Elevated market expectations in an uncertain growth landscape
Risk assets, such as U.S. equities, have continued their advance in May with the S&P 500 reaching a new high (1647, +15% YTD). In Treasuries, the yield curve has been steepening. After a global economic soft patch in the first quarter of the year, market expectations are now focused on further global monetary accommodation in the context of a dis-inflationary environment. In our view, the global growth outlook remains contingent on policy execution in order to reach a sustainable equilibrium. At this stage of the business cycle, we remain focused on income generating instruments (MBS) and industries with late-cycle/secular growth characteristics.
As we can see below, global growth (economic surprise index) appears to be stabilizing in the interim. We also note the recent rise in U.S. real rates and weakness in traditionally safe assets such as gold and utilities. In the Pacific, following the Bank of Japan’s bold monetary policy shift (doubling of its balance sheet by 2014; 2% inflation target), we are assessing its impact in the currency and sovereign bond markets. Thus far, JPY weakness has largely been tolerated by the G7 and it remains to be seen how exporting nations such as Germany and S. Korea may eventually respond. A recovering Japanese economy is positive for global growth, especially as Japan is facing severe demographic headwinds and an overwhelming government debt profile (225% debt/GDP). The Bank of Japan’s bold policy shift can only be successful as long as the JGB market remains under control via the BoJ balance sheet expansion. We highlight the recent steepening of the JGB yield curve. We also note that capital outflows from JGBs and into other sovereign bond markets have increased in recent quarters. These flows contributed to the suppression of European peripheral yields; along with domestic European bank purchases. Therefore, global growth remains contingent on sustainable systemic stability.
In the emerging markets (EM) arena, we remain cautious with regard to the impact of USD strength on the EM balance of payments profile. Broadly speaking, USD strength leads to tightening of credit conditions in emerging markets as EMs seek to repay USD denominated debt. In China, policymakers face dilemmas as the housing market is still heating up and inflation pressures are still evident due to rising wage costs. We are also monitoring China’s excess credit growth which has been a significant source of funding for China’s infrastructure spending. Therefore, even though we see some room for China’s exports to Europe to recover, we are cognizant of China’s structural hurdles as they transition to a consumer driven economy.
On a more positive note, despite some fiscal headwinds, we are relatively constructive on U.S. growth. Leading indicators such as weekly initial jobless claims, corporate credit spreads and CEO confidence are encouraging. This is important as revenue growth for the S&P 500 in Q1 of 2013 has ran at a rather uninspiring rate of +1% (y-y) and profit margins seem to have peaked in 2012. The recent Federal Reserve loan officers’ survey has indicated a broad loosening of business credit conditions. On the other hand, household mortgage credit conditions remain relatively tight.
Consumer confidence expectations seem to be tempered, as shown below by the tight confidence spread of current and future expectations. U.S. households are progressing with their debt deleveraging efforts and debt service costs are making new lows, as a result of the low interest rate environment. On the other hand, the upcoming Affordable Care Act (Obamacare) is likely to increase healthcare costs for certain individual health policies. Moreover, some small businesses are keeping their employee count to less than 50 and part-time employee hours to less than 30, in an attempt to avoid increased healthcare costs. Therefore we remain cautious with regard to pure consumer spending and we prefer corporate spending exposure e.g. technology.
Lastly, the U.S. energy sector outlook remains promising as shown by record domestic oil production (blue line). We are also encouraged by the decline in oil imports (inverted orange line) and its positive impact on the U.S. trade deficit. Along with the housing recovery, the U.S. energy sector remains an important pillar of U.S. growth. As oil imports have accounted for 60% of the trade deficit, over time we expect the energy sector to help alleviate some U.S. fiscal pressures; that are likely to arise from future entitlement expenditures.
In conclusion, the global growth landscape remains in a state of flux and still dependent on policy execution. From our point of view, we continue to focus on visible cash flow and earnings opportunities; whereby the risk-reward profiles at the micro level are favorable from a valuation perspective.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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