Commentary:
It’s been no secret that it’s been a surprising, low volatility year. Despite the fireworks last week, the YTD moves in most major asset classes has been broadly limited, and mostly against consensus expectations. Rather than focus on where consensus could be surprised further, I thought this would be a good time to sketch out a broader and longer term view of global asset price dynamics.
We can be reasonably sure that we’re currently around the middle part of the business cycle. The Fed has not started hiking yet, credit markets remain open, and economic uncertainty is low. However, it’s now been 5 years since the end of the last recession, and imbalances have been starting to build. From a strategy perspective, global macro is likely to continue to lag returns in long risk strategies like long/short equities or credit. The reason is simply that with macro volatility and uncertainty low, there will be fewer mispricings for asset prices as a whole. The chart below of the Citi G10 economic surprise index highlights the narrowing range of economic surprises – a phenomenon that we also saw during the previous cycle:
US treasury yields may go lower, but will be due to falling potential growth expectations and/or a later fed hike. In other words, movements will be limited in both directions. 30y yields are not far from ‘fair,’ with the risk to the downside as every growth spurt we’ve gotten thus far in this cycle (including the current one) has been disappointing – which are leading people to downgrade their estimates for potential growth. In addition, risks to the longer term growth outlook are also to the downside. In addition to slowing & aging demographics, the math around entitlement financing is mostly red colored.
With High Yield spreads near historical tight levels, spread compression as a source of return is probably over for credit holders. (Barclays 10y HY Yield to Worst chart below) HY companies are likely to continue raising debt, but the trend toward lower carry per unit of leverage will continue, but via increased leverage and worse fundamentals, rather than lower spreads.
This leaves the most junior part of the corporate capital structure, equities. The most important observation is that the equity risk premium is still very high. Next year earnings estimates imply an earnings yield of 6.7%. This is a real yield measure, since earnings usually grow in line with inflation. The real yield of 30y TIPS, by comparison, is just 1.2%. The ~550bp return differential priced in between asset classes is very, very wide by essentially any metric at this stage in the cycle. (It arguably SHOULD be high during recession / early recovery periods – but not mid cycle) Certainly, the high levels of both corporate profit margins as well as earnings as a percentage of GDP suggest the potential for some mean reversion. But with the risk premium at these levels, a mean reversion in corporate profits, IF it occurs, is already more than priced in. Yes, PE ratios are not low anymore, relative to history, but NOTHING is cheap relative to historical prices. Unless you think 30y yields are well below where they should be, AND are willing to sit on cash until all financial assets re-price, the current P/E ratio should NOT be a reason to be out of the market.
Furthermore, the deterioration of credit fundamentals mentioned earlier are likely to occur to the benefit equity holders. Corporate balance sheets remain healthy, especially at the banks, which suggests ample room to re-lever. In addition, the differential between credit and equity yields make such re-leveraging an easy call for most CFO’s. Corporate share buybacks are likely to continue while the risk premium remains this wide, and is likely to continue to be an important source of returns for equity holders.
To summarize, given where we are in the business cycle and given where we are given relative asset prices, equities are by far the best asset class to own on a risk/reward basis, in this writer’s opinion.
In terms of timing and seasonals, unfortunately the outlook is less bright. Beyond the ‘sell in May’ bias, the historical pattern around mid term elections are bearish through September, but turn sharply bullish thereafter, according to GS: (we are currently 29 weeks away from the midterms)
I ran the numbers myself by month and found a similar result for equities, and also unsurprisingly a bearish bias for 10y yields. I calculated both sample medians as well as averages to adjust for outlier effects. There wasn’t a significant difference, with the possible exception of Aug returns for equities:
Special note on EM:
A lot of bearish talk that the adjustment in FX and real rates may not be sufficient, and this recovery may be only temporary. This is certainly a risk. There are some other considerations, however. First, unlike DM currencies, the long term fair value for EM currencies are much less certain. For DM currencies, some measure of PPP or the equivalent, such as the Economist’s Big Mac index, are pretty reasonable measures. But for EM, due to increases in productivity relative to DM, the ‘fair value’ metric increases over time. This is further compounded by the fact that there is substantially more uncertainty around the measurement of inflation, which is a key component of both the fair value for FX as well as real rates. Furthermore, there are often substantial uncertainties around the measurement of the current account. Transfers between parent and subsidiary companies, for example, could be counted as part of the trade balance or as FDI or as something else altogether. This makes claims such as ‘the C/A deficit of this country is X so the currency must rebalance by Y’ subject to substantial amount of uncertainty. The point is – yes, the EM rebalancing story may have more to go – but since there is substantial uncertainty around the data, one shouldn’t be putting big bets on it either way. What IS clear, however, is that EM currencies and fixed income products (but not necessarily equities) have cheapened substantially over the past several years, especially relative to DM counterparts.
A key source of uncertainty for the poorer countries, however, is food prices, which is obviously dependent on the weather. And J.P. Morgan meteorologists have been repeatedly upgrading their probability of an El Niño later this year. It is still early to be sure, but there are strong signs we will see one. There have only been two in the past 15 years. The implications of this are likely to be bullish agriculture prices, although more so for some crops than others. North America is unlikely to be meaningfully affected but South America and Asia are at risk of adverse weather.
Notable:
- US Retail sales improved to 1.1% vs 0.9% exp and 0.3% prev. The Control group was also strong, improving to 0.8% vs 0.5% exp and 0.3% prev.
- ECB has been trying to ‘verbally’ ease. Nothing substantially concrete… but the hard references to the exchange rate is new and suggests that the ECB is getting more concerned:
- Draghi noted that further EUR strength will necessitate additional easing: "In a sense, if you want our monetary policy to remain as accommodative as it is today, a further strengthening of the exchange rate – I don’t want to give you a level where we will act or not, I am giving you an orientation – would require further monetary policy stimulus.”
- Coeure spoke about “Asset Purchases as an Instrument of Monetary Policy.” whether reducing term premia would in turn be effective in reducing real interest rates for firms and households depends on complementary policies, in particular the continued repair of the banking sector. For example, the sizeable reduction of spreads we have witnessed since July 2012 has not in itself translated into higher credit volumes and lower bank lending rates. This is largely because the restructuring of the euro area banking sector remains ongoing. Thus, an essential complement to any monetary policy strategy is a strict implementation of the ongoing Comprehensive Assessment of euro area banks and swift corrective action to bridge identified capital shortfalls.
Citi: (via GS) core EPS of $1.54 vs. our like estimate of $1.36 (beat mainly on fee income in the Institutional Securities Group). We think investors will like today’s results (especially given how out of favor Citi was after failing CCAR) Upcoming Data:
- Mon: RBA Minutes
- Tue: UK CPI, Germany ZEW, US Empire Mfg, CPI, NAHB Survey, NZ CPI, China GDP
- Wed: UK Employment, US Housing Starts, BoC, Yellen Speaks, Kuroda Speaks
- Thu: Canada CPI, Jobless Claims, Philly Fed,
- Fri: Good Friday,
Global Macro Trading 