Quarterly economic and market outlook
Commentry by Jonathan Bell and Charles Franklin at Stanhope Capital:
Political developments dominated markets over 2012 and are likely to continue to dominate markets over 2013. For most of 2012, the key issues were in Europe but, more recently, markets have been focusing on the US and its fiscal problems.
Fortunately, from a short term perspective, the immediate crisis presented by the January deadline for rolling the Bush tax cuts forward has been averted. As most people expected, there was a last minute compromise between Republicans and Democrats in Congress, the majority of the tax cuts were rolled forward and the US economy has not fallen off the so called “fiscal cliff‚Äù (i.e. over US$600 billion or 4% of GDP will not be sucked out of the economy over 2013).
Unfortunately, with only modest tax increases agreed, the underlying fiscal problem in the US remains unresolved. With the annual deficit running at close to US$1 trillion and total debt now over 100% of GDP, the US authorities must at some point raise taxes or cut spending significantly, with obvious consequences for growth.
The year end compromise has successfully “kicked the can down the road‚Äù but it only buys a little time before the next deadline as total Federal debt already exceeds the legal debt ceiling (US$16.4 trillion). The debt ceiling must be raised at the start of March or automatic spending cuts of US$1 trillion will kick in. There will undoubtedly be more political brinkmanship to unnerve investors over the coming few months.
In Europe, the various actions taken by the Eurozone authorities over 2012 ‚Äì in particular, the massive injection of liquidity into the banking system by the ECB early in the year and its promise later in the year to support bond markets directly if required ‚Äì have gone far to reduce the sense of crisis, which is clearly visible in the dramatic fall in government bond yields in fringe markets.
Europe is, however, not yet out of the woods. The actions taken over 2012 have bought the authorities time but the fundamental problem in the Eurozone ‚Äì i.e. too much government debt in fringe countries combined with anaemic economic growth ‚Äì remains largely untouched. The Eurozone effectively remains in a vicious economic circle of government cuts leading to slower growth and slower growth resulting in larger government deficits, the need for more spending cuts and more pressure on growth.
Growth: Europe and Japan to remain the laggards
Even without political uncertainty, the economic outlook is mixed. In the US, the consensus is still relatively optimistic: according to Bloomberg, the consensus is looking for US GDP to grow a reasonable 2.0% in 2013 and 2.6% in 2014. This is on top of the growth of 2.2% expected to be reported shortly for 2012.
Assuming no further tax increases or government spending cuts over the next year, the consensus forecast does not seem too demanding, although the Fed clearly remains concerned about the outlook given the extension of its quantitative easing programme during the fourth quarter (it will now effectively be injecting some US$85 billion a month into financial markets, perhaps until unemployment hits its target of 6.5%).
Understandably, given government austerity programmes, the consensus is more cautious about the outlook in the UK and Europe. In the UK, GDP is thought to have contracted by 0.1% over 2012 but forecast to grow 1.1% in 2013 and 1.6% in 2014. In Europe, GDP is likely to have fallen 0.4% in 2012: the consensus expects zero growth in 2013 and 1.2% in 2014. It would be a brave man who would forecast stronger growth than this.
The best growth will almost certainly continue to be seen in emerging economies, even if the developed world undershoots consensus expectations. Among the BRICs, growth is forecast to be around 7-8% in China this year and next, 5-6% in India and 3-4% in Russia and Brazil. China could even surprise on the upside given that the new Politburo will wish to start on a positive note. There is, however, a potential wild card among developed economies at the moment. The consensus expects growth of just 1% in Japan in 2013 and 2014. However, if the new LDP government follows through on its recent election promises and increases spending significantly, cuts corporate taxes in half and forces the Bank of Japan into aggressive quantitative easing, growth might be stronger than expected, not least because the yen is likely to fall further as a consequence. This is a very big “if‚Äù, however, and experience of Japanese politics suggests that one should not place too great a bet on this scenario.
Inflation: to remain under control in 2013
Inflation was little changed in most regions over the past few months and the consensus remains sanguine about the outlook, expecting it to remain under control over 2013. This is a fair assumption given sluggish economic growth, government austerity programmes and relatively high levels of unemployment in the developed world.
In the UK, the consensus is now looking for CPI inflation to fall from 2.7% to 2.2% over 2013, which would be only marginally above the Bank of England’s official 2% target, while RPI inflation is forecast to fall from 3.0% to 2.5%. In Europe, the consensus sees CPI inflation easing from 2.2% to 1.9% over the next year. No improvement is expected in the US but inflation is already just 1.8% and the consensus for next year is 2.0%.
The key short term risks to the consensus view remain the same: oil and food prices. Developments in the Middle East could easily cause oil prices to spike up and offset the benefit of increasing US production from its shale oil reserves. Another year of bad weather could also cause food prices to surge again as they did in mid 2012. Though the impact of food prices is limited in the developed world, as food is now a relatively small part of overall consumer spending, any further move up could be devastating in emerging economies, as food remains the largest expense for most consumers in these areas. A spike in oil or food prices would, of course, ultimately be deflationary, as it would likely drive the global economy into recession.
Interest rates: to remain low
With inflation apparently under control and growth still sluggish in the developed world, it is very unlikely that central banks will raise interest rates in the near term. Most central banks, including the Fed, are publicly committed to maintaining rates at current record low levels ‚Äì the Fed at least until spring 2015 ‚Äì with some hinting that they could be cut further. Unsurprisingly, money markets continue to take their lead from the central banks and forward rates imply only very modest increases in interest rates over the next year (around 15 basis points for sterling and 20 basis points for the US dollar).
Government bonds in core markets such as the US, UK and Germany have performed extremely well since the credit crunch but, unsurprisingly, given the level to which yields have fallen, they are now struggling to make further headway. Looking forward, with real yields in most core markets negative or close to zero on all but the longest dated bonds, it is difficult to recommend holding government bonds other than as a hedge against deflation (which is still a possibility) or financial crisis (undoubtedly still a possibility). Markets should be supported by central banks through quantitative easing programmes but the potential upside is obviously limited given the low level of yields (below 1% on ten year bonds in Japan and Switzerland, below 2% in the US, the UK and Germany).
Corporate bonds have performed extremely well over the past year, not least because their yield premium over government bonds has attracted investors looking to maintain their income. Yield premiums have fallen sharply over the past few years but remain above the long term average at around 200 basis points on sterling bonds and 150 basis points in the US: this should continue to attract investors wanting income.
Nevertheless, one suspects that the upside from current levels is now limited given the absolute level of yields. According to Merrill Lynch indices, the average yield on investment grade sterling corporate bonds was just 3.9% at the end of 2012; on US dollar bonds, it was just 2.8%.
Index linked bonds have performed in a similar fashion to conventional government bonds over the past few years. With real yields on all but the longest dated index linked bonds negative, like conventional bonds, it is difficult to describe them as attractive. One can, however, justify holding some in portfolios as insurance against a sharp rise in inflation, which is still possible given what central banks have been doing through quantitative easing (i.e. printing money). With pension funds still forced to buy them by their actuaries, index linked bonds will remain expensive compared to historical levels.
Equities: valuations appear reasonable
Equity markets performed well over 2012, with the MSCI World Index rising 16% in local currency terms. Given the scale of the intervention by the authorities in Europe, aggressive quantitative easing by key central banks, particularly in the US, UK and Switzerland, and some encouraging signs in the US economy in the second half of the year, the rally in markets is possibly unsurprising.Will the rally continue? Liquidity and valuations suggest it could. The scale of the liquidity poured into the financial system by central bank quantitative easing programmes is undoubtedly one of the key reasons for the rally. This should continue to support markets over 2013, thanks primarily to the Fed’s extension of its quantitative easing programme. If the LDP are successful in forcing the Bank of Japan to become more aggressive in its quantitative easing, it would provide an additional boost to markets.
Despite the move over 2012, valuations in most equity markets remain reasonable for income hungry investors, with dividend yields continuing to look attractive compared to cash and bond yields. The FTSE All Share Index, for example, yields 3.4% compared to the average gilt yield of 1.9% and the average sterling corporate bond yield of 3.9%. The German market currently yields 3.4% compared to a yield of 1.3% on ten year government bonds; in France, equities also yield 3.5% compared to 2.0% for ten year bonds. Earnings valuations also continue to look attractive, with most markets still trading well below their long term averages ‚Äì some emerging markets, including Brazil and China, look particularly cheap despite their bounces from recent lows.
Despite valuation support, political events will upset markets at various points over the year. The inability of US politicians to agree on anything until the very last minute almost guarantees a setback at some stage as the uncertainty created means sentiment will swing widely on leaks and rumours ahead of any deadline. In Europe, the authorities have done a lot over the past year but there are still hurdles to jump before the debt crisis in weaker countries is finally resolved and the grim economic environment in the Eurozone means there will be constant pressure for further action. The key player in the European drama, Angela Merkel, faces a general election this year; there will also be a general election in Italy, with Silvio Berlusconi once again unsettling the equilibrium. In the Far East, markets will be watching out for further developments in the stand- off between China and Japan over the Senkaku islands, which has already had a considerable negative impact on Japanese exports.
Currencies: the yen heads south
The key issue in currency markets at the moment is the yen. It has fallen sharply since the victory of Mr Abe and the LDP in the recent Japanese general election, on hopes that the new government will be able to force the Bank of Japan to print money aggressively and thereby turn deflation into inflation. If the Bank of Japan succumbs to the new government’s pressure, the yen will fall further.
One suspects, though, that the Bank of Japan will do no more than the minimum required to silence the politicians as it is well aware of the social consequences of letting the inflation genie out of the bottle in a country with such a high proportion of pensioners and savers. Inflation would also almost certainly lead to a sell-off in the Japanese bond market and create the risk of systemic collapse, as bank holdings of JGBs are a multiple of their capital base.
Elsewhere, it remains difficult to differentiate currencies on fundamentals, which suggests that they are likely to continue to trade sideways within broad ranges. Valuations based on purchasing power parity suggest that the US dollar is modestly undervalued against sterling and the euro (10- 15%) but very cheap relative to the Swiss franc (30%) and Australian dollar (45%).
Commodities: prices remain range-bound
Despite the Fed’s announcement of more quantitative easing and continued strength in equity markets, commodity prices generally fell back over the fourth quarter, giving up much of the ground gained in the previous quarter.
Assuming that the global economy grows in line with consensus forecasts and central banks continue to pump money into the financial system, commodity markets should remain reasonably stable. It would, however, require an external shock or significant acceleration in economic growth, particularly in China, for prices to break decisively out of the recent trading range. With regard to agricultural commodities, it is possible that global warming has made an external shock (i.e. extreme weather) more likely.
Expected equity return analysis
A global, diversified portfolio of equities is likely to generate 4.5% above inflation on average over the next 10 years. We are wise enough to know that it is almost impossible for us to predict correctly what return investors will achieve from equities over the next 10 years. There are too many known unknowns and unknown unknowns. Nevertheless we are foolish enough to give it a go!
We have formalised and codified our view that valuation analysis, as oppose to economic forecasts, is the key to understanding future returns and we have created a 10 year equity return forecast. Our analysis assumes that in the very long run equities will continue to generate a return of 5.5% above inflation, with an additional 0.5% return in times of relative peace. We also assume that when the market is expensive compared to history, the return over the following ten years will be lower; likewise, when the market is cheap, we assume that the return over the following ten years will be higher. There is considerable evidence going back to 1871 (courtesy of Robert Shiller) to suggest that this approach works: buying equities when they are priced at low valuations generates higher returns than buying equities on higher valuations. This should not surprise you.
Our forecast model predicts that a portfolio of global equities split equally between the US, Europe and the rest of the world should generate an average return of around 4.5% above inflation over the next 10 years. Athough this is below the very long term average of 5.5%, it is high enough above the expected returns from cash or bonds that even if equities undershoot our forecast, they are still likely to give a better return than these alternatives.
In constructing the model we have included a number of valuation variables. Our reasoning is simple: a mix of factors is less likely to be skewed by one-off anomalies. These factors include comparing the current and cyclically adjusted price to earnings (‚ÄòP/E’) multiple against the long term averages for both. Of these two p/e values, we place a greater importance on the cyclically adjusted p/e as it gives a better indication of sustainable value. We also compare the current net book value of company assets against the market value of equities for the US and make an adjustment to take into account current profit margins.
The metrics we use are biased to the US because data is more easily available there. However, the fact that so many companies are international means that this bias should not really distort the forecast too much. But as a measure against a US bias, we make a forecast for the US and a separate forecast for global equity returns and then combine these to create a forecast which mimics the equity allocation of our portfolios, which normally have one third allocated to the US.
On a backtested basis, every forecasting model ever proposed looks good and ours is no different. The relationship between our forecast and actual returns is reasonably close. The current forecast of 7%, or 4.5% real, assumes 2.5% inflation. This global forecast can be broken down into a forecast for the US of just over 2.5% above inflation and around 5.5% above inflation for the rest of the world.
So what does the current forecast tell us?
Assuming 2.5% inflation, the most likely outcome over the next 10 years will be between 3.3% and 10.7% p.a.
It is easy to think that this range is too wide to be of value. But if you consider that the range of 10 year returns in the past has been between -4.5% and +20.8%, it is actually fairly instructive. It is almost impossible for our forecast to be exactly right. However, it can be used as a guide and indicates the likely general direction of equites. It is also useful for comparison with forecast returns for other asset classes such as cash and bonds. Given that the latter two asset classes offer negligible or negative real returns today, there is a 4.5% margin for error in our forecast for equities!
With the exception of the high levels the model predicts for the late 2008/early 2009, it is forecasting higher returns on equities today than it has for the past 25 years. The case in favour of equities for long term investors appears strong.