A nervous Federal Reserve (Fed), toppy short-term indicators and the US debt debate may create a brighter outlook for bonds for a while, but ongoing growth will likely keep monetary normalisation on the agenda. On a 3-6 month view, the investment climate still favours risk assets and – less clearly – developed markets most.
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Economies in the driving seat
Central banks are entitled to some mystique – it may even enhance their authority – and while the Fed’s 18 September announcement of no QE taper was surprising, it was also understandable. We think the US economy is capable of standing on its own two feet, but housing data had been patchy, bond yields had risen sharply, and looming budget and debt impasses also posed a threat (and still do – see comments and essay below).
Where next? We think little has changed. Through the summer we argued that the big moves in interest rate expectations on both sides of the Atlantic – the long process of monetary normalisation – would effectively be driven by economies, not their central banks. We also felt that it is too soon to expect higher bond yields themselves to start acting as a drag on growth. This remains the case. We think the US will continue to grow, and the UK and euro area to recover, and that sooner or later both long-term and expected short-term interest rates will likely resume their rise. Central banks will eventually rubber-stamp the moves, but economies will be in the driving seat.
Softer economic data would not be a surprise: some cyclical indicators are running out of headroom (Figure 1). A pull-back might be seized on as evidence that the Fed and other major central banks, who’ve all been trying to “guide” interest rate expectations down, know something (bad) about the economy we don’t.
Alongside a backdrop of simmering geopolitical tension; a still-smouldering euro crisis; a US political process capable of snatching fiscal defeat from the jaws of victory; and disappointments in some high-profile emerging economies, such collective thinking could easily make investors more risk averse.
As we see things, however, softer data now are more likely to reflect the volatility that is part of every business cycle, of the sort seen several times already since 2009. It is too soon to expect the next recession, not least because there are few obvious excesses yet visible in consumer or business spending. The US private sector – the most important single driver of the global cycle – is still running a sizeable financial surplus (its savings comfortably exceed its investment – Figure 2). In Europe, the upturn is younger still. And in the US and euro area, and on balance across the developed world, the headwind posed by governments’ fiscal retrenchment is poised to fade in 2014 (Figure 3).
Meanwhile, the evolving humanitarian tragedies in the Middle East may not spread: as we write, the rest of the world has backed away from intervention, and neither Syria nor Egypt alone are central enough to the global economy or oil market to have a big direct impact. In the euro area, the next governing coalition in Germany will likely – as expected – continue to support (and conditionally underwrite) the single currency project. If and when the crisis in the periphery sparks back into life, this – and the European Central Bank’s continuing willingness to do “whatever it takes” – can continue to contain the economic damage. The US fiscal situation has in fact moved on a little, but the politicians don’t seem to have noticed.
The disappointments in the emerging world are difficult to ignore. Prospective growth rates in Brazil and Russia are now little better than those in the developed world; the material current account deficits in Brazil, India, Indonesia, Turkey and South Africa were not part of the strategic emerging market script; and the bloc clearly remains as sensitive as ever to portfolio outflows. However, the case for long-term structural growth in Asia in particular remains intact, and we think that the region’s short-term vulnerability has also been overstated. Specifically, we think that a re-run of 1997’s Asian crisis is unlikely. Wellian Wiranto, our Asia strategist, makes the point more carefully below.
In conclusion, we see growth continuing, and tapering staying on the Fed’s agenda (probably from December). Collective risk appetite may wobble, but not for long.
Most assets have done well after the Fed’s inaction in September, but bonds and emerging markets have seen the biggest reversals in trend. The liquidity climate does seem likely now to be a little more benign than we’d thought, but in light of our assessment above we are reluctant to chase some of those rallies. If considering a shift in stance to take advantage of the delay in monetary normalisation, we’d favour assets that were already looking – or starting to look – attractive in the context of our central medium-term scenario in which economic growth and corporate profitability are resilient, and interest rate risk is rising, not falling.
Our Tactical Allocation Committee currently has a relatively recent (July) overweight in cash alongside a longer-standing overweight in developed stocks. That cash position is an opportunistic one, and in the slightly altered short-term landscape it is the emerging markets whose appeal may have improved most. We are currently neutral on emerging stocks, and underweight emerging bonds. Some relative valuations for the former recently hit 10-year lows. However, the relative weakness of emerging markets in the summer – and since 2010, in the case of emerging stocks – was not solely attributable to the outflows inspired by prospective tapering, and the dress rehearsal may not have shaken out all the potential outflows. For the time being, on our 3-6 month tactical view, we retain our preference for developed markets – but it’s a closer call than it was.
This leaves us again arguing that strength in many bond markets should be used to shorten duration and reduce positions. Our strategic holdings of core government bonds are relatively low, because we see yields in the core government bond markets rising beyond the levels seen in early September. In this context, euro area benchmarks will likely outperform those in the US or UK because Italian and Spanish yields will rise less as economies recover. High yield credit markets look more appealing than investment grade, though we are no more than neutral on the sub asset class tactically: it does face interest rate risk, but default risk may be edging lower as economies improve.
In absolute terms, developed stocks are not cheap any longer. But nor are they dear – and relative to other asset classes, they still offer the best risk-adjusted value on a 3-6 month view and beyond. The big rebound in price/earnings ratios is likely behind us, but if prices simply rise in line with earnings from here, prospective returns are still likely to comfortably exceed those on most other assets. For clients holding fewer equities than our tactical weightings would suggest, we continue to advise using setbacks to add to holdings.
We still think the US equity market is attractive, but we have long favoured continental European markets alongside it, with our corresponding underweights being in the UK and developed Asia ex Japan (we are neutral on Japan itself). We also favour a mix of cyclical and technology sectors ahead of more defensive sectors such as utilities, telecoms and consumer staples. Our convictions remain strongest, however, at the asset class level: we expect most stocks to outperform bonds and cash in most regions.
US consumers and businesses – the drivers of the business cycle – are still running a large cashflow surplus
Raising the financial signal-to-noise ratio
Here are two useful rules of thumb: be wary of arguments that rely on accounting identities, and keep esoteric stock market valuations at arm’s length.
For example, many argue that because accounts present profits as a residual, they can only grow at the expense of other income. In practice, profits and wages can grow together indefinitely (we’re not saying they will, only that they can). For sure, the share of profits in the economy cannot rise forever, and the corporate sector’s financial balance – the gap between its retained profits and its fixed investment – can only rise if another sector’s balance falls. But these points – which apply at the national (economy-wide) level, not directly to the quoted (stock market) sector – are often of limited use. The next big fall in profits will likely be driven by a recession and/or another round of bank write-downs, not the laws of arithmetic.
We discussed two examples of esoteric stock valuation methods in a recent In Focus. ‘Tobin’s Q’ and long-term cyclically-adjusted price earnings ratios each have vocal advocates. The former is flawed in design – the value of a firm is not driven only by the replacement value of its assets. Both face measurement problems, and have been popularised only after the events they’re supposed to have predicted. In practice, they tell us little more than stock prices alone, as the chart makes clear. Setbacks in stocks now are more likely to reflect events than overvaluation.