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A Spectre is Haunting the World, the Spectre of Deflation

Open up a financial newspaper and you will see the word “Deflation” again and again in articles on the general economic situation, usually in combination with the words “fear”, “concerns” or “risk”. This negative association is reinforced by the fact that Mario Draghi, president of the European Central Bank, often speaks of a “deflation risk” which must be combatted.

Given the big impact that central banks have on financial markets through their key rates and other monetary policy measures, it is important for investors to understand what influences these institutions and what they have to do with deflation and deflation risk.

To address this topic, I will present a short series of blog posts on deflation from an investor’s point of view.

The first point to understand is what exactly is meant by “deflation”, how we experience it in everyday life, what causes it, and why it occurs so seldom on a macroeconomic level. In the following posts I will address related themes, such as “deflationary spiral”, “excessive debt and deflation“, and, above all, what this means for an investor.

Deflation is defined in economics as an across-the-board, significant and sustained decline in prices of goods and services.

The main cause of falling prices is greater efficiency, i.e., the ability to offer a better product or service and/or the ability to offer it at a lower price. This phenomenon can be seen in computers and consumer electronics. An iPhone today costs about one third what an Apple Macintosh computer cost in 1984 (about USD 2500) and is capable of doing so much more.

But there are other, less well-known examples of deflation caused by enhanced efficiency. According to the Cologne Institute for Economic Research, in Germany prices of the main staple foods (butter, sugar, milk, bread, etc.) have risen in nominal terms since 1960 and even since 1991. On the other hand, in 1960 an “average” worker had to put in 51 minutes to buy 10 eggs; in 1991, nine minutes, and in 2009, only eight minutes. More generally, in 2009 a German worker had to work only one third as long in order to buy the same basket of goods as in 1960.

A further important cause of deflation – surplus supply and flat demand – is currently being illustrated in oil prices. Keep in mind, however, that demand for oil is not fully price-elastic. That means, for example, that if oil prices rise there will be only a slight decrease in driving, and if oil prices fall there will be only a slight increase in driving. Moreover, it is easy to expand or shrink supply in the very near term. The “oil tap” can be opened up or closed relatively easily.

For various political and economic reasons, oil producers are not currently on the same page and are trying to sell as much oil as possible. This has led to a global glut in oil, and the price of all types of oil has fallen by more than 50% in the last 18 months.

But why has this long- and short-term deflationary trend very seldom or never led to macroeconomic deflation? There are two reasons.

On the one hand, lower prices put more money in consumers’ hands, which they use to purchase more goods, the same goods in greater quantities, or goods of higher value. This alters the basket of goods on which basis the consumer price index is calculated. This change in consumer behaviour offsets the deflationary impact.

On the other hand deflation naturally depends on money supply and growth in money supply. And, although money is created from lending by commercial banks, it is ultimately the central banks that determine growth in money supply. In the past politics led to too much money creation which triggered (moderate) inflation.

Even so, deflation has occurred in the past. In my next blog post I will describe when and how it has done so.

Groundhog Day for Financial Markets

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Mes de la marmota para los mercados financieros — Photo: Fut Und Beidl. Groundhog Day for Financial Markets

Financial markets have endured their own version of Groundhog Day in recent months: the three issues that troubled investors earlier in the year – namely the precise timing of the Fed’s first rate rise, the subdued pace of global growth and the ongoing macroeconomic uncertainties in China – are not that much closer to being resolved now than they were back in the summer. So perhaps it is worth considering what has changed in markets, and what hasn’t.

The Fed, for its part, has worked very hard to try and keep the December policy meeting alive (current market pricing suggests that a December hike is now likely, having been less than a 30% probability prior to the October meeting). Nonetheless, it is still impossible to predict with complete certainty whether or not the Fed will move before the year is out, particularly given the seasonal decline in market liquidity that is seen in December. Critics of the Fed would argue that the Federal Open Market Committee (FOMC) has simply been too transparent, and that policymakers have painted themselves into a corner. If the FOMC itself is not sure about what it should do, it is impossible for anyone else to predict what the Fed will do with any accuracy.

While the Fed’s moves (or ‘none moves’) have occupied the lion’s share of the column inches in recent weeks, it is the muted tone of global economic data that is perhaps most vexing. The Lehman crisis took place well over seven years ago, and yet signs of a traditional cyclical recovery remain very hard to find. If anything, the current concern in markets is overcapacity in China and what that will mean not only for commodities and energy producers but also industrial profitability in general. Whilst we do not expect an economic recession, it is clear that life for a number of global industries is very difficult and likely to get worse. Talk of a recession in industrial profits may sound alarmist, but is probably not too wide of the mark if you happen to be a maker of mining equipment or agricultural equipment, areas where there is significant global oversupply. If you produce a commoditised, undifferentiated product – such as steel plate, for example – life is incredibly tough and companies are failing.

Why has global growth been so subdued? One explanation is that while QE has created the conditions (i.e. near-zero interest rates) for companies to invest, it only makes sense for companies to invest if they think that there is demand for what they will then produce. Post crisis, that demand has been notable by its absence, outside of emerging markets. Of course, as has been discussed ad infinitum, emerging markets are now under significant pressure (particularly the ones that have built their economies to feed Chinese demand for commodities) meaning that the global consumption outlook is muted at best. In that context, it is perhaps not surprising that companies have chosen to cut costs and use spare cash to pay dividends (or special dividends) and latterly they have used financial engineering (such as share buybacks) to support their share prices. In a world where organic growth is hard to find, it makes much more sense to buy back shares than committing to expensive, long-term projects involving huge amounts of capital expenditure and uncertain pay-offs – as many mining companies have found to their cost.

A lack of corporate confidence to invest is only part of the story. When oil prices slumped, we expected the consumer to benefit from a ‘cheap energy’ dividend, but this simply has not emerged in the way that we expected. Why is this? Rather like corporations, which are reluctant to spend on large-scale investment projects, we believe that many consumers are simply thankful to have a job in the post-crisis world and are therefore banking the gains they have made from low energy prices. Perhaps more significantly, and despite tightening labour markets in countries such as the US and UK, wage gains have been very modest. We should also not forget that a generation of people who left school or college in the late ‘noughties’ will have grown up without ever knowing the cheap and abundant finance that was available pre-Lehman. Leveraged consumption is not returning in the US or elsewhere and this will have a material impact on the level of GDP growth we will see next year and in the coming years. To put this another way, the unholy trinity of tighter regulation, higher legal costs and tougher capital requirements will mean that retail banks will increasingly look like utilities in the future.

What does this mean for investors? In our estimation, organic growth will be hard to find and that perhaps explains the recent pick-up in M&A. Companies that have already shrunk their cost bases and used financial engineering to lift their share price have few other options left in the locker. Indeed, increased M&A and the fact that companies have become more creative with their balance sheets has driven the recent deterioration in credit fundamentals in the US.

The fact that growth is likely to be subdued means that interest rates will be lower for longer. Indeed, the terminal fed funds rate for this cycle could be as low as 2%. On paper, this is positive for bonds but it is hard to get excited about government bonds given where yields are and the fact that the Fed will be raising rates. European high yield does however look interesting, given a meaningful yield spread over government bonds and the fact that the asset class is usually a beneficiary of M&A, unlike investment grade.

A low discount rate is in theory a major positive for equities but all the issues discussed above suggest that economic growth – and therefore earnings – are likely to be weaker than they would have been if some of the excess global productive capacity had been burnt off. We think that a selective approach in equities will pay off, particularly as Chinese growth concerns are unlikely to abate any time soon. We also think that investors will focus more on valuations and fundamentals as global liquidity continues to ebb, and in that world investors should be ready for more stock-specific disappointments. In future, the Fed will not be underwriting equity markets and despite the likelihood of further action by the ECB, there will no longer be a rising tide of global QE that lifts all boats.

Mark Burgess is CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.

Economic Disappointment in Japan Should not Worry Equity Investors

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Japan’s GDP for the third calendar quarter of 2015 showed weakness, much like the consensus expectation, but once again, this kind of negative result should not cause much concern at all for equity investors. Indeed, there were some good signs in the data, with personal consumption rising above consensus expectations and net exports rising quite smartly, which indicate a GDP rebound in the coming quarters.

As always, there are important things to know about GDP statistics in Japan:
These statistics are often heavily revised and it would not be surprising if the most recent quarter was revised up, especially as there were several anomalies in the data.

Firstly, real (inflation adjusted) inventories fell sharply, and if they had been flat, GDP would have actually grown 1.1% QoQ SAAR. Note that Japan has reduced real inventories for 23 of the 27 quarters since 2009 began, equating to a 55 trillion Yen (about $550BB using an average 100:USD rate) reduction in accumulated unit inventories since then, while the economy has meanwhile expanded 5%. It seems that Japan doesn’t have any inventories at all by this measure. So, this factor clearly understates GDP growth in our view and by comparison, the US has boosted real inventories by $812 billion over this period with GDP rising 12% despite utilizing similar technology to improve the efficiency of inventories.

Secondly, a major anomaly was the “discrepancy factor” (the difference between the sum of the real components and total real GDP) which remains at a very large negative number and indicates that GDP is likely understated.

Thirdly, GDP statistics have no correlation with corporate profits in Japan. As our Evolving Markets reports have long-shown, despite lacklustre GDP, Japanese corporate profits have surged during the last ten years, with the trend clearly continuing in 2015, evidenced by profit margins at historical highs. Of course, the weaker yen played some role in this recent trend, but service sector profits have been especially strong, which indicates that the economy is not as poor as the statistics suggest. Corporate governance improvements are also obviously a key factor to profit growth in Japan, greatly outweighing the effect of any economic softness and we expect this factor to continue, as it has now become deeply engrained in corporate culture.

As for the outlook, the Bloomberg consensus is for a rebound in GDP growth in the next two quarters, but the trajectory of growth has indeed been lowered, so we need to reduce our CY15 estimate to 0.7% from 1.0% (vs. the Bloomberg consensus of 0.6%), with 3.1% QoQ SAAR growth estimated in the current quarter. Within this, we expect:

Real inventories to rise to positive quarterly figures
The discrepancy factor to be reduced
Personal consumption to rebound more strongly in the 4Q
Net exports to decline mildly after their sharp 3Q increase

The consensus estimate for CY16 growth is 1.1%, which may seem meagre, but it is slightly above Japan’s natural growth rate.

In sum, as has long been our view, disappointing economic data should not worry investors in Japanese risk assets very much at all; indeed, TOPIX, driven by strongly rising profits, has risen quite smartly over the past year despite the weak GDP data, thus confounding those who concentrate too much on the macro-data.

Moreover, TOPIX has outperformed global equities this year in USD terms; yet, not only are equity valuations still much lower in Japan than the US and Europe, but earnings growth remains higher. Meanwhile, for Japanese investors, the relative outperformance of equities vs. other domestic assets has been crystal clear for several years and coupled with incentives created by Abenomics, an “equity culture” is finally flourishing, which should support the equity market in the years ahead and in turn support domestic economic growth via the wealth effect.

Opinion column about Japanese equity investing by John Vail from Nikko AM

Is Merging Innovative Financial Technology with Credit Unions the Key to Banking the Unbanked in Latin America?

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Credit unions play a critical role in local economies of countries throughout Latin America and the Caribbean, serving as a vital savings and credit conduit to vast numbers of people, especially those in the lower rungs of the income pyramid who are in many cases, priced out of the traditional banking system.

These organizations, created with the primary purpose of encouraging people of ordinary means to save money while offering them loans, are able to charge lower rates for loans (as well as pay higher dividends on savings) because they are nonprofit cooperatives. Rather than paying profits to stockholders, credit unions return earnings to members in the form of dividends or improved services.

With lower cost structures, they are in a better position to provide millions of unbanked Latin Americans with access to financial services that can have a transformative effect on the social and economic development of nations. This is a particularly important function in a region where the population, according to McKinsey Consulting, remains 65 percent unbanked.

Despite the benefits credit unions provide to large segments of the population, the fact remains that these not-for-profit organizations simply lack the resources necessary to significantly alleviate the exorbitantly high rate of unbanked throughout the region.

So the question becomes: what can these institutions do to increase the effectiveness, efficiency and reach of their vital products and services?

A Challenging Environment

Credit unions, and small banks for that matter, face the same issue as larger banks in that consumers of all kinds are beginning to solidify the digital user experience they expect from all of their service providers, including financial services. As platforms such as Facebook become more and more accessible to individuals in all social and economic levels of society coupled with the exploding penetration of smart phones, which is forecasted to total 219.9 million users by 2018, these users will begin to increasingly demand the same convenience and intuitive ease of use in their financial services. Fortunately, technology today allows for credit unions and small banks to deploy platforms that provide their customers with exceptional capabilities to not only meet their banking needs, but to do so in the mobile and user-friendly manner they want and expect.

Adding to the hurdles faced by credit unions in the region, governments and regulators are adding restrictions that require these institutions to only provide differentiated services to specifically defined market segments through channels not served by traditional branch banking infrastructures.

Finally, with the proliferation of cyber crime, building secure infrastructures that protect the identities of customers is of paramount importance to every single financial services stakeholder.

Technology Changing the Game

Throughout the world, a surge in venture capital investment into financial innovation has created exciting new business models that are poised to effectively and efficiently transform the financial services industry.

Last year, according to Accenture, the financial technology industry attracted over US$ 12 billion in venture capital investment in 2014, fueling the creative innovations in the uses of analytics to evaluate, approve and process financial transactions that are greatly expanding the access to once prohibitively expensive and cumbersome financial services for individuals of ordinary means and small and medium sized enterprises.

Much of the changes in the market paradigm for financial services are being driven by the proliferation of mobile phones, especially the smartphone, which is essentially providing supercomputing power to consumers all over the world. Companies such as M-Pesa, Lenddo, Abra and Konfio are just a few of the thousands of new companies transforming the financial landscape by making world-class financial services available to the masses.

However, systematically scaling and bringing these solutions to large numbers of people remains one of the most daunting challenges for even the most well funded startups.

The ability to partner and collaborate with large institutions that have established customer bases and reach into communities could be a massive “win-win” for both the startups and the credit unions.

This obviously complimentary collaboration has one wrinkle. Most credit unions operate on antiquated technology frameworks that inhibit, if not outright prevent, the onboarding of technologically agile startup solutions onto their core-banking platforms.

Adding to the challenge is the fact that as non-profits, credit unions lack the time, human resources and budgets to invest in updating their technology platforms. Until now, there had been limited options as most core-banking technology companies focused their products on larger bank infrastructures, pricing many smaller players out of the market and putting them in competitively vulnerable positions of not being able to offer state-of-the-art solutions.

Agility is Key

One of the most disruptive aspects of the innovations in fintech are the ability to provide financial services quickly and inexpensively.

The big banks, by in large, have the financial and technological ability, if not necessarily the will and desire, to compete for the unbanked population. If the credit unions and smaller banks do not prepare a strategy to engage in the competition for this huge, untapped market, they may find themselves ultimately outside looking in as their market share decreases.

The other “elephant in the room” is the coming era of millennials. Today, there are 160 million in Latin America, representing roughly 30% of the entire population of the region. These digital natives being raised on social media are a critical market segment for institutions both big and small which must be addressed through smart technology.

So what is the solution? As technology becomes faster, cheaper and more accessible, it allows for the creation of affordable state-of-the-art, digitally agile solutions that can allow credit unions and small banks to operate with the speed, security and sophistication of large, global financial institutions. This enhanced technology capability coupled with the localized understanding of under and unbanked market segments can help credit unions continue to be a critical financial link for millions of consumers.

Opinion column by Martin Naor, CEO of Bankingly

Rising Interest Rates: The Big Picture

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While macroeconomic news out of China, and the price of oil has dominated the most recent financial market headlines, the U.S. Federal Reserve policy has been a subject of debate and intense focus for years. Investors, bankers, economists and reporters alike are fixated on every word the Federal Reserve and its board of Governors releases. The examination of, and some might argue obsession with, Fed statements has reached a point where the market can rapidly change direction based on just an alteration of word choice, even when the overall message remains the same. These statements garner so much attention because traders and investors are trying to gain an edge in predicting when interest rates will rise. Setting aside the debate on when the exact date of an interest rate hike might be, this paper examines what rising rates mean for your investment portfolio and argues that the long-term benefits are something investors should welcome not fear. In order to examine this in detail, we first must have a good understanding of how the Federal Reserve works and why its policy affects interest rates.

What is the US Federal reserve and why does it matter?

The U.S. Federal Reserve Bank (commonly referred to as the Fed) is the central bank of the U.S. financial system and its primary function is to enact monetary policy that helps to stabilize and improve the U.S. economy. The Fed’s three main objectives are: to maximize employment, keep prices of goods stable, and moderate long-term interest rates. As the economy goes through cycles from economic booms to recessions, the Fed takes action to moderate the booms and minimize the probability and depth of recessions. One of the key tools the Fed uses to keep the economy stable is interest rates. In this case, interest rates reflect the yield paid to buyers of U.S. Treasury bonds. The Fed can influence the level of interest rates by buying large quantities of Treasury bonds on the open market, thereby pushing prices of the bonds up and yields down and vice versa. In general, the Fed will increase interest rates in order to slow down the economy and decrease them to stimulate growth.

Why do investors fear rate increases?

Investors have feared the prospect of rising interest rates for two main reasons: the potential for slower economic growth and negative returns for bonds. The Federal Reserve uses higher interest rates to slow the economy by increasing the cost of doing business and buying a house. Companies looking to build a new factory or invest in new technologies often raise funds for these projects by issuing bonds. As interest rates rise on Treasury bonds they rise correspondingly on corporate bonds, increasing the cost of financing for companies. As the cost of financing increases, companies are less likely to invest in new projects, slowing the economic growth rate of the economy. Similarly as interest rates rise on Treasury bonds, the interest rates for mortgages on homes also rise. This increases the monthly payment required to build or own a home, subsequently slowing the pace of growth in the housing market. While we think this is a legitimate concern in the long run because slowing economic growth can act as an impediment to earnings growth and stock prices, at this point in the interest rate cycle the effects should be limited.

Interest rate changes don’t just affect the economy; they can also have sudden and material impacts on performance of investment products. Interest rates and the prices of bonds have an inverse relationship, as rates rise bond prices fall and vice versa. During the past 30 years, investors have enjoyed a long cycle of declining interest rates. In September of 1981 the 10-year Treasury Bond peaked at an interest rate of over 15%. Since then, interest rates have been steadily declining, producing an environment of sustained strong performance as bond prices rise. The U.S. Barclays Aggregate Index has delivered an annualized return of nearly 8% over that time span, with only a few short periods of mild negative returns, conditioning investors to expect strong consistent positive returns in fixed income. Many fear that when the Fed changes its policy and begins to raise interest rates, negative bond returns will cause widespread selling of fixed income products causing further declines in bond prices. This concern is certainly warranted and we have positioned our clients’ portfolios to protect against this risk, however, we continue to believe that higher interest rates is a healthy outcome for investors and the market in the long-run.

What are the benefits?

At Federal Street Advisors, we believe that rising interest rates do present real near-term risks that investors should be prepared for but recognize that higher interest rates will also bring long-term benefits to those who are well positioned. Higher interest rates are an indication of economic strength, improve income available for investment products, and promote rational capital markets.

While the Federal Reserve does use higher interest rates to slow economic growth late in a business cycle, it is important to understand that the potential upcoming interest rate hike is not an attempt to slow growth but rather to return interest rates rate to a normalized level. During the financial crisis of 2008/2009, the Federal Reserve lowered their interest rate policy target effectively to zero where it has remained since then. This was a historically extreme measure designed to promote business investment, stabilize the housing market, restore confidence in the stock market and stimulate economic growth. The Federal Funds target interest rate (the interest rate that the Fed targets for monetary policy) has been 0%-0.25% since December 16^th, 2008, well below its long run average of 7.4%¹. An increase in the Fed’s target interest rate today would be indicative of their confidence in the economic strength and stability as they seek to bring interest rates to a normalized level, and not an attempt to slow the growth rate of the economy.

While a declining interest rate market has resulted in strong performance from bonds, low absolute levels of interest actually significantly reduce the potential for future returns. One of the primary goals of a zero interest rate policy is to reduce the cost of financing for companies. Companies have been able to issue bonds to investors at all-time low interest rates. While this is a good deal for companies, it’s not a great outcome for investors, who are forced to take increasingly lower compensation for the risk of lending this money. The yield on the Barclays U.S. Aggregate Index was just 2.3% as of September 30^th, compared to 6.6% twenty years ago. Low coupon rates generally mean poor opportunities for returns and more recent results have reflected that as the Barclays Agg has returned just 1.7% in the last three years. While an increase in interest rates will likely result in negative returns for bonds in the near-term, it greatly improves the long-term return potential by allowing investors to reinvest coupons at higher interest rates. In our estimation, investors in the Barclays U.S. Aggregate Bond Index might experience a drawdown of as much as 7.5% if interest rates were to rise by 2%, but would still be expected to achieve a 10-year annualized return 0.7% higher than a scenario in which interest rates remained unchanged and no drawdown occurred². This scenario analysis highlights both the importance of protecting against the near-term risks of an interest rate increase but also the improvements to long-term total return opportunities.

Low interest rates can cause investors to take on more risk:

Sustained low interest rates also have significant impacts on investor behavior, which can cause imbalances in the capital markets. Low interest rates means the retiring baby boomer generation in particular are not able to depend on the same level of income from their municipal bonds portfolios. Due to the lack of income in bonds, these investors have been forced to buy areas of the equity market that pay dividends, such as the utilities sector, but may expose themselves to more risk than is appropriate as a result. Increases in interest rates will bring increases in income from bond portfolios, and allow investors with lower risk profiles to return to more suitable asset allocations.

Pension funds will also benefit from a rising rate environment. These funds are required to report an estimate of the value of their future obligations to pay benefits to retirees. Since the bulk of these payments will occur in the future, they use a “discount rate” to calculate the value of the future payments in present terms. This discount rate is tied to the prevailing interest rates in the market. Lower interest rates means a lower discount rate, which results in larger future obligations. As interest rates fall, the pension fund’s financial health deteriorates and they are also forced to adopt a more aggressive or risky asset allocation to achieve the returns needed to pay retirees. Conversely, if interest rates rise, pension funds should regain healthier financial conditions, the risk levels of their investments can be reduced, and payments to the beneficiaries will ultimately be more secure.

Active management will benefit:

Sustained low interest rates have also presented challenges to the performance of active managers through the encouragement of irrational investor behavior and unsustainable low financing costs. While influencing the equity markets is not a stated goal of the Federal Reserve, it is an outcome of their zero interest rate policy. As described previously, low income and poor total return expectations in bonds have pushed fixed income investors into buying stocks in the utilities sector. In 2014, as interest rates fell, this sector returned 29%, outpacing every other sector in the market. Active managers were broadly underweight the sector on fundamental concerns that high relative valuations and chronically low growth rates posed significantly greater risk than the promise of 3-4% of income. In this environment, active managers posted one of the worst years of relative performance on record (link to previous paper here?).

In addition to changing investor behavior, low interest rates offer greater support to companies in poor financial condition making it more difficult to separate good investments from bad ones. Low interest rates mean low financing costs for companies raising money through the issuance of bonds. This low cost financing benefits companies in poor financial condition or those that have been mismanaged disproportionately to high quality, well-run business. The best-run companies are typically rewarded with low financing costs in all market environments, or in many cases do not need to rely on debt financing at all because they are able to fund new projects and investment from cash flow from their existing business. A decrease in interest rates has little effect on the cost structure of these companies. Conversely, when interest rates are low, low quality companies that need to raise cash from the debt markets are able to do so at lower costs than ever before. The stocks of these low quality companies can be rewarded in low interest rate environments as their fundamentals appear improved, but as interest rates rise and the costs of financing increase, these results will be unsustainable. While the style of active managers can vary, most look to buy companies with superior business models and strong management teams, which should benefit on a relative basis as interest rates rise leading to active manager outperformance.

Conclusion:

Given the attention the media gives the topic it is easy to get caught up in the intense debate of when the Fed might raise interest rates, but as recent history has shown it is difficult to predict. In the beginning of 2014, 46 economists polled by the Wall Street Journal expected the Federal Funds rate to be an average of 1% by the end of 2015 and yet today the effective rate remains roughly 0.1%. At Federal Street Advisors, we believe the game of attempting to time an unpredictable interest rate rise is not one that our clients will benefit from playing. While we recognize that there are near-term risks to bond portfolios associated with an interest rate increase, it is increasingly important to keep the big picture in mind: a higher interest rate environment is both inevitable and healthy for the market, and investors who are well prepared will benefit.

¹“Historical Changes of the Target Federal Funds and Discount Rates.” Federal Reserve Bank of New York, n.d. Web. 30 Oct. 2015. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

²Analysis assumes a parallel shift in the yield curve occurring evenly over the first 12 months with income being reinvested at higher rates. Full scenario analysis is available upon request.

Should Quality Company Growth Be Highly Valued in Today’s Abnormal Cycle?

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¿Deberían estar mejor valoradas las compañías que crecen en este ciclo económico? — Photo: Chase Elliot Clark. Should Quality Company Growth Be Highly Valued in Today’s Abnormal Cycle?

Good businesses are more expensive than they have been in the past, but ironically far more valuable in today’s world.

The reason for this is simple. In a world bereft of growth opportunities, growth is priced at a premium. Normal cycles produce an abundance of economic growth, which is good for the performance of average businesses. They also create opportunities for higher company earnings. However, this cycle is far from normal and requires differentiated thinking to achieve meaningful returns, not a reliance on what has worked in the past.

In December 2008, as the world was gripped by the onset of the great recession, US 10 year bond yields fell to 2.12%, a low not seen for more than 70 years. At that time very few grasped the deflationary risks the world was facing, apart from perhaps central bankers studying the Great Depression. Now, more than eight years on, despite higher stock markets, we still have a term lending rate to the US government of 2.03%.

Why have yields remained so low, when the world is in recovery mode?

This question has been perplexing economists and has occupied the brightest minds. Part of the riddle might be better understood if the message from the current commodity price landscape is considered, with oil prices at levels last seen in 2008. We believe low commodity prices and low bond yields confirm depressed levels of economic activity at a macro level, paired with intrinsic business model risk at the asset level.

What should an asset allocator do?

If the Federal Reserve is unwilling to raise interest rates from near zero, should you consider investing in growth assets if there is no meaningful growth? Quality equities can help. Quality businesses are more likely to produce consistent levels of growth during times of economic uncertainty. They can:

Provide compelling value: There has not been much new investment in Quality equity strategies over the past twelve months. This encourages us. Despite our funds delivering strong performance, we still see compelling value in owning a portfolio of businesses growing at high single digit rates, with no leverage and paying out 75% of the cash produced.
Manage their businesses for different trading environments: Stable cash generating businesses in consolidated industries have the ability to manage their pricing structures better than other industries. They can also cut costs through optimising distribution and marketing, paving the way for higher margins in the good times or protecting cash flows in the bad.
Become more active in M&A: South African Breweries is a good example. Our portfolios have enjoyed a value uplift from the proposal from Anheuser-Busch InBev. But if we look at the deal multiples paid on this acquisition, it would suggest our portfolio is around 50% below fair value on similar terms. As such, we would expect more of these corporate deals to occur.

Clyde Rossouw, Co-Head of Quality at Investec Asset Management.

Equity Income: Why Big Is Not Necessarily Best When it Comes to Dividend Yield

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¿Existen indicios de que están repuntando los beneficios europeos? — Photo: KMR Photography. Equity Income: Why Big Is Not Necessarily Best When it Comes to Dividend Yield

In the current low interest rate, low growth environment investors are increasingly looking to equities for an attractive level of income. There are still lots of interesting investment opportunities around the world, but I believe investors should be wary about simply looking for the highest yields on offer.

Diversification

History shows that dividends from the highest-yielding stocks can often be unsustainable (as illustrated in the chart below). This is one of the reasons we believe that investing across a diversified list of moderate-paying companies that have the potential to offer both dividend and capital growth over the medium to long term is the best approach.

Sustainability

The chart below looks at the sustainability of dividend yields across developed markets between 1995 and August 2015 and highlights the risk of chasing high yields without considering the underlying strength of the company. It shows that, in general, an estimated yield above 6% is less likely to be realised, as seen by the difference between the red and grey bars, than a forecast yield of 6% or below.

Enlarge

Avoid value traps

We believe in avoiding value traps. This is because high-yielding equities can be more risky than their lower-yielding counterparts, particularly after a period of strong market performance (equity price rises push yields down). The high-yielding companies that are left are often structurally-challenged businesses or companies with high payout ratios (distributing a high percentage of their earnings as dividends) that may not be sustainable. An investor simply focusing on yields, or gaining exposure to this area of the market through a passive product, such as a high-yield index tracker fund, may end up owning a disproportionate percentage of these companies, which are often known as ‘value traps’.

We believe that an active, stock-picking approach is essential to equity income investing because it allows fund managers to analyse and understand which higher-yielding companies may have been undervalued by the market. To establish whether there is a real value opportunity we analyse a company’s earnings, strategy and the industry fundamentals to determine whether it is structurally at risk or whether it is just temporarily unloved, undervalued, or its earnings power underappreciated by the market.

Growing cash generation

Investors utilising a barbell investment approach, holding very high yield stocks to deliver income and very low dividend payers with more growth potential, may end up facing a greater than average number of dividend cuts than they appreciate. We prefer to spread risk by having a diversified portfolio of moderate dividend payers. Our focus is on investing in companies with strong and growing cash generation with the aim of finding attractive capital and dividend growth.

There are still plenty of opportunities for income investors with a global universe of more than 1,300 stocks in the MSCI All Country World Index that currently yield 2% or more. We focus on dividend paying companies that are generally yielding between 2% and 6%. This helps to ensure the yields we deliver to investors are at a healthy level and are suitably diversified with no reliance on any one sector or stock. This is in line with our philosophy of avoiding overvalued areas of the market.

Ben Lofthouse is a fund manager in a range of Equity Income mandates at Henderson.

Why the BOJ Does Not Need to Ease Much, If At All

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¿Por qué el Banco de Japón no necesita flexibilizar mucho la política monetaria? — Photo: Japanexperterna.se. Why the BOJ Does Not Need to Ease Much, If At All

Most economists expect the BOJ to ease further, quite aggressively so in many cases, later this month or shortly thereafter. Certainly, Japanese economic growth does seem to be lackluster, with industrial production and machine orders recently forcing many economists to lower their 3Q GDP forecasts to near zero growth from the 2Q. But there are several reasons to be more sanguine about the situation.

Firstly on economics, core inflation excluding all food and energy (which should be called “standard core”) ran at a 1.4% six month annualized rate in August, and this includes a housing rent component that continues to decline. Excluding rent as well, the CPI is rising about a 2.2% six month annualized rate. Note that Japan’s CPI rent is slightly lower than it was a decade ago (while the US rent CPI has risen about 35%), and if was rising at a 1% rate, then Japan’s standard core CPI would be rising at a 1.8% six month annualized rate, or very close to the BOJ’s goal.

Ampliar

Secondly, there are several political reasons why Japan should avoid a weaker yen, which would be the obvious consequence. Already the US has been quite generous in not complaining about the yen at 120 against the US dollar, but there is not likely much tolerance for further weakening. US protectionist sentiment is rising and it is even questionable now whether the Trans Pacific Partnership (TPP) will be passed. Hillary Clinton, in stating her opposition to the deal, suggested that there was not enough effort on the foreign exchange component, and most Congressional Democrats would agree with her. In fact, a separate bill on monitoring foreign exchange matters had to be passed in conjunction with the Trade Promotion Authority in order to get enough votes for it to pass. A dramatic weakening of the yen would further harm the prospects for this major “third arrow” achievement of Abenomics, especially over the next three months before the US vote in TPP occurs. Lastly on the political side, Japanese voters are getting quite tired of inflation.

Thirdly, there are financial stability considerations. If Japan buys more JGBs and pushes long-bond yields even further near zero, then insurance companies, banks and other financial institutions, including pensions will complain that it is impossible to meet their long-term obligations with a reasonable amount of risk, as regulated by the government. Although there has been no major trouble so far, despite the fears of many doomsayers, an over-aggressive BOJ policy may unsettle the JGB market.

Many in the investment world are encouraging the BOJ to act, but from my readings of their thoughts, the BOJ would like to look past the short term considerations and count on wages rising enough to spur personal consumption, housing rents beginning to rise and Japanese corporations accelerating domestic investments instead of overseas ones. Indeed, the BOJ should be pleased that it has raised the standard core CPI from the negative annual rate extant since the late 1990s (except for a few months in 2008), at great risk to its reputation. Relying on a weaker currency or more aggressive monetary policy is not the key to success for Japan, but rather, continued structural reforms, including the TPP and components of Abenomics 2.0, corporation’s confidence in their own country and workers, and of course, a continued sturdy global economic backdrop.

Opinion column by John Vail, Chief Global Strategist, Nikko AM.

Happy Halloween. Five Scary Charts That Freddy Krueger Would Be Proud of

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M&G and bondvigilantes.com proudly present the scariest charts on the global economy. Some will make you laugh, some will make you cry. You will be amazed, you will be enchanted, you will be mystified, you will be amused. Of course, the following is not for the faint of heart. You have been warned.

1.- Companies are scared of risk

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There has been a glut of corporate bond issuance since the financial crisis, as companies have issued debt at low interest rates. What have companies done with all that cash that capital markets have leant them? Overwhelmingly, US companies have embarked upon equity buy backs and M&A activity, which has helped shift the equity market higher. Only a small amount of proceeds raised by US companies in bond markets have been used for capital expenditure. This suggests that corporations remain hesitant to take risk, even in an environment where many perceive that the US economy is ready to withstand higher interest rates.

2.- Nowhere to hide for investors

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In the old days, an investor could expect the bonds in their investment portfolio to do well when equities sold off and vice versa. Not anymore. Analysis by the IMF shows that asset classes are increasingly moving in the same direction, meaning that the famous rule of investing – diversification – no longer applies to the same degree that it once did. Worryingly, the tendency for global asset prices to move in unison is now at a record high level and correlations have remained elevated even during periods of low volatility. A large scare in investment markets could really test the fragility of the financial system should asset values deteriorate across the board.

3.- Terrible forecasts

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Commodity prices are highly volatile and unpredictable as evidenced by futures market pricing for crude oil. This poses a significant challenge for policymakers in resource-rich countries. In the majority of commodity-exporting nations, a large share of government revenue is provided by the resource sector. The current shock to commodity prices could put severe pressure on government balances, particularly in geopolitical hotspots like the Middle East, Russia, Nigeria and Venezuela. Those forecasting (hoping) that commodity prices rebound may be disappointed.

4.- Monstrous derivatives exposure

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The notional value of derivatives in the global financial system is around $630 trillion. To put this in comparison, the value of global GDP is $77.3 trillion. Whilst $630 trillion is a huge number, it does overstate the dangers lurking in the global derivatives market. The notional amount does not reflect the assets at risk in a derivatives contract trade. According to the BIS (Bank for International Settlements), the gross market value of the global OTC derivatives market is $20.9 trillion (close to a third of global GDP).

5.- Not enough is being done to prevent global warming

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And finally, the scariest chart of the lot. Global greenhouse gas emissions continue to increase, putting further pressure on the environment. The OECD estimate that greenhouse gas emissions will increase by more than 50% by 2050, driven by a 70% increase in carbon dioxide emissions from energy use. Energy demand is expected to rise by 80% by 2050. Should this forecast prove accurate, global temperatures are expected to increase by between 3-6 degrees Celsius. This is expected to alter precipitation patterns, melt glaciers, cause the sea-level to rise and intensify extreme weather events to unprecedented. It could cause dramatic natural changes that could have catastrophic or irreversible outcomes for the environment and society.

From an economic perspective, the main problem with attempting to reduce carbon emissions is that the developed world must find a way to subsidise developing nations to adopt (more expensive) renewable energy technologies. This could cost hundreds of billions of dollars. Developing countries argue that the developed world should bear the brunt of any emission cuts, as emissions per capita in richer nations are higher.

Fortunately, there are actions underway to attempt to limit the increase in greenhouse gas emissions. Eighty one global companies signed a White House-sponsored pledge to take more aggressive action on climate change. Later this year, France will be hosting “COP21/CMP11”, a United Nations conference aimed at achieving a new international agreement on the climate in order to keep global warming below 2 degrees Celsius. And for the innovators, there is a $20m carbon X prize on the table for anyone who can develop technologies that will convert carbon dioxide emissions from power plants and industrial facilities into valuable products, like building materials, alternative fuels and other everyday items.

Opinion column by Anthony Doyle, M&G and bondvigilantes.com

China Explained

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¿Qué le pasa a China? — CC-BY-SA-2.0, FlickrPhoto: Skyseeker. China Explained

The Chinese economy is in a transition phase as it works through the competing needs of growth, reform and deleveraging. Many of the country’s engines of growth are not firing as strongly; the export sector has been losing competitiveness for a number of years under the influence of rising wages and a strong currency. Meanwhile, investment expenditure is being held back by growing local government debt burdens and Communist Party officials scared to act because of the anti-corruption crackdown.

As a consequence, economic growth is being dragged southward. Concerned that growth is too weak, the government has announced that it will increase fiscal expenditure to boost activity levels.

Economy and policy driven by competing needs

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But none of this is new to us − what is new are signs of change in the reform agenda. In 2013, the relatively new President Xi embraced market forces with welcomed initiatives such as the Hong Kong-Shanghai Stock Connect, which facilitates cross-border share trading, and promoting development of a bond market to reduce the reliance on banks for financing.

However, weakness over recent months in the stock and foreign exchange markets have been met by government intervention, aimed at supporting markets with measures including compelling brokers to buy stocks and prohibiting major shareholders from reducing their holdings. There has also been indirect intervention, for example imposing additional reserve requirements for banks when hedging renminbi for clients, with the aim of reducing speculation in the currency−essentially a mild form of capital control.

Policy pro-reform, action anti-reform

In theory, the reform agenda continues, but in practice the government’s actions are reflecting the Communist Party’s unwillingness to give up control, by exercising considerable financial muscle to influence the market forces it should be embracing. This is an important change and warrants close monitoring as it impacts the attractiveness of China to foreign investors.

Currency weakness is a new phenomenon

The liberalisation of the foreign exchange mechanism in China, with the aim getting the renminbi accepted into the International Monetary Fund’s Special Drawing Rights (reserve currencies basket) is subjecting the currency to market forces. Early indications are that the government will utilise its vast foreign currency reserves to support the renminbi. However, as a consequence, this will cause a contraction in domestic money supply, which may undermine efforts to boost the economy with fiscal stimulus. It may also provide a window that encourages rich Chinese to take money out of China. These reasons strengthen the argument for a weaker renminbi.

Foreign investors have been used to a relatively strong Chinese currency. The renminbi was pegged to the US dollar from 1994 to 2005 and has appreciated in recent years − so currency weakness is a new headwind for overseas investors.

Summary

These developments mean it will be imperative to monitor government actions as much as policy rhetoric, while investors will be dealing with a new dynamic of a weaker Chinese currency. In the meantime, as China’s economy muddles along we believe the best approach is to continue investing in the strongest, best managed, cash generative businesses that stand to benefit as China’s economy transforms. One positive from this point of view is that owing to the macroeconomic pessimism, many of these companies are currently trading on attractive valuations and we will continue to seek to take advantage of this on behalf of investors.

Charlie Awdry is China portfolio manager at Henderson.