Outside Chances

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¿Apuntan las nóminas no agrícolas de Estados Unidos a una recesión?
CC-BY-SA-2.0, FlickrPhoto: Kurtis Garbutt. Outside Chances

So just when the Fed had finally convinced markets that rate hikes were possible this summer, the labor market data had to go and ruin everything. The 38,000 (38k) new jobs as reported by the US Department of Labor this past Friday was clearly well below expectations, and can only be partly explained away by the strike at Verizon (which when added back would almost double the number). Everyone is dissecting the number, and looking at the details to try to understand it. But sometimes it is worth stepping back and asking: On Thursday what probability would you have assigned to the likelihood of Friday’s payroll number being below 50k?

This does not require any real expertise. The simplest way to do it would be to ask what the probability would be of any random month you select giving you a number below 50k. It turns out the answer is about one in three over the last two decades. This naive approach was dubbed the ‘outside view’ by psychologists Daniel Kahneman and Amos Tversky, because it does not rely on any information about the specific circumstance of today’s economy.

So for example, the outside view on whether it is likely to rain at least 1mm on any given day in London is 35% over the last two decades. Well that’s all very well, but surely you know it is June. OK, we can narrow down the outside view a bit to just look at days in June over the last two decades. Sure enough the probability of rain drops (but just to 30% – England has a well-deserved reputation for rain). But that does not take into account any unique information about tomorrow.

In a similar way, we can narrow down the outside view on the nonfarm payrolls to help test a hypothesis. Suppose that you want to ask yourself what the likelihood of this kind of payroll number is when the economy is still in an expansion. By ruling out all the months in and the twelve months around recessions, we can find out how likely we are to get this  kind of outcome. It turns out the probability is 18% over the last decade (chart 1). So over the last five years we might reasonably have expected around eleven months with the first release of payrolls below 50k. In the event, the US was lucky: there were only three (including the most recent).

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So if these low numbers are to be expected, how much should we read into a weak jobs report? Does it mean that a bounce back the next month is likely? As always, start with the outside view: how often is a low number followed by another low number (below 50k)? For the full sample it is 72%, but excluding recessions it is 41%. So experience tells us that a bounce back is marginally more likely, but by no means certain.

We can make things more sophisticated by bringing in more outside information to inform the outside view. For example, the number of people making initial claims for unemployment benefits is widely viewed by economists to lead the payrolls data and to be more reliable at identifying turning points.

So instead of conditioning on whether we are in recession, we can ask ourselves how likely it is that the payroll data will bounce back if the initial claims data has remained strong, as it has recently (fluctuation down by no more than half a standard deviation). When bad payroll data is not matched by bad initial claims data the payrolls tends to bounce back 65% of the time.

Now we can start to examine the individual circumstances, and ask ourselves whether we can add any further information. We can’t use excuses like the Verizon strike, because plenty of those past instances of low payrolls could have also been caused by strikes. One thing to consider is what is happening in the labor market overall. For example, it could be argued that slowing employment could even be a sign of a tighter labor market.

This may sound counterintuitive, but it is possible. The logic is that when there is significant slack in the labor market, all those unemployed people are happy to get work even if wages have not risen. So in chart 2, as demand for labor moves from the first to the second demand curve, employment grows a lot but wages only rise a little. So firms have all the bargaining power. However, as an economy approaches full employment the trade-off becomes less favourable for businesses. For the same increase in demand (the second to the third curve), businesses now need to pay higher wages to lure those now scarce additional workers to sign a contract with them. Businesses get fewer employees but have to pay more.

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Not every economist would agree with this characterization (no surprise there), but the point is that this is approximately the model that central bankers have used for decades. And to the hawks, it tells them that if the economy is growing at the same speed, eventually you should have slower job growth and higher wages. And that means that the Fed should have to hike rates.

Of course, if the nonfarm payroll data continues to worsen then the hawks need to consider some other outside views. In the last twenty years, when the first release of nonfarm payrolls has been below 50k for four months in a row it has signalled a recession half of the time.

Joshua McCallum is Head of Fixed Income Economics UBS Asset Management.

 

“Rexit” in Context

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El gobernador del Banco de la Reserva de la India no renovará su mandato, ¿perdurará su legado?
CC-BY-SA-2.0, FlickrPhoto: Reserve Bank of India Governor Raghuram Rajan. University of Chicago. "Rexit" in Context

Over the weekend, the big news out of India was that Reserve Bank of India Governor Raghuram Rajan would not be seeking an extension to his term, which will expire in September. He said that he would be returning to his “ultimate home in the realm of ideas,” at the University of Chicago. Rajan also said that he was open to seeing current developments through, but that upon due reflection and consultation with the government, has decided not to seek an extension. While change is always uncomfortable and creates uncertainty at times, our reaction to this event should consider the broader context.

Over the past three years, Rajan has been an influential and skilled central bank governor. He can be credited with enacting a few key policies, including the adoption of inflation targeting using the consumer price index (CPI), instead of the wholesale price index (WPI). CPI holds a larger component of food, affecting the average citizen. Hence, to have accommodative monetary policies, the government has to make structural improvements to lower food inflation—which has been a historical pain-point for everybody.

Rajan also pushed banks to recognize non-performing assets in the banking system. This cleansing of the banking system along with India’s newly created Bankruptcy Law, should serve the country well over future credit cycles. Rajan, along with the government, also announced the formation of the new Monetary Policy Committee (MPC) into a law. The formation of the MPC borrows best practices from other countries and further institutionalizes the mechanism for setting interest rates. Putting into motion a few of these changes, which perhaps will be part of Rajan’s legacy, are already underway and should produce results even after his departure.

Rajan could have stayed to see these changes through by extending his term, but there are a number of factors outside his control and domain. During his tenure, commodity prices collapsed and India’s trade/current account benefited and helped the currency. That tailwind is less likely to exist going forward. Therefore, the next two years could potentially pose a more difficult environment than the last three years.

Rajan will wrap up as the 23rd RBI governor since 1935. The average tenure of an RBI governor is only three and a half years, unlike longer tenures in U.S. Even with a term extension, Rajan would have served only for another two years. RBI as an institution, among others including the Supreme Court, has always been a pillar of strength in India. Previous RBI governors have also been reputed policy makers.

There are a number of qualified individuals already being considered to fill the role. More broadly, terming Rajan’s departure as “Rexit” sensationalizes the event. Such heavy “personalization” of the role of governor of an important institution also plays well to the media. However, given the RBIs strength as an institution over many decades, I believe even though the direct style of communication as embodied by Rajan may change, the substance of RBI’s policies will endure.

Rahul Gupta is a Portfolio Manager at Matthews Asia and co-manages the firm’s Pacific Tiger Strategy.

Which Afores Make the Best Investments?

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¿En qué son buenas las Afores en materia de inversiones?
CC-BY-SA-2.0, FlickrPhoto: Danielle Bauer. Which Afores Make the Best Investments?

For pension funds such as Afores, although short-term yields are relevant, considering that the funds they managed will be used for the retirement of workers at 65 years of age, the results should be analyzed on the long-term.

According to CONSAR the annualized nominal net returns between January 2009 and March 2016 shows: Sura, Banamex and Profuturo as the three best performing Afores with 10.5, 10.1 and 10.1% returns respectively.  (Report to Congress 1st quarter of 2016 Page 46).

The weight of different asset classes in their portfolios average: 74% in fixed income (53% in government bonds, 20% in corporates and 1% in international debt); 20% in equities (13% in international equities and 7% in domestic equities); while 6% of AUM are invested in structured instruments and mexican REITS or Fibras.

In the report, CONSAR presents the performance attribution by asset class for each one of the 11 Afores. The analysis (page 48) shows that 3/5 of the performance comes from debt instruments; 20% equities and the difference by others asset class incluiding Fibras and structured (where are included CKD’s). Fibras and CKD´s, only have contributed to portfolio performance 0.1% of 9.5% average return. It is noteworthy that the first CKD emerged in 2008 and the first Fibra was born in 2011 so the contribution do not reflect the maturity period requiring investments in CKDs and in the case of the Fibras considered a lower time investment since inception.

Reviewing the performance attribution by asset class for each Afore it can be seen that the most profitable Afores lead returns in two or more asset classes. Sura for example excels in Bonds, international equities, as well as structured and Fibras relative to the others Afores. Afore Banamex is distinguished by good results in the inflation linked bonds (Udibonos and CBIC) and international instruments. In the case of Profuturo, inflation linked bonds, corporates and local equities are where the afore leads.

Looking at results by asset class, Invercap generates higher returns in bonds which allows for it to place 4th place in returns. Azteca is the second most profitable in this asset class, however this result is not good enough to place it at the top. This Afore also excels in domestic equities.

XXI-Banorte also is among the Afores with better results in local bonds and corporates papers, however these results are not enough and the returns of this Afore are below the average performance of the 11 Afores (9th place).

Looking at investments in inflation linked bonds, the Afores that have obtained the best results in these instruments are: Profuturo, Banamex, Pensionissste and Principal. Pensionissste has also good investments in corporate debt , which allows it to stand in fifth place in the returns table while Afore Principal also excels in international equities ttaking the 7th place.

For the asset class of structured instruments and Fibras, the Afores with the highest returns are Inbursa and Sura contributing 0.4 and 0.3% compared to an average performance in this asset class of 0.1%.

Overall each one of the 11 Afores have at least one asset class in which they stand out for their results, however, if the weight is not important in contributing to performance, its advantage is not enough to take them to the top performance on a stage of just over seven years (January 2009-March 2016). Not only does the manager have to be good in asset classes that have greater weight in the portfolio compared to competitors, but also they need not be so bad in the others asset class to offer attractive returns.

Column by Arturo Hanono

Are Bond Yields Forecasting Equity Weakness?

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Are Bond Yields Forecasting Equity Weakness?

Beware distortion in yield curves and discount rates. Last week was certainly a jittery one in equity markets, but in bond markets history was being made.

The yield on Germany’s 10-year government bond went negative for the first time ever. A Swiss government bond set to mature 32 ½ years from now also saw its yield go red. Bank of America Merrill Lynch offered a chart showing global interest rates hitting their lowest levels in 5,000 years.

What happens in the world of fixed income matters a lot to equity portfolio managers: It gives us valuable signals about what’s going on in the macro environment, and hence the potential for companies to grow revenues and earnings; and by providing us with discount rates it directly influences how we value those potential earnings.

So what are these historic numbers telling us today?

‘Brexit’ Risk Has Jolted Markets…
On the macro side there was certainly a bout of risk aversion last week. As bond yields plummeted, gold rallied to test the $1,300/oz. level. Last Monday the VIX Index rocketed from 17 to 23.

Much of this seemed to come down to a spate of opinion polls showing momentum for the “Leave” camp in the U.K.’s referendum on membership in the European Union. Brad Tank, Erik Knutzen and I will discuss the longer-term implications of that vote in a special edition of CIO Weekly Perspectives this Friday, so keep an eye out for that.

… But Equities Are Still in a Rally
For now, it’s enough to point out that this binary risk may well be priced back out of markets by this time next week. In the meantime, while bonds trade with historic low yields, U.S. equities are still only down around 2.5% from their recent high, itself close to an historic level.

How do we make sense of these apparently contradictory market signals? Is one of them spectacularly wrong in its growth forecast, and if so, which is it—the bond market or the equity market?

This is the wrong question to ask in the post-financial crisis world. Instead we should ask about the extraordinary forces causing these fixed income records to tumble.

U.S. Curve Shaped by Fed and Non-U.S. Investors
Take the shape of the yield curve, for example. A flat or inverted curve tends to make investors anxious: A flat or inverted spread between the two-year and 10-year U.S. Treasury yield has been quite a reliable forward indicator of a U.S. recession over the years.

Today that spread is around 90 basis points. A year ago it was as steep as 175. But this move has been not only, or even mainly, about investors reducing their long-term growth expectations. Indeed, part of it has been a move upwards at the short end of the curve as the Federal Reserve has talked about normalizing the Fed Funds rate in response to the U.S. economic recovery.

At the long end, rather than a new sense of economic gloom, yields have declined due to demand from investors in the Eurozone and Japan, where rates are low or even negative. In comparison, long-dated U.S. Treasuries look relatively attractive. There is simply a shortage of high-quality yielding assets in the world.

In short, we shouldn’t assume that bond markets are forecasting a hostile environment for equities.

Low Discount Rates Make Equities Look Expensive
We should also think about how low risk-free discount rates affect our views on equity valuations. Through the simple mathematics of discounted cash flow models, lower discount rates lead to higher P/E ratios for the same level of future earnings. Higher levels of inflation and interest rates are one important reason why the average P/E ratio for the S&P 500 Index was around 15x from the 19th century until 2007, and 16.5x between 1950 and 2007. In the type of low-rate environment we have experienced in more recent years, the average has been 17-19x.

To be clear, we still caution that current equity market valuations represent optimistic expectations for earnings growth over the next 12 months—but we do not think they represent “irrationally exuberant” expectations, as a cursory look at relative value versus bonds might suggest. Bond markets still provide useful signals to equity portfolio managers, but we need to be clear about what they are—especially when those markets rewrite the history books as vigorously as they are at the moment.

Neuberger Berman’s CIO insight by Joseph V. Amato

IMF and Devaluations, Two Preliminary Attempts at a Solution

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IMF and Devaluations, Two Preliminary Attempts at a Solution

The collapse of Lehman Brothers, the Greek debt crisis, the end of US quantitative easing, the slump in commodity prices, the slowdown of the Chinese economy and depreciation of its currency, the war in Ukraine, sanctions against Russia… a series of events that contributed to putting an end to a decade of strong growth in emerging markets. Some of these countries are more exposed to the slowdown than others.

IMF returns to favour
In the “noughties”, following sovereign defaults in Latin America, Russia and Asia in the 80s and 90s, the IMF was severely undermined. In his book analysing recent crises and the roles played by international institutions, Joseph Stiglitz, Nobel Prize-winning economist, wrote that the IMF made mistakes in every area in which it intervened: development, crisis management and the transition from communism to capitalism. From Stiglitz to Varoufakis (the former Greek Finance Minister), its critics have been blistering. Leading emerging countries have even gone as far as proposing an alternative to the Washington institutions with the creation of the New Development Bank (NDB) 70 years after the IMF was founded. The NDB, launched in July 2014, has authorised capital of 100 billion dollars. Its principal objectives are stated to be infrastructure and sustainable development. Eskom, the South African electricity production and distribution company is one of the beneficiaries of its financing operations.

Meanwhile, the 2008 crisis put the institution that had always been considered as the guarantor of global financial stability back in the saddle. This is reflected in the subsequent history of IMF loans, which had sunk in the preceding decade. In 2012, Greece was one of the first economies to turn to the Fund and in March 2012, the IMF approved a 28 billion euro loan to the Greek economy.

The IMF went on to sign a number of other agreements, particularly in 2015, including:

  • flexible credit lines for Mexico and Poland, for 47 billion and 15.5 billion SDRs respectively (equivalent to 67 and 22 billion dollars).
  • a 36-month extended arrangement for Ukraine for 12.3 billion SDRs (17.5 billion dollars).

Apart from the credit arrangements, in common with other countries, Ukraine benefits from a technical assistance programme.

The elixir of devaluation
Irrespective of what was happening in the eurozone (social tensions, increasing protests and breakthrough of populist parties, from Madrid to Paris), the fact is that the sharp rise in commodity prices encouraged various emerging markets to massively increase their spending. The Greek debt crisis turned out to be an early sign of what was going to happen in other regions of the world.
In many cases, the noughties led to excessive debt and unsustainable deficits once prices fell. This is illustrated by the situation in Brazil and Venezuela. Unfortunately, the reforms to achieve sustainable growth, such as they are, were not sufficient.

These countries therefore needed more than recourse to international institutions to try and counter the deterioration in their public finances. Devaluation or the adoption of a floating exchange mechanism are another potential solution. China and Argentina were the first to go down this road at the beginning of 2014. They were followed by several other countries, mostly commodity exporters, such as Russia, Kazakhstan, Nigeria and Venezuela. After its currency fell nearly 30% against the dollar, in November 2014, Russia’s central bank allowed its currency to float almost freely, leaving itself the possibility of intervening if needed. Due to its efforts to defend the rouble, its currency reserves dropped from 475 billion dollars to 373 billion dollars between November 2013 and November 2014.


Without going into too much theory, it is useful to remind ourselves of some of the hoped-for objectives when countries devalue their currency:

  • in terms of financial balance: to limit the haemorrhaging of a country’s currency reserves which are often needed to cover foreign obligations (such as a high debt in dollars),
  • in terms of fiscal balance: offset the drop in income by revaluing foreign receipts in local currency,
  • in terms of balance of trade: improve competitiveness and increase exports. This can have indirect effects such as increased production and lower unemployment.

In fact, many countries that let their currency depreciate have already seen a boost in their exports. This is largely the case for manufacturing countries (less so for countries that are net exporters of commodities). The differences are also regional as can be seen from the graph below. Emerging Europe is the region that has benefited most.

Not yet the panacea
Recourse to the IMF or currency depreciation are just a few of the remedies that have been adopted by governments in difficulty. They are not sufficient to resolve the ongoing structural problems. In particular, corporate debt seems to be one of the main variables in the equation. Companies in emerging countries are facing growing difficulties. Some, like Pemex, need to be restructured and recapitalised as their prospective income streams have been undermined. In Malaysia and Brazil, 1MDB and Petrobras have suffered severe governance problems. The remedies described above are only a first step in the search for solutions.

Column by Jean-Philippe Donge, Head of Fixed Income at BLI
 

Let the World’s Leading Companies Work for You

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Deje a las mejores empresas que trabajen para usted
CC-BY-SA-2.0, FlickrPhoto: Pictures of Money. Let the World’s Leading Companies Work for You

Quality global franchises often have strong disciplined business models which can provide some certainty in uncertain markets. They tend to create enduring competitive advantages, such as strong brands, patents, licences and copyrights and high barriers to entry. This means they tend to create some certainty around their profitability and cash flows.

Given the recent uncertainty in markets, many investors are looking for investments that are likely to perform well in a lower return world and have good defensive characteristics.

We believe the Investec Global Franchise Fund neatly fits that requirement. The types of companies it invests in have proven how their competitive advantages have helped them secure pro tability and income streams over the long term.

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As the chart below shows, the Investec Global Franchise Fund has participated meaningfully in strongly rising markets, outperformed in moderate markets, displayed excellent defensive characteristics in falling markets and, most importantly, provided strong outperformance over the long term. The Fund has achieved this with relatively low levels of volatility since inception.

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The Investec Global Franchise Fund takes a differentiated approach to investing in quality companies.

  • Is a high conviction 25-40* stock portfolio of some of the world’s leading companies
  • Seeks to provide consistent, reliable growth through an actively managed portfolio of quality companies
  • Avoids leveraged and capital intensive businesses, so holds no banks or resource stocks
  • Has a strong track record with very attractive risk characteristics
  • Managed by a top team with a long history of employing the Quality investment approach.

Clyde Rossouw is co-Head of Quality at Investec.

Stimulating Conversation

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Japón busca apoyo a su política monetaria en el G-7
CC-BY-SA-2.0, FlickrPhoto: Stefan. Stimulating Conversation

The G7 looks like a rather anachronistic grouping. Once upon a time it was the group of the seven largest economies. Only five of the seven are still ranked in the top seven. Huge economies like China and India are not members. But to concentrate on the size of the economy is to miss the whole point of the G7. The G7 is a club of like-minded, influential economies. Taken together, the voting power of the G7 in organisations like the IMF, the World Bank, the UN and the WTO is huge. Any deal that the G7 put together between themselves has a good chance of becoming the official policy of any of these organisations.

It was Japanese Prime Minister Shinzo Abe’s turn to host the G7 meeting last week. He took the opportunity to argue that the current economic situation is as bad as the post- Lehman crisis. He noted that commodity prices had fallen by over 50% and that investment growth in EM is at its slowest pace since 2009 (chart 1a).

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The scale of the commodity price movements may be similar, but that does not make them the same. There is a world of difference between a collapse in prices that comes from a negative demand shock (a recession) and one that comes from a positive supply shock (over-supply). Neither are great outcomes for commodity producers, but the positive supply shock is great news for consumers.

More interesting are not the similarities, but the differences. Emerging market growth is higher, export growth may be low but at least is positive, and the unemployment rate in the G7 has been dropping (chart 1b). And these are just a few of the comparisons. Equity markets, core inflation, confidence, you name it – all look markedly better now than they did in 2009.

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So why has Mr Abe suggested such an odd and palpably incorrect comparison? What is his ulterior motive? Quite simply it looks like he wants political cover for more fiscal easing in Japan. Mr Abe had committed to raising the sales tax in March next year (a fiscal tightening) unless there was either an earthquake or an economic crisis. Hence his efforts to get the G7 to agree things are as bad today as in the post- Lehman crisis.

Regardless, deferring the sales tax looks like an obvious solution. Just look at the performance of the Japanese economy over the last decade or so. First the financial crisis hit and knocked real GDP well off its pre-crisis trend (chart 2), just as happened in most other economies. The recovery was quite rapid, but then the Tōhoku earthquake hit, and once again real GDP was thrown off its trajectory (not that the trajectory could have continued at that pace). After the earthquake, the recovery resumed at a slower pace. Then the sales tax hit, and derailed growth once again.

The experience of sales tax increases in other countries would not have given cause for concern beforehand. Consumers tend to bring expenditure on durable goods forward to avoid the higher tax, which boosts growth in the prior quarter and then slows it in the subsequent quarter. Expenditure patterns then normally recover and smooth out. But in Japan they did not. The hit to expenditure appears to be permanent. After that experience, why would you want to do it again?

Some would argue that a sales tax is necessary for fiscal solvency. But the market disagrees: they are so unworried about the Japanese fiscal outlook that they are willing to pay for the privilege of lending the Japanese government money for 10 years. Yet the government has not been keen on using fiscal policy, so they have been relying on monetary policy. But increasingly unusual monetary policy may be upsetting some of Japan’s G7 colleagues.

The international knock-on effects of monetary policy tend to be more significant than those of fiscal policy. Exchange rates are linked to relative short-term interest rates; in other words, by expectations of monetary policy in the central banks of each country. Looser monetary policy will push down your exchange rate, which by necessity means a higher exchange rate for other countries. This is why big monetary policy moves often lead to accusations of exchange rate manipulation and currency wars. It is also why in the past central banks have sometimes coordinated their easing.

It also explains why there are so many rumours that the G20 (a wider group than the G7 that includes emerging markets) put pressure on Japan to stop cutting interest rates. Given that the marginal negative rate structure the Bank of Japan introduced arguably has little effect on the economy (since it does not affect all rates) but has a lot of impact on the exchange rate, it would not be surprising if other countries may be getting somewhat annoyed.

Fiscal policy has a far less direct effect on others, so should be more acceptable. Extra easing is only really likely to affect the exchange rate if markets expect the central bank to react to the potential inflationary consequences by raising rates. But even if that happens, it pushes the exchange rate up, not down.

While fiscal policy is more palatable from an international perspective, it is not necessarily so palatable from a domestic perspective. In recent years the byword has been austerity: G7 economies have been tightening policy. For economic growth it is not the level of the budget deficit, but rather the change in the budget deficit. This year is forecast to be the first year when this fiscal thrust is positive since 2010 (chart 3). The forecast is for an end to additional austerity but no stimulus. Apparently Mr Abe hopes to change that. For Japan, simply not tightening would be a welcome first step.

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Joshua McCallum is Head of Fixed Income Economics UBS Asset Management.

Least-Loved Cycle Looks Less Lovely

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Una prolongada sequía en los beneficios corporativos podría dañar los márgenes y la rentabilidad de la renta variable
CC-BY-SA-2.0, FlickrPhoto: Scott Beal. Least-Loved Cycle Looks Less Lovely

We are now more than six years into one of the longest-lived — though least-loved — business cycles in history. Markets have shown a much greater ability than the public to shake off the effects of the global financial crisis. Why is this? If you listened to the pundits, you’d think they have been held aloft by nothing but a combination of hot air and central bank liquidity. But that couldn’t be further from the truth. It has been profits, not punditry, that have driven markets to new highs. Since the market bottom in early 2009, the value of the S&P 500 has tripled. Not coincidently, S&P 500 company profits have tripled as well.

 Earnings of large multinational corporations — like those in the S&P — have been propelled by the productive use of labor and capital, rapid asset turnover, low energy costs and, yes, the historically low cost of capital, thanks to accommodative central bank policies.

In recent months, however, profits have begun to flag, and with them my confidence in the market’s upward trajectory.  The drag on profits and earnings seems to be coming from two sources. The first is excess global manufacturing capacity, particularly in China. In the developed markets, production is quick to respond to changes in demand. Demand in China does not respond as quickly, given the political realities there. This leaves excess capacity in the global economy, which tends to depress pricing power, not just for Chinese companies but worldwide.

A second factor that has weakened profits is tepid consumer demand. I had expected the “energy dividend” from spending less on gas and home heating to translate into greater demand from consumers in developed markets. But we’ve actually seen a significant percentage of that energy dividend going into savings rather than back into the economy. At the same time, energy costs have begun to rise, suggesting more downward pressure on consumer demand down the road. That could further crimp topline growth for many companies.

That lack of topline growth has translated into weak capital expenditures at big global companies. That’s a worrisome sign, since in my view, capex is the main driver of jobs and profits.

Here are the conditions I’d need to see before venturing back into riskier assets:

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While we wait to see if these occur, I’d advise investors to be cautious with new money. My concern is not that recession is imminent in 2016, but that we’re facing a prolonged profits drought which could disrupt margins and returns. This could become the new theme for the final years of a market cycle that, while remarkable, could become even less loved. 

James Swanson is Chief Investment Strategist at MFS Investment Management.

US Market Watch: The Fed’s New Policy Tool

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La nueva herramienta de política monetaria de la Fed
CC-BY-SA-2.0, FlickrPhoto: Donkey Hotey. US Market Watch: The Fed’s New Policy Tool

Markets have been too sanguine about the chances of further rate hikes this year. For the past three months, the futures market has been pricing in only a one-in-five chance of a second rate hike in June. In response, the Federal Reserve appears to have stepped up its rhetoric to change those expectations. The minutes of the April meeting made it very clear that most Federal Open Market Committee (FOMC) members believed it appropriate to raise rates again in June.

What could change the call slightly is the timing of the “Brexit” referendum in the UK just a week after the 15 June FOMC meeting. While the June rate hike probabilities have remained steady, the likelihood of a July move has shot up well above 50% at the end of May – suggesting markets are catching up with the Fed.

This doesn’t mean we are now likely to see a typical market reaction to a Fed rate hike cycle. The use of forward interest rate guidance – in the form of the “dot plot” of FOMC members’ policy rate forecasts – has given the Fed a second set of interest rates to manipulate, a policy option that didn’t exist in the past. When the committee raised actual policy rates in December, it also cut future interest rates by lowering the number of expected rate increases by 50 basis points. The market reacted in kind; the dollar fell and stocks rose.

We expect the Fed will raise actual policy rates in June or July – depending on Brexit risk. But we also expect the Fed to cut interest rates again in the second half of the year. Right now, the dot plot still signals four rate hikes in 2017 and five in 2018. So there is plenty of room to cut future interest rates to offset macro volatility or, potentially, excessive tightening of financial conditions.

Market moves have been mostly positive

US equities continued to push higher in May despite growing conviction of a summer Fed rate hike and lingering Brexit risk. The US economic news flow may still not be convincingly bullish. Yet the picture that is emerging two months into the second quarter supports our thesis of a growth reacceleration after an extended six-month period with GDP growth trending well below the previous 2.1% recovery average. The S&P 500 index gained nearly 2%, driven by energy, materials, and financials. Bond returns were essentially flat. The Barclays Aggregate index was unchanged for the month, though performance year-to-date is still ahead of the S&P 500.

Benchmark 10-year Treasury yields were little changed. Yet shorter maturity yields increased notably, reflecting the possibility of another Fed rate hike. High yield bonds posted small gains, enough to push returns to 8% for the year. The dollar enjoyed one of the strongest month in the past four years. The Fed’s trade-weighted dollar index was up 3%, and the DXY index, which includes only the six most traded currencies, was up 2.6%. West Texas Intermediate oil prices continued their upward move, albeit at a much slower speed compared with that in April and March, briefly touching the $50-per-barrel mark intraday before retreating.

The economy looks good, right?

US equity markets seem cautiously optimistic about the outlook, and the economic news flow is starting to tilt in that direction. However, we are not without our fair share of question marks. Seasonality has played a major role in recent years, leading to slower growth at the start of the last three years, averaging just 0.2%. In the last two years, growth reaccelerated back to 3% in the remaining three quarters. That is, essentially, what we are looking for again this year. Retail sales, industrial production, and virtually all housing-related numbers rebounded in April, starting the quarter on the expected bullish note. What’s more important is that strong April household spending suggests consumption, still 69% of total GDP, is on track to grow between 3% and 3.5% this spring. This sets the stage for the now-familiar spring and summer growth reacceleration.

One question mark arises from business and consumer surveys. If economic prospects are looking good, then why are they more consistent with sluggish economic growth? The average of the two main US consumer confidence indexes reversed the surprise April decline, but this doesn’t signal a material improvement over the previous six months. The average of the two manufacturing purchasing managers indexes improved marginally, but at 51 is barely trading above the expansion/ contraction threshold for the sector. Weak business activity was partly the result of a profit recession last year. Reported profits fell more than 3%, the first decline in seven years. Profitability improved marginally in the first quarter, with domestic non-financial corporate profits up about 4%. Yet financials and profits from overseas operations continued to contract, highlighting the difficulties of a low-interest-rate environment and weak trade growth.

The economy is on track for the second-quarter US growth reacceleration we have been forecasting for a while. However, there is a question mark here, too: Can that stronger pace can be sustained in the second half of this year? US business activity needs to rebound more convincingly to make the stronger growth trend stick. Yes, housing activity is picking up again, but the sector is too small to make a significant difference. Purchasing managers indexes show little evidence of a global growth bounce, so trade will remain a headwind. Rising inflation could be the next problem if wages and income don’t keep pace. We already saw a noticeable slowdown in real disposable income growth in April. The Fed should be careful what it wishes for.

The outlook is warming up for summer

Now that we are through the bad news of the winter quarter, US GDP growth is set to pick up again. Our forecast of a 3% average between April and December is well above the 2.3% consensus among the economists polled regularly by Bloomberg. US inflation has moved up and is likely to trend between 1% and 1.5% for much of the rest of the year. Traditionally, rising policy rates would also push up bond yields. Yet we see a dichotomy between rising actual rates, but likely falling future policy rates, and the pull from extremely low government bond yields in the eurozone and Japan. This means 10-year Treasury yields are likely to remain range-bound between 1.75% and 2.25% for the rest of the year.

Markus Schomer is Chief Economist at Pinebridge Investments.

Investors in Europe are Recognizing the Need to Become Engaged with China

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Investors in Europe are Recognizing the Need to Become Engaged with China

A week in the UK attending our annual client symposium which was this year focused on China and a long weekend in Berlin highlighted that a year on from the Shanghai stock market crash, investors in Europe are recognizing the need to become engaged with China, albeit they are in no great rush.

It was this week last year that the Shanghai Composite hit its peak as a speculative bubble built around the potential inclusion of the China A share index in the MSCI indices, which would mean, according to the narrative, that a wave of  index tracking ‘dumb money’ would be forced to come in regardless of price and valuation. As is so often the case, those buying into a ‘bigger fool’ theory turned out to be the bigger fools themselves. As previously discussed the decision not to include the China A shares triggered a run for the exits, but this was turned into a stampede as the Chinese authorities unfortunately decided to further limit leverage by brokerages the following day. With so much of the Shanghai Composite held by ‘weak hands’ and with the added impact of forced de-leverage, the market followed the old adage of up the staircase but down the lift shaft and the Chinese authorities morphed in the eyes of the western press from arch manipulators to keystone cops almost overnight. A year on and the market has stabilised, albeit at around 40% below those levels.

However, one of the points I made at our China symposium in London two weeks ago was that international investors need to realise that the Chinese stock market, despite its apparent size, does not play the same role in the Chinese economy as the S&P 500 does in the US. It represents only around 7% of household assets and is only really held by around 5% of the population. As such the wealth effect in either direction is relatively minor, while the composition of the index, dominated by state owned enterprises in terms of its market cap weightings, gives us little insight into the dynamics of the Chinese economy. This is a classic case of an increasingly common phenomenon, a belief that because we can measure something it is therefore important and even more that because we can plot the data on a chart, we can therefore infer predictions from it. The same applies to aggregate data such as GDP and inflation. The reality is that half of China is growing too fast and the government is trying to hold back excess leverage and liquidity, while the other half is barely growing at all and the government is trying to keep it ticking over. Clearly we want to have a greater exposure to the former than the latter – although opportunities exist in both areas and as such, at both the equity and the credit level, we continue to believe that this is an environment for stock selection and credit research – the index contains too many of the companies and credits you do not want, particularly if you use market cap weights. After the capitulation from emerging markets and to some extent Asia earlier in the year, the panic has subsided as people take a more considered look at the economics, but flows are still on balance negative, which is leading to a feeling of treading water.

This gives us time to focus on the structural trends and the big story remains the build out of a proper financial services infrastructure and in that sense the development of the bond markets in China are almost certainly a more important first step than the equity market as China moves away from the dominance of the (inefficient) banking system. At our symposium, while many of the clients were interested in understanding more about the prospects for Chinese equities, the potential for infrastructure bonds, corporate bonds and muni-bonds was also of great interest, especially in a world where over $10 trillion of government debt is now yielding less than zero. The notion that China can produce the same product (or perhaps even better) for half the price is coming to financial products as well. Recent announcements have made it even easier for international investors to access Chinese onshore bonds, while Chinese companies continue to issue onshore and redeem offshore bonds. This is a phenomenon we have discussed on previous occasions, not least because it appears in the national accounts as a reduction in foreign exchange reserves, and has been a strong stabilising factor in the market for Asian fixed income.

Perhaps I am spoiled by now living in Asia where there is (generally) a very different approach to work in the service sector. I was interested to see a report out last week based on a study from UBS – commented on here – showing that on average people in Hong Kong work over 50 hours a week – 62% longer than those in Paris. (Note to my colleagues in Paris and HR – I am simply picking the top and bottom cities honestly!) This could be that the people of Hong Kong are keener to earn money to buy ‘stuff’ – the money earned for a 50 hours’ worth of work in Hong Kong is almost enough to buy an iPhone – a good measure of purchasing power given Apple’s pricing model. Whereas the Parisian would have to work a longer week – 42 hours on UBS’s calculation. However, the Hong Kong worker is probably more focussed on trying to pay the rent while generally the cost of living in terms of goods and services is about the same in both cities – this is not true for rent. A three bed apartment in Hong Kong is twice the price of one in Paris. This is changing however. Hong Kong rents are starting to fall, as they are in much of Asia due to excess supply. Although as my colleague Simon Weston pointed out after a trip to Singapore last week, many of the developers are concerned that prices are not clearing properly. It also raises an interesting point about one of the long term fears about robotics – the idea that nobody will have a job and thus there will be significant social unrest. Workers in Hong Kong could work 40% less hours than they do at the moment and still be full time workers on a western European model, not to mention 28-30 days holiday rather than the current average of 17.

Excerpt from AXA’s Market Thinking column by Mark Tinker, Head of Framlington Equities Asia