GLOBAL MACRO OVERVIEW
The global markets received an unexpected shock from the Brexit vote that quickly translated into fears of a recession, particularly in the UK and across the Eurozone. The surprise vote also brought into sharp focus the rising tide of voter discontent against the establishment that is rightly or wrongly blamed for a lack of wealth creation and rising inequality. Whether the UK vote can tip the global economy into recession is a moot point and in our judgement these fears have clearly been overdone. In our view Brexit in isolation should not derail the US economy or seriously dent the faster growing Chinese and Indian economies. However, any sober assessment would also conclude that the outlook for the UK economy is certainly a lot more uncertain whilst the political heat-map in Europe is also not conducive to economic or social stability. Unfortunately, Europe does continue to be the laggard in the global context and as it faces over a year of significant political tests it is relatively easy to paint a rather gloomy picture particularly as there is already insurmountable evidence supporting the undoubted drift in voter sympathy towards populist parties be they left or right of centre.
In the face of rising market nervousness, concerns about economic activity, low inflation and political uncertainty, the central banks have had no option but to step back into the fray. The Bank of England (BoE) has thankfully stepped into the vacuum in the UK and has provided significant verbal support and is now poised to act decisively. The Fed pulled in its rate hike horns whilst the European Central Bank (ECB) and Bank of Japan (BoJ) have been more than happy to talk of continued monetary support. There are also hints indicating that the era of fiscal austerity may be coming to an end in 2017 across Europe and possibly even this autumn in the UK.
In light of these uncertainties London & Capital's asset allocation has been risk averse whilst continuing to focus on the well-established income theme within both our equity and fixed income strategies. Risk markets have rallied and our strategies have continued to record gains but this rally seems to be tenuous.
London & Capital's asset market outlook is not materially different from what was expected last quarter. In the equity spectrum there is a greater domestic bias within our US and European portfolios whereas the UK exposure will have a greater international focus. Corporate earnings are expected to rise by low-digits but with no multiple expansion expected. In fixed income we have identified pockets of value within financials, selective emerging markets as well as within high yield corporate bonds.
In this update, the first section examines some of the risks such as low growth, European banking and negative interest rates. The second section outlines key country level macro analysis and the final section outlines the asset market outlook.
Economic Risk Analysis
The post-Brexit political scene in the UK has resembled a mix of a Shakespearean tragedy and Machiavellian intrigue, with the Brexiteers rapidly vacating the stage with a complete lack of planning for the eventuality of a leave vote. However, the UK does now have a new Prime Minister, who has an exceptionally full in-tray. However, rather than dwell on the political aspect, this section will focus on the key themes that will shape our asset allocation in coming quarters.
Getting accustomed to a new tepid growth cycle
Market and consensus estimates for economic growth have been pared back in recent weeks largely due to the sharp falls in risk markets post the UK referendum result. Even though the bounce in markets has been significant, the doubts over the stability of the economic system remain in place. Subsequent country sections examine the risks and key growth drivers in the major economies and conclude that there is significant resilience and a recession due to the Brexit vote should be easily avoided. What is also starkly apparent is that the global economy has failed to break into a faster growth trajectory despite continuing monetary accommodation.
And herein lies the main issue that is a continuing hurdle for risk markets; will the relatively tepid growth cycle finally become the new norm constricting potential returns? Our view remains unaltered with our base scenario of the global economy, expanding by a very modest 2-2.5% over the next year. We expect the US to retain growth leadership within the developed world and China and India are expected to display sufficient strength to keep world trade growth at a reasonable rate. It is likely that over the next few quarters the gap between Emerging Markets (EM) and Developed Markets (DM) widens in favour of the former.
What Is Really Going On With Growth?
The global economy has continuously disappointed the growth bulls since 2009 and if one were to look at projections for 2016, issued by leading forecasters late last year, they have been way off the mark yet again. Some of this is due to new factors such as the UK vote but others were more predictable. Indeed growth has been bumping along in the first half of 2016 at sub-2% as the US expanded by less than 1% in the first quarter and there was evidence of a loss of momentum in Europe and Japan. Within the Emerging Markets the commodity exporting countries slowed significantly, with Russia and Brazil in outright recessions. Offsetting this, India and China surpassed expectations, with the former recording the fastest growth rate for many quarters. Thankfully the situation is beginning to stabilise in Brazil with a new leader in place alleviating some of the concerns. Nevertheless, growth rates are tepid but are not implying a recession. Both the developed and developing economies are growing albeit not at the rates that would be consistent with historically loose monetary policy.
The following features remain supportive
- Consumer demand continues to expand and as this accounts on average for c55% of GDP, it is key driving force
- Housing and ex-energy capital investment remains on a positive trajectory in most major economies, although there is clearly a growing risk of a downturn in the UK
- Currency depreciation in a number of countries/zones has provided a positive impulse to growth through improving terms of trade
- Extremely accommodative monetary policy and supportive fiscal policy across the majority of developed economies
The negative factors
- Energy and commodity related investment took a battering over the past 12-months, with the reductions at unprecedented levels. In some countries the drop was c25% last year lowering growth by c0.4%. The drag from this in the developed world is almost behind us but within oil exporting countries in particular a further downward adjustment in spending is factored in to our growth projections
- Sluggish world trade growth as China rebalances. There are also continuing concerns over a currency devaluation if the Public Bank of China (PBoC) undertakes an aggressive Yuan devaluation strategy
- Low manufacturing confidence translating into lower industrial production
- Low inflation rates and negative interest rates across a number of major economies
The UK’s negotiation with the EU will be yet another potential negative factor that will have to be taken into account. However, as the UK accounts for just 3.5% of world output the direct impact of a near-term recession is fairly marginal. Trading links with many countries across the globe are fairly marginal and should not trigger a step down in world trade growth. The indirect impact can be gauged through examining a number of factors. The main risk transmission would include a tightening in financial conditions, a rise in systemic risk across various sectors, including banks, a disruption to world trade, a negative wealth impact on consumer sentiment from a slump in stocks and housing and a potential contraction in investment. Despite concerns, financial conditions have generally been loosened as central banks have been active and will continue to ensure there is significant liquidity. Bank share prices initially slumped across the board but have recovered in many cases apart from in Europe and the UK. However, this does not directly lead to systemic risk as banks do not face a freeze in wholesale funding (unlike 2008), there is no loss of general investor confidence (unlike 2008), risk weighted assets are lower, balance sheets are stronger and capital ratios are all significantly higher than in 2008. Inevitably it would be unwise to completely ignore the potential of uncertainty within the banking sector hitting sentiment but the impact should be contained.
An additional concern is the backdraft onto the Eurozone from the UK vote. The fear is that a successful exit would trigger a surge of populist voting in elections in France and Germany (next year) and the Eurozone would soon unravel. However, the Spanish vote three days after the referendum did not see a further drift to Podemos (although they stayed in third place) and is positive news. Nevertheless, given the events of the past few weeks, it would be foolhardy in the extreme to completely discount an adverse outcome. Europe’s response to populism is also rather important as ignoring it and hoping that over time the tide will just naturally change would be foolish. A shift in emphasis is necessary, meaning that the dreaded austerity message, has to be ditched. There is some good news on this front but as always Europe drags its feet. The elections in France next year are now absolutely critical because if the National Front wins the Presidential election the end for the Eurozone would be nigh. In such circumstances it is hoped that policy makers and politicians will change tack or they will sleep-walk into disaster. As this discussion shows the probability of a damaging election period in Europe derailing Eurozone growth cannot be zero but neither is it the central case.
Overall, given all of the political hurdles (without even mentioning the autumn US elections) it is quite easy to become quite pessimistic. It is important to remember that even with the weaker growth profile in the US, Europe, UK and Japan, a recession would require a contraction in consumer spending which remains a remote possibility given the underlying factors: Positive nominal and real wage growth, positive job creation, supportive housing, low interest rates and higher credit availability. We will continue to monitor underlying trends in consumption and non-energy capital expenditure and look for any significant deterioration in either of these key forces.
It would seem that part of the explanation for the fear of recession is that global growth remains trapped in a sub-par trajectory and any mishaps can act as an instant destabiliser. This leads to even looser monetary policy and continues to feed the cycle.
European Banks Back In Focus
European banks and policymakers were very slow off the mark post the financial crisis and only accelerated their response post the onset of the Greek economic and banking debacle. But they have now come a long way in re-capitalising their balance sheets, lowering risk-weighted assets and have been far more transparent about their holdings as well. The regulators have also been increasingly active with more thorough risk assessments whilst pressing ahead with implementing Basel 3 and 4 regulations. The ECB has also pumped in liquidity and is continually providing long-term funding, encouraging banks rather successfully to re-engage with the wider economy through enhanced lending programmes. However, the complexity and depth of the European banking system still leaves it vulnerable at times.
European bank stocks have taken yet another severe battering over the past month with a number of leading institutions trading at multi-decade lows, with what looks like deceivingly fragile price-to-book-values. The catalyst is yet again fears of deteriorating earnings, the potential negative impact of negative interest rates, and crucially the onset of a bad loan crisis in Italy. However, in stark contrast to earlier this year, CoCo debt has held up much better in the majority of the cases and credit spreads have also generally been much better behaved. The fact that stocks have lagged is wholly justified in our view given the deleveraging of bank balance sheets and the resultant lower return on equity.
The deteriorating situation in Italy has now emerged as a new catalyst for the sell-off in bank stocks. The crux of the problem is that unlike Spain and Ireland, the Italian authorities have dragged their feet on recognising the size of non-performing assets and have only belatedly set-up a rather small and inadequate bad loan facility. To complicate the situation there is a scheduled vote of confidence in parliament that may unseat Prime Minister Renzi in October. Ahead of that, there are finally efforts underway to recognise the scope of the problem and set-up an extended bad loan bank that will allow the wider banking system to offload these positions so that capital adequacy ratios rise significantly. There are clear indications that in this process the primary aim of the Italian authorities is to ensure that credit investors are protected. Right now this runs contrary to EU/ECB thinking which makes a state bailout or capital injection rather difficult in the absence of credit investors (in bank debt) shouldering the burden or indeed taking the initial hit. There are circumstances that allows for a state injection and it is likely that these avenues will be looked at in far greater depth in coming weeks. In the background, banks such as Unicredit have taken steps to bolster their balance sheets. As always in Europe it is pretty clear that there is a workable solution but it takes time to get there as all parties fight it out in public. Italian banks are expected to remain highly volatile and although we now have zero exposure we are monitoring the situation closely with intention of re-entering the market. Italy is no Greece and no one would inadvertently want the situation to reach crisis point.
Markets are less fearful of AT1 coupon risk
Following the furore at the beginning of the year over an imminent coupon skip by Deutsche Bank (amongst others) the ECB and European Banking Authority (EBA) have moved to clarify the issue. Initial comments have stated that Additional Tier-1 (AT1) investors deserve particular protection and that their intention was not to impose any hard restriction on banks with regard to coupons. They also clarified the primacy of coupon payments above dividends and bonuses. In essence the regulation clarification removed the threat of on-going volatility over AT1 debt around earnings release. Further clarity is expected later in the year with regulators removing the threat of a temporary period of low earnings or a loss leading to a suspension of coupons. In essence the regulators want new style AT1 debt to be a permanent component of the capital structure and will not want to undermine confidence in what is still an asset class in infancy.
Our basic thesis of running a strategic long-term position in bank debt (focussed on Global Systemically Important Financial Institutions and National Champions) was stirred but not shaken over the first half of the year and we reiterate some of the key points underlying our positive stance:
- Far more resilient balance sheets – rising Core Equity Tier-1 (CET1) ratios
- Improving quality of balance sheets
- Increasing amount of liquid assets
- Regulatory drive enabling banks to become standalone economically viable entities
Negative bond yields
Almost a quarter of major government bond yields are now trading in negative territory generally within the Eurozone bloc. Yield levels have also fallen to historic lows across the US and UK bond markets, partially due to the Brexit vote. However, the drift to ever-lower yields had been in motion for some time but certainly the move accelerated in recent weeks.
What is causing this extraordinary drive to a period of negative yields, as it has important implications for asset allocation?
- The yield levels partially reflect the reality of a new norm of prolonged tepid economic activity and low inflation. The market correctly fears that a low growth scenario could get derailed by either a policy error or other exogenous factors
- Political and economic uncertainty has fed a flight to safe haven assets and in particular government bonds
- Accommodative monetary policy is rightly seen not just as a temporary phase but rather a new long-term central scenario
- Central bank asset purchase programmes have also driven yields ever lower. The ECB’s buying programme has coincided with lower bond issuance as well and has exacerbated the situation
- There have been large inflows from asset liability investors adding to the demand for low risk government bonds. This is generally long-term sticky investment and will not be reversed in a hurry
Negative risk free rates are not desirable in the long-term as it can lead to distortions in asset pricing and a misallocation of capital. It also erodes confidence in the economic system itself as it generates uncertainty and in some cases fears of systemic risks. In addition, it makes it more difficult for central banks to step away from not just the zero rate policy but also the unconventional measures.
It also raises issues over managing fixed income portfolios as it would be logical to expect interest rate volatility to intermittently spike reflecting either better economic data or expectations of re-allocation out of government bonds. Our overall bond strategy is discussed in detail within the asset outlook but as far as duration management is concerned it is important to stress that we have taken a number of steps. First we have made a conscious effort to raise the natural maturity spectrum of the portfolios in recent months, the underlying credit quality has also been raised whilst selective exposure to risk assets (financials, high yield and emerging debt) has been maintained.
US Economic Outlook
- A rebound from a weak Q1 will leave 2016 growth at c2% led by domestic demand
- Consumers remain the main source of growth
- The Fed has already hit the pause button and will be on an exceptionally gradual monetary tightening path in the next 12-months
The domestic economy rebounded from Q1 weakness and should grow by 2-2.5% in the remainder of this year leaving overall growth at a steady 2%. Early 2017 projection is for steady growth but will be reviewed in the coming months. As ever the path has not been smooth with significant volatility in some of the key high frequency economic data such as non-farm payrolls. However, the short-term noise is merely a distraction as in the background, the US economy continues to expand but at a steady pace. Given that this is the 8th year of this current expansion phase it would be logical to argue that it would be difficult for the economy to break out into a higher growth trajectory given the external factors that are at play. In addition, it is rational to argue that over the next 12-18 months a number of domestic sources of growth will gradually begin to fade.
The employment backdrop is crucial to the Fed’s monetary stance and despite monthly volatility, the underlying pace of monthly job creation is a respectable 150k per month. The unemployment rate has been rather sticky at around 5% over the past few months, with a marginal upward drift in wage growth. All of this information implies that the Fed can afford to stick to its cautious monetary stance. As always there are challenges ahead but these should not outweigh the undoubted domestic strengths.
Domestic demand will continue to be the main source of growth this year, with consumption, housing and business investment all set to grow steadily. Consumer spending continues to be the key component and has remained resilient in the face of market turbulence, political machinations, external volatility and the ebbs and flows of interest rate expectations. It is pretty clear that the fear of a steep rise in rates should no longer be a concern for households. The ingredients are certainly present for relatively robust personal spending this year given solid employment gains, higher real disposable income, lower household leverage and supportive household formation. A robust jobs market in particular should underpin consumers, with the unemployment rate at its lowest since 2008. A broad range of employment indicators continue to improve removing a large part of the labour market slack. Employment growth should continue to expand steadily in 2016 and wage growth should also continue to tick higher boosting real disposable income. However, offsetting this will be the end of the boost from lower inflation following the steep rebound in oil. Away from consumption, ex-energy business investment is continuing to expand modestly. The external sector will be the main drag on growth as it is being buffeted by a combination of a strong dollar and lacklustre domestic demand in many partner countries. We continue to stress that world trade growth has slowed to the weakest since the 2008 crisis and the outlook is not particularly rosy with the US dollar still expected to strengthen against major trading partners whilst a rise in US consumption will inevitably lead to higher imports.
The Fed’s policy stance has clearly been increasingly influenced by external factors and this is apparent from its policy minutes. Intense market volatility at the beginning of the year was the initial reason for Fed reticence and concerns over Brexit and Europe has also acted as a restraint. This has resulted in a dovish tone and has led to market expectations basically discounting any further rate hikes this year. Federal Open Market Committee (FOMC) doves have been in the ascendancy (although the hawks are still present) and the Fed’s internal projection implies a very gradual tightening process later this year and into 2017. The peak in rates is expected to be significantly below historic norms.
Our base case of rates rising gradually by 1% over the next 18 months has changed in light of external factors and the fact the US economy is growing at a very modest pace. We now project just one further rate hike this year and the potential for just another two hikes in 2017 but this will be wholly dependent on the underlying strength of the economy. We will keep a close eye on inflation numbers and in particular price expectations as this could alter the future flight path of rates.
Herein lies the danger for the Fed in its stance as it is pretty clear that external conditions have been a key driving force in their change of tone but if domestic growth picks up or inflation rises, will they continue to ignore these pressures and risk a loss of market confidence (remote as this may seem right now)? The Treasury market has of course been underpinned by market volatility and a flight to safe haven assets and given the political calendar in Europe and the forthcoming UK exit negotiations, the safe haven aspect will remain in place. Fiscal policy remains on the side-lines and we expect no change with Presidential election season ahead.
Canada Economic Outlook
- 2016 growth outlook modest and volatile due to the impact of the Alberta wildfires
- Consumers and net trade key sources of growth but energy will be a drag on growth
- The Liberal government loosens fiscal policy but is blessed with low government debt levels
The domestic economy picked up steam in Q1 growing by a more than respectable 2.4% annualised rate and defying expectations of a material slow-down. Both domestic and external demand boosted growth, with the former at +1.3% and the latter contributing 1.7%. However, Q2 growth has been more subdued largely due to the significant impact of the wildfires in Alberta and the on-going impact of the cut in energy capital expenditure. There should be a rebound in Q3 as oil sands production comes back on stream but despite this we have maintained our projected modest growth rate for 2016 of 1.25- 1.5% as we expect a continuing drag from the energy sector and capital expenditure. However, net trade and consumer spending should provide a boost. The fact that the US as a major trading partner is continuing to expand is a positive. The Bank of Canada (BoC) has maintained its accommodative stance and is likely to remain on the side-lines for some time ahead despite the loosening in the fiscal stance announced by the Liberal government in May.
Business investment was a large drag on the economy in 2015 and remains a risk in 2016 despite the recent rise in oil and broader commodity prices. Significant cutbacks have already been announced in the commodity and oil sectors (centred across certain Provinces such as Alberta). There has been a surprisingly large movement of labour out of Alberta into better growth provinces such as Ontario and Quebec. It feels as if the restructuring in the energy sector is not just a temporary phenomenon. Away from energy there are indications that capital expenditure should begin to rise but the overall contribution will be extremely small and the risk is that it may well be a drag yet again this year. A weaker currency should help, as net exports should emerge as a main strength helped by relatively strong US personal spending, whilst imports should be lower this year. The outlook for consumption will be critical given the weakness elsewhere in the domestic market. There is good news as consumers should be supported by a buoyant labour market, higher real earnings, looser monetary policy and higher credit lending. As inflation eases real income growth will receive an additional boost on top of the tax related changes introduced by the new Liberal government. This sets the scene for spending to rise by c1.5% this year and should record faster growth rates in the medium-term.
The BoC hit the monetary pause button in Q1, partially due to slightly better economic data but largely as it waited for the new budget. The Liberal government’s new budget was expansionary and will lead to budget deficits of c1-1.5% over the medium-term. The main focus is on an extra C$120bn of infrastructure spending over the next decade and this should provide a direct boost of 0.5% (per annum) to economic growth over the next few years. There are further measures to redistribute taxes to low/medium wage earners that are also growth supportive. This fiscal loosening will lead to higher bond issuance across the yield curve including a new 3-year bond. However, Canada has fairly low debt levels and will run fairly small budget deficits so that its AAA rating should be in no danger. The BoC will be in no rush to loosen policy at this stage. It gave itself room for manoeuvre by shifting the lower bound on interest rates to -0.5% from +0.25% late last year and also included the possibility of asset purchases in its armoury.
European Economic Outlook
- 2016 growth still projected to be in a 1.5-2.0% range led by domestic demand.
- Consumers and business investment will be the main sources of growth.
- The ECB has responded to low growth and low inflation and will remain a force.
The Eurozone economy performed credibly through the first quarter but lost a little bit of steam in the second quarter and now faces a number of challenges including the impact of Brexit and the growing Italian bad loan issue. Offsetting this is the ultra-accommodative ECB stance that has led to negative government bond yields and lower borrowing costs for companies and households. Overall across the Eurozone there are better labour market dynamics and stronger consumer sentiment. Germany will remain the shining light but other countries are close on its heels despite the political concerns in Spain and the terror attacks in France. The ECB has been extremely active this year and recent action may not be the end. Politics will increasingly take centre stage in coming quarters and as always this carries significant risk for the economy.
Domestic demand will remain the main source of growth this year as consumption and business investment accelerate modestly. Households have escaped the crisis era as the employment picture has improved, as highlighted by the drop in the area wide unemployment rate to its lowest since the financial crisis. Real wage growth has also picked up and confidence levels have risen from relatively depressed levels. Pre-Brexit confidence levels had held up relatively well although there was weakness in German factory orders and industrial production towards the tail end of Q2. The direct Brexit impact on confidence and the real economy should not be a major issue this year. However, next year could be a lot messier as negotiations with the UK begin in earnest and French and German elections come into focus. In our base scenario we have knocked-off a couple of tenths off the growth projection this year.
Looking at purely internal Eurozone indicators, capital expenditure should be supportive as investment across the Eurozone is on a firmer footing. Capex plans have been helped by ECB action leading to a significant drop in lending rates and a resultant pickup in bank lending to companies. This remains important for Europe as companies are far more reliant on banks than their US counterparts. Weakness in world trade growth has not had a significant impact to date but remains an area of concern. Improving terms of trade due to a weaker Euro and lower labour costs has certainly been beneficial and on balance should be supportive in 2016.
The Italian banking problems revolve around a number of key issues including the recognition of non-performing loans (NPLs), the set-up of a bad loan bank or special agency and the pricing mechanism for the transfer of such assets. Unfortunately Italy has dragged its feet on this unlike Spain and Ireland. In its favour the largest banks such as Unicredit and Intesa are well capitalised and have taken concrete steps to reduce Risk Weighted Assets (RWA). Without doubt an Italian banking blowup has significant ramifications for Europe unlike Greece and we fully expect a workable solution to be found and implemented in the next few months. In the interim this problem will constrain economic growth particularly as the confidence vote in the Italian parliament is a very close call at this stage.
The upcoming political timetable is long and tortuous, presenting a succession of potential hurdles given the surge in populist voting across the Eurozone. The challenge for us is to quantify the potential economic impact of the political uncertainty. What we can quantify is the continuation of the ECB’s loose monetary stance which will provide both direct and indirect support to banks, companies and households. In our base case scenario we do not expect the political calendar to derail the Eurozone economy in 2017.
The ECB has responded aggressively in the aftermath of lowering both its growth and inflation projections. It is successfully pursuing a three-pronged approach: Negative rates, an expanded asset purchase programme and new Targeted Long Term Refinancing Operations (TLTRO) programmes. Although the end date for QE for the time being is still March 2017, in reality this is likely to continue for longer given the tepid growth backdrop. The measures are of course designed to support growth whilst also boosting banks but the main target is higher inflation or at least ending the threat of deflation.
UK Economic Outlook
- The Brexit vote brings a near-term recession into play and raises medium-term uncertainty ‧‧ Consumer demand should remain the key source of growth
- The BoE to be ultra-supportive post BREXIT vote
The UK has been a star performer over the past few years but this position is now under threat as we wait to begin the negotiations over the EU exit. We have already seen the currency plunge and government bond yields fall to historic lows as the BoE signals zero rates. Of course it has been just a few weeks since the vote and we have no real economic data at hand as this will only come to light from mid-August onwards. However, there is already considerable survey evidence that suggests that even prior to the vote, consumer and corporate sentiment had turned cautious and the economic momentum into this year had been lost. The travails within the commercial real estate market has also added to the uneasiness. In light of this, our central economic scenario has been downgraded both for this year and for 2017 but a recession should be avoided. However, these projections are likely to change once negotiations get underway and the tactics become clearer. The one bright spot is the BoE’s supportive stance.
Despite the appointment of a new Prime Minister, there is no clarity on when the UK will trigger Article 50 or how and when the negotiations will commence and what the UK will attempt to achieve. If Brexit is seen as Brexit (as has been continuously stated) there seem to be just two choices (at this stage): The Norwegian option with EU market access and freedom of labour movement or an exit and new trade agreements. It would seem that the Swiss option is no longer on the table but politicians can always change tack. The experts will kill many trees in the coming months penning their views on this and we will steer clear and instead focus on the elements that matter from an economic perspective. The salient facts that we are taking into account in our economic outlook include:
- Just over 50% of UK’s trade is with the EU
- The UK is one of the largest developed country recipients of foreign direct investment (FDI)
- The direct contribution of financial services is around 10% of the economy (indirect would be even higher)
- UK’s net contribution to the EU (taking into account the rebate and the flow back from the EU back into the public sector finances such as aid to farmers) is c£9.9bn. This falls to £7bn when other private sector flows are also taken into account
- UK is running a current account deficit approaching 6% of GDP and a budget deficit of 4.3% of GDP
Given the complexity of the underlying issues it is reasonable to argue that companies will be in no hurry to increase investment in the UK and the best that can be hoped for is stability. It is probably far too early for these international companies to switch investment to Europe given the other aspects that have made the UK an attractive target for overseas investors such as low corporate taxation and a highly flexible labour market. Capital investment has been a good source of growth over the past couple of years and we now expect this to be a drag on overall growth both this year and in 2017.
Consumers have been the main driving force and housing is integral to the fate of consumer spending and anecdotal evidence suggests that prices have been marked lower and activity has also slowed. A crash such as 2008 is certainly not on the cards particularly as household finances are in better shape and interest rates are likely to remain low for a prolonged period. However, there is potential downside from a weaker labour market eroding consumer confidence and higher inflation squeezing real income growth. There is more downside than upside.
Given the uncertainties, weaker consumer and corporate confidence, lower labour hiring intentions, the fall in housing and commercial real estate prices, the BoE’s direct negative economic assessment and anecdotal evidence on lower retail spending and capital expenditure we have lowered 2016 and 2017 growth to c0.5%-1%. Although we are not projecting an outright recession in 2017 a great deal will depend on how the negotiations unfold.
We are in for a prolonged period of near zero rates and a weak currency. As far as rates are concerned the BoE kept both the base rate and the asset purchase programme unchanged in July despite the warnings both pre and post-Brexit and the sober economic assessment within the minutes. It would seem that the Bank has decided to wait for real data and the August Inflation Report before cutting rates. Additionally, it is also in discussion with the Chancellor on responding through all channels rather than in in a piecemeal way. The Minutes did mention the fact that inflation is likely to rise short-term reflecting the sharp fall in the currency and higher oil prices. However, there is little danger of inflation posing a risk given the underlying weakness of the economy. It is likely that the BoE will unveil a more comprehensive programme in August including measures to deal with business lending, mortgages and corporate bond buying. The BoE Chief Economist has already hinted at his voting intention.
The new Chancellor has rightly ruled out an emergency budget. However, there seems to be a more flexible approach being adopted, with the strict fiscal rules that were designed to deliver a surplus of 0.5% by 2019/2020 likely to be ditched. This plan was based on roughly 0.8% of fiscal tightening in each of the next 4 years. In our judgement the most likely outcome is that the majority of the departmental spending guidelines will be maintained but extra infrastructure spending and selective tax cuts will be enacted. The infrastructure spending is likely to be financed through targeted bond issues but by their very nature these are long-term and any positive impact over the year or so will be limited. Of course the confidence impact should be positive but should not be overplayed.
Japan Economic Outlook
- Failing Abenomics leads to weak economic growth with falling prices
- Consumption is key and is mixed
- Further monetary and fiscal measures needed to bolster economic growth
Unfortunately, Abenomics has slipped off the rails, as most of the key objectives including a higher potential economic growth rate, an end to deflation and a stronger fiscal position have all fallen short. Indeed recent official estimates would suggest that the potential growth rate has actually declined not risen. Growth has slowed despite the first quarter growth rate, inflation is close to zero as deflationary concerns have returned and the Yen has rallied despite negative interest rates. Worryingly inflation expectations have continued to move lower. The economic momentum into 2016 was still relatively weak, with headwinds from China and an erratic consumer. The economy is still expected to expand but by a rather modest 0.5-0.75%, with the risks on the downside. The support of a weaker yen has waned. Although, the Bank of Japan (BoJ) has moved rates into negative territory further monetary and fiscal action is on the cards.
A 1.9% jump in Q1 GDP is rather deceptive as there was a significant positive impact of a leap year whereas growth over the past four quarters has been flat which is far better indicator of underlying trends. As far as Q1 is concerned, business investment was revised higher (well to -0.7% from -1.4%), consumption was a tad stronger and net exports were positive. However, Q2 is likely to see a contraction leaving growth in 2016 at c0.5% with weak growth next year as well unless there is a significant fiscal and monetary boost in coming months.
Consumption posted a small rebound in Q1 and should be supportive in coming quarters. Prime Minister Abe took the correct decision to delay the next consumption tax hike (to 10% from 8%) by two years to 2019. It should be noted that spending levels are still struggling to recover from the 2014 hike and as the Prime Minister rightly stated that “a rise next year would be a significant risk to domestic demand”. This suggests that overall consumption growth will remain tepid this year. A tight labour market should be good news for wage negotiations but maybe outweighed by lower inflation expectations that tends to reduce wage growth. There is some positive news as nominal (and real) earnings have drifted higher. Business investment that had been fairly resilient following upward revisions in Q3/Q4 last year is set to weaken given the most recent Tankan Survey and the downward revision to corporate profits in the Finance Ministry survey. There is also the continuing external threat to growth. The continuing uncertainty in China is hardly positive for Japan and it remains vulnerable as about a fifth of Japanese exports go to China. Although some of this may be offset by the US, slower world trade growth will clearly be negative for overall growth prospects.
The accommodative BoJ monetary stance will continue as Quantitative and Qualitative Easing (QQE) is bolstered by the introduction of negative nominal interest rates. Policymakers remain rightly concerned by the sharp decline in inflation expectations as surveys covering businesses and consumers all point in the same direction. The Yen’s appreciation has also tightened financial conditions. Prices are declining yet again with deflation the base case scenario. We expect the BoJ to lift the size of asset purchase programme to 100 trillion from 80 trillion Yen (almost 20% of GDP). This programme already includes corporate bonds, equity-linked ETFs, J-REITs and was extended to acceptance of foreign currency denominated loans on deeds as eligible collateral and extending the maturity of Japanese Government Bonds (JGB) purchases. The BoJ is likely to cut rates further into negative territory. Fiscal policy is likely to be loosened with a new supplementary budget likely to provide an extra supportive leg to economic growth including ditching the consumption tax hike.
China Economic Outlook
- Policy intervention has raised the short-term growth profile but at the expense of rebalancing
- Our GDP growth projection is raised to 6-6.5%
- Active policy intervention will continue in 2016
The early year market rout didn’t leave a lasting mark on the economy but investor sentiment seems to remain nervous in stark contrast to the real economy that is growing at a decent clip. Part of the nervousness stems from the continuing belief that the much vaunted rebalancing towards consumer spending is way behind schedule. However, there is no point attempting a rapid rebalance and risking a damaging slow-down. Instead rightly the focus is on maintaining a growth rate that does not disrupt the global economy at a time of intense uncertainty. We re-iterate our comments from last quarter: A gradual rebalancing is underway but this transformation will take time given that fixed investment accounts for almost half of GDP. In light of Q2 GDP, our economic growth projection has been raised to 6-6.5% reflecting a stronger growth profile in the first half of the year with growth of 6.7%. There are still significant challenges for the policymakers, including articulating a clear FX policy and managing deleveraging in key parts of the economy.
A whole spate of recent economic data has been stronger than anticipated led by Q2 GDP growth at 6.7%. The mix though was a bit of a concern as consumption slowed whereas steady infrastructure investment and a rise in exports were positive features. In addition, June industrial production, retail sales and monetary data were all stronger than expected implying that the momentum seems to be flowing into the third quarter as well confounding expectations. However, there is an offset from lower manufacturing and housing investment, with real trade activity also easing. Headline numbers probably don’t tell the full story as behind the scenes the real struggle is to wean the economy off continual government support. Total Social Financing (TSF) has been on an upward trend throughout the first half of the year directly showing the support through higher government lending, be it to infrastructure investment or direct lending to real estate firms.
In essence this sums up the dichotomy within the Chinese economy: relatively robust growth but lack of progress in the key areas of supply side structural reforms including reducing the overcapacity in sectors such as housing and manufacturing. The housing oversupply stretches across various sectors including Tier 3 and Tier 4 cities but this will take time to erode and will inevitably reduce consumer confidence.
Overall, the divergence between external perceptions and internal growth will remain in evidence. Economic growth is higher than consensus but is lower than official projections.
The authorities will continue to use a combination of monetary and fiscal measures. On the monetary front, the PBoC is likely to play a more passive role but this does not preclude a further injection of liquidity into banks and a cut in interest rates including the Reserve Requirement Ratio (RRR). There is room for further monetary easing although the pace of such a move will be gradual. In theory rates could still fall by another 100 bps over the next year but in practice the easing is likely to be 25-50bps this year. The authorities have managed a near 4% depreciation of the CNY over the past year or so and look determined to continue to a use further measured depreciation. There seems to little appetite to repeat the sudden FX move of last August that led to significant spike in volatility. Instead the government is likely to opt for a measured approach using a drawdown in FX reserves to allow the CNY to fall by a further 3-5% in the next 12-months.
On the fiscal front, the authorities were extremely active in the first half of the year with social financing through direct lending rising sharply. There are other medium-term measures including a new “urbanisation” policy to help new migrants and will provide direct assistance to local governments to facilitate this. Whereas local government borrowing is being cut back, the central government will ramp up the fiscal deficit to transfer money to the provinces.
India Economic Outlook
- Headline growth over 7% but underlying growth closer to 6-6.5% (still impressive)
- Improving investment backdrop
- The Reserve Bank of India (RBI) remains accommodative as external risk indicators improve
The economy strengthened over the past few quarters and has topped recent global growth charts. A number of factors have come to bear including the positive impact of lower inflation, easier monetary policy and a more constructive fiscal backdrop. Micro reforms introduced by Prime Minister Modi also helped in alleviating some of the roadblocks although more work is still needed. The economy is set to grow over 7% but there are risks particularly from slower world trade growth. The fears of significant capital outflows are less of a danger as the current account deficit has improved significantly. The economy is now far more resilient than 3 years ago and should be able to withstand intermittent volatility spikes. However, more action does need to be taken to ensure that the external vulnerability is reduced. The RBI has built up quite a bit of credibility and has the room to cut rates even further even though Governor Rajan is set to step down in late summer.
The acceleration in the second half of 2015 was sustained into the first half of this year helped by strong manufacturing and a pickup in investment. However, it has to be noted that there is some controversy about the underlying economic strength as the GDP numbers include a fairly large residual component or discrepancy within the manufacturing sector. This has probably boosted growth by some 0.5-0.75%.
The underlying trends point to growth of c7-7.5%, with the risks marginally on the downside. A potential drag from the external sector and slower investment remain downside risks. In the case of the external sector, export growth has been hit primarily by the slowdown in demand across Asia. Any further slowing in world trade growth will have a negative knock-on effect. However, it is important to note that China is not a major trading partner and the country is less prone to Yuan devaluation. Investment risks had generally emanated from a backlog of stalled projects but the government is beginning to have a positive impact on the investment climate with a number of reforms enacted and further changes in attracting FDI. Investment is set to grow by 6-7% but without the constraints it may well have been closer to 8%. There are a number of high profile longer-term infrastructure projects in the pipeline including a potential high-speed rail network that should boost long-term potential growth. Indian consumers have remained cautious but signs for the second half of 2016 are more promising. As consumption is far more important for India than China it is important that this slow-down is just temporary. The labour market and wage growth remain supportive and if inflation eases in coming months it will provide a further boost.
The star Governor has decided to leave the RBI at the end of his first term and even though there is some disappointment the reforms that he enacted (with support from the current management) should mean that policy should continue to be supportive. The central bank has loosened monetary policy and is likely to remain on hold short-term. However, the RBI’s overall accommodative stance will remain in place and it has room to cut rates further this year. The moderate monsoon season should alleviate pressure on food prices (headline CPI remained stuck at 5.8%) giving room for manoeuvre. The central bank continues to pursue a number of micro measures that are designed to improve the monetary transmission mechanism. Fiscal policy (in contrast to China) is unlikely to be as active as the government is facing tax shortfalls and is determined to reduce the budget deficit. The state owned banks will receive further capital injection and some further reforms will be enacted to ease up the investment bottlenecks.
ASSET MARKETS OVERVIEW
The second quarter of 2016 continued to experience highly volatile price movements in equity markets which ended with huge uncertainty descending on indices from the UK referendum in favour of leaving the EU.
- US equities are still being viewed as a relative safe haven and experienced a lot less volatility than other equity markets.
- However, the valuation of the US Stock Market is fairly full and earnings growth forecasts are continuing to move lower.
- The markets continue to be driven by the FOMC which moved from considering a rate hike during the summer on the strength of the US jobs market to again being on a prolonged period of holding rates after Brexit.
- This pushed longer dated US government bond yield down to new lows and resulted in further multiple expansion for equities but balanced off by a lower growth outlook.
- US companies have started to look at acquisition opportunities to fill the current growth vacuum e.g. Microsoft buying LinkedIn.
- The US Presidential elections in November are likely to ensure that volatility remains higher than the last few years.
- Another weak period for equities in Europe ex UK. The major issue was the UK referendum vote
- European financials collapsed on the fears of the ramification of Brexit and on Italian banking reforms.
- The UK was a strong performer over the period as asset prices were boosted by a 10% depreciation in sterling.
- In the UK the divergence of performance was stark with international companies performed strongly on translational benefits from sterling weakness but UK domestic stocks were hit hard on growth fears and cost pressures.
- Equity valuations appear optically cheap for the region but there is very little confidence in earnings estimates given the high level of uncertainty.
- It will continue to be a period of heightened risk for European equities given the unknown impact of Brexit.
- The strategy remains unchanged in European equities which is to focus on international franchises with a diverse earnings stream.
- Japan continued to underperform global equity markets with the Nikkei 225 now in bear market territory and down significantly year to date.
- The perceived belief that the BoJ has limited ability to ease further has caused the currency to strengthen and impacted earnings expectations of exporters which are a considerable percentage of the Japanese stock market.
- Additionally, consumption has struggled to grow causing a stagnant environment for Japanese domestic stocks.
- Valuations are clearly low by historic standards but earnings estimates are falling sharply due to the deteriorating environment.
- The outlook is still very difficult and the stock market will continue to struggle unless the Yen moves on a weak trajectory.
- Emerging equities ended Q2 2016 unchanged and matched the performance of global indices despite the increased market volatility following the Brexit vote.
- Stabilisation of US Dollar and an uptick in commodity prices combined with revised expectations as to US Fed actions (from a moderate hike to now no hike or even marginal easing) have all fuelled relative resilience of the space. Traditional oil exporters were the primary beneficiaries of these trends with Brazil up 40% and Colombia and Russia returning close to 20% since the beginning of the year.
- It is still difficult to find fundamental factors that would support a sustainable commodity rally going forward. However, we believe that downside risk to emerging markets is also limited given their still relatively stronger growth profile compared and valuation discount to the developed world.
- We currently see China (propelled by quantitative easing and a weaker currency) and Brazil (posed for significant interest rate cuts that would cushion the necessary fiscal consolidation) as offering the best value.
- However, we will continue to look to South East Asia (Taiwan, Indonesia, and Thailand) for exposure to quality growth.
The second quarter recorded strong returns for most sub-sectors within the fixed income space. The powerful combination of the ECB’s asset purchase scheme and growing evidence of slowing economic growth helped drive many government bond yields to new record lows. Towards the end of the period, the uncertainty generated by the surprise Brexit vote, added to the rush to safety; despite this, the more risky credit sectors also finished the quarter higher. The outlook for sovereigns and investment grade corporates remains positive despite record low risk-free yields, as market demand should be maintained at recent levels from both private and official sources. The protracted period of abnormally low rates will most likely continue to direct yield hungry investors towards corporate high yield and subordinated debt.
- Mixed signals from the FOMC confused markets early in the quarter as many voting members pushed hard to get a second 0.25% rate hike out of the way, responding to a stream of reasonably upbeat economic data releases seen in the first 4 months of the year. However, this hawkish tone took a back seat after the release of a surprisingly weak May payroll data, and US Treasury bond yields continued to fall, buoyed by Fed Chair Yellen’s concerns that future economic growth may soften from current levels. The benchmark 10-year yield ended 37bps lower at a new record low of 1.47%. The bond markets are finally getting acclimatised to the unusual mix of stable growth, steady employment and unchanged/marginally higher rates for the next year or so. This should continue to provide a strong prop for Treasuries.
- The ECB on the other hand was busy with its Asset Purchase Scheme, with most of the focus being on buying sovereign debt in the open markets, but augmented by the newly created parallel programme to purchase up to €8bn of qualifying corporate credit per month. This sheer weight of money drove most of the German yield curve further into negative territory, and in reaction to the Brexit result the benchmark 10-year Bund went into negative yield for the first time, ending 27bp lower at -0.13%. The ECB has committed to continue the asset purchase scheme to March 2017, and long-dated Bunds in particular should benefit given this commitment. Large institutions such as insurers and banks are still required to hold sizeable allocations to sovereigns, supporting the positive technical backdrop.
- Gilts have been the strongest of all major government markets, with the 10-year benchmark yield falling by 56bp to 0.87%. The effect of the post-Brexit era has brought with it fears of a deflating economy, and should prompt the Monetary Policy Committee (MPC) to both cut rates in the summer as well as prepare markets for potentially more forms of QE. The new Tory cabinet has pledged a loosening of the fiscal purse strings. This would normally sound alarm bells for the gilt market, but as it will be crucial to keep the Treasury’s financing costs very low, a joint effort of higher gilt issuance with a fresh asset purchase scheme should keep 10-year gilt yields at sub-1%.
- When compared to the swings seen in US Treasuries, spreads on US IG credit spent a relatively quiet period during Q2. Net issuance of high grade paper was lower than normal, and given the stable corporate environment being enjoyed by large-cap companies, investors continued to back the sector. Last quarter saw a stable monthly pace of $10bn into IG from mutual funds alone; institutional flows would have far exceeded this flow. Expect more of the same over the next 3-6 months, especially with Treasuries unlikely to surrender much of its recent gains.
- In the Eurozone, it looked like much of the party celebrations took place before the ECB started its corporate bond buying programme. Despite Bund yields falling, most of the yearto- date spread tightening had already happened in the Q1. A surge of new IG issuance by both eligible and non-eligible entities under the ECB’s rulebook appears to have more than satiated the demand for bonds. Some investors also took advantage of attractive terms to switch into USD IG, which looked like a sensible move as the Brexit effect is more relevant to Eurozone domiciled companies than to US corporates. Expect some new spread contraction after the mixed Q2 performance.
- UK IG credit continued to look like a closed market, with little by way of new issuance year-to-date. Spreads did widen post Brexit, but because much of this sector is owned by domestic investors and despite the sharp drop in sterling, there was little by way of external selling pressure. With the uncertainty around EU exit timetable, it is likely that the UK IG market remains reasonably closed, but domestic investors may well take advantage of the relatively wide spread levels seen towards the end of the reporting period.
- After the assault staged on subordinated financials in the first 6 weeks of 2016, the subsequent recovery needed to navigate through some choppy seas. Whilst CoCo debt in particular did stage an impressive rally from those depressed levels, the market is still short of end-2015 close, making this sector among the weaker YTD performers in the fixed income universe.
- There are a few factors at play. The Brexit effect certainly affected UK banks, especially those which carry a reasonable exposure to the real estate sector. The likelihood is that there will be a short period of house price softness but most home mortgage lenders have been quite strict on their loan-to-value policies, so the effects on their balance sheets should be comfortably absorbable. Commercial real estate however may take a little more time to recover given the questions raised over the post-Brexit consequences for the UK’s financial sector.
- Elsewhere, much of the international focus is on how Italian banks manage to remove the high levels of bad loans that remain on their books, without taking massive write-down hits on the balance sheets. This issue is quite contentious as any potential government sponsored schemes will be looked upon as unconstitutional by other EU member nations. The release of the ECB’s biennial stress tests will make interesting reading when released in late July.
- US banks are performing well, despite the challenges from the weak energy sector to which some banks had extended quite a large amount of loan facilities. However, most operational areas are performing well, as witnessed by the recent release of the Fed’s annual stress tests. This explains why yield spreads on US banks remain tighter than on European institutions.
- The more senior parts of the debt structures have performed well, supported by the rally in underlying government bonds during the period. The lack of supply of senior unsecured debt will also help this sector to remain firm.
- Much of the revival of US HY was generated by the sharp rally staged by oil and resource markets. The effective doubling of crude oil prices from the $25 seen back in February provided a fresh level of interest in the overall sector which had been beleaguered during the previous 2 quarters. Strong domestic mutual fund interest helped to make US HY one of the strongest performing sectors during the past quarter, and further repatriation support by investors who had switched into European HY also propped returns.
- The European HY sector surrendered some of the strong performance recorded in the first quarter, as the sheer weight of money that had left IG in favour of HY failed to be repeated in Q2. The outlook for the next few months is stable, as few new HY borrowers are likely to come to the markets.
- Quietly in the background, both hard currency sovereign and IG EM debt continue to be among the most stable performers over the past few months. Much of the new sources of performance have come from a region that had been a major drag on the sector for the past few quarters, namely LATAM. The successful impeachment trial procedures for Brazilian President Rousseff has given Brazilian markets a boost, especially as the new political team appears to be more growth-friendly than the incumbent government.
- Also helping LATAM was Argentina’s return to the international capital markets, after finally settling its debt differences with the “hold-out” investors group relating to its old-style debt. Elsewhere, the relatively stable economic period in China and India provided additional support for hard currency EM debt. The revival in the resource sector has re-introduced an interesting opportunity set for many of the EM names, and while not totally out of the woods, the outlook for such producers/nations appears somewhat less opaque than had been the case in the previous quarters.
The broad hedge fund industry has continued to underwhelm this year with poor performance compared to broader risk assets, with even some of the large, marquee names in double digit losses for the year. This has strengthened the case for a highly selective approach among upper quartile hedge fund managers with a strong track record of alpha generation.
Overall industry fund flows have turned negative in some sectors and we believe that a lot of activity among market participants is focused around a shuffling of the pack; re-allocating to recent winners and less correlated names. This is a trend we expect to continue in the coming months as investors adjust to a higher volatility market regime.
The broad London & Capital hedge fund selection contains a core of uncorrelated strategies combined with some higher risk/ return opportunistic funds for those clients with the risk appetite, which we believe will provide the optimal approach moving forward. We continue to see good opportunities for alpha generation and London & Capital will look to take advantage multiple strategies across the asset class:
- Equity Long/Short: We continue to focus on sector specific strategies in financials, technology, healthcare and biotech. Continued intra- and inter-market dispersion is creating strong opportunities for those with specialist knowledge that can take advantage of both long and short opportunities.
- Equity Market Neutral: Both discretionary and systematic market neutral strategies have exhibited strong alpha and we believe this will continue in a bifurcated market. In addition, the low risk profile of neutral strategies ensures a focus on capital preservation in volatile markets.
- Macro/Commodity Trading Advisors (CTA): Macro and CTA strategies will continue to benefit from diverging global macroeconomic policies and dislocating events such as Brexit. In addition, CTAs are poised to benefit from any extended periods of risk off sentiment as evidenced by Q3 2015 and Q1 2016 performance and therefore we believe these strategies provide a complimentary hedge to traditional asset classes.
- Opportunistic: we continue to favour niche strategies in power, agriculture and volatility trading. We believe the uncorrelated nature of these strategies is extremely attractive in the current environment if sized correctly.
This year has been marked with bouts of intense volatility and rising political and economic uncertainty. UK’s surprise Brexit vote has raised the prospect of a destabilising period for the global economy. Europe is particularly vulnerable as it faces a year-long political test beginning with a crucial no confidence vote in Italy. The US Presidential election may well throw up a new leader that will test the resolve of many around the world. This political backdrop is undermining an already weak global economic outlook which is leading to central banks extending the extraordinary period of accommodative policy. London & Capital's asset allocation continues to be conservative whilst ensuring that the main strategies still have enough room for manoeuvre to capture risk market rallies.