History doesn’t repeat exactly, it rhymes: despite the parallels with the mid-1990s, we think the emerging world needn’t face crisis now. We also think it is still too soon to expect a renewed downturn in the developed world, not least because there have been few recent excesses needing correction. We still expect a slightly faster growing and more synchronised global economy in 2014 – and we think this favours stocks ahead of bonds.
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It’s not different this time – it’s different every time
We’ve noted here before how history is rhyming quite significantly in 2014. Exactly 20 years ago the Federal Reserve unexpectedly raised interest rates, triggering financial volatility in the developed world and the tequila crisis in the emerging bloc. The latter extended into a prolonged period of emerging market underperformance, and of course the traumatic Asian financial and economic crises of 1997.
The Fed now, as then, is slowly normalising monetary conditions after a prolonged period of lenience: no wonder people are nervous, and quick to extrapolate recent emerging market underperformance into a rerun of 1994-8. If history is going to repeat itself more exactly, then Figure 1 is telling us that emerging markets could underperform markedly further from here: we’re still little more than halfway down that long-term rollercoaster.
Investors fear another emerging market crisis
We have ourselves preferred developed to emerging markets for quite some time tactically, but it has been a closer call of late and we doubt that such a pessimistic outlook is warranted. For one thing, the Fed is proceeding slowly, and very transparently, in marked contrast to 1994, and some relative disappointment at least is priced in to emerging shares: Figure 1 shows that the underperformance this time began well before the monetary normalisation, and Figure 2, which plots relative valuations, is both less obviously cyclical, and closer to historical lows (lows that occurred after emerging market relative price performance had already begun to recover – Figure 1 again).
For sure, the current bout of emerging market nerves is not simply being driven by Fed tapering and the associated capital outflows that might accompany it. In several instances, extending beyond the so-called “fragile five” markets of Brazil, India, Indonesia, South Africa and Turkey, local political unrest and policy uncertainty has unsettled investors’ risk appetite.
Argentina, Egypt, Thailand, Ukraine and Venezuela are too small to have much direct impact on global markets, but investors hearing those historical echoes are aware of just how powerful emotional contagion can be. As a result, they are having an indirect effect, and not just on their immediate neighbours, though that is where contagion risks are greatest – most obviously perhaps in the case of the Ukraine and Russia, where troops are on standby. Many investors will remember the Russian government defaulting on some of its local currency bonds in 1998, albeit when oil prices were very low (that said, we think that much of Russian markets’ recent weakness has been driven by local concerns).
China ought not to be affected much by tapering concerns: it is not dependent on overseas finance, it has a current account surplus and capital controls, and its inflation is subdued. Nor are there any new signs of political strain visible domestically (the confrontation with Japan in the South China Sea is another matter, but not an emerging market one). Nonetheless, in the current climate, investors are unsettled by the slowing of growth indicated by recent survey data (Figure 3), and the shadow banking sector is tipped by many as the source of a financial accident. Concerns about China’s rapid credit growth are not new, however, and we still think that the slowdown is a manageable one. If anything, the policy statements from the Third Plenum of the Communist Party’s Central Committee in the autumn made us more, not less, confident that China will be able to transition to a more liberal economy, but the market is clearly still jittery.
We have taken advantage of New Year weakness to reinstate our tactical overweight in developed stocks
For Asia as a whole, the biggest emerging market bloc, economies are in better shape than in 1997: there are fewer exchange rate pegs to be stressed, marginal external funding is less important, and policies and balance sheets generally are more credible. We doubt that a full-blown economic crisis – driven by the retrenchment that could be triggered by a sharp withdrawal of funds – looms now. But, as noted, the historical echoes are most pronounced there, amplified of late by events in Thailand. In a recent roadshow, we found investors in Hong Kong and Singapore (two developed markets surrounded by emerging ones) and Indonesia uncharacteristically skeptical that emerging markets can do well in 2014. We are still not confident enough to translate our economic optimism into a tactically positive call on emerging markets as a whole, though we continue to note that, despite those nerves, investors seem to be becoming more selective and are increasingly differentiating. The dispersion of recent performance is larger than that seen in the initial taper-inspired setback in 2013.
The main news in the developed world during the last month has been the marked disappointment in economic data from the US. Two of our favourite economic indicators – the manufacturing ISM survey and retail sales – have fallen short of expectations, the former dramatically so (the new orders component – shown in Figure 3 – fell at its fastest since 1980). However, no indicator should be relied upon unthinkingly, and it looks as if the data has been affected to some extent by the severe weather that gripped much of the mid-west and eastern parts of the country. We know that recessions do sometimes fall upon us from a clear blue sky, but in our view there simply hasn’t been the sort of economic excess in the current cycle to warrant some sort of corrective retrenchment yet. The private sector’s financial balance – its free cashflow – remains well above historic averages, and we’ve written often about its healthy balance sheet position. All this means that we still expect to see the US economy grow by around 3% in 2014, its healthiest pace since 2005.
Meanwhile, in Continental Europe and the UK the economic data is broadly consistent with the more gradual recoveries expected. Perhaps only Japan stands out among the larger developed economies as having disappointed with no obvious alibi in sight. We have not been convinced by Abenomics, but the scale of the disappointment is not enough to affect the global economic picture, which remains one of slightly faster and more synchronised growth in 2014, with the big central banks on hold (see Figures 6 and 7 – the ECB is likely to ease a little further).
Bond markets have rallied in early 2014 (Figure 4) as the US economic data has disappointed and emerging market concerns have sapped investors’ risk appetite. Nonetheless, the Federal Reserve has indicated it will persist with its tapering of Quantitative Easing, and is confronting readings from a key economic indicator – the rate of unemployment – that are at levels that its own forward guidance had suggested would soon translate into higher short-term interest rates. We expect the Fed to rethink that guidance – as has the Bank of England, which finds itself in a similar position – as it is clear that the central bank does not yet want policy rates to rise. For us, the public rethink, and the ongoing taper, confirms that this is still not the most obvious phase of the business cycle to be chasing bonds.
Admittedly, inflation has been soft, particularly in Europe (including the UK, where inflation is back below target – and this is not a sentence I’ve written very often). But we doubt that deflation looms (even if it did, we’d be relatively relaxed about its implications for growth). As yet, the disinflation is not enough in our opinion to deliver a sustained reduction in bond yields, which to us look low in both real, and nominal, terms (Figure 5). Our wariness remains most focused on the US and UK markets, despite the improved near-term inflation outlook in the latter. The eurozone faces slower real and nominal growth, and its benchmark indices include Italian and Spanish bonds, which continue to trade pro-cyclically, since they are bonds that can benefit from faster economic growth (because investors worry more about their governments’ creditworthiness than about inflation: growth brings with it higher tax revenues and smaller deficits). Eurozone bonds may thus continue to outperform a weak global market.
If anything, after the recent rally, we would re-emphasise the importance of keeping the duration of fixed income holdings relatively short, and would keep an eye open for floating- rate opportunities, though we doubt that even the Bank of England will raise official policy rates this year.
Our strategic asset allocation advises a relatively low weighting in government bonds, and tactically we would not go lower. However, we have been tactically underweight investment grade credit, which looks expensive and is exposed to the modest re-leveraging of corporate balance sheets that may occur if merger and acquisition activity, dividend payouts, share buybacks and capital spending gather momentum as we expect.
Overall, we see the big economies growing reasonably healthily. Relative to trend, China remains a cyclical laggard. US order books have fallen sharply, but we think they have been hit by severe weather
Cash itself still looks unattractive in its own right: its real yield is negative across most of the developed world, and we doubt that short-term interest rates will rise soon. Despite this, we continue to advise an overweight position tactically, because we feel that some upturn in volatility is likely, even if only a modest amount, and a larger than usual cash holding will allow us to capitalise on this as risk assets sell off.
We have already done so in the case of developed stocks, where we reversed our mid-November decision to move down to neutral by going back overweight on 7 February, funding the move from that cash position (which fell back to overweight from strong overweight as a result). Developed stock markets are not especially expensive – the obvious excesses in some social media and other internet-related stocks are as yet small in comparison to the telecoms, media and technology (TMT) craziness of 2000 – and if we are right about the business cycle, profits are going to grow in 2014. They may not grow quite as quickly as analysts expect, but markets are not priced on those bottom-up forecasts and to us the profit growth in prospect (say 5-10% from the US, taking operating earnings per share on the S&P 500 to around $110-115) makes potential returns attractive. For the developed world index we see prices broadly moving in line with earnings growth, and, together with the dividend yield, this suggests a potential total return in the high single digits – a marked slowdown from 2013’s 27% in dollars, but a return that compares favourably with other assets, even after adjusting for risk. The US and continental Europe remain our two favourite markets, and developed Asia, excluding Japan, is our balancing underweight (we have moved the UK up to neutral, alongside Japan).
Emerging stocks are still less expensive than developed markets: indeed, they are trading at the largest discount to developed markets in terms of forward price-earnings (PE) ratios since May 2005. However, as noted above, we doubt that sentiment will stabilise imminently, and remain tactically neutral. We are more wary still of emerging market bonds, particularly those denominated in local currency, where we stay underweight (they are combined in our composite asset class with conventional high yield bonds, where we are neutral). Despite the increased differentiation visible in recent weeks, emerging currencies as a bloc may not settle until US bond yields have moved upwards more decisively, which might require 10-year Treasuries to break above the 3% that has proven a resistance level to date.