Only eight months on from the Investment Forum in Hong Kong, our constructive outlook amid much market gloom seems justified. We were confident that, rather than break-up, the European Monetary Union would be strengthened, and that the central banks, notably the European Central Bank (ECB), would continue to do their very best to stabilize financial markets. Meanwhile, our cautious approach to government bonds from industrialized countries, together with our preference for spreads (such as corporate High Yields and Asian bonds) and for equities with strong, sustainable dividends have turned out to be good calls for both us and our clients.
The position we have been advocating since 2011, and refined further in Hong Kong, has held true: Financial Repression is at work and is here to stay.
The changing mission for central banks
History has shown that Financial Repression is a slow and insidious process. There is every reason to believe that history will repeat itself and that the search for real returns will remain the most pressing challenge for investors in the foreseeable future, as governments and central banks contend with massive levels of debt, which have been transmuted rather than reduced through repeated rounds of Quantitative Easing in a number of OECD1
As central banks — in particular the US Federal Reserve (Fed), the Bank of England (BoE), the Bank of Japan (BoJ), and even the ECB — have become increasingly active market participants, our understanding of their shifting priorities and analyses has become pivotal for predicting inflation developments and valuing assets. The Fed now appears to be pursuing employment targets and the BoJ yen / export targets. The BoE looks likely to target nominal GDP2
growth once its new Governor takes office. Only the ECB’s financial stability measures have an expiry date.
There was consensus that inflation, a global phenomenon in trend if not quantum, would remain subdued. Inflation expectations appear well anchored at least for the next 18 — 24 months, with an output gap preventing rising demand from driving up prices. In addition, the massive expansion of central banks’ balance sheets has been accompanied by continually depressed money multipliers. However, on a medium- to longer-term view, risks are on the upside, as central banks, namely the Fed, look likely to voluntarily stay behind the curve to ensure that they don’t repeat the errors of the BoJ over the past twenty years and choke off the recovery.
History provides many warnings with respect to inflation: it tends to be sticky until it changes; when it changes, the change tends to come as a surprise; such ‘shocks’ tend to alter inflation expectations. As long as inflation remains below four per cent in developed economies, any increase may be good news for inflation linkers and equities, but bad news for bonds. If it creeps up above that level, history suggests that equities might suffer, too.
With central banks being now the major holders of treasuries, they are not only the lenders of last resort
, they are also the buyers of last resort
for treasuries. By keeping yields low, their actions are underpinning valuations at artificially high levels. This has a strong bearing on other asset valuations and allocations.
In the absence of an obvious exit strategy, any unwinding of central banks’ positions will probably be very gradual at first, so sovereign bond valuations look stable in the short term. For investors with a longer time horizon, we may soon reach the point — if it has not already been reached — that there is no external market for such government debt. Any resultant asset re-allocation could have knock-on effects for the valuation of other bonds and asset classes.
Consistent with our stance following the Investment Forum in Hong Kong, we maintain a favourable outlook on Asian fixed income. Compared to the low to negative real returns on US treasuries, Asian bonds seem to offer investors an attractive risk-return profile. The scope for currency appreciation in a number of the Asian markets is an argument for investments without currency hedging.
Elsewhere, our favoured valuation tool — the “Shiller PE”3
— is telling us that equities are attractive, though not without caveats. We have seen a strong recovery in equities over the last six to nine months. While data from the US housing market bode well in our view, EU and ASEAN equities look cheaper than US equities.
The short-term indicators point towards a soft rather than hard landing for the economy. In addition, our assessment of developments within China and the scope for progressive structural reforms there reaffirm our constructive position on the economy.
The target GDP growth rate and the assumptions about population growth imply that China remains committed to a significant increase in consumption, which is consistent with its stated policy of rebalancing its economy. Urbanization looks set to continue, with a focus on increasing the number of people with access to social safety nets.
While the development and direction of China’s economy will be the subject of continued discussion and market speculation, we continue to form our position based on extensive local market insight.
Based on our understanding of the forces at work across the global economy, we see the following investment implications:
- While the diminishing universe of AAA-rated issuers gives those that are left a scarcity value (and, in turn, increases the cost of such assets), these assets are protected to some extent because the steepness of the yield curve has led to high forward rates.
- While break-even inflation rates remain very low, our outlook for inflation linkers is positive.
- Provided inflation remains under control, the environment for spread and some equity investments remains benign.
- During the financial crisis, emerging market bonds have been less volatile than feared. Emerging market / Asian bonds offer an attractive risk-return profile in our view. Most of them are investment grade. Global capital flows are driving demand for these assets, and we believe there is still room for a potential currency appreciation.
- In the case of European high yields, valuations based on default risk seem attractive. Investor demand is higher than issuer supply.
- With respect to US-high yields, corporate balance sheets look robust with leverage ratios and interest coverage ratios near, or better than, levels seen in the past 20 years.
- US equities look relatively expensive from a valuation perspective (the premium for US over European equities is the highest for 30 years), European stocks look cheap and the emerging markets still seem to be the most attractive segment.
- Chinese A-shares look even more attractive now when set against H-share valuations, and we expect to see a Renminbi appreciation over the longer term.
Real Return On
In short, the latest Investment Forum has confirmed rather than confounded our broader positioning since 2011. When we talk of Financial Repression, we are referring to an era, to a policy response to excessive leverage that will be spread over many years. Regardless of whether the flavour of the month is “risk off” or “risk on”, investors should do well in the long term to maintain a somewhat different focus: “real return on”!