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By Hottinger Investment Management

Optimism rises that the world economy will escape further deceleration

For the last few months, we have taken the view that the all-important US economy is ‘late-cycle’ with growth decelerating and a recession looming. The latest slew of data might appear to challenge this view.

The Bloomberg Economic Surprise Index has reached an 11-month high after four indicators released last Thursday, including existing home sales and jobless claims, each surpassed expectations. The gauge swung to positive from negative last week for the first time this year. The data also pushed a similar measure produced by Citigroup to the highest level since April 2018.

Last week, the Fed highlighted the US economy’s strength even as it moved forward with another interest rate cut to guard against elevated risks to the expansion. Risk-on investors are growing more confident too, lifting U.S. equity benchmarks back near to records this month; meanwhile, over the last four weeks US Treasuries have sold off. It appears that investors are starting to buy the Fed’s talk of mid-cycle adjustment.

The US data follow reports from both Europe and Japan that sentiment has surprised on the upside.

But let’s be clear, while imminent recession risks are receding, we argue that the environment is still most plausibly late cycle. US firms are still reluctant to ramp up capital investment against a backdrop of trade policy uncertainty and tepid global demand. It is unlikely – absent a pre-election fiscal boost from the Trump Administration – that US GDP will return to the 3%+ rates it enjoyed last year. Indeed, despite the release of the latest hard data, the Atlanta Federal Reserve continues to predict an annualised expansion for Q3 of closer to 2%, the same level it forecast for that period at the end of July, when bonds were still well and truly rallying. That would represent a clear deceleration.  

Meanwhile, manufacturing and industrials continue to act as drags on the economies of Europe and South East Asia. The euro area’s industrial output contracted 0.4 per cent in July over the previous month, according to official data from Eurostat. Compared to the same month last year, factory output in the 19 eurozone countries was down 2%, worse than the 1.3% fall expected by economists polled by Reuters. There’s still a risk that central banks will not move quickly enough to re-loosen policy sufficiently to keep the global cycle going further. The Fed has of course cut rates and the ECB has announced an innovative subsidy scheme for large banks by raising the deposit rate on excess reserves above those at which banks can borrow from the ECB. But it may still be too little to reverse the slowdown in global growth.

Signs of stress in dollar financing markets also remain – even if last week’s spike in repo funding costs was due to technical reasons rather than a symptom of seizure in financial markets. As we discussed recently, dollar shortage is pushing up trade financing costs, which will only ever be an impediment to business.

But perhaps by focusing so obsessively on the US and the Federal Reserve, we have missed the Chinese story. Have China’s policy actions in the face of trade headwinds turned around its economy and, in the process, improved conditions globally? It is too early to say conclusively but we can certainly point to signs.

The Chinese authorities have not been sitting on their hands this year. Since the turn of the year they have been responding to political hostilities by allowing their currency to depreciate, cutting taxes on incomes and consumption, and expanding loan availability to private firms that have been shut out by the clampdown on shadow banking operations in the country.

If we see a repeat of late 2015 with a rapidly rising Chinese credit impulse, the effect of that could far outstrip the real economy consequences of a 25bps cut in US interest rates. This would reflect the fact that the centre of the global manufacturing economy is now in Asia generally and China specifically. For that reason, we should keep a closer eye on policy developments in China.

What matters globally right now is the manufacturing and industrial picture. Until we see a reversal in fortunes in this space – and that will require both a resolution to the trade standoff and looser monetary conditions – we must still assume that recession risk globally is elevated, with Europe leading the way and the US not immune.

By Tom Wickers, Hottinger Investment Management

WeWork announced yesterday evening that it has shelved its initial public offering (IPO) after the reduced price-tag failed to turn investors’ heads. While the firm has not yet announced how long the delay will be, financial pressures would suggest it cannot postpone for long unless its current major financier, SoftBank, forks out more cash. The WeWork shelving leaves the IPO market in an awkward position, not dissimilar to the global economic environment, where analysts will wonder whether there is much more petrol left in the tank.

IPO investors have enjoyed a successful 2019 so far. Whilst the performances of ride-hailing firms Uber -24.28% and Lyft -34.74%* have been stuck in reverse, many IPO companies have rocketed up on the voracious appetites of investors. The year-to-date performance of the Renaissance IPO Index, which invests in recent US IPO stocks, is at +32.79%. This is a result of strong growth in 2018 IPO holdings as well as monstrous growth from recent IPOs such as Beyond Meat +511.72% and Zoom Video +126.47%. 

Now, while the global economy stumbles and contemplates its position and a WeWork offering looks precarious, there are still several listings that continue to plough forward. Peloton has kicked off its roadshow, Airbnb is expected to list this year, AB InBev has renewed its pledge to go public and Aramco may yet push forward with its IPO plans when it has repaired its infrastructure and tightened security. This may be seen as surprising given the cyclical nature of IPO deal flow and the current uncertainty embedded in the markets.

Assessing historical IPO returns can shed some light on whether this market should be attractive at all. First Trust US Equity Opportunities ETF (FPX US Equity) trades in stocks which have recently undergone an IPO. Since inception their performance has outstripped the US equity market. Even when accounting for different risk exposures through a Carhart four-factor model regression, the fund still averaged 1.44% higher return per year than we would expect.

These findings concur with a recent study conducted by Goldman Sachs which evaluated the performance of 4,481 IPOs since 1995, and found that an IPO portfolio outperforms the market. It is, however, worth noting that the median IPO actually underperforms, meaning that the portfolio relies on the high returns of a minority of companies.

Perhaps more pertinently, Goldman Sachs also found that IPOs appear overpriced compared to the market before a recession^^, which would suggest investors may want to steer clear of new IPO stocks if they are forecasting a looming downturn.

The performance of the top 5 largest IPOs in each year between 2011 – 2017 also bears bad news. Analysing the returns of these stocks for a year post-launch reveals that they have underperformed the market by 0.25% per year on average and underperformed an asset with similar risk exposures by 0.21% per year (using a Carhart model). A potential explanation for this is that big IPOs are subject to “market hype” and so suffer more from a post-offer waterfall. Large IPOs have also tended to be mature companies this decade, which have less room for growth. This, however, does little to explain the poor risk-adjusted returns. The volatility and downside risk of the returns on these stocks are also particularly unattractive and would dissuade the majority of investors from holding a sizeable position in an IPO stock.

IPO activity has been piping hot so far this year, but the numbers suggest a cooler outlook on performance in the near future might be wise. With big companies still pushing to go public and high levels of market uncertainty, there is a risk of the general listing being overvalued.

When assessing a specific case, it is also worth evaluating the motives for listing at this time – is it an action born of confidence or desperation?

* Percentage change on stock price since inception. Statistics were as of 13/09/2019.

** Data taken from the Renaissance Capital website

^ Data from Goldman Sachs Global Investment Research, as of 28/08/2019.

^^Source: https://markets.businessinsider.com/news/stocks/5-most-important-factors-for-successful-ipo-performance-goldman-sachs-2019-9-1028507003#valuation3

 

By Hottinger Investment Management

There is a statistic hidden in a report for the Bank for International Settlements (BIS) that is a little surprising.

According to the World Trade Organisation, not only does some 80% to 90% of world trade rely on some form of trade finance (trade credit, insurance or guarantees), though mostly of a short-term nature; research from the BIS’s Committee on Global Financial Services found that up to 80% of this is denominated in dollars. Whilst firms finance most global trade (65%) themselves, either by the seller in the form of “open account financing” or by the buyer paying upfront in a “cash-in-advance” purchase, the banking system underwrites the rest – a sizeable 35%.

This means that not only the value of the dollar, but also the state of dollar financing conditions, matter well beyond US borders. In recent months, despite intentions having been signalled by central banks since late last year to start to ease monetary conditions, there are signs that the opposite is happening. Bloomberg’s index of dollar financing conditions has flirted with contraction since August.

What does this mean? The Bloomberg U.S. Financial Conditions Index¹ tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.

The availability of credit is arguably as important as the cost of credit, and the two are interlinked. We can see some signs of this by looking at the dollar’s cross currency basis (XCB) with major developed market (DM) and emerging market (EM) currency pairs. As the chart below shows, the dollar XCB is currently strongly negative against the euro, yen, Korean won and Turkish lira. The dollar XCB is positive with some currencies such as the Mexican peso and the British pound, but on balance it is broadly negative. Any ‘basis’ – positive or negative – should not be possible; the theory of covered interest parity means that there should not be a difference between the own-currency interest expense that a foreigner pays on her dollar borrowings and what they would pay if borrowing the same funds in their own currency for the same period of time. A negative basis means that foreigners are effectively paying a premium to borrow dollars in the swap market and this typically arises when there is excess demand for dollars in the global system.

The Federal Reserve and US banks are essential suppliers of dollars, and it is more than possible that the Fed’s hiking cycle, which began with the tapering of QE in late 2013, has squeezed global liquidity.

Compounding the problem is the persistent strength of the US dollar, which few analysts expected this year as they made bets on the recovery of emerging markets. The combined effect of higher US interest rates, the growing importance of the dollar in global trade and the role of American markets as safe havens during times of economic stress has kept the dollar strong. Since early 2018, the Indonesia rupiah (-3%), the Taiwanese dollar (-7%), the Indian rupee (-10%), the Chinese yuan (-12%), the Korean won (-12%) and the Brazilian real (-20%) have all weakened substantially against the dollar.

It is not surprising, therefore, that global trade is in the doldrums. Policy uncertainty no doubt has had a role to play, but we cannot underplay the effect of tightening dollar financing conditions, the restricted supply of the dollar and the increasing reliance of international business on the greenback.

¹All of the indicators included in the composite BFCIUS index are normalized by subtracting the mean and dividing by the standard deviation for each series. The mean and standard deviation are calculated from observations during the pre-crisis period, which is defined as the period from 1994 to July 1, 2008. The normalized values are then combined into the composite BFCIUS index, which is itself normalized relative to its pre-crisis values. As such, the BFCIUS index is a Z-Score that indicates the number of standard deviations by which current financial conditions deviate from normal (pre-crisis) levels.

By Tim Sharp, Hottinger Investment Management

Global tensions and softening economic conditions disrupted the thoughts of many market practitioners as they relaxed on vacation; a combination of previously tightening monetary conditions, the intensifying US-China-EU trade war, and the secular slowdown in China have – we believe – all contributed to the downward shift in global economic activity. In Europe, export-facing manufacturers continue to struggle as China reduces demand for capital goods and car manufacturers wait as the US considers a round of tariffs aimed specifically at the industry.

The data released in August confirmed the trend towards a coordinated global slowdown that we have been signposting for the best part of the year. US Q2 growth came in at 2.1% annualised (vs 3.1% Q4 2018); in China, Q2 expansion was 6.2% annualised (vs 6.4% Q4 2018), and for the euro area the Q2 quarter-on-quarter growth rate was 0.2%, down from 0.4% in Q4 2018. Within the European region, two major economies – the UK (-0.2%) and Germany (-0.1%) – contracted over the quarter, whilst Italy saw no growth.

The rally in global government bonds continued, while in equity markets there was no sign that the great valuation divergence between US equities and Developed Market-ex US equities that has opened since the early 2010s was beginning to close. US Treasuries rallied 3.60% with the biggest gains in longer-dated maturities, where 30-year bond yields fell below 2% for the first time and 30-year German Bund yields joined shorter-dated bonds in negative territory, finishing the month at -0.179%. The US Federal Reserve has done more than any other central bank in ‘normalising’ monetary policy in the last few years; higher rates do not seemed to have constrained US domestic activity but the offer of higher yields has kept the dollar strong despite many predictions to the contrary, which has underlined our decision to be wary about further investment in emerging markets.

The rally in US equities during 2019 (+16.74%) has been based almost entirely on valuation expansion rather than a sustained uptick in earnings. However, the fall in the S&P500 of 1.81% in August stems from the anxiety that central banks will be unable to prevent the global economy dipping into recession in 2020. This means that earnings estimates – although they have weakened significantly throughout the year – are probably still too optimistic (according to Morgan Stanley). European equities were also down -1.34%, and Japan fell 3.80% while emerging markets struggled and fell -5.08%.

Late cycle is a challenging time for investors. The conventional wisdom, for the US at least, is that an inverted yield curve is a leading indicator for recession, and recession – in so far as company earnings are likely to underperform – is usually bad for equities. However, while an inverted yield curve may well be a leading indicator, it is a fairly blunt one. On previous occasions during which the US Treasury yield curve inverted, it took anything between six months and two years for a recession to actually materialise. In that time, equity markets can continue to rally until falling earnings take valuations to unsustainable levels.

Consumption has driven the UK economy since the EU referendum, with households cutting their savings rate and liquidating foreign holdings to keep the economy buoyant. Following the election of Boris Johnson to leader of the Conservative party and, therefore, Prime Minister, a more hardline approach to the Brexit negotiations was generally expected. However, the decision earlier this week to prorogue parliament from September 9^th until the new policy agenda is announced in the Queen’s speech on October 14^th was largely unexpected and met with widespread opposition.

Given the heightened political risk of both a disorderly Brexit and the election of a Corbyn administration, we believe that UK gilts are overbought. The UK gilt market gained 3.76% over the month and 11.29% year-to-date, with the 30-year gilt yield falling to just 1%. This is notwithstanding the high level of UK inflation expectations, which suggest that inflation could rise towards 3% in the coming months. Nevertheless, the UK controls its own currency and it is not inconceivable that future coordination between the Bank of England and the Treasury could lead to a policy that holds the yield curve down, to the benefit of investors who are already in the market.

As the pound bounced back 0.34% during August after the weakness caused by heightened no deal fears, the FTSE 100 (-5.68%) outperformed the FTSE All-Share (-4.38%) on the downside. That aside, moving towards October 31st we are seeking solutions to protect capital but still maintain upside participation to equities, as well as looking to rotate into large cap UK stocks that have greater exposure to foreign sources of earnings and are better prepared for a hard Brexit.

 

By Hottinger Investment Management

“In this world, nothing can be said to be certain, except death and taxes”

What US founding father Benjamin Franklin didn’t say (but perhaps knew) was that death and tax policy are deeply interlinked.

That’s the thesis from Kenneth Scheve and David Stasavage, who have studied the history of taxation in Europe and the United States, in their book Taxing the Rich – A History of Fiscal Fairness in the United States and Europe. They find that what we think drives high taxes on the rich – inequality, envy and the ability to pay – doesn’t really show up in the data. It wasn’t universal suffrage or the politics of left- and right-wing governments that drove large increases in claims on the rich in the 20th century, but the need for equal sacrifice in a time of war.

In the 19th century, John Stuart Mill wrote that taxes should be levied to ensure “equality of sacrifice”, but that left open the question of what form these taxes should take: should they be proportional or progressive? This is an unresolved moral issue at least half a millennium old. The introduction of the decima scalata, a progressive tax on land income, in Florence in the year 1500 created a vigorous debate that Francesco Guicciardini – statesman and friend of Machiavelli – summarised in a brief text. There one can find statements that match the sentiment we find across the political spectrum today. Depending on political persuasion, the ideal principle ranges from one that emphasises the ability to pay (progressive taxation, with richer folk paying more as a share of their resources) to one extolling the virtues of equal treatment (proportional taxation, with everyone paying the same share of resources in taxes), or one where everyone pays the same flat fee (regressive taxation).

But there is another way of looking at “equality of sacrifice” that has entertained recent studies in tax history, not least Thomas Piketty’s seminal work on inequality and capitalism in 2014. Following Piketty, Scheve and Stasavage conclude that the effect of two all-consuming and devastating world wars explains the very large increases in taxes on the rich in the 20th century, with those taxes gradually falling back in the following decades. The 1918 Labour Party manifesto called for a ‘Conscription of Wealth’ from the older members of the British population who made money from the war but were not enlisted to fight in the trenches. Equality of sacrifice here meant short-term confiscations from the wealthy in the form of income and wealth taxes, as well as levies on capital and excess profits, to finance the costs of the war and social reconstruction in the years that followed.

Scheve and Stasavage’s major insight is that the countries that mobilised for war – such as the UK, US and France – raised top income taxes on the rich by much more than those that didn’t. While rates were below 10% before the First World War in most industrial countries, they rose to an average of 40% by 1919 in the belligerent industrial states, compared to just 15% in those that stayed out of the war. In the UK, top taxes on income rose to 98% and on large estates to 80% in the period after WW2 in order to fund a growing welfare state that was seen as a reward for the sacrifice of those who went to fight.

As the impact of the wars subsided, so did the demands on the rich – yet the demand for public services has continued to grow. Average top rates of income tax fell from 65% in 1945 to below 40% in 2010 at the same time as the size of government doubled from 20% of GDP to 40%, funded by a broader tax base. What is surprising about this book is how robustly the authors discount other widely held explanations for the gradual reduction in tax paid by the richest 1% since 1980. The influence of political lobbying, liberalised capital flows and the breakdown of the post-war consensus are, in their view, inadequate answers. What has changed is the focus on ‘equality of sacrifice,’ which has returned to a debate about fairness, a concept under which both ‘equal treatment’ and ‘ability to pay’ can coexist and compete on normative terms. Fairness can be invoked to defend taxes that are high or low; flat or progressive.

So in the light of the global financial crisis, the rise of Jeremy Corbyn, and the intensifying focus on the so-called 1%, what are the likely consequences for tax policy in the US and Europe?

Not much, say Scheve and Stasavage. In a 2014 study with YouGov, 2,000 US taxpayers were asked what they believed the marginal tax rate should be for different income levels. For those earning over $375,000, the median preferred rate was 30%, which is less than the 35% rate that is actually charged on incomes above $375,000 today. Even when respondents are informed of the scale of inequality in the US – which is significantly greater than many people imagine – their preferred rate of tax for top incomes does not change very much.

Despite the challenges thrown up over the last decade by the financial crisis, there is no clear evidence of a widespread impulse to bring down the rich. There is still an appreciation among many that wealth can be built by good work that improves society, and that sensible progressive taxation gets the balance right between ability to pay and equality for all under the law.

But that appreciation is not guaranteed to last. If there’s reassurance from this work that we’re unlikely to see the emergence of a politics of envy riding on the back of confiscatory taxes, there is a warning too that reinforces the urgency of reforming capitalism. We need to promote a popular, inclusive capitalism from which everyone can benefit; and a social contract that offers a level playing field, chances for individual fulfilment, social solidarity, and compassion for the less fortunate.

Public sentiment may change for the worse if the majority of taxpayers start to believe the economy is systematically rigged in favour of the rich in a way that is fuelling inequality. If electorates feel that too much of the burden of funding the state falls on low- and middle-income earners, especially in the form of indirect taxes, there could well be greater support for higher, compensatory levies on wealth and top incomes. If there is another banking crisis that calls on states to bail out failed actors, there would be calls for retribution. And if a perception grows that the rich not only benefit from favourable effective tax rates but also get special treatment by the state when it comes to building a successful career or business, or influencing political and social life, the public mood could easily sour during a future downturn.

The job for those who support the free enterprise system is to make sure that doesn’t happen.

By Hottinger Investment Management

A week after the UK posted negative Q2 economic growth figures, it was Germany’s turn for disappointing news. According to the Federal Statistical Office (FSO), Germany’s gross domestic product (GDP) was 0.1% lower at the end of June than it was at the start of April. Persistent weakness over the last twelve months means that the German economy is only 0.4% larger today than it was a year ago.

Softness in the country’s macroeconomy has been reflected within export-facing industries that are highly exposed to the global economy. Data from the Verband der Automobilindustrie reveal that annual production of passenger cars has fallen by more than a million units (from 5.8 million cars in mid-2017 to fewer than 4.8 million cars today).

The slowdown in China and the adverse development of the politics of international trade have hit German car-makers hard. According to ING, one quarter of all cars sold in China were German – with BMW, Daimler and Volkswagen relying on Chinese demand as the source of over one third of their total car revenues. Daimler has issued four profit warnings in recent times and Continental expects a 5% drop in global car production.

But it is not just car makers who are feeling downbeat; some of the country’s largest industrial firms have released warnings of some description. Chemical producer BASF has cut profit expectations by 30%, Henkel announced that it missed its Q2 revenue target, and Lufthansa announced that H1 2019 profits were €800m lower than the corresponding period a year earlier.

Even though Germany’s service sector is showing more resilience, the poor performance of industrials (down over 5% over the last 12 months according to the Federal Statistical Office, FSO) is a major issue for the country because this sector is a significant driver of German exports, which itself account for 47% of GDP according to the World Bank (considering imports, the excess of exports over imports amounts to around 7% of GDP). As global demand is a major determinant of a country’s export demand, and small economies such as Germany have little influence over global factors, the country must be willing to boost domestic demand if it wants to stabilise its overall GDP.

Fiscal policy is the best understood method of boosting a struggling economy. It involves deficit spending, where the government spends more than it takes in through taxes, usually by borrowing funds from investors in the bond markets. This should create additional demand that, in theory, percolates through the economy and reduces the effects of a slowdown on employment and wages. The problem is that the German political class has developed an almost allergic stance to deficit spending in recent years, exposing the economy to the vicissitudes of global trade.

In recent weeks, the situation moved into absurd territory with investors now willing to pay the German government to borrow for a period of a generation (or thirty years). It is worth putting this into context. The negative yield in 30-year German government bonds implies that the state could destroy resources and still make good on its debts, even before inflation is taken into account. At one-point last week, the 30-year yield fell to as low as -0.27% (See figure 1); this means that at this yield a €100, 30-year zero-coupon bond would generate funds of about €108.45 from the markets. With the government due to return only the €100 in thirty years’ time, markets are basically saying that the state can waste about 8% of the nominal funds that investors lend to it and ensure that the rest is only preserved – in nominal terms – over the holding period.

It is even more striking once one considers the effects of inflation. If the rate of German inflation averages 2% over the next thirty years, the government would in real terms have to return only half of what investors lend to it today.  It is an extraordinary situation,  yet the German government is still not taking advantage of it. Why?

The key factor is the law. In response to the rise in public borrowing after the global financial crisis, the then German government amended its constitution to introduce the Schuldenbremse (or debt brake), limiting structural deficits at 0.35% of GDP for the federal government and 0% for German states (Länder) after 2020. Article 109, Paragraph 3 of the Basic Law essentially forbids meaningful deficit spending unless it is caused by ‘cyclical’ factors, such as an economic downturn that pushes down tax revenues and raises payments on items such as unemployment insurance. As a result, public indebtedness in Germany has been falling rapidly over recent years (see figure 2).

The €50bn stimulus package that Finance Minister Olaf Scholz floated as a suggestion last week is therefore very much dependent on the economy first falling into recession and is in any case constrained by the 60% debt-to-GDP ceiling imposed by the European Union’s Maastricht Treaty and protected by the Schuldenbremse law. In other words, the spending pledge risks being too little, too late.

But this only shifts the question as to why the government won’t change the law to allow for structural deficits. There would be plenty of uses for deficit spending, whether it’s repairing roads and bridges, installing digital infrastructure, investing in schools, or getting the country retrained and retooled for the green energy transition whose first casualty could be Germany’s car manufacturers if it continues to rely on the internal combustion engine. The longer the country neglects areas in serious need of investment, the harder it will become for it to overcome the problems that such underinvestment will inevitably cause.

There is something else too. Structural deficits can be inflationary, and inflation is anathema to the key players in Germany’s political economy. Earlier in the year, Martin Höpner, a scholar at the Max-Planck-Institut in Cologne, published a paper on the history of what he calls Germany’s “undervaluation regime”. He describes how this regime started not with the euro but in 1944 with the Bretton Woods system of fixed global exchange rates, allowing Germany to run trade surpluses by keeping inflation low and its real effective exchange rate weak and thus competitive. A combination of German industry looking to expand into new markets, trade unions hoping to protect job security and the Bundesbank burnishing its low inflation credentials created conditions for the country’s strong position in global trade markets. Expansive fiscal policy, however, disturbs this equilibrium by generating upward pressure on wages via the public sector that can push corresponding wages in exports firms up too, thus reducing the export competitiveness in what is a very well-protected business sector.

A more challenging global environment may change this calculation. It appears that a slowing China, which is looking to source more of the capital goods that it has recently imported from Germany domestically, combined with political tensions that are negatively impacting global trade, could create serious problems for Germany’s export-driven accumulation model.

If these trends were to continue, Germany would have to start looking closer to home for sustained economic growth. That would mean deficit spending, which could have benefits for both Germany and the wider European region. Government spending would make up for years of under-investment and could provide conditions for the German economy to better face structural changes in the global economy – as it faces the rise of digital technologies and the transition to a low-carbon production model. If it raises Germany’s nominal GDP growth rate while keeping bond yields low, the deficit could effectively more than pay for itself (see figure 3). For Europe, higher domestic demand in Germany should raise demand for imports from other euro area states, and any higher German inflation that results could improve the competitiveness of those states.

The German government is starting to talk about stimulus and that is good. But the fear is that when it comes, it will be too little and too late.

By Hottinger Investment Management

During the second quarter of this year, the UK economy contracted for the first time since 2012. The Office for National Statistics (ONS) revealed earlier today that the British economy was 0.2% smaller at the end of June than it was at the beginning of April.

Market watchers have put forward a number of preliminary factors to explain this. One was the strong growth in Q1 due to the stockpiling of intermediate goods among manufacturers and other goods producers. Even if Brexit had taken place as planned at the end of March, the effect of this activity was always going to fall out of the second quarter’s figures as factories took their collective foot off the pedal.

The next factor is the state of the global economy. Some of the UK’s largest trading neighbours – including Germany and Italy – are seriously flirting with recession. Last week saw another dreadful round of factory data out of Germany and the Netherlands, and this follows disappointing numbers out of France, which hitherto had been seen as a bright spot.

The UK remains closely integrated into the European economy and will catch a cold whenever the old continent sneezes. It should be noted that even at the height of the British Empire and under the system of Imperial Preference that elevated – for example – the lamb of New Zealand over that of Spain, the European continent was often the UK’s single largest trading partner¹. Gravity is hard to suspend.

But the biggest factor has to be the Brexit uncertainty. For over a year, businesses have more or less stopped investing in the UK. In 2018, according – again – to ONS figures, growth in investment (or gross fixed capital formation) at 0.2% was the lowest in the G7 group of nations. This compared to an average annual growth rate in investment for the UK of 4% over the past twenty years. Lack of business investment has been contributing negatively to growth, leaving the consumer to carry the burden.

Consumers have been able to carry the burden because since the EU referendum, they have cut their savings ratio from 7% of GDP in Q2 2016 to 4.1% in Q1 2019. More recently, wages have been growing faster than inflation, providing tail winds for the consumer.

The obvious problem with this model is that it ought to be unsustainable. Higher inflation brought about by continued sterling weakness amid concerns over an acrimonious Brexit would suppress real wage growth. And there is only so far the household sector can cut its savings before dangerous financial imbalances build up among the subsets where income and wealth are lower. Household debt-to-GDP has steadily risen from roughly 85% of GDP during 2015 to above 87% today, according to figures from the Bank for International Settlements.

But there is an even bigger question of ‘sustainability’, involving the British economic model and its relationship with the rest of the world, which makes the outcome of Brexit a critical factor. For most of the period since the UK last saw a quarter of negative GDP growth, the country has run a current account deficit of more than 4% of GDP. This means, crudely, that for every £100 of resources that entities within the UK produce, those same entities (whether they are households, companies, banks or governments) consume £104, with the extra £4 arising mostly through an excess of imports over exports. It is where the phase ‘living beyond one’s means’ is most credibly used when describing the British economy, because the country has to borrow funds from foreign sources to pay for this excess. The question is whether this assessment is right.

Since the EU referendum, all domestic UK sectors (households, businesses and government) have been borrowing from the only foreign sector, the ‘rest of the world’. Whilst it is not surprising that the foreign sector is a net lender, it is highly unusual for a domestic economy as a whole – even one with a large current account deficit – to rely exclusively on foreign funding for its consumption. This is because the household sector is usually a net lender, providing funds to domestic businesses and government. But such is the current state of the UK that stretched consumers appear to be carrying the economy in the way that an airliner’s engine picks up the slack of its busted twin.

The source of this foreign funding is essential. If the source constitutes foreign direct investment or portfolio flows from non-UK citizens whose base currency is not sterling, then the UK is at serious risk of a sudden stop in funding in the event of a hard Brexit. The threat of a deep depreciation could then combine with a spike in inflation, a rise in interest rates and a cut in consumption in a manner which might push the UK into recession. This follows logically from the sectoral balances – whose elements must in toto sum to zero – if foreigners choose to stop lending to Brits. We may already be seeing early signs of this with the fall in sterling against both the US dollar and the euro in recent weeks.

However, given the rally in UK gilts in recent months, in line with the global search for safe assets, it is not obvious that this scenario will play out in the event of no deal on the 31^st October.

There is also an argument backed by research from the Bank of England that downplays the importance of this imbalance. It relies on the assumption that while ‘foreign funds’ are financing the domestic-facing UK sectors, these foreign funds are largely held by British citizens whose base currency is sterling. A fall in sterling would therefore increase the sterling value of the UK’s overseas assets. It would mean that the imbalance we see in the chart above could actually be sustained beyond Brexit.

If this story is right then we would then have to rewrite our story as one in which the UK is progressively running down its foreign holdings to fund the consumption of present resources. In practice, this manifests in asset owners liquidating their foreign holdings to fund either their own consumption or that of other British entities – whether households, firms or governments – through lending.

Notwithstanding the global situation, Brexit is a big factor behind the slowing UK economy. The question is whether further downside could yet come and how deep that could be. If the UK does head for a hard Brexit, the outlook for the country depends as much on who is funding the profligate British economic model as it does on the prospect of tariffs or regulatory barriers resulting from a hard Brexit.

¹ In most of the years between 1840 and 1880, Europe accounted for around 40% of the United Kingdom’s exports, a share that remained broadly stable as trade with other regions fluctuated. Sourced from Schlote, W. (1952) British Overseas Trade from 1700 to the 1930s.

 

 

 

By Hottinger Investment Management

July was the month in which markets started to get what they wanted from central banks. On 31^st July, the US Federal Reserve (Fed) delivered a 25 basis point cut to interest rates, the first of roughly four such cuts expected by investors before next spring.

Other central banks continued the soothing mood music, with the European Central Bank’s (ECB) Mario Draghi signalling rate cuts and renewed asset purchases and the Bank of Japan’s Haruhiko Kuroda committing strongly to stimulus if the global slowdown continues. By supporting liquidity, the Federal Reserve’s action has emboldened central banks in emerging market economies seeking to provide their own stimulus. The Central Bank of Turkey cut its benchmark one-week repo rate by 4.25 percentage points in July, from 24% to 19.75%, and signalled further cuts in the future. Brazil’s central bank cut rates by 50 basis points for the first time in a year, and in Indonesia and Russia rates fell by 25 basis points last month.

In financial markets, activity was mostly placid. The positive correlation between the total returns of stocks and bonds – rising share prices coinciding with rising bond prices – has started to break down. In July, the price of 10-year US Treasuries fell by 0.34% as the S&P 500 pushed higher by 1.65% over the month. Positive correlations are still strong in the UK, however: 10-year UK gilt prices rose by 2.31%, while the FTSE All-Share rose by 1.02%. UK 10-year government yields have fallen from 1.2% in May to 0.625% at the end of last month as investors – in the search for safer assets – shrug off British political instability and the likely resumption of deficit spending. Meanwhile, German bunds have consistently rallied since October last year, when the first signs of volatility on the back of slowing global activity emerged. Since then, the price for 10-year bunds has risen by 10.5%; in July prices rose by 0.9%. However, European equity markets were negative on the month with the Dax down roughly 3% and the Euro Stoxx 50 1% lower than it was in June.

European equity markets declined sharply, with cyclical sectors leading the fall due to unfavourable global trading conditions and the fading effects of the previous round of monetary stimulus from the ECB. With weak industrial production weighing on activity in Germany and Italy, investors looked to France and Spain to provide a boost to the Eurozone economy. However, French Q2 GDP figures were weaker than expected and confirmed to many that the region as a whole could be moving into a slower lane. Disappointing European earning results, along with Brexit concerns, also contributed to subdued returns from European equity indices.

It is not surprising, therefore, that we saw some evidence of a defensive rotation in the European markets. The only European cyclical sector that saw positive expansion was Consumer Discretionary, which saw price growth of 0.5% in July, according to MSCI indices. Industrials (-1.03%), Financials (-2.31%), IT (-0.95%) and Materials (-3.36%) all saw price declines. Conversely, the defensive sectors either held their own or saw modest gains: Consumer Staples (+2.55%), Utilities (+0.23%), Healthcare (+0.12%) and Telecoms (+0.25). The picture is less clear for the UK, which saw defensive sectors such as Consumer Staples (+2.96) and Healthcare (+9.25) rally, but Utilities (-2.33%) fall back. Ongoing concern over the prospect of a new government that could seek to purchase utility companies at unfavourable valuations continues to bear down on that particular sector.

At the end of July, Fed Chair Jay Powell described his rate cut as a ‘mid-cycle adjustment’ to address softening inflation and sentiment. Asset markets are behaving as if this assessment is correct. Both cyclicals and defensives expanded in the US; the MSCI’s US Technology index (cyclical) and its Consumer Staples index (defensive) rose by over 3%. We think that the US economy is actually in late cycle, a period of the economic cycle where the growth rate of the economy is positive but falling before turning negative. Slower growth means that company earnings are less likely to meet investors’ expectations, raising the likelihood that share prices will fall. We are concerned that the implied earnings expectations priced into valuations are ambitious given the current macroeconomic environment.

Despite the move to ease monetary policy in the United States, the US dollar index strengthened by 1.73% against a basket of other developed currencies. Of particular interest has been the performance of sterling, which weakened by 3.82% against the dollar and 2% against the euro. Concern over the new British Prime Minister’s comfort with the prospect of leaving the European Union with no deal has forced sterling down at a time when wage growth and consumer spending are strong and the Bank of England is more reluctant than others to engage in monetary stimulus. 

Further, the gold price (up by 1.9% in July) has been boosted by central bank purchases as these organisations reduce their exposure to US dollar reserves due – in large part – to the unresolved trade stand-off between the US and China and the risk of politicisation of the Federal Reserve.

In a late-cycle environment, real assets can be more attractive than credit products, and it often pays to take some equity risk off the table. While bond yields are low, the rally in this asset class could have some distance to run. We will keep an eye on this as the short-term benefits of capital appreciation could offset the low or negative yield over the holding period.

By Hottinger Investment Management

A new conventional wisdom has emerged in recent weeks among people who want the equity bull market to run on and on, and it goes like this: The rally in global bonds and race to loosen monetary policy may be reactions to slowing global trade and activity passing through to sluggish earnings, but this does not mean that the great bull market in equities must come to an end. On the contrary, this view holds that lower bond yields boost valuations and should allow the party to keep going.

Usually, when central banks cut rates it is because economies are in ‘late-cycle’, which means growth starts to slow and company earnings soften. It is usually too late for central banks to stop this deceleration and their cuts to interest rates often kick in only once the economy is in a state of recession. Equities therefore typically fall as rates go down, which is evident in the charts below for two periods in the 2000s. In other words, during ‘late cycle’, there is a negative correlation between the total returns of bonds and equities.

People who hold this view are implictly saying that the positive correlation between total returns of stocks and bonds – something we have not seen much during the period of independent central banking – could be here to stay. They could be right. Although we are not convinced, it is worth mentioning four reasons which may support their case. While they may not be right today, they could be in the not-too-distant future.

The first is that recent US history shows rate cuts can coincide with sustained expansion in US equity markets. When the Federal Reserve cut rates in the mid- and late-1990s, first amid concerns of growth slowdown and then to fight any contagion from the Asian financial crisis and the Russian debt default, equity markets continued to rally. In 1995, the then Fed Chairman Alan Greenspan spoke of ‘insurance cuts’: pre-emptive reductions in interest rates to engineer a soft landing for economic growth. It seemed to work; it wasn’t until 2001 that the US next experienced a recession.

We could be in a similar situation today. There is again talk that the Fed will make an ‘insurance cut’ later this month and at least one more in the Autumn, but markets want four such cuts by Spring next year.  As in 1995, when Greenspan speculated that US inflation was “being held down by events in the rest of the world,” today global factors – emanating in China in late 2017 before passing through Europe last year – have acted as headwinds to an American economy that has been growing at above 3% per year for a considerable period of time.

A bout of monetary easing could reveal a US economy that remains resilient to global factors, one that is mid-cycle rather than late-cycle. The Fed would then have successfully permitted the party to go on. Many, however, are skeptical that the US economy has been immune to global events – particularly the trade war; US corporates that have high revenue exposure to China have performed relatively poorly in recent months.

A key reason for the global slowdown reaching the US last is the country’s unconventional fiscal policy – with the Trump adminstration presiding over a pro-cyclical fiscal deficit that recently exceeded 4% of GDP, according to the US Congressional Budget Office. Unconventional fiscal policy is the second factor that could support the idea that equity markets can stay strong as interest rates and bond yields fall.

Fiscal-monetary coordination is a dry phrase describing a concept that is in vogue within international policy-making circles.  Most notably, President Trump has been keen to politicise the Federal Reserve’s activities through the medium of Twitter, but the idea that central banks should work with government treasuries is one that is popular among serious policymakers too.

The incoming ECB governor, Christine Lagarde, has previously spoken about the need for fiscal-monetary coordination. She will play an important role in encouraging European governments to spend more and persuading EU institutions to let them do so. What this means is that lower interest rates could provide the fiscal space for governments to spend more as they would be able to borrow more cheaply. Extra spending could then translate into stronger nominal GDP growth that feeds into earnings and valuations. In this scenario, share prices would rise. We have previously argued that such a switch to policies of ‘fiscal dominance’ could drive inflation in a way that means that stocks and bonds move in the same direction.

The third reason supporting the equity bulls lies in the possibility that central banks will in the future support equity markets directly. There has been speculation that in the event of a serious downturn, central banks may directly intervene in the equity markets by taking stakes in public companies. The Bank of Japan has already implemented such a policy, last year purchasing 5.6 trillion yen ($50bn) in Japanese equity ETFs, taking its total ETF balance to around $300bn. The central bank aims to use ETF purchases to stoke inflation by spurring gains in asset values, as well as promoting active private consumption.

We are not convinced that outright direct equity purchases do more than just aggravate inequality, but governments could design sensible equity purchase policies where their central banks would buy equities when they have suffered a drawdown, sell them as the market recovers and distribute the gains to the public ahead of the next downturn. The point, however, is that this policy would support an environment where rising equity prices could coincide with falling bond yields, as the central bank would be active in both markets.

Lastly, the Federal Reserve is arguably the world’s central bank. Anyone who has read Crashed by the peerless Adam Tooze can appreciate how it was the Fed, not the ECB, which bailed out European banks during the 2008 crash through its liberal supply of dollar swap lines. The Fed’s interest rate policy is also closely tracked by a great many emerging market economies, whether or not they peg their currency to the US dollar.  

Last year, economists Matteo Iacoviello and Navarro Gaston studied the global transmission of the U.S. Federal Reserve’s interest rate policy and what they found was striking. Looking at macroeconomic data covering the period 1965-2016, they found that the effects of monetary tightening from the Federal Reserve on economic growth are almost as strong outside the U.S. as they are within it.

“A monetary policy-induced rise in U.S. rates of 100 basis points reduces GDP in advanced economies and in emerging economies by 0.5 and 0.8 percent, respectively, after three years. These magnitudes are in the same ballpark as the domestic effects of a U.S. monetary shock, which reduce U.S. GDP by about 0.7 percent after two years.”

The authors explain the transmission of US policy worldwide as occurring through standard exchange rate and trade channels, with countries that trade with the US and manage their currencies in line with the dollar more strongly affected. As US rates rise, the dollar appreciates. In countries for which a stronger dollar causes inflation to rise or balance sheets to deteriorate, or where the government has tied its currency to the dollar, there is pressure for interest rates to rise too. As the experience of 2018 showed, emerging market countries with exposure to the dollar, current account deficits and low foreign reserves – such as Turkey, South Africa and Argentina – can be severely constrained by tight U.S monetary policy.

Certainly, then, lower US bond yields and interest rates can be very positive for dollar liquidity in emerging markets (EM). They can support  EM companies’ balance sheets and ultimately asset prices too. Given the growing weight of EM in global markets, there could be positive feedback for US equities too.

So, there we have it. The equity bulls may be right, but we think the rally in global bonds is more likely a reflection of the hard economic data pointing to a moderately slowing world economy, which should be negative for equities as earnings fail to meet ambitious expectations. In time, therefore, equities should come down even as interest rates do too.

However, there are good reasons to suggest that investment dynamics could change in favour of equity bulls over the longer term, but only if the political-economy environment changes too: If the policy regime changes to one involving deep fiscal and monetary coordination, if central banks start directly supporting equity markets, or if emerging markets increasingly become dependent on dollar liquidity delivered through a low interest rate policy from the Federal Reserve, the picture could look very different.

By Hottinger Investment Management

Last week, the Italian treasury issued €3bn in 50-year bonds. According to Reuters, the issue drew over €17bn of bids, 80% of which were from foreign investors, with Germany the single biggest source of capital. The final yield came out at 2.877%.

International interest in Italian bonds comes in the context of a general scramble for government bonds amid fears of a widespread global slowdown. In the belief that interest rates are broadly coming down and the ECB will stand behind Italy’s public debt, investors appear to have parked their concerns about Italy’s political situation.

Last May, Italian 2-year yields spiked above 2.7% and 10-year yields rose to over 3.5% in the following months as the Italian government threatened to break the EU’s budget rules in order to increase public spending. Even though Italy’s de-facto leader Matteo Salvini and others in his administration have since toned down their rhetoric, it is hard to make the case that Italian public debt is now a safe asset. Investors may come to regret piling into global government bonds generally and Italian bonds specifically.

Who can blame the Italian debt management office for capitalising on the great rally in global bonds? Academic research by Martin Ellison and Andrew Scott finds that issuing long-dated bonds actually costs most governments more over the long-term compared with rolling over shorter-dated bonds as they fall due. This is because the premium that investors charge for duration risk, combined with the fact that we live in an environment in which central banks have anchored inflation at low and stable levels, amounts to a subsidy from the government to investors. Italy, however, is a different case and we should ask why the country might be interested in issuing more longer-duration bonds.

Issuing large amounts of very long-dated debt only really makes sense if you cannot rely on the market to offer you stable short-term rates, if you are planning to announce a big spending programme and do not want refinancing costs on your existing debts to rise, or – more perversely – if you are intending to generate a bout of surprise inflation in the future to reduce the real value of the debt you have issued. This last reason does not really apply to Italy because it does not have control over its money supply and – as a member of the eurozone – it has only a limited ability to generate inflation in its own country independent of the European Central Bank.

Nevertheless, this lack of independence makes the situation for Italy quite interesting. Italy currently carries a debt-to-GDP ratio of over 130%. That ratio is high not because the Italian government has been feckless in recent years; in fact, since the early 1990s, in every year except 2009, Italy has run a primary budget surplus. Italy’s problems lie in the fact that it built up huge debts in the 1960s and 70s as it expanded its welfare state; since then, it has simply rolled those debts over rather than paying them back. Italy has had difficulty repaying legacy borrowing as economic growth and inflation have struggled to exceed the rate of interest that investors charge on bonds. Even today, Italy’s economy is still smaller than it was in 2008 and not much larger than it was in 2001. The German economy, by contrast, is over 50% bigger than it was at the turn of the millennium.

With Italian growth anaemic and the ECB conducting a monetary policy that is too deflationary for the country, Italy’s indebtedness is a problem for markets, which tend to react sensitively to developments in Italy’s economy and politics, quickly repricing Italian debt. It is also problematic for the Italian government, as high legacy debts constrain its ability to vary fiscal policy, either according to movements in the economic cycle or according to structural requirements such as the need to invest in infrastructure and education.

It therefore makes sense for the Italian government to reduce its reliance on short-term debt as it cannot know in advance whether maturing bonds will come due in a period in which the markets have very little confidence in the Italian economy and the Italian government wants to spend more money – such as during the euro crisis. Issuing longer-dated bonds can therefore reduce repricing risk and thus default risk.

Even still, it is costly. The 2.8% yield on the 50-year bonds is a little above the peak of the spike in 2-year yields, which occurred after the announcement of the Italian government’s intentions rapidly to increase spending in May 2018. So, the second and third justifications for issuing long-dated debt also still stand: future spending and higher inflation. If the Italian government is secretly preparing a large fiscal stimulus or thinks that an Italy-friendly ECB will generate inflation that exceeds the spread between 50-year and 2-year bonds, then the Italian government will benefit from issuing long-dated bonds. This is because, in the first instance, markets will have less ability to punish Italy for pushing its debt level higher by increasing interest rates; and in the second instance, the eroding effect of higher inflation will help bring down Italy’s debt burden by forcing real-terms losses on long-term bondholders. If any rise in public spending pushes debt beyond sustainable levels, then long-term bondholders could face capital losses as the risk of default and haircuts rises.

It is too much to infer intentions from relatively small issues of long-dated debt, but if this trend continues as other existing bonds mature in the coming months and years, alarm bells ought to start ringing among the foreign investors who are piling into Italian debt today in the search for ‘safe’ assets. The expectation that a dearth of safer German bunds will force the ECB to hold more Italian bonds in any future round of quantitative easing is not the strongest insurance against any possible long-term erosion in the real value of Italian sovereign debt.

The narrowing of the 30yr-2yr spread appears to suggest that investors are more comfortable in Italian bonds that mature well into the future, or at least after the passing of the current, populist administration. They appear to be less concerned about long-term Italian inflation and debt dynamics than they are about the risk of a sudden re-emergence of a budget crisis in Italy. With 10-year bonds now yielding less than they did before the Italian government took on the EU over public spending whilst 2-year yields are still above their pre-event levels, one could argue that shorter dated Italian debt continues to carry a small risk premium.

We think there is also a general possibility that this global bond rally is a bit overdone. Investors are scarred by the financial crisis and have seized on the link between the ongoing trade tensions and slowing global manufacturing as foreboding a global recession à la 2008. If we learn that at worst, any coming recession will be shallow and that at best fundamentals are still actually okay, then all those who are piling into bonds today could quickly get burned. This applies to Italy too, but the more pressing concern is an escalating political disaster that pits Italy against the EU in a future crisis over its budget. In that situation, investors who are scooping up 50-year Italian debt at under 3% may come to regret it.

By Tim Sharp, Hottinger Investment Management

The S&P 500 has had its most successful half year since 1997, rising 17.35% following signals from Fed Chairman Jay Powell that the Federal Open Market Committee (FOMC) is on the verge of a rate cutting cycle. Based on 12-month earnings estimates, the index is trading at 17x, vs its 10-year average of 14.8x, last reached just before the sell-off in 2018. This shows that upward revisions in earnings have not been forthcoming, as Philip Georgiadis reported today in the Financial Times.

Markets have been pricing in more aggressive monetary easing from the Federal Reserve, as indicated during the June FOMC meeting mid-month, when Powell was quoted as saying “an ounce of prevention is worth a pound of cure”. The S&P 500 gained 6.89% on the month, leaving the Euro bloc (4.93%), the UK FTSE 100 (3.68%) and Japan’s Nikkei 225 (3.27%) languishing in its wake. Markets now expect three or four 25bps rate cuts by the end of December, which may mean a cut at four of the next five meetings of the Federal Reserve Board. Despite falling inflation in the US providing cover for rate cuts, the Committee expressed scepticism about the likelihood of the expected 100bps in cuts happening, which, if it turns out to be well-founded, could cause a tanrtrum in equity markets and a rise in bond yields.

The move by markets to expect central banks once more to bail out risk asset markets was matched by the European Central Bank (ECB), indicating that further stimulus could be forthcoming. Regardless of whether investors bought equities, corporate bonds, developed market government bonds or indeed gold, the latter of which rallied 7.96% to $1409/oz, these investment decisions would have yielded a positive return in June. The threat of lower rates in the US pushed the dollar index down 1.66%, which partly explains the rise in gold and the strong performance from emerging market equities, which were up 5.70%.

This leaves the financial markets with a dilemma as to whether the global economy is in late cycle or indeed mid-cycle. This is because the timing of the next round of stimulus will either catch the falling global economy and keep the expansion going, or it will merely soften the effects of the weaker environment now showing itself but fail to prevent an economic downturn. In line with research from Morgan Stanley, we think that interest rate cuts in late cycle will likely coincide with declines in equity markets shortly afterwards. Central banks often overshoot with rate rises and these take time to work their way through the economy; by the time the rate cuts come through, the economy is often in a slower gear. If, however, we are mid-cycle, rate cuts – such as those seen in the 1990s – might actually support equity markets.

Global manufacturing Purchasing Managers’ Indices (PMIs) remain suppressed, as hard data on shipping volumes and inventories suggest that global trade is slowing. Export and import growth in China has dimmed, and European industrials in major exporting countries continue to disappoint despite a brief glimmer of hope in April. Notwithstanding a boost to the US growth outlook through retail trade and industrial production prints, the country is unlikely to sustain the current 3%+ annualized rate of growth.

The extent of the effect of the US-China trade war on the global economy became more evident in June with the release of global manufacturing statistics. Manufacturing surveys around the world have been falling – most notably in the US, China, Japan and Europe – leaving global new orders at the lowest point on record and business optimism pointing to falling output. South Korea, often used as an indication for the global market, saw exports fall year-on-year by the biggest margin for 3 years. In the UK, the PMI data fell to 48 in June vs 49.4 in May, the lowest level since 2013, suggesting a fall in output for 2 consecutive months. Many industries are suffering from the continued Brexit hangover as inventories are run down after the build-up prior to the original leave date in March, but many are also pointing to continued weakness in global export markets.

The UK continues to be dominated by the Brexit narrative and the Conservative leadership campaign that will decide the next Prime Minister before the deadline to leave the EU on 31 October. It remains to be seen whether and how either candidate will be able to negotiate a deal with the EU, persuade Parliament to leave without a deal or indeed unite the Conservative party to solve the impasse. Effective government has largely ceased in the UK, so companies will be relying on the Bank of England to join the central bank moves to add further stimulus to reinvigorate the economy. Uncertainty saw the pound fall back into negative territory for the year in June, weakening -0.65%, and gilts were unchanged despite the rally in sovereign bonds in other developed countries.

The G20 meeting on the last weekend of June saw the US and China agreeing to continue trade talks with no escalation in tariffs, taking away the immediate fears of financial markets, with the added good news that the US softened its rhetoric surrounding the security questions of trading with Huawei. The ongoing uncertainty will continue to weigh on sentiment, but we can expect short-term relief that the can has been kicked a little further down the road.

We join the many investors who have decided to wait and see whether central bank policy manages to reaccelerate global growth or fails to prevent it slowing further, which will offer an indication as to how late in the economic cycle we currently find ourselves. Equity valuations are elevated and US 10-year bond yields have reacted to the Fed’s comments by dropping from 2.26% at the end of May to 2% by the end of June, as asset classes once more become correlated and some traditional relationships break down. A rate cut in July is likely, which should provide opportunities for profit-taking, however the longer-term outlook from the Fed meeting should really inform the global picture for the second half of the year.

By Hottinger Investment Management

 

There has been a rise in interest in what one might ordinarily consider to be a mundane subject: the correlation between stock market returns and bond returns. It is an important topic because portfolio asset allocation since the turn of the century has been built using assumptions about the correlation between market movements in stocks and bonds that are beginning to look a bit weaker. If these assumptions break down, then the consequences for investment strategy and performance could be profound.

First, we must be clear on the concepts because it is easy to get confused. Analysts often use terms such as prices, returns and yields inconsistently when talking about correlations between stocks and bonds. When thinking about the subject, one should therefore bear the following in mind:

1. The price of a fixed coupon bond is always negatively correlated with the yield of the bond. A more expensive bond “yields” less as the interest payments (or coupons) are usually fixed against, in this example, the higher cost of purchasing the bond. Exceptions may apply to inflation-linked bonds, where higher inflation could raise coupons and therefore yields in a way that attracts demand from investors that pushes bond prices higher.
2. The total return of a fixed coupon bond is always positively correlated with the price of the bond. The total return of a bond comprises both interest income received from the bond and any gains or losses in the capital value of the bond, measured by its price. Interest income is often – and confusingly – referred to as yield, but – as explained above – this is usually a fixed amount determined in advance of purchase.
3. The total return of an equity comprises both dividend income and any gains or losses in the capital value of the equity, again measured by its price. The total return of an equity is usually positively correlated with the price of that equity unless companies explicitly tie their dividends to share price performance.

So if, for example, an analyst says that stock prices are negatively correlated with bond yields, they are almost certainly also saying that (i) stock prices are positively correlated with bond prices and (ii) total stock returns are positively correlated with total bond returns.  

Analysts have been studying the long-run stock/bond correlation data and believe that an important recent trend is coming to an end.

As Figure 1 shows, during most of the period since 1937 in the United States, the correlation in total returns has been positive, meaning that neither asset class offers protection from poor performance within the other. However, since the late 1990s, the correlation between total returns of stocks and bonds has been sharply negative, supporting a popular portfolio allocation model that puts roughly 60% of capital in equities or stocks and 40% in bonds. This is done with the expectation that when one asset class performs badly, the losses can be capped by stronger performance in the other asset class.

Alternative data series show that strong positive correlations in total returns were the norm not just in the U.S. but also in developed economies going back to the 1800s before turning negative in the 1990s. However, this era of negative correlations may be coming to an end everywhere.

Our view, shared by others in the investment community, is that the period of negative total returns correlation has a proximate cause in low inflation, which the US has experienced since the late 1990s. We think the causes of low inflation are central bank independence – which only really took hold in the late 1990s and early 2000s – and weak bargaining power of labour, which is a trend that goes back to the 1970s. The share of national income in the US (and other developed economies) to wages has fallen from about 52% in 1970 to about 43% today, according to the Bureau of Economic Analysis.

In the last 20 years, monetary policy has prioritised low inflation and has typically taken the lead over fiscal policy when economies slow down or move into recession. It makes sense, therefore, for bond prices to rise as stock prices fall in the period before a recession as central banks prepare to cut interest rates. And it makes sense for this to unwind as economies recover. With anti-inflation central banks keeping a lid on demand and fewer opportunities for labour to push for higher wages, inflation has recently barely registered as a factor compared to how it has done throughout most of the rest of post-WW1 history.

Take, for example, the 1960s, the only period on historical record during which the correlation flipped from negative to positive. CPI inflation rose from around 1.2% in 1964 to 5.5% in 1969. According to Federal Reserve Economic Data, over the whole five-year period between 1965 and 1969, US 10-year Treasuries returned just 0.06%, a strongly negative real return given the high inflation. The S&P 500 returned 27%, which was not significantly more than the cumulative inflation – of 19.7% – over the period. Inflation may have affected both asset classes negatively; in the previous five-year period between 1959 and 1963, the S&P 500 returned 59.2% and US Treasuries rose by 19.2%. As both bonds and equities struggled together, the correlation between the two became positive and the historical 10-year correlation as shown in Figure 1 steadily rose. 

This may have been a singular case, but it is worth investigating whether there are any lessons for today.

Populist demands for a higher share of national income to be reallocated from capital to labour could create a structural shift which, combined with inflationary pressures, would push down returns across asset classes as higher labour costs cut into companies’ margins.  This appears to be what happened in the 1960s. Unemployment was below 4% – as it is today – which is considered a level that represents a tight labour market and raises the risk of wage-inflation.

This is a view developed in some detail in a recent paper by Marco Pericoli for the Bank of Italy¹. In it, Pericoli claims that before the 1990s, inflation and economic growth were negatively correlated as it was typically supply shocks that pushed up costs and brought about recessions. He found that in the stagflation period of the 1970s to 1990s, “good” news regarding future cash flows to equity was correlated with lower expected future inflation; in other words, supply factors such as labour or input costs were driving inflation higher and hitting company margins. Since 2000, however, inflation and economic growth have been positively correlated as demand shocks have driven the business cycle.   

Equally, populist demands for more active fiscal policies could generate higher wage inflation during stress periods for the economy. If wage inflation rises in response to a fiscal stimulus, stocks could fall as costs rise; bonds would be hit by higher price inflation. Therefore, total returns for bonds would tend to move in the same direction as total equity returns.  With increasing demands for fiscal stimulus at a time when unemployment is at record lows, it is not surprising that the stock/bond total return correlation is moving back towards positive territory.

The implications for asset allocation are potentially significant. If total returns between stocks and bonds stop offsetting each other, then the justification for running portfolios around the 60/40 model of roughly equal weightings to equities and bonds will start to fall away. Attention then ought to turn to judging each asset class on its own merits and allocating capital according to attitudes to risk and tolerance for drawdown. This may well be good news for active asset allocation and bad news for those who are simply resting on their laurels.  

¹The paper also shows that the trends for historical stock-bond correlations apply for other developed economies such as the UK, France and Germany.

By Hottinger Investment Management

Investors are not impressed with Europe’s escape from near-recession. Traders have pushed down the Forward 5y5y Inflation Swap Index, a proxy for future expectations for inflation, towards 1% this week. This is the lowest level for inflation expectations since at least 2004 and reflects the rally in several European government bonds, including the sovereign paper of Italy and Greece.

The movement has, at best, shot to pieces the ECB’s hope that the market would take the reversal of QE and higher interest rates in its stride. At worst, it suggests that the ECB’s Governing Council may have to start thinking creatively about the next round of stimulus, starting from the unenviable position in which interest rates are already negative.

We have previously argued that Europe’s manufacturing sector has been at the heart of the region’s weakening economy as a slowing China and trade tensions weigh on global demand and exports. It appears that despite some good news in recent months, the European economy remains highly sensitive to global developments and this is what is causing concern among investors.

Last week, Germany’s Federal Statistics Office announced the biggest monthly fall in German industrial production in four years, with factory output in April 1.9% lower than it was in the previous month. Shortly after the German industry report, the Bundesbank issued its latest forecast for the economy, cutting its 2019 prediction from 1.6% to 0.6%.

According to Eurostat, during April eurozone industrial production shrank at a month-on-month pace of 0.5%, a greater rate than the consensus of -0.3%. Among the bloc’s other economies output was weaker in the Netherlands (-1.7%) and Italy (-0.7%) while in France (0.4%) and Spain (1.7%), it was higher. However, compared to a year ago, industrial output across the eurozone is 0.4% lower.

Export-facing categories of goods have fared particularly badly. Output of durable consumer goods was the weakest, shrinking by 1.7%, followed by a decline of 1.4% in the production of capital goods such as factory tools and machinery. With the euro area building up a large trade surplus to recover from the region’s extended financial crisis, there are renewed fears that weaker exports could infect the domestic economy and its services sector, which have so far shown a resilience supported by strong real wage growth and falling unemployment.

So what can the ECB do? In recent weeks, Mario Draghi has talked about targeted long-term refinancing operations or TLTROs. These are loans that the central bank offers to commercial banks at attractive rates on the condition that they use the resources to lend these funds on to the real economy. We have previously argued that TLTROs as currently designed are somewhat impotent. The implicit subsidy in the TLTRO lending rate of -0.4% is not large enough to incentivise big increases in lending to the kind of risky economic projects that generate growth. Chronically weak productivity growth and soft demand in the eurozone mean that banks struggle to find good ventures with an acceptable level of risk.

Eric Lonergan, a macro fund manager at M&G, has been promoting a novel tweak to TLTROs that would turn one of the central notions of banking on its head. The first principal of banking is that the bank charges a higher interest rate on its loans than it pays on its deposits, generating revenue on the spread between these two rates.  Central banks such as the ECB replicate this idea by setting their deposit rate below their borrowing (or refinancing rate).

Lonergan’s suggestion is that central banks flip this order, lending to commercial banks at steeply negative rates and allowing them to deposit reserves at zero or positive rates. The ECB could introduce simple rules to prevent churning (i.e., redepositing borrowed funds) by requesting that, similar to the rules for TLTROs, any borrowed funds be on-lent to the real economy. Such an idea is radical and amounts to potentially a huge subsidy to commercial banks. If the ECB set a sharply positive deposit rate, the central bank would be subsidising consumers too if the ECB were to request commercial banks pass the returns to savers. Lonergan considers this as a ‘dual interest rate’ policy, where the central bank sets two interest rates and allowing them to diverge from one another at certain parts of the cycle. 

The idea is interesting but is not without its problems. Sharply negative rates potentially encourage speculative bubbles and by subsidising possibly unproductive projects they could lead to a waste of resources. However, such an idea could go far in re-establishing the ECB’s credibility at a time when inflation expectations are falling and the ECB’s Governing Council is flirting with the appointment of perma-hawk Jens Weidmann as its leader.

Conversely, a Weidmann ECB could ensure that Lonergan’s dual interest rates idea never gets off the ground. If so, the Eurozone could be more reliant on fiscal stimulus than ever before.