26 Feb Boom & Gloom: December 2017
OUR VIEW OF THE INVESTMENT MARKETS: DECEMBER 2017
This table reflects our view of the relevant assets, based on expected performance.
The Global Scenario
Global trade has accelerated to levels last seen in the 2004 to 2007 bull market. There is synchronised growth across most of the major regions, allowing for very low unemployment across the developed world, driving confidence levels.
Confidence levels in the USA are close to highs seen in 1989. CEO confidence and small business confidence are close to the highs seen in the previous bull market. The confidence is fuelling US retail sales, growing at 5.4% YoY, above the current Nominal GDP of 5%. Real GDP is growing at 2.5% YoY.
In the EU, growth is close to levels last seen before the great recession. Real GDP is growing at 2.7% YoY. Consumer confidence is at a twenty-year high and Euro Zone inflation is close to the 2% target.
The strong growth in the USA supported by good employment growth and healthy wage growth is driving inflation just above the target of 2%, this will allow the FED to hike shortly the FED Rate by 50 to 75 bp this year. US long bonds have adjusted for the higher inflation risk as yields touched 2.79% from a low of 1.32% mid 2016.
In the Euro Zone inflation is reaching levels that the European Central Bank (ECB) is getting more comfortable with. The ECB is in the process of reducing the level of monetary easing but should maintain the ultra-low repo rate for the next year or more. However, the ECB should start tapering the Quantitative Easing programme from September 2018.
The domestic economy is benefiting very little from the elevated global growth, being dominated by politics, bad economic policy and the potential ratings cut to junk by Moody’s. The euphoria created by the election of Cyril Ramaphosa as President of the ANC, has supported the rand, allowing for re-pricing of interest rate sensitive stocks and bonds. Re-structuring at Eskom is looking positive with hope that more state owned enterprises will follow suit.
These pro-active actions of Ramaphosa might just help to delay the imminent ratings cut which will allow for currency stability. However, policy decisions taken at the ANC June policy conference and the December elective conference are not encouraging, especially the potential nationalisation of property without compensation. This is touching the core of economic development and can be potentially destructive. The damage done by the Zuma administration will be felt for a long time and we expect economic growth to be subdued over the medium term.
Global equity markets had a strong quarter for most markets except in Europe where the Euro Stox 50 ended the quarter in negative territory.
Emerging inflation, strong synchronised growth and high levels of confidence will lead to normalisation of the monetary policy. Monetary tightening is expected, initially in the USA, but Europe will follow. We can expect elevated volatility in global equity markets, given the current equity valuation in developed and most emerging markets and the rising interest rates.
Asset allocators will re-evaluate the relative attractiveness of high yielding equities and bonds as the re-pricing in the bond market evolves. We are already seeing switching out of utilities, staples and other high yielding equities. Asset class selection over the period since the great recession has been equity focussed, by selecting equity styles, like high yielding equity or utilities, to replicate bonds. This focus is changing as bond yields normalise and we move back to an environment of a more “normal” asset allocation regime. We do see a higher risk to a recession driven by policy error, but that is not our main line scenario. Sustained growth, even in a higher interest rate environment should still drive earnings up. Table 2 below shows the de-composition of expected total returns. In most regions, earnings growth is the largest contributor to returns and the rating of equity generally detracts.
The US long bonds are finally reacting to inflation risk. After nearly a decade of artificially supressing volatility via QE programmes, we are finally seeing US long bonds behaving as they usually did, a great leading indicator of risk. Figure 5 plots the US inflation and the US long bond over a decade. From 2008 the long bond yield was forced flat using QE showing little regard for inflation. The average spread between the long bond and US Personal Consumption Expenditure was around 2.5%. We expect the spread to be around 1.5% to 2%, targeting a yield of 3.5% to 4% for long bonds over the medium term, as long as inflation is under control.
Growth and Inflation
Not much has changed over the past quarter, global risks are still centered on three main groupings:
1. Geo-political risk
North Korea is dominating but the rest are still present.
2. Policy error
The change of guard at the FED is a major risk, hopefully sanity will prevail, and the FED will remain cautious in moving the monetary policy.
3. Market leverage
Market leverage is a major concern, it is never a problem until it becomes a problem. The underlying asset is currently extremely difficult to value. All we know is that yields are not going to stay at the current level, and that the road is going to be bumpy.
Return expectations in the various equity markets generally look attractive. However, the biggest contributor to return comes from earnings growth, and the PE rating detracts return in all regions except Japan. This results in markets that are not cheap.
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Data source: Bloomberg LP
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