Geopolitical risk has become more visible in the last month, but the West’s recovery looks more resilient and emerging economies continue to expand solidly. We still expect a slightly faster-growing and more synchronised economy in 2014, and see this – together with relative valuations – favouring stocks ahead of bonds. Tactically, developed markets still have the edge, but this is likely a good long-term entry point for emerging markets, particularly those in Asia.
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Business cycle: upswing intact
The sharp fall in the new orders component of the US ISM Manufacturing Index has been partially reversed, suggesting – as we’d thought – that the decline had a lot to do with severe New Year weather (Figure 1). Business surveys from the UK and continental Europe continue to show manufacturers’ order books at above-trend levels. Manufacturers’ optimism in Japan has taken a dive, likely reflecting the higher consumption tax, but it remains above trend and experience suggests that such tax-related effects even out eventually. China’s order books tell a different, below-trend story, but the shortfall is not dramatic and the trend there is, of course, much stronger to start with. On balance, the business cycle still looks to be in an upswing: we think global growth will be slightly faster, and more synchronised, in 2014.
Of course, Russia’s threats to the Ukraine, and the possibility of more severe Western economic reprisal, represents a very obvious source of near-term risk. Our advice there has been to eschew the analysis of the armchair warriors, and avoid the temptation to become an instant expert in the politics of the region (which have been complex for many decades, if not centuries). Even the principal protagonists do not know how things are going to turn out, not least because the actions of paramilitaries are unpredictable, as will be the protagonists’ own responses to as yet unknown events. Instead, we’d suggest that there is a dominant strategy for both sides – namely, not to escalate things militarily, because the possible costs so hugely outweigh any gains – and that this logic will likely and eventually prevail. Of course, in this centennial year above all others, we are aware of the limits of logical analysis.
A more fundamental risk – in economic terms – is the slow normalisation of the monetary climate. This is a process that we welcome as a sign that the US and Western economies are now generally (as we’ve long believed they would be) more able to stand on their own two feet. But the process still has the potential to unsettle markets for a while at least. Many investors are complacent in their assumption that central bankers’ forward guidance counts for much beyond the next month or two – as indeed may be some of the central bankers themselves, even after they have already had to back-track so visibly in the UK and the US. In the UK, some unexpectedly good inflation data have been more than countered by some remarkably robust retail sales and employment reports (Figure 2), and if rates have to rise unexpectedly quickly – possibly even this year – this is perhaps where the risk is greatest.
China is another source of risk, not so much because of the current below-trend readings from its manufacturing surveys (as noted its trend has been a remarkably strong one), but instead because of the possibility of a sudden lurch lower, sparked by a financial accident. As we discuss in the special essay below, however, the government’s hands are far from tied: it has the potential – and the balance sheet – to respond aggressively should dramatic action be needed. And we remain unconvinced that it will be.
We see few signs yet of US economic excess
The shadow banking sector is the focus of many investors’ concerns, but as Joe Zhang notes in “Inside Shadow Banking: The Next Subprime Crisis?”, it may be only a symptom. The underlying problem is the lack of a fully functioning capital market, and what it has become fashionable to call ‘financial repression’. Until China’s interest and exchange rates are determined more decisively by market forces, and less by administrative fiat, China’s massive flows of household savings will be allocated inefficiently and potentially riskily. Incremental liberalisation has long been underway (the essay below provides more detail). Recent weeks have, for example, seen the country’s first default on an onshore corporate bond, and a widening of the renminbi’s trading bands against the dollar. The process is slow, and room for an accident remains. But, as noted, we doubt that a systemic threat will materialise: household and government balance sheets are unremarkable, and the government has massive foreign exchange reserves available for any necessary recapitalisation of banks.
For the time being, then, we continue to give economic growth the benefit of the doubt. The US recovery is now mature at 57 months (NBER data show the average post-war upswing to have been 59 months), yet we still see few signs of the sort of excesses that might call time on it. The private sector’s free cashflow remains firmly in positive territory, and a big surge in cyclical spending – new houses and business capital expenditure – may still be yet to come.
On this reading, we are still in the stock-friendly phase of the business cycle, though it is not the easy call that it has been for most of the last five years. Stocks are no longer cheap, and on some measures are looking a little expensive (Figure 3). Analysts’ earnings-projections revisions are not yet being boosted by improved growth prospects – indeed, they have just fallen markedly. Moreover, rising interest rates and bond yields, as noted, have the potential to unsettle markets.
Nonetheless, other valuation measures are less elevated (Figure 4), and other large asset classes look more expensive. Government bonds and investment grade credit are the two most expensive of the nine asset classes in our balanced portfolio. High yield and emerging market bonds, and cash, also look more expensive than developed stocks, while emerging stocks are now the cheapest of the nine. Analysts’ forecasts, as we’ve regularly noted , often take on a life of their own, falling much more often than they – and earnings – rise. And volatility inspired by monetary normalisation is likely, in our view, to be short-lived. This is partly because the recovery in stocks has been soundly based, and is not simply a product of central banks’ quantitative easing (QE) and low interest rates (the rebound in profits has been too big, and too predictable, for it to have been simply a result of QE).
The most pressing question is not whether to bail out of stocks, but whether to tactically tip emerging markets
Indeed, the most pressing question tactically may be not whether we should switch from stocks to other asset classes, but whether it is yet time to turn more positive on emerging stocks relative to developed markets. We continue to think it may be premature to tactically overweight emerging markets. They have started to outperform in the last month or so, but the trend is tentative, and it is perhaps the capital market that is most exposed to those monetary nerves. We think that most of the footloose international capital will have been repatriated by now, but we’d feel happier with an overweight call if we could see more of that normalisation priced into the US bond market itself – a 10-year Treasury note yield holding above 3%, say.
In the meantime, our optimism on emerging stocks is more strategic (five years) than tactical (3-6 months). We know that economic growth is not enough, but it helps. Figure 5 reminds us that China has been a fantastic economy but a disappointing investment in recent years, and US investors especially would have done far better to stay at home. However, if the government means what it says about market forces playing a more decisive role across the economy, and if those financial reforms continue (discussed in more detail below), we might yet see China’s structural slowdown coinciding with improved stock market performance. There may be less prospective GDP growth in China, but what there is may be more valuable to investors if more of it makes its way to the corporate bottom line.