November 2016
(Merlea Investments)
Summary
As 2016 draws nearer to a close, all eyes will be on U.S. politics and policymakers. The voting public has had enough of apathetic politicians bearing false empathy. Politicians generally have been put on notice. Wednesday the 9th of November was therefore a great result for democracy, regardless of whether one is left or right.
Trump is apolitical. And with a clear mandate from the American people (for the first time since the early 1900s) the Republicans control the White House, the Senate and the lower House. Unlike Obama, Trump has no excuses not to get things done. Trump will challenge the establishment and shake it up, which is long overdue. I think for the markets, Trump will manage the US budget better, but this still won’t prevent higher rates of inflation which are going to surely follow next year and thereafter.
Therefore we anticipate the populist forces of discontent to spur a directional easing of U.S. fiscal policy over the course of the next year. Meanwhile, investors expect the Fed to hike rates for a second time, in December. Unlike during the Fed’s move to tighten in 2015, the global business cycle is in better shape to withstand the effects. With time, it’s possible that policymakers in Europe and Japan will move closer to the U.S. by providing slightly less monetary accommodation and slightly more fiscal relief. The mix of receding deflationary pressures, still-easy global monetary policies, easier fiscal stances, and underlying global cyclical stability would indicate a potential upside surprise in inflation.
Bonds
The rise in bond yields in recent months has removed one of the lingering supports for global equities, particularly given (as I have long noted) the fact that price-to-earnings valuations remain elevated and earnings growth is sluggish. With the Fed seemingly intent on raising rates in December – while the Bank of Japan and European Central Bank are still contemplating further easing.
The big question is, is the recent increase in bond yields the start of a new uptrend, or just a temporary bump in the road? It all depends on whether nominal growth and inflation are finally picking up. My guess is that they are, and that we have seen the yield lows-at least for now. So, with earnings and inflation picking up, we may have finally reached the moment where markets can withstand another rate hike as well as slightly higher bond yields.
Based on my fair value estimate for the US 10-year Treasury, we could see its yield move to 2% or more. As long as earnings growth picks up-even if only to the low single digits-the market should be OK. But if growth does not materialise, then yields can probably only rise so much before upsetting the delicate balance between growth and rates. Having said that, it’s looking more and more like Treasury yields have seen their lows for a while.
America
Donald Trump stated in his speech that “we are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure which will become, by the way, second to none and we will put millions of our people to work as we rebuild it.”
There is no reason not to believe him. Fiscal spending in the US is about to be substantially increased next year. As a result we would expect inflation and interest rates to follow on the upside. The next focus for the equity markets will be on the US Federal Reserve and the next interest rate hike. US inflation and wages have continued ticking up and until recently a December rate hike was very likely. We will have to wait and see whether this unanticipated Trump victory will have any bearing on their decision.
Looking into 2017, the US economy remains in good shape and should continue to improve at a moderate pace going forward. Growth is likely to be supported by the strong labour market, robust consumption and the continued recovery in the housing market. In general, there is still abundance of investment opportunities in the US but one has to be conscious that we are in the advanced stages of the business cycle, and at aggregate levels, margins are high and valuation multiples are not low.
Moreover, growing wages and interest rate pressures, combined with the still strong US dollar, could weaken margins in some sectors. It is important to be selective in the current market environment.
Europe
In early October we had a first taste of what a European Central Bank (ECB) taper tantrum might look like. A Bloomberg Markets story suggesting the ECB had started to consider how to gradually wind down its massive asset purchase program created a brief stir. The program will eventually end, but contemplating how to cease quantitative easing does not mean such a decision is imminent.
In fact, ECB rhetoric remains extremely dovish, highlighting the continued low rate of Eurozone inflation. Finally, the ECB doesn’t talk about it, but rising political risk will prevent any early stimulus withdrawal. Anti-immigrant populists have already dealt two punishing blows to the established political order in 2016.
But before the year ends, there are two more elections that could cause additional market turmoil. And they’re both slated to happen on the same day: Dec. 4. That’s when Italians will head to the polls to vote on a constitutional referendum, and Austrians will vote in a presidential runoff election where Norbert Hofer, the far-right Freedom Party’s candidate, has a shot at becoming the European Union’s first far-right leader . A victory by the “no” camp on the Italian referendum could trigger another sharp selloff in the euro as investors revisit the question of whether the shared currency can survive.
A victory for Hofer, meanwhile, would embolden European populists, who have several opportunities to upset the established political order when Germany, France and the Netherlands hold elections in 2017. Tapering is unlikely to become an issue until after the German elections next September or, more likely, after Italy’s May 2018 elections.
England
The British pound continues to weaken, the Bank of England continues to ease its monetary policy, and there is increasing talk of fiscal stimulus on the horizon. Yet the FTSE 100 Index-a benchmark of U.K. stock performance-is back at its old highs. So much for the conventional wisdom that Brexit would spell doom and gloom in the U.K. It also goes to show that stocks love reflation, no matter what the cost, and that the U.K. policy trifecta of currency devaluation, monetary easing, and fiscal stimulus could well become the model for other developed countries facing stagnating growth, aging populations, and excessive debt levels.
Japan
The Bank of Japan seems much closer to reducing asset purchases following its decision to switch focus from outright asset purchases to yield curve control. Yet maintaining the level of stimulus while buying fewer government bonds requires a strategy the bank has yet to formulate. Purchasing foreign currency denominated bonds is still probably the most effective way to achieve the bank’s goals, but so far decision makers have shied away from taking that step.
China
Improved economic stability in China has been a big part of the resilience we’ve seen in global equities lately. China has adopted the same policy trifecta that the U.K. is flirting with: monetary stimulus, fiscal stimulus, and currency devaluation.
The People’s Bank of China is funding the commercial banks, the government is in full-on deficit-spending mode, and China continues to allow its currency to slide, seemingly without any of the nasty contagion that was caused by similar-magnitude devaluations in August 2015 and January 2016. Driven by substantial fiscal policy stimulus and other easing measures, China is experiencing a broad-based pickup in economic activity.
Industrial production has recovered meaningfully since bottoming in late 2015, and industrial company profit growth has turned positive for the past eight months after declining through 2015. Additionally, producer prices in China rose on a year-over-year basis for the first time since early 2012, suggesting deflationary forces have receded. Mortgage lending restrictions have been enacted to cool the overheating property sector. China has entered the early-cycle phase on the back of sustained policy stimulus, but typical early-cycle upside may be absent given continued industrial overcapacity and an overextended credit boom.
Australia
There has been a rotation out of high priced defensive income stocks in the Australian equity market in recent months -towards sectors offering relatively better value, such as resources. We have been consistent in our view all year that the resource sector would not only turn around, but would underpin strength in the Australian market. Australian banks appear to be conceding that their past relatively high (by global standards) returns on equity can’t be sustained, due to pressure on net-interest margins and increased capital requirements. That said, given the underperformance of banks over the past year or so – especially compared to other high yield sectors like listed property – this downward adjustment in profitability has arguably already been priced into valuations. At least on a relative basis, the Australian financials sector now appears good value, especially if long-term bond yields rise further. What’s more, concerns that new capital requirements could crimp bank dividend yields may be misplaced. It won’t be one-way traffic though necessarily for Australian share investors, with a number of domestic headwinds. Not least of which is a cash-strapped consumer, and this was evident in Westpac’s latest monthly consumer sentiment survey. The index slipped to 101.3 in November against October’s reading of 102.4.We believe there remains a case for being highly selective, and I have noted in particular our concerns over the construction sector, which looks to be nearing a cyclical peak.
Gold
Gold prices responded to initial fear and rallied with the sell-off in stock markets. However, the real driver of Gold prices is going to be inflation and the US CPI. With much higher levels of fiscal spending virtually guaranteed next year, gold should challenge its old historic highs around $1,900.
Commodities
I think that markets generally have been very complacent about future inflation, but the penny is ready to fall. This will underpin commodity prices, which will be positive for the resource heavy ASX. We are seeing pricing pressures across the board, with yet another example being spot metallurgical coal’s move yesterday above US$300 a tonne for the first time in five years. Supply constraints after years of underinvestment, and recovering demand will only add further fuel to the commodity complex.
We have been consistent in our view all year that the resource sector would not only turn around, but would underpin strength in the Australian market. In my view, higher oil prices will be positive not only for energy stocks, but for the resource sector generally in Australia. If the resource sector does well then we will certainly see further outperformance in the high quality diversified miners; BHP Billiton and Rio Tinto.
Resilience in the Chinese economy will also help, and notably with respect to iron ore prices. While we like the resource sector, it will not always be a rising tide that lifts all boats, and there will always be a case for being selective. Even though the resource sector has had a strong year to date (up over 40 percent), we are not in the camp that it is time to take the gains and run. What we have seen is a key inflection point which also needs to be put in context of a particularly steep fall last year.
Oil
The oil-producing cartel may have to battle weaker demand for crude if global economic growth slows in the wake of Trump’s victory, and on the prospect of increased U.S. oil output given Trump’s pledge to open all federal land and waters for fossil fuel exploration In an attempt to boost prices, OPEC agreed in September to cut output, although investor doubts have grown that it will be able to implement the deal at its next meeting on Nov. 30.
Property
A-REITS having outperformed over the last few years are likely to go through a period of relative underperformance at some stage in the period ahead. Since hitting a high in early August, the S&P/ASX 200 AREIT index has since declined around 13%. I’d suggest that non-traditional investors attracted to the sector by the recent impressive capital gains got cold feet. Seeing the bond rate tick up just a little was enough to get them to hit the sell button.
Recent returns have been well in excess of long term averages and, as we’ve been suggesting for a while, should revert to a more realistic 9-10%pa over a period of time (yes, there might be more volatility in the short term. The key threats to keep an eye on would be a recession in the Australian economy and/or a sharp back up in bond yields. So far there is little sign of the former, with the economy continuing to gradually rebalance towards non-mining related activity, or the latter as global and Australian economic growth and inflation remain constrained.
AUD
The Australian dollar has shown resilience over the past year. After some volatility in early 2016, the AUD has traded within a narrow band over the past three months. While the AUD has traded a little higher than we had anticipated, it remains close to the mid-70 cent range where we had expected it to stay for the remainder of this year.
Stronger-than-expected commodity prices are the major factor keeping the AUD elevated. Monetary and fiscal stimulus in China has driven a resurgence in Chinese demand creating key support for commodity prices and the Australian dollar. We do not expect a significant appreciation in the US dollar, and that it will track broadly sideways over the next year.
