BCA, Independent Investment Research Since 1949

Stuck In A Rut

Mr X. – more conflicted than ever about the 2016 outlook – poses some tough questions to BCA’s editorial board.

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook.

This year, he rightly pointed out that extreme monetary policies continue to create major economic and financial distortions that ultimately will have significant unintended negative consequences. As well, he forced us to acknowledge that there has again been little progress in reducing elevated debt levels around the world. Meanwhile, economic growth remains dangerously fragile and deflation is a risk.

Indeed, we were not able to assuage Mr. X’s fears.

We wish we had grounds for being more optimistic, but it is a challenging investing environment. A more positive stance on risk assets would be warranted should the corporate earnings outlook improve significantly, though the odds of that seem low at the moment. The other way to improve future return prospects is for asset prices to decline and establish attractive valuations. That is enough of a threat to warn against an aggressive investment stance and is why we recommend no more than a benchmark weighting in equities. And we would not argue strongly against a modest underweight.

To read the edited transcript of our recent conversation, please click here: Stuck In A Rut.

Global Fixed Income Strategy: Where To Hide

We have recommended a long duration stance for some time because we believe that the Fed will not be able to tighten as quickly as the dot-plot suggests. Global deflationary pressures, and quantitative easing in Europe and Japan, will anchor the long-end of the curve across the major countries. Nonetheless, we have emphasized the near-term risk of a convergence of the OIS curve toward the Fed’s ‘dots’, leading to a temporary U.S. Treasury selloff.

In each of the past U.S. rate hike cycles, there is a period of rapid upward adjustment in market expectations for the pace of Fed rate hikes that occurs near the time of policy lift-off. It is an “ah-ha” moment, when investors are shaken from their complacency about the outlook for short-term interest rates. This is the phase of maximum pain in terms of total return losses in the bond market.

The mid-2000s “conundrum years” provide a roadmap for how things could play out. Treasury investors suffered losses during the period of rapid increase in the 12-month Fed Funds Discounter, which occurred just prior to the start of the rate hike cycle. However, once this phase was complete, the Treasury index provided a positive return over the course of the tightening cycle. The yield curve flattened massively.

Markets discount some upward movement in the fed funds rate over the next year, but we have not yet seen the same violent upward adjustment that has occurred in rate hike cycles since the 1980s. This raises the question of where absolute-return focused, long-only bond investors can hide during the rapid adjustment phase. Please see the next Insight, “Hawkish Fed” Yield Curve Scenario.

U.S. Equities: Deflation Still Prevails

The most widely telegraphed Fed interest rate hike in history ushered in a brief sigh of equity market relief. However, we doubt the sustainability of any rally attempts, because deflation remains the dominant stock market threat.

Domestic goods prices continue to plunge. China’s slow but persistent exchange rate devaluation will continue to export deflation to the rest of the world. China’s export prices are contracting in both local currency and U.S. dollar terms. Sinking emerging market currencies are unleashing a similar dynamic. Rising domestic bond yields constitute rising financial stress.

To help gauge corporate sector health, our U.S. equity strategists updated their industry group pricing power gauges, which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. Please see the next Insight, (Part II) U.S. Equities: Deflation Is Still The Prevailing Wind.

Same Macro Headwinds

New York Fed Governor Dudley’s comments yesterday underscored what we already know: that the Fed is unlikely to lift interest rates while markets panic. But ultimately, the same global macro headwinds, and poor final demand conditions persist.

 

 

Dudley’s soothing words, along with a late day surge in Chinese equity prices, has shifted investor sentiment in a positive direction for now. But we maintain that the dynamics of the global economy have not materially changed. The Fed backing off from September could give financial markets some breathing room, but unless the dollar weakens substantially, the poor U.S. profit picture is unchanged.

In addition, DM equity markets are no longer ignoring the risks from China and EM. As highlighted in the next Insights, our EM strategists believe the EM selloff has further to run, implying that a cautious DM approach is still warranted.

Chinese Stocks: The New Unknown

There are two forces driving Chinese stocks:

 

  • The PBoC is among the few major central banks that can engage in further monetary easing, and China’s ongoing fiscal stimulus programs will likely shift into high gear in the coming months. This, together with a stable household sector and service industries, should preclude major growth disappointments.
  • But investors are no longer just worried about the growth slowdown. Even though the flash manufacturing PMI last week may have contributed to the selloff in Chinese shares, the growth slowdown is not new news, and should not have caused such dramatic market reactions. The new unknown is the Chinese authorities’ willingness and ability to keep things “under control”. Notoriously poor policy transparency has further worried investors, leaving fear and anxiety dominating sentiment. As a result, anything China related is aggressively liquidated.

Our China strategists expect that the growth outlook will eventually matter for stock prices from a cyclical point of view, but it will be an uphill battle for the Chinese authorities to regain credibility. Until then, the risk premium attached to Chinese equities will stay elevated.