The biggest economies have gathered some momentum, even as inflation is surprising to the downside and central banks assure us they won’t be raising rates soon. This investment outlook isn’t quite the fairy story it seems – investors in emerging markets are sceptical – but we still expect a reasonably happy ending in
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The story so far
This has been one of the more lacklustre economic recoveries (Figure 1), and was expected to be so. But to have focused on that, and to have held back accordingly from investing in risk assets from 2009, would have caused you to miss one of the most profitable US stock market rallies on record (Figure 2), underpinned by the biggest-ever rebound in corporate earnings.
The latter at least should not have come as a surprise. The biggest-ever fall in US corporate profits that preceded it was driven largely by financial asset write downs, and these were always going to slow, stop and (partially) reverse. As the US housing market has stabilized and recovered, they have duly done so.
Economies have been lacklustre in this upswing – but US stocks have sparkled
So where next? The economic recovery is showing signs of gathering momentum and broadening out. As developed economies warm up, however, stock market returns are likely to cool – though they still look to us to offer the most attractive risk-adjusted returns in multi-asset portfolios on a medium-term view.
A warmer developed world economy is visible in forward-looking business surveys, even in the euro area. The long-established and widely influential German Ifo survey recently registered a reading of 110.6, its highest since July 2011 and well above an 23 year average of 101.2; the euro area composite PMI, a younger data series, is at its highest level since May 2011, and firmly above its 8-year average. GDP growth in the bloc is now estimated at an annualized 0.5% in the second half of 2013 - hardly a boom, but an improvement on the recessionary conditions of late 2012 and early 2013. It seems likely to accelerate modestly in 2014 (Figure 7).
In the US and UK, annualized GDP growth in the second half of 2013 now looks to have been running at around 3.7% and 3.0% respectively (a much stronger outturn than economists thought likely even as it was happening). These growth rates are unlikely to be sustained in 2014, as they were each flattered by some one-off events (most visibly in the US, a big stock-build in Q3; in the UK, a remarkable surge in retail spending in December). But at roughly 3% in each case we expect growth in 2014 to be stronger than that achieved in 2012 and 2013 as a whole. Encouragingly, in both countries unemployment is falling briskly – and faster than both the Federal Reserve and the Bank of England seem to have expected.
The improvement in economic momentum in the developed world has some solid foundations, overlooked perhaps by pundits who’ve become too attached to the rhetoric of the “Great Deleveraging” – a rhetoric that always looked overblown. Fiscal drag is set to fade as austerity programmes (and US spending sequestration) become less intense; cashflow, profitability, new technologies and old plant are making the case for boosted corporate spending on fixed investment; and, in the background, ongoing productivity gains have been steadily lifting potential output all along (as they usually do). In the euro periphery, measured cost competitiveness has improved markedly (Figure 3), alongside slow but distinct progress on labour and product market reforms, suggesting a degree of structural adjustment missed by much media commentary.
There are few signs of this more solid growth yet leading to higher inflation: immediate risks seem tilted more towards further disinflation. In the euro area, core inflation of 0.8% in January is close to December’s record low of just 0.7%, and while unemployment has stopped rising the labour market has yet to tighten appreciably. In the US and UK, where unemployment has been falling briskly, wage and price inflation nonetheless remains subdued. In the UK, CPI inflation in December 2013 actually dipped to the Bank of England’s target of 2% for the first time since November 2009.
Economic momentum is not yet having a visible effect on inflation
Japan is an exception: Abenomics’ monetary arrow has pushed inflation up (largely by weakening the yen) to the (locally) dizzy heights of 1.6%. But the jury is still firmly out on whether the Bank of Japan’s cyclical objective of 2% will be hit, let alone whether the third arrow of structural supply-side reform will be loosed and hit the target.
This benign inflation outlook is keeping the big central banks dovish. The “forward guidance” from both the Fed and the Bank of England is being amended to reassure investors that short-term interest rates will be permitted to stay low for many months yet. Most notably, in the UK, the central bank’s threshold level of unemployment looks likely to be breached more than two years ahead of schedule, but the Governor continues to stress the MPC’s reluctance to allow rates to rise. We think the ECB is poised to actually trim interest rates further – taking the deposit facility’s nominal rate formally into negative territory, something we’ve long thought feasible if not desirable. We also think the bank of Japan will announce further quantitative easing in the summer to nudge the CPI closer to that cyclical objective.
As an investor, what is there not to like in this outlook? Growth will be boosting corporate profits, while central banks remain reasonably generous (remember, the Fed’s “tapering” of its quantitative easing is a reduction in the pace at which it injects liquidity: it is not yet talking about mopping it up). If we didn’t know better, we’d be talking about a Goldilocks scenario.
Growth with low interest rates – what’s not to like?
In practice, however, as we’ve often noted in these pages, central banks are not always the driver of the big moves in interest rates. They are neither prescient nor omnipotent: economies might surprise them, and they may not be able to retain control of more than a small portion of the yield curve. We can’t quite bring ourselves to believe that there will be no growing pains in this cycle, and the most obvious source of them would be a faster than expected pace of monetary normalization.
The point is not lost on emerging market (EM) investors. EM currencies, bonds and stocks continue to underperform developed markets, driven partly by continuing outflows as institutional investors reallocate portfolios to benefit from the eventual rebound in developed-world interest rates (and the higher bond yields already on offer).
We note below that poor EM returns have also been driven by a number of local disappointments, including: large current account deficits, slowing growth and inflationary hangovers, and political unrest and policy uncertainty. Some EM policymakers’ responses to further pressure on their currencies in the New Year have not been helpful. Meanwhile, the calendar – and cycle – is also reminding many investors of the period of emerging underperformance sparked by the monetary normalization and Tequila crisis of 1994, which eventually segued into the Asian crisis and lasted for roughly 5 years (and cumulative stock underperformance in common currency of roughly 75%). Currently, EM stocks have underperformed for 3 years, and by a cumulative 54%, since their October 2010 relative peak. They look inexpensive, but could remain so for a while.
As yet, the poor sentiment and outflows that have are dogging emerging markets are associated with economic performance that is not actually that bad: most developed economies still envy the growth rates of Asia in particular, and the EM bloc overall seems, like the developed bloc, if anything poised to grow a little more quickly than in 2013. But the growing pains are there, and amplified by the developed world’s cyclical upswing.
It may still be too early to turn tactically bullish on emerging markets
The long-overdue setback for developed stocks may be upon us as of late January, but as we write the retracement has been modest: the MSCI developed world index in dollars is down some 3.3% from the post-crisis high reached on January 22nd, and the direction-setting S&P500 index of US stocks is down by just 3.0% from a new all-time high reached on January 15th.
Our Tactical Allocation Committee cut its position in developed stocks to neutral in mid- November in expectation of some such setback. We retain a positive strategic view of the asset class: this is still the stock-friendly phase of the business cycle, and while stocks are no longer cheap they are still reasonably valued. We see the MSCI developed world index and the S&P500 as trading on plausible forward PE ratios of 14.9 and 15.6 respectively, for example. These are above 10-year rolling averages, but not worryingly so, and they are below the levels that might be consistent with prospective levels of profitability and the cost of capital.
Talk of an equity “bubble” seems to us misplaced. Profits can of course fall suddenly if an unexpected recession looms, but the business surveys are showing few signs of that (as noted), and the social media companies whose valuations have troubled some pundits are simply not big enough to significantly affect wider market valuations (in marked contrast to the telecoms, media and technology craziness of 2000, for example). We have noted here how more esoteric valuation metrics such as long-term cyclically adjusted PE ratios (CAPEs) and Tobin’s Q, which suggest that stocks are more expensive, are flawed in measurement and, in the case of Q, design. Most of their statistical “explanatory” power comes from their stock price numerators, not their fancy denominators – a point that seems to have been lost on their advocates, who see their co-movement as an almost mystical indication of accuracy.
At some stage, then, our TAC may turn more tactically positive on developed stocks again (Continental Europe and the US remain our recommended overweights, and the UK and developed Asia ex-Japan are our underweights, though we expect each stock market to outperform its local bond market). The Committee seems more likely to continue to drag its heels over a similar move on EM stocks, despite their lower valuations, for reasons touched on above. We do, however, prefer EM stocks to EM bonds and currencies.
Developed bond markets are rallying as stock markets fall. A setback in stocks can itself be positive for bonds, inasmuch as it reflects a fading in risk appetite, and as noted above the near-term inflation news is good. However, we remain reluctant to chase higher bond prices, and stay tactically neutral (at a very low strategic weighting) on government bonds and underweight investment grade credit and emerging market bonds (as noted). If we are right, this is the wrong time to be turning positive on fixed income – which didn’t look attractively priced to us even when the 10-year US Treasury yield was back up at 3%, as it was a few short weeks back. We’d continue to focus on shorter-duration, euro-oriented bonds as offering the best insulation against what we think could be a long, grinding bear market for the asset class.
Finally, we remain tactically wary of commodities. Supply has been boosted by the high prices seen in the supercycle to date and China’s buying is becoming a little more considered. Our favourite sub-sector remains energy, particularly oil, and we continue to suspect that gold’s investment attractions are more likely to wane than wax in the context of the slow but steady monetary normalization that we expect.