GLOBAL MACRO OVERVIEW
The global economy survived the scare of the Brexit vote; and the resultant sharp correction in asset markets that followed, due to the aggressive response by the Bank of England (BoE). In the aftermath of the vote, there was a collapse in government bond yields across all markets with a huge swathe trading with negative yields. European bonds, including the UK, were at the forefront as official asset purchases added to the buying by traditional long-term investors. However, as the global economy survived a recession scare, discussion has inevitably turned to the efficiency and effectiveness of monetary policy. There seems to be growing unease that the Central Banks are running out of ammunition and will be unable to respond to any adverse developments. The issue of Central Bank policy is discussed at some length in the overview.
The global macro outlook is no rosier than the last quarter, despite the recession scare being overstated. There is little evidence of an acceleration in underlying economic activity. Although the risk of a recession has abated in recent months (partially due to decisive Central Bank action), the global economy is still stuck with sub-par growth. Leading agencies such as the Organisation for Economic Cooperation and Development (OECD) and International Monetary Fund (IMF) have recently delivered a fairly sober economic assessment for 2017 that we concur with. The macro overview focuses particularly on the impact of slower world trade growth on economic activity, a feature that we have mentioned previously.
In light of the macro outlook, London & Capital Asset Management’s (LCAM) asset allocation remains relatively risk averse whilst continuing to focus on the well-established income theme within both our equity and fixed income strategies. Risk markets have been mixed, with European equities lagging the US and Emerging Markets whilst bond markets made further headway. LCAM strategies have continued to record decent gains and the 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 portfolio, whereas, the UK and European 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 and high yield corporate bonds. In this update, the first section examines the monetary policy backdrop, the macro overview and the path of government bond markets, whilst the second section outlines key country level macro analysis and the final section outlines the asset market outlook.
Monetary policy reaching limits
Central Banks are in focus yet again as the viability of sustained monetary accommodation is called into question. The Fed is deemed to have lost credibility by failing to raise interest rates, whereas, the BoE is accused of responding to an economic downturn that has failed to materialise and the European Central Bank (ECB) is in the docks for driving a large proportion of bond yields into negative territory. In the background there is also a growing concern that as Central Banks run out of ammunition and the transmission of traditional tools is undermined, they may have to resort to the use of helicopter money.
Have Central Banks lost the plot and should monetary accommodation be removed? The best way to frame the response is to examine the evidence and the reason for prolonged monetary accommodation. From a global perspective there is little reason to doubt the Central Banks as global growth continues to disappoint and inflation despite low interest rates, has remained significantly below targets. The reason for disappointing growth has been examined in detail in the recent IMF and OECD reports and in our opinion the weakness in world trade growth is a notable feature. Indeed, world trade growth has slowed markedly as trade intensity has weakened. The latter is a direct product of weak consumer demand and paltry investment growth.
(1) Global growth continues to disappoint:
Both the IMF and the OECD have recently painted a fairly gloomy picture for the global economy, with growth trapped in a sub-par trajectory. There is certainly a far lower risk of a global recession, however, in the major developed countries, there is not a backdrop for accelerating growth, whilst within developing countries there is a mixed outlook. Each of the major economies have issues that continue to supress activity (these are examined in the individual country sections).
(2) Low inflation persists:
Despite intermittent fears of rising price pressures, there has been no follow through into higher inflation. In almost all cases, inflation is either significantly below stated targets (three-quarters below target) or is moving lower and further away from official Central Bank targets. In fact, almost a fifth of countries are currently facing deflation. Both lower commodity prices and subdued wage growth continue to depress prices. This is consistent with the output gap which is continuing to dampen inflation, even though there is now less slack within the major economies.
(3) Keeping real interest rates low:
Real interest rates and real bond yields have undergone a secular decline over the past couple of decades and in the case of the former, have moved negative over the past year. This move has largely been driven by rate cuts into negative territory by Central Banks. The underlying aim was to force a change in behaviour by consumers, companies and investors, i.e. hoarding cash was made unattractive. However, as banks and government balance sheets have been de-leveraging at the same time, the impact on the real economy has not been as large as would be suggested by traditional economic models. Companies have built-up record cash balances with low investment outlays. Although consumers have spent, they have also de-leveraged, leaving the global economy trapped in a subpar straitjacket.
The main impact of the Central Banks has been to force investors away from cash into riskier assets, be they equities, Emerging Markets or higher yielding corporate bonds. They have succeeded given the underlying returns in most risk markets.
The move lower in real interest rates has also been mirrored in benchmark real bond yields. As official asset purchases have continued to rise it has forced nominal bond yields ever lower, clearly with the aim of moving capital into the real economy and into riskier asset markets.
Over the past few years a number of papers by the Fed, other agencies and academic institutions have pointed to the likelihood of real rates remaining low for a long time and that when policy is reversed, rates will peak at much lower levels (nominal and real) than historical experience would suggest. Indeed when the Fed tightened policy in December 2015 it was at pains to point this out and it has continued to re-iterate this point.
Key Central Bank policy
A gradual Fed tightening path: The US Federal Reserve has maintained a gradual monetary easing path even though the year began with expectations of three or four rate hikes. However, both domestic economic weakness and crucially the volatility in financial markets kept the Fed on the side-lines. However, pressure for another rate hike has intensified recently (partially fuelled by the emergence of some hawks on the Federal Open Market Committee (FOMC)) feeding through into much higher expectations for such a move at the December meeting. Even though the case for a rate hike is not overwhelming, on balance, there is enough evidence for the Fed to raise rates by another 25bps whilst reaffirming the gradual tightening path in 2017.
What about the Fed’s two key targets? The unemployment rate has been edging lower over the past few years and at 5% it does support the case for lifting interest rates. But the Fed is rightly cautious, as despite 8 years of steady employment growth there has been little upward pressure on wages. In contrast, the core Personal Consumption Expenditure (PCE) data does not support a rate hike at present as it is still below the target of 2%. Looking ahead, the recent rise in some commodities may be seen as inflationary but should be offset by a strong dollar. Of course the Fed has a wider brief, with weak growth, external factors, a strong dollar and a lack of fiscal support , all pointing to a shallow rate path in 2017. Our base case is for rates to rise by just another 50bps over the next 12-months.
The BoE is set to maintain loose policy despite the absence of an imminent recession. The BoE responded aggressively post- Brexit by cutting the key interest rate, beginning large-scale asset purchases and providing support for the housing market. However, policy makers have faced criticism as the economy has shown resilience and in stark contrast, consumers have stepped up spending. The BoE has been successful as it stopped the immediate crisis in financial markets, stabilised commercial and residential real estate and drove the cost of borrowing to record lows. To some extent the current economic backdrop should not be seen as a victory for the new post-Brexit UK, as negotiations have not even begun and there is little visibility on what type of negotiations are likely to take place. The BoE could not wait for an economic slow-down to respond and is unlikely to sit on the side-lines in coming months either. The banks internal agent’s reports have been focusing on investment intentions and this does not paint a particularly optimistic picture. Although investment intentions have moved sideways so far, the obvious danger of a sharp decline and the inevitable turn in the labour market is a real threat to the economy.
The Prime Minister has decided to trigger negotiations by the end of March 2017. On the face of it, the option is for a hard Brexit (i.e. cutting migration) meaning policy-makers will now need to be even more vigilant as these changes will dictate the overall strategy. The omens from the business sector are not good in the event of reduced access to the single market, and sterling’s sharp decline in the aftermath of the Conservative conference, should not be seen as positive signs. A weaker currency and the impact on inflation does complicate the situation for the BoE but on balance we expect policy to be loosened further in coming months. Although the BoE has voiced concerns over negative interest rates, it may yet be forced into just such a move if Brexit negotiations have an adverse impact on sentiment and the real economy.
Talk of the ECB Quantitative Easing (QE) tapering is a sideshow given the economic issues faced by the Eurozone and, to a large extent, has been misinterpreted. In recent days the bond markets have been spooked by what seems to have been a technical analysis paper prepared for the ECB about possible tapering of asset purchases ahead of the scheduled end in March next year. The negative market reaction, in a sense, reflects both the likelihood of volatility spikes when yield levels are at historic lows but more importantly the increasing reliance on official intervention in markets. It would seem that the bond and equity market has an insatiable appetite for the drug of QE and even though there is still almost 6-months before this programme elapses, there is appetite for even more. Mr. Draghi has certainly left the possibility of an extension in play as the ECB focuses on the underlying economic developments. This still points to the need for loose policy to be extended, with growth still disappointing and inflation closer to zero than the 2% target.
It is likely that at the next ECB meeting the policy board will have to adjust the current QE programme, given its limitations with regard to the assets that can be bought. This will be followed in December by the economic assessment for 2017 and 2018. Current projections for both growth and inflation are rather optimistic in our assessment. If the new projections are as downbeat as they should be it will set the scene for an extension of the asset purchase programme beyond March 2017. It may well be that the pace of asset purchases is eased back from €80bn to €40-50bn post-March 2017. This is still further monetary easing but at a slower pace and will also partly reflect the lower issuance of government bonds expected in 2017 and 2018. Underlying all of the ECB’s assessment is the fact that growth is sub-par, structural adjustment in a number of Eurozone members is still paltry and banks are still undergoing a long-term recuperation. We will need to get accustomed to periods of intense volatility but this should not detract from the importance of a prolonged period of low rates and asset purchases.
The Bank of Japan (BoJ) has taken further monetary loosening steps, although the market has not really focused on these for the time being as there have been no adjustments to the asset buying programme. Whether they succeed this time remains debatable as the underlying structural forces at play (rapidly ageing population, the on-going economic adjustment in China and the Yen’s appreciation to name some amongst many) will continue to supress economic activity.
This time round, the BoJ’s dual policy is to keep long-term yields close to zero and to sustain this policy until inflation is above the 2% target for some time. In essence, Qualitative and Quantitative Easing (QQE) has been enhanced. The problem for the BoJ is that despite all its efforts, inflation has failed to respond as it expected and, if anything, it is moving back into deflationary territory. Inflation expectations are also edging lower and this may provide the catalyst for further action later this year. It is likely that the BoJ will cut rates further into negative territory and step up the bond-buying programme as well.
Central Bank policy summary:
The effectiveness of monetary policy is increasingly been questioned, but in a sense, the only way to settle the debate is to wind the clock back and reverse all the rate cuts and asset purchases to see how the economy and asset markets would have performed. This may be possible in films but not in real life. It is however, possible to carry out quantitative analysis on the impact of rate cuts on real rates and the way that the lower trajectory bailed out the global economy. For us, the answer is simple – at a time of deleveraging by consumers, companies, banks and governments, if the Central Bankers had kept rates higher the global economy would have floundered.
In our assessment, the Central Banks are setting monetary policy on the basis of the underlying economic fundamentals and cannot ignore the impact of asset price volatility or risk averseness. The Fed has been very clear in adopting a gradual rate tightening policy and will stick to this stance unless the economy suddenly picks up steam 8 years into this cycle. All other major Central Banks are set on a path of further rate cuts and asset purchases, even though they may wish to bring this period of extraordinary policy to an end. Ultimately, it is the economy that will dictate policy and as a result, our main task will be to analyse the underlying fundamentals. If these change, so will our expectations for monetary policy.
The global economy has had yet another disappointing year and has confounded most economic forecasters, although, there have been some notable exceptions. However, looking ahead into 2017, the leading forecasters are providing a more sober outlook. Both the IMF and OECD are projecting relatively poor growth (c3-3.5%). Interestingly, both agencies have also carried out rather detailed analysis on the impact of lower world trade growth on the global economy, as they have highlighted this development as a key area of concern. This has been epitomised by lower trade intensity (exports plus imports/ GDP). This lower intensity is a product of weaker consumption and investment across a wide swathe of economies. The IMF’s analysis suggests that the majority of slowdown is due to weak investment. However, it also reflects the changing pattern of growth in China that had been a major driving force of world trade growth over the past decade or so. Additionally, the collapse in commodity prices also led to significant cuts in capital outlays across emerging economies. Similar sharp cuts in energy related expenditure has also taken place in North America and in the case of Canada, has been a significant factor behind the weakness in the broader economy.
As long as trade intensity is low, and therefore world trade growth remains depressed, global economic growth will find it difficult to break out. The situation has also not been helped by the sense that trade protectionism seems to be on the rise, be it due to “populist politicians” or by delays in major global trade negotiations. There is a thorough analysis by the IMF of the impact of trade agreements throughout the 1990s, its impact on ever lower trade tariffs, lower transportation costs and enhanced global value chains. The threat of disruption to globalisation is seen as a growing impediment to global economic growth. Of course we know that the Canadian/EU trade pact has been delayed and the Trans-Pacific Partnership (TPP) is also under threat from both Presidential candidates. UK’s Brexit negotiations will also unleash a potential challenge to free trade across Europe and adds to the fears over global trade growth slowing markedly and hitting growth prospects.
Away from trade, politics will be in focus, not just with the key US Presidential elections but also within Europe, with a confidence vote in Italy, elections in Spain and critically in Germany and France next year. The EU agenda will also be dominated by the onset of UK’s Brexit negotiations and the lingering threat from a migration-led drift towards populism. In the face of economic and political challenges, it is not surprising that growth has been bumping along for most of 2016 at sub-2.5%, as the US could not even manage 1.5% growth in the first half. Growth was also subdued 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. The situation is beginning to stabilise in Brazil, with a new leader in place alleviating some of the concerns. The corruption scandal is large in scale but could be a catalyst for a positive change.
Global growth rates remain 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 supportive features remain in place:
‧ Consumer demand continuing to expand and, as it accounts on average for c55% of GDP it is a 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:
‧ Investment has been weak in this current cycle, with the commodity related capex cut savagely over the past 12-months or so. However, even stripping out energy capital plans have been poor. In light of a stabilisation in some commodity prices, there may be a more positive impulse in coming quarters but not enough to change the underlying dynamics
‧ Sluggish world trade growth as China rebalances. There are still concerns over a currency devaluation if the People’s 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
Overall, given all of the political hurdles, it is quite easy to become quite pessimistic. However, 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.
Government bond market volatility
In recent weeks there has been increasing speculation over the state of the government bond markets with yields either in negative territory or close to historic lows across the major markets. Almost a quarter of major government bond yields are now trading in negative territory, generally within the Eurozone bloc and Japan. Yield levels had also fallen to historic lows in the US and UK but have reversed this decline in recent days. In tandem with the fall in sovereign yields, corporate borrowing levels also fell dramatically and this raised concerns over a breakdown in valuation relative to fundamentals. It is important to remember that this drift to ever-lower yields had been in motion for some time but did accelerate during the summer months, however, is not divorced from underlying uncertainties in the global economy as discussed earlier and in the major country outlook section.
In order to understand the trajectory of bond yields, it is useful to examine the forces that have driven this move to a period of negative yields. We are acutely aware that a sharp reversal in fortunes will in most likelihood have a significant impact on broader asset markets and economic activity.
‧ The nominal and real yield levels partially reflect the reality of a new norm of prolonged tepid economic activity and low inflation. The market has correctly feared that a low growth scenario could get derailed by either a policy error or other exogenous factors
‧ Lower world trade growth does not seem to be a temporary blip, but rather a new norm that will undermine confidence
‧ Productivity growth has been extremely disappointing across all major economies, undermining the longer-term growth potential
‧ Markets fear that globalisation and free trade agreements may be under threat from a new political environment
‧ Brexit negotiations will introduce a new period of uncertainty for Europe, particularly if discussions are fractious given the political timetable
‧ 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, as discussed in an earlier section
‧ Central Bank asset purchase programmes have also driven yields even lower. The ECB’s and UK Monetary Policy Committee (MPC) buying programme has coincided with lower bond issuance, thus exacerbating the situation. The situation in 2017 will be no different
‧ 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
‧ The new regulatory regime for banks and insurance companies is adding demand for low default assets even if there is far greater duration risk
We have continually argued that 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 can pervasively erode confidence in the economic system itself as it generates uncertainty and in some cases fears of systemic risks. It also makes it more difficult for Central Banks to step away from, not just the zero rate policy, but also the unconventional measures.
There are undoubtedly 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 an active approach will be necessary in forthcoming quarters. We have increased the natural duration of the bond portfolios over the past six months or so, whilst also raising the credit quality. Over the past month we have lowered the underlying duration of the portfolios and have made a strategic limited switch out of sovereign bonds into spread product.
US Economic Outlook
‧ A rebound from a weak first half will leave 2016 growth at c2% led by domestic demand
‧ Consumers remain the main source of growth
‧ The Fed is set for another modest rate hike but should persist with its gradual monetary tightening path over the next 12-months
The domestic economy has rebounded from the weakness in the first half of the year and should grow by c2-2.5% in the remainder of this year, leaving overall growth at around 1.75%. The 2017 projection is for slightly faster growth, albeit still around 2%. The projection will be reviewed in the coming months, after the Presidential election. 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, durable goods orders, confidence data and housing statistics. It should be noted that this is the 8th year of this current expansion phase and 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 and domestic factors that are at play. It is also easy to see 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 200k per month. Although the 156k gain in September was below expectations, the underlying trends were relatively strong and support the view that the Fed can raise rates modestly again late this year after a yearlong pause. The unemployment rate has been rather sticky at around 5% over the past few months, with a marginal upward drift in wage growth. As always, there are challenges ahead but these should not outweigh the undoubted domestic strengths.
Domestic demand will still be the main source of growth this year, as consumption, housing and business investment are all set to grow steadily. Consumer spending has remained the cornerstone of the economy and remarkably has remained resilient in the face of market turbulence, political and external volatility and the ebbs and flows in interest rate expectations. The backdrop is 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 relatively solid jobs market in particular should underpin consumers, with the unemployment rate hovering around 5% and set to gradually trend lower in coming quarters. 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 into 2017 and wage growth should also continue to tick higher, boosting real disposable income. Average earnings growth is close to 2.5%, with surveys pointing to a pick-up in coming months. We will monitor this closely as there is some scepticism over such a late cycle jump in earnings. However, any positive impact on real incomes may be offset by the end of the boost from lower inflation, following the steep rebound in oil. Ex-energy business investment is continuing to expand modestly but overall investment is expected to contract this year and rise modestly in 2017. 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. As discussed earlier, 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 economy expansion is continuing, albeit at a modest pace. The risk of a recession is very low but it is also difficult to see a catalyst for a breakout into a faster growth trajectory
Canada Economic Outlook
‧ 2016 growth outlook modest and volatile partially due to the impact of the Alberta wildfires
‧ Consumers and net trade are key sources of growth but energy will be a drag on growth
‧ Looser fiscal policy is supportive but rates to remain low
The growth trajectory this year has been significantly affected by 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. 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 in the short-term. However, should retain an accommodative bias for some time ahead, despite the loosening in the fiscal stance announced by the Liberal government in early summer.
Business investment has and will continue to be a drag on the economy and remains the key risk despite the recent rise in oil and broader commodity prices. There have been significant spending cutbacks already announced in the commodity and oil sectors, whilst the wildfires in Alberta have also had an adverse impact in the second quarter. Although there should be a decent rebound in production in Q3, a sustained turn around in capital expenditure remains a remote possibility. There has also been a significant movement of labour out of Alberta into better growth provinces - such as Ontario and Quebec - suggesting that the restructuring in the energy sector is not just a temporary phenomenon. Ex-energy, there are indications that capital expenditure should begin to rise but the overall contribution will be extremely small and there is a risk 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 some good news on this front, as consumers should be supported by a relatively buoyant labour market, higher real earnings, loose monetary policy and higher credit lending. Real income growth is also set to receive an additional boost from 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 has been fairly patient this year partially due to slightly better economic data but largely because it wanted to weigh up the new fiscal stance. As expected, the Liberal government’s budget was expansionary and should 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, providing 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 projection unchanged at 1.5% and steady growth in 2017
‧ European politics to come to the fore and Brexit negotiations also provide a distraction
‧ The ECB will continue to be supportive well into 2017
The Eurozone economy continues to stumble along, with growth of c1.5%. In some quarters this is seen as positive but this merely highlights the very low bar that has been set for the Eurozone, given that official rates are negative and asset purchases have been at record levels. A huge swathe of European government bond yields are now trading in negative territory in a major attempt to kick-start the economy whilst targeting higher inflation. Across the Eurozone there are better labour market dynamics and stronger consumer sentiment. Germany is still the shining light but other countries are close on its heels despite the political concerns in Spain, terror attacks in France and the increasing focus on 2017 elections. The ECB has been extremely active this year and recent action may not be the end. The political timetable will be key issue for the Eurozone 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. This 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 have 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.
In last quarter’s outlook we focused on Italy’s bad loan problems that were seen as a stumbling block not just for Italy but also for the Eurozone block. There have been some positive developments on this front, with an expanded bad loan bank and the transfer of certain assets off the Unicredit balance sheet. In the absence of appreciably faster growth, the issue will continue to rear its ugly head. To some extent Italy was pushed off the front pages by Deutsche Bank’s (DB) travails as the US Department of Justice (DoJ) imposed a $14bn fine for its part in the mortgage market blow-up in the US in 2007. As a systemically important bank, DB’s sharp fall in its market capitalisation (as the share price hit new lows) cast a shadow over the broader European banking sector and the stock market. There was some better news in recent days as the DoJ settlement should be significantly lower if in line with the precedent set by other bank settlements over the past few years. Nevertheless the DB episode highlights the critical role of the banking sector.
The upcoming political timetable is also likely to be 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.
UK Economic Outlook
‧ The Brexit vote did not trigger a near-term recession however medium-term uncertainty remains
‧ Consumer demand remains the key source of growth
‧ The BoE to be ultra-supportive as a hard Brexit looms
The UK has confounded all expectations since the referendum vote by not only avoiding a recession but by actually outperforming Europe. Although our central case ruled out a recession, we have been surprised by the strength of the domestic economy. It would seem that the momentum in the first half was fairly strong and that the BoE’s aggressive threepronged response also had a major impact. Of course the main test is still ahead as we now know the Brexit timetable. Sterling’s sudden plunge is not a good start. In light of recent economic data, our central economic scenario for this year is slightly stronger, but weaker growth can be expected for 2017, although 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 will be the BoE’s supportive stance. It is also likely that fiscal policy will be loosened as the balanced budget has already been delayed.
The Conservative Party Conference set out the timetable for Brexit, with Article 50 set to be triggered by March 2017 and the UK exiting Europe by March 2019 (at the latest). We also now know that the option is a hard Brexit, with controls over immigration of paramount importance and at this stage placed ahead of free trade access to the biggest trading partner.
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
‧ The political timetable is not conducive to an orderly negotiating process
‧ Financial passporting arrangements are crucial to UK financial firms as is the role of the City of London
Apart from this, there are additional key issues such as EU citizens working in the UK and vice-versa, the presence of non- EU companies in the UK getting access to the internal market and jobs that are dependent on European investment in the UK. Some of these are difficult to directly quantify but will need to be factored into any assessment.
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. Investment intentions tend to support this view. As negotiations will start in 2017, international companies will begin to weigh up the cost of more expensive trade against other favourable factors that are in play in the UK, 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 of the economy and housing is integral to the fate of consumer spending. The BoE’s supportive stance has been very helpful and seems to have stabilised the market and 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. A weaker sterling may help exports but the far greater worry is the impact on prices and the squeeze on real disposable income in coming months.
To some extent looser fiscal policy could be supportive as the Chancellor has hinted at a more flexible approach, with the strict fiscal rules - that were designed to deliver a surplus of 0.5% by 2019/2020 - likely to be discarded. 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 next year or so will be limited. Of course, the confidence impact should be positive but should not be overplayed.
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 the 2017 growth projection to c0.5%-1%. Although we are not projecting an outright recession in 2017 a great deal will depend on how the negotiations unfold.
Japan Economic Outlook
‧ Abenomics has failed leading to weak economic growth with falling prices
‧ Consumption is the key and the outlook is mixed
‧ The BoJ sets out a new stance and further monetary and fiscal measures are likely
As expected, 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 suggest that the potential growth rate has actually declined, not risen, largely due to the ageing population and the shrinking labour force. 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 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 BoJ has moved rates into negative territory, further monetary and fiscal action is on the cards.
The 2% jump in Q1 GDP was rather deceptive as the economy lost steam in the second quarter and has remained sluggish into the second half of the year as well. Our central projection for growth of c0.5% in 2016 and in 2017 remains intact unless there is a significant fiscal and monetary boost in coming months.
Consumption has been mildly supportive of overall growth, with the decision to delay the next consumption tax hike (to 10% from 8%) by two years to 2019, being a positive step. However, it should be remembered that spending levels are still struggling to recover from the 2014 hike and as the Prime Minister rightly stated “a rise next year would be a significant risk to domestic demand”. This suggests that overall consumption growth will remain tepid this year. Although a tight labour market is good news for wage negotiations, income growth is only marginally positive. Additionally, it is being outweighed by even lower inflation expectations. A stronger Yen (reflecting concerns that monetary policy is becoming less effective) will not only hurt exports but will add to lower deflationary pressures. Business investment that had been fairly resilient - following upward revisions in Q3/Q4 last year - is set to weaken given recent Tankan Surveys and the downward revision to corporate profits. 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.
China Economic Outlook
‧ Policy intervention has raised the short-term growth profile but at the expense of rebalancing
‧ Our GDP growth projection is stable at 6-6.5%
‧ Active policy intervention will continue into 2017
The early year market rout left no lasting mark on the economy with investor sentiment recovering. The economy has regained some poise but the much vaunted rebalancing towards consumer spending is way behind schedule. However, we re-iterate that there is no point attempting a rapid rebalance and risking a damaging slow-down. The focus is rightly on maintaining a growth rate that does not disrupt the global economy at a time of intense uncertainty. A gradual rebalancing is underway but this transformation will take time, given that fixed investment accounts for almost half of GDP. In light of recent data, our economic growth projection has been kept stable at 6-6.5% (which was higher than consensus) 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 retail sales, corporate and real estate investment. The good news is that, unlike earlier this year, when consumption had slowed, the indications are that retail sales have picked up steam. Indeed in August, retail sales expanded at over 10% and car sales also bounced. The latter could reflect the expiry of incentives and may just be a temporary factor. Nevertheless, consumer demand has been stronger than anticipated and is in line with the rebalancing that has been a key feature of the new economic model. However, this does not mean that investment is running out of steam, with infrastructure investment receiving a boost this year that should be sustained into 2017 as well. This is highlighted by Total Social Financing (TSF) remaining on an upward trend, thus showing the support through higher government lending. A further boost is expected in areas such health and education. In addition, technical changes in taxation will also be supportive as the tax burden should be lowered.
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. This still 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 75 bps over the next year but in practice the easing is likely to be 25-50bps this year. The authorities have managed a near 5% depreciation of the China Yuan Renminbi (CNY) over the past year or so and look determined to continue to a use further measured depreciation. There seems to be 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 via direct lending rising sharply. There are other medium-term measures including a new “urbanization” policy to help new migrants and to 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 overstated but underlying growth at 6.5-7% is impressive
‧ Improving investment backdrop
‧ The new Reserve Bank of India (RBI) remains accommodative as external risk indicators improve
The economy has been relatively strong over the past few quarters and has topped recent global growth charts. A number of positive factors have come to bear including the positive impact of lower inflation, easier monetary policy and a more constructive fiscal backdrop. Micro reforms introduced last year have 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. The departure of RBI Governor Rajan was not disruptive as the RBI set out on a new policy regime.
There was a slow-down in economic activity, from 7.9% in the first quarter, to a still sprightly 7.1% in the second quarter. The slow-down was driven by consumer demand and capital expenditure offsetting the pick-up in external trade and government spending. The loss of momentum in consumer spending is rather puzzling as most high frequency data was implying quite the opposite and it may just be a statistical aberration that will be reversed in coming quarters. Overall, the trend is for an acceleration in activity helped by strong manufacturing and a pick-up in investment. There has been 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 c6-6.5% compared to the headline number of 7-7.5%. 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.
There was a smooth transition within the RBI from the star Governor Mr Rajan to a popular internal appointment and the introduction of 6-strong MPC. Surprisingly, a dovish Central Bank cut rates by 0.25% to 6.25% taking advantage of a dip in inflation to 5% in late summer. We sense that the RBI will adopt a more flexible approach to the inflation target of 5% and is likely to look through short-term deviations and focus instead on the longer-term horizon. In light of this we would not be surprised by further monetary loosening as the RBI’s overall accommodative stance will remain in place and it has room to cut rates further in 2017. The better monsoon has alleviated pressure on food prices 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
Following the gyrations of the second quarter of 2016, which ended with Brexit, the third quarter was much calmer with equity markets making steady progress through the quarter.
‧ US equities experienced a rotation towards more economically sensitive sectors away from defensives which is seen as mini taper tantrum with the market expecting more than a 60% chance of a rate hike by the Federal Reserve in December.
‧ However, the presidential election is imminent and the polls have moved towards a Clinton victory which is perceived to be more favourable for global trade and equity markets.
‧ The upcoming Q3 reporting season is expected to show moderate earnings growth with 2016 estimates for the whole year ranging between 0-2%. For 2017 market estimates are for more than 10% growth. This appears optimistic, and mid-single digit earnings growth is more likely.
‧ US economic data remains broadly supportive for equities with little change to the structurally lower growth and lower rates environment. This is perceived to persist into 2017.
‧ The US dollar and US Equity markets are expected to continue to be seen as safe havens, despite fuller equity market valuations, given the current uncharted economic environment.
‧ European markets, excluding the UK, are still struggling to make much progress this year despite a better domestic GDP environment. The political concerns are ongoing with Spanish, Italian and French elections or referendum to occur within the next six months.
‧ Conversely, the UK has performed strongly in local currency terms due to the weakness of Sterling, boosting international earners profits because of a large currency translation effect.
‧ The Euro has been relatively stable against the US dollar since the step change occurred in 2015, when the market predicted the impact of the ECB’s monetary plans to stimulate the economic area. This stability is likely to continue in the short term as recent ECB communications favour continuation of the existing monetary measures without further adjustments.
‧ The Eurozone is still lagging behind the rest of the developed world in terms of margin recovery which has now begun and is seen as potential upside to profits.
‧ UK Brexit has been a major event for European equity markets and the longer term implications are far from certain. This uncertainty does provide a drag on equities for the region with some big tail risk which could see the fundamentals of the EU being questioned.
‧ The BoE cut rates for the first time in seven years as a preventative measure to deal with a potential softening due to Brexit. Further QE measures were announced and the door was left open to increase monetary stimulus.
‧ Valuations are appealing in Europe and the UK in general and especially relative to other regions on a cyclically adjusted basis. However, the vast political uncertainty and the huge implications this could have, does make the region higher risk and curtails our enthusiasm.
‧ The LCAM strategy remains unchanged in European equities which is to focus on international franchises with a diverse earnings stream
‧ The Japanese stock market continues to underperform in local currency, due to the strength seen this year in the Yen. Unfortunately, the reason for this strength is not due to a better economic outturn but because the market believes that the Bank of Japan is out of options for further extension of monetary policy.
‧ The domestic economic is also struggling due to the consumer displaying ongoing reluctance to spend, demographics are creating a large ageing population and saving rates are still high despite negative rates.
‧ The BoJ’s recent communication shows the difficult situation it is confronted with as the Bank is reluctant to go in further negative rates territory due to the side effects. This leaves little room for further monetary stimulus. The BoJ is now attempting to use yield curve management but the creditability of this measure is questioned by the markets.
‧ Japan’s stock market is still very dependent on the success of exports. The currency strength and increased competition has left exporters vulnerable to market share losses.
‧ The outlook for Japanese equities remains unattractive given the mix of population decline creating no domestic growth, export competitiveness pressures and limited further Central Bank upside surprise potential. Furthermore, valuations looks expensive.
‧ Emerging equities have seen a strong revival this year following a weak 2015, as many of the economies are now showing signs of recovery from a low base.
‧ Additionally, effects of China’s most recent stimulus have boosted economic activity in Asia and is set to continue to have an impact for the rest of the year.
‧ However, as a strong period of performance for Emerging Markets, it is entirely possible that there is a consolidation as US rate hikes focus continues, fund flow moderates from high levels and shorter term investor looks to take profits.
‧ The longer term outlook remains appealing as Emerging Markets are likely to show higher growth than Developed Markets over the next five years but still trade on a significant discount even after a risk adjustment is considered.
‧ The LCAM Emerging Market equities strategy is still highly selective with faster growing Asian markets favoured and a few Latin American value markets.
Looking into Q4-16 and beyond, the broad outlook for global fixed income markets is constructive. Central Bank policy remains highly accommodative, with a strong probability that the BoE, BoJ and ECB will ease further.
The outlook for G-7 government bond markets remains constructive, even though absolute yield levels are extremely low and close to, or at, record lows in a number of countries indicating stretched valuations.
‧ The factors that led to a modest rise in US Treasury yields in Q3-16 are likely to remain in place. Markets presently attach a 60% probability to the FOMC, raising the Fed Funds target rate by 25bps in December, in the drive to ‘normalise’ interest rates. A slight pick-up in activity in H2-16, accompanied with a modest rise in inflation will probably see the rise delivered, nudge Treasury yields a little higher, and flatten the curve. This is not expected to trigger a protracted rise in yields, given that any move higher in the Fed target rate in 2017 will likely prove modest, and the peak in rates will be significantly lower than the peak in previous post-war cycles. Any rise in yields will also likely be moderated by overseas factors, where European and Japanese growth remains muted, and significant QE programmes remain underway.
‧ The Bund market is expected to be well supported through the winter, as the Asset Purchase Scheme remains in place until March 2017, and probably beyond, in spite of a report suggesting tapering. This leaves the ECB purchasing €70bn of government bonds each month, and goes a long way to explain the low/negative yields in core government markets. Amid concern that the ECB is struggling to purchase its target amount, constrained by a shrinking pool of eligible bonds, ECB plans are likely to be revised, probably before year-end. This could come in the form of the programme being extended beyond March 2017, and through a relaxation of the technical parameters governing the scheme such as lowering the yield floor for purchases, raising of the issue and issue share upper limits, and an extension of the permitted maturity range. There may also be adjustment of the ‘capital key’, possibly allowing greater purchases of some peripheral sovereigns.
‧ The Q3-16 rally in the gilt market was extended by the BoE lowering the official rate 25bps and the re-opening of Asset Purchase Facility (APF) at the August meeting. The BoE will purchase a further £70bn of gilts (plus £10bn in corporates) over the coming 18 months. The yield on the 10-year gilt fell to a record low of 0.5%, but has retraced slightly. The APF scheme is expected to lend strong support to the market in coming quarters, together with any slowdown in the economy as a result of the Brexit vote once UK-EU negotiations get underway after ‘Article 50’ is triggered.
‧ In an important refinement to its QE programme, the BoJ announced it would target the 10-year Japanese Government Bond (JGB) yield at 0%, implying the yield will not move into positive territory, and Consumer Price Index (CPI) at above 2%.
This suggests that much of the JGB curve remains anchored in negative territory. This relatively constructive outlook is not without risks, including the FOMC bringing forward a rate hike from Dec- 16, a sharper-than-expected pick-up in headline inflation (especially if crude moves sharply higher), and political uncertainties with the US presidential election and referendum/ elections in key Eurozone economies.
Investment Grade (IG)
The growth, inflation, and policy backdrop all bode well for IG bonds. Couple this with still relatively defensive corporate management styles, and the attractiveness of the sector stays intact. Leverage is controlled, and certainly not extended by comparison with previous cycles, and corporates have healthy cash flow to meet their interest obligations. Cash still remains at record highs, reflecting a reluctance on the part of businesses to embark on programmes of rapid expansion. Indeed CAPEX is restrained, and often directed at maintenance and renewal of existing plant, rather than new entrepreneurial projects.
‧ Over the course of Q3-16, US IG spreads narrowed nearly 20bps, to 138bps. The spread is expected to compress slightly further over the winter period, as investors continue to direct capital to higher yielding markets in their hunt for capital. The US offers by far the highest absolute yield in the Developed Market IG sector, even though some of this is surrendered once FX exposure is fully hedged.
‧ Euro IG spreads narrowed over 20bps in Q3-16, to 110bps. Spreads will likely tighten/remain stable in coming months underpinned by fundamentals and QE. The ECB continues to buy €3-5bn each month, and this provides a significant prop to the sector. Further policy accommodation from the ECB will be supportive.
‧ The sterling market enjoyed a very strong rally in Q3-16 with spreads narrowing by nearly 50bps to 135bps. News that the BoE had re-opened the corporate buying programme surprised investors, and commenced in September. This is a highly supportive development for the sector, and will likely ‘crowd-out’ other buyers. There had been very limited supply in recent quarters, hindering market liquidity, especially as most participants are ‘buy and hold’ investors. The Bank’s initiative does appear to have helped stimulate market supply with primary activity picking up in Q3-16. Looking forward, demand is expected to outstrip supply, even if the Bank’s actions encourage more borrowers to come to market.
‧Financial bonds from across the capital structure performed well in Q3-16, with CoCos doing especially well, delivering +5.1% over the period. This marked a significant recovery from the January-February set-back, with CoCos now returning +3.9% YTD
‧The backdrop to the sector remains constructive. Regulators keep dictating higher levels of capital for the banking system, for the large global banks in particular, making the sector safer, and. This capital increase will run through to 2022. At this point, the capitalisation and liquidity of the banking sector will probably be at its strongest in the post-war period
‧ This is not to say that there have not been set-backs in Q3-16. The Italian banking sector still needs to write off a significant sum of Non Performing Loan's (NPLs), and this is unlikely to be resolved quickly. It depends not only on the outcome of the December referendum framed to endorse the reformist policies of PM Renzi, but also the ability to somehow ‘socialise’ some of this burden, something Germany opposes fiercely. Deutsche Bank has been another flashpoint, with investors running scared at the sheer scale of regulatory fines proposed by the US and German authorities, although this has now been scaled back and retracted. UK lenders fear regulatory fines and a sharp Brexit-induced housing/economic slowdown. US banks have been shaken by the ‘fake’ accounts scandal at Wells Fargo.
‧ Behind this, the operating background is stable, improving and bodes well for the sector.
‧ Investors are well rewarded for taking more risk by trading down the capital structure in European CoCos, US preferred bonds and Tier 2 issues. These instruments offer some of the highest returns in a near zero interest rate world.
‧ The more senior parts of the debt structures have performed well, with spreads narrowing slightly versus government bonds. In recent years the deleveraging of the banking sector has reduced the need for bond-driven funding, and this lies behind the lack of supply of senior unsecured debt, a situation that is unlikely to change any time soon.
‧ US high yield was in high demand in Q3-16, returning 5.5%, and lifting YTD performance to a lofty 15.3%. From a fundamental perspective, the sector has been driven by the favourable macro background and relatively stable credit position of many borrowers. It has also benefitted from investors hunt for yield, as absolute yield levels in government and IG bonds have fallen progressively over the last 12 months, to ever lower levels. Even though it is relatively late in the US cycle, valuations are not overly stretched. The spread over government bonds on the Merrill Lynch benchmark index finished the quarter at 500bps, not far away from its medium term average, but considerably wider than the 353bps low reached in June 2014. As a percent of absolute government yield, valuations appear even more attractive.
‧ US high yield energy bonds extended their rally in Q3-16. They have benefitted from crude prices bouncing from the $26/brl low reached earlier this year, where it looks like the market has formed a base, and the recent OPEC production agreement suggests the price may move slightly higher in coming months. Such a development would help the recovery and restructuring of the US high yield energy sector.
‧ European high yield has performed well too, returning 3.5% in Q3-16, and 7.1% YTD. Although it has not benefitted from a recovery in the energy sector in the same way as the US sector has (because it does not have the borrowers), corporate balance sheets are stable, and the economic fundamental background favourable. Additionally, investors have been attracted to value in the sector as the ECB has steadily purchased eligible corporate bonds in the IG market, as part of its QE programme. This has enhanced the relative value of Euro high yield, a dynamic that has a further six months to run, at least, and is expected to underpin values.
‧ Hard currency emerging market bonds have enjoyed a stellar performance so far this year, and side-stepped much of the broader market volatility. The sector returned over 3.25% in Q3, and is around +13% YTD.
‧ The fundamentals for hard-currency Asian bonds appear favourable. India continues to grow at a fast pace, and many of the concerns over China are receding. This should help underpin credit quality of the regions borrowers. Even though the sector has performed well, valuations do not appear too expensive. Spreads are close to their narrowest levels since the financial crisis, but still appear attractive given the absolute level of risk free rates and the relative dynamics of the borrower’s vs similar rated borrowers in the Developed Market.
‧ Prospects for Latin American debt are improving. Economic growth is slowly returning, helped by signs of stabilisation in Brazil, as the crisis moves to the next stage. Brazil still has a long way to go before it leaves this behind, embarks on a stronger growth trajectory, the political stability returns, and policy moves away from crisis management to focusing on the country’s needs and ultimately boosting prospects. Argentina is returning to the international fold, having settled its debt differences with the “hold-out” investor group. Significant domestic political challenges remain, but for the moment expect the Macri government to muddle through and attempt economic reform.
The broad hedge fund industry has made steady progress following the drawdown in the first two months of 2016, and while lagging wider risk assets, hedge fund performance is now in positive territory for the year. Nevertheless, several of the large, marquee names still exhibit double digit losses in this period which has instilled discontent among some of the investment community. We believe 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 remained negative in some sectors but we believe that a lot of activity among market participants is focused around a shuffling of the pack; reallocating to recent winners and less correlated names. This is a trend we expect to continue in the coming months as investors adjust their portfolios.
The broad LCAM 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 moving forward and LCAM will look to take advantage multiple strategies across the asset class:
‧ Equity Long/Short (L/S): 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 Advisor (CTA): Macro and CTA strategies will continue to benefit from diverging global macroeconomic policies and dislocating events such as Brexit. In addition, CTAs have the potential to benefit from any extended periods of risk off sentiment as evidenced by Q315 and Q116 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 tests beginning with a crucial no confidence vote in Italy this year and critical elections in France and Germany next year. The US Presidential election is just around the corner and has been dominated by personality and bitterness rather than a debate on policy. There has also been a general shift towards protectionism in words, if not in action, over the past few months posing a new risk to the global economy. The political backdrop is undermining an already weak global economic outlook which is leading to Central Banks extending the extraordinary period of accommodative policy. LCAM’s asset allocation continues to be conservative whilst ensuring that the main strategies still have enough room for manoeuvre to capture risk market rallies.