29 Oct Boom & Gloom: September 2018
The Global Scenario
The US dollar, recognised as the global reserve currency, has been driving global liquidity up since the great recession as a result of ultra-low interest rates and central bank balance sheet expansion. This mass of money pumped into the global economy was supplemented by large volumes of Euro and Yen, created via their respective monetary authorities. This influx resulted in ultra-low US unemployment, good US growth and healthy inflation. However, this means the time has arrived for monetary policy normalisation. Interest rates are going up to normal levels and the US Federal Reserve Bank (“FED”) will be reducing the size of its balance sheet.
To place the above into perspective, the four major developed world central banks, FED, European Central Bank (“ECB”), Bank of Japan (“BOJ”) and the Swiss National Bank (“SNB”) had $ 1 trillion assets on their balance sheets in January 2006. This grew to $ 2.5 trillion by January 2010 and peaked at $ 6.1 trillion in January 2018. To give further context, the US Nominal GDP which is made up of all goods and services produced in the country was $ 20.4 trillion for the second quarter of 2018 (Seasonally adjusted and annualised). Based on the above, it is clear that the central bank balance sheets are enormous.
Source: Bloomberg LP
Why should the above global scenario be of a concern to us?
- Share buybacks to dwindle and the cost of debt to increase
Globally, share buybacks over the past couple of years were partly financed by corporates issuing extremely cheap debt. The demand for shares being bought back was a large contributor to equity price performance, driving earnings up. As interest rates, increase debt will become more expensive and buybacks will dwindle. Corporates will have to start rolling existing debt used for the buybacks at much higher rates, resulting in a potential earnings squeeze in the near future.
- The carry trade is busy unwinding resulting in weaker emerging market currencies
One of the ways that dollar liquidity was channelled into emerging markets (“EM”) was via the carry trade. Traders borrowed dollars, also Euro and Yen, at low interest rates and sold the dollar to buy EM currency, such as the South African Rand or Brazilian Real and bought domestic EM assets like bonds or equities. This trade weakened the dollar because of oversupply and strengthened EM currencies through the huge demand. EM assets became more expensive as the demand for assets rose. The demand resulted in EM funding at very low interest rates and asset prices spiking. The carry trade is busy unwinding as US debt becomes more expensive, resulting in weaker EM currencies because of slight panic and over supply. The dollar is strengthening as the dollar pool shrinks and the short sellers cut their positions, and lastly during this unwind EM assets are dumped.
- Emerging markets will struggle to roll dollar debt and debt service costs to spiral
Some EM countries grew their dollar-based debt aggressively in the low interest rate and strong EM currency environment. As dollar interest rates increase and EM currencies weaken stresses are starting to show as we have seen in Turkey and Argentina. Countries will struggle to roll debt and debt service costs are spiralling.
- Changes to asset allocation due to interest rate increase, and a decrease in demand for EM equity
In the Boom & Gloom published in September 2016 (follow this link), we described the influences of low interest rates on market valuation measures, the short of it is that long-term interest rates find their way into most equity valuation models. Most analysts would use what they call “normalised long-term interest rates” or something similar which is their best guess on where long-term interest rates will average through the cycle. The fact is that the ten-year government bond spot rate is commonly used to discount cashflows and as interest rates go up, asset prices will be valued lower. As these interest rates increase, asset allocators will slowly allocate a higher exposure to fixed income assets in comparison to other risky assets like equities. We have already seen some re-allocation causing a strong sell off in EM equity. The MSCI Emerging Markets Index is down more that 7% year to date.
The points touched above are only some of the drivers in the market that needs to be monitored. The crux of the matter is that the dollar pool is shrinking as liquidity is being extracted from the market and this is causing uncertainty.
Source: Bloomberg LP
Economic PE = 1/Cost of equity, therefore, low interest rates will justify higher economic PE. As interest rates and equity risk premiums increase, one would expect PE’s to de-rate. From the graph above, the US stands out as being expensive and MSCI EM and MSCI EU have de-rated slightly already.
Global Return De-composition
The table below presents a return de-composition, using a long-term average yield, looking back to 2006 as model input. In this scenario the US rate is at 2.9%. Using 1990 as a starting point, the yield jumps to 4.6%. So what is realistic? The truth is we can’t say for certain, probably around 3.5% to 4.5%.
The table below is a stressed scenario. We reduce the exit PE’s, one-year forward earnings and one-year forward dividend by 10%, to reflect the higher risk premium. The stressed scenario does not include any “panic selling” which is typically experienced in a corrective phase.
Behavioural Finance and other relationships
Behavioural analysts believe that market psychology plays an important role in asset price determination. The graph below plots the S&P 500 Index.
The general rule in the Elliot wave analysis is that, on completion of a five-wave structure, the market tends to correct after the fifth wave as illustrated below. The projected correction is also at the 50% retracement level from the 2009 low to the 2018 peak, indicated by the blue line below. Furthermore, the MACD, a momentum indicator, is losing momentum as can be seen in the lower panel.*
The graph below plots the FTSE JSE Shareholder Weighted Index which is gathering negative momentum as can be seen by the negative trend of the MACD in the lower panel. It could potentially retrace to the 2015 low, which is the 50% retracement level from the financial crisis of 2008.*
It is worth monitoring other relationships to get an idea of the potential impact one can expect to materialise for risky assets. In a recent study, Nedbank CIB published a note evaluating the relationship between US real interest rates, as defined by the Laubach-Williams r* estimate, and the S&P 500 Index.
The principal is that high real rates eventually cause a risk-off scenario, therefore the relationship between real interest rates and, the US 10 year and S&P500 Index correlation, moves from positive to less positive, or to negative. *
Following from the comments above, global bond markets are reacting to the inflation expectations and change in monetary policy. As the global risk-free proxy, the US 10-year bond pricing will be reflected across the globe. The South African long bond fair value is typically calculated as, US 10-year bond + country risk premium (use South Africa long term CDS as proxy) + inflation differential. This theory is applied across the globe resulting in a flow through effect of the US long bond price, to the fair value of equities as mentioned above. The important question being, what is the market’s view of the long-term rate?
The FED’s FOMC Dot Plot, is a graph plotting the expected FED Funds target rate over the next three years and the long- term level, by the Federal open market committee (“FOMC”) members’ individual projections. The graph shows the expected path that the FOMC members expect the Fed Funds target rate to take over the next three years and importantly, the long-term level. Focusing on the long-term expectation, the median members expects the rate to be 3% . The median members expect the rate to increase by 12 basis points (“bps”) in 2018, 87 bps in 2019 and one 25 bp hike in 2020.
From the below graph you can see that the members view of the long-term average rate has come down substantially over the last six years, from 4.25% to 3%. At the end of 2017 the long-term average rate was at a low of 2.75%.
The biggest risk for South African bonds is the potential for a credit rating cut to junk status by Moodys. This could be the result of various factors but mainly due to government spending which creates funding risk, poor country growth potential over the medium-term and government policy uncertainty. These risks are reflected in the country risk premium and can be quantified by the price of the South African five-year Credit Default Swap (“CDS”).
The price of a CDS is what an investor is willing to pay, in basis points, to insure against the default of a credit. The graph below plots the South African USD 5-year CDS. Note the spikes at the end of 2015 as a result of Zuma’s cabinet reshuffle and during the GFC in 2008, which shows that investors will pay up if they get nervous. This is not unique to South Africa. The increase from December 2017 to date was mainly driven by the change in sentiment towards EM and is also reflected in the increase in domestic bond yields over the same period.
Although we do not attach a high probability to a downgrade by Moodys, a downgrade would drive the CDS to 2015 levels, around 130 basis points higher.
We do believe that the risk sentiment for EM will deteriorate as dollar liquidity reduces and the carry effect dissipates. EM will have to pay-up to fund themselves and investors will require a higher risk premium. This will cause EM currencies to sell off further, which will have inflation effects. The higher risk premium, potential for higher inflation and a higher US long bond yield will weaken EM bonds.
Growth and Inflation
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 have an effect on 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.
We are entering a corrective phase of the global cycle. This will cause uncertainty and bring about volatility. The contraction of dollar liquidity will cause asset repricing and the cost of equity will go up. High levels of leverage in global markets will have to be unwound, we have already seen aggressive unwinding of carry trades.
Volatility also presents investment opportunities for those who are patient, but it is important not to get sucked in. Our more bearish view has been reflected in our asset allocation. We have increased exposure to US cash, which includes short duration bonds. We reduced the allocation in EM equities and base metals and we have maintained the underweight to US equities.