Investment Outlook 11.2015
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
CHINESE HARD LANDING FEARS BANISHED
In October markets calmed noticeably and risky assets enjoyed a significant rebound. European and Japanese equity markets outperformed with the DAX rising 12.3%, the EuroStoxx50 10.2% and the Nikkei 225 9.7%. The S&P500 rose 8.3%, the Chinese Hang Seng index 8.6% and Emerging markets 7%.
European government bonds rallied on the back of a dovish ECB with 10Y Bund yields declining 7 basis points. Meanwhile US bonds sold off and 10Y Treas-ury yields rose 11 basis points. In line with the risk-on environment, credit spreads — especially of high-yield and emerging markets bonds — tightened.
The USD and the GBP strengthened in October, driven by diverging central bank policies. The Chinese CNY strengthened somewhat after the devaluation of recent months. The Swiss franc rose slightly vis-à-vis the EUR.
Gold rose in October by 2.4% compared to end of September, reaching a peak in mid-October at about 1,185 USD/oz, started a marked decent thereafter and currently trades at about 1,090 USD/oz. Oil rose slightly by about 1% in October, while industrial metals fell by about 3%. As discussed previously this is a result of growth concerns but more importantly the outcome of large structural supply surpluses.
At its 22 October meeting the ECB left rates unchanged. However, president Draghi’s comments that the ECB would reexamine the degree of stimulus in December, were interpreted by many as a possible hint that the ECB could consider accelerating its bond-buying program. As a result, the EUR fell sharply after the announcement.
At its 28 October meeting the Fed unsurprisingly left rates unchanged. In its statement the Fed highlighted soft inflation and slower growth but also said that labor-market slack has diminished since the beginning of the year and that the housing market has improved. As a result, market participants were divided about the odds of a December rate hike. After strong Labor market data in early October, however, the market-implied probability of a rate hike increased significantly.
Meanwhile, at its 7 October meeting the Bank of Japan left the tempo of its quantitative easing program unchanged, thus disappointing 42% of the economists taking part in a Bloomberg survey who had expected additional quantitative easing measures
The US ISM manufacturing index fell further to 50.1 from 50.2 in September. Non-farm payrolls rose by 271,000, the strongest increase this year and clearly exceeding expectations. This pushed the unemployment rate down to 5% from 5.1%. Average hourly earnings also increased. The Markit European composite PMI rose to 52.3 from 52.0 in September and confirmed that Europe-an growth dynamics remain intact. The Japanese PMI also climbed sharply from 51.0 to 52.4, its highest level since October 2014 in its sixth consecutive month of expansion. The Chinese Caixin manufacturing PMI also rose clearly from 47.3 in September to 48.3, but it re-mains in the contraction zone below a level of 50.
Is the equity bull market coming to an end?
This is the question investors globally are most concerned about, especially since the current equity bull market, which started in March 2009, is in its seventh year and is thus the third longest on record. Only the bull markets in the 1950s and 1990s lasted longer. This question is, in our view, related to three major equity market drivers, which we think are the following:
1. Earnings growth, which is strongly related to the economic cycle. As a rule, the stronger the overall growth dynamics, the greater the earnings potential for corporates.
2. Central banks’ reflationary policy, which is designed to make risky assets more attrac-tive. Central banks provide ample liquidity and push interest rates to zero – and in ex-tremis, as seen in recent months, sometimes even below zero – to encourage corporates and investors to invest and take on more risks, which should boost economic activity.
3. Valuation of equities, which determines re-turns expectations. Obviously it is harder to gain positive returns when equities are al-ready very expensive. In extreme situations, when valuations are excessively high, we may classify this as a bubble, which can lead to serious losses.
Let’s have a look at the current situation regarding all three of the above-mentioned factors. Global growth, after the depression in 2008, has been slow to pick-up. Excess capacity and huge leverage had to be reduced and many would argue that the process is still ongoing. As part of the de-leveraging operation, governments took on a lot of bank and other debt, which resulted in the sovereign debt crisis of 2012 and 2013. However, the combination of ultra-expansive monetary policy and slow economic growth has prevented overheating and led to a steady development in most equity sectors, with by and large healthy corporate balance sheets. This environment is especially friendly for corporate credit but also for equity markets in general. As a result, earnings growth is steady but not stellar, which provides the ground-base for a longer lasting expansion.
Despite the fact that the Fed is starting to reduce its monetary support, central banks globally remain very expansive and we do not see signs of economic overheating. As a result, it is possible and likely in our view that the current benign market environment is here to stay. Down-side risks clearly remain and need to be watched. A hard landing in China is certainly one of them.
As mentioned above, we think that monetary expan-sion will continue for the next couple of years. While there is a certain risk that markets will be disrupted by the start of the Fed hiking cycle, history shows that a hiking cycle is usually a positive environment for equity markets. Also, it is very likely that the Fed is moving very gradually to prevent the USD from rising too strongly. Low and negative bond returns make equities very attractive, especially on the basis of relative valuations. Very often dividend yields exceed equivalent bond returns.
With regard to absolute valuations, equity markets do not look overly expensive historically. Admittedly, though, they do not look cheap either. There are, however, regional differences, which we would recommend taking into consideration. European, Japanese and most emerging markets look more attractive than US equities, as far as valuations are concerned. We certainly do not see bubble-like valuations at present.
As a result, we are still cautiously optimistic for equity markets but remain mindful of risks related to the start of the US hiking cycle and of growth risks, e.g. in China. Ultralow interest rates and continued reflationary policy will, in our view, support equity markets. Based on valuations we continue to favor European and Japanese equity and certain parts of the emerging markets.
We also continue to see value in credit, especially in high-yield and emerging markets. Break-even inflation has fallen to very low levels, which we think are unsustainable. As a result, we prefer inflation-linked bonds over nominal government bonds.
Given October’s upbeat labor market data and recent Fed statements, we expect the Fed to hike rates in December. Market-implied probability has gone up to 75% without disrupting equity markets, while Treasuries have sold off. This may be seen as an indication that markets are well prepared for the first Fed hike.
At the same time, the ECB and the Bank of Japan could accelerate their bond-buying programs. We see a higher probability for the Bank of Japan and a somewhat lower probability for the ECB.
The diverging monetary policies will favor the USD over the EUR and JPY, and we see further downside potential for the EUR-USD exchange rate. US Treasury yields will gradually move towards 3% in our view, and the Gold price is likely to fall below 1,000 USD/oz when real rates start to rise in the US.