16 Oct Boom & Gloom: September 2019
OUR VIEW OF THE INVESTMENT MARKETS: 3rd Quarter 2019
This table reflects our view of the relevant assets, based on expected performance.
Previous asset allocation.
* Includes short duration bonds up to 3 years.
The Global Scenario
Global Purchasing Managers Indices (“PMI”) are forward looking indicators of economic activity. An index level above 50 indicates growth, and below 50, contraction. On a global level, using the JP Morgan Global Services PMI, one can see slight expansion, although down from 54.6 in mid-2018 (see graphs 1 & 2). However, the JP Morgan Global Manufacturing PMI has dropped below 50, indicating a contraction. This is the theme across most PMI’s, where the Manufacturing PMI’s are contracting, and the service sectors growth is slowing down. This is driven by the contraction in global trade, spurred by the US – Sino trade war.
Graph 3 below illustrates the average tariff rate on all US imports from China if all announced tariffs take effect. The tariff hike is huge and the effect on manufacturing is notable.
Global Industrial Production (“GIP”) has been subdued since 2014 with sporadic rebounds, notably after the 2016 stimulus pumped into the market. From 2018 GIP decelerated as global trade was disrupted by the US tariff announcements.
The contraction in global trade, and the effect on manufacturing, will gradually flow through to the services sector and impact confidence. Global trade is a big driver of global money supply, notably Dollar supply. The deceleration in trade has caused a shrinkage of the Dollar pool (Dollars available in the market), thus strengthening the Dollar. The recent cuts in the US Federal Funds Rate had little effect in expanding the Dollar pool. The reduction in manufacturing and a strong Dollar, have a damping effect on commodity prices and Emerging Market currencies as the carry trade unwinds.
Equity markets react to stimulus as can be seen from the 2008/2009, 2012 and 2016 stimulus, as monetary authorities pumped into the market. The S&P 500 Index has been losing momentum and is catching up to earnings. Markets that overestimate earnings, as can be seen from 2016 to 2018, need to correct as the PE ratio gets over-extended. The high PE and uncertainty around earnings growth are causing volatility and global growth risks are not helping, impacting investor confidence.
Emerging Equity Markets performance was mediocre over the past nine years. The 2016 stimulus caused a strong recovery, only to see a strong drawdown in 2018. The FED extracted Dollars from the system via interest rate hikes and started the unwinding of its QE inflated balance sheet, the latter caused an unwind of the carry trade. Note how the strength in the Dollar (see graph 8) caused a slump in Emerging Market earnings.
Graph 10 below summarises the market valuations. Historical PE is above long-term average PE for all regions except Japan and South Africa, the MSCI Emerging Market is at the average. What is notable is that the consensus is expecting earnings to grow from current levels, which seems a bit optimistic. I inserted the valuations of the MSCI South Africa to use as a comparison to the FTSE/JSE Top 40 Index (“Top 40”). The former index has a lower concentration than the Top 40.
The Top 40 behaved well up to 2012. The Mario Draghi “whatever it takes” speech on 26 July 2012 sparked an equity rally across the world. In some regions, like the US, it lasted for several years but in South Africa it only lasted for two years – the problem being that it was not supported by earnings growth. From mid-2014 to date, the market has moved sideways to allow earnings to catch up.
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, whereas scenario 2 is more likely in the current market environment.
Both Japanese, European and South African returns look attractive, however most of the Japanese and South African returns depend on a re-rating of the PE which will need a catalyst. We do not see this correcting in the near to medium term.
European equity return is driven by an earnings recovery, which could be a bit optimistic. Most of the earnings growth for European equity is expected to come from the financial, technology and industrial sectors. The risk is around the industrial sector and to some extent the financial sector. The industrial sector will be impacted by slower manufacturing growth whereas the financial sector, notably banks, will struggle to grow in an extremely low interest rate scenario.
Looking back at the structure of developed world long bonds over the long-term, there was a clear bull trend that accelerated after the Great Financial Crisis (“GFC”). The introduction of quantitative easing and operation twist forced long bonds lower and central banks bought substantial volumes of assets. The FED balance sheet topped out at $ 4.3 trillion, to put this in perspective, the 2nd quarter Real GDP in the US was $ 19.021 trillion. The balance sheet was around $ 800 billion in 2007, with the current level at around $ 3.8 trillion. The European Central Bank and Bank of Japan are also sitting with extremely large balance sheets. The FED ended QE 3 in September 2014 and started to increase short-term interest rates in the 3rd quarter of 2015.
Focusing on the recent past, the US bond markets started to price in some inflation risk from late 2016 and topped out at just above 3% when the market realised what impact the trade wars had. High yield credit spreads, which are generally leading indicators of risk, started expanding in 2018 and should be monitored closely. The combination of a very low US long bond yield, a low inflation risk, and expanding high yield credit spreads is pointing to market risk.
Credit risks tend to lead equity markets, we see a divergence from the beginning of 2018 and our bet is that equities will capitulate and correct.
Graph 15 below is an excellent illustration of the drivers of South African (“SA”) bonds. Firstly, note the co-movement of the SA dollar bond and the US long bond. The US long bond is seen as the risk-free rate and generally drives the SA long bonds. Secondly, one can see how the SA rand bond follows the SA Credit Default Swap (“CDS”) price, this is an indicator of the credit quality of SA, it is also embedded in the SA dollar bond. The last element that drives the SA rand bonds is the inflation deferential. The South African Reserve Bank (“SARB”) has done a stellar job in managing inflation expectations and have driven inflation successfully to the middle of the target range of 3% to 6%.
This caused the inflation differential to contract from the long term 4% to 5% (6%/7% – 2%) to, 2.5% to 3.5% (4.5%/5.5% – 2%). This buffered the credit risk some-what and allowed for some strength in the SA bond yields which was further assisted by a bullish US long bond.
The risk currently revolves around potential US dollar strength and to some extent the outcome of the medium-term budget policy statement as well as the Eskom solution, thus resulting in domestic credit dynamics.
We see no change in major risks:
1. US / Sino trade war
The outcome of the trade negotiations is close to impossible to forecast. Added to this is the inelegant Trump tweets that are causing more damage than good.
2. Policy change and error
The risk of policy error and sudden change was seen with the U-turn the FED made in January.
3. Geo-political risk
Issues in the middle east, Syria and Turkey are only a few potential time bombs, add Brexit, and the rise of populism and life can get very interesting.
4. 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.
Global risk is not dissipating, growth is slowing and catalysts to drive asset prices up are getting fewer. Dollar liquidity is not improving, global trade is slowing, labour costs in developed markets have been rising and credit conditions are getting worse. This is not a good recipe for earnings growth and improving corporate profitability.
Domestically, assets seem to be cheap, however political risk is still building up, making the equity market valuation seem to be fairly priced and not cheap.
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