It’s hard to argue with 1st H 2017 returns. Global stocks& bonds are up; led by non-US equity and US/EM fixed income. Commodities have disappointed, with oil down and gold up. In FX land, the story has been muted USD weakness and Euro/EM strength. Global balanced benchmarks of publicly traded securities are up roughly 10%; private assets continue to see better inflows than performance. All in all, it’s hard not to just say that one will take more of the same thanks very much!
In fact that may be just what one should say (and expect in the 2H) but in order to feel comfortable doing so one needs to understand both the factors that have led to this point and what the 2H risks to such a stance might be. The Global Risk Nexus (GRN) framework remains the preferred way to analyze the interplay between economics, politics, policy & markets before concluding with portfolio implications.
THE GLOBAL ECONOMY - STEADY AS SHE GOES
The global economy remains on a gentle, broad based upswing across both developed and emerging economies, supported by still buoyant Central Bank provided liquidity, easy financial conditions, rising employment and benign inflationary conditions. The synchronized nature of the upswing & the lack of visible, large excesses in the global economy suggest this low growth, low rate, low inflation steady state can be sustained at least though year end absent a policy mistake.
Policy risk exists mainly in the US where the Fed is leading the globe’s Central Bank normalization charge. Other Central Banks in the news (ECB, BOE) are more smoke than fire. With its 4th & most recent rate hike, the Fed has brought the short-term rate structure close to underlying core inflation, a much more comfortable place for the Fed to be relative to a year ago. The Fed now has optionality; it can ease should a shock occur while the long end of the UST curve has absorbed the normalization process like a champ, thus reducing the risk to the real economy and financial markets.
The Fed should be feeling pretty good right now and thus is likely to go slow in regards to both future rate hikes and balance sheet normalization. The shape of the yield curve combined with the absence of the fiscal – monetary policy joint venture we expected this year makes such a careful stance all the more necessary. Even the IMF, in its recent downgrade to US GDP forecasts (2.1% this year AND next vs. prior 2.3% and 2.5%) noted the lack of progress on the fiscal side.
The other source of policy risk would seem to lie across the Pacific via China’s efforts to rein in its financial sector. For all the ink spilled on China credit crunch risk, the reality would seem to be a well-targeted approach allowing for the continuation of a near steady state of affairs with low inflation, decent economic growth, good profit growth, a stable currency (helped by a crackdown on outflows but still) and a growing number of globally relevant technology companies.
POLITICALLY SPEAKING, POLICY ACTING
The political action has been mainly US and EU led, something that is likely to continue though the 2H will include China’s important Party Congress. In the US, the Trump administration has clearly been of the “unmoored” variety rather than the “full bore” variety discussed in the 2017 Outlook piece (2017 Global Investment Outlook: America First? Dec 2016). Very little has been achieved in the First 100 days or since. A focus on repealing Obamacare has led to several months of fruitless activity casting tax reform and fiscal stimulus into the wind or at least into 2018.
It seems unwise to expect much from an understaffed (by choice) Administration, operating under a cloud of Russia related uncertainty and led by a President who is himself the focus of a special counsel investigation. To date, the surprise is that such an outcome has been just fine for US financial assets.
Examined from a Tri Polar World point of view however, all this US thrashing about means it is in danger of falling behind a revitalized Europe and a proactive Asia. The opportunity exists to deepen integration within the Americas by extending NAFTA to include South & Central America; unfortunately there seems little liklihood that such a forward thinking path will be adopted.
The political breeze blowing across Europe has whisked away worries about populism’s rising tide and replaced them with a sense that sunny days are here again. What a difference a year makes! Brexit is the bane of the British while the M&M team of French President Macron and German Chancellor Merkel strategize about how to best deepen European integration. Elections are forthcoming in both Germany and Italy; the German elections are being fought on who is more supportive of deeper EU integration while Italy should benefit from its best economic outlook in a decade or more.
The news in Southern Europe is also uplifting. A positive outcome in Greece together with a clean up of weaker banks in Spain and Italy suggest a positive policy tilt as well. The weak bank and NPL problems long bedeviling Europe are finally being faced. While sausage making is never pretty the outcome usually tastes pretty good and so it is the case here. European senior bank debt insurance is now priced at levels last seen in 2011, suggesting a Continental lifting of bank sector risk.
Europe’s robust economic recovery has occurred sans credit; cleaner, healthier, more consolidated banking systems should provide further leverage. Rates should rise, helping savers & banks alike. More needs to be done to clarify the bank resolution process and to develop a common deposit insurance process that will finally break the link between bank debt and sovereign credit. Yet, when viewing the Tri Polar World’s three main regions through a GRN framework, Europe stands out as having the most upside in the years ahead.
2H POSITIONING – PORTFOLIO IMPLICATIONS
Absent being cashed up and bearish, it was pretty hard to go wrong in terms of asset allocation during the first half of this year. Is the 2H likely to be the same?
One of the best pieces of research I have seen of late was a report noting that in past periods of limited S&P drawdowns (under 5%) in the first half of the year, 2H US equity results tend to be quite positive, averaging roughly 8% which is well above the average 2H return. In other words, low volatility begets more low volatility unless there is a shock to the system. This suggests one should look to add on pullbacks especially if they are driven by Central Bank concerns.
However, one should also focus on what those possible shocks could be. The most visible economic risks, a Fed policy mistake and a China credit crunch, have already been covered. Let’s add two more, an earnings shortfall and a Black Swan risk of war in the Gulf leading to sharply higher oil prices and a potential inflation shock. Of the two, an earnings shortfall is the more worrisome given the importance of earnings to global equity markets.
Earnings risk stems from the reliance on the easy comps generated by the energy sector’s recovery from last year’s oil price collapse. Oil, now down 20% from its recent peak and facing US inventory levels well above five-year averages, implies much tougher comps in the 2H. An additional concern revolves around the likelihood that CEOs reduce 2H outlooks given US policy inertia. A reduced pace of stock buybacks in the US provides another reason for concern.
One of the keys to understanding the current earnings environment is that capital is being rewarded more than labor, driven in part by the spread of disruptive technologies across more segments of the economy, which limits wage gains and arguably boosts earnings & financial asset prices. This is true in both the US and Europe where unemployment is at an eight year low but wage gains are running at roughly 1.4% pa. If wage gains were to rise sharply then profits would fall and interest rates would rise, neither of which would be good for risk assets.
The Black Swan risk of war in the Gulf is non trivial given the recent breakdown in relations between Saudi Arabia, its allies and Qatar, home to the US’s largest military base in the Middle East. At the very least, this crisis threatens the Gulf Cooperation Council (GCC) and illustrates why the Middle East is not an active part of the Tri Polar World thesis. Potential conflict risk also exists in the Korean Peninsula which has the potential to draw in the US and China.
The case for non-US equity outperformance vs. the US remains intact; an overweight position in non US DM equity should be maintained. An unmoored Trump Administration leads to policy inertia, C suite hesitation, earnings risk and a poor risk reward profile. In comparison, a revitalized Europe and recovering Japan both offer better earnings growth and more attractive valuation. The non-US equity markets remain in the early stages of taking global equity leadership from the US (From Fluke to Fact: Is the Anti Trump Trade Sustainable? April 2017).
A real question for US equities is where is the leadership to come from? Financials remain hostage to a slow rate rise environment while technology seems to be on the cusp of rolling over. US equity exposure should be concentrated in sectors where there is change at the margin such as Industrials (XLI) where a new cap ex cycle is getting underway or where performance has been muted such as Consumer Staples (XLP).
Europe’s positive news flow has been matched with equity market profit taking, a healthy state of affairs that sets the stage for another leg up in the 2H of the year. Broad regional exposure (EZU), country specific ETFs such as Spain (EWP) and sector specific ETFs like the banks (EUFN) all remain attractive. Banks will benefit from the NPL clean up, increased lending, rising rates and further consolidation.
An overweight European position has many supports: shrinking political risk, new impetus on bank cleanups, a large amount of economic slack, attractive valuation, powerful earnings growth and lack of investment alternatives (10 year Bunds yield .35%) all suggest a favorable risk reward profile. Sovereign bond yields should rise in Europe as political risk falls and the economic recovery deepens; stocks should see rising rates as supportive, especially in the bank sector. Euro strength, up 8% or so year to date, is far from worrisome levels (1.20 +). The ECB is likely to be very slow in removing its accommodation though an end to negative rates would be a plus.
Japanese equity also looks appealing. A 1st H laggard, due perhaps to a stronger than expected yen, Japanese corporates are undergoing a governance revolution leading to a greater focus on shareholder returns while benefitting from better global & domestic growth. Attractive valuation, underownership, especially by foreign investors and very strong earnings growth support an attractive risk reward profile. Hedged equity remains the favored way to allocate (DXJ) as the BOJ will remain very accommodative.
Emerging market equities have done well after a long period of underperformance. Within a neutral position, selectivity matters; favored markets remain Mexico (EWW) and China (MCHI). Mexico’s economy remains robust with great upside in the consumption story while political risk (elections in 2018) should not manifest in the near term. Corporate profit growth in China is running over 20% y/y, valuation is attractive, foreign ownership is light, the market remains well off its highs and its technology companies are becoming more and more important on a country, regional and global basis.
FIXED INCOME, FX & COMMODITIES
Within fixed income the focus remains on USD investments including High Yield (HYG), Preferred (PGF) and USD EM debt (EMB). The search for yield continues and is likely to remain in place through the end of the year and beyond. There is more demand for high yielding assets than supply, a condition that is also likely to remain in place for years to come. The Fed’s balance sheet normalization process is likely to be a very gradual and drawn out affair.
FX volatility has been near record lows supporting carry trades and local currency EM debt in particular. The Mexican peso for example is back below Nov 2016 level versus the USD. A gentle drift upward in the Euro and downward in the Yen should leave the USD range bound through year-end.
Within commodities, gold and silver (GLD, SLV) remain appealing given the black swan risks noted above. Oil seems caught between growing supply and slowing rates of demand growth. Technology & capital markets have combined to cause near term pain via US shale production while the longer-term case for autonomous electric vehicles suggests limited upside.
On the private side, the issue seems more capital than ideas. Little sticks out as attractive with PE firms sitting on a record $1.5T in dry powder, hedge funds underperforming and real estate buffeted by the changing nature of retail, the glut in high end residential and the copious amounts of capital looking to invest in the industrial space. Logistics remain interesting but small. Infrastructure suffers from having far more capital to deploy than projects to invest in, while private debt is likewise oversupplied with capital. Opportunities are more niche related, which is problematic for the large pools of capital struggling to make their targeted returns (Market Environment Driving Asset Owners to Revolution, April 2016).
One would like to have something punchier to say but… this time it feels different, it feels like more of the same.