Triggers For The Next Phase Of The Investment Cycle by Standard Life Investments
When a variety of economic, political and market factors give conflicting signals, it is important to examine the deeper fundamentals of the investment cycle.
Triggers For The Next Phase Of The Investment Cycle – A tug of war
Financial markets are at an interesting juncture. Global equity markets have been in a broad trading range over the last 15 months, interspersed by two episodes of considerable volatility in summer 2015 and spring 2016. Similarly, global bond yields have traded in a wide band, reflecting sizeable shifts in view of the growth and inflation outlook. Where next? The tug of war represents a complicated mix of economic,1 financial and political drivers: on one side are weak growth statistics and corporate cashflows (see Chart 1), expensive valuations for many financial assets and a rising political risk premium. On the other, are ever more innovative ways from central banks and governments to support the broader economy in general and financial markets in particular. Another way of expressing the sharp differences of view is by contrasting the rather low level of volatility in indices such as the VIX, with surveys suggesting that cash levels are high in investor portfolios. Accordingly, our House View continues to prefer to go up the capital structure and hold credit over other asset classes.
Analysing key drivers
2016 is expected to be another difficult year for the global economy. Growth was unusually low around the turn of the year, hence the spike in financial stress, although we expect that recent support from the Federal Reserve (Fed), the People’s Bank of China and the ECB should lead to a moderate improvement into the summer. While economic variables, such as current account balances, labor market slack and credit growth, do not generally show late-cycle characteristics, a number of financial variables, such as credit spreads or the shape of the yield curve, are flashing amber warning lights. How can we determine whether the next major phase of the investment cycle will be a recession in corporate earnings, or a surprising acceleration in company cashflows, or conversely a lengthy period of muddle through? This requires careful examination of key drivers, exemplified by the prospects for China, core inflation, the dollar, oil, politics and productivity.
Financial markets have suffered two sharp declines in the past year, triggered by growth concerns in general but worries about overly tight US monetary policy and Chinese policy errors in particular. Miscommunication about the Chinese government’s policy towards its equity and currency markets has broadened out to include questions over a series of issues: the lack of reforms of state-owned enterprises, the slowing pace of economic activity after a period of poor investment and the degree of deflationary pressures being exported overseas, steel for example. Looking ahead, two key triggers would be the efficacy of China’s recent turnaround in credit growth feeding through into better Asian trade data or, conversely, more signs that industrial profit growth in China has turned back down again.
The relationship between inflation and interest rates is more moderate than in the past, but it has certainly not disappeared. The Fed has made it clear that it will be cautious about raising interest rates aggressively in 2016-17, wary of the potential effect on the US economy or, via the currency, on the global economy. At present, markets are only pricing in interest rates 0.5% higher by end 2017 (see Chart 2). We expect more; the Fed’s hand should be forced as core inflation pressures begin to grow too strongly at this phase of the cycle, with a lower unemployment rate and rising unit labor costs.
Another area to analyze concerns the high correlations between oil prices and movements in a number of financial assets. The oil price plunge has mattered; in the first instance, markets priced in the negative news, for example from such factors as the cutbacks to capital spending. In due course, there should be a positive impact for certain consumer and industrial-related stocks as the improvement in real incomes or corporate margins from cheaper commodity prices feeds through into stronger consumption. So far that effect has been muted – as an example US consumer spending on durable items has been surprisingly weak in recent months despite the benefits of low gasoline costs and healthy disposable incomes. Stronger business and consumer confidence may be the trigger to allow savings ratios to be run down.
Supply/demand balances are at last improving in oil markets, but in general commodity trends link very closely with an important driver of risk-seeking behavior, namely the direction of the US dollar. The linkages between oil and the dollar are complex (see Chart 3), reflecting the increased ‘fictionalization’ of oil markets as well as the ways petrodollars are recycled into US assets and changes in different countries’ terms of trade. The Fed has clearly realized the importance of the US currency in transmitting policy tightening through the emerging market complex. A battle between expensive valuations and positions versus relative interest rate differentials is taking place for the next major move in the dollar.
Another factor which is likely to affect confidence and cross-border capital flows is politics, whether domestic, regional or geopolitical. A wave of issues require careful examination in 2016-17, including the UK’s Brexit referendum, Brazil’s impeachment proceedings, migration pressures within Europe, Middle Eastern conflicts, the US elections in November, and then French and German elections in 2017. A key issue to consider is how much good or bad news is priced in in advance of any of these events. Sterling would be a prime example, as it has fallen over 10% on a trade-weighted index since the start of the year.
All the triggers discussed so far have been cyclical. There are important structural issues which investors also need to analyze, especially relating to the slowdown in productivity and its implications for trend rates of growth in real incomes, corporate profits or GDP, and political responses. There are many potential explanations for the productivity downtrend, including a hangover from previous underinvestment, a technology boom that has run its course, regulatory headwinds, educational attainment or demographic trends. Whatever the rationale, there are two important conclusions. Firstly, that any government response, for example in terms of raising education and skills levels, will take years to have an impact. Secondly, the House View has to emphasize that this is a world of low numbers, whether sales or revenues, interest rates or borrowing costs, with all that implies for profit growth and valuations.
The House View
The House View assumes that policymakers will take sufficient action to forestall any material slowdown in the major economies, but also that they will resist the siren calls from some quarters for ‘helicopter money’ or similar expansionary policies which could lead to a major change in inflation expectations. Although central banks are calling for more supportive fiscal policy and structural reforms to drive activity, we doubt governments are yet in a position to agree. Accordingly, our portfolios are still positioned for a medium-term outlook of moderate but positive corporate cashflows, supporting in turn a focused approach towards risk assets. Following the recent bout of market volatility, corporate credit is attractively valued relative to government bonds and also remains an effective way to hedge equity exposure. Furthermore, the hunger for income – about 25% of the global government bond market now has a negative yield – and the possibility of ECB purchases of corporate bonds also support this view. Similarly, the House View continues to like global real estate in general and European commercial property in particular. More expensive areas, such as parts of the UK market, face a less favorable demand/ supply balance.
We expect equities to perform moderately well in this low growth environment, but to experience significant volatility, which may provide trading opportunities at various points in time. The good news for shares is that surveys of fund manager positions show relatively high cash levels and cautious levels of sentiment. The bad news is that equity valuations are not offering much room for error. Corporate earnings are coming under pressure from the weakness in top line sales growth; the consensus does not expect a strong recovery in S&P 500 profit growth until Q4 2016 – and that requires stabilization in the dollar and commodity prices, and wider net interest margins to enable it to come about. European prospects look better than other countries at this phase of the business cycle. The debate about a convergence between nominal bond yields and nominal growth rates remains as strong as ever. We favor European bonds, reflecting ECB support and regulatory-driven demand, and are concerned about the prospects for US Treasuries against the backdrop of modestly rising inflation and interest rates.
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