Balancing Act - Nikko AM Multi-Asset's global research views to assist clients in balancing their portfolios to produce superior returns.

Snapshot

It’s all about the bonds. The ructions in the government bond markets that started in late April have continued into early June, with sovereign bond yields continuing to move higher. German 10-year Bunds are yielding 0.95% as of June 9, 2015, almost a full percent higher than six weeks earlier. The European Central Bank (ECB) has re-affirmed its commitment to continue buying EUR 60 billion of bonds until September 2016, so at some point yields should stabilise. Unfortunately, given the artificial nature of price setting in a ‘QE-controlled’ market, it is difficult to assess when that point will be with any degree of confidence.

Across the Atlantic, US Treasuries appear to be grappling with a similar question. What is the appropriate level for bond yields now that the US Federal Reserve (Fed) is not buying USD 85 billion of bonds a month? The Fed had expanded their balance sheet by almost USD 4 trillion (USD 4,000,000,000,000) since 2008 to create the artificial bond prices that prevailed until early this year. Now, as the Fed has stepped away and bonds move to more market-based pricing, investors are struggling to decide what the appropriate new level should be.

At Nikko AM, we are not that surprised by the recent bond volatility. As you move from ‘artificial’ pricing to ‘market-based’ pricing, the transition was always going to be difficult. The old anchors of real yields and inflation expectations have been actively manipulated by central banks since the crisis. Trying now to allow these anchors to be driven by conventional market forces introduces considerable volatility.

In the medium term, this return to market-based pricing is a healthy dynamic as bond yields become anchored to more traditional drivers of return rather than manipulated by central banks. But the transition will be volatile. We remain underweight sovereign bonds as this level of volatility is not a characteristic we want to see in the ‘safe and defensive’ portion of our portfolios.

Asset Class Hierarchy

Asset Class Hierarchy

Note: Sum of the above positions does not equate to 0 in aggregate - cash is the balancing item.

Equities

Japan is still at the top of our equity hierarchy. The rally in Japanese equities and accompanying multiple expansion has seen valuations deteriorate from positive to neutral. We do not see this as a cause for concern for three reasons:

  • Valuations are still supportive - with the score at neutral, valuations are not problematic. A P/E of 18 is not historically high for Japan and compares favourably with other developed markets.
  • Japanese equity earnings continue to deliver - in a world of low growth, visible growth will be rewarded. Japanese equity earnings continue to deliver growth. The further depreciation of the Yen to 125 will help to reinforce this picture.
  • The quality of earnings is improving and has further to go - following years of economic stagnation, profit margins in Japan declined to exceptionally low levels. This is turning around.

Encouraging companies to be more productive with the excess cash on their balance sheets has also led to ROE improvements in Japan. Given the improvement in earnings quality and our expectation for ‘Third Arrow’ growth strategies to be supportive for Japanese equities, we maintain our positive score for Japanese equities despite the deterioration in valuations.

An improving macro backdrop in China keeps Asian equities near the top of the equity hierarchy. Valuations in Asian equities remain supportive although the strong rally in China has seen multiples expand considerably. Table 1 shows that the selection of index for accessing Chinese equities is a key determinant in the level of ‘expensiveness’. There are areas of expensive stocks, particularly in the Tech sector, and there are areas of cheap stocks, mainly in the Financial sector.

Table 1: P/E Multiples of Chinese Equity Indices

Index Characteristics P/E
Shenzhen Composite ‘New’ economy stocks – largest weight is Tech 73
Shanghai Composite ‘Old’ economy stocks – largest weight is Financials 25
CSI 300 Mix of stocks from both exchanges 21
H-Shares Hong Kong-listed Chinese companies 10
MSCI China Financials Chinese financial companies 8

Source: Bloomberg 2015

It is well documented that China has seen an explosion in credit since the 2008 crisis. As growth slows, and the resultant misallocation of capital becomes evident, it is also conventional wisdom that Chinese bank balance sheets will implode under the weight of non-performing loans. This is the primary reason the MSCI China Financials Index is trading at a P/E of 8 times earnings.

On March 8 of this year, the government announced a 1 trillion Yuan facility that would allow for local governments to re-issue off balance sheet debt from local government funding vehicles (LGFVs) as new debt with a government guarantee, significantly lowering borrowing costs. Although 1 trillion Yuan is only a portion of the potentially problematic debt outstanding in China, we believe of greater consequence is the fact China has now demonstrated a coherent plan for dealing with problematic debt channels.

We see this as the Chinese government removing the tail risk on the debt problem, improving the macro outlook for the economy and in particular the Financial sector. With valuations for Chinese equities at neutral and momentum still positive, we remain overweight Chinese (and Asian) equities.

We have upgraded peripheral European equities in our hierarchy. We upgraded Germany earlier in February this year as it appeared the announcement of a significant QE programme for Europe would be of most benefit to competitive German companies. We remained sceptical on peripheral Europe due to the poor condition of equity earnings, particularly in Italy.

As can be seen in Chart 1, the momentum in Spanish and Italian equity earnings is improving. Peripheral European companies had suffered through the global crisis (2008-09) and the European crisis (2011-12), with earnings expectations now coming off a very low base. Going in to 2015, the deflationary scare in Europe looked like it might cause another earnings collapse.

Chart 1: European Equity Momentum

Chart 1: European Equity Momentum

Source: Bloomberg 2015

The stabilisation in earnings expectations is a positive development and a key reason we upgraded the macro outlook for peripheral European equities to neutral. Should the improved backdrop result in top line growth actually turning positive, we would look to upgrade the score further. But at present we remain neutral.

Credit

We continue to prefer a highly liquid (high quality) and low duration allocation to credit. We have been advocating this credit position for some time in recognition of both the deterioration in credit fundamentals as a result of the strengthening US dollar and the duration risk presented by the imminent rise in US interest rates. The recent poor performance of credit shown in Chart 2 reinforces our conviction to maintain this conservative approach to credit.

Chart 2: Credit Performance

Chart 2: Credit Performance

Source: Bloomberg 2015

Over the past 12 months, Asian investment grade credit has delivered the best returns as shown in Chart 2. The worst returns have come from the lowest quality sectors – EMD and US high yield. All credit sectors have suffered in the last few months as the volatility in sovereign bonds has translated into poor returns.

Momentum in US investment grade turned negative in our models this month. Valuations remain neutral and the macro outlook is not supportive given pending interest rate increases and the deterioration in leverage ratios. We considered downgrading investment grade credit to negative given this further deterioration in scores. However, we maintained our neutral score since our current conservative approach (high quality and low duration) has insulated our credit exposures to date and we expect this to continue to be the case going forward.

Chart 3: Credit Spreads

Chart 3: Credit Spreads

Source: Bloomberg 2015

Sovereign

We remain underweight sovereign bonds. As discussed in the introduction, we expect the volatility in sovereign bond markets to continue. Allowing bond yields to become anchored to more traditional drivers of return rather than being manipulated by the central bank will produce a volatile rebalancing period. As can be seen in Chart 4, volatility in US Treasuries has steadily increased since QE3 ended in October last year. We do not expect this to subside in the near future as the rebalancing period continues.

Chart 4: Merrill Lynch Option Volatility Estimate (MOVE) for US Treasuries

Chart 4: Merrill Lynch Option Volatility Estimate (MOVE) for US Treasuries

Source: Bloomberg 2015

The recent sell off in sovereign bond markets has seen valuations improve in the short term, but they still remain expensive when considering a longer time frame. Real yields are still negative in Japan, Germany and the UK and as discussed last month, inflation expectations remain low compared with historical ranges.

One other valuation metric we look at for each sovereign bond market is the relative spread to comparable US Treasuries. Chart 5 shows that Bunds, Gilts and Australian bonds are all relatively expensive when historically compared to the US. Given this valuation discrepancy and with real yields positive and climbing in the US, we have recently elevated US Treasuries above Gilts in the bond hierarchy.

Chart 5: Sovereign Bond Spreads to US Treasuries

Chart 5: Sovereign Bond Spreads to US Treasuries

Source: Bloomberg 2015

Australian bonds remain at the top of the hierarchy despite being expensive relative to the US. Bond yields are above 3% and the central bank is still easing, providing a strong macro support for the sovereign market.

We remain negative on sovereign bond markets. Valuations are still expensive and the added volatility of the current rebalancing in prices contributes additional risk to an asset class that is supposed to play the defensive role in the portfolio. As we have highlighted before, through this rebalancing process we prefer to hold cash as our defensive asset.

Commodities

We retain an underweight allocation to commodities but are more aware than ever of the elephant in the room - commodities do well in a reflationary environment. We have discussed in previous issues our view that inflation expectations are too low and should revert to more normal levels, particularly given the nascent wages recovery in the US. If this view transpires, our analysis suggests commodities should also perform well.

Chart 6 shows the relationship between commodity prices and forward-looking inflation expectations, based on the University of Michigan Survey of Consumers Inflation Expectations data, over the last three and a half decades.

Chart 6: Relationship between Commodity prices and Inflation Expectations

Chart 6: Relationship between Commodity prices and Inflation Expectations

Source: Bloomberg 2015

A 100 bp increase in forward-looking inflation expectations (say from 2.5% to 3.5%) has corresponded to a 3.4% monthly gain in commodity prices over the period. The magnitude is small due to the stickiness of inflation expectations in consumer surveys, but the high degree of statistical robustness in the relationship is the more important conclusion to draw from the analysis.

While bearish fundamentals such as a stronger US dollar, slowing demand in China and oversupplied commodity markets globally continue to provide good reasons to remain underweight commodities, we are watching the unfolding reflationary dynamic closely as a guide to start cutting that underweight. The labour market in the US is at the centre of the reflationary thesis. If strong payroll growth continues and wages pick up in a rapidly tightening labour market, then history suggests that commodities may well rally off their multi-decade lows.

Based on our current research, all commodity sub-groups still rank poorly on our momentum models and offer mixed signals on the range of valuation models through which we assess them. We retain our relative preference for Agriculture and Precious Metals relative to Energy and Base Metals given the latter two register the weakest fundamentals and lowest ranks on our models compared with the former.

Currency

USD remains our favoured currency as the desynchronisation in monetary policy trends intensifies across the major countries. It is worth recognising a lot of the expected tightening by the Fed is already reflected in the USD exchange rate, with valuations looking expensive in the short term. However, when compared with a longer history, as in Chart 7, valuations look more neutral.

Chart 7: US Real Effective Exchange Rate

CChart 7: US Real Effective Exchange Rate

Source: Bloomberg 2015

USD momentum is still strongly positive. The macro backdrop is supported by interest rate tightening, but the recent slight deterioration in the US current account deficit bears watching as it may signal a change in liquidity of USD for the rest of the world.

We still expect the Yen to be the worst performing currency, but our view has been tempered somewhat by rhetoric from the Bank of Japan suggesting Yen depreciation has run its course. Valuations for the Yen are cheap, but with momentum strongly negative, the chances are they will get cheaper.

Our view on EUR is mixed. The large QE programme to be implemented by the ECB has caused a flight from the European capital account. However, in future it may be more difficult to weaken the EUR given the huge current account surplus in Europe. We expect any further depreciation to be difficult.

Process

In house research to understand the key drivers of return:

Valuation Momentum Macro
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
Example
+ N N
Final Score +