Emerging Market Domestic Rates: More Downside?

Even though EM domestic bond yields have fallen to their previous lows, they may still have further to fall.

Emerging Market Domestic Rates-More Downside?

E  merging market (EM) bond yields are now at their 2008 lows, but countries the EM universe will continue to ease monetary policy in response to slumping growth both globally and domestically.

One telling sign that the rate cycle is not over is that EM domestic interest rate expectations/bond yields have failed to rise amid EM currency depreciation: the reflationary boost from weaker domestic currencies has not been sufficient to reverse the ongoing growth slowdown in these developing economies.

In the past, weak currencies have pushed up inflation in EM countries, but this dynamic does not currently seem to exist. Even rising food prices may turn out to be more deflationary than inflationary: the more EM consumers spend on food, the less income they have to spend on discretionary items, and a lack of non-food demand could push down a broad index of prices.

This, in turn, will weigh on nominal bond yields.

Bottom line: Although there is little value left in EM bond markets, it is too early to bet against even lower EM bond yields.

Housing Recovery And Related Assets

Housing has shifted from a major drag to a small positive factor for the U.S. recovery. There remains upside potential for some of the assets related to U.S. housing.

Housing Recovery And Related Assets

Y ear-to-date total returns for housing-related assets have been impressive. Homebuilder stocks, REITs and bank stocks all beat the S&P 500 by a wide margin so far this year. Even in the fixed income space, several assets rivaled the S&P 500 in total return, while high-yield home construction bonds rewarded investors with a whopping 20% gain.

Assuming a 5% rise in home prices, a 20% increase in new home sales and a 5% rise in total housing starts to 800,000 by year end, our U.S. Investment Strategy service estimates housing-related assets should continue to outperform in the second half of this year. Importantly, all of the fixed-income housing-related assets are still cheap despite excellent returns already generated so far this year. As a result, valuation should not be a reason to exit any of these investments, unless housing activity takes a turn for the worse, which is not our base case.

Homebuilders are expensive by traditional valuation metrics, but measures such as price/book and price/cash flow are distorted by the extreme weakness in book value, cash flow and sales in recent years. There is plenty of upside for these equities if housing starts continue to move higher. Thus, value is arguably better than the standard valuation ratios currently suggest.

Bottom line: Exposure to housing-related fixed-income securities and homebuilder stocks is still warranted.

U.S. Earnings: A Worrying Start To Q2

Seasonally-adjusted EPS could decline slightly in Q2. Does this herald a sustained downtrend in U.S. earnings?

US Earnings - Worrying Start To Q2

T he second quarter earnings season is not off to an impressive start and guidance has been particularly poor, suggesting a slight decline in EPS in the second quarter (after adjusting for seasonality).

The stall in the uptrend is concerning because earnings have acted as a key pillar of support for the equity market since the economic recovery began three years ago. Even just a flattening-off in the level of EPS could erode the argument that equities remain the cheapest asset class from a relative value perspective. More importantly though, earnings rarely contract on a sustained basis outside of recessions. When a contraction did occur in a non-recessionary period, it was always associated with a mid-cycle slowdown in output alongside accelerating labor costs. Currently, the economy is in a soft patch, but unit labor costs (ULC) remain very tame and corporate GDP growth has accelerated recently relative to ULC growth. A temporary contraction in year-over-year earnings growth is possible, but should be shallow in nature barring a significant further downdraft in global economic momentum, or a spike in the dollar.

Bottom line: A sustained downtrend in earnings is unlikely absent a recession or a surge in unit labor costs.

Is Europe Facing A Lost Decade?

The euro zone economy could go through a lengthy period of painful adjustment similar to Japan’s post-bubble experience.

Is Europe Facing A Lost Decade?

E quities account for 55% of capital resources in both the U.S. and Europe, but European banks are much more important to the economy, accounting for about 40% of financial resources allocation (versus about 20% for U.S. banks). The key difference is that the U.S. has a deep, liquid and vibrant corporate bond market, which has also allowed companies to bypass the banking system to obtain financing at times of severe banking crises and credit crunches. This is a key reason why the U.S. economy has sprung back much more quickly from the 2008 Great Recession than either Europe or Japan, where economic activity is held hostage by banking retrenchment.

Going forward, the credit crunch in Europe will get worse before it gets better.

European banks are not as well capitalized, but much more leveraged than their U.S. counterparts, and the credit crunch in the euro area has barely begun. To bring capital ratios up to a level equivalent to the U.S. average, the largest European banks will have to either raise €900 billion in new capital or cut back their asset base by €9 trillion. In Japan, credit contraction lasted well over nine years in the aftermath of the asset bubble bust. During that time, deflation prevailed and economic growth averaged a measly 0.5% annual pace.

According to our Global Investment Strategy service, euro zone growth could be even worse than Japan’s during its deleveraging period. Unlike in Japan, the European credit crunch will be compounded by severe public austerity, creating a potential downward spiral in output.

Bottom line: The risk that Europe goes though its own version of a lost decade is not trivial.

Watching France

The French bond market has been reasonably calm with spreads over German bunds staying at 100 basis points. But this is unlikely to last.

French Bond Market | France Recession

T he French public sector is not in good financial health and is in worse condition than that of Italy in many respects. Italy has run large primary surpluses through much of the last two decades, while France has run large deficits. The Italian debt/GDP ratio was rather stable, while France’s has been rising sharply. In fact, France has accumulated 60% more debt than Italy since 1999, and its debt service costs are rising. More worrisome is that France’s combined private and public sector debt load is higher than that of Italy, putting the French economy in a perilous situation. The only variable where France looks better is economic growth, but even this has mostly come from larger government spending, and in turn at the cost of escalating debt.

France is currently headed toward mild recession and according to our Global Investment Strategy service, there is a non-trivial risk that if the French recession turns out worse than ’mild’, then its debt problem will be in the spotlight, creating intense pressures in the French bond market.

On the positive side, the domination of the French Socialists in recent legislative elections gives French President Francois Hollande the necessary flexibility to pursue structural reforms once market focus inevitably turns to Paris. However, pushing structural reform in France will be difficult because of electoral commitments to do otherwise.

Bottom line: Fiscal difficulties in France will be under scrutiny and France’s perceived safe haven status may not last long.