It’s the Global Economy, Stupid
With many investors struggling to figure out what is really going on with the global economy, James Carthew, Head of Research and Director of Marten and Co tries to make sense of it all
On the face of it, things seem to be improving; Global powerhouse, the US, is growing and the US Federal Reserve (Fed) is contemplating a rise in interest rates.
More normal lending rates will drive up yields on US government bonds, which have reached absurdly low levels. Most managers we know are avoiding these in favour of higher yielding corporate debt. The feeling is that rate rises will be small and the impact on pricing modest.
We expect rates to rise very gradually, thereby avoiding panicking markets and triggering a slowdown in investment and consumer spending.
Some managers have been hoarding things like inflation-linked bonds and gold in case the Fed allows economic growth to accelerate too quickly and this translates into inflation.
The US Presidential election race is underway with some alarming rhetoric being bandied about. The only statements that have had much impact on markets so far though have been Hilary Clinton’s comments on curbing the prices of drugs which has knocked the previously strong Biotech and Pharmaceutical sectors.
A key driver of the US economic recovery has been the phenomenal growth in the production of oil from shale which has reduced imports. The decision by Saudi Arabia to maintain levels of production and the improvement in relations with Iran allowing it to recommence legal exports, have combined to trigger a collapse in the oil price. This has stymied the growth of the shale oil industry but benefits the US consumer as petrol prices have fallen.
The world is waiting to see how long the Saudis can tough it out with a big budget deficit and falling foreign exchange reserves.
‘the world is waiting to see how long the Saudis can tough it out’
The UK economy appears to be echoing, but lagging, that of the US with UK rate rises likely to be some time off – possibly 2017.
The Conservative election victory was seen as positive and triggered a re-rating of domestically focused companies; however, that recovery is running of steam and investment managers are looking for earnings growth from companies for the market to move forward decisively.
A looming issue that stirs up strong views is the UK referendum on Europe; suffice to say that many overseas asset managers are nervous about a BREXIT (a UK exit from the European Union).
Europe was seen as the laggard in addressing the issues that were holding back its growth. However with Greece sorted for now, there are signs of a recovery in many European economies and European smaller companies have been outperforming larger ones; again future market growth requires strong corporate earnings.
So where are the problem areas? The most obvious one is China. The world has become so reliant on Chinese growth that the absence of it is depressing markets across Asia. A US recovery is seen as bad news too as US investors start to repatriate money to profit from US growth.
‘many overseas asset managers are nervous about a BREXIT’
The slowing Chinese economy has compounded the oil price problem and devastated the suppliers of the raw materials. These companies now trade on very low valuations. Some feel that things are as bad as they are going to get and it is time to start to rebuilding positions in this sector.
The collapse in commodity prices has hit some emerging markets hard and, where they have home grown political problems to contend with (as Brazil and Malaysia do for example) this has compounded the problem. Russia’s actions in Ukraine and latterly in Syria have created their own tensions and sanctions have hit that market hard.
The Middle East may be dominating the news headlines but, unless the conflict spills over into Saudi Arabia or Russian/ NATO tensions increase, we don’t see much of an impact on markets.
The direction of the global economy is, as ever maybe, hard to call. We asked two respected investors, Wouter Volckaert, manager of Henderson Global Trust, and Peter Elston, Chief Investment Office at Seneca IM, manager of Seneca Global income & Growth for their views.
Wouter thinks that it might be too early to be outright bearish on the market going into 2016, but would certainly suggest that it is too late to be bullish. The market has more than doubled since the lows of March 2009. Most of that return has been generated by multiple-expansion on the back of a loose monetary policy. Low interest rates and quantitative easing have created a wealth transfer from non-owners to owners of assets.
‘it might be too early to be outright bearish on the market going into 2016, but would certainly suggest that it is too late to be bullish’
Wouter also believes equity valuations could continue to move up on the perception that “There Is No Alternative” (TINA). Investors who want to put cash to work increasingly turn to equities, especially now that fixed income is losing its appeal in a rising rate environment. But TINA is unlikely to have the same enchanting spell on the market as the central banker – Draghi, Bernanke and Yellen, – the impact of real fundamentals on valuation will increase going forward.
He goes on to say that economic data and corporate earnings growth will become the most important driver of equity markets, and the outlook remains muted. Nominal GDP growth should remain low on the back of a further slowdown in Emerging Markets. Inflation will remain low thanks to the deflationary impact of the echnology/internet revolution, the ageing consumer, the debt de-leveraging cycle, and the stronger-for-longer USD. There is little room for corporate margins, especially in the US. And the pace of company share buybacks is slowing.
Relative to other regions, Wouter prefers Europe top-down. But I do like the US bottom-up (i.e. looking at individual companies). He thinks Europe is cheaper and there is more room for positive earnings surprises as we start from a lower level. However, in order to benefit from that you need to invest in the riskier cyclical European stocks. Quality defensive European stocks are near record valuation levels. We see the opposite in the US, where the market is slightly more expensive but quality stocks are cheap and growth is expensive.
So in short, Wouter is not calling the top of the market just yet. But does believe investors should be cautious and that the year ahead will be volatile and challenging. And stock picking will matter as much as regional allocation.
Peter Elston points out that it’s now almost seven years since the global financial crisis and interest rates are still flat on their back. That there is something unusual going on is without doubt. The question is, what?
In a nutshell, those wishing to save, whether companies or households, currently far outweigh those wishing to invest. This has pushed down real interest rates to a very low level (in some cases negative) that should discourage saving and do the opposite for investment demand. The problem is that investment demand is weak because of such things as falling population growth and the impact of the internet (the latter is counter-intuitive, but smaller companies that previously accounted for a large share of global investment now have to compete with global on-line operators, and their investment plans have been impacted as a result).
He thinks desire to save (rather than to consume) on the other hand has been driven by the uncertainty and lack of confidence that still prevails following the global financial crisis. Nonetheless, things are gradually improving, as evidenced by unemployment rates that continue to fall and in some cases still have a long way to fall. The length of the global economic recovery will be commensurate with the severity of the 2008-9 crisis, so expect economies to continue to eke out growth for a while yet, all the while supported by central banks.