Economic trends & Market overview
The US economy continues to recover well with recent data showing surprising strength. Economists expect the growth level to be at 1.5% for 2013.
For next year, we anticipate a stronger rebound and an increase in gross domestic product (GDP) of 3.1%. The good news for investors is that the Federal Reserve (Fed) wants more evidence of the sustainability of the recovery before starting the so-called tapering which will gradually reduce the very accommodative environment we are in.
Our preference towards risky assets, such as equities and high yield bonds, are delivering very good returns in this context. Of course, markets cannot go up forever but at this stage we expect this trend to continue, especially for the developed equity markets. US equities remain our top pick, but the UK is entering our favoured selection with its improving economic conditions.
In the Eurozone there has been some improvement, but we are concerned that this is partly related to governments increasing their spending. While it could be positive in the short run, it is clearly not sustainable.
In the emerging world, we continue to favour Asia, but we fear Emerging Markets (EM) as a whole could be impacted by large outflows the day global liquidity conditions start to normalise.
WATCHING THE CREDIT CLOCK
Written by Andrew Dalton Deputy CIO
Investors are entering the last quarter of 2013 with mixed feelings. Whilst equities performed, “safe havens” such as gold or government bonds suffered one of the worst years an EM assets did not match expectations.
The looming threat of rising yields finally materialised and damaged many unprepared portfolios. Losses on US bonds were similar to 1994, remembered as the “bond market massacre”.
To avoid any further disappointments, it would be tempting for many to take profits on winning positions such as stocks to secure a slightly positive year. However, this calendar perspective does not constitute a strategy, it merely fits an accounting mindset without broader perspective. No matter how close we are to year-end, quarter after quarter, we review our strategy on the same principles and processes: defining the structural factors driving the big picture, assessing the cyclical economic outlook and immediate key issues and finally monitor risks by checking investments (funds likely to be withdrawn on any sign of a downturn) flows and scenario.
The Big pic ture: still turning the clock
We believe disinflation in the early 80’s and globalisation enabled financial integration and faster investment flows across the globe. As a result, real activity became heavily linked to the financial cycle with causality going both ways. From aninvestor’s perspective, it meant asset prices around the world being driven by what many have named the Credit Clock, because credit is at the heart of any modern financial cycle based on fiat currency (i.e. is not backed by gold or other reserves).
Our Credit Clock tracks each country’s trends in GDP (accelerating, decelerating) and credit (growing, contracting). This helps us to predict the economic trends in each country and region.
Right now, the US is entering the sweet spot of economic growth with credit expansion that usually generates asset appreciation, which is the cornerstone of the present tactical outlook. It is followed by the UK and Japan where credit is still idle, but growth is recovering. If this process accelerates, these markets should see a re-rating of their assets. Far behind is the Eurozone, where growth has bottomed and the road to recovery is far from being certain, mostly because peripheral countries such as Spain and Italy are still stuck in a contraction phase of deleveraging. Way ahead of everyone is China – it has turned the corner into slower growth that should soon lead to credit contraction (which is a reduction in the amount of loans available). We expect China to enter a multi-year transition process.
This framework also shows how the fashionable buzzword of “New Normal”* only relates to some countries (i.e. the ones deleveraging), where assets remain depressed until credit excesses are cleared or growth finds a new path driven by technological progress; a process which usually takes years and relies on active policies. For instance, countries such as Spain, Portugal, Italy, France have joined Japan in the league of countries growing less than 1%, with stocks’ prices now averaging 1-1.5 times book value, which is the value at which an asset is carried on a balance sheet. These countries used to be at 2.5 times in the 90’s. The US , Switzerland or Mexico are trading at 2.5 times. How did the US turn so fast? Part of the explanation is that 50% of their household debt reduction took place with debtors defaulting on their debt. Unfortunately, debt relief is a bold policy that the Eurozone has yet to incorporate.
Over the next 3 to 6 months, given the disparity of countries and regions in their cyclical and structural evolutions, their respective assets should experience diverging fortune. It is likely the geographical allocation will matter as much as the balance between duration risk (exposure to interest rate changes) and market risk (stocks price changes). Therefore, we keep our view from late last year that with systematic risk dissipating, market movements will depend more on local factors and the selection of investments will be more important.
The macro view : A brighter outlook but increasingly diverging fortune
The global macroeconomic outlook is brighter for 2014, as most activity indicators across the world have already been well behaved this summer and most are in expansionary mode and accelerating. Although looking “under the hood of recovery” reveals large disparities. The US is expected to continue on its growth path with less headwinds from fiscal contraction and reach 3% growth. Japan and UK are following its footsteps with at least a 12-18 month lag to reach 2%. However, the Eurozone cannot be expected to gather speed right after clearing out of its recession given the lack of institutional progress in the Union. EM, led by China, are slowing down. Having reached their peak, their recent rebound in activity is expected to be short-lived, since their structural weaknesses are now apparent. Issues in the EMU and China are key concerns, but it is expected that none will derail global recovery, especially as monetary conditions throughout the world are still expected to remain accommodative, even with normalisation policies.
Our overall allocation towards risk assets from our assumptions on a brighter economic outlook remains in line with our previous tactical stance; positive on stocks and cautious on “safe haven” assets such as gold and government bonds, which tend to decline or underperform in accelerating phases of the cycle. Low inflation and growth, even moderate, has been the setting for valuation expansion in addition to earnings growth. Inflation is clearly not a threat, so monetary tightening is out of the question. Therefore, equity prices should not be at risk of an interest rate shock. Indeed, during the phase of fast growth and low inflation, equity markets tended to reach high valuations relative to earnings, while in peak, high interest rates compress valuations even if profits rise.
To sum up, the asset allocation is therefore biased toward risky assets that will benefit from accelerating activity driven by an American cycle. Stocks, high-yield bonds and energy commodities are our preferred assets. US , UK and Japan are our preferred stock markets, while the USD and the GBP are our preferred currencies.
Emerging markets assets, namely currencies, bonds and equities are not attractive given our outlook on these countries and we remain underweight on most. Economic releases since early summer tend to confirm that the recovery is gaining speed, but that EM are still a question mark.
The message from the market
As we are forecasting a continuity of the last 12-month trends, our current positioning, therefore, is by nature not contrarian. Fortunately, hot money flows (mutual funds) show that these trends are not overbought. Trends in stocks and cyclical commodities are steady with no exuberance as yet.
On the opposite side, beware of EM assets, gold and bonds (Investment Grade), where there is no evidence of a clear strong sell off to compare with the heavy accumulation of hot money of the past years.
We continue to monitor three main downside risks that would affect our current pro-risk positioning, namely: an oil crisis, a hard landing in China and an interest rate shock.
Also, looking over 5 to 10-year well beyond tactical horizon, we are aware that the valuation of most assets are boosted by ultra low interest rates and appear demanding. Therefore, they will require close monitoring to realise profits. Indeed, at these valuation levels future long-term returns are likely to be meager on bonds, gold and possibly stocks. Delivering performances for portfolio over the long term will be challenging and will require active tactical contribution because a passive buy-and-hold balanced portfolio may barely beat inflation.
*The “new normal” refers to the view that we are now, post the 2008 crisis, in a long-term environment where economic growth will be low and unemployment high and it will not be possible to return quickly to the rates of growth considered normal before.
Mark Carney took over as the first foreign-born Governor ofthe Bank of England at the start of the third quarter. His arrival has coincided with a general pick up in economic numbers. For example, GDP grew 1.5% year-on-year. UK Construction PMI jumped to 59.1% in August, their best levels since the first quarter in 2011 and the third quarter in 2007 respectively. Mark Carney’s first set of monetary policies are supportive of the still fragile UK recovery, giving forward guidance on interest rates which will stay low for longer – at least until the unemployment rate is below 7%.
The UK equity market and sterling have reacted positively to these developments. With UK companies still trading at a relative discount versus their US peers, we have retained our positive stance on the UK market.
The biggest company news in the third quarter was Vodafone selling its stake in the US Verizon Wireless operation to Verizon Communications for $130 billion. This deal is likely to have a profound impact on the global Telecom sector as Vodafone looks to rebuild itself and aid its struggling business in Europe.
The economic improvement in the US continues to roll on from both a sentiment and an employment perspective. Weekly Initial Jobless claims are now markedly lower than both last quarter and last year and trending strongly downward, whilst consumer confidence levels are at post-crisis highs and trending higher. US auto sales are also in rude health, approaching levels not seen since 2007. The housing market continues its improving trend of both existing home sales and new starts.
The bond market continues its move higher in yields in anticipation of the Fed, announcing a reduction in the amount of stimulus (by way of bond purchases) that is currently being provided. However, it is important for the market, and as clearly stated by the Fed, that this reduction in Quantitative Easing(QE) does not signify a rise in base rates as these will remain anchored for a long time to come yet.
Post this announcement, the wobble that was seen in equity markets has been short lived so far, with markets pushing on after a decline in low-volume trading during August. A glimmer of hope for those who have long been anticipating a boom in the low levels of Mergers and Acquisitions (MA) activity came during the quarter, with the third largest corporate deal in history. Verizon Communications finally agreed to purchase the remaining stake of Verizon Wireless from Vodafone in the UK for $130 billion, part funding this with the worlds largest corporate bond deal in history, raising $49 billion.
Despite ongoing volatility over the summer holidays, the broader European markets hit 2-year highs in August and continue to trend higher. Rather interestingly it has been the perennial laggards, Spain, Italy and France that have provided much of this recent impetus.
Manufacturing data across the region has been improving quite sharply of late and it would appear this has encouraged investors to start looking for pockets of value where they can. Whilst the Eurozone economy clearly has much to do in terms of structural reform, and despite continuing austerity, the feeling seems to be that the worst is behind us. Nonetheless, caution may be warranted in the near term, as oil prices remain stubbornly high and evidence of emerging market demand recovery remains elusive.
The German elections returned Angela Merkel as Chancellor with a strong mandate and her pronouncements on continuing austerity will be keenly anticipated, as her cachet in a broader European context has increased. However, as is often the case, upcoming US monetary policy announcements will likely have a more immediate impact on European stock markets as we move into the fourth quarter.
Japanese equities tread water during the last quarter with profit taking in the summer months following the stellar start to the year. However, investors wanted more evidence that Abe-nomics, the economic policies advocated by Shinzo Abe, the current Prime Minister of Japan, is going to prove a real and lasting solution. Investors became much more discerning in choosing between sectors and companies who will potentially lead the way out of two decades of economic malaise rather than simply investing in either domestic or export-orientated sectors. In stock specific news, Tokyo Electric Power came under pressure as further radiation level scares made investors nervous. Trading houses such as Mitsui, Sumitomo and Mitsubishi rallied thanks to optimism over the global economy and rising commodity prices. Much focus now will be on whether Prime Minister Abe successfully implements the rise in sales tax scheduled for the New Year.
Written by Paul Stappard, Senior Portfolio Manager
Emerging Markets continued to live up to their reputation in the third quarter with the big volatility and wild price swings from the summer months continuing across equity, bond and currency markets. In many countries, this prompted governments to use various forms of intervention in order to try and restore some stability and order including exchange rate manipulation, provision of liquidity and interest rate moves.
This seemed to work as the selling experienced during June was completely reversed by September. Commodity driven markets, such as Brazil and Russia, quickly erased losses with large caps, such as Vale and Gazprom, leading their respective markets higher.
Better economic data out of China left the Shanghai Composite registering solid gains with financials such as Industrial and Commercial Bank and China Life Insurance amongst the top gainers. The strengthening dollar, which particularly impacts India, meant that the Sensex was a laggard with financials including HDFC Bank and ICICI Bank performing relatively poorly.
Emerging Markets have benefited from positive investment flows over the last few years and we expect this trend to be reversed as the Fed tapering begins. We are therefore cautious on emerging market equities in the medium term despite their reasonably attractive valuation levels.
We have seen a rout in the UK Gilt market. Since the beginning of May, 10-year yields have risen from 1.6% to spiking above 3%. This is not what the Bank of England wants to see and we believe that the rise is not warranted by the recent developments in the UK economy. However, after a slew of upbeat economic data and George Osbourne going on the PR offensive, markets are defying the Bank of England. The Bank has given guidance that interest rates will remain on hold until the unemployment rate falls below 7%. However, this is contingent on inflation remaining anchored and the fact that they do not judge low rates to jeopardise financial stability.
Elsewhere, the prospect of the Fed’s tapering in the US has pushed government bond yields decidedly higher. The 10-year Treasury yield is on the brink of breaking through the 3% threshold which is close to double the lowest level seen in early May. In the meantime, German yields have risen sharply as well with the 10-year Bund rising above 2% for the first time in 18 months. There are still question marks around the debt sustainability of Greece and Portugal and others which may come back at some point, but for the moment it is the Fed’s tapering and economic expectations that dominate.
Unsurprisingly, credit has lost some of its shine, especially in Emerging Markets. The risk remains of an ongoing rise in developed market sovereign yields. However, as many companies have strong fundamentals, there have as yet been no large outflows from corporate bonds.
Written by Neil Bruce, Investment Adviser
We maintain our bullish dollar view for 2013. By 22 May 2013, the trade-weighted dollar (i.e. a measure of the value of the US dollar relative to other world currencies) had enjoyed an 8.5% year-to-date gain. Three weeks later, this has been cut to less than 4%. Fears of a Fed exit (starting with QE tapering) made global markets nervous, causing a cleaning of crowded positions including the long-dollar trade (i.e currency trades where the investors had bought dollars and sold in another currency). The drawback has been severe, due to the crowded positioning. Fundamentally, the case for a strong dollar remains: the US economy will be leading the global (moderate) economic upswing and the Fed will be the first major central bank to take steps towards the exit.
From mid-July, GBP has strengthened versus USD. However, despite improving data in the UK, real yields remain the lowest in the G10 due to high inflation. Mark Carney has also expressed his willingness to push against any tightening of financial conditions which, going forward, should weigh against sterling.
Euro strength has been attributed to short covering (when investors who have bet on a security falling in value close their position) coupled with a pick up in economic indicators, driven largely by easing of austerity measures by governments.This looks unsustainable. Going forward, we expect the euro to weaken.
Over the last few turbulent months, kicking off in late May when the Fed indicated they were looking increasingly likely to begin tapering in the third quarter, it was quite an indiscriminate sell off with more traditional bonds affected as well as the riskier assets like equity.
More encouraging was that the hedge funds were quite resilient during the period and the peak to trough losses was less severe. Equity markets fell nearly 8% at one stage during June while hedge funds as per the HFRX Global HFRX Index fell only 2.5%.
The trend continued for Event Driven and Equity Long Short managers as our preferred hedge fund strategies. The average hedge fund, as measured by the HFRX, is up 4.2% this year while Event Driven strategies are up 9.99% and Equity Long Short is up 6.78% but again selection of individual manager / fund remains more important.
Hedge funds we continue to avoid are Commodity Trading Advisers / managed futures or Global Macro strategies which had a torrid time during last quarter – drawdown has been over 4% (most funds in this space remain in negative territory this year). They continue to get their timing wrong especially with currencies and commodities and the political intervention is playing havoc with a lot of these hedge funds’ models which struggle to spot sustainable trends given the uncertainty.
Despite continuing to lag the equity markets this year, their performance during the sell off was more promising and we believe they can serve a valuable place in a diversified portfolio provided used correctly.
Whilst gold has seen an up tick in performance through August, our longer-term view is bearish on the gold price.
Disinvestment from physical ETFs has been greater than the demand for jewellery and investment. With this outflow from investors continuing, there should be a remaining drag on the gold price. The outflow is largely supported by an improving US economy, expected tapering by the Fed feeding through to a rise in US treasury yields and the potential for a rise in the US dollar. With yields rising, investors can see the potential for better opportunities elsewhere. The weakness in the Indian rupee (Rp) is also having an effect on demand as the gold price almost reached Rp100,000/ ounce this quarter.
Unrest in Syria and the prospect of intervention from the international community saw the oil price tick up through the quarter, but then dip as the potential US strike was put on hold.
Any further flare ups could see further rises in oil price and potential harm to emerging economies and global GDP.
Markets were driven by signs of economic improvement and the associated fear that central banks would move to a less easy monetary policy. They continued the pattern seen over the first half of the year of negative returns to government bonds and positive returns to equities. Accordingly the bond benchmarks show losses, but as one moves up the equity content and risk levels, the returns are increasingly positive.
Written by Andrew Dalton, Head of Investment Services