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.
CC-BY-SA-2.0, FlickrPhoto: Camilo Rueda López. Countdown To Brexit: What You Need To Know
Tomorrow, Britain will vote on whether or not to leave the European Union. Given the deep economic ties between Britain and the EU, “Brexit” would have implications across the global economy. “Before we understand the implications, it’s important to establish that Britain is an open economy actively involved in the global economy and heavily intertwined with the EU. Here’s what that looks like”, explains Colin Moore, Global Chief Investment Officer at Columbia Threadneedle in the firm´s Global Perspectives Blog.
Britain’s EU membership
Britain joined the EU in 1973 and is now one of 28 current member states. Nineteen of these share the euro as a common currency, accounting for around three quarters of EU gross domestic product (GDP). Britain is not part of the common currency and continues to use the British pound. The existence of the British pound with a floating exchange rate has given the Bank of England an array of policy options to manage the shocks to which Britain’s economy is subject.
The sizable impact of Britain’s role in the EU
While we may not be able to measure the precise impact of EU membership on Britain’s economy, it can demonstrate the interconnectedness of Britain and the EU. The following is extracted from the EU membership and Bank of England Report, published October 2015. British pounds have been converted to U.S. dollars based on an estimated exchange rate of 1.42.
Population
505 million people live in the EU, approximately 7% of the world’s population.
Britain is home to 12.5% of the EU’s population, the second most populous EU country.
Economies
EU is the largest economy in the world with GDP worth £11.3 trillion (approximately $16 trillion) in 2014, which is larger than the U.S. ($15 trillion).
Within the EU, Britain is the second largest economy.
The U.K. GDP was worth £1.8 trillion (approximately $2.6 trillion) in 2014, nearly one-sixth of EU output.
Cross-border trade
One-third of all global trade is with the EU, the largest exporter and importer in the world.
The EU is Britain’s biggest trading partner.
The U.K.’s exports and imports are worth 60% of its GDP.
70% of Britain’s largest import and export markets are fellow EU members.
The EU serves as the destination for or source of more than two-fifths of Britain’s cross-border investments.
Britain is one of the top destinations for foreign direct investment (FDI) within the EU and globally.
Two thirds of all global cross-border investment involves the EU.
Foreign investors own £10.6 trillion (approximately $15 trillion) of U.K. assets while U.K. investors own £10.2 trillion (approximately $14 trillion) of foreign assets.
The EU has one of the world’s largest financial service sectors, second only to the U.S.
The EU is home to 14 of the world’s 30 globally systemically important banks (GSIBs) versus eight for the U.S., and accounts for half of all global exports of financial services.
Britain is the largest financial center in the EU, with financial services accounting for 8% of Britain’s national income.
The British financial sector is heavily interconnected with the rest of the EU, with 80 of the 358 banks operating in Britain headquartered elsewhere in Europe.
A long goodbye
Global Chief Investment Officer at Columbia Threadneedle reminds that even if the referendum passes, a decision to leave the EU will not be effective for two years after a formal notice to leave is issued by the British government. The time between vote and exit would be critical to untangle the myriad of interconnections and negotiate new agreements. Agreements on trade, people movement, investment and financial services are important to both Britain and the EU. They are also important to the global economy.
Bottom line
“Overall, it is clear that a post-Brexit world would have its challenges. Only time will tell how the world reacts if Britain decides to leave the EU, but this is a global event not just a British or EU event. Many financial markets are at or above fair value and any disruption to growth would be cause for concern. In the event of market disruption caused by the vote, investors should keep in mind that an exit from the EU is not immediate and the required changes would take years to see through”, concludes Moore.
CC-BY-SA-2.0, FlickrPhoto: Hendrik Dacquin. European Equities Supported By Continued Earnings Recovery
Despite the bumpy start to the year in global equities, Investec has not changed its fundamental view for a recovery in European corporate earnings, and it remains cautiously optimistic about the outlook for European equities.
As Figure 1 indicates, expliains Ken Hsia, portfolio manager at Investec European Equity Fund, European companies have not seen the same recovery in their ROE as their US counterparts. And despite seeing a drop in the ROE of the MSCI Europe in recent months, largely due to declining returns from the resources sector, we believe they should continue to close the gap. “While increased instances of consolidation across some industries has helped to unlock cost synergies, merger & acquisition (M&A) activity in Europe has been slow compared to the US”, points out.
Furthermore, as a net consumer of oil, says, Europe is set to bene t from lower global commodity prices and this tailwind should help to support a gradual recovery in the European economy.
Those are current investment themes in the Investec European Equity Fund:
1. Global winners
Investing in Europe means investing in European expertise and not countries. Europe is home to many world class companies with strong competitive advantages, which we believe give them strength in any global economic environment.
Pernod Ricard SA – As the second largest spirits company in the world, they have strong market positions. This, coupled with the aspirational nature of its product portfolio, has led to strong returns.
2. Exposure to Europe and seeing less competition
Country reforms in recent years have provided a strong basis for stability in the region. We are seeing European exposed companies gaining more market share as consolidation across some industries has helped to unlock cost synergies.
Michelin – Second-largest tyre manufacturer in the world that is undergoing an ef ciency programme to boost returns. Additionally, demand for SUV tyres, which have better margins, is on the increase.
3. Knowing what to avoid
Investec constructs its portfolios from the bottom-up, as such we are able to selectively capture investment opportunities. This adaptable nature also means we are able to avoid challenged industries, enhancing the potential to outperform.
“While our bottom-up portfolio construction process allows us to avoid challenged industries. It also means we monitor good European companies that are becoming cheaper due to current market environments”, concludes Hsia.
CC-BY-SA-2.0, FlickrPhoto: 401(K) 2012
. SEC Approves IEX Proposal to Launch National Exchange
The Securities and Exchange Commission on Friday approved Investors’ Exchange LLC’s (IEX)application to register as a national securities exchange. At the same time, the Commission issued an updated interpretation that will require trading centers to honor automated securities prices that are subject to a small delay or “speed” bump when being accessed.
“Today’s actions promote competition and innovation, which our equity markets depend on to continue to deliver robust, efficient service to both retail and institutional investors,” said SEC Chair Mary Jo White. “A critical role of the Commission’s regulatory framework is to facilitate the ability of market participants to craft appropriate market-based initiatives, consistent with our mission to protect investors, maintain market integrity, and promote capital formation.”
IEX must satisfy certain standard conditions specified in the Commission’s order before it is able to begin the process of transitioning its operation to a national securities exchange, including participating in a variety of national market system plans and joining the Intermarket Surveillance Group.
The Commission’s interpretation applies to the Order Protection Rule under Regulation NMS, which protects the best priced automated quotations of certain trading centers by generally obligating other trading centers to honor those protected quotations and not execute trades at inferior prices. Under Regulation NMS, an automated quotation is one that, among other things, can be executed immediately and automatically against an incoming immediate-or-cancel order.
The Commission’s updated interpretation determined that a small delay will not prevent investors from accessing stock prices in a fair and efficient manner consistent with the goals of the Order Protection Rule. In doing so, the Commission interprets the term “immediate” under Rule 600(b)(3) of Regulation NMS as precluding any coding of automated systems or other type of intentional action that would delay access to a security price beyond a de minimisamount of time.
Additionally, Commission staff issued guidance concerning the duration of the de minimis intentional access delays. The staff guidance states that delays of less than one millisecond are at a de minimis level.
Within two years of the Commission’s interpretation, staff will conduct a study regarding the effects of any intentional access delays on market quality, including asset pricing and report back to the Commission with the results of any recommendations. Based on the results of that study, or earlier as it determines, the Commission will reassess whether further action is appropriate.
CC-BY-SA-2.0, FlickrPhoto: Steven Lilley
. Premia Global Advisors Named to 2016 Financial Times 300 Top Registered Investment Advisers
Premia Global Advisors has been named to the Financial Times 300 Top Registered Investment Advisers, as of June 16, 2016. The list recognizes top independent RIA firms from across the U.S. Premia Global Advisors is a member of Dynasty Financial Partners’ Network of Advisors.
This is the third annual FT 300 list, produced independently by the Financial Times Ltd. in collaboration with Ignites Research, a subsidiary of the FT that provides business intelligence on the investment management industry.
The “average” FT 300 firm has been in existence for 22 years and manages $2.6 billion in assets. The 300 top RIAs hail from 34 states and Washington, D.C.
More than 1,500 pre-screened RIA firms were invited to apply for consideration, based on their assets under management (AUM). Applicants that applied were then graded on six criteria: AUM; AUM growth rate; years in existence; advanced industry credentials of the firm’s advisors; online accessibility; and compliance records. Neither the RIA firms nor their employees pay a fee to The Financial Times in exchange for inclusion in the FT 300.
The FT 300 is one in a series of rankings of top advisers the FT produces in partnership with Ignites Research, including the FT 401 (DC retirement plan advisers) and the FT 400 (financial advisers from traditional broker-dealer firms).
CC-BY-SA-2.0, FlickrPhoto: KMR Photography. Old Mutual AM Acquires Majority Stake In Landmark Partners
Old Mutual Asset Management (OMAM) has reached an agreement to acquire a 60% equity interest in Landmark Partners, a global secondary private equity, real estate and real asset investment firm.
The cost of the transaction amounts to around $240m in cash with the potential for an additional payment based on the growth of the business through 2018. The deal is expected to close in the third quarter of 2016.
“The overall investment is expected to result in a purchase multiple of 8-10x economic net income generated by the Landmark transaction, prior to financing costs,” OMAM specified in a statement.
OMAM said it intends to fund the closing payment using available capacity on its existing revolving credit facility or may seek alternative sources of debt financing depending on market conditions.
The firm expects the transaction to be up to 12% accretive to 2017 ENI per share.
“Landmark is precisely the kind of industry leader with whom we seek to partner,” said Peter Bain, OMAM’s president and CEO.
“The depth and breadth of their management team are exemplary and we look forward to collaborating with them to grow their existing product set and further diversify their business into emerging secondary asset classes. Our global distribution team is excited about bringing Landmark into certain domestic channels as well as new markets outside the US”, points out Bain.
Founded in 1989, Landmark has completed over 500 transactions for a total amount of $15.5bn since its launch. The company has acquired interests in over 1,900 partnerships, managed by over 700 general partners. Landmark operates through locations in Boston, London, New York, and Simsbury, Connecticut.
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.
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.
Photos: Old Mutual's Conference in Punta del Este, Uruguay. Old Mutual: "The High Levels of Political Risk Are the Key Driver behind the Pessimistic Sentiment in the Market"
The second Old Mutual Global Investors investment conference in Latin America began in mid-May. On the 12th and 13th of May, Chris Stapleton, Head of Distribution in Americas, Andrés Munho, Head of Sales in Latin America, Florida and Texas, and Santiago Sacias, Regional Manager in Southern Cone, met with more than 60 investment professionals from Uruguay, Argentina, Chile, Colombia and Peru, in Punta del Este under the banner “Global thinking, Local understanding”.
Following an overview of the capabilities and strategy of the British fund management company, a discussion panel among the five fund managers attending the event, was moderated by renowned Uruguayan economist Michele Santo. Major themes for the evening were China, the stimulus policies of the European Central Bank, market sentiment and its divorce from fundamentals and political risks which threaten markets with the arrival of Bréxit, as well as the presidential elections in the United States.
The first round of questions began with concerns about the continued low oil prices and a weaker dollar, and how these two factors could have affected the Chinese economy. Josh Crabb, Head of Asian Equities and Principal Portfolio Manager at Old Mutual Pacific Equity and Old Mutual Asian Equity Income, commented that the fact that oil prices remain low is positive for Asia: “The fact that oil prices have stabilized at these levels is also important because investors use the price per barrel as a measure of risk. As per the US dollar, whatever happens with the path of rates in the normalization process, I believe this is already taken its toll in the market and that investors have adjusted for that. If you go to Indonesia and India, you can pick up the best part of 10 cents bond yield around the world, as pretty impressive as it is in Brazil, and I think, once you start seen currency stability, people are going to start chasing those yield down again”.
Ian Ormiston, fund manager at Old Mutual European Smaller Companies (Ex UK), added his insight into the behavior of oil following interviews with the management teams of oil service companies: “Because we have a very deep deflation in the cost curves, decisions have been deferred. One of the companies with whom we met last week is very confident that they will see a sudden recovery in the projects, but at the same time they are telling their clients that they may get the same project next year 20 % cheaper. So as I putted to the company’s CEO, ‘if you can get it a 20% cheaper, why not do that?’ to what I really received no response.” Ian is confident that the industry related to shale oil will recover if the oil price continues to strengthen; and he believes it is conventional crude oil which will face more challenges, once it reaches a threshold where there is a risk of delay in project margins.
What is the outlook for the Chinese economy?
On returning to the China issue, as a major player in the global economy, Josh Crabb revealed the two factors which in his opinion are most relevant in order to understand what is happening in the Asian giant’s economy: “Ironically, not as much is happening in China as people think. I think the reality is everything happens at a much slower path that people gives a credit for. From my perspective, there are a couple issues to consider: the first is the currency, let’s put what actually happened into context, we had a currency that was pegged to the dollar. Chinese authorities announced that, going forward, the Renmimbi would be linked to a basket of currencies, but did not really specify what currencies would make up this new basket, the only two options were the yen and the euro, both of those currencies depreciated suddenly, authorities made a one-time adjustment, and the whole world panicked.” Josh is confident that from now on, greater communication by the Chinese government will provide more clarity and intra-day variations, so this problem will disappear with time, now that the levels of speculation in the yen and the euro have drop off.
Josh Crabb’s second concern is the real economy and the excess credit perceived by a large part of the market’s participants: “Many people believe that the Chinese economy is back to a debt driven disaster because they are only looking at the credit data, but considering how credit works in China, where banks receive a quota on how much lending they can do over the course of a year, if they can lend at the beginning of the year or at the end of the year at the same interest for the whole year, the more likely is that they are going to try to lend at the beginning of the year, and as a result there is seasonality at the beginning of the year, and then comes back off again “. In relation to where the government’s stimulus measures are being directed, Josh insists that it’s not being spent on building ghost cities or bridges that lead to nowhere, but on real projects: “The stimulus is being directed at things as simple as metro systems, and the question that arises is, ‘how many metro systems can be built?’ That is because people do not appreciate that there are 190 cities with a population of over one million people in China, which involves the construction of 190 metro systems, a very significant figure”.
Another factor that is changing Chinese society is concern about pollution, five years ago nobody cared, they are now more aware about the high levels of pollution and require large investment amounts.
The subject of the conversation then changes, beginning a discussion regarding the return of high levels of volatility to markets, Justin Wells, Investments Director on the Global Equities team, who is involved in the management of the fund Global Equity Absolute Return (GEAR), a Market Neutral strategy that is the one flagship funds of Old Mutual, among other strategies,commented: “One of the areas which is more difficult to understand when assessing the environment in which we invest, is the fact that North America has seen the highest levels of volatility according to our indicators; and the greatest deal of pessimistic sentiment, a fact which is contrary to the economic growth embedded in that great nation, in that great economy. There are a lot of strange things happening in the markets today.” For Justin, this volatility has returned to stay for a while, but the positive side is that it can create opportunities for the active investor, which is the approach that his team is taking for the forthcoming months ahead.
ECB’s Purchasing Program
As for the effectiveness of the latest measures announced by Mario Dragui, Bastian Wagner, the fund manager who, along with Christine Johnson, makes the investments decisions on the structure of the Old Mutual Monthly High Yield Bond, expresses his opinion on the market reaction to the European Central Bank’s purchases program, which includes the purchase of corporate bonds: “I think the market was quite surprised by the magnitude of purchases announced with the new measures. When you think about it, the most challenging part will be to buy between 3 and 5 additional trillion on top of established government bonds purchases every month. They explicitly expressed that they wanted to buy investment grade debt denominated in Euros and up to 70%, which represents a large amount when taking into consideration that 5 billion Euros represent almost 2% of the all eligible market.”
Bastian refers to the generalized narrowing of spreads in the investment grade bond markets, but mentions that the effect on speculative grade bonds will be greater. He also points out several issues that have yet to be answered, such as what the effect of a new rate cut may be on the real economy, and what would happen if any of the bonds purchased by the European Central Bank loses its investment grade.
Meanwhile, Huw Davies, co-manager for the Old Mutual Absolute Return Government Bond fund said to be quite impressed with the ECB’s performance: “We believe that the program of the European Central Bank is aggressive and most likely to work. We have already seen some of these effects in falling unemployment rates, which really were at very high levels”.
Complementing previous opinions, Ian Ormiston pointed out that it is important to mention that, for the first time, the Central Bank recognizes that there is a problem in the European banking system, particularly within the Eurozone: “The negative interest rates are compressing spreads and are causing issues for the banks. It’s good that it is good that they now are talking about it, because the debilitation of bank credit is probably the biggest problem in Europe”.
Investor sentiment and divorce from the fundamentals
When asking Ian about the sentiment of the management teams of the companies in which he invests, the divorce between investor sentiment and fundamentals rapidly arises: “It’s amazing the way it is evolving. Especially, when comparing the first quarter reports to the end of year reports three months earlier, a time when CEOs were not providing guidance or giving very cautious guidance. Then the market fell, influencing the opinion of those who thought that Europe was heading back into a recession.”
Ian Ormiston mentions the case of the French economy as a symptomatic case of the entire European economy. In which most investors talk about France as a country which will never grow, and for which bad sentiment is developing due to the lack of proposals for economic reforms by the French government: “Just when everyone had given up on France, its economy begins to grow, fantastically, but not dynamically. Many equities basically reflected no growth at all; but growth is starting to come back. In France, one of the biggest impediments for growth are the labor laws which have really affected large companies. While small companies can more easily hire and fire, they can also help large companies by providing them with employees who are not necessarily included in their payroll.”
Meanwhile, Bastian Wagner compares the differences between the European and US markets, amongst which there is a curious divergence. While during the past four years the United States has seen significant activity in projects of M&A (mergers and acquisitions) and private equity; in Europe, this activity has either decreased or remained flat. “In Europe, we have not seen many private equity firms entering the market, making purchases, or with big M&A operations, which is a sign of lack of confidence. Which raises the question of whether the ECB’s measures are sufficient for the company directors to sit and decide whether an investment project should be executed, or whether maybe we need to go a step further, and the government should provide confidence to the private sector.”
But this lack of confidence doesn’t only occur in developed markets, Josh Crabb comments that sentiment towards emerging markets has been quite pessimistic for a long period of time, so that current valuation levels are very low. “Current levels are as low as they can be in a world without crisis. So, in that respect, they are quite negative, but the interesting part comes when we consider the positioning in stock. During the last six months we have seen that commodities stocks rallied a 100% to 200%, we have seen markets like Brazil which, with the wonderful news of the ‘impeachment’, rallied 50% in the course of three weeks. And most investors have missed it, which is a clear indicator of how extreme the sentiment is, therefore, a simple little event which makes the current situation somewhat less bad, can really change the market.”
Crabb also adds that perhaps it’s time for fiscal policies to begin to step in. In his opinion, fiscal policy tends to benefit emerging countries and obtains better results for the majority of the population by redistributing wealth.
As for the political risks facing the markets, Huw Davies believes that it’s unlikely that the UK exits the European Economic Community. For the fund manager, much of the risk of that event has manifested in the currency, the sterling pound. As the date of the consultation approaches, the strategy in which he participates will be distancing their exposure to the event, as it is an event of a binary nature. As for the US presidential elections, he admits to not having a sure bet: “Six months ago nobody imagined that Trump would get the Republican nomination, currently everything looks possible.”
Finally, Justin Wells refers to the role that these events are playing in terms of market sentiment. “All regions where we have positions are in pessimistic sentiment territory, the higher levels of political risk are the key driver behind that.”
CC-BY-SA-2.0, FlickrPhoto: Russ Oxley. Old Mutual Global Investors Strengthens Absolute Return Government Bond Team With New Hires
Old Mutual Global Investors, part of Old Mutual Wealth, announces that, as a consequence of a difference in opinion regarding future strategic direction, Russ Oxley will leave the business with immediate effect. Old Mutual Global Investors would like to thank Russ for his valuable contribution in supporting the launch of the ARGB capability.
Adam Purzitsky and Paul Shanta have been appointed Co-Heads of the Absolute Return Government Bond team, reporting to Paul Simpson, Investment Director.
Adam and Paul joined Old Mutual Global Investors in early 2015 along with the other members of the ARGB team. They have been instrumental in the management and development of the Absolute Return Government Bond strategy over the last seven and eight years, respectively.
Old Mutual Global Investors also announces the enhancement of the ARGB portfolio management team with the appointment of two highly experienced investment professionals, Mark Greenwood and Peter Meiklejohn. Both Mark and Peter have already made valuable contributions to the ARGB team during the time they have been working alongside the team as consultants. These appointments bring the total number of portfolio management professionals working on the ARGB strategy to six, supported by two additional specialist investment professionals.
Supported by the rest of the team, Adam and Paul will continue to co-manage the Old Mutual Absolute Return Government Bond strategy. Their focus will remain on meeting clients’ expectations and delivering the outcomes and investment journey clients expect. Adam and Paul were among the first members of the team to join Old Mutual Global Investors, and were instrumental in the pre-launch preparation, as well as actively managing the strategy since launch in October 2015. The managers will continue to employ exactly the same investment process and philosophy that they have been at the heart of developing over many years.
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:
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.
