February 2017 - The Cycle Reflates
Updated: Jul 10, 2018
Understanding where we are in the economic cycle is critical for making effective asset allocation decisions. While it may be impossible to accurately predict the exact level of future global growth, interest rates and inflation, knowing the path of their trajectories as a function of the current economic cycle is instrumental in the capital allocation process.
In this regard, we would like to focus our newsletter on a discussion of the state of the current global economic expansion and what differentiates this year from the start of 2016. We believe we are currently in the midst of a cyclical pickup to global growth following a recession in the manufacturing sector which bottomed out in 2016. The prelude to this inflection point was the collapse in commodity prices, deterioration in China’s growth momentum, and sustained declines in inflation and interest rates which fell to record lows in 2016.
The second half of 2016 witnessed the emergence of a regime shift within markets as a result of a pickup in the cycle, which was confirmed by the bottoming of yields on the U.S. 30-year Treasury bond on July 11 and set the stage for a reflationary pickup which characterizes markets today. The decision by the Bank of Japan on September 21 to reorient its monetary policy towards yield curve targeting at the expense of negative interest rate policy and automatic balance sheet expansion provided further momentum to the regime shift as it became clear global central banks would pay more attention to bank profitability and yield curve steepening to support growth. The election of Donald Trump on November 8 further accelerated these reflationary trends as the market turned its attention towards expansionary fiscal policy. Since his election, inflation expectations have picked up markedly across economies. The cyclical pickup underway has important implications for asset allocation.
Most importantly, it means that reflationary assets will outperform and supports our preference for equities over fixed income and credit over sovereign debt. It also sets the stage for higher inflation and rates. In the U.S., average hourly earnings rose 2.9% in December, their strongest gains since 2009. In the eurozone, headline inflation rose to 1.8% in January, the closest it has been to the 2% target of the European Central Bank since the first quarter of 2013. Inflation expectations have also picked up globally, rising to 1.4% in Germany and 0.6% in Japan over the next ten-years. In China, producer-priceinflation rose to 5.5% year-over-year in December, its highest level since 2011 making China a contributor, rather than detractor, to the global reflationary impulse.
We are positioning our portfolios for a continuation of this reflationary pickup and prefer equity markets which are more leveraged to the global cycle. In this regard, we believe Japanese equities will outperform on a currency hedged basis. Japanese equities are highly cyclical; according to Morgan Stanley, close to one-third of industrial profits are tied to exports while another third are tied to overseas operations. The fact that both monetary and fiscal policy are in expansionary mode should also benefit the Japanese share market as increases in government spending feed through to gains in inflation, especially in wages. The fact that Japanese equities continue to trade close to one-standard deviation below the MSCI World on a price-tobooks ratio makes the market attractive on a relative value basis.
European equities also look attractive given their cyclical orientation, the resiliency of the current economic recovery, expectations for a pickup in corporate profits against the backdrop of a weaker euro, and relatively attractive valuations. The eurozone is in a much earlier stage of its economic recovery relative to the U.S.; the current cycle is just ten quarters old compared to the average of 20 quarters. The fact that 45% of Eurostoxx 50 profits are generated outside of Europe means that the region’s equities should perform well against a synchronized global pickup. A steeper yield curve is also benefiting European bank shares, which are up 24.3% over the last three months and account for onethird of Eurostoxx 50 profits. While political risk is elevated, we believe a large portion of this is priced in as fund managers remain underweight European equities compared to history according to the Bank of America-Merrill Lynch Global Fund Managers Survey.
While we remain constructive on U.S. equities, we are maintaining our neutral positioning on account of elevated policy risk and relatively richer valuations. The S&P 500 has gained 6.9% since the election of Donald Trump and the markets are pricing in a prompt and successful implementation of a number of stimulatory policies including corporate tax cuts, major infrastructure spending, and regulatory overhauls. While we expect corporate taxes will be cut from the effective rate of 27% to 20% and boost earnings over the next 6-12 months, getting congressional support for the latter two will prove more difficult and are more likely to be 2018 stories than 2017. At the same time, U.S. equities are trading in their 90th percentile on a cyclically adjusted price-to-earnings ratio basis which augurs for more modest returns going forward.
Our stance towards emerging markets remains cautious in the nearterm but constructive over a medium-term horizon. We are principally concerned with the impact that protectionist trade measures and a stronger U.S. Dollar will have on emerging market equities, especially those with large U.S. Dollar denominated liabilities. On this basis, we prefer emerging market Asia given the region’s higher savings rates and a stronger external position making it more resilient to a stronger U.S. Dollar along with stronger economic momentum.
We continue to have a constructive view on U.S. high-yield, which delivered 1.3% in January.
2016 was likely an intra-cycle peak in defaults given the carnage in the energy and metals and mining sector that took place in the first half of the year. That said, U.S. high-yield spreads have compressed to 400 basis points according to the Bank of America-Merrill Lynch High Yield Index, making a repeat of 2016 highly unlikely in which the asset class delivered 17%. At the same time, a backdrop of stronger company earnings should support an improvement in balance sheets while earnings to interest coverage remains healthy at around 5x for the high-yield market. While we expect yields across the U.S. Treasury curve to rise through the year, some additional spread tightening along with coupon could produce returns of between 5-7%.
The reflationary theme will support risk assets in 2017 though we remain prepared for continued bouts of volatility. Europe has a jampacked political calendar including elections in Germany, the Netherlands, and France. In the U.S., policy uncertainty remains high and we await more clarity on issues related to tax reform and trade policy. Meanwhile, the process of interest rate normalization in the U.S. will generate additional volatility as the Fed responds to higher inflation.
The interplay of these market drivers should give rise to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation in credit. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally