International outlook (commentary for the first quarter of 2013)
01 April 2013 - Tony Gibson
Performance was generally very positive from developed market risk assets for the first quarter of 2013. The Nikkei (up 20.1% in yen) spearheaded the total return performance charts on the back of Japan’s rhetoric on inflation targeting and monetary policy. Other core developed equity markets also performed well, with the S&P 500 Index, FTSE 100 Index and the DAX Index up 10.6%, 10.0% and 2.4%, respectively. However, given the large moves in currencies year-to-date, the substantial nominal returns for the Nikkei and FTSE 100 translate to a much more subdued 9.7% and 2.6%, respectively, in US dollars.
Looking at the other end of the performance spectrum, peripheral European and emerging market equities as well as selected commodities were the relative underperformers. Indeed, in equity markets, the BOVESPA in Brazil (-7.5%), FTSEMIB in Italy (-5.7%), the Greek ATHEX (-4.3%), Russian MICEX (-2.4%), IBEX in Spain (-2.0%), and the Shanghai Composite (-1.4%) all recorded negative returns for the quarter. The month of March proved negative for Spanish, Italian, Greek and European financials as a result of the latest bail-in strategies for Cyprus. This put into question the future template for resolving euro area banking crises alongside the prospects for Europe’s oversized financial institutions. Commodities were mostly down during the quarter, as illustrated by the 4% fall in the gold price.
Turning to fixed interest assets, total return performance for credit, while still positive, was subdued when compared with equities. US and European high-yield indices were up 2.4% and 1.4% respectively, while core government bonds were largely flat on the year. Core interest rates benefited from the renewed European wobbles in the last two weeks of March, which helped offset some of the weakness at the start of quarter.
In aggregate, equity markets as summarised by the MSCI World Index rose by a decisive 7.9% over the quarter, which begs the question: ‘Why – in the face of significant headwinds such as the worsening political gridlock in the US, continued structural and growth stresses in Europe and defiance of international will by troublesome states like Iran and North Korea – have equity markets, on balance, moved firmly upwards?’ The answer, in our opinion, lies in the fact that investors are becoming increasingly wary of entrusting their savings to ill-disciplined governments. Rather, they are realising that growing income flows from well-managed corporations will better protect them from the financial repression that lies ahead. To give support to this assertion, the following points set out our thinking:
The coming – and indeed already present – financial repression
Since the global financial crisis began in 2008 there has been a ballooning of sovereign debt on the balance sheets of most developed country governments. The main reason for this has been the issuance of government debt needed to stabilise the global banking system. The result is that, for example, the US government faces total outstanding debt of close to 100% of its gross domestic product. History gives us some interesting pointers as to how this will unfold. The first is that a debt to GDP ratio of 100% is unsustainable, due to the huge strain that this places on a country’s finances following a sharp rise in interest rates. This is of course often a self fulfilling cycle as weak balance sheets inevitably lead to higher cost of capital. The second pointer is that there are only a limited number of ways in which governments can reduce debt overhangs that have become unmanageable: default, financial austerity or rapid economic growth. Looking at the options it is clear that the first two are non-starters. Default would be financial Armageddon, while financial austerity has already been loudly rejected by electorates – with Prime Minister Monti receiving just 8% of the popular vote in Italy as the most recent example.
Governments, therefore, only have the economic growth option at their disposal. However, unlike in previous cycles where growth was inherently strong, in the current environment growth remains elusive and fragile. It is for this reason that, again using the US as the most important example, financial stimulus – via zero short-term interest rates and quantitative easing – is at unprecedented levels. Although it would be heresy for a central banker to admit to it, the policy adopted in the US increasingly seems to be one which is focused on nominal growth rather than real growth. In essence, politicians – when faced with the choice of growth at 2% and inflation at 0%, or alternatively growth at 4% and inflation at 3% – would take the second option. It really is the only way in which sovereign debt levels can be reduced to more manageable levels.
When in doubt we should learn from history. In 1945, following the financially draining WWII, the national debt levels in the US were 116% – with projections to 140% by 1955. But the true outcome was in fact quite different. In 1955 the debt level had fallen to 66%; and the reason – financial repression. For the 10 years from 1945 –1955 this phenomenon had reduced debt levels at a rate of 6.3% per annum. The ‘financiers’ of the repression were the holders of US government bonds – mainly pension funds – who received returns well below the prevailing inflation rates during this period. Over the 10 years, holders of long-dated US government bonds received real returns of -3.3% per annum. By comparison, equity investors received real returns of 5.8% per annum during this period.
This phenomenon should by now be playing a role in shaping investors’ decision-making. Notwithstanding the fact that equities have produced extremely volatile returns since 2000, investors are faced with increasingly uncomfortable choices. The first one is the prospect of lending capital to governments at nominal income returns of around 1.8%, with no prospect of growth in the income yields in the face of insidious inflation. The second choice is investing capital in well-managed companies at an income yield of 3%, with every expectation that these yields will grow with time. Additionally, the balance sheets of those corporations (in aggregate) are in a much healthier condition than those of most governments. Given that bond yields are near record lows (US 10-year treasury bond yield is 1.7%), we are well aware of the danger in ‘anchoring’ a pro-equity argument on current low levels. That said, were bond yields to rise by 250 basis points to 4.2%, we would not reach any different conclusions. After all, taking a long-term perspective, bonds are currently in the 99th percentile of their valuation history, while equities are only in their 47th percentile. Surely this wide margin provides scope for equity values to appreciate, while simultaneously allowing for bond valuations to return (fall) to longer-term norms?
The multi-year flows out of equity funds into bond funds do, at last, appear to be slowly reversing. The downside risk facing investors making this switch will inevitably be periodic bouts of volatility. However, the upside is the knowledge that inflation (even if relatively contained in the sub-3% range) will not steadily erode the value of their capital. For the record, and to provide perspective, a 250 basis point rise in 10-year bond yields from current levels would lead to a 20% reduction in the capital value of these bonds.
A re-assessment of the US economy’s recovery
In our opinion, the following extract taken from a recent stockbroker’s commentary on the US economy sums up current consensus sentiment: ‘US data is clearly interesting to watch from now on as the market will perhaps start pointing to the fact that if data momentum continues to slip it would be the fourth successive year that data has surprised on the downside at this time of the year. Indeed the seasonal pattern in US data had been fairly consistent in the last three years where we usually see data beats in the final quarter of the year before momentum starts to weaken in spring.’
The consensus sentiment seems to us to be one of paying lip service to the nascent US economic recovery, but at the same time not really believing in it with any degree of conviction. At the slightest sign of any ‘momentum slippage’ in positive economic statistics from the US economy, the suspicion is that we are back to the period of very insipid economic growth that has dogged the US economy since 2008. Our conclusion is a different one. We believe that the US economy, while not returning to the credit-fuelled pre-2007 growth levels, has embarked on a period of more robust and sustained economic growth. There are a number of factors that lend credibility to this contention:
- Housing construction and home prices (housing accounts for one third of the average American’s personal wealth) have most definitely turned around and are rising. To give this perspective, new home sales fell from a peak of 2 million units in 2006 to a low point of 500 000 in 2009. For the last 18 months, this trend has decisively changed and is now approaching the 1 million units mark. This will return the housing industry to a more sustainable level of growth as was the case prior to the credit boom of the 2000-2007 period. This recovery is, in no small part, due to the US government’s support of the housing finance agencies, such as Fannie Mae. These agencies buy mortgages, provide a credit guarantee and then securitise them. In recently reported profit numbers, it emerges that Fannie Mae took a 48% market share of new mortgage-backed securities’ issuance in 2012. Without this support the housing market would still be in a very depressed state.
- US auto sales have also rebounded strongly from a low point in 2009. At that point, annual sales had slid from 18 million units in the pre-2007 period to around 9 million in 2009. Current annual sales are now around the 15 million mark.
- Unemployment, while clearly still a major worry to the authorities, has also improved. While the medium-term average is around 6.5%, the peak level in 2009 was 10%. Today the level is at 7.6% and, putting the very recent weak statistics aside, looks set to improve.
- A dramatic boost to the supply of natural gas and oil in the US is proving to be a major boost to the US economy – and the benefits are only now starting to filter through to the manufacturing sector. To give perspective, in 2005 the US imported around 13 million barrels of oil per day. By 2012 this number had reduced to 7 million barrels per day. This saving of 6 million barrels per day is equivalent to making the US the world’s third biggest producer of oil, after Saudi Arabia and Russia! This is a massive boost to the competitiveness of the US economy as compared to, for example, Europe and Japan. Gas and electricity prices in the US are now around 40% of those in these countries. The reason for the energy boost to the US economy is due to the benefits of fracking to extract shale gas and oil.
As mentioned above, sovereign bonds are now extremely overvalued. In the face of financial repression – as is currently the case in the UK and becoming a reality in the US – the ‘search for yield’ is now forcing investors to invest in more ‘risky’ assets. It has been our belief for some time that this risk-normalisation process will gather momentum in 2013 and onwards. In doing so, it will push aside smaller risks such as the Cypriot taxation of deposits and the Italian political stalemate.
Although equity prices have rallied sharply over the past two quarters, money managers in developed markets generally remain underweight risk, while sovereign wealth funds have barely begun to restore a more normal risk profile to their portfolios. The increased risk positioning that we expect to gather strength will, increasingly, see money leaving safe havens in pursuit of the positive yield that risk (growth) assets, like equities, provide over time. This move will, in all likelihood, continue until central banks begin to exit the financial markets, and even then it will take time to change perceptions of distrust in the returns offered by cash and sovereign bonds. This does not seem to be in prospect for quite some time. As recently as March, at an ECB press conference, Mr Draghi promised to keep monetary policy ‘accommodative as long as is needed’. Please do not ignore the lessons from history!
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