As the global economy adapts to a new post-crisis world, multiple transitions are underway, and they are occurring at different speeds. This is a challenging investment landscape to navigate, and it will exhibit volatility.
Barring any sharp deterioration in global geopolitical risk, the medium-term outlook for equities is quite positive in an environment where we see subdued growth and inflation amid healing economies.
It is therefore important to systematically, and in measured ways, take advantage of the fears that might arise during this transition to gain exposure to equities in balanced portfolios. Slowly rising interest rates -- if they are taking place amid normalisation and reflect some level of growth, even subdued -- are positive for equities.
Major changes are afoot in all of the key sectors of the global economy. The US is transitioning from quantitative easing to tapering to gradual normalisation of monetary policy, as evidenced by the Federal Reserve’s recent statement. Consumer optimism is growing, thanks to rising asset prices.
Fiscal policy is no longer a drag on aggregate demand and is becoming a contributor. The outlook for the job market is improving, but shifting demographics supporting lower labour participation are also helping the overall unemployment picture. The Fed’s recent “holistic” guidance -- giving indications of the timing of the end of QE and the roadmap for possible rate increases -- is both an evolution of its communication format and part of the transition we highlight above.
While the UK and US appear to be in the same 'wagon of the train', Europe and the rest of the world are not. In fact, they may be on a different train altogether.
In Europe, there is room for more QE as financial conditions remain tight with the repayment of the long-term refinancing operation, sluggish bank loans and a strong euro.
While Purchasing Managers Index data in Europe show continued improvements, the combination of the underlying low-growth environment, the ongoing need for structural adjustments, and political challenges also remains. Other challenges include the implementation of the banking union within the eurozone; unusually high unemployment, particularly for youth; and navigating disinflation in order to stave off the threat of deflation.
However, those challenges are quite well known and, barring unforeseen developments, should be for the most part discounted by the markets. The newest challenge for Europe, in the face of developments in Ukraine, underscores its energy dependence on Russia: 30 per cent of Europe’s natural gas comes from its Eastern neighbour. And established plans to secure energy through projects such as the South Stream pipeline -- intended to link the EU and Russia through the Black Sea by 2018 -- now appear ‘dead’ or at least sidelined.
In Japan, the triple stimulus launched by Prime Minister Shinzo Abe 18 months ago constituted of more flexible fiscal policy, more aggressive monetary easing and structural reforms has brought Japan to a new era. The “third arrow”, structural reform, may be the most challenging one to implement.
While Japanese wage growth seems desirable, if it is implemented in a framework disconnected from the shape of underlying demand, or if it inhibits companies’ ability to pass on some price increases, it could put pressure on corporate margins.
That said, corporations continue to benefit from the weaker yen. If the yen remains weak, some level of on-shoring might take place over the next few years, which could help support domestic growth. It is crucial for Japan to continue to focus on lifting growth to temper the impact of higher rates and its demographic challenge.
Japan has a government debt-to-GDP ratio over 220 per cent and is entering its fifth year of demographic contraction. Its elderly population will benefit from higher rates on savings, but with a quarter of its population over 65 -- almost twice the amount of children -- additional savings revenue for the elderly will most likely not generate a pickup in consumption sufficient to offset the negative impact of higher rates, particularly in the absence of further structural reforms and productivity-enhancing catalysts.
In fact, interest expense as a percentage of government revenues, currently at about 25 per cent, could increase to 80 per cent if interest rates reach 2 per cent. Japan is clearly in a transition phase.
China is also going through an important transition. Shifting from an investment-driven growth model to a consumption-driven growth model, while developing a viable middle class, is necessary at this stage of its economic maturity. The sheer size of the economy and the pace of the population shift make implementing the right policies and sustaining political stability a challenge. The effective execution of the sweeping structural reforms announced and the transformation of its financial system from a directed to an efficient economic model are critical.
Broad emerging market equities have been in the process of adjusting to the prospect of a post-QE world and higher interest rates for the past 12 months, resulting in underperformance versus developed markets by about 40 per cent since January 2012, according to the MSCI EM and MSCI World Indexes.
A big part of this underperformance was driven by the announcement of tapering in the US and subsequent capital outflows. Some of those outflows are linked to ‘hot capital’ that found refuge in higher emerging market relative yields in the wake of the crisis and that are now, with the expectations of developed market interest rate normalisation, returning to developed markets.
Countries with healthy balance sheets and large current account surpluses have been in a better position to sustain capital outflows than their neighbours with large current account deficits or excessive external debt.
During the past 12 months, however, some current-account-deficit countries have made healthy adjustments that may not be reflected in the markets yet. Furthermore, even though emerging market economies have become increasingly fragmented, it is important to remember that they have dealt with rising rates in the past.
The recent Fed announcement on guidance related to policy normalisation should help temper investors’ aversion to emerging markets. In fact, we would argue that emerging market economies with attractively priced, quality companies and an appetite for reforms should regain some level of interest from long-term fundamental investors who are currently underweight emerging market equities.
To make larger moves, investors will need to see clearly continued progress in current-account-deficit economies and some level of growth revival in countries such as Brazil. The growth issue is in fact the next big question to be answered.
As some emerging economies mature, they may be unable to replicate the same level of economic growth seen in the past. Their growth relative to many developed market economies, though, might still be attractive over the medium term. With over half of the world’s economy coming from emerging markets, it’s important to understand how the maturing of those economies will affect global growth. A stronger US and possibly Japan, and a slowly recovering Europe, will help balance the healing process in emerging markets in 2014.
The key question investors must ask is at what speed and under what banner will the ongoing normalisation take place around the world. Certainly, the adjustment process will progress in various phases, but it will also need to deal with an unusual two-faced economic reality: risky asset prices amid an underlying economic revival.
While both are linked, asset prices have recovered well ahead of the underlying economy as liquidity pushed prices up once systemic risk was assumed to have receded. Ultimately, we need to see the high levels of cash on corporate balance sheets find their way into the real economy. While buybacks and dividends have been popular, at this point of the cycle we should expect capital expenditure and mergers and acquisitions to pick up.
While stress points around geopolitics (Russia, elections in emerging markets, maturing of the Chinese financial system) and new models (adapting to the outcomes of the post-transition world) will create uncertainty, they can provide fertile hunting ground for investors.
From a markets standpoint, valuations are not very expensive. They’re not cheap, but they’re not expensive versus historical standards for the market overall. Emerging markets are particularly cheap and should not be ignored by investors with no or low exposure. The key is to find the right stocks, no matter the style used to exploit the market’s inefficiencies.
© Pacific Investment Management Company LLC. Republished with permission. All rights reserved.