The US Federal Reserve (Fed) decided to keep interest rates unchanged at their September meeting, citing ‘downward pressures on inflation’ and ‘international developments’ as the main reasons to continue with a wait-and-see approach. A large portion of the market had expected an increase in rates so you would have expected no move to elicit a positive response. Perversely, the initial market reaction was negative as investors appeared to be thinking ‘what do they know that we don’t’, suggesting the Fed may know the US economy was weaker than expected. The poor September payrolls number only added fuel to the fire.
This type of policy uncertainty has become more commonplace in recent times. Post-crisis policy used to be characterised by forward guidance and transparency as central banks simply provided a timeframe for how long they would keep rates at zero. Now the decision-making is decidedly more complex as the Fed weighs up whether now is the right time to start the tightening cycle. With the extra complexity comes added risk and uncertainty. Given the dominant and expanding role central banks have played in markets since the 2008 crisis, it should be no surprise that the unwinding of the expansive policies is causing extra volatility.
At Nikko Asset Management, we believe this added risk has the potential to cause a re-rating in equity multiples as the market prices for policy uncertainty. As discussed in last month’s Balancing Act, almost half of US equity returns since 2011 have been driven by multiple expansions as the price-to-earnings (P/E) ratio has increased from 12.5 to 18.5 on the S&P 500 index. Scope exists for these multiples to revert to lower levels as the market prices for the increased risk of policy uncertainty.
Our investment approach toward equity markets remains unchanged this month. Valuations for most equity markets are not yet at levels attractive enough to compensate for the increasing risks. Until adequate value appears, we remain neutral on equities and will maintain our strategy of implementing risk hedges and holding elevated levels of cash (our preferred safe asset).
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
We remain positive on German equities despite the recent setback.
We upgraded German equities to a positive score in August as valuations were not stretched, momentum was still positive and the macro backdrop was improving. A lot has happened in Germany since that time, not least of which was a 10% fall in the equity market. This has caused a deterioration in the momentum scores, but that is being offset by an improvement in valuations to the point where our models now suggest German equities are cheap.
Deteriorating momentum is a red flag, particularly for an expensive asset. However, with German equities cheap and earnings of German companies still delivering growth (see Chart 1), we are not too concerned about the negative price action at this point.
Chart 1: German equity earnings
Source: Bloomberg 2015
The most interesting developments for Germany have occurred in the macroeconomic arena. When we upgraded German equities, we were positive about the macro outlook for the following reasons:
- European Central Bank monetary policy settings being extremely accommodative for German companies through both cheap borrowing costs and a weaker Euro;
- A stabilisation in the situation in Greece demonstrating fiscal leniency on behalf of the Euro technocrats; and
- As an energy consumer, Germany benefitting from cheaper oil.
All these factors still hold true but there have been two recent developments that introduce new risks in to the German macro outlook.
First, the scandal with Volkswagen (VW) where US authorities discovered that the software measuring emissions from VW’s diesel engines had been set by the manufacturer to give favourable readings. This grand-scale deception appears limited to only VW at this point and not representative of a broader malaise in German car makers. However, the damage to the brand of German Inc. is undeniable.
The second and more profound change in the German macro outlook involves the refugee crisis arising from the conflicts in the Middle East. Depending on the news outlet you read, Germany is set to take anywhere from 1 million to 1.5 million refugees this year. That is a large number of displaced people to process in a short time and comes with a number of potential risks, not least of which is the simple logistics of where they actually sleep (particularly with winter approaching). In time, there should be substantial benefits for Germany from this unexpected influx of able-bodied workers, but the short-term risks associated with this logistical nightmare are real.
Despite these new headwinds to the macro outlook in Germany, we remain positive as the tailwinds of cheap funding and a weak Euro should continue to support company earnings. We will closely monitor the equity earnings in Germany to try and assess the impact of these new developments.
Despite valuation improvements, we are still neutral on Asian equities.
Since their highs in May, Asian equities have fallen almost 30% in USD terms to levels not seen since the Euro crisis in 2012. This has resulted in valuations improving markedly, with our models now suggesting Asian equities are at very cheap levels (see Chart 2).
Chart 2: Asian equity price-to-book multiple
Source: Bloomberg 2015
Given the importance valuation plays in our investment process, this usually signals us to look to move overweight in an asset class. However, in this case we are keeping Asian equities as a neutral allocation for the following reasons:
- Momentum is still negative; and
- The macro outlook is clouded by policy uncertainty in China and the current squeeze on USD borrowers.
Debt growth has been strong in emerging markets (EMs) since the 2008 crisis, Asia included (as shown in Chart 3). EM corporates and households have binged on cheap and freely accessible credit as lenders from growth-starved developed countries chased better returns. The stronger USD and threat of increasing rates in the US has reversed this flow of funds resulting in a liquidity shortage for borrowers.
Chart 3: Asian credit growth
Source: Bloomberg 2015
The broader macro outlook for Asia is still bright with strong reform agendas and cheap oil providing lasting tailwinds for productivity and growth. Our concern is more in navigating the short-term disruptions from the current liquidity shortage. Once these risks have passed, we will look to upgrade Asian equities to positive.
US equities are still near the bottom of our hierarchy.
We have held a negative view toward US equities since downgrading them at the start of the year, with the driving factor being expensive valuations. The recent market selloff has improved valuations but only to neutral levels on our models. With momentum still negative and the macro outlook clouded by policy uncertainty, we maintain a negative score for US equities.
Momentum in US equity earnings has clearly stalled. Having posted strong and consistent earnings growth since 2009, US company profits are slowing in the face of the numerous headwinds that have been building including:
- An energy sector in reverse;
- Stronger US dollar;
- Rising borrowing costs from both widening spreads and increasing interest rates;
- Falling margins; and
- Slowing demand from EMs.
It is worth recognising analyst expectations for earnings to a large degree already reflect these challenges as 2015 earnings are already factored to be below 2014 levels. This low hurdle provides the potential for upside surprise in earnings growth. We have been carefully monitoring company sales growth in the US, particularly ex-Energy, to get a sense of the state of top line growth. As can be seen in Chart 4, company sales growth stalled earlier in the year but appears to be turning around.
Chart 4: US sales growth
Source: Bloomberg 2015
If sales growth continues to improve in the US, companies stand a good chance of outperforming the current low expectations in earnings. We will be closely monitoring the third-quarter earnings season to see if this dynamic continues and results in an upgrade in the US macro outlook. We have stated many times before, in an environment of low returns and growth, investors are willing to pay for visible return streams.
We continue to favour low duration and high quality credit.
Low quality credit spreads widened again in September despite the Fed not increasing interest rates (see Chart 5). Growth concerns and a focus on the capacity to service burgeoning corporate debt levels appear to be dominating investor sentiment at the current time.
Chart 5: Credit spreads
Source: Bloomberg 2015. HY–High yield. IG–Investment grade. Sov–Sovereign.
The level of corporate debt outstanding has increased alarmingly in the developed world. Zero interest rate policy settings across the majority of the developed world have been encouraging corporates to increase leverage. Servicing these liabilities has become harder given borrowing costs have already increased as credit spreads have widened and could potentially increase further if the US raises interest rates.
Borrowers have been afforded a respite with the US Fed not increasing rates in September. Since the 2008 crisis, any sniff of an ease in policy has been met with solid demand for spread product. That may be the case once again this time but we are approaching it with a bit more caution. Deteriorating credit fundamentals and the sheer size of the existing debt stock make it more difficult for an easier stance in monetary policy to have the same benefits it has had in the past. We appear to be approaching an environment of diminishing returns from easing and the potential for policy fatigue.
Until such time as the adjustment in valuations reflects these increasing risks, we will maintain our conservative approach to credit.
We remain underweight sovereign bonds.
Sovereign bonds across most developed markets remain expensive on our valuation models, but for a fund manager they can still play the role of ‘defence’ in a portfolio. Given the recent tendency to increased volatility in bond markets, sovereigns are becoming less attractive for this role as well. We have been and will continue to favour cash as our safe asset.
At Nikko AM, we expect the volatility in bond markets to continue for two key reasons:
- Policy divergence in the major economies; and
- The growing threat of policy fatigue.
As discussed in the introduction, central banks were always going to struggle to unwind their post-crisis expansive policies/experiments. The US Fed is discovering now that being the first to embark on this unwind is even more complex than expected as its policy settings attempt to diverge from the other major central banks. This uncertainty in policy response will continue to stoke volatility in the bond markets.
The second factor that bears watching is the growing potential for policy fatigue. Quantitative easing (QE) has two clear goals as we see it – to reduce real rates to encourage borrowing and to increase inflation expectations to encourage investing. The hoped-for outcome from these two goals is then to see productive growth.
We have shown multiple charts on the excessive levels of debt over the last few months, suggesting QE has been very successful in achieving the first goal. Corporates and households have been enticed by the manipulated lower borrowing costs to increase credit to record levels in some cases.
But on the second goal, QE has clearly failed. As can be seen in Chart 6, inflation expectations have continued to fall, despite the best efforts of the European Central Bank and the Bank of Japan to prop them up. Similarly the US Fed struggled to get inflation expectations to rise during their more recent QE2 and QE3 experiments.
Chart 6: Inflation expectations
Source: Bloomberg 2015
The potential reasons for declining inflation expectations are many and varied – globalisation, commodity glut, stronger USD, currency wars, debt overhang and capital misallocation to name a few. Central banks are aware of these factors and yet continue to follow the same QE policies despite empirical evidence suggesting they are having little to no effect in raising inflation expectations. It is this dynamic that raises the potential for the market to suffer from policy fatigue.
Granted inflation expectations might have been lower if the central banks had not poured trillions of dollars of QE into the market, but investors’ appetite for a continuation of the same policy response with few results may be tested if the evidence does not change soon. The clock is ticking on the efficacy of QE for many investors and if the benefit of the doubt shifts away from central bankers, a re-rating of markets should be expected. At the least, we expect continued volatility.
Overall, we remain underweight sovereign bonds given the poor valuations and bouts of volatility. We expect the volatility in sovereign markets to continue as we move from an era of manipulated pricing (QE) to an era of more market-based pricing. For this reason, cash remains our preferred safe asset at this time.
We retain our underweight allocation to commodities.
Momentum is still very weak across all commodity markets and value has yet to emerge while the macro backdrop remains challenging.
Commodity prices ended down for the month of September. Our cautious view on the asset class and our relative sub-group preference of Precious Metals and Agriculture over Energy and Industrial Metals remains unchanged too.
Demand remains weak and supply has not adjusted both for declining production costs and for the different motivations of OPEC (Organization of the Petroleum Exporting Countries) and other producers required to continue production to sustain cash flow.
This month we take a closer look at gold for its insurance characteristics against potential policy mistakes. Gold clearly remains depressed – down around 40% from 2011 highs – but further downside from current levels may be more limited with potential asymmetric risk to the upside as risk of policy mistakes is on the rise.
One of the chief arguments against owning gold is rising real rates, where there has been a tight relationship over a number of years. Gold yields are effectively negative for the cost of storage, while higher real yields simply increase the opportunity cost of owning it. Real yields were deeply negative back in late 2011, while their gradual recovery has continued to weigh on gold prices.
Chart 7: US real rates and gold price
Source: Bloomberg 2015
Typically, real yields continue to rise in a rising rate environment and as the Fed prepares to tighten, the argument against gold seems reasonably supported. However, given the steady compression in growth expectations over the last decade, unless growth surprises significantly to the upside, real rates are more likely to settle at a lower equilibrium which would be supportive of gold prices.
As discussed in the sovereign bond section, a clear objective of QE has been to lift inflation expectations. Chart 8 shows how inflation expectations (as measured by US 10-year breakeven rates) rose significantly in the first round of QE (2009), rose slightly in QE2 (2010) and then fell in QE3 (2012). Many factors are at play, but there is a distinct diminishing return from each round of QE.
Chart 8: US inflation expectations and QE
Source: Bloomberg 2015
Currently, as the US Fed prepares to raise rates, inflation expectations are collapsing to levels not seen since 2009. The hope is that growth accelerates to lift inflation expectations, but after six years of easing, the Fed is falling short of its objective, which means that policy risk (and policy fatigue) is rising. Gold has always been a useful insurance against policy mistakes and given policy uncertainty, not just in the US but globally, holding some amount of insurance makes sense.
USD remains our favoured currency.
It is worth recognising that a lot of the expected tightening by the US Fed is already reflected in the USD exchange rate, with valuations looking expensive on our models. However, momentum remains firmly positive and the recent Yuan devaluation places further pressure on the USD to appreciate.
We are neutral on the Yen and Euro as expansionary central bank policy is countered by the level of depreciation that has already occurred. This is particularly true for the Yen where our valuation models have the currency as cheap. We also expect both currencies to bear some of the adjustment required to balance the Yuan devaluation given currency moves on aggregate need to sum to zero.
AUD remains at the foot of the currency hierarchy as the forces of narrowing interest rate differentials and deteriorating terms of trade continue to weigh on the currency.
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 +|