Global growth remains decent, but weaker than expected and more vulnerable. The dovish stance of central banks and more details on ‘mini-deal’ (phase-one of a US-China deal), may save the day for risk assets allowing them to trade in a range. While this (resilient but vulnerable growth) remains our central scenario through the year end, there are other two possibilities for next year. First, an escalation in trade war causes a full-blown contagion from manufacturing into services, thereby affecting consumption. If this happens, we would be in for a very defensive stance. Secondly, growth moderately re-accelerates driven by fiscal and monetary policy and improvement in trade situation, a trigger for some repositioning in risk assets.
In our view, four key themes will likely set the direction of opportunities and risks for investors:
- More uncertain communication from CBs as internal disagreements grow and divergent views within the Fed and the ECB affect markets. These conflicting views and lack of consensus will be the new source of volatility. Moreover, this comes just when market expectations on Central Banks actions are very high, too high in our view.
- Dispersion in growth due to less globalisation and rising idiosyncratic risks (Brexit).
- Resilience of internal demand. Countries with strong internal demand, relatively isolated from the trade war and with higher visibility on fiscal policies would be better able to withstand the slowdown. The US needs to watch whether a manufacturing slowdown spills over to the consumer and services sector which could aggravate slowdown risks. Now, this risk is low: consumption is backed by growing disposable income and we do not anticipate big job cuts.
- Uncertain earnings path. There is low visibility on earnings outlook in the short term. Expectations have already come down for the next quarters, but the risk for further disappointment is not negligible. A profit recession can occur without an economic recession, and this is still not priced in by the market.
Our four convictions below:
- Cautious stance in risky assets to continue amid increasing growth vulnerabilities and limited earnings visibility for the near future. Equities generally bottom out with ISM manufacturing indices, which are not likely to stabilise before next year. Earnings growth is already pointing south and there is no particular sign of euphoria, but it is also not the time to be excessively negative in equities.
- Biggest opportunities in equities will come from sector rotation, not from directional moves. As most of the market directionality is likely behind us, being right in sector rotation will be important. Growth outperformance vs. value remains extreme. Value in Europe is at multi-year low. For value to outperform, some pick-up or stabilisation in yield is needed: we are not there yet but looking for triggers (fiscal expenditure could be one) and good quality companies in the value space could be an opportunity to play moving into 2020. Companies that have sustainable balance sheets, adequate cash flows and strong business models can deliver strong risk-adjusted returns.
- We will witness more dispersions among regions, due to less globalisation that will renew focus on a selection of themes/sectors and securities both in the developed and the EM world.
- The overall picture is not rosy, it is important to monitor the evolution of the key risks in the market and hedge against a possible worsening of the scenario and prepare to be more defensive, should trade talks deteriorate and manufacturing recession spreads to services and affect consumption.
Central banks have now embarked on a recession-fighting mission. This should support both economies and markets in the months ahead. The more than 25 global interest rate cuts since May 2019 together with fiscal stimulus measures should accelerate global growth. These rate cuts are a shot in the arm to the world economy and should support consumer spending and help reduce the adverse impact of the uncertainty created by the US-China trade conflict. Thus, central banks are flooding the world with liquidity, which is laying the seeds for some shoots of growth early next year.
Back in the last quarter, market participants fled into safe-haven assets, as exemplified by the more than USD 17 trillion in negative-yielding bonds globally. However, meaningful interest rate cuts in the face of excessive investor pessimism tend to be followed by the outperformance of riskier assets, particularly if they help to ignite growth as we expect them to. This drives the case for investing in equities and taking measured credit risk in the fixed income space in the months ahead. However, growth will not be equally distributed and thus, the environment remains attractive for stock-picking strategies.
Growth investors look for companies that exhibit above-average growth, such as in earnings. Many are highly valued relative to a fundamental metric (such as this year’s earnings) given their (earnings) growth potential. On the other hand, a value stock is a company trading at an attractive level relative to a fundamental metric. Once market participants realise that a stock offers good value, investors move in and the stock price rises. To quote Warren Buffet about value investing: “Price is what you pay, value is what you get.”
Currently, value stocks are trading at a record discount to growth stocks. Thus, we would expect value stocks to outperform in the coming months, if history is any guide, with the likely catalysts being stronger growth and higher bond yields given the cyclical tilt of value stocks.
For more than a decade, developed countries have been stuck in a low‑inflation environment despite the best efforts of central banks to engineer pressure on prices. This setting has been a significant driver of the sharp decline in rates, which has pushed many government bonds yields to historic lows and a record amount into negative‑yield territory. Markets are painting a bleak picture for the inflation outlook, which is worrying central banks as they already used an arsenal of tools over the years attempting to revive it. From interest rate cuts to bond buying and cheap lending to banks, central banks have done as much as they can. It is now time for governments to step up to help stimulate the economy. Our biggest fear for 2020 is that central banks in developed economies step back and do not extend the accommodative stance they embraced in 2019. With lower short-term risks around Brexit and US-China trade tensions, our central economic scenario is one of reasonable optimism, with global growth stabilising next year. However, if the US Federal Reserve and the ECB revert to the normalisation of 2018, we fear equities and bonds could both suffer.
Whether we like it or not, markets and some parts of the economy have become highly sensitive to interest rates and available liquidity. Very accommodative monetary policies will become a permanent feature of our ageing, indebted developed economies – as has been the case in Japan for the past 20 years. As 2018 showed, if central banks withhold the sugar, they receive a tantrum – such as unsettled markets, lower inflation expectations and higher downside risks to growth.
Since the beginning of this year, financial markets and expectations have turned decidedly bearish. Concerns about a Sino-US trade war, along with the so-called ‘inversion’ of the US yield curve, have heightened apprehension of a US-led recession.
This is highlighted by the recent increase in negative-yielding bonds. As per the chart below, the amount of global bonds with a negative yield to maturity has surged to represent a record US$16 trillion in value. It’s been an incredible 12 months in financial markets, from ‘interest rates are certain to rise’ to ‘deflation and low interest rates are here to stay’. Economists, market participants, elected officials and other commenters are beginning to realise that the traditional tools of central banks will not be enough to offset the next economic crisis.
We know negative interest rates don’t help. We know quantitative easing has been all but useless in Europe, Japan and the United States. And some express concerns that most governments have run out of money and thus won’t be able to respond with fiscal stimulus if we were to suffer another downturn.
However, we believe there is a change coming. We believe inflation will return because the role of central banks in managing the economy will change dramatically. In our view, there is a shift from relying on monetary policy to using fiscal policy is almost certain and will potentially have major ramifications for all markets and strategies well beyond the bond market. As we enter the 2020 US Presidential election year, the emerging political debates and electoral response will be worth watching. By increasing the deficit in favour of households (who are most likely to spend incremental money they receive) rather than the wealthy (who are most likely to save incremental money they receive), there is, for the first time in a generation, the real possibility that modern Western economies can achieve near full employment, improving wage gains and a corresponding return of inflation. When that happens, those ‘lower for longer’ bond holders and equity investors need to watch out – the losses could be staggering.
Over the 12 months to September 2019, AREITs posted an impressive total return of 18.3% (5.8% higher than the S&P/ASX 200 return of 12.5%). One of the forces responsible for this return was a fall in market interest rates. The Reserve Bank of Australia (RBA) has already cut the cash rate to a new record low 0.75%, in line with the global trend. Bond yields across the globe declined as investors position themselves for a slow growth environment. Even though the Australian 10-year government bond yield increased 12bps from 0.89% to 1.01% during September, compared to the same time in 2018, the Australian 10-year government bond yield was 168bps lower.
Equity market volatility remained high as multiple uncertainties remained in global markets, although some progress was made. While global share markets rallied in September, AREIT securities underperformed as their defensive features made them relatively less attractive compared to growth assets.
However, AREITs’ earnings yields continued to be attractive relative to various interest rates. Currently, AREITs earnings yield is 5.2%, which is higher than yields of both cash and Commonwealth Government bonds. The premium to Australian 10-year government bonds is 4.3%, a historically high premium. Traditional, safe sources of investment income, from cash, term deposits or fixed income are simply not performing in the current economic environment where low interest rates show no sign of rising substantially in the short to medium term. Investors may want to look further afield and consider other asset classes which can provide better outcomes for them.
Operating conditions continue to vary among the segments of Australian Real Estate Investment Trusts (A-REITs). The headline valuation of the sector appears attractive, as history indicates a decline in bond yields means listed property outperforms broader equity markets. While this has remained the case in 2019, the strength of the outperformance has been relatively weak, attributed in part to an A-REIT index which has significant exposure to retailing that, in turn, is facing uncertainty over cash flow. Hence, the sector is not as defensive as it once was. The price/earnings multiple of the A-REIT sector is at a -0.8 percentage point discount relative to the ASX 200, having inverted from a 1.7 percentage point premium since May 2016. At the end of September, AREITs were trading on a 46.8% premium to net tangible assets (NTA) on an index-weighted basis. This measure implies the sector is expensive, with a limited upside in asset valuations remaining in this cycle.
Australian economic data was a mixed bag. Home building approvals rose in September, but this was due to a bounce in volatile unit approvals with the fall in dwelling approvals over the last year pointing to further weakness in home building construction over the next six months or so. Fortunately, this will be partly offset by non-residential building where approvals have been trending up solidly and unit approvals look like they may be stabilising. Rising new home sales are also consistent with a stabilisation in home building approvals. Meanwhile credit growth slowed further in September with weakness across the board including housing investor credit, but credit data is lagging, includes debt paydowns and rising housing finance commitments point to stronger housing related credit growth in the next few months.
Finally, the terms of trade rose again in the September quarter with a stronger than expected rise in export prices relative to import prices. This is good news for national income but the stronger rise in export prices means weaker than otherwise export volumes so net exports look like being a detractor from growth in the September quarter. There are so many cross currents in all this – but the bottom line seems to be that the economy is still growing but remains constrained. On the inflation front, consumer price inflation remained weak in the September quarter as noted earlier, as did producer price inflation at just 1.6% yoy.
CoreLogic data for October showed a continuing rebound in home prices – led by Melbourne and to a lesser degree Sydney but with most other cities also seeing decent gains.
Quite clearly pent up demand unleashed by the election outcome, rate cuts and the lowering in APRA’s 7% interest rate serviceability test is continuing to impact. We have been off the view that after an initial bounce price gains would settle down to around 5%pa through next year, but the risk is that the positive momentum is starting to feed on itself again pointing to continued strong gains into next year. For the time being the RBA is not too fussed as housing credit growth remains low – at just 3.1% over the year to September – but if house prices are to continue to surge this will see credit growth pick up too, which will invite renewed regulatory controls on lending growth.
The tax cuts already implemented have done little to spur consumer spending confidence. The propensity to spend extra cash has been reduced as Australian consumers remain overleveraged and devoid of any pickup in wage growth while economic uncertainty is on the rise. More substantial fiscal stimulus will be needed as monetary stimulus loses its potency in order to boost productivity and reignite the private sector.
We remain cautious on the Australian share market, which has continued to rally throughout 2019 despite the weakening macroeconomic outlook that has forced the RBA to cut interest rates. The forward price to earnings ratio (PE), a measure of market valuation, has risen back to close to 16x, which has served as somewhat of an upper limit on valuations over the past 15 years, while the earnings outlook has deteriorated over the course of the calendar year. It appears that investors are placing less emphasis on these fundamentals considering low cash rates and lower prospective returns in defensive asset classes. Consumer staples tend to pay reliable if not as spectacular yields but are truly “defensive” in that even in a recession consumer will still have to eat, drink, wash etc. In the case of utilities, REITs and other bond proxy-type asset (infrastructure funds, toll roads, airports…), the allure has not just been “defensiveness” but yield in a little-to-no yield paying environment. Aside from having been pushed beyond typical valuations due to demand, these assets are at risk of any decision by central banks to hold off on or even reverse further easing.
We believe the issues behind the current low interest rate environment – a slowing economy, low inflation, stubbornly low wages growth, poor capital investment (noting future capital expenditure surveys remain weak) and household indebtedness being amongst the highest in the world – remain prevalent and key causes for concern. We are now holding lots of cash, looking for the right opportunity. We are comfortable with the view that the defensive position is warranted. If markets shoot higher, then we will underperform, but we think the trade-off is justified. Downside protection is more important at this point in the cycle than chasing stock markets higher.
October defied its ominous history as the global equity markets posted another positive month, sending the major indices up roughly 20% for the year. Positive developments on China/US trade negotiations, a Federal Reserve interest rate cut, and corporate earnings that have largely exceeded expectations contributed to investor optimism. Asian markets led during the month largely on hopes for progress on trade. Japan saw a large jump in consumer spending in advance of an increase in the country’s value added tax and was the strongest market in the month. Overall, economic growth continued to show signs of slowing, with business investment showing the sharpest decline. Currency movements were pronounced as the UK pound rose sharply against the US dollar on expectations of a Brexit deal after the upcoming December election. Emerging markets also rallied sharply on the trade prospects, stability in commodity prices, and lower interest rates. They have now outperformed developed markets over the past year.
Given expectations for ongoing volatility, investors should take a more defensive stance without deviating from their long-term strategic asset allocations. However, beware of crowded trades, especially in traditionally low volatility sectors that may have become risky due to lofty valuations. Into this group we can place the likes of utilities, REITs and consumer staples – the traditional “defensives” – which have been bought up heavily in the US but also in Australia.
Adopting a defensive posture in equity portfolios could mean complementing growth-oriented holdings with higher-quality companies with histories of paying dividends. The late stage of the economic cycle continues to favour companies that can use their competitive advantages to drive profit growth regardless of economic conditions. These leaves “companies that can use their competitive advantages to drive profit growth regardless of economic conditions” as a rather select group locally.
If we break the period into regimes of stronger or weaker real USD, then a clear pattern appears. Whenever the USD strengthens, the US equity market outperforms the world ex-US and emerging markets and vice versa. Some form of USD intervention is the next logical policy step. Monetary policy has lost its effectiveness and fiscal stimulus is coming to slowly to offset the weakness in the global economy (the OECD’s leading indicators have been declining for 18 straight months). A great irony of any USD intervention is that it will partly help China, which is not exactly the strategy of the Trump administration but as with everything in life there are always trade-offs. US equities are expensive in both relative and absolute terms. They remain expensive due to multiple factors ranging from higher share of buybacks, safe-haven status, higher profit growth driven by technology monopolies and finally a healed financial sector. Valuation metrics are difficult to use as timing tools because the market can often remain elevated for long periods and maybe we are going through such a period. But rich valuation premiums to other equity markets are typically not a good starting point for relative superior returns in the future.
In mid-September, the European Central Bank (ECB) delivered its biggest package of measures in three years, as it cut the deposit rate further into negative territory and restarted its bond-buying programme with €20 billion of open-ended monthly purchases. The central bank also eased lending terms for banks in the euro zone and implemented tiered interest rates in a bid to ease the pressure on their lending margins. The ECB’s move to insulate European banks from the harmful consequences of negative interest rates caused investors to warm to the sector after months of shunning it, resulting in a bounce alongside other value stocks and economically sensitive areas of the market.
Outgoing ECB President Mario Draghi also stressed that fiscal policy needed to pick up the baton from monetary policy, through tax cuts and more spending, particularly by those countries in a position to do so. It was clear in the ECB September meeting that the Draghi ECB era is over and that the central bank is at the end of its policy rope, because virtually all core EU country representatives were against the resumption of QE. We like EUR/USD significantly higher as there is plenty of room for fiscal measures in Europe and new EU leadership in Q4 may well deal with the EU’s economic weakness. When the strong USD regime ends, investors should overweight European and especially emerging market equities. There is also good support for this strategic position from a valuation perspective as the valuation spread — measured on the dividend yield — has soared to historically attractive levels for the world ex-US and emerging markets.
Britain edged closer to its first recession since the financial crisis after the country’s dominant service sector unexpectedly plunged into contraction in September, in a sign of the mounting stress facing the economy. Because of Brexit, Shares in UK-focused companies have rallied strongly in the past month, amid hopes that a disorderly Brexit can be avoided. Typically, a surging pound would trigger a sell-off in the FTSE 100 as the firms in the blue-chip index make a significant proportion of their profits in overseas currencies. However, the FTSE 100 has fallen by a relatively modest 100 points in the past month. The more domestically focused FTSE 250, with more companies operating solely in Britain than the FTSE 100, has rallied by almost 300 points over the past month. The changes come in a relatively flat month for stock markets around the world, against a backdrop of heightened concerns over the health of the global economy. The Brexit deal negotiated by Johnson is expected to sacrifice as much as 6.7% of lost GDP growth over the next 15 years, or as much as £130bn that the UK economy would grow by if Britain stayed in the EU.
After a four-year delay, Japan finally raised its consumption tax from 8% to 10% on most goods and services. The tax increase carries the risk of causing a recession, but in our base case, large mitigating measures by the government will keep recession at bay. Inflation is expected to get a much needed, but temporary, boost. The central bank left its monetary policy unchanged but hinted at the possibility of easing in October. We expect it to maintain its current stance unless the yen appreciates notably. Last week, the U.S. and Japan reached a limited bilateral trade agreement, decreasing the likelihood of the U.S. placing tariffs on Japanese autos. Though a positive development, the deal is not much of a gain to the Japanese economy but is instead the avoidance of a shock.
The Chinese economy has continued to slow, with the manufacturing sector feeling the most pain. The divergence between services and manufacturing that we’re seeing globally is also apparent in China. Employment indicators are pointing to a slowdown in hiring across the economy, which increases the imperative of the Chinese government to either negotiate some form of trade deal or introduce new measures of stimulus. On the stimulus front, there have been several announcements from the Chinese government regarding new measures. These have included further cuts to the Reserve Requirement Ratio and reform to the Loan Prime Rate. However, the issue now for credit creation isn’t a lack of funds, but instead a lack of demand. The latter could encourage a pickup in demand, as this reform effectively acts as a reduction in interest rates. Nevertheless, it is concerning that we have not yet seen meaningful signs of stimulus in the data—and as a result, we have become slightly more cautious. We continue to think that the monthly credit numbers will be the first to show signs of stimulus and will be closely monitoring them.
We believe that looser monetary policy will benefit emerging markets in several ways. By taking some upward pressure off the US dollar, it should provide room to emerging markets central banks to support their economies and allows countries with twin deficits (current and fiscal account) or significant debt in US dollars to adjust. It should stimulate global growth, which increases demand for emerging markets products, and it supports risk appetite for assets such as emerging markets equities. However, the potential for easing could change quickly if the US dollar appreciates, which would force central banks to raise rates to defend their currencies. Leading indicators of emerging market growth have rebounded recently and have shown signs of stabilisation, but it is unclear whether the improvements represent the green shoots of a sustainable recovery. Many large economies in emerging markets—such as Brazil, Mexico, Russia, Turkey, and South Africa—stand to benefit from favourable base effects for forward-looking growth, but emerging markets are unlikely to decouple from developed markets, in general.
The US-China trade war is a deep source of uncertainty for global investors, but it will likely produce winners as well as losers. Global manufacturers are trying to diversify their supply chains to countries that are not subject to tariffs—e.g., Vietnam and Taiwan.
Gold, which finally left five years of range-bound trading behind to reach $1485/oz, looks set to continue to benefit from numerous tailwinds over the coming months. The Q3 rally was driven by the collapse in global bond yields —without any support from the dollar which strengthened by almost 2% against a basket of major currencies.
The biggest risk to rising precious metal prices is the potential that a major trade deal between the US and China will reduce expectations for how much US rates will have to fall. However, looking at the data, credit impulses globally continue to indicate that the economic low point is ahead of us, not behind us. The rapid accumulation of long positions through futures and exchange-traded funds is another potential challenge. Overall, however, the bullish outlook for gold should be able to withstand a correction all the way back to $1384/oz, the level which signalled the breakout of its five-year range. We maintain a bullish outlook for gold, based on the assumption that the dollar will weaken, and global bond yields stay low. Following a period of consolidation, gold could move higher to reach $1550/oz by year end before moving higher into 2020.
Crude oil remains stuck in a wide range, with the price movement continuing to swing between the risk of lower demand as global economic activity slows and the risk to supplies from sanctions and conflicts. The IEA sees the risk of a supply glut emerging into 2020 with OPEC and other producers potentially being forced to cut production in order to avoid an even lower price. However, the mid-September drone attack on the world’s biggest processing plant in Saudi Arabia showed just how vulnerable the global oil supply chain can be. A supply-driven price surge at a time of slowing demand rarely ends well. While we see Brent crude at $60/b by year-end a geo-political risk premium is likely to keep the market higher during the coming weeks until Saudi production normalises, and the threat of a conflict hopefully begins to fade.
Source: The material and research presented has been sourced from Merlea Investments.
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