View From The Top
Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
View from the very top: we think it remains possible both for yields on government debt to fall further and for global equities to continue their rise, subject to any major deterioration in the geopolitical environment. While a little GDP growth and not much inflation are helpful for equities and credit, there are more structural factors at work too. A supply-demand imbalance should help continue to flatten the US yield over time curve, while in Europe and Japan, further Central Bank easing should send yields lower. Expect also a weaker Euro and Yen relative to the Dollar. Equities will be helped by simple relative valuation arguments, but augmented by global earnings momentum having turned positive for the first time in over three years. Europe, Japan and emerging markets are our favoured regions.
Equities: A notable improvement in earnings momentum can act as a highly supportive driver for further equity market gains. This is now occurring globally and can be sustained, again, subject to geopolitics. In Europe and Japan in particular, weaker currencies, below-average margins and stimulus (monetary and broader economic) should help. Fewer of these drivers are available in the US, where valuation levels are also more demanding. Emerging markets have shown a notable improvement in outlook since the start of the year, and we expect this to be maintained. We also continue to favour global bottom-up approaches, despite the fact that active managers have struggled year-to-date (although stock correlations are low, so are dispersion levels).
Credit: Few would have foreseen at the start of 2014 that the yield on US 10-year Treasury debt would have fallen by close to 70 basis points to 2.3%, nor that German debt of equivalent duration would yield less than 1% – for the first time ever in its history. Even if yields may compress still further, the relative attractiveness of this asset class (compare a 0.9% German Bund yield against a 3.6% dividend yield on the Euro Stoxx 600) seems limited. Our broader approach within credit remains one of highly selective allocations, particularly towards managers with flexible mandates and differentiated strategies.
Alternative Asset Managers: Our conviction in event-driven managers remains. Despite the break-down of some recent high-profile transactions, M&A activity remains on track to reach levels last seen in 2007. Some $2.9 trillion of activity has already occurred, equivalent to more 20,000 deals. Less than 1% of these have collapsed and CEO confidence levels remain high, as do corporate cash balances. Such managers also continue to outperform.
Last month’s annual gathering in Jackson Hole, Wyoming of the great and the good in finance perhaps provides an appropriate starting point to consider whether the current environment of low but positive growth, not much inflation and generally easy Central Bank policy provides an adequate explanation for both the fall in yields and the rise in equities. Arguably the most interesting speech given was by the European Central Bank’s Mario Draghi, less so for his headline-grabbing comment that the ECB would consider using “all available instruments” in its policy, but more because he was at pains to highlight the growing differentiation between the US and European economies. A simple comparison of key metrics reveals the currently stark disparity between the two regions: annualised Q2 GDP expanded by 4.2% in the US (revised up from an earlier estimate), while the Eurozone saw no growth; core inflation is running at 1.6% in the US versus just 0.3% and falling across the Atlantic, and while unemployment is close to 6% in America, it is almost double this level in Europe. The reason why Draghi stressed the need for an increasingly flexible mandate and expressed a clear desire to use all available instruments is precisely in order to close the gap between the regions and avoid the possibility of a potential Japanification of Europe, a lost decade (or two) with no growth and no inflation.
More importantly, the relative state of these two economies provides a meaningful insight into current levels for bond yields. Different reasons lie behind the trend in Europe and the US. Europe is easier to explain: yields are low, precisely because of the fear of potential deflation, and also in anticipation of further (much-needed) stimulus. The US is more intriguing. Admittedly low yields may partially be explained by the seeming dovishness of the Federal Reserve, but surely given the robustness of the economy, they ought to be higher? Two considerations follow: might not (as some sceptics assert) the US economy be in such strong health as the headline figures suggest; and, might there be a superior explanation for currently low yields?
Despite US factory orders at all-time highs, job openings at their best since 2001, and bank lending accelerating for the first time in seven years, we often have the argument put to us that American economic growth (measured by any proxy) is below where it ‘ought’ to be for this stage of the economic cycle. In defence of the US economy, it should be remembered that the current recovery needs to be seen in context. The law of large numbers correctly shows how it is much harder to grow from a bigger base: in 1980, US nominal GDP was less than $3trillion, and therefore a 1% increase required only ~$30bn of additional output, a more than attainable target given the number of baby-boomers entering the workforce, the emergence of supply-side economic policies and the revolutionary potential of technology. Now, with nominal GDP of ~$17trillion, an additional $170bn of output – almost six times as much as previously – is needed just to generate that 1% expansion. In other words, the US has to work harder than it did previously in order to achieve a similar level of output expansion. Moreover, this recovery ‘feels’ weak to many owing to the lack of wage growth. This has been on a downward trend since 2009 and is currently running at below 2%.
Such a scenario, nonetheless, also sits comfortably with Janet Yellen’s current interpretation of the current economic outlook: a healthier economy is gradually drawing more searchers into the labour market, yet the influx of labour is holding down both wages and inflation. Against this background and with the economy still some time away from reaching its natural rate of unemployment (at least a year, although a debate remains over the extent of structural versus cyclical factors), the Federal Reserve can afford to be relatively sanguine about the evolution of its monetary policy. Rates will most likely start to rise next year, as has been broadly discounted, but with regard to the magnitude of increases and their longer-term destination, investors should probably expect the continuation of a market-friendly stance.
While such an outcome may account partially for 2.3% 10-year Treasury yields, this is not sufficient. An analysis of the US fiscal deficit provides an additional and very useful insight. The US fiscal deficit has been shrinking, and is set to reach 2.9% of GDP in 2014, down notably from its recent peak of 9.8% in 2009 and also to a level below its 40-year average of 3.1%. The deficit may even become a surplus in either 2015 or 2016. This has clear implications for the US Treasury: it is under less pressure to borrow, and hence issue new debt. However, low supply (of debt) contrasts with high demand. In other words, there remains a clear search for yield, in particular in order to fund the liabilities and longer duration assets associated with an ageing and increasingly pensionable population. The baby boomers that fuelled the growth of the last 30 years are now entering retirement, just as birth rates are falling. It is therefore clear that the trend seems to be towards a further and potentially structural flattening of the US yield curve: lower supply at the short-end is being offset by high demand at the long-end. The direction of travel for Treasury yields may continue to be downwards.
Europe’s declining debt yields need less explanation: almost non-existent core GDP growth, recession in its third largest economy (Italy), the weakest German factory orders in more than two years and consumer confidence at its lowest in over a year suggest that some form of action needs to be taken to put the Eurozone back on a more stable growth trajectory. The commencement of its targeted long-term refinancing operations this month (up to €850bn will be available) should certainly help and its looks increasingly likely that the ECB will also move towards the purchasing of asset-backed securities. Whether there is a move to full quantitative easing at some stage remains to be seen. Nonetheless, the expansion of the ECB’s balance sheet (in whatever form) should lead to a further weakening of the Euro. In the last month alone, the Euro has moved from €1.34 relative to the Dollar to €1.31 (against a May peak of €1.39), but when the ECB’s balance sheet last reached its peak – in June 2012 – the Euro was worth just €1.20 against the Dollar.
There are some clear parallels between Europe and Japan, and interestingly, investors can now earn more on Japanese two-year debt than on the German equivalent. Both face clear demographic challenges and reform is needed to drive growth. When quantitative easing finally came to Japan, it was larger than most had anticipated at the time, but with GDP currently running at a pace last seen post the 2011 Tsunami and a current account deficit at its worst in 30 years, more easing seems likely, perhaps even before the end of 2014. With a popularity rating still above 50, Prime Minister Abe will also likely continue to push for further (Third Arrow) deregulation of the economy. The lesson for Europe is twofold: first, structural reform needs to happen – and quickly – especially in France and Italy (where problems seem most pronounced); second, if we do get more formal ECB easing and further, then expect it in size.
The conclusion from all of this: for credit yields, flat and potentially lower in the US, and most likely still lower in Europe; for currencies, a weaker Euro and Yen (and most likely Sterling) against the Dollar; and, for equities, well… actually pretty good. Admittedly equity markets have failed to undergo a notable drawdown for over two years, while geopolitical instability, and in particular the rapid deterioration of the situation in the Ukraine, remains a perennial source of uncertainty worth monitoring carefully. Nonetheless, a simple recourse to valuation makes the relative equity argument compelling. Given the choice of locking-in to 10-year German debt at 0.9% yield or investing in the Stoxx Europe 600 with a 3.6% yield, the answer ought to be clear (as an aside, more than 80% of German-listed businesses now yield more than the Bund). Furthermore, the case for equities should be enhanced by the fact that global earnings revisions are now turning positive for the first time since June 2011 (according to Credit Suisse) and should continue to improve, particularly in Europe and Japan, given weaker currency outlooks and margins still well below peak levels.
Alexander Gunz, Fund Manager, Heptagon Capital
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