This week we met with the team at JP Morgan. They provided a paper arguing why we should include their Global Macro Opportunities Fund in our absolute return bucket. The paper is written below and we concur on many of the points listed but it is important to understand that much of the notes come from a vested interest. The article highlights five thematic issues worrying investors that shouldn’t.
- Global growth: Peak to plateau
Global growth stalled in the first quarter, puncturing economic confidence and calling into question the very ubiquitous synchronised global growth narrative. There were myriad reasons for this weakness; feeble household consumption, companies taking a breather on capital spending and extreme weather. Although a downshift in business sentiment remains a risk as political concerns linger, strong corporate profits and elevated business and consumer confidence suggest otherwise. Also, helpfully, fears of a trade war are moderating.
The most recent global PMI for manufacturing figures, a key barometer for economic health, stabilized at the start of the second quarter (see chart). This might suggest growth has peaked as many economies have recaptured all the lost output from the great recession and are operating near full capacity. But the peak means the global economy has reached a very high plateau, and does not look to be rolling down the other side.
- USD strength: Don’t call it comeback
The U.S. dollar has bounced recently, unnerving investors and rattling markets as the direction of the dollar is key to the outlook for many markets. For a long time the U.S. economy was the driving force for the global economy, but 2017 was the year when the rest of the world caught up. As such, money flowed from the U.S. into other regions, weakening the greenback. The difference in growth rates between the world’s regions had been driving currencies, rather than interest rate differentials, which theory tells us should be the more meaningful determinant. More recently, however, the U.S. economy is retaking the lead in growth thanks to a soft patch in Eurozone growth and U.S. fiscal stimulus. Additionally, interest rate differentials are favouring the U.S. dollar once again as there is greater acceptance that the Fed will hike rates at least three times this year and monetary policy is diverging again.
There may be near term support for the U.S. dollar, but it should still weaken over the medium-term for a couple of reasons. Eurozone growth is likely to lift again and monetary policies will converge as the ECB ends its QE programme this year and prepares the market for rate hikes. The burgeoning fiscal deficit in the U.S. will mean increased foreign borrowing and a larger current account deficit, weakening the currency over a longer time frame (see chart).
- Bond yields: Rise and shine
Rising bond yields are making equity investors nervous as markets become more sensitive to changes in yields. Bond markets are starting to reflect higher rates of expected inflation from stronger growth and added fiscal stimulus, as well as the gradual tightening of monetary policy. The U.S. 10-year Treasury yield recently breached the key psychological level climbing above 3%. Eventually higher bond yields will create a headwind for equities, as borrowing costs become punitive and the risk premium for owning equities over bonds evaporates. However, there is still room for yields to rise before this occurs.
Rising bond yields reflect the solid nominal growth story, an environment that should support corporate earnings. Rising input costs and input inflation should be largely offset by increased sales and revenue growth, which protects operating margins. The chart shows the relationship between bond yields and market returns for the last 26 years. When the 10y Treasury yield has been low and rising, equities tend to deliver positive returns, which is the case today. Historically, it hasn’t been until bond yields have exceeded 5% that equity market returns have become negative.
Admittedly, many historical relationships haven’t performed as expected after the financial crisis. Given the current low interest rate regime, the suggested 5% could be as low as 3.5% to 4%. However, when operating margins are still robust and companies have pricing power, this is still a healthy time to hold equities.
- EM: Running out of puff
EM equities finished 2017 strongly, but have had difficulty maintaining that performance in 2018. Trade, rate hikes and a stronger USD have all dampened investor sentiment. However, the risks to the outlook for the asset class have shifted from internal to external, leaving EM equities in a stronger position. Historically, emerging markets have suffered as their economies ran the risk of overheating, or they had to act to defend currencies pegs or outsized positions in debt denominated in a foreign currency. That has changed, and there is little sign of overheating and countries are less sensitive to higher U.S. interest rates.
Emerging equity markets should outperform developed markets as long as the emerging economies are growing faster. The chart shows that the difference in economic growth between EM over DM is tracked by the relative performance of EM over DM equities. The faster pace of growth across EM is expected to continue and when combined with better relative valuations to developed markets, stable and potentially higher commodity prices, and a USD that we believe is on a long term weakening trend, all those factors point towards better EM equity performance.
- Debt doubts: Rising corporate leverage
The longer the cycle lasts, the more market participants look for signs that it is drawing to a close. But with little to indicate any large imbalances in the economic landscape, the focus shifts to the corporate world. Households, outside of Australia at least, have de-leveraged significantly since 2008 and debt servicing costs are close to historically low levels. At the same time, companies have taken advantage of the low interest rates to lever up, and U.S. non-financial corporate debt levels as a share of GDP are now higher than the peaks before the 1999 and 2008 recessions. Rising corporate leverage should be monitored closely, particularly in a rising rate environment. However, high leverage looks like less of a worry when compared to the net worth of the companies (see chart). On this basis, non-financial debt has been in steady decline since the 2008 peak. Another mitigating factor is that U.S. companies are cash rich. Cash as a proportion of current assets has risen from 20% to 30% since 2008, implying that companies have more flexibility to cover short term funding if necessary.
Rising debt levels in non-financial companies is one sign that the cycle is nearing the end. However, as leverage among financial companies is less of a concern, the threat of systemic risk to the broader financial system is lower.