26 Apr Boom & Gloom: April 2018
The Global Scenario
Global markets are currently driven by three major factors:
- US monetary tightening.
- Trump policy.
- Global geo-political risk.
The factors above will play a major role in the value of the US dollar, direction of US short and long-term interest rates, and appetite for risk assets globally. Other factors, like the European and Japanese monetary policy, will also influence markets but to a lesser extent.
Theory taught us that, as the scarcity of an asset increases, so does the price. One can thus assume that monetary tightening will reduce the pool of dollars as the FED reduces its balance sheet size. The rising interest rates will increase the cost of carry which will lead to lower money supply growth, resulting in a stronger currency.
However, the current cycle is not that simple. Trump policy introduced substantial fiscal stimulus via tax cuts. This will support US growth, but also result in a larger budget deficit that needs to be funded. This will place pressure on treasury bond yields (investors will offer lower prices / higher yields due to increase in issuance) and as foreign investors hold a substantial portion (+-30%) of US treasury bonds, pricing will filter through to the currency market, weakening the dollar.
The higher interest rate environment in the US will lead to lower growth which will drag the US asset prices down. This will cause less demand for US assets versus European and Japanese, resulting in a weaker dollar. Over the medium term, high corporate re-financing, over the period 2019 -2022 in US and in 2020 in Europe, will maintain upwards pressure on interest rates. Also, investment flows in US investment grade bonds has been very high over the past year, driven by returns. As returns start waning, down 2.8% YTD, the price momentum driven flows will turn around and drive out-flows, causing yields to rise. Lastly the effect of higher interest rates on the Equity Risk Premium will impact on risky assets, driving asset re-allocation.
The question will be which of the two forces will be the strongest? History has taught us that these relationships are not that simple but that leads and lags occur, driving volatility in uncertain periods. We expect to see a weaker dollar over the medium term and that the effect of a smaller dollar pool will only influence the dollar over the longer term.
The less attractive US asset base will drive asset allocators to higher growth regions including emerging markets, being supported by stronger commodity prices.
Equities are not cheap, globally only two regions have historical PE’s below their long-term average, but the market likes the realised earnings growth and is expecting more to come. The graph below plots the YoY EPS growth of the S&P 500 index and selected sectors. The expected growth is still very healthy.
On a macro level Euro zone profit, as a percentage of GDP, looks very good but European companies are not returning profits to investors as US companies have been doing. They are reducing debt and investing, where as their US counterparts have been buying their shares back and leveraging. The latter strategy might be risky as interest rates start to increase. We see the buybacks and large Tech sector in the US as one of the main reasons why the S&P 500 has been outperforming the Euro Stoxx 50. The stronger Euro effect on exporters and banks’ exposure to low interest rates also contributed.
Given the unattractive equity ratings (PE`s) one would expect dismal performance expectations, however, global growth is still very healthy, and earnings expectations is high. Earnings growth contributes the bulk of the return in our models.
In the global bond market, it is all about monetary policy normalisation in the US and the budget deficit or inflation expectations and how Trump will fund the tax cuts. US inflation averaged 2.6% from the IT bubble to the great recession, and is currently close to that at 2.4%. PCE, the FED’s preferred inflation measure, averaged 1.94% over that period and is currently at 1.6%. US 10-year interest rates averaged 5.2% over the period, thus 2.8% real which makes sense in a normal market.
The point is that US long bonds will start pricing in a more realistic term spread as inflation expectations get anchored at current levels. The South African bonds are linked to the US long bonds which will place pressure on our yields. Given a reasonable stable inflation differential between the two countries over the next couple of years and a positive domestic political scenario (Ramaphoria), one can expect the country’s risk premium to contract a bit more which will counter some of the rise in the US long bond.
The major risks still persist:
1. Geo-political risk
The US, more specifically Trump, have been the biggest driver of geo-political risk. This can be seen around his new trade policies, specifically issues around imports from China but also general relations with Russia, driven by the link to Syria.
2. Policy error
The FED has resumed the rate hike process as US growth excels and inflation picks up. The biggest risk is a rate hike pace that creates an over kill.
3. Market leverage
Market leverage remains a great cause of concern. As monetary policy change and rate hikes gain momentum, one can expect some positions to be squeezed causing volatility. We have seen a lot of this in the currency and equity markets lately.
Most Equity markets have produced very little performance over the short term, however, apart from the Euro Stoxx 50, longer term performances are reasonable for offshore equity. Domestic performance has been dismal, especially on a real basis. The graph below looks at various South African indices, sector indices and other selected indices. Emerging markets have performed substantially better over the longer term than the All Share Index.
Global growth looks good but change in monetary policy will cause volatility. The US dollar will have a big influence on global markets driven by the FED, and fiscal policy. We expect emerging markets to outperform but with a lot of volatility.
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Data source: Bloomberg LP
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