels have risen partly as a function of the FX mismatch, whereas dollar denominated debt has risen proportionately to the 50% currency adjustment across the region. As shown in Chart 5, this dynamic is particularly acute in Mexico and to a lesser extent Brazil where, as of the end of 2015, USD debt as a proportion of total corporate debt stood at 66% and 18%, respectively.
Chart 5: EM USD corporate debt
Source: BIS 2015
The debt overhang is being addressed with asset sales and restructuring. Also, as inflation has mainly peaked across the region, rate cuts will help to reduce debt servicing costs. Currently, the market is paying a premium on forward earnings – 15X versus a long term 12X average. For the moment, LatAm equities appear expensive in light of the risks, not just in the execution but particularly on the timing of the improvements.
We prefer US to Asian Investment Grade credit
In February, valuation support pushed US Investment Grade (IG) to the top of our credit hierarchy, overtaking Asia as our preferred region. The last six months have seen credit markets rally around the world, eroding some of that support, particularly in Asia. Asian credit is now expensive, with government yields at record lows and credit spreads historically tight. Hence we downgrade Asian IG to neutral. As this leaves US IG as our only overweight across credit we also downgrade our view on the asset class to neutral. In terms of relative valuation between US IG and Asia IG, the spread is back around historical averages, at 48 basis points vs 59 basis points (bps).
Given stretched valuations and weaker relative momentum compared to credit outside of Asia it would be fair to question whether even neutral is an appropriate positioning for Asia IG. As shown in Chart 6, the risk on rally in emerging markets credit has caused higher beta regions to outperform year-to-date (YTD) within even greater spread tightening. However, these regions are recovering from a far lower base, given the macro pressures seen throughout 2015. As emerging markets, and even developed markets, see their growth forecasts drift lower, Asia remains more resilient, with relatively limited forecast cuts. This has seen Asian credit spreads trade much tighter than other EM regions, delivering smoother returns with much less volatility.
Chart 6: EM corporate credit spreads
Source: Bloomberg 2016
Some stresses appear to be building in Asia, particularly in China. Slower economic growth, high leverage and capital outflow has led to deteriorating credit metrics onshore. Defaults on the onshore bond market have risen sharply and could remain elevated in the near term. Investors are watching carefully to see whether this continues to build or whether it starts to spill over to the offshore credit market. However, most of the stresses appear to be within the high yield (HY) space, with most deterioration well flagged and the brunt of it coming from the property and commodities space. The HY space in Asia is even more richly valued than their investment grade counterparts. The spread between the two is close to 200bps, well below the historical average. This is concerning given the bulk of the credit deterioration is coming from the high yield space.
Investment grade corporates have relatively stable and improving credit metrics, with ample liquidity buffers. Interest coverage is still low but seems to be improving and cash to total debt has risen strongly. Furthermore, investors still appear to be underweight emerging market (EM) corporates, particularly in Asia, which could be positive for the asset class if this reverses. Unlike other EM regions, local investors account for over 75% of new issues YTD, providing a more stable footing for the asset class. Hence we believe while valuations look expensive there is still enough support to continue holding a neutral weight in Asian IG. We balance our neutral to overweight positioning in IG however with a continued cautious stance in HY globally and in EM ex Asia credit.
The Bank of Japan has introduced price targeting
At its September meeting, the BoJ introduced another ‘imaginative’ strategy for reflating the economy. Going forward, the 10 year part of the curve will be anchored around 0%, in the hope this will keep longer rates positive. It is hoped this type of price targeting will reduce the negative impact low long rates have had on banks, pension and insurance balance sheets.
Only a few weeks have passed since the announcement, so it is too early to judge how successful the BoJ will be in controlling this part of the yield curve. But with the 10 year Japanese Government Bond (JGB) currently still in negative territory, it would appear the BoJ will need to sell bonds to achieve their target. Given they have pledged to continue buying Yen 80 trillion in bonds per year to help expand the monetary base, selling bonds as part of the program does seem a little counterintuitive: Hopefully they know what they are doing.
Flattening yield curves have been a persistent dynamic for a number of years, as shown in Chart 7. In this environment, banks have struggled to generate cash flow with the available carry constantly shrinking. With its new price targeting mechanism, we assume the BoJ is attempting to use the 10 year as an anchor point from which the rest of the curve can steepen.
Chart 7: Government bond yield curves
Source: Bloomberg 2016
The unfortunate reality is that unless investors see evidence that inflation expectations are rising, there is little in the way of lost opportunity cost purchasing long bonds. Unless the policy makers (BoJ and the government) can get inflation expectations up, it is hard seeing the latest central bank policy trick being able to steepen curves and having a useful effect. The problem is not the price of money; it is the demand for money.
Sovereign bonds are expensive. With recent evidence suggesting central banks are debating the efficacy of negative interest rate policies, the chance of a dramatic repricing is increasing. We remain underweight sovereign bonds in our portfolios and continue to prefer cash as our defensive asset.
We maintain our neutral stance in commodities
After a 25% surge in the first half of 2016 and a flat Q3, Gold prices have plunged recently. The market appears to be discounting a higher probability of a Fed rate rise in December and believes that it will be accompanied with a stronger USD and higher real yields. We have discussed the relationship between Gold prices and market expectations around Fed monetary policy and concomitant effects on USD and real yields in previous reports. This relationship helps explain some of the recent weakness but we believe there may be more at play here. Chart 8 plots gold prices against Fed policy expectations proxied by market implied probability of a 2016 Fed rate hike. The latter is shown on an inverted scale so the decline since July corresponds to a 2016 rate hike probability rising from 10% then to the current 60%. Gold prices remained well bid at between $1,300/oz to $1,350/oz for most of Q3 but were at $1,250 and $1,100, in June and January respectively, when the market last priced similarly high odds of a 2016 rate hike. As such the recent repricing lower would appear to be well warranted.
Chart 8: Gold prices and 2016 US rate hike probability (Inverted)
However, expectations of policy remain volatile as shown in the same chart. Fed communication and dissenting opinions of the Federal Open Market Committee (FOMC) members suggest expectations could swing the other way just as quickly. As such, it is instructive to look at the relationship between Gold prices and real yields themselves as shown in Chart 9. Over the last year Gold has traded in a tighter relationship with real yields than it has with either Fed policy expectations (shown above) or with USD and policy uncertainty (shown in previous reports). Over the last few days, real yields too have risen but by not as much. It would appear that the market continues to dare the Fed. Given that it is the Fed that has been coming closer to market implied expectations on Fed policy path and not the converse, it seems prudent to us to wait for a convincing break higher in real yields before we downgrade our positive view on Gold.
Chart 9: Inflation adjusted gold prices and US 10 year real yield (Inverted)
In addition we see the following as strong pillars of support for Gold going into year end and beyond:
- Elevated macro-political risk and policy uncertainty heading into US presidential elections, Italy referendum, European politics and Brexit fallout
- A flight to safety to Gold prompted by a sell-off in USD assets in the immediate aftermath of a potential Trump win
- Potential for a much more stimulatory fiscal policy in the US post elections
- While Gold speculative positions have come off sharply recently, holdings in Gold exchange traded funds (ETFs) have remained stable suggesting recent correction has been more speculative in nature
- Strong seasonal demand for physical Gold from India and China in 4Q/1Q respectively
As such, we continue to retain Gold at the top of our commodities hierarchy and above Agriculture, Energy and Base metals.
The Yen remains in the middle of the currency hierarchy
The Yen has been one of the strongest currencies in 2016, outperforming the USD by over 15% year-to-date. A dovish US Fed has been part to blame, but the inability of Japanese authorities to increase inflation expectations has also driven Yen performance. With inflation consistently disappointing to the low side, real rates in Japan have continued to rise over the year, placing upward pressure on the currency. Chart 10 shows how the real yield differential between the US and Japan is a key driver of the currency cross rate.
Chart 10: US Japan Real Yield Differential vs USD/JPY
Source: Bloomberg 2016
This differential is starting to move back in favour of the USD. The Fed has been intimating at increasing rates later this year, subsequently real rates in the US have been moving higher this month. We expect to see the differential in real rates to move higher and support the USD going forward.
A by-product of the Yen outperformance this year is it no longer shows up as cheap on our valuation models. For these reasons we believe it makes sense to keep the Yen in the middle of our currency hierarchy.
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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