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Category: Investment Committee

Asia ex Japan Equities: Will The Rooster Crow?

Posted on by admin@hottinger.co.uk

After five years of uninspiring relative returns, will Asia ex Japan equities crow loudest in the Year of the Rooster? The Asian markets beat global equities comfortably during the 2000s but have lagged since late 2010. However, on a medium term view, this may be about to change.

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Improving Economics. China is of course the biggest player in the region and changes in the Chinese economy help to explain strong equity returns in the 2000s and weaker ones since. The Chinese authorities have deliberately slowed the economy, seeking more sustainable growth led by consumer demand and services output. The markets doubted whether China would succeed but may be changing their minds.

The IMF said last month that it expects Asia’s emerging economies to grow by 6.4% this year. China will slow a little to 6.5% and India pick up to 7.2%. Private sector forecasters are pencilling in 6.4% and 7.4%. Despite large error bands around any economic forecast, Asian growth looks impressive.

Looking at more timely indicators, Asia’s purchasing managers’ indices are mainly above the key 50 level: South Korea is the key exception. More interestingly, Citi’s economic surprise index for Asia Pacific recently hit a six-year high. The markets did not anticipate the better figures.

At an industry level, DRAM prices are rising sharply. In fact, they have doubled over the past eight months. Meanwhile, the International Air Transport Association noted late last year that shipments of components for consumer electronics, a regional strength, are rising. It also reckons that total freight volumes rose 9.8% yoy in December.

Cheap Equity Markets. After a long period of weak equity returns, it is no surprise that valuations are attractive. As of 31st January, MSCI calculated a forward P/E ratio of 12.7x for Asia ex Japan equities versus 15.7x for MSCI World and a price-to-book ratio of 1.5 compared with 2.2. This is despite a strong rally in Asia ex Japan stocks in January. Today’s valuations also compare favourably with those over the past decade.

Under-valued Currencies. Foreign investors can also take heart from generous currency levels. Over the past couple of years, the Korean won has depreciated by 5%, the Indian rupee by 8% and the Chinese renminbi by 9% versus the US dollar. As trading nations, these currency declines have given exporters an edge and also reduced the risks for overseas equity investors.

Investment Conclusion. Leaving aside active funds, many investors will seek to invest via an MSCI Asia ex Japan ETF rather than pick individual stocks. 85% of the index covers five economies (China, South Korea, Taiwan, Hong Kong and India) and over 60% is in three sectors (information technology, financials and consumer discretionary). Thus, exposure is concentrated in a few economies and industries.

True, there remain concerns over how China handles its transition and also rising private sector debt ratios. There are also worries over US-China relations in the Donald Trump era. However, the fundamentals seem good and both equities and currencies offer fair value. The only caveat is the 8% rally for sterling investors since Christmas. It may be wise to wait for a setback.

US Equities and La La Land

Posted on by admin@hottinger.co.uk

The major US stock indices and the film La La Land both broke records this month. The S&P 500, Dow Jones and Nasdaq hit all-time highs and La La Land won seven Golden Globe awards. But the question for investors is whether US equities are now in La La Land.

The Positives. Let us round up the reasons to be cheerful under three headings. First, animal spirits. President-elect Donald Trump has given US corporate morale the feel-good factor without actually doing much. However, importantly, he has nominated a business-friendly senior team. Ray Dalio of Bridgwater reckons that the key eight personnel have just 55 years’ experience of public office (mostly in the military) but 83 years in business. The equivalent figures for Barack Obama were 117 and five(!) respectively.

Second, fiscal stimulus. While artfully avoiding specific numbers, Trump has promised lower taxes and more infrastructure spending, which will give the economy a budget boost. We should get a sense of how big next month when the White House delivers its draft budget to Congress.

Third, micro measures. Mr Trump has dangled a raft of measures before the public and the markets. His proposals include a corporate tax rate cut from 35% to 15%, reducing the personal income tax bands from seven to three, a bonfire of regulations and a shake-up of energy policy. These plans could be partly paid for by getting rid of tax breaks and widening the tax base and also by a one-off 10% repatriation tax on firms’ overseas earnings.

The Negatives. However, there are also reasons to be gloomy. Here are a few:

The pre-election reasons for caution – a sluggish economy and expensive valuations – are still there. This economic recovery has been lacklustre at best. And, while equity valuation is an imprecise art, the chart shows that both the forward price/earnings and price-to-book ratios are around cyclical highs.

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Furthermore, President Trump is not guaranteed to get his agenda through Congress. Trump has been talking in terms of tax cuts and spending increases but Congress prefers fiscally neutral programmes.

Also, part of the Trump package is trade barriers and immigration curbs. These were popular on the campaign trail but may not be good for either the economy or the corporate sector.

Even if Donald Trump does deliver a sizable fiscal lift, it may result in more inflation rather than more growth as the economy over-heats. And the latest FOMC minutes openly suggest that rising inflation would be offset by faster interest rate increases.

And, finally, a policy mix of easier fiscal but tighter monetary policy is a recipe for a stronger US dollar. The dollar has risen by a manageable 5% over the past six months but further appreciation will put downward pressure on corporate earnings.

Conclusion. We think the best explanation of the post-election rally is the prospect of corporate tax cuts. There is a fair chance that Donald Trump will push this initiative and that it will get through Congress. The result may be higher after-tax earnings for years ahead which discount to higher equity prices now.

However, all the good news may now be in the price and the markets could be entering La La Land. Could Inauguration Day on Friday be the start of the next downturn?

UK Gilts: Good Value Again?

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It has been a V-shaped year for UK gilts. Starting the year at nearly 2%, the ten-year yield fell to 0.5% during August but has rebounded to 1.4%. Is the ten-year gilt approaching good value again?

Real Yield and Inflation Expectations. One starting point is to break the nominal yield down into expected inflation and a real yield. Interestingly, the rally to 0.5% was driven largely by a decline in real yields but the climb back to 1.4% was mainly due to rising inflation expectations. The real yield is off its absolute 2016 lows but remains very subdued by past standards at -1.75%.

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The chart gives a longer view. During the 1990s and the early 2000s, the real yield and the breakeven inflation rate roughly tracked each other. If the nominal yield was 4%, then the chances were that the real yield was 2% and the breakeven similarly 2%. However, from 2003 onwards the real yield continued to decline while inflation expectations moved broadly sideways. Currently, the nominal yield of 1.4% comprises a real yield of -1.75% and expected inflation of over 3%.

Expected Inflation Too High. Even noting that UK index-linked gilts are tied to the RPI rather than the CPI, the rise in breakeven inflation looks overdone. Sterling’s fall is the root cause of this move but, unless the pound continues to fall, the increase in actual inflation will be short-lived. We expect CPI inflation to approach 3% next year but then to ease back to around 2%. Thus, ten year gilts have some protection in the form of over-done inflation expectations.

But Can Real Yields Remain Deeply Negative? Economists are not entirely sure what drives real yields. There are plenty of theories but not much conclusive analysis. After a few moments’ thought, we have come up with seven likely drivers of real yields:

  • Global yields – international government bond markets have a strong herd instinct, often driven by the US Treasury market. Where the ten-year Treasury yield leads, others (mostly) follow.
  • Larger debt/deficit – in most economies, public debt ratios and budget deficits are higher since the financial crisis. This is certainly true for the UK, boosting the supply of gilts.
  • Growth prospects – whether you call it “secular stagnation” or “productivity puzzle”, there is a malaise affecting growth in the UK and elsewhere. We expect UK growth to slow next year.
  • Ageing population – the retired population is increasing rapidly and, with it, the propensity to save.
  • Declining capex growth – for whatever reason, businesses are investing at a slower pace now than twenty or thirty years ago, which means fewer physical investment opportunities
  • Political uncertainty – the three big votes of 2016 (in the UK, the US and Italy) have resulted in increased political uncertainty, giving investors an incentive to head for the safe haven of government bonds.
  • Inequality – whether income or wealth inequality, the outcome is greater flows into financial assets, including the most liquid asset of them all, government bonds.

Investment Conclusion. The above seven influences are carefully ordered. Broadly speaking, we reckon the first two are negative for gilts at present but the latter five are positive. Thus, there are good reasons to like gilts at these levels but there is a distinct danger that further increases in US Treasury yields could overwhelm all else. Our view is a cautious buy for now.