Allocation chaos as conventional thinking fails

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There is a lot of press today about the relative performances of global and Australian bonds and equities. All of it is late to the party and not much of it has a clue. Let’s being with US equities where Goldman sees:

  • The prospect of higher short-term interest rates is now within the investment horizon of many fund managers for the first time since before the financial crisis
  • Both the futures market and Goldman Sachs Economics anticipate the initial hike will occur in roughly 12 months (3Q 2015)
  • Kansas City Fed … annual Jackson Hole economic symposium … investors will look for information on how policymakers will assess when tightening should begin
  • Markets do not always follow historical patterns, but we expect the S&P 500 will climb by 6% during the next year, ahead of the first hikeS&P 500 posted positive returns during the 3, 6, and 12 months ahead of first Fed tightening actions in 1994, 1999, and 2004.
  • Compared with prior episodes, the level of interest rates is much lower and the trajectory of economic recovery is far more gradual. However, the starting forward P/E multiple on an aggregate basis is actually lower than it was in 2004 (15.5x vs. 16.4x), although on a median basis it is similar (16.6x vs. 16.4x).
  • Goldman Sachs Economics forecasts the Fed will start lifting the funds rate in 3Q 2015 and continue hiking until it reaches a neutral level of 4.0% in 2018. However, some market participants believe the US economy is experiencing “secular stagnation” and GDP growth will remain below trend indefinitely. In that situation, the neutral fed funds rate will be lower than we anticipate, perhaps only 2%.
  • The neutral fed funds rate matters for equity investors. A lower neutral rate in five years translates into a lower discount rate on future earnings and a higher equity valuation. On the other hand, a higher neutral rate means a higher discount rate and a lower present value of future earnings. From a sensitivity perspective, a 50 basis point shift in the estimated neutral rate will adjust our year-end 2018 DDM-implied fair value of the S&P 500 by roughly 9%.

That’s close enough to my own view, though I do see the possibility of a good correction along the way as the thousand cuts of geopolitics weighs on the market. Secular stagnation is here and although bonds will have their periodic inflation panics they’ll remain strongly bid.

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Indeed, the lessons of Japan’s long stagnation tell us that the oft quoted “no-brainer trade” of today – shorting US bonds – is a fiction. After two decades of the same trade making widows of money managers in Japan, you would think monetarists might have learned that the only no-brainer trade in a post-credit growth and zero bound economy is to go any time that bonds sell materially.

Turning to Australia, we have some real wasted breath. Although we are one cycle behind the US in our asset price bust, and have benefited much more from the rise of China, the same secular stagnation has also taken hold here via conservative household spending. Yet, talk in the media is still stuck in yesteryear. From the SMH blog:

Economists can’t keep pace with Australia’s biggest bond rally in three years, forcing them to slash yield forecasts even as they stand by calls for a sell-off.

Australia’s sovereign debt has returned 6.2 per cent since December 31, on pace for the best annual return since 2011, a Bloomberg index shows. The 10-year yield is trading at 3.34 per cent, having dropped 90 basis points this year.

Economists surveyed by Bloomberg News this month predicted the benchmark will increase to 3.85 per cent by December 31, cutting their median estimate from July’s 4.25 per cent, the biggest change in more than a year.

Investors are piling into Aussie bonds on bets the RBA will keep its interest rate at an all-time low, extending a pause to a record stretch, as US and European policy makers pledge to maintain accommodative measures.

Yields should rise into year-end as the RBA’s first rate increase since 2010 approaches in the second quarter of 2015 and traders realise the market is overpriced for economic weakness, according to ANZ.

“We do think that bonds are too expensive but to some extent, we’ve been saying that for some time and we’ve been wrong,” says Zoe McHugh, an interest-rate strategist at ANZ in Sydney. “Mixed global data, geopolitics, much lower German and Japanese bond yields, and this whole reach for yield is continuing and does seem to be broadly ignoring the improving macro-fundamentals, but we don’t think that can continue indefinitely.”

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Can it really be that the banks, direct beneficiaries of the stagnation, still don’t get what it even is? The next move in Australian interest rates is still very likely to be down and even if that’s wrong, any rise will be very brief. Mac Bank’s Global Horizon turns its hand to the same question today:

  • Stay overweight US equities. We remain bullish on US equities given the structural growth drivers of the housing recovery, cheap US energy, cheap labour costs, a well-capitalised banking system and the Silicon Valley growth engine. With the acceleration in the leading indicator, and expectations that EPS growth will rise to 10% a year, we don’t see the US as expensive.
  • Get out of bonds. Fed hikes are coming in 2015. We also see a rise in inflation as spare capacity in the economy is used up. Expect CPI inflation closer to 3%-plus by late 2015. With the Fed also hiking by that time, real yields on long-term bonds purchased today will likely be negative.
  • Buy more equities in China. China is easing policy to boost growth, and it’s working. Investors are anchored to today’s cheap valuation, but we see a rerate as the cycle improves. The rally in property developers suggests a trough in house prices is also at hand, which would remove a key downside
  • risk. We suggest to overweight Asia ex-Japan as it rides China’s coattails. For more, see China Contrarian Call: Get Bullish (Jul 2014).
  • Neutralise cyclical bets on Europe. We cut Europe to Neutral as cyclical momentum looks to have peaked. ECB stimulus and a lower Euro will givesome support to the cycle, but the banks are not lending and corporate EPS is not rising enough to keep up with the rise in equity markets.
  • Underweight Japan and Australia. We cut Japan to underweight in July, and we think the economy continues to lose momentum. Without further stimulus, we would rather buy China. We cut Australia to underweight on concerns over the domestic economy and suggest an overweight to global exposures. Like Japan, Australia needs more stimulus. Unlike past cycles, the benefits of past rate cuts are being offset by the high currency, fiscal drag, low wage growth and falling investment in the economy.
  • Outlook
  • We remain bulls on global equities given the lack of returns and rising risks in bond markets. The key question is which country to own, and we see the best buying opportunities in the USA and China. Korea also looks more interesting given the reforms to encourage investment and dividends.
  • We think returns for long bonds purchased today will likely deliver negative real returns in the next few years as inflation rises and the Fed hikes. Bond linked sectors like REITs, Utilities and Telecoms are also likely to lag the market in the lead up to the 1st Fed hike. We expect to see better value in Treasury bonds and bond-linked sectors after the Fed starts to hike.
  • Commodities remain in limbo. If you want exposure to a better global economy, we think the risk-reward is better in stocks. If your bull case for commodities is based on a China upturn (which it often is), we suggest to instead buy China property developers or other MSCI China cyclicals.

Spot on on Australia but more conventional thinking for the US and China, as if this is regular business cycle. US inflation is going to remain weak on slack labour markets and falling commodity prices as China stays on its structural adjustment path and does not “recover” in any cyclical sense. Any back-up in Western bond yields will be muted, very much focused at the short end, and brief. That offers a distinct repricing tailwind to equity based upon the Goldman argument we began with.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.