Fed Changes the Script, But Not the Ending…

24th September 2013

“I am perplexed and baffled. I do this for a living. I shouldn’t be so confused and confounded.” Strategist at a leading investment bank last week, after the Fed ‘shocked’ markets

Maybe he should book some therapy or a career break, but his dismay is a reminder of the remarkable faith investors still have in the elaborate general equilibrium macroeconomic models that drive central bank policies, despite proving hopelessly inaccurate both pre and post crisis. Macro forecasting, particularly at economic inflection points, is as much art as (pseudo) science. Of course, investors understandably crave certainty and predictability, but as I highlighted last week looking at the employment market, there are huge uncertainties which generate confusion even among Fed researchers. Regardless of which month a Fed exit begins, higher yields largely reflect a reduction in perceived global tail risks and related inflows to ‘safe haven’ assets. The broad dynamic is similar to that which has seen gold plummet this year. It seems inevitable that central bankers will squander hard won credibility if they fumble the exit from this period of extraordinary intervention and/or attempt to reverse underlying market forces driving higher yields higher from unsustainably negative real terms back in May.

With TIPS break-evens suggesting long term inflation expectations in the order of 2.4%, it is clear that a 10-yr bond yield sub 3% reflects extraordinarily low implied risk premiums. Implied long-term bond yields are so low partly because of the Fed’s dominance of incremental Treasury issuance, but also by very bearish medium term growth expectations and hence inflation risks, both reflected in portfolio positioning and net flows. Most observers assume that interest rates were abnormally low until May because of QE, but investor liquidity preference/risk aversion reflected in $1.2trn in bond fund inflows from 2008-12 was a bigger factor. As I’ve highlighted, the US labour market is not as strong as the headline number suggests and the fall in the unemployment rate has probably surprised most Fed members, who would have expected the participation rate to start picking up by now. Ahead of last week’s Fed meeting, the average rate for a 30-year fixed mortgage had risen to 4.5% from 3.4% in May so the market has already tightened credit conditions meaningfully. Overall, the endless tapering speculation by investors has usefully reduced the froth that had developed in risk assets like EM debt and HY credit/MBS over the first half of 2013, and highlighted structural GEM vulnerabilities to tighter policy.

I went to a lunch last week with a very prominent central banker, who expressed the frustration of his peers that bond markets have simply refused to follow the script in recent months and from the UK to US, efforts to manage medium term interest rate expectations via ‘forward guidance’ are meeting growing scepticism. We’re seeing a very gradual asset reallocation shift from ‘safe haven’ precious metals/government paper i.e. this year’s bond sell-off largely reflects normalizing bond risk premia rather than a change in central bank rate or inflation expectations and there is little central banks can (or should) do about it. The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation and the Fed will be unable to stop that ultimately healthy process with further QE over the next couple of years, so may as well make a virtue of an inevitability and wind down the current stimulus program in an orderly fashion.

Where Have Six Million Missing US Workers Disappeared To?

18th September 2013

Are the unemployment statistics giving a seriously misleading indication of the timetable for Fed policy normalization? Back in the 12th June weekly on this topic, I noted that: ‘The Fed has no idea how many of those workforce exiles have left for structural/demographic reasons rather than cyclical ones; if the latter is the key factor, then unemployment would probably rise in the initial stages of an accelerating recovery, as discouraged potential workers began actively looking again, and thus prolong easy policy. We won’t get a clear answer until y/y employment growth accelerates to 3-4% for several successive months, and then see if there is a strong participation rate response.’  The head of the SF Fed has recently pointed out that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures derived from other sources such as private employment surveys/job openings etc. As it likely tests the 7% level by early 2014, the  Fed’s hand will be forced on exiting extreme monetary stimulus…

While markets have been cheered by Larry Summers having dropping out of contention as the next Fed Chairman, inspiring hopes for a slower QE exit, the bigger issue is the underlying state of the employment market and whether it will prompt the Fed to lower its 6.5% unemployment threshold for a rate hike, which on current trends looks likely by H1 2015. A key issue for global investors to watch is the falling participation rate but also rapidly slowing workforce growth. If the same percentage of adults were in the workforce today as in January 2009, the measured unemployment rate would be 10.8%, and the Fed would be launching QE4. Over the past three months, the US has averaged 148,000 new jobs, a slower pace than the previous six months and yet the unemployment rate dropped to 7.3% in August, the lowest since December 2008, because over the summer a further 312,000 people dropped out of the workforce.

Between 1960 and 2000, the proportion of Americans in the workforce surged from 59% to a peak of 67.3% of the population before dropping to the current 63.2%, driving overall economic growth and household incomes. That was largely due to women entering the labour force while improvements in healthcare allowed working lifespans to be extended.  For the Fed and investors, the question is how much of this downshift is cyclical (the still weak employment market discouraging potential workers) versus structural (i.e. demographic trends).  If the same trends in employment/population growth were in place as pre-recession, total employment would by now be about 6m higher.

The employment/population ratio has hardly changed at all since 2009, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio. Since 2000, the labour force growth rate has been steadily declining as the baby-boom generation has begun retiring and under-25s enter the workforce at a later age. Bureau of Labour Statistics and Chicago Fed researchers have forecast the participation rate to trend even lower by 2020, regardless of how well the economy does in the interim. The extent to which this workforce shift is cyclical rather than structural has huge implications for trend US wage inflation, productivity and GDP growth.

According to the February 2013 CBO estimates, potential growth of the labour supply has been slowing from 2.5% annual growth from 1974-1981 to only 0.8% from 2002-12 and is projected to slow further to only 0.6% over the next five years. At current levels, working-age population growth is at multi-decade lows. Part of that decline in working-age population growth reflects lower immigration to the US as a massive post 9/11 increase in border security spending since 9/11 has curtailed Mexican illegal immigration, and tougher visa rules have slowed legal migrant flows.

The CBO has estimated that the non-inflationary unemployment rate (NAIRU) has risen for temporary reasons to 6% of the labour force, but in the long term it will drop back to 5.5%. At the rate of jobs market progress seen recently, this implies that slack will be wholly eliminated in about 24months, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance. The standard way of estimating the number of people who have temporarily  withdrawn from the jobs market until it improves is to compare the actual participation rate to that predicted if the demographic composition of the workforce had remained unchanged after 2008. This method implies that about 1.3% of the labour force has dropped out since 2008, but should come back if the jobs market improves and that the amount of slack in the labour market might be at least a percentage point higher than implied by the unemployment rate. However, for several important demographic groups, there appears to have been a long term downtrend in participation rates for structural reasons unconnected to the economic cycle, while the potential supply of labour is now constrained, leaving a lot less lack in the system than many assume.


Can Chinese Smartphones Bundled With Local Apps Challenge Silicon Valley?

Is Apple really worth 45x Lenovo’s market value or Samsung 21x, given the shift in incremental smartphone penetration growth to emerging markets? Is Facebook worth more than 10 times Sina and Qihoo combined? I very much doubt it and although the valuations of US web stocks are touching euphoric levels, there is no question that we are now seeing similar investor excitement over the potential of the mobile internet as the original PC based model back in 1999 (reflected in China’s buoyant Shenzhen market). The winners from the current land grab in China’s mobile search and social networking markets will likely become leading emerging market technology brands over the next 5-10 years by bundling localized versions of their services in the new wave of cheap Chinese smartphones. Local pure internet plays are highly valued; the cheapest, Sina, trades at 4.3x book and 8x EV/sales,  Baidu on 9.5x book and 11x sales while star performer Qihoo, is on 21x EV/sales and 17x book. The hottest web stocks in the US like LinkedIn and Yelp are valued at about 20x EV/sales range, but all are further along with monetizing their audiences. However there are several credible Chinese stocks offering pure play exposure on low double digit earnings multiples, from Giant Interactive to NetEase and in a global tech portfolio, I’d be switching Chinese for US mobile internet exposure.

China is the only country in the world with a domestic technology sector of sufficient scale to compete against the US web giants, and the breadth of software innovation combined with an indigenous hardware sector makes it unique among emerging markets. As the PC cycle ebbs (although reports of its death are exaggerated) we are already beginning to see Chinese brands expand beyond their home market – Tencent’s WeChat for instance now has 100m subscribers outside China while Baidu has launched a range of its services in Indonesia. The symbiotic relationship between Chinese smartphone makers and local internet brands monetizing web services via gaming and advertising revenues is crucial. Back in the 29th January note on the potential for a breakthrough by Chinese smartphone manufacturers, I noted that: The rise of the ultra-cheap smartphones from upstart vendors which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a brand premium has proved impossible amid endless discounting.’ Samsung and Apple wouldn’t disagree with that analysis. The recipe is to take MediaTek chipsets, Korean touch screens, add say 8GB of flash memory, and load the phone with the Android OS stripped of all traces of Google but pre-loaded with about 30-40 Chinese apps, which are increasingly being localized for Asian export markets.

The internet sector is unique within the Chinese economy in that it is dominated by a handful of forceful self-made entrepreneurs, and yet has benefitted from de facto protectionist government policies shutting out global competitors. The local media market is already highly sophisticated and focused on mobile. Compared to the US, where Americans spend 42% of time watching TV and a combined 38% on internet (mobile plus PC), the Chinese spend a much larger percentage of their media consumption on the web. This in part reflects the dismal quality of local TV and the need to go online for American TV steaming downloads (under 25s in China watch foreign TV series on tablets rather than TV sets), but it should still enable and encourage Chinese innovation in the mobile space.

Will Emerging Market Slowdown Undercut S&P Earnings?

The global portfolio stance all year has been long DM versus GEM equities on relative GDP and earnings growth momentum, but there will be a negative feedback from the current EM turmoil on S&P earnings with Indian and Brazilian growth rates having halved since 2011. The import purchasing power of about 40% of the emerging economies has declined by 10-20% in USD terms in recent months, and while the pick-up in Europe will help, the earnings headwind is clear and geographical revenue exposure should certainly inform stock selection in coming months. Almost all S&P 500 companies have now reported Q2 earnings and while 72% have reported earnings above estimates, only 53% have reported sales above estimates, well below the average of 58% recorded over the past four years.

The blended earnings growth rate for the S&P 500 for Q2 2013 is 2.1% but the surge in financials sector earnings (28% y/y) flatters the aggregate data. The blended revenue growth rate for the index for Q2 is 1.7%. In terms of preannouncements, 85 companies have issued negative EPS guidance for Q3, while 19 companies have issued positive EPS guidance. As covered below, while rental versus mortgage costs are supportive, the housing market is showing signs of slowing after a 120bps spike in mortgage rates since May; the 25% slump in house builder stocks from recent highs is telling.

So are US stocks expensive or fairly valued on long-term valuation metrics? Value, like beauty, is in the eye of the beholder and the debate rages as to which metric to use from the 10-year cyclically adjusted real price earnings ratio (CAPE) to Tobin’s q (market valuation versus replacement cost, currently historically stretched above 1x for US stocks).  Like most LT valuation measures, CAPE isn’t often useful for 3-6 month tactical allocation and emerging market investors have tended to dismiss it, since local GDP trend growth (and thus in principle EPS) has been on an accelerating LT path over the past decade. The ‘shock’ slowdown in aggregate emerging economy GDP and earnings growth over the past couple of years should serve to shake that complacency and if we rewound back to April, when I advised avoiding India and ASEAN markets, the CAPE calculation below showed Europe offering the most attractive LT expected returns and markets like Indonesia clearly overvalued. Of course, the financial sector distorts the 10-year earnings analysis for developed economies given that peak pre-crisis sector profitability won’t be achieved again in the foreseeable future, particularly in Europe, but the allocation signal remains strong.

I was making the bearish ASEAN/India call on macro risks based on clearly deteriorating external balances as much as valuations, but this approach looks useful for GEM as a ‘reality check’. The MSCI Indonesia Index has declined by 34% in USD terms from its May high, while the MSCI Malaysia Index has fallen by 16%. Stretched starting valuations colliding with very predictable macro volatility created a bloodbath for careless investors. ASEAN still doesn’t look bargain basement. Indonesia is on a 12-mth forward PER of 12x and Malaysia on 14.3x; GDP growth will slow in both, and is probably headed sub 5% in Indonesia while ROE is falling across the region. Operating profit margins in Indonesia at 18-20% are one source of comfort but Thailand (10.6x) alongside the Philippines look the most attractive bottom fishing opportunities for those brave enough to move underweight amid the consensus euphoria back in Q1. I’d retain an overweight on China (8.5x) and Korea (8.2x) given their late cyclical global exposure and FX resilience.