Starting with the US (page 2), we would not read too much into the recently “disappointing” industrial production data. Much of this is to be blamed on first and second round (e.g. transportation) effects of the bleeding oil producing segment – as well as the hit to exports from the strong dollar. Remember, however, that the US is a predominantly consumer- and services-oriented economy, areas in which the picture is more positive thanks to (precisely) the lower oil price, as well as rising wages. Market fears of a US recession thus look overdone to us.
In Europe (page 3), the low interest rate environment is set to persist throughout the year. This is not, we would argue, because a hike would hurt the economy. Believing that zero rates are necessary to fuel borrowing is a flawed proposition. It is the level of end demand, not of interest rates, that drives credit. Rather, we feel that the European Central Bank’s (ECB) real motivation for maintaining such an accommodative monetary policy lies in the financial (un)healthiness of European banks. Zero rates make for gains on banks’ large government bond holdings, which can in turn be used to offset losses taken on their substantial portfolio of non-performing loans. Rates should thus stay low for as long as the ECB can resist pressure to align with the Federal Reserve, and the European economy should continue on its slow growth path – with the consumer taking over the lead from the export sector.
Turning to China (page 4), as we have written previously, we are not in the “hard landing” camp. Rather, we are intrigued by the strong energy and metals import figures, when measured in volume terms. Why such stock building? One hypothesis is that Chinese policymakers see the current cheapness of commodities as a unique buying opportunity. Or else there could be a link between the inventory accumulation and the five-year economic plan, the details of which are to be released in March. Needless to say, we await these details with some impatience.
Finally, on the asset allocation front (page 5), while recognizing that monetary policy will remain globally supportive in 2016, we feel that central banks are losing their grip on financial markets (the January Draghi and Kuroda “effects” lasted barely a week). That said, the sharp correction year to date has brought equity valuations, outside of the US, to levels that are starting to look quite fair, even with low/no earnings growth. Their dividend yield should also help equity markets find a footing in the not too distant future. In the bond space, most investment grade names still yield next to nothing, but opportunities have emerged in the disliked energy and material sectors. Interestingly also, gold ETF inflows are picking up for the first time in three years.
US CONSUMER SUPPORTED BY CHEAP OIL AND RISING WAGES
Fourth quarter 2015 GDP figures tell it all: the US economy remained in positive territory (+0.7%) thanks to healthy consumption growth (+2.2%).
In worrying about the outlook for the US economy, financial markets have in our view been overly focussed on the negative news (read: falling industrial production, in particular in the oil and related segments). Yet, all is not bleak, even in the industrial sector. Positive base effects from the currently low inventory levels should materialize in coming months, and credit to the industrial sector is increasing – an indicator that typically leads activity by six months.
More importantly, industrial production accounts for “only” 12% of the US economy, compared with the 70% weight of consumers, who actually stand to benefit – with a lag – from cheap oil. Beyond oil, the labour market should be a strong tailwind for consumer spending in 2016, with unemployment still on the decline (now below 5%) and wages improving.
All told, far from expecting the US economy to fall into recession this year, we anticipate GDP growth similar to that posted in 2014 and 2015. Company earnings are, however, unlikely to follow suit, held back by the rising wage costs and a fading energy windfall (under our hypothesis of a gradual oil price rebound towards the USD 60 level). While being forced to progressively cut its estimates, consensus is still expecting ca. 5% earnings growth in aggregate for US (S&P 500) companies in 2016. We think that the final number could be close to zero, in a repeat of the downward revision pattern observed last year. This, of course, is not a good omen for the US equity market, particularly given its still stretched valuation levels in absolute terms (more on page 5).
A final word on the Federal Reserve. Following rate lift-off last December, the market correction during the first weeks of this year virtually erased investors’ expectations of further rate hikes during the course of 2016. Again, we see this as misguided. While we have never been proponents of substantial monetary policy tightening in the US until there is some form of coordination with the other major central banks across the globe (lest the impact on the US dollar become too strong), the fact that wages are on the rise, plus a possible oil price rebound, could well jolt investors back into more realistic expectations of a couple of rate hikes during the coming year.
This might actually hurt bond markets more than their equity peers – to the extent that it would go hand-in-hand with a positive reassessment of the US economy’s outlook. In the bigger picture, it would also improve operating conditions for banks and insurance companies, in turn strengthening the necessary flow of credit into the economy – not to mention providing the Fed with some ammunition to cut rates when the next recession does eventually materialize.
EUROPE: ZERO RATES MAINLY AS A REMEDY FOR NON-PERFORMING LOANS
“We have the power, the willingness and the determination to act. There are no limits to how far we are willing to deploy our instruments within our mandate to achieve our objective of a rate of inflation which is below but close to 2%.”
The true motive for such a loose monetary stance in Europe may, however, be less clear. Even though credit has started to tick up in Europe, we beg to disagree that near zero rates are a means of fuelling corporate and individual borrowing. Companies borrow money to invest in their business because they see end demand for their products and services – not because rates are low. Similarly, households take out mortgages because… well, they just want to buy that house.
We would contend, rather, that the ECB is focussed on the bad loan problem still plaguing the European banking industry. Italy is currently in the limelight, in talks with the European Commission and the ECB about setting up a “bad bank” structure that would purchase the EUR 200 billion of non-performing loans accumulated by Italian banks – without adding to the already ballooning government debt (how would that even be possible?) Negotiations notably involve the value at which the “bad bank” would buy the non-performing loans. European institutions are arguing for a purchase at market value, which could result in a EUR 60-80 billion (or more) hit to Italian banks, in turn requiring massive recapitalizations.
But the bad debt problem goes far beyond Italy. For European banks as a whole, non-performing loans amount to a staggering EUR 900 billion according to the IMF. So how do zero rates alleviate the situation? For a number of reasons, including favourable regulatory treatment (i.e. risk-weightings used to compute capital requirement ratios), banks are big holders of sovereign bonds. Falling interest rates have increased the value of these bonds, generating gains that can in turn be used to offset losses on the non-performing loans.
The ECB is under pressure to move fast on this front, because it knows that it will not be able to decouple its monetary policy from that of the Fed for that much longer. At some point (in 2017?) it will have to follow in the steps of US rates.
In terms of the European economy, a still very accommodative ECB in 2016 should make for continued (slow) growth. In the largest economy, Germany, recent wage agreements are likely to enable a welcome pick-up in consumption, sufficient to offset the present woes of the export sector that had so benefitted from the Far Eastern boom in the post- financial crisis years. As in the US, though, European company earnings probably stand to disappoint current 6.5% growth consensus expectations.
AWAITING DETAILS OF THE CHINESE FIVE-YEAR PLAN
Is it not curious then that the recently published 2015 Chinese import figures show volume growth across all commodities save coal? China is in the process of stocking up on copper, iron ore, zinc and, above all, oil (for which policymakers have communicated their intent to accumulate a further 150 million barrels in 2016). Beyond signalling that China is not the culprit for the drop in the oil price, this begs the question of why such commodity stockpiling.
Before attempting to answer that question, let us note as an aside that the same trend could at some point be observed in coal. Indeed, of the coal used in China only a small part is imported (even if that makes for a huge nominal amount). Ongoing mine closures in China are widely seen as both proof that the economy is slowing and a positive signal within climate change discussions. Our alternative view, recognizing that adapting infrastructure to cleaner technologies will be a multiyear process, is that China may have decided that its domestically produced coal is too expensive relative to imported coal at current prices. It could thus surprise the world by importing more, rather than less, coal this year.
Returning to the broader question of why such stockpiling, we see two possible answers. Either Chinese authorities are buying commodities because they are extremely cheap, without an intention to put them immediately to use, or it has to do with their five-year economic plan, the details of which are to be provided in March.
What we already know is that the plan includes the realisation of the “silk road”, officially named “one belt, one road”, linking China to Europe by road and rail. By cutting the transport time of goods from weeks (on ships) to only days, this rollout should enable Chinese producers to move up the export value chain and reduce their inventory costs. We also know that economic development of North-West China is a notable target of the five-year plan. This region is where central government faces the strongest political opposition. As such, Chinese policymakers’ reasoning is probably that improving living conditions in the North-West will make the region easier to control.
Needless to say, we await with eagerness the unveiling of the details of the plan. In particular, we are interested to find out how far China has progressed in negotiations with countries along the projected “silk road”, and how much will actually be invested in the North-West. Given the prevailing pessimism about China, we feel that a positive surprise is possible. The country certainly has the means to spend (the much berated “huge” debt overhang mostly consists of borrowing by State-Owned Enterprises from State banks, i.e. a form of zero-sum game). And while Westerners would view such public spending as stimulus, Chinese authorities would think of it in different terms: necessary investment in an undeveloped region.
ASSET ALLOCATION: PATIENCE IS A VIRTUE
The economic views just described for the US, Europe and China are clearly quite far-removed from the Armageddon scenario that has caused such financial market angst since the onset of this year. The US is not, we have argued, about to fall into recession, monetary policy will remain globally accommodative in 2016 and China could actually surprise on the positive side.
What appears to be underway in financial markets is a fading of the so-called “TINA” (There Is No Alternative) effect. Over the last few years, vanishing yields as a result of central bank printing and buying have forced investors (institutional then retail) to take on risk – shifting first to longer bond maturities and lower quality paper, then to equities. The payback has been that any marked correction in risky assets simply led to yet more central bank intervention/talk and an V-shaped recovery. Recent market behaviour may well be signalling a break in this pattern. The late January Draghi and Kuroda “relief” proved short-lived, despite the prior 10% correction, and retail funds are starting to experience redemptions.
A lesser central bank grip on financial markets is not necessarily a bad development. It also means greater focus on fundamentals, specifically valuation. And in this respect, the situation is shifting rapidly. Outside of the US, we feel that equity valuations are finally starting to look quite fair. Enterprise value to EBITDA ratios have fallen to around 8x in Europe, Japan and China. On a price to earnings basis, the Eurostoxx index is now trading at 12-13x forward earnings, making for an 8% earnings yield.
Some caution must be exercised in thinking of equity valuation relative to 10-year yields, since that is tantamount to comparing a free market to a manipulated one. Instead of being interpreted as a pull towards equities, is the high earnings yield not simply a sign that interest rates are too low? Certainly, but we would argue that the now-attained 8% earnings yield level on European equities would be acceptable even if long term interest rates were to rise to 4%. As such, we have just elected to increase our (long-underweighted) allocation to equities in both defensive and balanced profiles.
We also intend to be patient on our existing positions in the (still hated) materials, shipping and energy sectors. Performance since purchase has been very disappointing, but we strongly feel that these investments will be (very) rewarding over the longer run. Valuation in the oil related stocks we hold has fallen to extremely low levels, and we remain convinced that the oil supply-demand gap will close later this year, setting the stage for a rebound. On oil, the issue is not so much supply (virtually all would agree that it is headed down, given the investment cuts by major companies and the natural decline rate of conventional oil wells) but the evolution of demand. In that respect, our views on China should be clear – and will hopefully be buttressed in March.
Turning to the bond markets, we have also recently made some investments. Indeed, and going back to the discussion of the presently large yield gap between equities and bonds, some upward adjustment to bond yields has been taking place in parts of the corporate bond market, including even some investment grade names. These are of course the sectors/names where “fear” is greatest – but it is a start. We have been taking advantage of such long-awaited opportunities, purchasing medium-term investment grade bonds in currently disliked – but high quality – materials and energy names now offering yields in the vicinity of 5%.
On a final note, we find the recent interest in gold, as evidenced by inflows into ETFs for the first time in three years, intriguing. What do investors turn to when no other investments appear to be working? We will certainly stand firm on our gold exposure.