Balancing Act – Nikko AM Multi-Asset's global research views to assist client's to balance their portfolios to produce superior returns.
We see 2015 as a 'rebalancing' year as the market adjusts to the destabilising moves in the USD and oil that occurred in late 2014. There will be new winners and losers as this rebalance takes place but we believe it will take time (and a considerable amount of volatility) for the market to establish a new equilibrium.
The volatility is already appearing in the foreign exchange markets as the 'currency wars' escalate. Central banks are intent on competitively devaluing their currencies either through cutting interest rates (through 0 in some cases), directly intervening or outright money printing in an effort to avoid the deflationary pressures of a stronger currency.
But currencies are en masse a zero sum game so there has to be a currency (or currencies) that appreciate as all these others try to depreciate – enter the USD. The deflationary forces the others are seeking to avoid come crashing on to US shores in the form of a stronger currency.
Having downgraded US equities to Neutral in September on fears a stronger USD would hurt equity earnings, we now downgrade them further to Negative. US equity valuations are expensive, momentum is waning and the macro risks in the form of rising interest rates and a stronger USD have combined to reduce our US equity view to Negative from Neutral.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
We have downgraded US equities from Neutral to Negative. US equities have been expensive for a while but in our research process we were comfortable holding them at a Neutral weight as long as momentum remained positive and earnings kept delivering. In a world of low growth and abundant liquidity, visible and consistent growth would continue to attract capital.
Unfortunately according to our models US equity momentum has recently rolled over and is no longer a positive contribution to the overall score. Of more concern is our analysis of Q4'14 equity earnings. With the majority of companies having reported, earnings and sales growth have both fallen again. There is a significant deterioration in earnings momentum as shown in Chart 1.
It would be easy to simply blame the move on a flagging energy sector but an analysis of earnings momentum ex-Energy also shows deterioration. We have been concerned the macro headwinds of stronger USD, rising cost of capital and peaking margins would impact US equity earnings and it appears our fears are being realised.
Chart 1: US Equity Earnings
Source: Bloomberg 2015
For these reasons we have downgraded US equities from Neutral to Negative. Momentum is waning and the macro headwinds have strengthened. With valuations stretched, it is now difficult to justify holding an expensive asset that is not delivering visible and consistent growth.
We are conscious there is a major risk to our downgraded view – the market has abruptly moved consensus earnings expectations for 2015 to 0% following the strong negative guidance from companies in Q4 reporting. This is obviously a low hurdle for the market to clear and positions subsequent reporting seasons for upside surprise. However we expect the stretched valuation multiples and record profit margins to revert and offset any earnings surprises.
Japan is still our most favoured equity market, but we expect earnings growth to be driven by '3rd Arrow' initiatives rather than Yen depreciation. The escalation of the 'currency wars' means we expect the tailwind for Japanese equities from a depreciating Yen to weaken in 2015. It was evident by policy moves in January that the European Central Bank was very uncomfortable with the Yen at 150 to the Euro. With many central banks actively devaluing their currencies it will be increasingly difficult for the Yen to depreciate against most currencies except the USD.
From a valuation perspective Japanese equities remain on the cheaper side as a healthy scepticism exists in the investment community that Abenomics may not be able to generate growth. We are sympathetic to this belief but are comfortable to remain overweight as long as two key pillars remain in place:
- Japanese equity earnings continue to deliver - as stated earlier, in a world of low growth and abundant liquidity, we believe the market will continue to reward visible and consistent growth. As shown in Chart 2, Japanese equity earnings growth continues to deliver.
- Authorities remain on track with '3rd Arrow' growth initiatives – a number of growth strategies initiated in 2014 (corporate governance and taxation, labour flexibility, pension reform, women in work) should start to bear fruit in 2015. As long as the political authorities stay the course then Japanese equities will receive a boost from the '3rd Arrow'.
Chart 2: Japanese Equity Earnings
Source: Bloomberg 2015
Asian equities have been upgraded to a single Positive in our research process. Emerging market equity returns have struggled as the USD has rallied and commodity prices have fallen. Severe reductions in revenues from commodity sales combined with pressure on external USD funding has seen many EM countries suffer from poor equity and currency returns, particularly in Latin America and Eastern Europe. This can be seen on Chart 3.
Chart 3: Emerging Market 2014 Currency Performance
Source: Bloomberg 2015
The underperformance of emerging markets has resulted in EM equities looking more attractive from a valuation perspective. We still do not believe valuations are cheap enough in Latam and EMEA to offset the macro risks of stronger USD and weaker commodity prices. However Asia is a commodity consumer and so on the whole benefits from weaker commodity prices and the external funding positions of most Asian countries are under control.
Valuations in Asia are cheap (particularly in the North) and with the macro tailwind of cheaper oil improving profit margins the outlook for earnings is positive. Asia is also embarking on a political renaissance as strong, well-supported leaders in China, India, Indonesia and Japan have begun implementing structural reform to improve their respective countries productivity moving forward.
The combination of attractive valuations, positive momentum and an improving macro outlook has led us to upgrade Asian equities in our research process to a single Positive.
Europe remains near the bottom of our equity hierarchy, despite the recent QE liquidity injection. We had been sceptical European policy makers would be able to achieve the political consensus required to enact a meaningful QE. The delivery in January of an intended €60bn a month through bond purchases shows Mr Draghi is a strong consensus builder.
However we still view European equities as unrewarded volatility. Our expectation is for periods of policy driven euphoria (like now) to be followed by the reality of growing structural imbalances and disappointing underlying growth.
The QE program may weaken the EUR which improves the competitiveness of an export power like Germany but does little to address the labour inflexibility of Italy and France. Viewed through this lens, QE has the potential to further widen the competitive imbalances that to date have been limiting European growth.
In December we upgraded our view on European equities to a single Negative due to the improvements in the Macro environment resulting from potential QE, falling Euro and an ease in fiscal austerity. With valuations on the expensive side (Eurostoxx P/E ratio of 22) and earnings expectations still on the unrealistic side (12% EPS growth for 2015) we remain reluctant to upgrade European equities any further. It would take an improvement in valuations or a more positive earnings picture to upgrade any further.
The possible positive beneficiary of the latest policy moves in Europe is Germany. Lower cost of capital through falling rates, increased competitiveness through a weaker EUR and the benefit of cheaper oil for their industrial sector all stack up as Macro positives for competitive German companies. With valuations closer to neutral and earnings momentum positive, we are watching German equities closely for a potential entry point.
We still favour a highly liquid, low duration allocation to credit as our view remains Neutral, although valuations have improved in certain sectors of the market.
Credit spreads have recently widened (Chart 4), particularly in high yield and emerging market debt, as energy sector weakness and USD strength have pressured balance sheets.
Chart 4: Credit Spreads
Source: Bloomberg 2015
The spread widening in high yield debt has not been sufficient to move valuations in to the attractive range, but simply from expensive to neutral. With momentum negative, credit fundamentals deteriorating and the risk of further contagion from energy sector weakness, high yield debt remains at the bottom of our credit hierarchy. However we are on watch to potentially allocate to high yield should valuations improve to attractive or momentum turns around.
Asian investment grade credit is still at the top of our credit hierarchy. Given the recent spread widening valuations are not stretched and still offer a useful pickup in yield to comparable US credit names. Momentum remains positive and the macro environment has improved with local central banks easing interest rates. The key risk for the region is companies' ability to manage the strengthening USD, and for this reason we have been favouring hard currency over local currency bonds.
As evident on Chart 4 European credit is expensive with both spreads and absolute yields at record lows. The recent announcement of QE for the region will see a glut of liquidity searching for yield, in all likelihood pushing spreads even tighter. Granted with this macro backdrop it is hard to see defaults rising in Europe, but given the extremely low compensation granted an investor to take on these risks we are still inclined to avoid European credit.
We downgraded US sovereign bonds in January as inflation expectations became too pessimistic. Falling commodity prices and a rallying USD drove inflation expectations significantly lower in January (Chart 5). This may be warranted in Europe where deflation is a very real threat but the potential for inflation in the US is more obvious. The employment picture continues to improve and most wage surveys are showing pressure building to increase compensation. Our valuation models suggested US sovereign duration was not priced appropriately and so we downgraded the asset in our sovereign bond hierarchy.
Chart 5: Sovereign Inflation Expectations
Source: Bloomberg 2015
Japan remains our least favoured sovereign bond market with real rates at -2% and policy set to continue reflating. We acknowledge JGB yields may stay at these low levels for a long period of time with the Bank of Japan effectively controlling the market. But at some point the BoJ will allow yields to rise to reflect the changing fundamentals, and so we do not allocate capital to Japan sovereigns.
We are underweight commodities as declining global demand and a strengthening USD provide strong headwinds to any price appreciation. Declining prices are providing an opportunity for better entry levels but we believe these are not yet low enough to warrant increasing allocations, particularly with momentum for most commodities still negative.
The year started with a continuation in the sharp sell-off in energy that began in earnest in 4Q14. The energy complex was looking at a fourth consecutive month of double digit price declines before stabilizing to finish down -8% on the month.
Brent crude may have succeeded in finding near term support in the $45 - $50 range due to three main factors: growing evidence of a cutback in shale production activity, growing expectation of a shift in OPEC policy no later than in 2H15 and hopes of lower prices spurring increased demand growth globally.
To the extent that the collapse in oil prices has been a function of both oversupply and declining demand we would hesitate to call a new equilibrium level in prices till the market has rebalanced itself via adjustments to both sides of that equation. We agree that the supply side response is becoming more evident but we may need to wait a few more quarters before any pick-up in demand. Till then oil and energy prices may continue to travel through a volatile, bottoming process.
We have been spot on in our overall underweight call on commodities as the asset class has underperformed both global equities and bonds by over 30% in the last 6 months. Where we could have done better however is in our relative preference for energy over ex-energy. The reasons underlying that relative preference have not changed however: energy looks cheaper on our mean reversion based valuation models and is less exposed than both industrial metals and precious metals to a slowdown in Chinese growth and to a stronger USD respectively.
Hence we continue to rank industrial metals at the bottom of the asset class hierarchy. Momentum is deeply negative while metal prices are still at or near their marginal cost of production. The cost curves themselves are being pressured lower due to lower energy prices and lower commodity currencies, particularly for Copper.
On the flipside, two near-term upside risks that we are monitoring closely include a near term rebound in economic activity in China as a result of the recent central bank easing and the potential for increased strategic metal purchases.
Precious metals have risen in our asset class hierarchy due to the escalation in currency wars as discussed earlier in this report. The USD may well continue to strengthen and real yields in the US rise, both of which exert downward pressure on Gold prices, but real yields will struggle to rise elsewhere. Indeed it might even make sense to measure Gold prices in Euro as the source of global liquidity shifts from the US to Europe.
Chart 6: Gold prices in USD & EUR
Source: Bloomberg 2015
Hence our order of preference within Commodities can be summarized as follows: Energy and Precious metals ranking near the top (although neither is without attendant risks and neither is an absolute preference relative to other asset classes), followed by Agriculture on which we are neutral and Industrial metals at the bottom of the hierarchy.
USD remains our favoured currency as the desynchronisation in monetary policy trends intensifies across the major countries. The US Fed appears likely to stay the course in tightening monetary policy in 2015 which will keep upward pressure on the USD. The risk to this view is a rapid further appreciation of the USD which could short circuit US growth.
As expected, the Yen continues to be the worst performing currency. However recent action from competitor countries to arrest the appreciation of their currencies against the Yen suggests further weakening may be less abrupt. We still see JPY as the least attractive currency with the political will in Japan very strong to stay the course of depreciation.
Our view on EUR is mixed. The ECB has surprised by delivering a sizable QE package. The test now comes in the execution. The balance sheet of the ECB continues to shrink and with Europe running a current account surplus the pressure is more up than down for the Euro.
In house research to understand the key drivers of return:
|Quant models to assess relative value||Quant models to measure asset momentum over the medium term||Analyse macro cycles with tested correlation to asset|
|Example for equity use 5Y CAPE, P/B & ROE||Used to inform valuation model||Monetary policy, fiscal policy, consumer, earnings & liquidity cycles|
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