Proclamations of a “Great Rotation” from bonds to equities have been premature, and a setback in stock markets remains overdue. Nonetheless, on a medium and longer term view we still prefer corporate to government securities, and stocks to most bonds
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The cycle, an ECB safety net and valuations still favour stocks
In the last month several of the most widely-watched business surveys have slipped back a notch or two, but remain at historically respectable levels (Figure 1). Growth is modest, but seems likely to remain above stall speed, and economic recovery remains one of the central supports of our glass-half-full view of global capital markets. Indeed, we should arguably have stopped using the word “recovery” a year or two back, since in a little-noticed development, global GDP per capita likely pushed above its pre-crisis levels at some stage in 2010: the economic expansion is not just regaining lost ground, it has pushed firmly into new territory.
Figure 1: Cyclical indicators are in neutral: selected manufacturing surveys
Economic growth does not guarantee stock market performance, but it can help. At the very least, it usually underpins corporate profits, and is currently helping keep valuations at unremarkable levels, even as the biggest market – the US – has hit new all-time highs in the last month (Figures 2 and 3). And with most bonds continuing to trade above their par values, and at levels that leave them very sensitive to changes in interest rate expectations, the relative valuation of the two largest liquid asset classes continues, in our view, strongly to favour stocks over bonds.
In the short-term, calling the precise turning point (upwards) in bond yields is a mug’s game, and in the last few weeks the Bank of Japan has created a few more of those with its aggressive shift in monetary policy. Equally, a slowing in the pace of US and Chinese growth, geopolitical rumblings in the Korean peninsula, the continuing angst in the eurozone and even the calendar – sell in May and all that – all suggest possible triggers for an overdue setback in stocks. But on a medium-term view and beyond, we think a combination of the business cycle, the likely euro backstop provided by the ECB, and those relative valuations, all suggest that owning businesses will be a better risk-adjusted investment than lending to governments.
Figure 2: Not an attractive prospect: the S&P500 and its precursor, 1871 – to date
Figure 3: A different view: the S&P 500, dividends included, log scale, adjusted for inflation
The Eurobloc continues to languish – but who thought otherwise?
Business surveys suggest that the eurozone economy is flatlining at best, but this ought not to be a major surprise. Very gradually, we expect expanding world trade, and stabilising domestic spending, to start pulling GDP up in the second half of the year. With a trend rate of growth in the 1-2% region in normal circumstances a more dramatic rebound in the bloc is not on the cards. This needn’t prevent its stock markets from rallying and eventually outperforming again, as they did in 2012: if global risk appetite continues to revive, their volatility can make them attractive in a risk-on climate.
The euro itself remains central to that global risk on/off debate: an implosion or fragmentation of the single currency would be a seismic event globally, not just locally. As we have written here often, there can be no quick fix for the euro’s existential crisis, and ongoing political uncertainty in Italy, missed budgetary targets in Spain, slippage in public expenditure plans in Portugal, banking worries in Slovenia, and the French government’s political embarrassments, all point to possible renewed market volatility ahead.
That said, we think that in one respect at least the picture has cleared a little in the last month. The ambiguity surrounding the potential treatment of Euro area bank depositors has been reduced by Mr Draghi’s statements at the latest ECB press conference to the effect that the initial proposed treatment of depositors in Cyprus was indeed “not smart”, and that the subsequent proposal should not be seen as a template for the resolution of banking difficulties elsewhere. As we noted last month, in future financial crises the situation may be different, but it is extremely unlikely currently that Spanish or Italian depositors would be asked to contribute towards any further bank restructuring needed in the current crisis.
In the meantime, we now think the ECB is likely to trim official interest rates in response to the flatlining economy. More importantly, it remains willing and able to offer some financial backstopping for a member government that requests support in stabilizing its borrowing costs (conditional, of course, on that government following an adjustment programme). In fact, Spanish and Italian bond yields have fallen markedly in the last few weeks without any official assistance, while interbank tensions have been marked by their absence.
Figure 4: Italian and Spanish bond yields have fallen, while interbank spreads remain stable
The UK – don’t look back in anger
There has been little to cheer in the UK economy either, but again investors shouldn’t have been expecting there to be. The first quarter GDP data at least suggest that the economy is capable of growth in 2013, in contrast to the Eurobloc, albeit at a glacial pace. And in one respect, the last month has provided a valuable source of perspective. The policies pursued by Mrs. Thatcher’s administrations were divisive, but few of us would welcome a return to the economic landscape that she inherited: levels of inflation, unemployment, interest rates, nationalization and other controls and industrial unrest were routinely much higher then, and profitability lower, than currently. The same is true of course of many other developed economies, including the US (Figure 5).
Figure 5: Misery indices for the UK and the US, %
The relevance for today’s investors is twofold. Generally, it reminds us that while times are tough, they have been tougher in the not-so-distant past, something to be borne in mind (for example) when considering equity valuations: the lower stock market PEs seen in the 1970s were there for a reason. More specifically, the famously hawkish 1981 budget demonstrated that a policy of fiscal retrenchment, even in a difficult economic climate, need not push the economy into reverse.
The US: time for another double dip debate?
The growth debate in the US seems set to heat up again as the economic indicators point to a likely slowdown in the second quarter. The growth profile continues to be dogged by a vigorous inventory cycle. Having been run down sharply in the fourth quarter of 2012, partly on account of the hurricane that disrupted East Coast production, inventories were rebuilt in the first quarter of 2013, and helped push growth above trend. Having been rebuilt, they will now lose some momentum and slow growth in the current quarter – just as the effects of public spending sequestration make themselves more fully felt.
This slowing, like similar events in the last three years, may cause some commentators to proclaim (again) an imminent double dip in the economy, that is, a renewed recession. We think these worries would again be premature, and our view remains that the US will continue to expand, with growth driven largely by the domestic private sector. We have noted many times that US consumer balance sheets are in better shape than many fear, and a reviving housing market and a gradually-improving labour market are underpinning confidence and incomes. Meanwhile, corporate spending on fixed investment (as opposed to inventories) is also capable of making a more pronounced contribution to growth, and with most corporate borrowing costs below the dividends paid out on US stocks, companies have a financial incentive to flex their balance sheets a little more also. (See essay below.)
Asia and the emerging bloc
A slowing in China’s GDP data has unsettled the commodity markets, but we still doubt that a hard landing is imminent. A growth rate in the 7-8% region is broadly in line with the government’s medium-term goal, and would (of course) be viewed as an outright boom in most developed economies. There are unresolved issues to be addressed in China's development – for example, its real estate market is frothy (see essay below), its capital investment looks inefficient, its money markets are underdeveloped, there are concerns about the scale of local authority borrowing and about the “shadow banking” sector – but for the time being we see China continuing to contribute significantly to global economic growth. The weakness in gold prices in particular we think tells us more about misplaced expectations there than about the scale of China’s slowdown.
Japan’s stock market may be flying, but its economy continues to languish. The extra monetary easing promised by the new regime is certainly keeping the yen under pressure – and we expect it to weaken further – but it may not have much of an effect on the economy’s cyclical performance, let alone its structural malaise.
Outside China, several other emerging economy stories have disappointed of late, including Brazil and India, two other members of the high-profile BRIC quartet. We still think that the long-term case for structural economic growth is a compelling one, particularly in Asia, but there are more current account deficits in the bloc than there were supposed to be at this stage of the story, and the bloc is no longer the one-way bet that many have seen it as for the last decade or so. Its stock markets have now underperformed developed markets since early 2009.
Investment conclusion: avoid action
Growth may be anaemic, but it’s not at stall speed, nor likely to be. The euro’s existential angst is chronic, but containable. The latest results season is again showing US corporate profitability to be resilient, and reports of an imminent collapse in operating margins in particular look again to have been mistaken. But bonds are the assets which are trading expensively, and stocks – even after their rally – look much cheaper.
The Federal Reserve and now the Bank of Japan are of course supporting their respective bond markets with their direct purchases of bonds. The Bank of England may no longer be buying, but it could re-start its programme, and in the meantime is certainly not selling its current holdings. Even the ECB stands ready potentially to intervene in the secondary markets, and we wonder whether, if asked to do so, it would sterilise such intervention quite as fully and quickly as its statutes suggest it should. However, central bank buying in itself does not make a strong medium-term investment case for bonds (or foreign exchange – see essay below).
A setback for equities was overdue last month, and arguably still is. The issue as we see it is whether it will be deep or lengthy enough to warrant repositioning portfolios for: if as we suspect the primary trend in equity prices remains upwards, then selling out may leave us exposed to a sudden rebound of the sort seen often since early 2009. Again this month we think the potential opportunity costs of doing so are too high: we are avoiding action, leaving our tactical asset allocation intact (see section below) and in favour of developed equities (with cash and investment grade credit as the corresponding tactical underweights). Details, as usual, are shown on page 7.
Barclays’ key macroeconomic projections
Figure 6: Real GDP and Consumer Prices (% y-o-y)
Figure 7: Central Bank Policy Rates (%)