Corospondent - April 2017

Corospondent - April 2017

Autumn Edition

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Tony Gibson

Tony Gibson

Tony is a founding member and a former Chief Investment Officer of Coronation. He has more than 40 years' investment experience.


All in all, the first quarter of 2017 was another good one for global asset performance. Although weakness in the US dollar somewhat flattered returns, almost every asset class delivered a positive total return – with the exception of certain commodities. Gold reversed its position as the worst-performing asset class of the fourth quarter of 2016 to end at the top of the performance tables in the first quarter of 2017, rising 8.4%. Global equities also did well, rising 6.9% and thereby continuing to outperform bonds (as has been the case since the global low point in yields seen around the time of the Brexit vote). The best returns came from the global technology sector, which rose 12%. To put this in perspective, it is worth noting that the top four megacaps of the sector (Apple, Alphabet, Amazon and Facebook) now have a combined market capitalisation twice that of the French CAC 40 Index. Energy was the only sector not to deliver positive performance, falling 5% on the back of lower oil prices.

In the bond and credit markets, returns largely appear to have followed a pattern commensurate with asset risk. Therefore, the lower the credit rating, the better the return. This is illustrated by the fact that despite the interest rate hike by the US Federal Reserve (Fed) in March, emerging market debt (in local currency) performed very strongly, producing a 6.4% total return. Additionally, returns were boosted by strength in emerging market currencies, with the Mexican peso, Russian rouble and Korean won rising 8% to 10% against the US dollar. Interestingly, despite a more hawkish Fed, US Treasury yields moved lower over the quarter, albeit marginally. In the currency market, the clear trend during the quarter was that investors’ long-standing preference for the US dollar has declined, with the currency underperforming every other major currency during the quarter. The Australian dollar (+6%) and Japanese yen (+5%) were the standout performers among developed market currencies.


Looking at economic statistics, global nominal GDP appears to be on track to record its second consecutive 6% annualised quarterly gain in the first quarter of 2017. This will represent a sharp acceleration from the 4.5% annualised growth rate over the previous two years. Supporting this assertion is the fact that manufacturing output growth is accelerating to a pace of 4.6% for the quarter, suggesting a significant boost from a positive turn in the inventory cycle. The strength in manufacturing activity appears to have been broad based, and has prompted economists to revise their GDP forecasts – particularly for western Europe and Asia.

As we already know, the US economy grew more modestly during the fourth quarter of 2016. That said, the US is also starting to experience the global pick-up in manufacturing (output is tracking a 3.8% annualised rise this quarter) and sentiment is improving. It seems probable that US economic growth is poised to bounce back to a level of around 3% as the year progresses, fuelling a faster gain in overall global GDP for the next couple of quarters.

Looking at Europe, growth dynamics in the region continue to improve: the European Commission’s Economic Sentiment Indicator is at a six-year high, the German Ifo Business Climate Index is improving and the European labour market is tightening. Again, economists are steadily revising their 2017 growth outlook for the region upwards. Given the pace of labour market tightening, it was somewhat unexpected that core inflation in March surprised significantly to the downside. At an annual rate of 0.7%, core inflation is now back at the low end of an already low four-year range. However, beyond this year, changing labour market dynamics should begin to put upward pressure on prices. While core inflation may only rise to 1.4% (year on year) by the end of 2018, the upward momentum in both growth and inflation should be sufficient to trigger quantitative easing tapering early next year. That said, the first rate hike from the European Central Bank (ECB) will most likely not come until late 2018. This forecast is reinforced by recent ECB comments.


Looking towards the medium term, it should be noted that the US Standard & Poor’s (S&P) 500 Index had been moving broadly sideways for nearly two years during the build-up to the 2016 US election. This period of muted performance coincided with the Fed beginning to normalise policy, during a time in which the economy was mired in a stop-go pattern of growth. Additionally, corporate earnings actually declined (mostly because of reported earnings declines from companies in the energy sector) during 2016. Then along came Donald Trump and the equity market changed tack, as it wholeheartedly embraced his reflation argument. The strongly bullish line of argument was that growth would be energised by a combination of deregulation, tax cuts and infrastructure spending.

Thus far, little that is either elegant or convincing has been forthcoming from the Trump administration. Investors have increasingly begun to wonder whether the recent healthcare reform failure is telling of how Trump’s other main policy proposals may play out. It has also raised questions about whether his policies will be sufficient to generate a sustained increase in the growth rate of the US economy. A worry is that tax reform legislation will be just as hard to achieve following the healthcare failure. Additionally, financial deregulation could face significant opposition and infrastructure spending plans may have a more muted impact on the economy than many believe, as it appears these plans are based on tax credits that will rely on private sector investment. Either way, whether bullish or bearish on the Trump administration, the events of recent weeks have to cast doubt on just how successful Trump will be in boosting the US economy.

Certainly, after the strong gains following Trump’s election, investors are more cautious that the healthcare debacle will have a negative impact on sentiment in the US. The question is essentially whether survey data were ‘leading’ actual economic data or simply getting ahead of itself. The most recent US Purchasing Managers’ Index release for February disappointed. That said, the services sector remains strong.


Taking a longer-term perspective, although fears of an unstoppable deflationary global contraction have reduced in recent months, expectations for a prolonged disinflationary environment are still built into developed world financial markets. The multi-year rationalisation, and acceptance, of negative real returns on short- and medium-term debt is fed by the self-reinforcing effect of momentum investing. This has distorted borrowing and investing patterns, and should not be seen as sustainable by any rational investor. As a reminder, and to offer perspective, US 10-year Treasury yields fell from the early 1980s to a low of just over 1.4% in mid-2012, and back to that low again in mid-2016. During the time before these already low yields were exaggerated by Fed bond buying, 10-year yields traded in a range between 4% and 5% from mid-2002 through to mid-2008.

Over the coming two to three years, as the Fed continues to raise short-term borrowing rates, it will also begin to retire (rather than reinvest) maturing Treasuries in its portfolio. Without this bond demand distortion (which has been in force since 2009), 10-year yields should continue to ‘normalise’ and slowly rise back to and above 3%. During this period, bondholders will most likely question the scenario again and might believe that tepid global growth – combined with the glut of global savings, continued bond buying by the ECB and the Bank of Japan, and (yet more) political gridlock in the US – will offset the reduction in Fed bond buying. This (bond-bull) argument therefore believes that further raising the federal funds rate would merely flatten the yield curve, slow the modest domestic recovery and force the Fed to pause – or even loosen again later next year or in 2019. We believe that this is bond-bull rationalisation rather than sound logic.

While prices of basic materials have risen significantly from depressed levels a year ago, the price of gold has remained relatively flat in US dollar terms. To give some context, year-on-year prices of natural gas, crude oil and copper are up by 69%, 34% and 21% respectively. By comparison, the price of gold rose by just 7% over this period. While the price behaviour of gold implies limited immediate inflationary price pressure, the year-on-year increase in the price of oil has triggered a near-term inflationary effect that will move through the supply chain during the course of 2017. Despite this, it is unlikely that the rise in the price of oil will materially suppress consumer spending power in the US, since most of the jump resulted from the over-sold conditions prevailing a year ago. More important is whether sustained higher energy prices later this year might trigger a second round of inflationary effects, which would lead to expectations of higher wage and consumer prices into 2018.


It is our opinion that during the next two years, the outlook points to a modest upturn in global economic activity, resulting in a synchronised period of global growth. This will be led by the US and will be supported by continued momentum from China and India. In China, it appears that to protect its consolidation of power, China’s ruling elite needs to support the momentum of growth this year. This in turn should support a further rise in base metal prices. As mentioned, the recent cyclical upturn in commodity prices should add to input price pressure over the next 12 to 18 months. Worryingly, over the longer term it appears likely that the global economic growth rate is set to slow and increasingly diverge between regions.

In examining likely future trends, investors need to be reminded that momentum investing (whether on a macro or share selection level) becomes self-fulfilling. In the late 1970s, inflationary expectations shaped group think, while by the late 1980s, it was Japan’s export-driven economic boom. A decade later, the collective focus had shifted to a US-led, tech-driven investment boom. By 2007, the masses of momentum investing were seduced by expectations of a super-long-term, China-driven commodity super cycle. The subsequent collapse, caused by the leverage-driven risk peak in 2008, led the next wave of consensus toward deflationary expectations. This saw the rationalisation of negative real interest rates and a critical mass of investors assuming chronic slow growth, a global savings surplus and a glut of production capacity. Distilled into one line, the belief was that interest rates would remain lower for longer for many years into the future.

All we can state with reasonable certainty is that looking ahead over the next 10 years, the environment that will shape the late-2020s is likely to be far different from the influences that shaped the critical mass of consensus thinking that exists today. We believe that the world will most likely be moving from the current period (which encourages excess savings and is characterised by lower debt yields) towards a period of demographic divergence, during which modest growth in the US will be insufficient to compensate for the ongoing contraction in most of Europe and North Asia. The worry is that rapidly ageing populations, and the resultant negative effect on economic growth, will drain savings and set in motion a process leading towards higher capital costs and reflation. As mentioned earlier, in each of the past five decades, such a transition and the resulting shift in the direction of momentum investing will be dramatic. At Coronation, we know well that during the early stages of such a macro change, inertia towards recognising the trend can frustrate premature contrarian investments.

Put another way, it may well take another two to three years before rising nominal interest rates produce a real rate of return (after inflation) for passive investors. However, it is our belief that the era of disinflation that led to negative real interest rates is over. It is the interference of central banks (by buying public sector debt) that is preventing markets from pricing capital, and thereby distorting risk and financial asset allocation. Without this temporary and artificial support, the transformation of the global economy and financial system would have already become more apparent.

Therefore, while near-term conditions favour a period of growth in 2017 that is likely to last into 2019, we foresee this fading quickly in the 2020s as the economic, financial and political environment will begin to deteriorate across most of Europe and North Asia. Collectively, the common thread is likely to be a steady contraction in the global pool of mobile capital. This will result in the cost of capital becoming increasingly unaffordable for those countries failing to manage their economies in a prudent and productive manner. SA will be particularly vulnerable to this trend.

With regard to global equity markets, the valuation of the US market is the benchmark from which investors generally take guidance. There is little doubt that US equities appear overpriced – especially when measured against long-term averages. Additionally, a recent survey undertaken by Bank of America indicates that over 80% of participants believed that the US equity market looks expensive. A measure that is often turned to when seeking valuation guidance is the cyclically adjusted Shiller index. This index is the S&P 500 price-to-earnings ratio based on average earnings over the past 10 years. This index is now well above the very long-term average of 16.7 times – currently standing at 29.7 times.

While this undoubtedly high valuation calls for caution, it is worth pointing out that this has been the case for a number of years in the severe post-2008 equity bear market. Additionally, statistical studies have shown that historically, the Shiller index has only explained around 10% of market movements over any subsequent five-year period. As we well know, we operate in very unusual times at present, when assessed in terms of ease of forecasting. Many fundamental demographic and social changes are currently unfolding, which make forecasting problematic. It is a time during which investors who draw on their ability to apply much-needed perspective and calm will navigate the uncertainty successfully.