THE WORLD economy continues to muddle along at a pedestrian rate of growth. For equity investors this has been a “Goldilocks” scenario – not too hot to worry about higher interest rates, nor too cold to be concerned about profitability.
For bond investors, the lack of inflationary pressures at a global level, and the likelihood of further monetary easing in Europe, has exerted downward pressure on bond yields. Meanwhile, geopolitical concerns rumble (sometimes loudly) in the background; while tragic at a human level, events so far have not had a major economic impact at a global level.
The euro zone has found itself at the centre of attention with regards to economic developments. Two of the bloc’s three largest economies – Germany and Italy – posted negative quarterly growth in the second quarter, while the second largest, France, was stagnant but nevertheless quashed hopes of modest growth.
Inflation in the region has continued to drift lower (to 0.3 percent year on year) and further away from the European Central Bank’s (ECB’s) mandate of just under 2 percent. Long-term market expectations have dropped below this target, as noted by ECB president Mario Draghi at the recent Jackson Hole economic symposium.
Accordingly, expectations have grown for the central bank to implement further monetary easing in addition to the pre-announced liquidity injections to be introduced this month. The most likely starting point will be outright purchases of asset-backed securities and we expect something to be announced on this front within the next couple of months.
The probability of the ECB engaging in large-scale purchases of government bonds has increased, although it may require further disappointment in terms of growth or inflation beforehand given the ECB’s reluctance to go down this path.
On the other side of the Atlantic, US economic data have been robust and consistent with decent, if unspectacular, growth. Second-quarter gross domestic product (GDP) growth was revised up to 2.5 percent year on year. While views vary on the extent of slack remaining in the US labour market (and US Federal Reserve chairwoman Janet Yellen’s Jackson Hole speech is a good summary of the debate), there is little argument that conditions are improving.
As such, in our view, the Fed remains on course to end quantitative easing (QE) next month and lift interest rates around the middle of next year.
The pace of US interest rate increases is likely to be gradual. Even so, the contrast between central bank policy next year in the US and Europe will be stark.
This divergent outlook for monetary policy is already manifested in the widest spread between US and German 10-year yields since 1999 (Figure 1), as well as the recent strength of the dollar against the euro. We believe this trend of euro weakness will continue against a broad basket of currencies.
Sterling may be caught somewhere in the middle of this crossfire. Recent UK growth has been impressive and we expect the Bank of England to raise UK interest rates in the next three to six months.
However, if we are right that the euro is likely to weaken against the dollar then it may be hard for sterling to buck this trend, although we do expect sterling to outperform the euro. Over the coming years, we expect the UK rate cycle to be more gradual than that in the US. UK households are more sensitive to short-term interest rates than their American counterparts due to structural differences in the two countries’ mortgage markets.
In the US, long-term fixed rate mortgages dominate the market, compared with the UK, where mortgages are predominantly either variable rate or fixed for relatively short periods (of two to five years). The movement in policy rates therefore has a much greater direct impact on UK households than those in the US.
In emerging markets, growth expectations have been fairly stable in China and India but there have been notable downgrades in Russia, Brazil and South Africa.
The Chinese property market continues to slow, representing a significant downside risk to the economy, although the authorities in the near term seem to have been successful in propping up growth with a series of mini-stimulus measures.
In India, a considerable burden of expectation rests on Prime Minister Narendra Modi’s shoulders in the wake of May’s resounding election victory but the reform process will inevitably take time. In the meantime the Reserve Bank of India is taking a prudent approach with regards to inflation as a shortage of monsoon rains and a possible cyclical recovery pose potential upside risks to prices.
From an asset allocation standpoint, we remain overweight in equities. It is worth outlining the reasons why we continue to favour equities in spite of their considerable appreciation over recent years.
While equity valuations have increased they are not yet at prohibitively elevated levels. Figures 3 and 4 plot the forward price:earnings and price:book value ratios for global equities. In absolute terms, these valuation multiples are not extremely high. It is true that US equity valuations look more elevated, especially on cyclically adjusted measures.
Even so, the main alternatives (bonds and cash) offer very low or negative prospective real returns, as shown in Figure 5, which plots a cyclically adjusted US earnings yield against real yields on US treasuries and cash. The recent lurch lower in global bond yields increases the attractiveness of equities versus bonds on relative valuation grounds.
In the current environment, where the available yields on competing assets are extremely low, it is very plausible that equities are bid up to “expensive” valuations to a point where prospective equity returns are likely to be lower in the future. In the interim, however, equity markets may continue to provide respectable returns as investors search for potential return in a low-yield world.
Of course, if corporate profits disappoint significantly over the coming year or if there is a sharp rise in the rate at which future profits are discounted then equities will be vulnerable to declines. We have to acknowledge that there is less of a cushion today than there was a year or two ago.
Our central macro view for the coming year, however, is for solid global growth, which should support corporate revenues and profits due to operating leverage.
We believe US growth will be robust, driven by income growth resulting from employment and wage increases; improving consumer and business confidence; a multi-year housing recovery; and reduced fiscal tightening.
European growth is more fragile, but we anticipate a gradual recovery to continue. Easier financial conditions, reduced fiscal tightening and a weaker euro should gradually take effect.
Emerging market growth will be dominated by China. Ultimately, China is trending towards slower growth and the authorities face considerable challenges rebalancing the economy. While consensus expectations for next year may be too high, we still believe solid Chinese GDP growth is achievable. We are also optimistic that Indian growth will accelerate from here.
If our base case view on global growth is correct, should we perhaps be worried about higher interest rates, especially if central banks have inflated asset prices with cheap money? While this is a concern, it is not yet sufficient for us to justify an underweight position in equities.
First, monetary policy is becoming desynchronised around the world. This is illustrated by the Fed looking to terminate its QE programme, while the ECB contemplates further stimulus. A co-ordinated, global tightening cycle is very unlikely at present.
Second, inflationary pressures remain contained. The world economy has suffered from a shortage of demand, not supply, despite hopes for stronger growth this year. This explains why the largest economies are struggling to deliver sufficient inflation to match central bank targets.
Third, if we are right that inflation will only rise modestly, then interest rates will only rise more rapidly in the event of much stronger than expected global growth. This would be an environment of stronger corporate revenue growth, providing fundamental support to equities.
So, even though valuations are higher than they have been in recent years, we still believe equities remain more attractive than cash or fixed income, where returns are likely to be very low going forward.
These views do not suggest an irresponsible attitude to risk. We are acutely aware that no one has perfect knowledge of how the global economic system functions and that unexpected events will occur. One possibility would be a dramatic worsening of geopolitical events, with developments in the Ukraine a particular concern, as well as various conflicts across the Middle East. But there are many other risks, some of which are foreseeable and others that are not (the “unknown unknowns”).
We remain alert to the risk that our central view does not transpire and look at ways to mitigate the possible downside risk to equities. For that reason, we hold partial put protection against our equity holdings and monitor the relevance of this strategy constantly.
We see little value in the government bonds of developed markets. We did not expect the downward moves that have occurred so far this year, which we believe have resulted from general growth disappointment and a global pull exerted by lower European yields.
Given where yields sit currently (the five-year German bond yields just 0.17 percent) Germany’s bond market looks unattractive, in our view.
We continue to see better returns from select emerging markets such as Mexico and India and corporate bonds (specifically in high yield), although we recognise that corporate spreads have narrowed substantially, thus limiting potential returns.
For our Multi Asset Cautious, Balanced and Aggressive funds we maintain exposure to property via a diversified holding in real estate investment trusts in developed markets.
In these funds, we also hold a small position in certain specific UK environmental energy and infrastructure assets, which we believe will deliver solid real returns with low levels of risk.
Tristan Hanson is the head of asset allocation at Ashburton Investments.