After a month of calm in July, August has been very bumpy, with nerves rising over the strength of the global economic recovery, a potential change in the Federal Reserve’s policy and capital flight from emerging market economies.
Performance of indices July – Sep 2013
Source: FE Analytics
They say that one swallow does not make a summer; well a raft of mini-crises certainly ruins ours. When one adds uncertainty over corporate earnings, the likely outbreak of a worldwide geopolitical event in Syria and seemingly endless flashpoints in the eurozone to the mix, it is understandable that markets have swooned in the summer sun.
I find it hard to believe that I am about to say this, but clearly the global economic recovery has become even more confusing over the last few months. The US, which was reassuringly strong, has seen some questionable data over the last few weeks, particularly from the housing market. Europe is improving and the UK is undeniably strong at this point in time, which will help compensate for the US slowdown.
Chinese growth has also been more resolute over recent weeks than the bears were roaring it would be, while useful leading indicators, such as Korean exports, have started to gather momentum.
Japan has slowed from early Q2 and clearly more help is needed there, which we expect from the Abe administration when the diet re-opens in September.
In short, the economic recovery remains boring, below-par, bumpy and brittle, but there are still enough positive signs for our forecast that the global economy could return back towards trend growth at some point in 2014. However, before we can be certain, we need clarity on a number of factors, which I will aim to address below.
Change in US monetary policy
The waves of summer volatility were first triggered by the US Federal Reserve’s hints in May that it would start to taper its bond purchases at September’s policy meeting.
This in effect let the cat out of the bag and global financial markets quickly moved to price in a new trajectory of policy: bonds fell, yields rose, equities wobbled and money started to flow from the emerging markets and back to the US dollar.
However, there surely now have to be some doubts over whether the Fed will actually start to wind up QE in September, particularly given the rise in mortgage rates and slowdown in housing activity.
This "will they, won’t they" discussion has become the investment world’s most boring but sadly important debate. Our weekly held view is that they will taper in September, as to backtrack now would undermine confidence even further.
However, markets have definitely moved too quickly to price in rate hikes, which we don’t see happening until 2016 at the earliest. This loose monetary policy is vital to keep the economy moving, credit flowing, mortgage rates under control and confidence high.
If the Federal Reserve messes this up and communicates its path unconvincingly, then we could be in for a rocky few years. The fact that it seems that Larry Summers, a supposed anti-QE economist, is about to take over at the Fed muddies the water yet further. The great debate continues…
The "great deceleration" in emerging markets
As you will know from previous missives, we have been surprised by how poorly emerging market assets have performed on a relative and absolute basis over the last year.
Performance of indices over 1yr
Source: FE Analytics
This has led to plenty of opportunities for long-term investors, but patience will be required.
Over the last week, my team and I have held five conference calls with our emerging market managers to try and ascertain whether what we are seeing in ASEAN and India is a mini re-run of what we saw in the Asian financial crisis of 1997. Thus far, we have been relieved to hear that nobody believes that it is.
However, it would be naïve to suggest that the capital flight we are seeing from markets like India and Indonesia is anything but negative. Drastic action is required by the affected Asian central banks.
We should note that we have no exposure to ASEAN or Indian equity markets. As long as the recent events are not the prelude to a major crisis, which at this point we don’t believe is the case, then emerging market assets are broadly cheap and have great potential to recover.
Our central view is that investors have swung the sentiment pendulum to negative too aggressively. However, we will be watching ongoing developments hawkishly and are ready to act accordingly. It is worth noting that our investments in China have recently recovered very well from their distressed valuation levels at the end of Q2 as the country has amazingly become considered a "safe haven".
The Syria crisis
We always say that it is very hard to prepare investment strategies for events such as the unfolding human tragedy in Syria. We also cannot add a huge amount of insight to what you will have all heard and read in the media.
However, diversification is helping soften the blows that are hitting markets caused by the threat of a military strike, with gold, the US dollar, US Treasury bonds, the oil price and energy company shares all gaining strongly over recent days.
If the Syria crisis spirals out of control, which is possible, and creates further shockwaves in the Arab world, then holding the aforementioned assets will be very sensible.
The never-ending eurozone story
Amazingly, Europe has fallen in the list of worries that are plaguing investor sentiment, but it is not something we should totally dis-regard, given the political issues in Italy, the fact that another bailout is required in Greece, perennial debt issues in Portugal and a structural lack of growth in France.
However, we are more positive on the wider eurozone growth outlook, as there seems to be a tacit approval of austerity reduction and we believe that Angela Merkel and her coalition will get the victory they desire at next month’s elections.
While we are not as optimistic as some, who believe that Merkel’s win will open the German liquidity taps to flow to the Med, we are more positive than the many bears who claim that there is no hope for the eurozone.
Things are gradually getting better, if admittedly from a low base, and we are seeking to increase our exposure to eurozone equities, which are undoubtedly cheap relative to the US.
Equity valuations/corporate earnings
There are definitely question marks appearing about the relaxed attitude of analysts towards US corporate earnings as this year progresses. The last reporting season was patchy, with only the financial sector really surprising to the upside.
Analysts still expect earnings growth of close to 10 per cent in Q4, which we find difficult to marry to the global economic situation.
US equities to us look expensive, with the S&P 500 trading on 15x earnings. We are also concerned about the incessant flow to "safe" US equities and the uniformly optimistic consensus.
Globally, the corporate results season was solid, if unspectacular. From a valuation perspective, Europe is much cheaper than the US on times earnings and we believe that earnings in the region should recover in the coming years.
Broadly the same rationale applies to Japan, where we believe that investors are too obsessed with the currency and ignoring the long-term earnings growth potential of Japan.
There is an obvious valuation opportunity in emerging equities, as companies across the emerging world are trading at a material discount to the US and other developed markets, ignoring the possible growth of these companies’ earnings.
Our views are contrarian, but we feel confident that value, both from a regional and a sector standpoint, will start to work powerfully in the coming years.
