Balancing Act - Nikko AM Multi-Asset's global research views to assist clients in balancing their portfolios to produce superior returns.
We received a valid question from investors regarding last month's change in positioning - was it a contradiction to downgrade both US equities and US sovereign bonds? The simple answer is technically no it is not a contradiction. US equities and US sovereigns have been strongly positively correlated through previous periods in history - think early ‘80s as they both sold off together and late ‘90s as they both rallied together.
But it might be instructive to delve a bit deeper in to why we downgraded both US core assets at the same time - because they were both expensive. When we looked at the valuation models for US sovereign bonds, they were expensive on a real yield and an inflation expectations basis. Momentum was still positive but the Macro environment was deteriorating for bonds as the labour market tightened.
US equities were also expensive across our valuation models, particularly Price to Sales with profit margins at record levels. The Macro picture was deteriorating as the stronger USD and cratering energy sector weighed on company earnings. Momentum finally waned in January and we downgraded the asset class.
This highlights expensive assets have been the norm rather than the exception in a world flush with liquidity from central bank largesse. As we discussed last month, we believe we are entering a more challenging environment for asset prices (the rebalancing phase) as markets seek to establish a new equilibrium following the destabilising moves in the USD and the oil price. During this volatile environment we expect to be holding excess levels of cash as we rebalance out of expensive assets (like US equities and sovereigns) and in to those more appropriately priced
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate - cash is the balancing item.
We have maintained our Negative view on US equities. Last month we downgraded US equities to Negative as Momentum rolled over and the growing Macro headwinds weighed on earnings. We had been concerned a stronger USD, rising cost of capital and peaking margins would be a challenge and this showed as earnings momentum deteriorated significantly in Q4'14.
Valuation multiples for US equities remain stretched with Price to Earnings, Price to Book and Price to Sales for the S&P 500 index all at or exceeding 2007 levels. We had been comfortable owning an expensive asset as long as it continued to deliver growth - in a world with excess liquidity, visible growth would attract capital. The big question mark for US equities is the ability for earnings to continue to deliver in the face of the following growing Macro headwinds:
- Stronger USD - Direct negative impact on the over 40% of earnings earned offshore
- Rising cost of capital - Spreads have widened, particularly for high yield issuers
- Declining CAPEX - the challenges for the energy sector has seen CAPEX plans shelved. It was one of the few sectors in the US with plans to spend on fixed capital
- Record profit margins - post-crisis cost control, low cost of capital and record low share of profits to labour have combined to push margins to record levels
- Wage pressures - industrial action on the West coast; Wal-Mart and Starbucks raising the minimum wage; NFIB Small Business Compensation in a clear upward trend - expectations for wage growth are rising
Despite these headwinds, in Q4'14 US equities were still able to deliver both positive sales and earnings growth. Although as Chart 1 shows below, expectations for future growth have been discounted significantly. This would seem appropriate given the building challenges to earnings.
Chart 1: US Equity Earnings Expectations
Source: Bloomberg 2015
We will maintain our Negative view on US equities until either valuations reduce to more appropriate levels or earnings reverse from their current negative trajectory.
Japan is still our most favoured equity market as we expect the Abenomics ‘3rd Arrow' growth initiatives to bear fruit in 2015. 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
Emerging markets equities ex-Asia remains our least favoured equity market. Emerging market equity returns have continued to struggle as the double whammy of a stronger USD and rising US interest rates negatively impact their funding positions. Combine this with plummeting commodity prices and the balance sheets of many commodity producing countries/companies have deteriorated significantly.
Chart 3: Emerging Market Equity Performance (in USD)
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. With Momentum still strongly negative (see Chart 3), EM equities ex-Asia will remain at the bottom of our equity hierarchy.
Asia is a different story. Valuations are still 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 risk for Asia is credit - Asian companies are not immune to the liquidity tightening effects of a stronger USD and higher US rates. Fortunately the reliance on offshore funding (except China) has diminished over the years and company balance sheets have been given some respite with local central banks reducing interest rates. Asian equities still score a Positive in our research process but we are monitoring the credit situation closely for signs of deterioration.
Germany appears the most likely beneficiary of European QE. We have been too bearish on the outcomes for European assets. The expectations for QE and a weaker Euro have compressed risk premiums across all European assets in local currency terms. Although it is worth pointing out that European equities are 15% lower over the last 6 months in USD terms.
That said we still view European equities as unrewarded volatility - periods of policy driven euphoria followed by the reality of growing structural imbalances and disappointing underlying growth.
As the ECB embarks upon QE European-style, we see little in the program that will help address:
- Undercapitalised banks - Flat yield curves, compressed risk premiums and negative interest rates hardly seem the panacea for recapitalising a struggling banking system
- Lack of aggregate demand - difficult to see ‘animal spirits' being awakened by negative interest rates
- Structural imbalances - labour flexibility, wage competitiveness, overall productivity may not be improved
The reality could be QE ends up further widening the structural imbalances between the North and the South.
Which brings us to Germany. The QE program will weaken the Euro which is a key positive for an export powerhouse like Germany. Lean and mean German companies will have access to a lower cost of capital and a lower oil price placing them in an even stronger position. As shown in Chart 4, German equity earnings have been improving and with these Macro tailwinds they look set to improve further. It seems ironic that the country brought ‘kicking and screaming' to the QE table may be the biggest beneficiary.
Chart 4: German Equity Earnings
Source: Bloomberg 2015
We still favour a highly liquid, low duration allocation to credit as our view remains Neutral. Credit spreads have stabilised following the energy sector driven sell off late last year. Valuations remain in the Neutral range (except European IG) across investment grade and high yield debt. We are conscious absolute yields are low, hence the low duration view. We are also aware credit fundamentals have deteriorated and with the continued rally in the USD may come under further pressure. For this reason we favour a highly liquid allocation to credit.
Chart 5: Credit Spreads
Source: Bloomberg 2015
The recent spread widening moved High Yield Debt to a Neutral valuation. 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. As mentioned previously we are closely watching for any further deterioration in fundamentals given the continued rise in the USD.
As evident on Chart 5 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.
Sovereign bonds are still expensive. The recent back up in US Treasury 10Yr yields (1.6% to 2.2%) has addressed some of the overvaluation in sovereign bonds. Real yields in the US have moved back to more realistic levels around 0.5%. However inflation expectations remain severely depressed with the proxy for 10 year inflation (breakeven) still at the bottom of recent ranges at 1.7%.
The rally in the USD and concurrent fall in commodity prices has resulted in falling inflation globally. The extent to which this is a transitory dynamic is the key question when considering future inflation expectations and their appropriate price.
Chart 6 shows the results of the NFIB (US National Federation of Independent Businesses) survey of 800 small companies regarding compensation (red line) and how hard it is to fill job openings (blue line). As you can see both measures are at historically high levels which in the past have signalled wage pressures. Combine this with the increase in minimum wage from large employers like Wal-Mart and we should start seeing wage increases showing in the official numbers in the near future. With wage pressures showing signs of building in the US, we still view US sovereigns as expensive despite the recent sell off.
Chart 6: NFIB Small Business Survey
Source: Bloomberg 2015
Australian sovereign bonds remain our favoured duration. Real yields are positive, absolute yields are high at over 2.5% (in the 10 Yr) for a AAA country and the central bank has room to ease further with cash rates at 2.25%. The end of the commodity boom means the income growth seen over the last 5 years should start to deteriorate and inflation remain well contained.
Japan remains our least favoured sovereign bond market with real rates strongly negative 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 Japanese 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.
Within commodities we retain a marginal preference on precious metals and agriculture commodities relative to energy and base metals.
We do not expect precious metals to rally in USD terms while real yields are still rising. However Gold provides cheap insurance to any reversal of USD strength and to any wage growth driven inflation in the US. We continue to monitor Gold prices in Euro as the source of global liquidity shifts from the US to Europe
Chart 7: Gold prices in USD & EUR
Source: Bloomberg 2015
Oil prices were up 18% from the recent lows, but are still 45% below last year's high. The market found support on the prospect of reduced supply, mainly driven by a fast declining rig count. While such signs are encouraging, these measures are often volatile and remain only one data point. Given the financial leverage in the energy sector there will be some producers increasing volumes to preserve revenues, so the near term direction of global supply is far from clear.
Demand remains relatively weak but it is projected to improve later in the year, responding to lower prices with the normal lag. At current prices there will be a significant shakeout of current supply, so the equilibrium price may not be far from current levels. But the oil price remains tightly linked with the USD where Dollar strength remains a key risk to the oil price (Chart 8).
Chart 8: Brent Oil and USD
Source: Bloomberg 2015
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. Initially QE has weakened the Euro, but with balance sheet expansion slow due to the shortage of bonds and Europe running a current account surplus, further downside to the Euro may be limited.
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|
|Final decision judgemental|
|Final Score +|