Autumnal themes

  • Written by 

    William Hobbs, September 2014

Five themes that will drive market activity as we head into the final stretch of 2014: diverging central bank policy in the US and Europe; a likely rally in European equities; sticking with US small- and mid-cap stocks; a focus on Asia in emerging markets; and using commodities as a hedge against geopolitical risk.

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Diverging central bank policy

As we have pointed out many times, fixed income yields across the developed world have fallen, despite a brightening outlook for the global economy, and have caught many market participants off guard. Government bond prices are rising in both the US and Europe, with US government bonds returning 6.5%, compared to 7.9% in US dollar (USD) terms1 for their European Union (EU) counterparts. In the former, yields have fallen less, causing the spread between the two to widen. (Figure 1)The yield spread between European and US government bonds will continue to expand, mainly driven by higher US yields and lower (or stable) EU yields.

US: path to higher yields

Factors pushing down US Treasury yields include: falling treasury supply, spiking geopolitical tension, and dovish statements from the Federal Reserve (Fed). These factors are unlikely to last for long, and downward pressure on yields should abate. There are many signals that suggest the US economy is on stronger footing. Second-quarter GDP showed that the economy grew at a solid 4.2% annualised rate. A detailed reading revealed that consumption and business spending, the key drivers of the economy, contributed 1.7% and 1.0%, respectively. More recent economic data, particularly on employment, gives reason for optimism. The July employment report showed a gain of 209,000 jobs, marking the sixth consecutive month in which payrolls have grown by more than 200,000. Also, the falling unemployment rate indicates that wage growth may be turning the corner.

Strong economic sentiment is prevalent in the Federal Open Market Committee (FOMC) minutes, as Fed officials acknowledged that progress is improving faster than previously expected for their inflation and labour market mandates. July’s post-meeting statement showed participants were hesitant to comment on labour market underutilisation. Chairwoman Janet Yellen delivered a neutral speech on labour market dynamics at Jackson Hole, reducing many investors’ dovish inclinations. The disconnect between solid economic fundamentals and interest rates is not sustainable. Fixed income markets begin to discount a change in the federal funds target rate well in advance of rate hikes.

EU: yields unlikely to rise materially from current levels

Euro zone and US inflation paths have been diverging since early this year, necessitating different policies from the European Central Bank (ECB) and the Fed. (Figure 2) In August, euro zone inflation fell to 0.3%, its weakest level in nearly five years. This raises concerns that the economy lacks the necessary momentum to bounce back from its weak growth. A policy error resulting in a deflationary spiral will likely further damage prospects both for return on and of capital. ECB President, Draghi showed his concerns about declining inflation during his Jackson Hole speech when he highlighted his preferred measure of inflation expectations, the 5-year, 5-year forward euro zone inflation swap rate, which fell below 2% in August. Due to lower inflation expectations, and recent weaker data out of Europe, the perceived probability of the ECB’s full-blown QE has increased. Many investors will be looking for central bank balance sheets to converge. (Figure 3) If this happens, it is highly likely to result in European government bond yields remaining at current levels, or dropping even further.

Figure 1: The spread between yields is elevated  Figure 2: Inflation rates are moving in opposite directions
The geopolitical landscape offers little hope for a de-escalation of tensions.

The arguments about the legality of a sovereign bond QE programme will be both numerous and loud as the ECB never has used this option. It’s important to note that should the ECB target sovereign bonds in its QE operations, it would not breach the treaties were the bonds purchased in the secondary market. A sovereign bond QE programme aimed at the periphery is likely to result in strong opposition from the Bundesbank, because it may undermine the Outright Monetary Transactions facility introduced in 2012, which remains unused.

As economic growth has slowed materially, the ECB has tweaked its June package conditions by progressing towards asset-backed securities (ABS) purchases and has started discussing sovereign bond QE.

So what?

Monetary divergence between the ECB and Fed presumably will push yields in different directions. US yields are set to rise on better economic growth prospects, and EU yields are likely to be limited by the ECB’s expansionary monetary policy and positive bond fund flows in the region. (Figure 4) European and US investors should sell their medium- and long-duration debt holdings, and purchase shorter-dated bonds or income-oriented stocks where possible.

Figure 3: Balance sheet divergence  Figure 4: Money is flowing into bond funds

A compelling case for European equities

A thawing credit market and significant earnings upside make Europe a risk worth taking. European equities are capable of outperforming the rest of the developed market in the second half of the year.

An anaemic European recovery has faltered recently, with Germany, previously the continent’s reliable engine, starting to splutter. Alongside this, the political backdrop in much of the region remains reliably chaotic: there is little cheer to be found in scrutinising France’s ailing economy, and the situation in eastern Ukraine remains precarious. In this context, investors are right to question the merit of taking investment risk in the region. European equities pulled back sharply over the summer, and there may be more to come. As interest rate increases loom larger in the US and UK, a global, albeit likely temporary, reduction in risk appetite could hit European stocks harder than they hit US or UK equities. Despite this, there are several reasons why now is a good time to add to European equities. We expect the region to outperform wider developed market equities over the next 6 to 12 months.

Economic backdrop

There is cause for unease regarding the European economy, and incoming data continues to provide scant reassurance. Nonetheless, there is no reason to see the Q2 pull back in German GDP as anything other than temporary payback for a very strong first quarter and some understandable corporate and investor angst regarding Russian President Vladimir Putin’s manoeuvring in the Ukraine. France’s problems may be harder to shift, but a new and more pro-business government may herald an inflection point. Meanwhile, the fortunes of the periphery remain mixed, but are considerably brighter than the dark days of 2012, when asphyxiate borrowing costs and rising unemployment forced many to question the euro’s very existence.

Importantly, employment in much of the periphery is now moving in the right direction, and its government bond yields are barely distinguishable from those of the core countries.

The latter indicates that investors no longer question the euro zone’s existence, just its future growth trajectory and inflation profile. We also are starting to see credit markets thaw in the region, and data shows that banks are more willing to lend, and customers more ready to borrow. The ECB’s targeted liquidity operation, due in September, alongside some catharsis from the end of the audit of European bank balance sheets, should further aid this thaw. Small- and medium-sized businesses (SMEs) will likely benefit most from this warmer credit backdrop. Much of this segment of the European economy has been starved of funding since the ability and appetite of banks to lend to the riskier areas of the market shrivelled in the wake of the euro crisis and a more demanding regulatory landscape. (Figure 5) With SMEs accounting for roughly two thirds of both jobs and value added within the EU, an easier credit environment will have important ramifications for both the wider economy and the more domestically focused small- and mid-cap sectors. All this, and the gradually solidifying prospects for more muscular measures from the ECB, involving asset backed securities (a move which would allow banks to lend to SMEs without drawing fire from the regulator), should help small companies.

Figure 5: Interest rate on loans  Figure 6: Global GDP and equity returns

European large-cap equities tend to dance to the tune of global GDP, a function of their diverse geographic revenue footprint. (Figure 6) With incoming data suggesting appreciably brighter prospects for the US economy through the end of the year, there is room for global GDP forecasts to move higher and provide a tailwind for large-cap European equities.

Politics and geopolitics

At the turn of the millennium, the American scholar, Robert Wright, suggested that in 1500 BC, around 600,000 autonomous governments existed; that number fell to 193 by the time he wrote his book, “Nonzero: The Logic of Human Destiny.” The implication is that mankind, with the many forces of globalisation at its back, is moving unevenly towards a single political (and even fiscal) authority.

This is a hotly contested view and, in the short term, is highly unlikely to be a one-way bet, although the European Union is one of the more successful recent examples of this trend. There is a long way to go before we see Europe speaking with a more unified voice. Nonetheless, we continue to see the euro remaining intact, driven by the weight of history and the lack of credible alternatives. There is, however, the potential for the openly separatist forces in Spain to gain momentum in the wake of National Day of Catalonia on 11 September and calling the twists and turns in eastern Ukraine remains hazardous. France’s political environment could become even less appealing. But the ECB’s proactive stance is likely to buy authorities time to construct a more convincing fiscal and political architecture necessary for the euro project to work.

Earnings upside

A large part of this story relates to the greater relative upside for European corporate earnings relative to their developed market peers. (Figure 7) This is a function of the banks’ plight, and the more geographically constrained mid- and small-cap universe. As both the European and global economies continue to improve, we likely will see European corporate earnings benefit. (Figure 8)

Figure 7: Earnings per share  Figure 8: Forward earnings growth

The case for European equities is finely balanced. Incoming economic data remains uninspiring at best, and the prospects for further sanctions against Russia are unlikely to be helpful. However, gradually thawing domestic credit markets, a process helped by the ECB’s various measures, alongside a brisker global economy, are among the reasons that suggest European equities remain attractive.

Sticking with US small- and mid-cap companies

After a stellar 2013, US small- and mid-cap stock performance has lagged this year. Stocks of all capitalisations had a rough start due to weaker Q1 US GDP and harsher-than-expected winter weather. However, since early April, large-cap stocks have performed considerably better than small- and medium-sized (smid) stocks, and this underperformance is not justified. Despite trading at a slight premium to their longer-term P/E multiples, several indicators point to smid outperformance into year end. The catalysts are: a confident US consumer, higher quality earnings growth, and the potential for increased mergers and acquisitions (M&A) activity.

A confident US consumer

After a weak first quarter, the US consumer has come roaring back. Retail sales have picked up, averaging 3.5% growth year-over-year in 2014. Even more positive, consumer confidence sits, at or near, post-recession peaks. (Figure 9) With the stock market at all-time highs, employment easier to find, and average hourly earnings growing at nearly 3% versus a year ago, the consumer has reason to be cheerful. Since small- and medium-sized enterprises are domestically oriented, a confident consumer is good for business, leading to higher revenues.

Figure 9: Consumer confidence is at, or near, post-recession highs  Figure 10: Large cap companies have been cutting costs more than smid cap companies

Higher-quality earnings

Sales figures for small- and medium-sized businesses show improving trends in US consumer spending. There is a stark contrast between the operating performance of smid- and large-cap companies. Since the end of the recession, large-cap companies have grown their earnings primarily by managing expenses, resulting in expanding margins. (Figure 10) Smid-cap companies have grown their revenues at a much faster pace. (Figure 11) Earnings driven by revenue are of higher quality than those driven by managing expenses.

Figure 11: Smid revenues are growing faster than large  Figure 12: CEO confidence is near post-recession highs

Increased M&A activity

Large-cap companies have struggled to generate organic top-line growth, yet they are sitting on historically high levels of cash. This cash is earning nothing. What has kept CEOs from putting this cash to work? Throughout the recovery, CEOs of large-cap companies have had trouble sustaining confidence. There has been no shortage of concerns, whether it was apprehension about the US consumer, a downgrade of the US credit rating, political debates in Washington, recurring sovereign debt crises in Europe, or rising geopolitical tension. However, these concerns have receded recently, and CEO confidence has trended near post-recession peaks. (Figure 12) Higher confidence has facilitated an increase in M&A activity this year. If the current pace is maintained, annual deal volume this year will exceed prior highs. When large-cap companies acquire smid-cap companies, they often pay a premium above current stock prices. The demand from large-cap companies seeking to ‘buy growth’, rather than generate it internally, should fuel further gains.

Sticking with SMID

Although smid-cap valuations appear rich, the catalysts to drive stock performance higher are intact2: US economic growth is set to accelerate into year-end, and small- and medium-sized businesses will benefit directly from a pick up in consumer spending, resulting in continued strong revenue growth. If CEO confidence remains at current levels, M&A activity likely will remain elevated into year-end. We are taking advantage of the recent underperformance to initiate a positive call on SMID over large cap for the reasons listed above.

Emerging markets: a tale of two regions

Emerging Markets (EM) equities underperformed their developed counterparts over the last four years as overstated earnings and growth expectations faltered under the weight of a synchronised regional slowdown. However, in February this year, the asset class reached an inflection point. The broad EM equity index has since rallied by almost 19%3, with much of this performance attributed to two regions: Asia and Latin America (LatAm).

Strikingly, the rebound has unfolded in spite of geopolitical headwinds, relatively passive global trade, and the looming prospect of monetary normalisation in advanced economies. Although low levels of risk aversion and positive election results have supported capital flows, the recent trend may indicate that the negative sentiment towards emerging economies is dissipating, and investors are, once again, looking to differentiate between the EM regions. Tighter monetary conditions in the US may result in challenging times ahead for these markets, but accounting for this – as well as for regional fundamentals and valuations – equities in EM Asia should outperform those in LatAm over the medium term.

Will higher US interest rates have a negative impact on EM equities?

The stream of positive data from the US suggests that the first rate hike is likely to occur in the first half of 2015 – sooner than markets anticipate. The pricing in of this event could see some downside for EM equities; although any setback is likely to be less prolific than the taper tantrum in 2013, given that much of the hot money has fled. Instead, many commentators overlook that normalisation of US monetary policy sends two signals to the emerging markets: (a) the outlook for external demand is improving, and (b) global liquidity conditions are tightening. Although the two factors tend to affect EM equities in conflicting ways, adverse effects of the latter are likely to be limited for the following reasons:

1. Rising US yields at low levels have not previously weighed on EM equities In the Fed’s previous three tightening cycles, the pace of domestic growth strengthened, warranting a less accommodative monetary backdrop that drove US yields higher. But any difficulties for EM equities were short-lived, and swiftly followed by an extended period of outperformance. In a low interest rate environment, equities in Asia and LatAm move in line with rising US yields, implying that a stronger US economy is a more potent driver of EM equity performance. (Figure 13) Gradual and limited rate hikes, coupled with the Fed’s forward guidance policy, have given markets ample time to prepare for such moves. This will make the impact of the next Fed tightening cycle historically unique.

2. The risk of contagion in emerging markets is lower Countries such as Turkey and South Africa – that rely on short-term external financing to fund current account imbalances – are vulnerable to higher global interest rates. However, intra-EM correlations have dropped since the end of last year (Figure 14), suggesting that country-specific factors have become more important relative to systemic drivers. Therefore, widespread contagion stemming from the downturn of a particular EM country (akin to Mexico’s default during the 1994 Fed tightening cycle) likely will be muted. The lack of substantial spillover from recent geopolitical tensions demonstrates how EM countries – with no direct trade links – can remain isolated from idiosyncratic risks.

Figure 13: EM equity returns and changes in US yields  Figure 14: EM correlations have fallen to pre-crisis levels

Although the focus for EM equities has centred on the aggregate impact of the first Fed rate hike, the medium-term prospects should be focused primarily on the situation within the emerging economies. As the recovery in the developed world takes off, the outlook for EM equities will be dictated largely by global growth and trade dynamics, rather than by higher interest rates, with varying impact across the regions.

Economic fundamentals and equity valuations favour EM Asia

A gradual Fed tightening programme – modest enough not to thwart the momentum of US growth – would benefit those Asian economies with close manufacturing links to US consumers and businesses. Moreover, cheap valuations, in a global equity market that offers few such opportunities, add to the appeal of Asian stocks. Despite the recent rally, equities in EM Asia, on average, trade at a 30% discount to those in the US.4

For LatAm, the task of revitalising growth via structural reforms requires an allocation of resources that will take time to filter through to headline output. This is a key problem for the region. Brazil, for example, needs a policy regime change to turn around a faltering growth and current account outlook. Demand for commodities, which boomed during the last Fed tightening cycle in 2004, is unlikely to provide support for the region’s commodity exporters this time around, given China’s attempts to shift its economy from a commodity-intensive, investment-led growth model to one that is more consumption orientated.

Instead, the shift in sentiment towards Chinese growth – from hard landing concerns to signs of stabilisation – is likely to have a positive spillover effect on surrounding countries. The manufacturing-intensive Asian economies are poised to recouple with the growing developed world. Forward-looking indicators are starting to evidence this: export orders in Asian countries with a higher share of manufacturing exports have risen relative to those in the commodity-exporting LatAm countries. Greater export growth will provide a welcome boost to employment, incomes, and domestic demand in emerging Asia. Likewise, favourable current accounts have helped sustain growth amid the recent EM slowdown (Figure 15), and lower external financing requirements and greater foreign exchange reserves will ensure that these economies are insulated from material capital flight as global liquidity becomes more expensive.

As the macroeconomic backdrop improves and export growth regains momentum, companies in EM Asia should begin to deliver higher profits. This theme is playing out: first-quarter earnings in Taiwan came in stronger than expected, and earnings in Korea show signs of bottoming out. Positive reform stories in Mexico, India, and the Philippines have resulted in greater returns for domestic equity markets, with new policies set to benefit both economic growth and corporate earnings over time.

Figure 15: Resilient growth for those with stronger trade  Figure 16: EM LatAm valuations look relatively stretched

Within the emerging market landscape, equity valuations for Asia remain attractive on both an absolute and relative basis. (Figure 16) LatAm equity prices, and multiples, have surged in a manner that seems irreconcilable with the structural weakness facing many of the region’s economies. Only a rebound in earnings growth can justify these rich valuations, the drivers for which we do not foresee in the near term.

Look within emerging markets for regional divergences

The emerging world can no longer be characterised as one monolithic market. Although EM equities, broadly speaking, performed well in the second quarter, sustained outperformance largely will be dependent on the regional drivers for growth. The economies of emerging Asia are well positioned to withstand the gradual tightening of global financial conditions, as cyclical demand for exports bounces back alongside the recovery in advanced economies. For LatAm equities, a more constructive outlook requires, inter alia, an improved regulatory environment for domestic businesses to prosper. This likely will take time, and in the absence of any material demand from emerging market commodity-importers, economic growth in this region is likely to remain subdued. With the need for differentiation, Asia continues to be our preferred region for EM equities.

The case for commodities

Diversification is key
Over the past decade, the diversified returns achieved across commodities have led investors to supplement their portfolios with the asset class. (Figure 17) Given the diverse drivers for each commodity segment, there may be opportunities to allocate funds tactically based on market conditions. There are a few illustrations of this in 2014.

Figure 17: Commodity Returns

The year began with inhospitable weather conditions for crop growth. Constrained supplies led to a 22.3% price increase for agricultural commodities through early May. Warmer temperatures have since reversed this trend, resulting in a 5% year-to-date price decline for these assets. Meanwhile, mounting tensions in the Ukraine, the Middle East, and Iraq in June attracted capital to crisis assets, such as oil and precious metals, driving prices up 3.2% and 8.6%, respectively. Finally, industrial metals, which stumbled during the first quarter US contraction, have benefitted from the surge in second quarter activity.

Collectively, commodities can operate well within a diversified portfolio due to their low correlations with other asset classes, as well as each other. (Figure 18) Maintaining a small commodity exposure could reduce the overall volatility of the portfolio, and act as a hedge against geopolitical hazard.

Figure 18: Commodity correlations with equities and fixed income

Growth drives commodities, but near-term caution is warranted

Economic growth is forecast to pick up across both developed and emerging markets this year. This typically bodes well for commodities because of increased demand. The correlation between GDP and commodities is illustrated in Figure 19. However, the risks associated with the transition to normalised interest rates in the US justify an underweight to the asset class.

The US economy is accelerating, and the Fed is taking notice. Recent FOMC minutes acknowledged better-than-expected progress on inflation and unemployment targets, which implies that an increase in interest rates is on the horizon. Rising rates create an opportunity cost to holding commodities in the form of storage fees. This reduces the asset class’s attractiveness relative to stocks and bonds, which compensate their holders with dividend or interest payments.

Figure 19: GDP effects on commodities and inflation

The US economy is accelerating, and the Fed is taking notice. Recent FOMC minutes acknowledged better-than-expected progress on inflation and unemployment targets, which implies that an increase in interest rates is on the horizon. Rising rates create an opportunity cost to holding commodities in the form of storage fees. This reduces the asset class’s attractiveness relative to stocks and bonds, which compensate their holders with dividend or interest payments.

Underweight, but not zero

We remain underweight commodities, given the prospect of rising interest rates and the conclusion of QE in the US, both of which could be headwinds for the asset class. However, maintaining a small exposure to commodities is still valuable to diversify or hedge against geopolitical uncertainty.

An actively managed collection of commodities is our favoured course of action. Global tensions throughout many key oil- and gas-producing regions provide opportunities within energy and precious metals. Any threat to oil and gas transportation routes will boost energy products, while other asset classes likely will struggle. Gold also tends to rally during tense times, since investors see it as a safe haven to protect their capital. These spikes generally are unpredictable, making it beneficial to hold a small amount of gold in a portfolio as a hedge against geopolitical risk.