30 Aug Boom & Gloom: June 2018
This table reflects our view of the relevant assets, based on expected performance.
The Global Scenario
Global markets are currently driven by four major factors:
- Trump trade war.
- Trump tax policy.
- US monetary tightening.
- Global geo-political risk.
Global markets were rocked by the evolving Trump trade war, especially with China. Link this with US monetary policy tightening, one can expect a lot of volatility in the coming months. The questions around the Trump trade war tend to revolve around “why now?”, and “what is the motivation?”, especially with regards to the link to China. The China issue can be analysed by explaining two possible scenarios.
Firstly, the China driven destruction scenario. The theory is that China, via the state driven economy, have been targeting global industries over the past decades. China having a non-market driven economy results in company profit not being the main objective. China have been able to sell products at below production cost over an extended period, which has suffocated industries and taken over market segments. In South African context it is known as Monopoly Capital. As a result, inflation has been trending down over the past twenty years. The Trump logic is that China has been destroying the US industry and thus jobs, by selling product below cost. By implementing trade barriers, Trump believes that China will be forced into adopting a market driven, fair-pricing structure and therefore compete fairly for business.
Secondly, the US natural industrialisation decline. US non-farm productivity has been declining since the IT bubble in 2003 and there has been a consistent increase in the unit cost of labour. This could be interpreted as labourers doing less work per hour, for more money.
In reality it is most probably a combination of both scenarios, however, it seems that the trade war is here to stay and that it will most likely escalate.
The US has also been very active in implementing further sanctions on nations like Iran, Russia and Turkey. The latest salvo on Turkey has highlighted the country’s fiscal problems and potential exposure to European banks, causing an aggressive sell-off of the Lira but also other emerging market currencies. This could develop into another Greece fiasco.
A major focus over the next year will be the effect of the US FED tightening monetary policy. The concept is simple, low interest rates and quantitative easing caused a huge spike in Dollar liquidity, thus lots of cheap and easy cash. This kept emerging market (“EM”) yields low via the carry trade (borrow cheap dollars and use it to buy EM bonds) and kept the Dollar weak (sell dollars and buy EM currencies).
We have seen the carry trade initially unwind in early 2014 but reverse thereafter. It increased from 2016 to late 2017, where the reality of US interest rate hikes started sinking in, causing a sharp correction. Over the next year we are going to see dollar liquidity contract further, and this will spill over into other asset classes.
It looks as though the dollar will strengthen as the available dollars in the market contracts. The stronger dollar will drive interest rates up, especially EM, which will reduce economic activity, commodity prices and could cause other risky assets like equities to de-rate.
We do believe that the fiscal stimulus Trump pumped into the market will eventually bite as the funding of it cashes up. This could counter dollar strength somewhat, but that will take a couple of years.
Historical & forward PE
Equities are not cheap. Using a forward PE, compared to long term average, developed markets are expensive. Some EM markets, like China, have been hammered down close to 25% over 2018. South African equities have retraced somewhat over 2018 but have not really reacted to the contraction of dollar liquidity. South African equities are not trading at demanding multiples, but we expect behavioural finance to drive the market over the short term. We expect the weaker Rand to support multinationals and commodity-based shares, but domestic shares could de-rate. We are in an uncomfortable position with risky asset markets in a transition period, we expect high levels of volatility. Long term, fundamental investors will be able to feast, as patience will allow for good buying opportunities.
From a fundamental point of view, using consensus expectations, returns should be driven by strong earnings growth. The returns will only realise if historical PE’s revert to their mean. In most instances we believe this will not happen in the current market environment as risk premium builds up.
The US long bond has been in a bull market over the past two decades. The strong US growth experienced over the past two years seems to have ignited US inflation, currently at 2.9% (Core CPI 1.9%, PCE Deflator 2.2% at the last FED meeting). This caused the US long bond to bottom out of the long-term bull channel following the inflation trend. We expect the US long bong to stabilise around the 3% level given the FED rate projection for 2019, expecting four hikes, which should taper inflation expectations.
Over the medium to long term we expect long term interest rates to normalise further. The current investment grade credit spreads are trading at very tight spreads. We expect credit spreads to weaken as US sovereign long bond yields sell off.
We prefer both low bond duration and credit duration. The current two-year treasury yield at 2.65% is very attractive given the risk. Domestic bonds have sold off along with their EM counterparts as the carry trade unwound over 2018.
We expect high levels of volatility but deteriorating fiscal dynamics will drive the yields up over time.
We see no change in major risks:
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.
MARKET PERFORMANCE TO 31 JULY 2018
Shorter term equity performance in EM was negative. Developed markets, ex Japan, have showed some gain.
Developed market growth still looks healthy, the US and Europe seem to have persistent inflation at controllable levels. Trade tensions and US monetary policy will place pressure on EM markets that could cause volatility.