September 2013 - What risks lie ahead?
With the summer days now firmly behind us, most of us would agree that it hasn’t been a particularly quiet and uneventful summer. Quite the opposite ! August was all about Emerging Markets (EM) assets entering into crash-mode as capital outflows accelerated in high currentaccount deficit countries like India, Indonesia, Turkey and South-Africa. If that wasn’t enough, expectations of military intervention in Syria pushed oil prices significantly higher throughout the month, while monetary tightening in the US has started to bite into the housing market recovery.
September is also shaping up to be a busy and potentially volatile month for financial markets: the Federal Reserve will hold a crucial meeting on September 18th, during which we believe it will announce a first ‘tapering’ of its asset purchases by $10bn (all of it in US Treasuries, so as not to disrupt the mortgage market, following the 100bps back-up in mortgage rates since May). Markets are all but pricing in a September ‘tapering’ scenario. A potential surprise could come from a larger than expected tapering decision (>$20bn) or from a tapering delay to December 2013, for instance on the back of a much weaker than expected US payroll release this Friday (less than 150,000 jobs created might be the trigger for that). Our bet is on a September tapering.
More importantly though, we will watch out for the Fed’s new rate forecasts for 2016, which will probably be centered around 2% - far below the long-term equilibrium rate for Fed funds over time - but in line with an economic recovery which remains sluggish and the lingering risk of disinflation
German elections will be held on September 22, which will be a decisive event for future European economic policymaking. Campaign talk from the Merkel camp has already indicated that Greece will need a third bailout. That didn’t come as a surprise to anyone.
Outside of politics, Europe is showing increasing signs of recovery through the manufacturing sector and thanks to monetary policy which continues to have a very calming effect on peripheral sovereign bond yields. As mentioned in our previous newsletter, we continue to like European assets in our global allocation, both in equity and credit, as a play on further recovery from the Old Continent.
The dramatic fall we saw in a number of EM currencies during August will continue to stay on our radarscreens during September. EM has clearly suffered the most from the Fed’s annoucement in May to look for an exit to the Quantitative Easing program. The heavy sell-off is pushing EM central banks to react with capital controls (India) or with rate hikes (Brazil, Indonesia). This may temporarily stop the bleeding but we continue to feel that these assets have not repriced enough yet to provide for an attractive investment opportunity. Be it EM local or hard currency bonds, EM equities or EM FX – there will be further pain as interest rates continue to normalize in the US and these countries’ balance of payments will continue to worsen. India’s high dependence on foreign oil imports, coupled with a rising oil price due to the Midle East standoff, is just one aspect of the equation that will continue to weigh on the Indian Rupee going forward.
With all of this in mind, we have not altered our asset allocation significantly going into September. We feel comfortable that the increase in bond yields since May is a healthy adjustment process after 5-years of exceptionally easy monetary policy. This policy is at the very beginning of its unwind phase, as the world economy shows enough signs of being able to stand on its own.
As mentioned in our previous publications, we think that credit markets and bonds in general will have a difficult time adapting to this new world of lower liquidity from the US. Consequently, we refrain from investing in long duration, illiquid assets with little compensation for interest rate risk.
Equities on the other hand are more attractively valued, are still under-owned by the entire investment community and offer the highest risk premium vs. other assets. Despite the upcoming risk events mentioned above, we continue to recommend a preference for equities vs. all other assets. Our stock-picking is highly selective and is focused on companies and sectors looking to benefit from an ongoing recovery in the US, further stabilization in China’s growth, monetary stimulus in Japan and a confirmation of Europe’s exit from recession.
What will it take for us to change our views and reduce our equity overweight:
1) the US housing market recovery showing further signs of stalling, following the sharp increase in US mortgage rates
2) China’s GDP growth dropping below the 7,5% treshold
3) Return of sovereign stress on peripheral european yields
4) Crisis in EM assets deepening, leading to more significant outflows
5) Oil price spike beyond $130/barrel endangering world growth
A high degree of volatility across financial markets is likely to persist throughout the end of the year as we transition into a ‘new normal’ of a less expansionary Fed. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.