Updated: May 18, 2022
From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.
This investment outlook is particularly hard to write. The world’s two largest economies, the US and China, are at critical junctures. While, the US is arguably much closer to the end of its business cycle than the beginning, as evidenced by unemployment that has been falling for six years and that has just recently hit 5%, China is undergoing a pronounced and persistent structural slowdown, as evidenced by plummeting industrial metals, iron ore and bulk shipping prices. Throw in the conundrum of low or negative real long-term interest rates, bloated central bank balance sheets, widespread wealth and income inequality, the impact on growth and inflation of the internet, the shift away from fossil fuels, aging populations, financial sectors in the developed world that remain huge and complex, and over-indebted private sectors, and you have an investment strategist’s nightmare – how on earth to make sense of everything?
"With market shrinkage on this scale it is no wonder than Japanese corporate investment is so weak"
My framework for thinking about markets and asset classes has a medium-term element and a long-term element. The former is based around the business cycle while the latter attempts to assess the aforementioned structural trends in order to form an opinion as to whether the world economy will grow or stagnate over the longer term (I think it will grow).
With respect to the business cycle I try to keep things simple, looking ostensibly at the unemployment rate in a particular country. This works better in developed countries where cyclical rather than structural forces dominate. In the US, for example, the unemployment rate has exhibited significant regularity over the last fifty or so years (chart 1).
The yield curve also tends to be a good leading indicator of growth – all five recessions in the US since 1975 were preceded by an inverted yield curve and not once did an inverted yield curve not ad to a recession (chart 2).
Correctly predicting recessions can help add substantial value to the performance of multi-asset funds from time to time (at business cycle extremes) given the strong link between recessions and inflation and thus bond market performance on the one hand and between recessions and corporate profits and thus equity market performance on the other. This is what our tactical asset allocation framework at Seneca seeks to do.
One third of the global economy on a purchasing power parity basis is accounted for by the US and China. Furthermore, between them, they accounted for 82% of global nominal growth over 2014-5.
As far as the overall world economy is concerned, it still appears to be operating below capacity, as can be seen in chart 3. Although the IMF output gap for advanced economies has risen since the crisis as should be expected, it is still -2%. This suggests there remains considerable scope for the global economy to recover and we are thus some way off from the point at which central banks will need to consider restraining growth rather than supporting it.
Employment in the US has been rising now for the best part of six years. The previous three expansions saw employment rise on average for 6 years, so on the face of it, it appears we should be nearing the end of the current expansion. The unemployment rate has fallen to 5%, which compares to trough rates during the last three cycles of 5%, 4% and 4.5%. Surely the current expansion is running out of steam?
If one looks in more detail at the employment data, one can reach a different conclusion. The number of employed as a percentage of the working age population has indeed been rising but not by much. During the global financial crisis, the percentage fell from 63.0% in June 2007 to 58.3% in December 2009. In the years since, it has retraced just 21% of the previous decline, and currently stands at 59.3%. And yet the unemployment rate has fallen all the way back to 5%, retracing 90% of its previous increase.
The explanation lies in the fact that the workforce as a percentage of the working age population (known as the participation rate) has been declining sharply (see chart 4). Some of this decline is due to demographic factors such as the aging population but not all of it. Many left the workforce because they gave up looking for work. What this means is that the economy in the US can continue to improve without putting upward pressure on wages, as supply of labour is boosted by people re-joining the workforce. This means that inflationary pressures should remain benign for some time, allowing the Fed to maintain an accommodative monetary policy – interest rates may rise but they will almost certainly remain low.
That said, there is no doubt that some parts of the US economy are struggling at the moment. The strong dollar has put pressure on manufacturers while the sharp decline in the oil price has led to a contraction in the oil and gas sector. The question is whether weakness in these areas of the economy will cause weakness more broadly.
I think not.
America’s economy is big enough, deep enough, and strong enough to absorb the pain. It should be remembered that services account for 80% of the US economy. If anything, contractions in manufacturing and energy sectors should be considered part of the process of creative destruction, with freed up labour getting employed in other, higher value-added areas of the economy.
This optimism, at least as far as the economy is concerned, is supported by yield curve data. As can be seen in chart 2, although the yield curve has fallen over the last 5 years, it is still well above zero, standing currently at 1.2% (recall that the yield curve falling below zero tends to indicate that a recession is not far off). During the last two cycles, it took 6 years and 2 years respectively for the yield curve to fall from 1.2% to below zero, suggesting that the next recession is some way off.
Of course there are other factors that complicate the picture. It is possible that with interest rates close to or at the zero bound, the yield curve is less useful as a recession predictor. Furthermore, the tapering of asset purchases by the Fed constituted a de facto tightening of monetary policy, so while we have only just seen the first increase of the Fed Funds rate, this hides the fact that monetary conditions have been on a tightening path for some time. This is illustrated in the chart below, which shows the actual Fed Funds rates along with what is known as Krippner’s shadow rate. Leo Krippner is a member of the research team at the Reserve Bank of New Zealand and he devised a method using:
“bond option pricing techniques to formally model the value of the option for investors to hold physical currency at the ZLB (zero lower bound). That enables an estimated “ZLB/currency option effect” to be removed from the observed yield curve data, leaving the “shadow yield curve”; i.e. a hypothetical yield curve that would exist if physical currency was not available.”
I don’t understand it either, but conceptually one should be able to grasp the idea that it must be possible to measure the effect of quantitative easing in terms of an effective interest rate below zero. Looking at chart 5, one can see that the effect of QE from 2008 to 2012 was to take the effective short term interest rate from zero to around -6% (note that this is a rate that cannot be observed, only felt). The tapering of asset purchases that was announced in the middle of 2013 has seen the shadow rate rise back to close to zero, and it is thus entirely logical that this is the point at which the Fed would raise the actual Fed Funds target rate.
The point is that if one uses the shadow rate rather than the actual rate, we have already seen a rise in short term rates similar to that seen from 2004 to 2006 that arguably precipitated the fall in the housing market and in turn the GFC.
As it happens, I don’t think we are very close to the end of the tightening cycle, for the reasons mentioned earlier with respect to the labour market, but I would imagine the end of QE makes things less predictable than would otherwise be the case.
While it is pretty clear that the fall in the oil price has been supply driven, with the Saudis playing a high stakes game of trying to drive out higher cost producers by turning on the taps, it seems the fall in industrial metals and iron ore prices is demand driven, with China principally to blame.
It is now well understood that China is in a transition phase, as its one dimensional growth model based around building stuff financed with bank credit reaches its limits. What it transitions to and how smoothly it does it are still unclear, but the shift has certainly caused a lot of pain in commodity producing countries such as Australia, South Africa, and Canada.
The strengthening of the US dollar has not helped matters, given the renminbi’s link to the greenback, and while headline GDP growth is still a very respectable 6.9%, there are suggestions that things could be much worse – how I wonder can electricity consumption be growing only at 0.6% year on year if the economy is growing at close to 7%? The fact is that it is very hard to get a good understanding of what is going on in China. For a country with GDP per capita of just over $8,000, China’s money supply is off the scale (see chart 6).
Although China’s shift away from manufacturing is evident in manufacturing PMIs that have been hovering around 50 for some time – a level that indicates neither expansion nor contraction, services PMIs have remained well above 50, though admittedly have been on the decline (chart 7).
Aside from the shift away from steel and concrete towards services and consumption, there are other important changes afoot in China. The collapse of Macau casino revenues is an indication that president Xi’s anti-corruption drive is biting, while reforms of China’s welfare system are ongoing, a good example of which is allowing migrant workers access to education and healthcare. While it remains to be seen whether China can make this transition smoothly, I suspect such change is more easily achieved in a command economy like China’s.
Europe and Japan
The two developed countries and regions where growth has been most elusive are Europe and Japan. As can be seen in chart 8, growth in Japan and Europe has been noticeably lower than in the US and UK. In Japan’s case this is because of severe demographic headwinds. The government forecasts that the country’s population will fall from around 128 million currently to 86.7 million in 2060 (figure 1).
Furthermore, the number of people aged 20-64 is expected to fall from 75 million to 41 million over the same period. With market shrinkage on this scale it is no wonder than Japanese corporate investment is so weak. Indeed this severe structural headwind is what is behind (or in front of!) prime minister Shinzo Abe’s so-called ‘three arrow’ reforms. Indeed, while the long-term outlook for Japan’s growth is not so good, the reforms are providing opportunities for the more innovative and nimble companies to get ahead of the more sleepy incumbents. Japan may not be interesting from a top-down perspective but that does not mean there are not interesting bottom-up opportunities.
Europe’s problems have also been structural but not demographic. Growth prospects have been weighed down by politics and the lack of reform with respect to the region’s banks, as well as high interest rates in Europe’s periphery. Nevertheless, recovery is now firmly in place, if some way behind the likes of the US and the UK. 10 year yields in the periphery on average are now close to 3% (chart 9) while employment conditions across the region are steadily improving (chart 10). Though the unemployment rate has fallen from just over 12% in 2013 to 10.7% currently, it is still high and still far above the pre-crisis low of 7.2%. This means one thing: monetary policy will remain very loose for some time to come.
As can be seen in chart 8, the UK’s economic performance has almost been on a par with that in the US. Growth since 2010 has averaged 2.1%. While this is lower than pre crisis growth of around 3%, it is nonetheless better than growth across the channel or in Japan. Bank of England governor Carney has conceded defeat to his adversary (or is it colleague?) across the pond in the race to be the first to raise interest rates, and it now seems that a rate rise in early 2016 is off the table. Inflationary pressures remain benign: although core inflation has been rising, at 1.2% year on year it is still well below the central bank’s 2% target.
As for the yield curve, it has fallen from the 3% post crisis level but is still steep at just over 1%, suggesting that growth momentum can be maintained for the foreseeable future (chart 11).
Asset class and market views
There is very little if any long-term value in developed government long bonds, with real yields either very low or negative (chart 12). However, this does not mean that in the short term they cannot perform well, before the long-awaited bond bear market finally begins. The trigger for good performance over the next year or two would be widespread global recession that would cause inflation to fall and real yields to fall even further.
However, I do not think this scenario likely, given that monetary policy across the developed world remains very stimulative. While the plunging oil price is no doubt causing a great deal of pain among higher cost producing companies and countries, on balance I think it is a net positive for the global economy. With inflation, real yields, and credit risk all at very low levels, and governments and their central banks providing a great deal of support, the risks would appear to be on the upside (for yields).
In sum, we continue to steer clear of developed sovereign bonds, though accept it may be a little while yet before this position really starts to work for us. That said, one can clearly see that there has already been a change in trend with respect to the performance of government bonds (chart 13). Pre-crisis, the DB Global Government GBP Hedged bond index in real terms was generating trend returns of around 4% per annum. Since 2009 however, this trend rate has fallen to 0.8% per annum. The drag of an underweight position is falling considerably.
High yield bonds
As can be seen in chart 14, high yield bond spreads had been nudging up since the first half of 2014, before rising sharply in recent weeks. Most of the pain has been felt in the US energy sector as a result of the strain being put on shale producers by the falling oil price. However, there has been some spill over, with yields in other sectors as well as in Europe also affected.
Given my view that the global economy will continue to grow this year, these higher spreads represent good buying opportunities, though we would continue to avoid the energy sector in view of the fact that the Saudis are unlikely to capitulate with respect to oil supply.
On the face of it, there appears to be a rather worrying decline in corporate profitability as measured by return on equity (chart 15). However, dig a little further and one finds the decline is concentrated largely in one sector: energy. Over the last four years the return on equity of the MSCI World Energy sector index has fallen from 17% to -3% (this helps explains why the oil and mining heavy FTSE 100 index has been such a poor performer this year). As can be seen in chart 16, the profitability of the consumer staple sector has been pretty stable in the 17-20% range.
As for global equity valuations, they remain very reasonable, and indeed have become even more reasonable in recent weeks. On both a price-to-book and dividend yield basis, the MSCI World index is on the cheap side relative to history. Sure, valuations are well above where they were at the depths of the crisis, but they are still below historic averages (chart 17).
As far as dividend streams are concerned, there are no obvious signs that they are overstretched. In the US, dividends per share have been growing at a decent pace since 2010, and indeed as can be seen in chart 18 have been keeping pace with the index (or is it the other way round?!) It should also be noted that over the last 50 or so years, dividends in the US fell only during the more recent bear market, and even then the falls were concentrated in one sector: financials.
As for the UK, dividends have also been growing at a reasonable pace since 2010 and if anything, as can be seen in chart 19, have been outpacing the advances in the market (dividend yields have risen).
Perhaps the starkest illustration of the decent value that is now offered by UK equities, at least in relative terms, is how the equity dividend yield compares with the real long bond yield. While the equity market’s dividend yield has undulated in the 3-5% range over the last 20 or so years, the real long bond yield has fallen from 4% to -1% (chart 20). For those who argue that one should subtract the inflation rate from the dividend yield, recall that Gordon growth says that the future market nominal return is equal to the dividend yield plus nominal dividend growth. The future real return is the dividend yield plus real dividend growth. In other words, inflation gets subtracted from the growth part not the yield part.
Finally, a mention of UK mid-caps (the UK equity portions of our multi-asset funds have a strong midcap bias). As can be seen in chart 21, midcaps in the UK have performed extremely well in relation to their large cap peers over the last two decades (the margin is around 4% per annum). Given the prospects of continued accommodative monetary policy and an economy that continues to improve, the prospects for midcaps remain decent. Indeed we think that our funds’ exposure to midcaps is one of our key differentiating factors. Not only would we expect midcaps to continue to outperform large caps over the longer term, but the subsector also provides better stock picking opportunities, given the thinner research coverage.
Published in Investment Letter, January 2016
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.