Corospondent - October 2016
International Outlook - October 2016
Equity market performance saw a quick turnaround during the past three months, with volatility accelerating towards the end of the quarter. Equity markets in the US were again boosted by technology shares, which rose by 12%, while bank shares had a strong quarter across most major markets, including the US, Europe and Japan. Energy shares also had a positive three-month period following production cuts recently announced by OPEC.
Emerging markets had a strong quarter as well, both at the equity market level and in terms of positive currency movements. Brazil and Russia were the stand-out performers. Year-to-date, the MSCI Emerging Markets Index has posted a positive return of 16%. This compares to a return of only 6.1% for the MSCI World Index of developed market equities, which has raised hopes that emerging market equities have finally turned the corner. A number of factors as to why emerging market equities have rallied this year are highlighted below:
- Importantly, the rally started in February from relatively cheap equity valuation levels and oversold emerging market currency levels that reflected highly pessimistic investor sentiment.
- China surprised investors with massive stimulus that generated a recovery in commodity prices, which are key drivers of emerging market equities and currencies.
- The US Federal Reserve backed away from its plans to tighten monetary policy in March, which helped both commodity prices and emerging market currencies recover after sharp sell-offs in 2015.
- The Brexit shock to global markets late in June helped push developed market sovereign bond yields to new lows, which boosted the relative attractiveness of emerging market bonds and currencies. Firmer commodity prices have also supported upward revisions to expectations for emerging market earnings.
With regard to China − following the recovery in its real estate markets − commodity markets have benefited from stronger demand. Copper imports for the three months to June were up by 34% from a year ago. Domestic steel prices in China have also risen by 52% since the end of November 2015, which has coincided with a strong rebound in JPMorgan’s Emerging Market Currencies Index. As always, it remains unclear how robust (or sustainable) China’s apparent stabilisation will be. Private sector investment has continued to slow down, while investment by stateowned enterprises (SOEs) has accelerated to a pace of 23.5% in the first half of this year (compared to relatively sluggish growth of 9.9% in the second half of 2015). The concern is that borrowing by unprofitable SOEs − a.k.a. ‘zombie companies’ − may be diverting credit from more productive uses in the private sector. But for the time being, the government seems to be prioritising stability at any cost.
The macro risk that remains for emerging market equities overall is the potential for major industrial commodity prices to resume their multi-year bear market trajectory as the effects of China’s stimulus begin to wear off. A look at a long-term chart of the inflation-adjusted Commodity Research Bureau's Raw Industrials Index provides some perspective, as this clearly illustrates a long-term downward trend since the late 1940s. This may well reflect the fact that, as Alan Greenspan once noted, the GDP of advanced economies has become notably ‘lighter’ over time as the share of services has increased, thereby reducing the share of materials-intensive heavy industries.
Moving on to the UK, the Brexit result of 23 June has brought about sharp downward revisions for growth, including for many of its European neighbours. According to a Bloomberg survey, economists cut their 2017 forecasts for UK real GDP growth from about 2.2% to 0.5% (essentially forecasting a recession) in the weeks that followed the vote. This growth forecast revision was accompanied by cuts to growth for 2017 ranging between 0.3% and 0.5% for many other European countries whose economies are exposed to trade with the UK.
In line with such forecast revisions, global bond yields fell on the view that central banks would need to either cut interest rates, as the UK has subsequently done, or signal that rates would be kept lower for longer. According to a Fitch Ratings report, the amount of negative-yielding sovereign debt rose by 12.5% in June to a staggering level of $11.7 trillion following the turmoil created by the Brexit vote. The drop in sovereign debt yields in developed markets has created a ‘stretch for yield’ trade that has boosted the relative attractiveness of emerging market debt, where yields generally remain higher than in developed markets. The result has been a resumption of portfolio capital flows into emerging markets following strong outflows through much of 2015. Data from the Institute of International Finance show a net flow into emerging markets of $107 billion in the six months to end August. Although that rate of change does not look excessive relative to the persistent pace of flows into emerging markets in previous years, there must be some worries that capital flows into emerging markets are overheating and setting the stage for disappointing returns and renewed outflows.
As highlighted already, bond markets have had another very strong year thus far, delivering double-digit gains. Bond investors continue to implicitly believe that secular stagflation is inevitable and growth in much of the world is settling at below-trend levels. They are conveniently overlooking the fact that there is a very meagre cushion in the value offered by long-dated US bonds. A mere 0.2% increase in Treasury yields would wipe out a whole year’s worth of interest income! Corporate bonds have been an even stronger performer over the quarter.
As we move into the fourth quarter of 2016, investors are essentially focusing on two key risks. One concerns the systemic risk in the financial system − related to the threat of a possible collapse of Deutsche Bank − while the second relates to US politics. Another risk that continues to cause concern is the fear that global economic growth – more specifically US economic growth – may falter. Naturally, this risk must be offset against the anticipation of a rise in US interest rates in the event that the US economy grows more robustly than anticipated. It is undoubtedly true that global equity and bond markets are in the late stages of a multiyear bull market, and this rightfully causes investors to be cautious. However, it is also true that since the 2008/2009 bear market, many money managers have viewed the equity bull market through the prism of mistrust that was caused by this painful experience.
Those equity investors who currently hold a negative view towards equities will argue that the stock market continues to be characterised by very high valuations and very low earnings growth. They believe that the only thing preventing this trend from setting off a bear market has been the equitybulls’ faith in global central banks keeping interest rates near, or below, 0%. Additionally, they will point out that, according to statistics provided by Standard & Poor’s (S&P), the market valuation for the S&P 500 Index stands at around 25 times reported earnings per share (EPS) and 22 times operating EPS. At the same time, earnings growth has been negative for the past seven quarters. Somewhat simplistically, it can be argued that in reality, most companies that are earnings ‘challenged’ trade at significantly lower levels than the current market multiple. As an example, Apple’s growth has slowed sharply and it is trading at 13 times EPS. In turn, IBM has struggled with EPS growth and it is trading at 12 times earnings. If the S&P 500 was a stock, they would argue, it would not be trading on a multiple of 25 times. Implicitly, the risk therefore lies in those consumer staple stocks that trade on mid-20 multiples due to the belief that their earnings will continue to grow at steady and predictable levels. This might well prove to be an overly sanguine outlook.
A further cause for concern is that, while equity valuations in the US are back to 2007 levels, the constituent companies have leveraged up in order to facilitate share buybacks. Currently, companies are much more leveraged than in 2007, with gross and net leverage respectively 40% and 25% higher. This was made possible, for now, by lower current interest rates. The federal government has levered up as well. If one strips out the amounts that the government owes to Social Security and other agencies, the federal debt held by the public more than doubled, from 35% to 76%.
That all said, in our opinion, the single most important issue undermining investor confidence is that, as was the case a year ago, many observers and investors are concerned that cyclical weakening in the US late this year and into 2017 may drag the global economy towards stagnation, or even a deflationary recession.
We, however, believe that despite the tepid pace of the post-2009 recovery, the US economy is far more resilient than many perceive it to be, particularly when relative comparisons are made with other major economies. Our reasons for holding this view are as follows:
- Populations are ageing and contracting in Japan and Russia, and poised to contract across much of Europe. Simultaneously, working-age populations are contracting in many leading emerging economies, including China, South Korea, Taiwan and Singapore. Meanwhile, the US population continues to expand by about 2.5 million people per year, providing fuel for growth in the labour force and domestic consumption. Additionally, the core of the large millennial generation is now gaining a foothold in the workforce and is poised to trigger a 15-year rise in household formations, a new baby boom and robust demand for housing, consumer durables and family-related goods and services. As this secular catalyst for domestic demand gathers momentum, the demographic divergence between the US and most of Europe and East Asia will become more apparent and somewhat transform the global economy, trade and capital flows, and collective demand for energy and raw materials. While this dynamic will only be fully felt in the 2020s, over the next 18 to 24 months, the momentum of cyclical recovery will dominate, led by resilience in US consumption and growth, modest growth in Europe and Japan, and the momentum of Chinese growth. This will also be fed by the late stages of urbanisation and government funding of infrastructure projects and financial support for leveraged SOEs.
- Looking more closely at the underlying demographic numbers, as the financial crisis began in 2007, full-time employment in the US peaked at 122 million. After falling to 111 million by the end of 2009, the gradual recovery over the past seven years has restored the 11 million fulltime jobs lost and created an additional two million. Yet, from 2007 through to the present, the US population has increased by between 23 million and 24 million people, with the core of the huge millennial generation moving into the workforce.
- While some baby boomers have left the workforce over the past nine years, the net increase of only two million full-time jobs since the 2007 peak reflects several disparate factors. Many older workers were forced reluctantly into early retirement. Many young adults unable to find work out of high school or college chose to continue studying. Meanwhile, six million Americans seeking full-time occupation are working part-time hours, limiting their incomes and spending power. Reducing ‘involuntary’ part-time work over the next year is vital to continued resilience of the current US cyclical recovery. While the value of overall US workforce participation is being clouded by young adults continuing their education and the early retirement of baby boomers, a valuable barometer of new job creation is the trend among workers (aged 25 to 34) just entering the workforce. The participation rate of this young adult group bottomed out between 2013 and mid-2015, and has been rising over the past year. A resilient US economy should lift this rate even further towards a normal level of about 83% in 2017.
- Based on the current US population, ‘normal’ annual demand for existing homes should total 5.5 million to six million units. In the past year, sales have rebounded close to the lower end of this range and should rise further in 2017. While the surge in construction from 2005 into 2008 triggered a sharp jump in the supply of unsold existing homes, inventory has been drawn down to very low levels over the past three years. Tight supply and delays in ramping up new home construction have fed house price inflation in many markets across the US. To meet the demand for new household formations, the rate of new home construction should be close to one million single-family units per year. While the number of homes built has risen over the past two years, delays in zoning and permits, as well as shortages of skilled labour, have kept this cyclical rebound far below the level needed to meet demand. The resulting upward pressure on residential construction will be a key driver of US economic resilience over the next three to four years.
In summary, the core of the huge millennial generation, born between 1983 and 1995, is now aged 21 to 33. The expected surge in new household formations was delayed by the deep recession of 2007 to 2011. However, over the next four to five years, pent-up demand from this group should drive new household formations up from 700 000 to 1.5 million units per year. In turn, this should trigger a positive ripple effect on the demand for property, housing and consumer-durable goods.
Turning to another key pillar of the US economy, while there is still considerable pent-up demand in the US for housing, the restricted demand for motor vehicles has largely been met. Yet, while total vehicle sales in the US have reached a cyclical peak, demand is likely to remain close to current levels for another 18 to 24 months before the reducing age of the fleet and other factors set in motion a reduction in new car and truck sales. US new vehicle sales for this year and the next are expected to be close to 17.6 million to 17.8 million units. In the shorter term, once we are past the uncertainty created by the presidential election, total US vehicle demand may surprise on the upside through year-end.
Looking at overall GDP growth in the US economy, the sharp drop in oil prices (since late 2014 and through to early 2016) triggered a significant drop in energy sector investment in the country. While consumers benefited from lower fuel prices, the drop in capital investment created a near-term drag on US GDP growth that heightened fears by late 2015 that the economy might slide into a recession. However, the drag on GDP growth from the energy sector has now run its course, setting the stage for a rebound in capital spending in 2017. Collectively, these near-term cyclical catalysts should support firmer than expected resilience in US economic growth over the next 12 to 18 months. Combined with nearterm investment-led momentum in China, and a modest cyclical improvement in growth for Europe and Japan, the outlook for global growth should prove surprisingly positive in 2017. The US economy (and hopefully the political system) is more resilient than many fear or doubt.