Reflation Trade Becomes Consensus…

In a vintage year for contrarian asset allocation, the trajectory for markets has been to overreact to China deflation/devaluation risks, the shock of the misguided negative rates experiment (which served to confirm deflation fears and therefore backfired as a signalling tool) and what we termed the  ‘sideshow’ of Brexit. Overly pessimistic expectations were reset from Q2 as macro data such as PMIs and net earnings revisions across the MSCI AC index rebounded (led by EM), reflected in the turn in bond yields from July as ‘macro hypochondria’ peaked.

Positioning for the commodity cycle and EM bottoming in Q1 looked to us like a compelling bet, as did overweighting value as a style factor. Globally, value has outperformed by about 20 ppts since July, the second-best run versus ‘quality’ as a portfolio factor in almost 40 years. Our rotation from bond yield flattening to steepening sector exposure mid-year (including long Eurostoxx banks) also generated huge alpha in the tactical portfolio. If there was one issue this year which reflected a spectacular failure of nuanced analysis and caused global shock waves, it was the Q1 panic over Chinese FX reserves and the risk of a ‘shock devaluation’ which coincided with equally hysterical forecasts of oil going to $20 to generate a deflation panic rippling across markets.

Our view was that at least half the apparent capital flight was in fact rapid FX debt deleveraging and that rather than a deflationary shock, China was poised to inject an inflationary impetus to the global economy as the investment cycle turned. Ironically, the rebound in China’s fixed investment (particularly residential construction) has been weaker than we expected but the surge in industrial commodity prices even stronger, now that reflation is suddenly fashionable as an investment thesis. We stuck with a $50-60/bl end 2016 oil price target as market rebalancing began, making global E&P stocks and US HY energy debt a contrarian overweight. Meanwhile, the RMB correcting from very overvalued real effective levels was something to be welcomed, so long as orderly.

The US election has provided an alibi for sell side strategists to wipe the slate clean on an astonishing series of analytical errors and belatedly jump on the reflation trade. If the overwhelming investor consensus a year ago was for further EM/commodity downside and long quality/growth, this year it is long USD and reflation winners and positioning has shifted accordingly but simplistic extrapolation remains the default forecasting tool of most analysts. Indeed, almost comical herding behaviour continues to define markets from oil to the JPY (for instance, the yen has seen consensus targets versus the USD gyrate from 125 in mid-2015 to 90 by mid-2016 and now back to 125 again). Investors have been stampeding in and out of markets with record speed as the narrative and momentum shifts. With the rise in AUM of systematic trend following funds and the retail ETF hordes that ride their coattails, markets have never been more of an ‘echo chamber’ of confirmation bias  – remaining strictly agnostic is key to getting ahead of crucial inflection points.

The consensus was hugely misguided a year ago, and the impact of the Trump regime whether in terms of tax policy or geopolitics looks less benign than it now naively expects. Ultimately, if Trump is to attract cheers rather than jeers at the rallies he intends to continue holding for his rustbelt true believers, low-skilled labour has got to get a bigger share of the economic pie i.e. companies will have to divert cash flow from shareholder distributions to capex and wages and shift their capital structure from debt to equity.

Tax cuts will accordingly come with strings attached designed to incentivise investment and manufacturing re-shoring. The USD and Treasury yields are not a one-way bet given subtle negative feedback loops and both look extended, global miners ex gold now look relatively expensive and quality growth/defensives decent value again. While 2017 is unlikely to be quite the contrarian bonanza this year was, it would be wise to read those investment bank annual outlook notes with a healthy degree of scepticism. Or perhaps safer still to ignore them completely…






Cyclical Bet Remains Attractive…

‘I would overweight MSCI China in a GEM portfolio, and particularly H-shares. Deep cyclicals in China remain favoured on growing evidence of a fixed investment recovery. That backdrop would force side-lined investors, as yet unconvinced by the sustainability of the Q1 rally, to reallocate. From a technically driven repositioning rally, the next leg globally would see a shift to a positive net earnings revision trend and multiple expansion.’ Weekly Insight, 12th April

That unfashionable cyclical bet has paid off but while the RMB proxy short via H-shares (particularly banks) has been much reduced over the summer, global funds are still underweight offshore China by almost 300bps, near a decade high. A key theme is that you have to ‘reality check’ economic data points more than ever in the current environment of rapid structural change and low amplitude trend growth that leaves Japan and Europe repeatedly on the cusp of apparent recession.

That’s even truer in a global economy where incremental growth is digitizing and the global economy is becoming ‘lighter’; it is significant that services added more to global trade growth than manufacturing last year for the first time ever. The standard macro data points used by consensus analysis are increasingly misleading and as Silicon Valley giants start employing large teams of PhD economists, it seems clear that the web giants now have a uniquely powerful perspective on economic data flow from ‘live’ consumer prices to merchandise inventory levels. Investors will likely be buying proprietary data packages from Amazon, Google etc. within a few years that are far more powerful than anything Wall Street can offer (the ‘billion prices’ project at MIT is an early view of the potential of big data and real-time online transaction networks).

There are now hundreds of data releases every week that didn’t even exist a decade ago, with dozens of bank economists commenting on almost every one, but little of that activity is of any practical help in generating actionable insight.  Back in Q1, scanning the outlook statements from key global cyclicals would have reassured any investor paralyzed by ‘sell everything’ headlines from excitable IB strategists. The granular corporate evidence has been more reliable than economist extrapolations all year and remains broadly encouraging.

As for China, Komatsu has seen a 10% rise in excavator utilization hours, the seventh consecutive month of growth. I spoke to a client recently who had attended a major tech conference in Taiwan and thought confidence among companies he met was at levels he had rarely seen over the past decade. To do this job, you need to have an analytical telescope and microscope and most importantly know when to switch between them.

Growth, inflation and earnings expectations are all turning modestly but decisively higher. That  more than central bank actions will generate volatility near-term as complacent bond investors front running central bank buying reposition for a less pessimistic economic outlook. It’s also clear that even central bankers are accepting that monetary policy is at the limits of both creativity and effectiveness, and as Harvard’s Larry Summers has recently argued, fiscal policy focused on infrastructure spending now looks a more rational policy response. By boosting the velocity of money in the real economy, that would be inherently more inflationary medium term than endless monetary stimulus that ex asset inflation effects simply gets trapped in bank excess reserves.

While recent US data has been mixed in housing etc., historically low level of combined debt service and energy outlays at just 14% of disposable income are offsetting soft wage growth, while balance sheets and net worth continue to improve. We have seen some slowing in growth in corporate bank borrowing as more companies tap booming credit markets, but the slowing in corporate bank loans has been offset by an acceleration in real estate and consumer lending.

An interesting lead-indicator granular data point is the Chemical Activity Barometer, published monthly by the American Chemistry Council, up 3.9% y/y recently and suggesting that US industrial production will accelerate into early 2017 now that the energy/inventory adjustment drags are abating. The biggest surprise to a consensus still suffering ‘macro hypochondria’ would be a synchronised cyclical growth rebound over the next 3-6mths and our overweight cyclical risk asset strategy since Q1 remains in place.

Beware Macro Gurus, as European Equities Look Attractive…

I luxuriated in the polemics of Marc Faber and James Grant and Nassim Taleb, in our own country, Albert Edwards, et al. I luxuriated as they ranted and it was fine for them to rant. But I am charged with the responsibility of making money…’

Hugh Hendry, manager of the (shrinking) Eclectica hedge fund, in a recent interview

Hendry is infamous for his YouTube videos from Chinese ghost cities like Ordos and claiming back in 2012 that gold mining companies could be nationalized and physical gold confiscated as the gold price headed to $3,000/oz. He suffered a classic and expensive case of confirmation bias, the psychological tendency to search for and prioritize information in a way that confirms preconceived beliefs or hypotheses. I’ll always recall visiting Asia in mid-2012, just after macro ‘guru’ Raoul Pal had terrified fund managers at a Shanghai conference with wild eyed predictions that they had a few months left before the Eurozone collapsed and financial cataclysm struck. It was, as I explained at the time, a sensationalist analysis based on a misunderstanding of the power of central banks to offset private sector deleveraging via their balance sheets.

Indeed, many investors overlook the fact that macroeconomic pundits are largely tribal, with most adhering to a dogmatic world view from monetarism, the notion that the money supply is at least a leading indicator of aggregate demand (and even determines it) to the rather stern Austrian school of economics (think Marc Faber), and more specifically the dubious Austrian theory of the business cycle. However, investing on the basis of what ‘should’ happen by applying rigid intellectual preconceptions has hurt performance since 2009, given the crucial role of policy intervention and the structural demographic and technology shifts.

What has worked is taking an agnostic view of the incentives and constraints within that shifting policy framework, initially in the US and most recently in Japan and now Europe.. Meantime, a chastened Hendry now thinks that “…to bet against China or Chinese equities, or the Chinese currency is to bet against the omnipotence of central banks. One day that will be the right trade, just not ready or sure that that is the right trade today.”  Indeed, and China was an easy contrarian bullish call back in early Q1 along with GEM in general amid consensus panic. A key call for 2015 will be whether the relentless US equity outperformance of recent years (almost 90% since the 2009 lows versus both developed and emerging market indices) can be sustained and whether European equities can restore earnings momentum.

Even without any further ECB action (which the deflationary impact of the oil slump now makes inevitable), we could well see Eurozone growth in 2015 accelerate to say 1.5%, as modest bank credit growth resumes, the fiscal drag from austerity ends and broad M3 money supply growth remains supportive. Property markets are now recovering across the periphery (Irish housing is up 50% since the 2012 lows), allowing bank asset write backs.  Downside risks are underwritten by the ECB, which will ultimately overcome German misgivings with more forceful QE. Eurostoxx 600 positive earnings surprises are improving already, a function of the euro slide as well as a stabilization/modest improvement in consumer demand across the periphery. The USD rally is in one sense taking earnings growth from US companies in the traded goods sectors and transferring it to European and Japanese, while the net macro benefit of the oil crash is far larger for the latter.

Since March 2008 in USD terms, US equities have re-rated by 30% versus the MSCI ACWI while European have de-rated by almost 40%. Even allowing for the weighting of high revenue growth, global franchise tech stocks in US indices, this massive divergence between US and Eurozone equity performance is likely to at least partially mean revert over the next couple of years as the earnings gap closes (Eurostoxx earnings are still 40% below their pre-crisis peak in real terms, largely due to banks, who are 2-3 years behind US peers in  the credit growth and asset write-back cycle). The overall relative valuation case is nothing like as compelling as it was for Japanese stocks back in Q3 2012, when they were hugely underweighted in global portfolios setting the scene for the powerful rally that followed and an ECB policy shift has been well flagged, whereas the BOJ action stunned markets.

Nonetheless, recent survey evidence indicates that overweight positions held in Q2 have been sold down with current allocations on the BOAML institutional survey at a quarter of US levels while Japanese allocations are at their highest since 2006. While we still like US discretionary consumer exposure in retail, hospitality and travel as well as the potential for further tech sector re-rating, the prospect for overall earnings upside looks better in the Eurozone over the next 6-12mths. Financials, real estate and exporters look particularly attractive as bank credit growth turns modestly positive in coming quarters and the euro weakens further…

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.