“The ‘bull market in everything’ under the extended quantitative easing regime is now giving way to an environment characterised by tighter monetary conditions and a process of price resetting.”
Consensus expectations for a continuation of the synchronised global growth environment that had characterised the previous 18 months came under pressure in 2018. Boosted by the Trump tax cuts, US growth was expected to be robust, but strong European and emerging market equity performance in 2017 proved to be a false signal as underlying growth failed to follow through.
Market elation would now appear to have been the result of a final flush of liquidity through the global banking system as opposed to a sound global growth dynamic. The much-anticipated moderation in Chinese growth, in response to policy measures to address poor capital productivity, seems to have been more significant than the official statistics suggest. Meanwhile, a sharp tightening of international liquidity conditions reflected in the dollar’s renewed strength, combined to reinforce divergence not only in US versus global growth, but in relative currency and equity market performance. At first, the crises in Argentina and Turkey were dismissed as idiosyncratic, but it became apparent that the macroenvironment was becoming more challenging.
The ‘bull market in everything’ under the extended quantitative easing (QE) regime is now giving way to an environment characterised by tighter monetary conditions and a process of price resetting. Global growth has peaked and is decelerating. The US economy has the momentum to buck the trend for a period. Indeed, there is little evidence of negative effects from quantitative tightening (QT) in the US, apart from higher short-term interest rates. However, at some point in 2019, a more convergent and weaker growth picture is likely to unfold. This need not result in a recession, but weaker growth, higher inflation and tighter liquidity represent growing headwinds.
Figure 1: US fiscal ‘sugar high’ set to fade
Forecasts are inherently limited and are not a reliable indicator of future results. Source: Evercore ISI, Investec Asset Management, Bloomberg, 31.10.18.
China’s approach has become more assertive under President Xi, compared to those of his predecessors who preferred Deng Xiaoping’s policy of ‘hiding China’s strength’ and what came to be described as its ‘peaceful rise’. This has finally precipitated a response in the form of a major reversal in US policy from one of accommodation to rivalry, which has served to reinforce the downward cyclical pressures on the Chinese economy, currency and markets over the course of 2018. Our central assumption is that growth will continue to weaken into 2019. More material steps will be taken to ease conditions and support growth, but the Chinese leadership will accept a weaker economy in the nearer term rather than compromise their longer-term ambitions to transform the economy into a more consumer-centred model.
Paradoxically, US trade pressure is likely to speed up the reform process rather than slow it down. The reforms are broad based, but of particular relevance to investors will be those related to the transformation of the economy – the shift from quantity to quality — and capital markets, which will increasingly reduce the reliance on an old-fashioned financial system. Indeed, the year is likely to be a decisive one in the opening up of China’s capital markets to foreign investors. MSCI is planning to increase China A-shares' weighting in its major benchmark indices from 5% to 20%, while it is probable that Bloomberg Barclays will include China in the Global Aggregate Index from April 2019. Other index providers are expected to follow suit.
Cyclical weakness sets up a long-term strategic opportunity: The transformation of China’s economy and opening up of its financial markets represent an important strategic opportunity for international investors who currently have very modest allocations. Chinese equities and debt are set to form a growing part of such investors' portfolios over the next 20 years and beyond. Cyclical weakness presents an opportunity to accumulate exposure at inexpensive valuations.
Industrial commodity prices have often benefited in late cycle environments in the past. We expect core inflation rates to move up further in the developed world. However, in our view, slower growth and lower commodity demand, particularly in China – the biggest source of demand – will likely dominate performance. The consolidated nature of the industry, and supply discipline at company level, should provide some support. Oil too may have peaked for now. Supply and demand is set to remain tight, due to a sharp decline in investment in conventional sources of production on the one hand, and a moderation in the rate of growth of shale-related production on the other. However, weaker global growth and demand destruction represent headwinds.
Gold tends to fare poorly in periods of rising real interest rates. US government inflation-linked bond real yields have doubled and dollar strength would seem to promise more of the same. But much of this is arguably ‘in the price’ and gold tends to perform well in periods of slowing US growth and rising uncertainty. Furthermore, longer-term Chinese plans to ‘de-dollarise’ will add a structural buyer of gold to the market.
Industrial metals face challenging headwinds, but supply and demand are in better balance than in previous cycles. Gold could be set to emerge as an attractive defensive asset, surprising on the upside.
US and emerging market fixed income markets have begun to adjust to the reality of higher official interest rates and greater supply resulting from both looser fiscal policy and the Federal Reserve Board’s determination to shrink its balance sheet. These forces have been powerful enough to offset the gravitational pull of continued quantitative easing effects in both Japan and the Eurozone.
We expect rising evidence of cyclical inflationary pressures in the United States to cause the Federal Reserve Board to continue on its current path to normalise policy, which could see US short-term interest rates reach a cyclical peak of c.3.0%.
Developed government bond yields with a maturity of five years and beyond have historically been relatively correlated, reflecting a global long-term rate. This leads us to expect further upward pressure, despite differing underlying economic conditions. Longer-dated US securities already largely reflect such a scenario, but could overshoot if late cycle inflation pressures become more pronounced.
We continue to believe that the developed world remains in a structural disinflationary regime, which would suggest that overshoots in longer-term bond yields represent buying opportunities. This is particularly the case in respect of countries with overextended consumer sectors and property markets such as the UK, Canada and Australia.
The adjustment in the pricing of credit to reflect tighter liquidity conditions has also diverged. Whereas US corporate credit spreads in general have remained very tight, reflecting strong corporate fundamentals and abundant liquidity in the United States, European and emerging market spreads have widened, the latter materially. We suspect that with the unwind of the formerly entrenched ‘reach for yield’ environment, the process of credit spread adjustment has further to run.
The differing paces of adjustment make selectivity at asset class, sector and security levels critical. It is also important to be aware of the risks associated with investor crowding in areas such as US leveraged loans, where the weakening of covenants is a testament to the maturity of the current credit cycle.
As 2015 and 2016 illustrated, repricing can be sudden. This has already been the case in emerging market hard currency credit in 2018. Indeed, the diverging path of the adjustment in an environment characterised by tighter liquidity and weaker growth also presents an opportunity for those with flexible total return approaches and the ability to invest across broad credit universes.
Despite generally registering solid revenue and earnings growth, equity markets progressively de-rated in 2018. Initially, this was a response to a sharp tightening of international liquidity but was subsequently reinforced by concerns about deteriorating growth prospects. Our central case for 2019 is that earnings will be negatively impacted by a synchronised slowing in global growth, and that this is not yet fully discounted. The divergence in growth and liquidity conditions between the United States and the rest of the world has resulted in wide valuation disparities, which should begin to correct in the year ahead.
Fading leadership from the technology sector, a lack of valuation support and fewer buy-backs should reinforce this tendency. From a strategic perspective, Asia stands out. Valuations already discount a severe earnings recession (Figure 2), while dividend yields are supportive and longer-term growth prospects are among the most attractive worldwide.
Figure 2: Significant dispersion in regional equity valuations
Source: Bloomberg, 02.11.18.
The unfolding cyclical downturn coupled with the fallout from the trade conflict between America and China should provide a compelling opportunity to build longer-term positions. Income could prove to be an important theme but one that is unlikely to be reflected in mainstream equity income indices, which tend to be dominated by indebted sectors such as utilities. Less conventional income stocks, with above-average dividends supported by profitability, seem better positioned in an environment dominated by tighter financial conditions and investor risk aversion. A case of history rhyming, not necessarily repeating.
The US dollar’s weakness in early 2018 came despite the Federal Reserve Board’s evident intent to raise rates and eventually shrink its balance sheet. This suggested that economic strength elsewhere in the world would be sufficient to offset the impact of substantial US tax cuts in 2018, which caught many out. In any event, divergence triumphed over synchronisation and the dollar’s medium-term bull market cycle was rekindled.
Going into 2019, investor positioning is strongly pro-dollar, but the dollar is overvalued, limiting further general upside. Although fundamentals are likely to remain supportive in the first half of 2019 at least, evidence of materially weaker US growth or a change in Federal Reserve policy would undermine dollar strength.
We continue to favour creditor nation currencies such as the yen, which is undervalued relative to the US dollar (Figure 3), and the Swiss franc for their defensive, diversifying qualities. The yen remains the cheapest major currency in our estimation. In line with our slowing global growth central case, we believe that Asian currencies, apart from the yen, remain vulnerable.
Figure 3: Japanese yen remains undervalued
Source: Bloomberg, 31.10.18.
Although 2018 was a corrective environment for emerging market assets generally, as liquidity ebbed and the dollar rallied, valuations now discount a weaker growth environment. Absent the prospect of a reacceleration of growth, risks are likely to remain on the downside. The fallout from tighter liquidity conditions in China, and elsewhere, will continue to be felt well into 2019 in the form of weaker commodity prices and slower growth across the developing world. Although China is moving to loosen policy and support growth, such moves have been too tentative in our view to reverse the negative growth trends in place.
Figure 4: Chinese deleveraging headwind
Source: Bloomberg, 31.10.18.
In many emerging markets in 2018, risk premia rose to reasonable and, in some cases, attractive levels. However, the asset class has historically been prone to undershoots; hence, reasonable long-term valuations alone are an insufficient condition for a sustainable turnaround. Investor positioning remains a vulnerability. With some notable exceptions, macroeconomic fundamentals at both national and especially corporate level are better than has been the case historically. Selectivity at the fundamental level remains essential, together with the flexibility to take advantage of both currency and bond undershoots.
Recent headlines regarding climate change have focused on the fact that even committed governments, such as those of Germany and France, would miss 2020 emission targets that were agreed in 2015. This has tended to obscure the fact that a confluence of critical developments suggests a prospective ‘take off’ of global decarbonisation as a mainstream investment theme.
Technological innovation and cost deflation have brought us to a point where solar and wind energy are cheaper than established energy. Electric vehicle production is on the cusp of a step change in 2019-20, suggesting that the key auto incumbents are ‘throwing in the towel’ on the future of the internal combustion engine.
Sustainability is increasingly becoming mainstream in the investment management industry and is impacting private sector capital allocation decisions. Finally, China under President Xi is firmly committed to becoming a leader in renewable energy. The ‘Beautiful China’ policy was announced in October 2017 and renewable energy and electronic vehicles were referenced in the ‘Made in China 2025’ policy document as two of ten priority areas.
As physicist Robert Muller observed, ‘if it isn’t profitable, it isn’t sustainable’. Decarbonisation is emerging as an important and investible growth theme and is likely to be so over the next 20 years and beyond. It is already spawning investment opportunities across the capital spectrum. We believe investors need to factor sustainable investing into their strategic thinking.
“We believe investors need to factor sustainable investing into their strategic thinking.”
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In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). All rights reserved. Issued by Investec Asset Management, issued November 2018.