Can The Debt Supercycle Migrate Beyond The Developed World?

The Debt Supercycle is on its last legs in the developed world, but investors should not look for a full-on migration to the developing world.

Can The Debt Supercycle Migrate Beyond The Developed World

T he supercycle could not have become entrenched in the G7 if policymakers did not believe that it worked. A simple comparison of year-over-year changes in private indebtedness with year-over-year changes in nominal GDP growth suggests that it did: increased borrowing was associated with expansion across the G7.

Developing world officials wishing to replicate the supercycle in their own countries would be abetted by currently light debt burdens. Emerging economy balance sheets are relatively pristine compared to developed economy balance sheets, with narrower budget deficits helping to keep them that way. But more credit-reliant economies in EM are not a foregone conclusion.

As a group, emerging economies lack the income, infrastructure and credit culture to make full use of their apparent capacity. Moreover, the leading emerging markets need time to digest the acceleration in the rate of credit expansion that has already occurred. Investors should nonetheless expect financial deepening and an expansion of social safety nets as developing world wealth increases.

Long-term investors can best position for the waning of the supercycle in the developed world, and financial deepening in the developing world, by increasing exposure to emerging market financials and health care equities and debt.

The Search For Yield Continues: Aristocrats Or High Yield?

Dividend stocks appear set to outperform high-yield bonds in the U.S. in all economic scenarios other than a recession.

The Search For Yield

O ur U.S. Investment Strategy service performed a scenario analysis comparing the prospective return performance of dividend stocks and high-yield bonds. While the total return to dividend stocks shows a wider range of outcomes, they manage to outperform high-yield bonds in three of the four scenarios. It is only in the “mild recession” case that the S&P Dividend Aristocrats (DA) index underperforms. This is consistent with the historical tendency for relative returns to be directional with the overall market.

Two main factors are behind the DA index outperformance in most scenarios.

  • First, the starting point for valuation favors dividend stocks over speculative-grade bonds. The junk index outperformed the DA index in the early 1990s, during a sluggish economic recovery, but the high-yield index began the period with a yield of 17.5%. With a yield of 7% today, there is obviously much less room for capital gains.
  • Second, the relative performance trend is generally directional, with sizeable declines in the DA index usually required for junk to outperform. The DA index is made up of companies that have lower leverage, higher returns on capital and stronger cash flows, and these higher quality firms are better suited to weather the business cycle.

Bottom Line: Dividend stocks should outperform high-yield corporate bonds as long as the economy is growing, even if very slowly.

Global Credit Cycle Lurches Down

After a brief period of stabilization, our measure of global credit impulse has plummeted. This does not bode well for European equities.

European Equities | Global Credit Cycle

T he credit impulses in all three major economies – the euro area, the U.S. and China – are now negative, albeit very slightly in the case of China. This is the first time in three years that all three components have been simultaneously negative. And after hovering at a point of inflection the combined credit cycle indicator has lurched down again.

For any open exporting economy, such as the euro area, the global credit cycle is much more important than the domestic credit cycle. This is because the sales and profits of large European companies are sourced globally, not just from Europe.

According to our European Investment Strategy service, a weakening credit cycle normally precedes a poorer return/risk trade-off for risk assets such as equities – through lower returns and/or higher volatility. After their recent strong rallies, European equities seem vulnerable to any new downgrades to growth.

Hence, for short-term investors we advise against an absolute overweight position in European equities.

Buy The Dip In U.S. Bank Stocks

The dip in U.S. bank stocks caused by narrowing net interest margins is a buying opportunity.

Buy The Dip in US Bank Stocks

R egional bank stocks sold off following third quarter profit results. Lower mortgage rates and the pick-up in prepayments have pressured net interest margins, while litigation costs and debt valuation adjustments also weighed on profits. But according to our U.S. Equity Strategy service, the earnings outlook remains encouraging, despite the compression in net interest margins.

Even a gradual recovery in housing has allowed overall bank lending to broaden beyond C&I loans, as residential mortgage origination is accelerating, albeit from a low level. Banks are able to originate long-term fixed mortgages and then offload them in the secondary market at better rates, locking in a tidy profit. This spread is near its highest level since the mid-1980s.

Bank lending is clearly highly correlated with bank earnings growth.

The implication is that evidence of increased lending volumes should be viewed as a critical positive earnings driver, despite the squeeze on net interest margins. Also, overall employment is climbing much faster than bank employment. This is favorable for relative profits and, by extension, relative share price outperformance.

Importantly, bank loans are climbing much faster than bank headcount, reflecting productivity improvement. With relative valuations still close to rock bottom levels,investors remain unconvinced about the durability of the recovery in bank profitability.

Bottom line: We recommend leaning into this pessimism by adding to overweight positions on the dip in the S&P regional bank index.

U.S. Elections And The Dollar

Macroeconomic policies and relative fundamentals will dictate the trend in the dollar.

US Elections And The Dollar

A ccording to our Foreign Exchange Strategy service, there is no relationship between the political party controlling the White House and the U.S. dollar. The dollar has been in a forty year secular bear market that was interrupted with just two cyclical rallies, each lasting about 5-6 years.

  • The first occurred in the early 1980s under a Republican president.
  • The second took place in the late 1990s under a Democratic president.

Rather than party affiliation, macroeconomic policies and relative fundamentals will dictate the trend in the U.S. dollar. Importantly, regardless of who wins the November 6 election, there is unlikely to be a major change to current economic policies.

Although there are different priorities between extending tax cuts and limiting spending cuts, both political parties want to avoid the “fiscal cliff” next year. Therefore, the near-term outlook is for large fiscal deficits under either party.

As for monetary policy, Governor Romney has said that he will not reappoint Bernanke as chairman of the Federal Reserve when his current term expires on January 31, 2014. Even if President Obama is re-elected, there is no guarantee that Bernanke will seek another term. Therefore, no matter who is in the White House, there could be a new Fed chairman in 2014. But from now until January 2014, the Fed’s balance sheet will continue growing.

Bottom Line: The November 6 election is unlikely to result in any immediate material changes to U.S. macroeconomic policies. Large fiscal deficits will persist and the Fed’s balance sheet will continue to inflate.

These policies will exert downward pressure on the dollar.