Mark Harris, 6th November, 2015
Backdrop
- We continue to believe that the overarching environment is one of ever present disinflationary threats due to the ongoing debt overhang and the ambition of many constituencies to delever. The global economy is desynchronised and countries appear to be caught in mini cycles of growth improvements which fail to sustain due to deep and unexplained structural impediments e.g. almost universal low wage growth and low productivity. Most central banks continue with accommodative policies but we are getting closer to the point when US and/or UK rates will rise.
- At the start of the month, the IMF stated that the world economy will grow at its slowest pace since the global financial crisis. This will be the fifth consecutive year that average growth in emerging economies has declined. The drag on global growth is sufficient to pull it down to 3.1 per cent even though advanced economies should post their best performance since 2010. The IMF went on to state that weakness reflected common longer-term forces slowing the potential for growth in many countries, including lower productivity growth, high public and private debt levels, ageing populations and a hangover from post-crisis investment booms in many emerging economies.
- We noted last month that Bill Gross of Janus stated that “monetary policy is basically exhausted in terms of producing real growth and even inflation”. However, this month Draghi repeated the exact same scripts as previously, in stating that the ECB was “willing and able to act by using all instruments available”. He also confirmed that they would be able to cut the deposit rate further into negative territory. It appears the ECB are aligning themselves closer to the IMF’s views that “economic policies should aim to boost growth now in all countries apart from commodity exporters with weak public finances. Monetary policy should remain loose.”
- US Q3 GDP growth was around the much reduced consensus expectation of 1.5% with the work-down in inventories a major headwind. However consumer spending rose at a healthy 3.2 percent, and spending on durable goods such as cars and appliances was up by 6.5 percent. Housing was up by 6.1 percent, and government spending rose at an annual rate of 1.7 percent. This is likely to have encouraged the Fed to think that the recent run of weak data is mainly due to an inventory cycle. Consequently, the Fed continued to downplay their earlier concerns over stability in world financial markets and reverted to their previous emphasis “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.” Their statement didn’t really acknowledge recent weaker data such as retail sales, which was at its lowest monthly reading since April, and durable goods, which suffered a second consecutive negative monthly print. Yet they downgraded their employment assessment to “The pace of job gains slowed.” which is more appropriate given the last payroll print. As they left December as a very real option for a rate increase, markets were forced to price the chances to 46% up from 35%.
- The Fifth Plenum has just taken place from October 26 to 29 and this should offer critical insights into the projected path for the Chinese economy, along with any increased stimulus measures. In the meantime China’s economy expanded quicker than economists forecast in the third quarter as the services sector offset weaker manufacturing. However, the Bank of China cut interest rates and reserve requirements for banks, to further support growth.
- After the largest quarterly loss in global equity market cap, we had the largest monthly equity market rally since 2011. The extreme moves show that investors are still wrestling with a slew of new complex issues with a wide range of outcomes that are truly confounding and extremely difficult to price. High conviction a priori positioning leaves markets open to violent rotational moves and we expect to see a continuation of this environment, where markets are treacherous to navigate.
Bull points
Macro:
- Central banks continue to leave constructive policy measures in place and in our opinion, interest rates will remain low for a long period. Draghi has just stated that he is willing to add to measures whilst the Bank of China cut interest rates and reserve requirements.
- Adding further fuel to easy policy was the Bank of England’s Shafik, who stated that “The risk inherent in this build up of leverage (in emerging markets) has motivated calls for a normalisation of advanced economy monetary policy sooner rather than later,” “But tightening advanced economy monetary policy solely to discourage further borrowing could make the job of getting inflation back to target more difficult.”
- In our opinion, the Bank of China will pursue a wider range of more drastic stimulus measures in a desire to transition to more balanced growth with less boom and bust characteristics. This should be viewed as a positive in the longer term.
- We are witnessing signs of improved lending in Europe and consumer confidence has reached eight-year highs in Europe.
Equities:
- European equities were positively impacted by Draghi’s comments and rallied aggressively with volume in index futures one of the highest seen since the previous “whatever it takes” speech in 2012.
- As most central banks continue with stimulus and some add to the programmes, equities look well supported from a liquidity perspective.
- We continue to see differentiated performance in Asia and Emerging Markets as drivers at a country level become clearer. Pro-reformist countries should do well along with those able to cut interest rates and stimulate growth without any inflationary concerns.
Fixed income:
- In our opinion, developed government bonds have travelled a long way and we believe shorter term tactical extensions in duration positioning are the best way to gain exposure.
- The default cycle is likely to remain relatively benign (excluding commodity and emerging market corporates) and we can see a lot of value in selective US and European high yield and distressed credits. Valuations already reflect a number of headwinds and we believe there is ample cushion in the high yield market’s coupon to absorb these challenges. Ex a recession, we believe the asset class can generate solid returns especially relative to other fixed income alternatives.
Commodities:
- We expect WTI oil to trade in a range of $45-$65 for the next 12 months.
- With nominal rates falling, lots of evident political issues, market shocks and high levels of pessimism, the longer term conditions have now turned decidedly more supportive for most commodities. As and when the US dollar starts to weaken, commodities should start to reward.
Currencies:
- We now believe that a turning point is approaching, in which the euro, yen and sterling will be stronger. This will be a surprise to most, who continue to anticipate US dollar strength.
Bear points
Macro:
- Markets and policy makers are grappling with a very messy transition to a better growth environment and we have already witnessed a sharp increase in volatility in most markets. The Fed appear resolute in looking to raise rates in 2015. We remain extremely concerned about the potential for policy error, with Sweden and Australia prime examples of what can go wrong.
- Real wage growth in many countries remains poor and consumer spending in the US may start to roll over given how selective it has been so far.
- China is struggling for growth and they have resorted to measures that will have negative knock-on impacts for the global economy. This will unleash further deflationary forces into an already weak inflationary environment.
- There continue to be many puzzling features of this recovery that wrong foot investors expecting a normal environment. This leaves many markets extremely difficult to navigate with many unintended second round effects.
Equities:
- Many developed equity markets have moved to ‘rich’ valuations for the expected level of earnings growth. Many companies are now at peak margins, with weak sales outlooks, which leave them vulnerable from a forward looking earnings and valuation perspective. It is hard to characterise this earnings season as anything but weak with the overall growth picture remaining challenging as companies struggle to beat lowered top-line expectations and estimates for the current period coming down at an accelerated pace. At this stage in the reporting cycle, the ratio of companies beating revenue estimates is the lowest seen in the recent past according to Zacks. Barclays point out that profit margins in S&P 500 companies declined by 60 basis points over the past 12 months, which is something which doesn’t usually happen unless the economy is heading into a recession.
- It is evident that many companies and countries are heavily indebted, with recent research for Societe Generale showing extremely worrying levels of debt for US companies. The legendary investor, Carl Icahn recently issued a video warning that stocks were overpriced and the US market was in dangerous territory. He stated that “earnings are misstated and sort of a complete mirage” primarily due to stock buybacks and financial engineering. We have a great deal of empathy with this view.
- Whilst European equity markets enjoyed a Pavlovian response to Draghi’s new stimulus commitments, we question their long-term efficacy and find it odd that he chose this moment to act given the improvement in credit expansion in Europe. Perhaps there is a hidden concern that growth will falter without more accommodation?
- Emerging markets remain under pressure. Those that do not embrace structural reform are very vulnerable to further deterioration, despite compelling equity market valuations.
Fixed Income:
- The debate over the path to normalisation is wrought with difficulty. Inflation is contained but wages continue to rise at the margin in the US and UK and if this trend gains further momentum, the Fed will come under intense pressure to increase interest rates. This could be extremely destabilising and we predict higher volatility; whipsaws in yields will continue to be a significant feature.
- We have been warning for some time that many emerging market bond and credit markets are likely to suffer as countries and companies struggle with the effects of the strong US dollar, weak global growth and weak commodity prices. It is evident that issuance of local and hard currency debt in Emerging Markets has markedly increased in recent years, with domestic loans and locally issued bonds of companies ex China moving up from $3.5 trillion in 2008 to $6.3 trillion currently. In addition, foreign loans and offshore-issued bonds have massively increased to about $5 trillion. It is no surprise to us that the International Monetary Fund has issued a double warning over higher US interest rates, which it said could trigger a wave of emerging market corporate defaults and panic in financial markets as liquidity evaporates.
Credit:
- There is little value left in Investment Grade credit and the effects on oil related credits will further intensify as the effects of a year weakness in the oil price continue to wash through. Connected high yield issuance is likely to come under much more selling pressure.
Commodities:
- The BP Chief Economist said shale oil and gas are acting like shock absorbers for the energy industry. More comes in when prices rise so expect lower for longer.
Currencies:
- We believe that we are near to a change in trend, in which dollar weakness will be a material feature of early 2016. The unwind of previous US dollar strength could be quite sustained and violent as long positions are extremely crowded and extreme optimism is evident. However the recent moves by both China and the ECB to weaken their currencies have raised the risks of an escalation in retaliatory manoeuvring to deliberately weaken the US dollar.
- The International Monetary Fund stated that total foreign currency reserves in emerging and developing economies suffered their first annual decline since the IMF data series began in 1995. We believe that many commodity reliant countries’ and emerging market currencies will come under further pressure, especially those who have engaged in large issuance of US Dollar denominated debt.
Conclusion
- We hoped that we could gain clarity on the path of transitional improvement in financial conditions as we worked through 2014 into 2015. However, we believe that a number of extremely unusual structural features remain present. This leaves it as a noisy and confusing asset pricing environment that no one forecast and consequently one in which we should continue to expect further major shocks.
- We remain very concerned about the growing indications that the credit cycle has entered an advanced phase that usually precedes a pickup in defaults and associated negative implications for equities. Typically, this is characterised by a large amount of debt-financed merger-and-acquisition activity, stock buybacks and dividends. This is already the second largest year on record for M&A behind 2007, there has been a tightening in lending conditions (Chicago Fed’s National Financial Conditions Index), a flatter yield curve, a stronger dollar and decreased credit availability to energy issuers. In essence, credit spreads are being priced close to recession levels whilst equities started to recover. This differential in pricing will have to be reconciled at some stage with the risk that high yield is correct.
- There appears to be little or no inflationary impulse, with weak US PPI adding to a series of similarly weak numbers. We saw only the second monthly deflation print in the UK in nearly 60 years, softer Chinese CPI as well as persistent PPI deflationary pressure, various soft European numbers and little evidence of a pickup in prices in Japan.
- Despite the above observations we still believe that the Fed will raise rates before the year is out. Whatever their motivations, whether this eventually causes the same cycle of risk aversion is the big question for investors. We feel that the risk of policy error is very high and some caution is warranted given it would result in extremely elevated bond, equity and currency volatility.
- China is experiencing a hard landing and the Chinese equity market now reflects this issue to a major extent. We maintain that their credit issues can be contained but more extreme stimulus measures will be deployed, including a large fiscal programme. As we suggested, the market now appears to be base building for a more sustainable but lower trajectory rally.
- A number of Emerging Market equities and currencies have now suffered a full blown bear market correction. Given the extent of the bad news, they have now become extremely sensitive to a marginal positive change. Whilst we are cautious of the longer term dynamics, a tactical opportunity for significant rewards may be about to present.
- We expect any short term US dollar strength will reverse into a trend change of dollar weakness in the last quarter of 2015 into 2016. This is one of the most crowded trades in markets with any unwind likely to be violent and sustained.
- The equity market rallies have primarily been narrowly led as a result of participants focusing on highly liquid large cap indices and the beneficiaries of more stimulus. For this to be a sustainable rally, we would now expect to see a broadening of stock participation. Without this broadening, some caution is warranted.
- There appear to be a number of disconnects priced into different assets that will have to be resolved at some stage. The obvious downside risk is that a marked slowdown or recession unfolds in the US, but in the meantime we see that most central banks have been given a free pass to extend stimulus and usually this has positively impacted asset prices.
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