09 May Boom & Gloom: March 2019
Previous asset allocation.
* Include short duration bonds up to 3 years.
The Global Scenario
Global growth has been choppy since the great financial crises (“GFC”). The recovery phase ended in 2014, where after global activity tapered down until the so-called G20 Shanghai Accord in 2016. This is more pronounced when looking at Global Industrial Production annualised growth in Graph 2 below. The recovery was short lived as the US Federal Reserve (“FED”) initiated interest rate hikes from an all-time low of 0.25% to 2.5% at the end of 2018. This was the start of the extraction of Dollar liquidity from the global system which impacted on the cost of capital.
The Trump tax policy countered this somewhat as tax cuts increased disposable income and economic activity. However, the Sino-US trade talks had a big impact on global trade as supply chains were disrupted, causing trade disruptions across the globe. The impact was especially felt in Europe, notably Germany, as the region is a large exporter. The slowdown of trade activity in China had a flow-through effect to Europe.
Another way to explore the drivers on the slump in global trade is to look at regional imports. Graph 3 below plots the contribution to quarterly growth on a regional basis. The slump in Emerging Asian imports is notable.
Focussing on China, their economic statistics are always questionable, especially their GDP numbers. To control this, we use the Li Keqiang Index, an independent economic activity index. What is interesting, is the effect of the reduction in the required reserve ratio in 2015, the effect on trade and production, as reflected in Li Keqiang Index, as well as the import numbers. However, this peaked at the end of 2018 and was one of the catalysts in the global growth slow down.
The question we need to ask is, where to from here? Developed world monetary policy will be one of the big drivers from here, as would the Sino-US trade negotiations. As for the latter, it is very difficult to forecast but the negotiations will disrupt markets and create uncertainty. The more dovish monetary policy, as we have seen in the latest Federal Reserve Bank (“FED”) minutes and the comment from the European Central Bank (“ECB”), eased market fears of further rate hikes in the USA.
We should however not be complacent, as the FED might stall rate hikes and increase them further over the medium-term and allow for the unwind of its massive balance sheet over time. This is not a short-term strategy; balance sheet unwind could take several years.
We see the pause in monetary tightening as a short-term effect. The FED will keep extracting Dollar liquidity out of the system over time, which will impact risky assets as the cost of capital increases. We have seen assets reprice since 2018 and might see some more repricing over time. The expansion of the US budget deficit, due to the Trump tax policy, will also drive demand for the Dollar as the US will have to tap foreign savings to finance the deficit. The policy is expected to add $ 1 .5 trillion to the Federal budget deficit over the next decade. Will the tax stimulus drive the Dollar to be stronger, leading to cheaper imports and a larger trade deficit? How will risky asset prices react? We believe that liquidity drives asset prices, notably dollar liquidity. The larger sources of liquidity are central bank stimulus, petro-dollars created in a strong oil price environment and growth in global trade. The latter is the only potential driver of substance at this stage.
Equity performance is driven by two factors, firstly, market rating as reflected by the PE multiple and earnings growth. Assuming the market rating is static over time, performance will be derived from the portion of earnings paid as a dividend and the balance should be reflected in the price of an asset. Therefore, one would expect share prices to follow earnings over time. The PE is driven by sentiment or the market’s expectation of future earnings. Graph 5 below illustrates this trend. There are stages that market expectation is dovish (index price is above the earnings line), as was the case from 2016 to 2017. This is an environment where markets re-rated, driving PE up. We can see from graph 5 below how the market drew down in late 2018 to date, as the negative sentiment seeped in and corrected on a more dovish FED stance.
The big question is, where will earnings go? Factors to consider will be the cost of capital that has been increasing as global monetary policy starts to move to a more normalised environment. Balance sheet structure also played a big role in earnings growth as corporates bought shares back, using cheap funding which lead to higher gearing. This debt will have to be rolled and it is not going to be at the ultra-low interest rates that were available over the past decade.
Earnings growth has been placid throughout 2018. Earning expectations are becoming more optimistic over the near term. The market expects the SP 500 Index to grow earnings by 6.9% in 2019 and 9.9% in 2020. Euro Stoxx 50 Index earnings is expected to grow by 6.5% in 2019 and 7.2% in 2020. The JSE All Share Index earnings is expected to grow by 7.2% in 2019 and 14.1% in 2020.
Global market ratings are generally priced cheap to fair on a rolled forward PE, but historical PE’s are in most cases above their long-term averages, with exceptions in Japan and South Africa. We would argue that South Africa has had a structural change (political space), as well as index specific issues (notably Naspers) and see the long-term average as too high.
Economic PE of the index, which is the Price to Book divided by the Return on Equity, is a comparison of the valuation of a company’s assets to the profitability of those assets. The economic PE of the index points to most regions as cheap and the US and Asia ex Japan as expensive.
In modelling our total return decomposition, we used two scenarios. The first, where the market mean reverts to long- term average PE’s and the second, where the market reverts to 90% of long-term PE’s. Scenario 1 would be logical in a normal market environment, where as scenario 2 is more likely in the current market environment. Both Japanese and European returns look attractive, however most of the Japanese returns depend on a re-rating of the PE which will need a catalyst. We do not see this correcting in the near term. European equity return is driven by an earnings recovery, which could be a bit optimistic and similar to South African equities.
US bonds have traditionally been a good indicator for inflation. Quantitative Easing (“QE”) disrupted this somewhat as the FED forced the yield curve flat, eliminating any potential term risk premium. As the FED started to normalise monetary policy the US 10-year bond reflected the market view of inflation risk more efficiently. The US bond market has been in a long-term bull market from the 1980’s, making it difficult to establish a long-term normalised rate.
Focusing on rates and inflation (PCE) from the late 1990’s, one can see a reasonably stable inflation range, but a huge spread difference between PCE and the US 10-year yield in the 1990’s to 2007 versus the current spread. This is partly due to QE and with QE3, the so-called operation twist, where the FED sold short-term treasuries and bought long-term treasuries to force long-term mortgage bond yields down. The US 10-year bond reached 200-year lows and QE3 was halted at the end of 2014. In 2015, the FED hiked for the first time and from mid-2016 the US 10-year rate started to steepen. This was the first time since the GFC that the famous US 10-year rate predictor started showing signs of life. The market started sensing growth but was not convinced that inflation was going to be a problem.
In a structurally sound market one could expect the US 10-year to move to around 4%. In the current market scenario, where very little inflation risk could be proven even at ultra-low unemployment rates in the US, we expect the yield to settle at around 3% – 3.5%, given a synchronised global growth scenario with the Sino – US trade dispute being settled. Back to the real world, we expect the yields to be volatile in a range between 2.5% and 3%.
Looking at the US yield curve in Graph 11 below, one can see how the curve has flattened. The short-term yield has risen in line with FED hikes and the long end dropped as inflation failed to materialise in any significant volumes. The term spread offered on the long end is not worth the risk, we would use the 1-3-year area for Dollar investment.
South African government bonds have been driven mainly by the currency but also by country risk dynamics like investment grade rating status, with Eskom as a major driver. We see USD as the main currency driver. Graph 13 below plots the South African 10-year domestic bond yield versus international peers. The South African credit rating is the same as Russia, and we trade 77 basis points above the Russian 10-year bond and 10 basis points above the Brazilian 10-year bond. Brazil is rated 2 notches below South Africa at Ba2 compared to Baa3. This highlights the investor risk mindset that South Africa is still risky and is trading in the non-investment space. An improvement in the economic climate in South Africa can have a huge impact on the country credit risk profile as tax revenue improves.
We see no change in major risks:
1. Policy change and error
The change in monetary policy will cause a contraction in dollar liquidity, which will influence global markets. Markets will react negatively if the policy is applied too hawkishly.
2. Geo-political risk
The US, more specifically Trump, has 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.
3. Market leverage
Market leverage remains a great cause of concern. As monetary policy changes 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 30 SEPTEMBER 2018
Total return over the holding period in home currency.
As mentioned before, we are in a mature cycle and the FED policy is critical to the way that the markets will evolve. We are cautious with our asset allocation as we believe that dollar liquidity will decrease and place pressure on the dollar.
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