Investors are once again scratching their heads. By the end of January equity markets around the world signalled the potential onset of much slower global growth. Bond yields in the US declined as investors accepted that inflation was not the number one risk. The dollar weakened and this set off concerns that the world had taken a further step toward competitive currency devaluations as a means to stimulate growth in the Eurozone and Japan, whilst emerging market currencies weakened on the back of a further deterioration in growth and capital structures. Just as anxiety levels reached a peak in mid-February, the Fed surprised the market by adopting a more dovish stance on future interest rate hikes. Equity markets responded positively in the belief that central banks would provide a new bout of stimulus whilst maintaining some level of co-ordination in terms of managing cross currency rates. The rally in equities coupled with a weaker dollar and marginally weaker US bond market suggests that the global macro environment is in a “safer” space as a result of renewed central bank intervention. But is the picture as simple as this?
As pointed out in previous reports, we believe the picture is far more nuanced. Commodity price declines over the past 24 months have not created the demand-led recovery typical of previous business cycles. Rather, the decline in prices has added to the deflationary environment as have poor levels of pricing power in retail markets influenced by tepid levels of consumer demand. In particular the very slow growth rate in credit around the world has meant that final demand has not picked up to anywhere near the levels seen in previous business cycles. What has flourished is asset price inflation driven by the very high levels of liquidity injected into the system over the past 9 years coupled with all-time low interest rates.
Cheap commodities have not sparked a fresh growth impulse in the major countries, and the global manufacturing sector is in recession. Many emerging markets have much higher levels of debt than they did in 2007 whilst the tension within the Eurozone in general and the banking system in particular – as linked to undercapitalisation – has not abated. Emerging markets are undergoing a high level of structural adjustment following a lengthy build-up. This keeps the risk of financial accidents elevated. Perhaps most importantly, there is a sense that investors have lost any remaining confidence that policymakers can do anything meaningful if there is another negative growth or financial shock as policy intervention has been pushed to the limit through a combination of negative nominal interest rates, currency adjustments and broad-based market interventions.
So why then have equity markets rallied when the outlook for earnings growth is fading in line with the macro-economic environment? Part of the answer lies in the degree to which the correction since August last year adjusted valuation levels to more attractive levels, particularly after adjusting for differing sector weights. Along with better valuation, it is constructive for equities that oil may be bottoming, the dollar peaking, and investor sentiment still skittish. Our sense is that a sustained market rally will require a turnaround in the earnings outlook, but the news is not great on that front. In the US the CPI report for January did not signal a general improvement in corporate pricing power. Estimates of global margins are still declining as are earnings estimates in nearly all regions and industries. Commodity prices and relative currency movements serve as a useful barometer of the degree to which pricing power is returning. Lower prices are positive to the extent that supply is the main driver, while the interpretation is much less rosy if weak demand is the culprit. On the demand side, the sluggishness in global capex has a large structural element to it, linked to the many years of over-investment in the sector. China, for example, is only just starting to address the structural oversupply in its steel and coal sectors. The challenge for the country is that some 25 million jobs are linked to these two sectors, with many regions almost completely dependent on those jobs for their economic survival. In addition many of the tailwinds that supported the commodity boom of the past 20 years have abated. Incremental commodity demand related to expansion in the global workforce will diminish significantly, implying that the commodity complex will face an ongoing demand headwind. Whether that headwind translates into even lower prices depends on the supply response. In the case of the oil market the deal to limit production by Saudi Arabia, Russia and Iran on its own will not generate a sustained price rally given the backdrop that still includes record global crude inventories. Nonetheless, the action taken creates the probability that oil prices will be higher on a 6-12 month horizon. This is because of the supply adjustment that is clearly underway in the U.S. shale sector as well as declines in production in the North Sea, Russia, Nigeria and Venezuela. It is a different story for base metals, where it will take longer for the supply response to put a bottom on prices.
European and Japanese policymakers are likely to drive short-term interest rates further into negative territory, and the FOMC will maintain a less-hawkish stance by revising down the ‘dot plot’ at its next meeting. These policy adjustments will help to mitigate the downside tail risks but will not make a significant difference to the base-case global growth and inflation outlook. Low bond yields alone are not enough to sustain an equity bull market. Support from earnings is also required. While we are not particularly negative on global growth, a world of depressed nominal income growth is a tough environment for companies because there is a limit to how far costs can be cut. Margins are likely to remain under downward pressure for a while.
The process of structural adjustment in both developed and emerging economies is likely to continue to impact on commodity, currency and interest rate markets for some time. In the event that something goes awry, the risk to investors is most likely to be reflected in the currency markets. Our biggest concern remains a dislocation in China or Brazil, where the magnitude of the debt build-up in China and the growth compression in Brazil could translate into a sudden and sharp devaluation of either currency. At this stage the sideways to slightly downward trend in the US $ has removed some of this risk but this could change quickly as a quarter seems to be a long time horizon in the world of macro-economics.
On the domestic front we note little to no improvement in addressing the key constraints to growth. Whilst Minister Gordhan delivered a most credible budget, the central policy directive remains inwardly focussed on preserving political status as opposed to running the country. This dynamic is likely to result in a downgrade of SA’s foreign denominated debt in June with a downward revision of government debt to just above “junk”.
Source: Tony Bell – KI, MiPlan; Fund Manager & CIO, Vunani Fund Managers