- After forecasting four interest rate rises in 2016, the US Fed has backpedalled, and have not raised rates so far this year. Weakness in the global economy, the risk of a hard landing in China, Brexit fallout worries and domestic uncertainties have all provided good excuses for the Fed to sit on its hands since last December’s initial US interest rate rise.
- The US Fed has telegraphed a December 2016 rate rise is on the cards as the US economy is currently performing reasonably. It is close to full employment and approaching the 2% inflation target. International uncertainties also appear to have eased over the past few months.
- Both Japan and the Eurozone appear to have reached a point where quantitative easing (QE) may be doing more harm than good. In both cases, central-bank bond purchases have resulted in flatter yield curves.
- We are sticking to a more defensive investment playbook given our view that we are late in the US economic cycle. While there are no alarm bells ringing yet that suggest a US/ Global recession is imminent, an aggregate composite of indicators shows the US economy is the most vulnerable to an exogenous shock since the expansion began 7 years ago.
- Emerging market economies appear to have stabilised as the $USD has stopped appreciating against their currencies in 2016.
- While China has embarked on a stimulus program in 2016, we remain of the view that it is in a terminal structural slowdown.
- Today’s macro backdrop, which includes high PE ratio’s on stocks and low yields on bonds appears an extremely challenging one for investors.
- The Australian economy has remained resilient as the easing of monetary policy has supported jobs and economic activity in Australia. While growth and inflation remain low, wage growth has recently shown signs of stabilisation. If this proves sustainable we have likely seen the bottom of the interest rate cycle in Australia.
Consequences for asset allocation and Portfolio construction
- Our base case remains not for any global recession or crisis in 2016 or the first half of 2017, but for moderate growth in Australia and the US, accelerating growth in Japan and for China and Emerging markets to continue to slow.
- Today’s macro backdrop – which includes high P/E ratios on stocks and low yields on bonds – appears an extremely challenging one for investors looking for outsized returns in public markets.
- We find it difficult to believe how traditional pension funds and individual investors are going to meet their historical return targets in a world when $9.9 trillion of liquid fixed income instruments now have a negative yield.
- For Global stocks, we too forecast more modest returns than in the past. This more modest outlook is largely predicated on our view that multiples will contract after the 51% increase they have enjoyed since the market bottom in March 2009.
- Assuming the global environment remains stable, we believe that there is reason for optimism regarding the outlook for Australian assets over the medium term (Sydney and Melbourne residential property aside).
- This difficult environment does not mean profitable investments can’t be made, but that being patient and buying in periods of dislocation, incorporating alternative strategies, Private equity and seeking illiquidity premium will likely be required to achieve satisfactory long term results.
In our most recent update in March 2016, we argued the fear that markets experienced in January was overdone and that a global recession was unlikely in 2016. Six months later, little has changed and we believe a cautious approach to portfolio construction continues to be warranted.
The big development over the year we did not expect has been that the US Federal Reserve has not yet raised rates in 2016. This lack of tightening has meant the U.S. dollar has not appreciated over the year to date which has relieved pressure on emerging market economies. In its recent communications the Fed now appears to openly acknowledge that ongoing dollar strength could tighten global financial conditions towards an uncomfortable level. In essence, it appears that it has expanded its criteria for monetary policy changes to include not only domestic growth and inflation but also a multitude of foreign risks, China and Brexit in particular. It seems the Fed is now more concerned about the risk of global deflation, and a flat to weaker dollar helps the reflation trade by putting an implicit bid into commodity prices. Weather this persists into 2017 as inflation approaches their 2% target remains to be seen.
Our view remains that we are still in a tricky global investment environment. Our indicators still point to the notion that we are later in the US economic cycle, volatility is headed higher, growth versus value valuation divergence is extremely wide, and profit margins/returns on capital have peaked in the US. We feel better today than in January that the U.S. dollar will not restrict financial conditions as much as it has in recent years, but we remain increasingly concerned about the diminishing impact of monetary stimulus on economies around the world.
Meanwhile, equity valuations appear full in many instances, and we see limited expansion for price-to-earnings ratios from current levels. Even with relatively generous assumptions, our five-year forward expectation for Global Equities is mid to high single digit. The rise of populism in Europe, the U.S, and China looks like it will complicate the reforms needed to spur economic growth (tax reforms, sustainable pensions, focus on productivity). Instead, we see proposals to restrict trade, immigration and anti-business regulation and rhetoric. This viewpoint is important because it suggests a higher risk premium is now required to compensate for outcomes that support the politics of blame at the expense of the politics of growth.
Our view remains that we are living in a slower growth, low inflation world where economic “lift-off” speed is hard to achieve. Thus far in 2016, we see nothing in the macro data that suggests we should change our view. Financial assets with predictable cash flows now appear to be overpriced in many instances. On the other hand, more cyclical stories that lack EPS visibility now seem to be trading at a discount, particularly in unloved sectors of the market. Despite the negative overhang of Brexit, which should have near term consequences for Europe and the UK, we still think a US Recession is a little while off.
Investors should continue to expect a lower returns across most asset classes. We believe because of global QE and ultra low interest rates – many asset price returns have been pulled forward amidst below average volatility, as central banks have driven yields down to record lows. This is particularly so for long duration assets such as Bonds, Property and Infrastructure. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:
- First, with $9.9 trillion in negative yielding bonds, we think that there are now diminishing returns to QE at this point in the cycle;
- Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked and may actually be declining in many instances.
From 2000-2010 an investor profited handsomely by being long China Growth (Materials, Energy and Industrials) at the expense of growth-oriented stocks and certain defensive stocks. From 2010-2015, doing almost the exact opposite produced rewarding results. Today, we see a world where growth and defensive investments appear quite expensive, but we are not yet certain that all “value” parts of the market fully reflect some of the structural caution we feel about China’s slowdown and/or the difficult position that many large global financial institutions now face. As such, we think a more balanced and diversified approach is required.
We continue to look for ways to mitigate risks in portfolio construction as the US economic expansion ages. In our opinion, when volatility is increasing and correlations are doing funny things, despite a short term low return, there is no substitute for Cash as an asset class. Meanwhile, we also think having some hedges makes sense. For most long term investors the use of alternatives such as Long/ Short, Market Neutral, Global Macro and CTA strategies are the most effective way of implementing this.
Overall, the key recent structural story for the U.S. remains intact—namely, resilient consumer and government spending is offsetting the hit to the more cyclical parts of the economy from the energy bust and the strong dollar. GDP in 2016 looks like it will finish between 1.8 and 2.0%, and we continue to see little scope for an upside break-out to growth. While the U.S. growth outlook remains muted, one thing that has been moving up of late is the inflation outlook. We now see U.S. CPI inflation coming in at 1.5% in 2016. As we move closer to the Feds 2% target in 2017 we believe the case to raise interest rates will become more convincing.
At the September FOMC meeting the Committee statement focused on the labour market. While the unemployment rate has remained steady, Chair Yellen emphasized that more people have entered the job market and the labour market has continued to strengthen, though she did acknowledge that growth thus far in 2016 has been less robust than in 2015. Current job growth may be enough to absorb new entrants into the market, but it certainly isn’t enough to also provide jobs for those with part time jobs who want full time work. Chair Yellen also stated that economic growth had picked up from the “modest” pace of the first half of the year. The last three quarters saw GDP growth that never exceeded 1.1%; and while consumer spending was strong in July, subsequent data suggest some moderation may be afoot. Household income did improve according to the latest data release, but information from the Fed’s own Beige Book suggests that growth is still not robust. Furthermore, business investment, the engine of job growth, has stagnated. Additionally, the Chicago Fed’s national business index and its four key components all declined in August. This performance is reflected in the significant markdown in the Committee’s Summary of Economic Projections (SEP) for the second half of the year as compared with its June forecast. Finally, the Committee noted that inflation is still running below target, a shortfall again partially rationalized away as being a transitory result of the lasting decline in energy prices. But this, too, is a stretch, since energy prices have remained relatively flat for the past three months.
Looking forward, the Committee’s SEP projections appear to be contradictory. For example, both in 2015 and this year, projected GDP growth has been continually marked down for both 2016 and 2017. Q4 growth implied by the forecast is not much above 2%. This pattern, combined with a largely unchanged unemployment situation and an inflation forecast that hovers below target through 2019, makes it hard to rationalize the Committee’s stated view that inflation will be pushed back towards target in a meaningful way. For demand to hold, there must be a resurgence in wages growth that will eventually drive up prices.
So while the Committee is increasingly concerned about the need to restore policy to a more normal stance, it is struggling to understand what the neutral interest rate is or should be. That struggle has been apparent in the public statements by several Reserve Bank presidents and board members. It was heightened by the three dissents at Septembers meeting. Chair Yellen was questioned about the dissents, and she rightly pointed out that the divergence of views was a positive indication that there was a healthy exchange of views during the meeting, and that it helped to avoid “group think.” So, while the Committee may want to begin restoring interest rates to a more normal level, in the face of ongoing uncertainty, it decided to wait a bit longer before acting.
US Corporate Earnings have been at or near a peak since 2013 with S&P 500 operating results ranging between $100–$116/share through that time. Stock prices are up 27% over that time because the pull of lower interest rates has been stronger than stagnant earnings. The US Treasury 10-year note yielded 2.75% three years ago; now, it yields 1.70%. While markets ended June with a Brexit swoon, the world didn’t end, and global central banks responded, so markets recovered in July and August. The force of thinking lower interest rates for longer prevailed over earnings stagnation and tepid growth.
S&P 500 Monthly Index
In September this tug of war has gained volatility. Central banks and interest rates are still the driving force in markets at present. But there is a growing consensus the Fed is on the edge of their effectiveness and there is a risk that ultra low interest rates are causing systemic damage to Pension Funds and savers. Meanwhile, earnings are still flat and inflation and growth are both low. In this environment current earnings and valuation metrics make it difficult for us to get excited about adding new capital to US equities at the present time.
In Europe, we are now expecting growth of 1.3% in 2016, down from 1.9% at the start of the year. We believe there will be a material hit to growth from the Brexit vote, which we believe will cut overall European GDP growth in half over the coming six months (from 40 basis points growth per quarter in 3Q16 and 4Q16 to under 20 basis points). Although the situation remains fluid, our big concern is that the European Union has a strong incentive to play tough with the U.K., meaning this situation may get worse before improving.
We believe that Brexit is an event with significant consequences for the European economy that will only become fully apparent with the passage of time. In our view the recent vote in the United Kingdom was really a referendum on important socioeconomic issues, including immigration, trade, and productivity. As such, we would argue that this shock will be measured in years, not in months or days as was the Lehman crisis in 2008, or even Grexit in 2011. Lehman involved a real and present danger to the global financial architecture, while Grexit introduced FX redenomination risk into an undercapitalized European banking system. We see the U.K.’s recent decision to exit the European Union as a significant and durable challenge to democracies around the world, but not something that will ultimately prevent investors from deploying capital in the region over time. In fact, we are likely to see some interesting opportunities amidst the dislocation and reorganizations that are bound to occur as many corporations, multinationals in particular, adapt to the new environment. We wait patiently for investment opportunities, but think much water needs to pass under the bridge before we would be comfortable investing in Europe yet.
Interestingly, even prior to Brexit, several macro variables across Europe began deteriorating. First is the strength of the euro, which has shifted from being a 10% tailwind at the start of the year to a two to five percent headwind throughout the first half of 2016. Without question, the euro’s sudden reversal was a big part of Europe’s dismal first quarter earnings season. Just consider that in the first quarter of 2016, 20% of companies missed their revenue estimates, the worst revenue miss in 10 quarters. Second, European regulators have punished banks beyond what most commentators expected to see – often with painful side effects. In fact, it looks like the regulatory tightening has effectively offset European Central Bank (ECB) accommodation, so that financial conditions in the Eurozone are worse now than they were at the start of the year, despite substantial further easing from the ECB. Thirdly, the European residential construction sector appears to be slowing.
In terms of inflation, we are now expecting just 10 basis points of inflation for 2016, compared to a 1.0% expectation at the beginning of the year. This reflects our expectation of weaker demand following Brexit. In addition, oil remains a major headwind to inflation, and is down 20% year-over-year in euro terms. Moreover, we note that each of the four major inflation sub-categories, including food, alcohol & tobacco, energy, services, and non-energy industrial goods, has either deteriorated or stood still, in year-over-year terms, since December 2015.
Even before Brexit, four of five key GDP drivers had turned less supportive
Data as at June 5, 2016. Source: Bloomberg, Eurostat. Eurozone residential permits are indexed to 2010=100. The Bloomberg Financial Conditions Index is indexed so that zero is the divide between accommodative and contractionary conditions.
While we remain concerned about the short to medium-term outlook for China, we do not believe that China is about to have a financial crisis or experience a hard economic landing. China’s rapid economic growth in recent years has been unsustainable and when demand for Chinese manufacturing exports deteriorated in the global financial crisis (GFC), China launched the largest credit stimulus in history, fuelling an investment boom that continues today. From 2008-2013, China’s state owned banks issued new credit of US$10 trillion, equivalent to the entire US banking system. Although credit growth has slowed, it continues to grow at 15% per annum. The problem is that GDP benefits from new loans have fallen from around 75 cents per dollar of loan to just 20 cents. Currently, it is estimated that $1.3 trillion in corporate loans are owed by Chinese companies whose profits aren’t sufficient to cover interest payments, which suggests potential bank losses of around 7% of GDP (excluding shadow banking exposures).
Almost half of China’s credit growth since the GFC (or around 50% of GDP) may have gone towards financing property market activity. There appears to be approximately four years of excess housing supply in China, comparable to recent property booms in the US, Spain and Ireland. According to the China Household Finance Survey, 22% of urban housing in China is vacant. Meanwhile, vacant floor space on developers’ books has increased by around 500% since 2007. Property prices are growing rapidly in Tier 1 cities with supply shortages, but are stagnant or falling in lower-tier cities where most of the excess supply is located. The potential implications of China’s property oversupply are serious, with real estate and related industries accounting for 20-25% of China’s GDP. Fiscal positions are vulnerable, particularly for local governments who have relied on land sales for 35- 40% of revenues. A large contraction in China’s property construction sector would cause a major slowdown in the economy and perhaps even a recession. Although economic data out of China is problematic, a range of indicators suggest that China’s economy is slowing as the housing oversupply problem broadens. Weakness is most apparent in the industrial space (41% of GDP), a large portion of which is linked to property. Cement production contracted by 2% per annum from 2013 to 2015, compared to 11% growth per annum in the decade prior. Steel production, electricity production and freight traffic have all slowed materially, growing at just 1-2% per annum in the past two years.
Although industrial sector data showed signs of improvement in early 2016, we believe this is due to a temporary credit stimulus by the Chinese government. Real trade data also shows that imports have slowed materially, while exports are contracting. Since 2010, China has contributed around a quarter of total global economic growth, despite its economy only representing around 12% of world GDP. We are cautious about adverse knock-on effects, including currency movements, linked to changing economic fortunes in China. A number of commodity exporters such as Russia, Brazil, Australia and Canada have experienced material depreciations in their currencies against the US dollar as commodity prices have fallen. Asian economies with strong trade and financial linkages to China could also be at risk. The outlook for the Chinese renminbi, which has appreciated around 50% on a real trade-weighted basis since 2005, is uncertain and difficult to predict. While modest RMB depreciation is likely over time to partially offset rising wages, a large devaluation is less likely.
In early 2016, China introduced new and tighter capital controls that appear to have stemmed outflows, at least for the time being. Chinese policymakers must carefully manage the credit and property excesses in its economy. If China moves too quickly to address the moral hazard and implicit government guarantees in its financial system, this could lead to a tightening of credit conditions and a pullback in loan demand from the private sector, triggering an economic downturn and possibly a panic in the poorly regulated shadow banking system. On the other hand, if credit stimulus continues unchecked or is ramped up to maintain GDP growth rates, returns to new credit may diminish further and result in material loan losses in the future. The Chinese leadership appear to be aware of the problems and have the policy tools needed to stabilise the economy; this makes a financial crisis unlikely. Fortunately, most of China’s debt is held domestically, which makes it easier for the government to manage large-scale defaults, as it did in the late 1990s. Further monetary stimulus will almost certainly be deployed to reduce interest burdens and ease banks’ reserve requirements. Meanwhile, a huge pool of foreign exchange reserves and a large current account surplus make China resilient to external financial shocks.
China’s GDP growth will rise and fall with stimulus, but the structural trend is downward sloping
`Data as at March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics.
It is well known Japan has been suffering from weak economic growth for the past two decades, along with stubborn deflation, ever-rising government debt, and an ageing and declining population. The BOJ has pursued quantitative easing, first during 2003–2006 and then on a much more massive scale since April 2013. This past January the BOJ announced it would supplement its QE program by setting a negative policy interest rate. These policies have clearly lowered interest rates and pumped enormous liquidity into the Japanese economy. However, spending by consumers and businesses has remained sluggish, and there has been no progress toward the BOJ’s objective of 2% inflation.
In September the BOJ announced a major resetting of its monetary policy, based on a “comprehensive assessment of the developments in economic activity” under its policy of “quantitative and qualitative monetary easing (QQE)” together with “negative (policy) interest rate” and a “price stability target of 2%.” The revamped policy is called “QQE with Yield Curve Control” and is combined with an “‘inflation-overshooting commitment’ in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2% and stays above the target in a stable manner.” These are very significant changes.
The yield curve control policy means the BOJ is now going to focus on the yield curve and, more specifically, target the yield on 10-year Japanese government bonds (JGBs) “so that 10-year JGB yields will remain more or less at the current level (around zero percent).” These changes towards rate targeting and increased flexibility in the Bank’s quantitative easing should dampen the debate about the possibility of the Bank running out of assets to buy and should address concerns about the excessive flattening of the yield curve and the adverse effects of the negative policy interest rate on banks and pension funds. The change in the inflation policy target to one of overshooting the 2% rate “in a stable manner” is clearly a dovish move, signalling to markets the strength of the BOJ’s commitment to press ahead with all means at its disposal to counter deflationary tendencies and achieve its price stability objective. This implies that monetary base expansion will be continued indefinitely.
We consider this policy revamp by the Bank of Japan to be positive for the Japanese economy and its asset markets. The Bank’s targeting of the 10-year bond rate while increasing the flexibility of its quantitative easing and maintaining its negative policy interest rate is clearly a move into uncharted waters. BOJ Governor Haruhiko Kuroda stated that controlling the yield curve is “quite doable.” It will likely be a challenge. There is no immediate increase in monetary policy stimulus from the policy reset. The changes should, however, reduce the negative effects of the Bank’s policy and make it more sustainable and easier to expand in the future. The new inflation target should give a needed boost to inflation expectations. These developments may eventually lead to some easing in the exchange rate for the yen, although the expected steepening of the yield curve and the US Fed’s delay in raising rates could work against yen depreciation.
Ever since the mining boom ended several years ago it seems the Australian Economy has been stuck in a slow grind. Unemployment at 5.7% and labour underutilisation at over 14% are higher than the Government would like and the Sydney and Melbourne property markets appear too hot. We are likely to see an oversupply of apartments in the next year or two and household debt levels are very high by international standards. This is cause for some concern.
As the biggest boom in our history has ended, it has hit our investment and national income. Given these events the $A is arguably still too high. Profits of listed companies fell around 7% over the last financial year. The RBA believe wage growth and inflation are still too low for comfort. The recent Election has not provided policy certainty, with a difficult Senate and no political ability to control the budget and undertake hard economic reforms.
Despite the highly publicised difficulties, there are some causes for optimisim that the worst may be behind us. First, economic growth is pretty good with the economy expanding 3.1% over the year to the March quarter and looking similar for the June quarter. This is in line with Australia’s long term average. It’s also way above most other advanced countries.
It appears the economy has successfully rebalanced. The slump in mining investment and national income due to the collapse in our export prices has been offset by a surge in housing construction, solid consumer spending, a pick-up in services exports and a surge in resource export volumes.
Source: ABS, AMP Capital
As a result of all this, post mining boom weakness in WA & NT is being offset by strength in NSW and Victoria as the much talked about two speed economy of several years ago has just reversed.
State of the States, annual % change to latest
Source: ABS, CoreLogic, AMP Capital
The worst of the slump in commodity prices and mining investment looks to be behind us. After sharp falls from their highs around the turn of the decade global prices for iron ore, metals and energy have stabilised as greater balance has started to return to commodity markets and the $US has stopped surging higher. While a new commodity price boom is a long way away the stabilisation should help our terms of trade and national income.
After falling for three years from a peak of 7% of GDP, mining investment intentions indicate that mining investment will have fallen back to around its long term norm of around 1-2% of GDP by mid next year. Reflecting the slump in mining investment, engineering construction has now fallen back to near its long term trend indicating that the wind down in the mining investment boom is almost complete and that it will be less of a drag on growth next year. This is important because the slump in mining investment has been knocking 0.5 to 1 percentage points off annual GDP growth over the last three years.
Source: ABS, AMP Capital
Public infrastructure investment is also ramping up strongly. This is partly driven by former Federal Treasurer Joe Hockey’s Asset Recycling Initiative that is seeing new state infrastructure spending, particularly in NSW and the ACT, financed from the privatisation of existing public assets. The upshot of a fading growth drag from mining investment and rising public capital spending is that it will offset the inevitable slowing in housing construction that we will see next year.
On the share market, profits have likely bottomed. 2015-16 was not great for listed company profits with earnings per share down around 8% driven by a 47% slump in resources profits and a 4% fall in bank profits. But it is notable that 62% of companies have seen their profits rise on a year ago and the typical or median company has seen profit growth of around 4%. While aggregate dividends fell 10% mainly due to a cut in resources company dividends, 86% of companies actually increased or maintained their dividends indicating that the median company is doing okay.
Source: AMP Capital
Overall profits are on track to return to growth in 2016-17 as the slump in resources profits reverses (thanks to higher commodity prices, cost and supply controls) and non-resource stocks see growth. 2016-17 earnings growth is expected to be around 8%.
Source: AMP Capital
The bottom line is that the recession many said was inevitable as a result of the mining bust hasn’t happened.
ANZ Bank (September 2016)
Cumberland Advisors, (September 2016)
Bank of America/ Meryl Lynch (September 2016)
Magellan Financial Group (August 2016)
Lazard asset management (August 2016)
PIMCO (August 2016)
KKR (August 2016)