Quarterly Publication - July 2016
International outlook - July 2016
In recent months global investment markets have had much to fret about – whether it be Brexit, worries over the post- Obama leadership in the US, the migration crisis, wavering confidence in the strength of the US economy or deflationary fears in Europe. In our opinion, the clear growth of populism (best exemplified by the utterances of Donald Trump) has unsettled investors the most. Markets are no doubt alarmed that ‘even’ the US economy is falling prey to protectionist and populist statements. Additionally, investors are concerned that globalisation is seen to be failing in advanced Western countries. Once hailed for delivering universal benefit, it is now facing a political backlash. The reason for this, it seems, is the delayed (but inevitable) effects of financial repression.
This is the phenomenon whereby central banks aggressively intervene to lower interest rates to effectively zero, in the hope that it will stave off deflation. The consequence of this strategy has been that, while staving off deflation, savers are penalised. Additionally, while the financial position of the median worker in the US has deteriorated in real terms since 2006, a small but very visible component of the business community has made extraordinary amounts of money. This is an environment in which antimigration sentiment flourishes as it is seen to be the reason for the lack of economic progress suffered by the working class. Similar sentiments are being expressed in Europe – exacerbated by the migrant crisis.
Accordingly, critics of globalisation contend that Western countries are failing to cope with the economic shocks that inevitably result from closer integration, particularly the stagnation of real average incomes for two decades. Another shock was the global financial crisis itself, seen as a consequence of globalisation, with its permanent impact on long-term economic growth.
A stark example of antiglobalisation sentiment is the dramatic reversal of public opinion in Germany about the benefits of free global trade in general. In 2014 almost 90% of Germans were in favour of free trade, according to a poll. That has now fallen to 56%. The number of people who outright reject the Transatlantic Trade and Investment Partnership (a proposed trade agreement between the EU and the US) has risen from 25% to 33% over the same period of time. Although these numbers do not suggest that the EU will become protectionist, the fast shift in those figures is a worrying trend. In many European countries, globalisation and technical innovation have together destroyed the jobs of the working classes. Now these factors are threatening the livelihoods of the lower middle class. Accordingly, a revolt among voters is unsurprising.
While workers in the West remain wealthy compared with most others around the world, their incomes and benefits have stopped improving and, more ominously, are increasingly deemed unaffordable. This has fuelled social uncertainty and the rise of anti-establishment politicians through Europe and now the US. Essentially, electorates believe there is insufficient factual evidence that countries that have reformed are performing better. The US and the UK have more liberal market structures than most of continental Europe. Yet the UK is exiting the EU and in the US the Republicans may be about to nominate an extreme populist as their presidential candidate. Politicians who advocate global market liberalisation are being forced to face up to the notion that both globalisation and European integration are increasingly seen as failures. Both were supposed to produce a situation where nobody should be worse off, while some might be better off. The key point is that if the politicians do not take action, the voters surely will.
Meanwhile, the influence of the global economy on the decisions of the US Federal Reserve (Fed) has become a topic of frontline importance in recent months. Since the start of 2016, events in foreign economies have conspired to delay the Federal Open Market Committee’s intended ‘normalisation’ of domestic interest rates, which had apparently been set on a firmly determined path last December. But the key question now is whether weak foreign activity will continue to trump (no pun intended) domestic strength in the US. The US central bank certainly has no responsibility to take direct account of the welfare of foreigners. That said, the impact of events overseas on the dollar and the domestic US economy are too important to be entirely ignored.
Remarkably, the ten-year German Bund yield reached a record low of -0.17% in the wake of the Brexit vote. The ten-year US Treasury note is around 1.45%. These bonds are now trading below the yields during the depressionary period of the 1930s and 1940s. This does suggest a serious bubble, representing a bigger problem in government bonds around the globe than what we saw following the technology bubble during the late 1990s. As has been well signalled, the Fed seems intent on normalising rates, albeit at a slower pace than in the past. While this may be undesirable, what the Fed does (or does not do) is critically important for the market. It seems the bond market is currently expecting two to three rate increases, followed most likely by a recession.
We disagree with that. While secular headwinds will pose a formidable barrier to global growth over the medium to longer term, a cyclical rebalancing should buoy growth over the next two to three years. As mentioned, fears of an impending recession in the US have been on the rise – both because the current expansion is growing tired and because declining profits are seen as a signal for firms to cut capital spending and hiring. We believe these fears are exaggerated, for several reasons. First, economic expansions do not necessarily simply end due to the flux of time. Rather, they die of natural causes, including overinvestment imbalances, policy tightening, and other exogenous or external shocks. Secondly, although profit growth rates have declined significantly over the past year and a half, this has been from extremely high levels. Profit margins are still quite high by historical standards – well above levels normally seen as the economy nears a recession. Margins normally peak at mid-cycle, not at the end of a cycle, and they decline for a number of years as the expansion matures.
We do not currently detect any of the various potential natural causes of recessions in the US. Frequently, it is aggressive Fed tightening in response to rising inflation pressures that induces downturns, but that prospect still seems a couple of years away. Overinvestment in housing and/or business capital has also been a traditional culprit, but underinvestment has been the mode so far in this expansion. Looking at other conventional causes of a recession in the US, oil shocks have often been major contributing factors. However, the shale industry has become a buffer to potential price spikes going forward, thereby arguing against this as a cause. China may offer a new potential shock, but Chinese officials seem to have both a desire to avoid and the resources to deal with any disruptions that do arise.
The more bearish commentators will point to recession probability models that suggest that the likelihood of a downturn has increased in recent quarters. These models, and indeed the economic profession, do not have an especially good record in predicting recessions a year or two out. In our opinion, a recession is not the most likely outcome over the next two years, with current conditions certainly not favouring a severe recession any time soon. This is validated by the fact that the median US worker enjoyed a pay increase of 3.5% year-on-year in May, according to the Federal Reserve Bank of Atlanta’s wage growth tracker. Wage growth has been accelerating since October, quickening to a pace not seen since January 2009. This measure of wage growth is far from the only metric suggesting that the US labour market might be close to full employment. The National Federation of Independent Business (NFIB) Small Business Optimism report for May indicated that finding quality labour remains one of employers’ biggest problems. Citing anecdotal evidence, the NFIB reported that the ‘failure rate’ rose over the course of the month, as the share of owners who could not fill a job opening lingered at historically high levels.
What will, ultimately, cause the US economy to move into a recession will be the slow but inevitable climb back to positive real interest rates, which will also increase the cost of debt service for many countries and corporations. While companies may have locked in longer-duration debt, most countries had been short-sighted and face a surge in net interest costs. While the timing of the climb will have a significant impact on near-term capital flows and asset allocation by country and industry, the end destination is still likely to be a rise of 200 basis points to 250 basis points in the Fed funds rate (and much of the US yield curve) over the next 24 to 36 months.
The primary reason for our view is the expected ripple effect of the year-on-year rise in energy prices over the next 18 months, which may prove to be a major catalyst of rate hikes. This will increase consumer prices and therefore boost (already rising) cost-of-living wage hikes. While the media and many investors focus on tepid year-on-year inflation in the US (up only 1.1% in the year to April), less attention is paid to the measure of consumer price index (CPI) less food and energy – which has been at or more than 2% year-on-year since November 2015, despite the ripple effect of sharply lower energy prices. With year-on-year energy prices poised to rise sharply during the remainder of 2016 and into 2017, top-line CPI is likely to rise above 2%. As a result, a normalised Fed funds rate would be 2.5% or higher by 2018.
That said, while the Fed will lead the climb towards positive real interest rates, it will be followed only after a considerable lag by the Bank of Japan and the European Central Bank. As a result, money is likely to rotate towards the dollar and US financial assets again. Despite popular belief, such a modest real rate of return may actually stimulate rather than dampen economic activity.
Looking at equity markets, some perspective is called for. Seven years of the Fed’s zero-interest rate policy have resulted in an increasingly over-extended search for yield. This has inflated valuations of many financial assets to historically high levels. Additionally, US equity markets have also experienced an extreme divergence since mid-2014 as the collapse in commodity prices and exceptional US dollar strength stoked fears of an industrial recession, which depressed the share prices of many value stocks and drove investors into perceived safe-haven assets, such as passive large-cap exchange traded funds (ETFs), mega-cap consumer staples and growth stocks. This equity market dynamic caused many investors to crowd into momentum stocks, inflating their valuation premiums over value stocks to levels not seen in the past 35 years, other than during the tech bubble period of 1998 to 2000.
As context, in 1998, the Asian financial crisis and collapse of Long-Term Capital Management created major macroeconomic disruptions and raised fears of systemic risk that caused equity markets to experience a sharp bifurcation. At that time, fear caused capital to leave the equity markets, while the remaining investments tended to gravitate towards large-cap stocks. The rise of passive investing (via ETFs and index funds) during the mid-1990s had already channelled large amounts of capital into large-cap and growth companies, particularly those focused on the internet, resulting in significant share price appreciation. As investors grew concerned about the macro environment, they crowded into these ‘safe’ investments. Value stocks, particularly small and mid-caps, became a source of cash and underperformed in late 1998.
By the end of 1998, the ten largest technology stocks, including Microsoft, Intel, Cisco, AOL and Yahoo, had gained an average of over 140%, driving the Nasdaq Index up 40% and the S&P 500 Index up 29% for the year. The S&P 500 Equal-weight Index gained only 10% in 1998, while most value managers performed well below that level. This extreme divergence reinforced itself over the next 18 months, as investors ignored fundamental analysis and rotated further from value into growth and momentum names. While the AOL-Time Warner merger in January 2000 should have rung a ‘bell at the top’, as it revealed the enormous gap between the prices and fundamentals of many growth companies, the actual inflection point for US equity markets came in March 2000. The ensuing collapse of the tech bubble triggered a long-overdue rotation back to value and initiated a seven-year cycle, from 2000 to 2006, during which value outperformed growth. Despite global economic growth that fell well below trend from 2000 to 2003, active value-oriented strategies outperformed the market meaningfully as the valuation differential between growth and value continued to narrow. Investors remained focused on fundamentals as the economy improved, which enabled value to outperform growth through 2006.
Equity markets experienced another significant bifurcation from mid-2014 to early 2016, with large-cap growth stocks again outperforming small- and mid-cap value stocks. Two major macro factors triggered this equity market divergence: firstly, a rapid and sustained decline in commodity prices, highlighted by a historic 70% peak-to-trough decline in the price of oil; and secondly, a similarly rapid and sustained strengthening of the US dollar, which appreciated by 25% to 40% against major developed market currencies, and by 40% to 80% against many emerging market currencies. These two disruptions caused fear among investors and pressured the earnings of US industrial and export-focused companies, prompting investors to rotate back to large-cap stocks at the expense of small- and mid-caps, and to growth and momentum at the expense of value stocks. Passive investing, already on the rise for years due to substantial capital inflows into ETFs, gained even more momentum during this period, exacerbating the bifurcation. The so-called FANG stocks (Facebook, Amazon, Netflix and Google) gained more than 80% on average in 2015, largely due to a multiple expansion in valuations, fuelling a double-digit gain in the Nasdaq 100 Index, which, without these four stocks, would have been down in 2015.
It would seem to us that the multi-year rotation away from value may be in the process of reversing after equity markets experienced their worst start to any year on record.
This sell-off was broad based, but as investors once again fled to the relative ‘safety’ of mega-cap consumer staple and growth stocks, small- and mid-cap stocks and many value stocks were disproportionately impacted, driving valuations to near historically low levels. The bottom in February 2016 and subsequent recovery of the equity market might have coincided with another major inflection point in the dynamic from growth to value. This inflection point appears to be a function of the stabilisation of the two macroeconomic factors (oil prices and the US dollar) that drove the recent bifurcation in equity markets: oil prices have rebounded significantly from their low, and the US dollar has gradually stabilised against major currencies.