Geopolitics was front and centre again following the shootings in Paris on Friday the 13th of November. The attack was engineered by ISIS and when considered along with the shooting down of the Russian passenger airline, suggested the sphere of influence of the world's largest terrorist organisation was expanding.
Whether this expansion is real or imagined, the threat is sufficient to warrant a response from European nations. It is difficult for politicians to continue business as usual when atrocities such as the Paris shootings are happening on their doorstep. Unfortunately and not coincidentally this need to increase national security measures is coming at a time when Europe is seeing the largest flow of immigrants across borders since World War II.
For this reason nations have reverted to 'every man for themselves' rather than seeking a coordinated European response. Countries in Eastern Europe, closer to the source of the majority of immigrants, have been inclined to close borders in an attempt to contain the potential threat. Western Europe, and in particular Germany, have stood by their intent to take on more immigrants — although the resultant decline in popularity of Chancellor Merkel may have the clock ticking on this policy.
The ideal of a united Europe is being openly questioned. The lack of coordination in the policy responses highlights the underlying difficulties of creating a union where the member states value sovereignty over the collective. The disparate nature of these responses also means European companies face increased difficulty moving goods (not just people) across borders. We will discuss later how this deterioration in the macro environment for Europe has led us to downgrade German equities.
With German equities being downgraded and no other region improving sufficiently to be upgraded, we now end up with an overall negative score for equities. At this point Japan remains our only positive equity market. We believe this is appropriate given the aforementioned macro issues in Europe, pending interest rate increase in the US and travails being experienced by emerging markets. Valuations are becoming attractive in select emerging markets but given the challenging macro environment we believe it is too early to upgrade these to positive.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate — cash is the balancing item.
We have downgraded German equities to neutral.
German equities are expensive on our valuation models, momentum is flat and the macro environment has deteriorated as the immigration crisis impacts consumer sentiment and earnings.
Early in the year we highlighted the potential for German equities to be the biggest beneficiaries of European QE as a weaker Euro and decreased borrowing costs could be best leveraged by lean and mean German companies. In August we then upgraded German equities to positive as valuations looked fair post the Q3 sell off and company earnings were displaying solid growth. Unfortunately that is no longer the case and so we have downgraded German equities to neutral.
As can be seen in Chart 1, German companies are no longer delivering solid earnings growth (light blue line below) and expectations for 2016 earnings are ratcheting down further (light green line on RHS). The deterioration in earnings growth impacts our valuation models and now German equities are expensive. Granted a large portion of the decline in the third quarter was driven by poor results for Volkswagen and Deutsche Bank, but the risks have increased that these are symptomatic of a broader deterioration. Earnings momentum across the majority of sectors has turned negative.
Chart 1: German Earnings Expectations
Source: Bloomberg 2015
At this early stage it is difficult to assess the impact of the immigration crisis on German company earnings. Chart 2 shows how consumer confidence in Germany has turned down since the middle of the year and it seems rationale to attribute some of this deterioration to the logistical issues associated with the influx of immigrants. However the Paris shootings did highlight that the risks have increased going forward.
Regardless of whether another atrocity occurs (and we all pray it does not), the disjointed response from European countries demonstrated the lack of unity within European decision making. From Hungarian border closures to the increased popularity of right wing nationalism, the lack of a coordinated response to the crisis increases the risks of counterproductive measures and clearly worsens the operating environment for German companies.
Chart 2: German Consumer Confidence
Source: Bloomberg 2015
Our research process is designed not to be too sensitive to changes in short term dynamics, instead trying to capture more meaningful medium term trends. German equities were upgraded to positive in August and now are being downgraded to neutral only four months later — this is unusual. But we believe the macro environment has clearly deteriorated as a result of the immigration crisis. Combine this with our valuation models showing German equities are now expensive and a neutral score seems appropriate.
Asia is closest to an upgrade in our research.
Asian equities are cheap on our valuation models. We have previously shown the attractive Price to Book levels of Asian equities and how historically they have signalled a buying opportunity. Chart 3 shows valuations across a number of different measures and it is clear Asian equities are almost as cheap as they were during the 2008 crisis (in the chart green signifies cheap).
Chart 3: Asian Equity Valuation Models
Source: Bloomberg 2015
So Asian equities receive a big tick for valuations, but momentum remains poor. In our research models we look at both short and long term momentum and both still score negative for Asian equities. Although they are cheap, negative signals in momentum suggest Asian equities may get cheaper.
We have discussed in previous editions the macro tailwinds for Asia of easing monetary policy, fiscal reform and the benefits of cheaper oil as an energy consumer. This would generally be enough to score well on macro outlook. Our view is tempered by two key issues:
- the liquidity issues being faced by corporate borrowers struggling with the rising borrowing costs associated with a stronger USD and increasing US interest rates
- the deteriorating earnings momentum displayed by Asian companies
Chart 4 shows the momentum of earnings expectations for Asian companies. If we focus on the last few bars on the right, it is evident expectations are steadily decreasing. This is partly a reflection of the debt challenges facing Asian companies, but also highlights the tougher operating environment where aggregate demand across the majority of economies is slowing.
Chart 4: Asian Equities Earnings Momentum
Source: Bloomberg 2015
Valuation is the cornerstone of our research process and Asian equities are cheap. But with price and earnings momentum poor, and a liquidity issue surrounding USD borrowers, we are inclined to delay upgrading Asian equities until these headwinds are reduced.
The performance of Russian assets reflect the improving geopolitical outlook.
Last year Russian assets struggled as the fallout from the Ukraine conflict (and associated sanctions) and the collapse in oil prices saw the Ruble depreciate around 50% and bonds yields soar. Going in to 2015 Russian assets were expected to continue to perform poorly as the oil price remained low. Chart 5 shows this did not play out with Russian assets performing well this year, particularly bonds.
Chart 5: Russian Asset Performance in USD
Source: Bloomberg 2015.
One reason for the relative stability in Russian assets is the underestimated strength of the domestic balance sheet. External debt servicing requirements are low, government fiscal balance is stable and Russia continues to run a current account surplus. The severe depreciation of the Ruble in 2014 acted as a necessary counter-cyclical stabiliser, helping to partially rebalance the economy.
The other key reason for the surprising performance of Russian assets in 2015 was the relative improvement of Putin's standing on the global stage. At the start of the year, Ukraine was the geopolitical hotspot and Putin was seen as the bully with threats of military intervention in to broader Ukraine. Sanctions from Europe and the US were imposed to demonstrate their displeasure at the turn of events.
Fast forward to now and Syria is the geopolitical hotspot and following some clever manoeuvring, Putin is seen as the saviour. Putin is viewed within Europe as the leader most able to engineer a productive outcome in Syria. This was in evidence last month when French President Hollande declared war on ISIS, he turned to Putin for help. Given the change in tone, the European sanctions against Russia may be short lived going in to next year despite the fact the situation in Ukraine has not fundamentally changed.
We are closely watching geopolitical developments in Europe and the Middle East given the changing balance of power. With the US stepping away from the region, a multitude of players are looking to fill the void. The role of Putin and Russia in this unfolding drama will require constant monitoring going forward.
We have not changed our long standing view on credit.
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 interest rate increases have on credit outcomes and the negative effects are more profound for lower quality borrowers.
Chart 6: Credit Spreads
Source: Bloomberg 2015
It is well documented that bond issuance has been very high since the financial crisis. For investment grade issuers, low interest rates and reasonably tight credit spreads have kept interest costs at manageable levels. Unfortunately for high yield, interest costs have kept rising in line with wider spreads as can be seen on Chart 6.
The other problem facing high yield or low quality issuers is the shorter maturity profile. Chart 7 shows the strong volume growth in the high yield space. A large portion of this outstanding debt needs to be rolled in the next few years. With default rates rising in the energy sector, regulatory crackdown in the leveraged loan space and overall corporate earnings losing momentum, raising finance for low quality borrowers is becoming increasingly more difficult.
Chart 7: Total Outstanding US High Yield Debt
Source: Bloomberg 2015
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 impacts 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 and given their recent tendency to volatility are of little attraction as a defensive asset. Until such time as inflation expectations adjust to more appropriate levels we will remain underweight sovereign bonds.
We recently downgraded Australian government bonds on our sovereign hierarchy. Valuations have been expensive for some time but the more recent move to extreme levels when compared to US Treasuries (shown on Chart 8) made it difficult for Aussie bonds to maintain their place in the hierarchy.
Chart 8: Australian v US Sovereign Bonds
Source: Bloomberg 2015
The macro environment in Australia has also deteriorated for sovereign bonds (improved for equities). Australia has been able to avoid a recession since 1991 with the majority of resilience being attributed to the lucky timing of the commodity boom. With the commodity boom well and truly over, it was expected that Australia would finally suffer for the sins of an overly commodity related economy and slip in to recession.
To date this has not occurred. The 35% decline in the AUD has sparked life in to the export sector, driven strong tourism growth and attracted significant offshore flows, particularly in to housing market. It is too early to suggest the Australian economy is out of the woods, but the macro headwinds have failed to stifle growth in the expected manner. The recent drop in the unemployment rate to 5.9% suggests pessimism on the Australian economy is at risk of being repriced. Combine the fluid macro outlook with poor valuations and recent poor momentum, and we feel it is appropriate to downgrade Australian sovereign bonds.
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 given negative momentum and macro concerns.
Commodity investing remains an exercise in picking the least worst out of an overall bad lot. Energy and Industrials have remained at the bottom of our hierarchy all year given concerns around the end of the OPEC-era (more on that below) and due to slowing Chinese demand for metals respectively. As can be seen in Chart 9 this has been the right call. Not only have energy and industrial metals been the worst performing commodity complexes but there has also been little to choose between them over various periods historically. For now we maintain this relative preference.
Chart 9: Commodity Price Performance in USD
Source: Bloomberg 2015
Precious metals continue to be buffeted by the tailwind of central bank policy uncertainty and the headwind of a stronger US dollar. Agriculture has found some relative support in an El-Niño year.
However the story doing the headlines currently is the failure yet again of OPEC to agree to any cuts in supply. Divisions between OPEC first came to light late last year when the committee arrived at a similar decision to maintain supply in the face of sluggish demand growth and an oversupply situation that threatened to create a major supply glut if not addressed.
The OPEC of the past would have cut supply to balance the market given its role as the swing supplier in global oil markets. However this time around, the Saudi Arabia-led position was to continue to pump oil to take market share from US Shale oil and other marginal cost producers. Chart 9 illustrates the failure of this strategy in supporting prices. Oil prices have fallen by another 35% since the meeting last December and have taken an additional leg lower since the meeting of last week. Divisiveness between OPEC members is becoming more evident putting any prospects of supply cuts even in the next meeting in June 2016 into serious question. Concerns around the end of the OPEC-era are likely to continue to keep sentiment exceptionally weak in the near term. Looking further out however there are three reasons to be less bearish:
First, demand in 2015 has beaten very low expectations at the start of the year to increase 1.7% or +1.6 million barrels per day, according to data from the International Energy Agency. Expectations for incremental demand over the next two years of +1.4m bbl or 1.4% growth also look easy to beat.
Second, the macro positions of Gulf countries have seen significant deterioration which suggests a revisit of supply policy might be in the offing. For instance Saudi Arabia's budget position has moved from a surplus of 10% in 2012 to a projected deficit of -20% in 2015, according to IMF Estimates.
Third, US shale drilling activity and supply have both started to come off, as has supply from other commercial operators globally. For commercial profit-motivated operators, a US$ 40 price is a strong incentive to curtail production further and could further help offset incremental supply expected from Iran's re-entry into global oil markets in 2016.
Chart 10: US Oil Rig Count
Source: Bloomberg 2015
In summary our overall view on commodities remains one of caution but not of outright despair. Portfolio level arguments to owning commodities have never been stronger. They offer valuable diversification benefits in an environment of crowded positioning such as with the US dollar, which remains a consensus long. Further after multiple years of falling prices, fundamental value may have finally started to emerge with several commodities such as Copper, Nickel and Zinc already trading at their cash costs.
USD remains our favoured currency, just.
It is worth recognising a lot of the expected tightening by the US Federal Reserve is already reflected in the USD exchange rate, with valuations looking expensive on our models. Momentum remains positive but it is waning, particularly against the Yen. We also believe the macro outlook is more balanced given the tightening in monetary conditions that has already occurred as a result of the stronger USD.
We are neutral on the Yen and Euro as expansionary central bank policy is countervailed 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. Both currencies also have priced in a significant amount of policy divergence with the US so any 'foot off the gas' in easing may result a repricing. This was in evidence when the ECB failed to deliver a substantial increase in QE and so the UR rallied.
We remain (slightly) favourable to the USD given the relative monetary policy trajectories and current apparent relative economic strength. But the magnitude of currency adjustment to date suggests the balance of risks is more neutral. With investor positioning strongly in favour of the USD, it would not be a surprise to see a period of repricing of policy divergence risks.
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|
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