Stock markets are the collective result of thousands (maybe millions) of individual opinions on the available information in the market. The stock price is the equilibrium level of all these different opinions. One of the wonderful quirks, or frustrations, of the market is that at different times, the same information can have the opposite effect on these prices.
Take for example the dynamic of returning cash to shareholders. In the 1990s, particularly the latter stages of the decade, any company seen returning cash to shareholders (through buybacks or even dividends) was penalised by the market. The ‘market opinion’ at the time was that the company should keep the cash to invest in productive capital that could generate higher growth — for which the market would be willing to pay a higher multiple and price.
Fast forward to today and the market opinion is the opposite. Any company announcing a buyback has been rewarded by the market with a higher share price, resulting in a record number of buybacks. This type of feedback loop is self-defeating in the long term as money that should be going to increasing productive capacity is being returned to shareholders. Where will future growth come from?
It is interesting to note that over the last few months, companies announcing buybacks have underperformed the broader market. Could market opinion finally be moving back in the other direction — Given the S&P Buyback Index (index of stocks with highest buyback ratio) has outperformed the S&P500 Index virtually uninterrupted for 14 years, we are not jumping to any conclusions just yet. However, if the market is finally becoming concerned about where future growth will come from, particularly in an environment where questions are already being asked about the ability of quantitative easing (QE) to generate growth, then the risks around current policy settings become even more heightened.
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 these 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.
US equities are near the bottom of our hierarchy.
US equities are once again expensive. Following the August decline, our valuation models suggested US equities were more fairly priced but the recent rally has pushed them back into negative territory. Within our process there is scope for a favourable view toward an expensive equity market if momentum is still positive or earnings growth remains strong. Unfortunately neither of these conditions is in place for US equities, with momentum flat and earnings growth declining.
As can be seen in Chart 1, this is the second straight quarter in which earnings have declined in the US (dark blue bars). This is not a surprise considering the Energy sector’s earnings are over 50% lower than a year earlier. What possibly is a surprise is that when the earnings are viewed ex-Energy sector, growth is still positive albeit slowing (light blue bars).
Chart 1: US earnings growth
Source: Bloomberg 2015
One of the key risks to our negative view on US equities is the ability for US companies to continue to deliver earnings growth in the face of the numerous macroeconomic headwinds that have been building over 2015 (stronger US dollar, increased borrowing costs, decreased margins etc.). Analyst expectations have already set the hurdle quite low so the potential exists for a positive earnings surprise. For this to occur, we believe it needs to be driven by sales growth, as margins are receding from record levels so it will be difficult to squeeze the lemon further without top line growth.
Chart 2 shows sales growth for US companies, both index level (dark blue bars) and ex-Energy (light blue bars). Again it is not a surprise to see negative sales growth at the index level given the turmoil in the Energy sector. But the fact that sales growth ex-Energy has been steadily declining to be almost flat this quarter suggests the ability for US companies to generate a growth surprise going forward may still be a while off.
Chart 2: US sales growth
Source: Bloomberg 2015
It may be a long bow to draw (and definitely too early) to suggest the decline in top line growth is a result of the lack of investment in productive capacity that we highlighted in the introduction. However, while sales growth for US companies remains in the doldrums and US equity valuations remain expensive, we will be maintaining our negative view on the asset class.
Japanese equities remain at the top of our equity hierarchy.
Japan is one of the best performing equity markets for the year at 8% in US dollar terms, but remains cheap according to our valuation models. A key reason for this is earnings have continued to advance despite the poor growth backdrop in Japan, with companies set to deliver the 14% earnings growth expected for 2015 over last year.
Expanding margins are one of the key reasons Japanese companies have been able to deliver this outcome. Chart 3 shows how operating margins for companies in Japan have continued to improve following the 2008 crisis and 2011 earthquake. Compare this to US where margins have been steadily decreasing over 2015. What is also evident from the chart is the almost 5% margin gap between US and Japanese companies — there is plenty of room for further expansion in Japanese margins.
Chart 3: Japanese operating margins
Source: Bloomberg 2015
We have discussed in previous notes our expectation for ‘Third Arrow’ growth initiatives and structural reform to provide a tailwind for Japanese equity earnings. The improvement in margins is a useful confirmation that some of this is beginning to take hold. Years of deflation have left Japanese companies very focused on the cost side. Now with earnings gathering steam, they can focus on profitability.
It is worth noting that it is not all rosy for Japanese equities. Last month we highlighted the improving competitive position that Asian competitors are achieving through currency depreciation following the Chinese Renminbi devaluation. The recent rhetoric from the European Central Bank (ECB) over potentially increasing QE suggests the competitive devaluation of currencies is far from over. This dynamic will continue to pose risks for the competitive position of Japanese companies.
Chart 4 shows the earnings and sales momentum for Japanese companies — both are still slightly positive but it has been a bumpy ride. External factors (like currency volatility) will continue to pressure earnings outcomes, but we are confident the initiatives are in place internally to enable Japanese equities to overcome these challenges. With valuations cheap, at least we have some wiggle room to accommodate the growing risks and so we remain positive on Japanese equities.
Chart 4: Japanese sales and earnings
Source: Bloomberg 2015
Emerging market equities still face challenges.
Emerging market equities have seen a 10%+ rally from the lows of last month but still face some challenging headwinds. The relative performance of the three emerging market regions can be seen in Chart 5. Asia and EMEA have tracked performance fairly closely to be down around 10% YTD, but Latin America (Latam) has been the significant underperformer, with losses exceeding 20% for the year.
Chart 5: EM equity performance in US dollars
Source: Bloomberg 2015.
We have discussed in previous editions our preference for Asia in emerging market (EM) equities given the attractive valuations and macro tailwinds of easing monetary policy, fiscal reform and the benefits of cheaper oil as an energy consumer. Our view is tempered by the current liquidity issues being faced by corporate borrowers struggling with the rising borrowing costs associated with a stronger US dollar and increasing US interest rates.
This debt dynamic is not unique to the Asian region. Corporates (and households) across EM countries have taken advantage of freely available liquidity to run up significant levels of debt. A sizeable portion of this is denominated in US dollars as until recently the US dollar was declining and rates were at historical lows. The unfortunate reality for these borrowers is that both these trends are now in reverse — the US dollar has strengthened significantly against EM currencies and US borrowing costs have been rising in expectation of rate increases.
EM corporate balance sheets now need to find an increase in revenue to offset this increase in borrowing costs. In an environment of decreasing global growth in US dollar terms (Chart 6), this is a very tough assignment. A weaker currency can help you get a greater share of the pie, but if the overall pie is shrinking then the upside is limited. We expect this liquidity issue to remain a challenge for EM companies as long as there is pressure for increased borrowing costs in the US.
Chart 6: Global GDP growth in US dollars
Source: Bloomberg 2015
We continue to favour low duration and high quality credit
As Chart 7 shows, high quality credit (investment-grade) has outperformed low quality credit (high yield (HY) and emerging market debt (EMD)) over the course of the year. For example, Asian investment-grade credit has outperformed US high yield debt by almost 8% so far in 2015.
Chart 7: Credit performance
Source: Bloomberg. 2015 US IG — US investment-grade. US HY — US high yield. Asian IG — Asian investment-grade. EM Sov —Emerging market sovereign.
We have not changed our long-standing view on credit. We continue to prefer high quality over low quality as our research suggests this late stage of the credit cycle is challenging for poor quality borrowers. Lenders typically tighten standards as the cycle matures demanding higher margins for lower quality. We have also looked at the impact that interest rate increases have on credit outcomes and the negative effects are more profound for lower quality borrowers.
We also still advocate a low duration stance in our credit portfolio. Absolute yields are low by historical standards, reducing the capacity for credits to absorb the performance impact of interest rate increases through tightening credit spreads. 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. In addition, given their recent tendency to volatility, they offer little attraction as a defensive asset. Until such time as inflation expectations adjust to more appropriate levels, we will remain underweight sovereign bonds. Our preference at this point is to hold the more appropriately priced duration of US Treasuries and Australian government bonds over German Bunds and Japanese government bonds where the exceptionally low yields provide little cushion for price adjustment.
US data suggests the labour market is growing tighter. Employment numbers continue to deliver and, more recently, wage pressures are beginning to appear across the broader market. With this backdrop, the extremely low level of expectations for inflation would appear incongruous with the evolving data (see Chart 8). We still believe inflation expectations are too low in developed markets and the risk of a correction is high.
Chart 8: Inflation Expectations in the US
Source: Bloomberg 2015
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. Despite the broad rally in risk assets, commodity prices ended essentially flat for the month of October. 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.
Last month, we discussed Gold as insurance against central bank policy mistakes, where policies have proven ineffectual in generating growth, which is reflected in declining inflation expectations. This month, dovish comments by the ECB suggest no change in direction and perhaps more of the same, so again risk of a policy mistake is rising and Gold is a sensible asset to hedge against this risk.
The risk in holding Gold is that it remains exposed to a strong US dollar, in which it is priced. The dollar strengthened during the second half of the month, mainly driven by a dovish ECB and by more hawkish comments from the US Federal Reserve. Chart 9 compares Gold with the US dollar (inverted) and clearly the dollar rally weighed on Gold.
Chart 9: USD Index and Gold price
Source: Bloomberg 2015
So far this year, we have ranked Agriculture over Industrial Metals and Energy on our hierarchy almost by default given our more bearish outlook on Metals and Energy. However, the increasing severity of the El Nino weather pattern this year also provides some reason to adopt a more constructive stance on soft commodities. El Nino has a mixed effect on yields and prices of different crops around the globe. For instance, in its current incarnation, it has lifted yields and pressured corn prices, while depressing production and lifting prices of sugar and cotton. However, history suggests that the net impact will be for prices to rise given the disruption to production and logistical supply chains.
US dollar remains our favoured currency.
It is worth recognising a lot of the expected tightening by the US Federal Reserve is already reflected in the US dollar exchange rate, with valuations looking expensive on our models. However, momentum remains firmly positive and the recent Yuan devaluation places further pressure on the US dollar 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.
The Australian dollar 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 +|