Assets, one by one, undergoing shifts in regime
The normalisation process in the global economy is spreading through the various asset classes; it started with gold, then equity markets in the developed world, and has now moved on to bond and currency markets. One of the most significant milestones along this long and winding road is the US economy gradually setting down sturdy roots for self-sustaining growth.
The US economy has progressively been sending down firmer roots to cement self-sustaining growth of around 3%, marking a key phase that will ultimately bring about a new regime for financial markets: one where GDP and earnings growth will be the influential fundamental risk factors, marking a shift from the 2008-2012 crisis era when systemic risk and central banks’ monetary policy played those roles.
In mid-2012, we chose to refer to the process whereby the crisis regime would transmute into a fundamentals based regime as one of ‘normalisation’. Of the many phases in this metamorphosis we have written about at length in Perspectives in the past year or more, two of the most significant were always going to be US economic growth turning selfsustaining to run at an estimated 3% by 2014 and the Fed reining in its buying of assets and modulating the tenor of its public comments (see the ‘Topic of the Month’ article on page 12). The prospect of a shift in market regimes is now spreading through all the asset classes. After witnessing regime changes for gold and equities in 2012, we have seen since spring US 10-year Treasury yields undergoing a U-turn, climbing from 1.5% to almost 3% in the space of a month and a half before drifting back to 2.65%. By osmosis, yields on other government bonds, such as German Bunds with the same maturities, also moved up. The process of the global economy reverting to a more normalised regime has been working against sovereign debt.
This shift from a crisis to a fundamentals-geared regime has also brought about a clear-cut change in the way forex markets have been behaving since the end of Q1 2013. Up to late spring, the US dollar had been on the slide against the euro, its downtrend paralleling the shifting rates of expansion affecting the relative sizes of the Fed’s and ECB’s balance sheets, but, since then, it has been appreciating faster than this model dictates.
Lastly, normalisation of economic regimes is providing significant support for companies’ profits, feeding through, by extension, into equity markets in the developed world. As we highlighted in our recent Horizon publication, this particular asset class can be expected to deliver some of the most attractive returns over the coming decade.
Equity markets in developed world still in pretty good shape
Shares traded on stock exchanges throughout developed nations have performed particularly impressively since the outset of 2013: year-to-date returns (including dividends) of some 20% in the US, almost 15% in Europe and 40% for Japan. These handsome gains stand in stark contrast to the meagre returns from emerging markets, with the MSCI Emerging Markets index in dollar terms actually down 4% for the year.
Although one-third of the rally on the Tokyo stock market can be attributed to upgrades to earnings expectations during the course of the year, the same is not true for Wall Street, where profit forecasts for 2013 have been flat, or, more pertinently, Europe where earnings projections have been downgraded by 10%, quashing the prospect of any increase in profits after the declining earnings reported for 2012. Despite this, Europe is heading for a turn for the better: fewer and fewer earnings forecasts for European companies are being downgraded, providing a key driver to fuel the market rally in the longer run.
Dashboards of risk indicators were flashing much less red and orange throughout all economic areas by late September, but some fresh clouds of uncertainty have been looming large in the skies. The latest plot twists in Rome’s corridors of power have managed to dilute political risks in Italy, but the fractious dispute over the US budget could dent growth in the US and, by contagion, hurt the recovery in Europe. So, although equity markets in the developed world do look likely to extend their rallies, they may be heading for more of a roller-coaster ride.
Emerging markets gaining second wind
The Fed’s decision not to rein back its bond purchases caused the dollar to lose a little ground. In contrast, emerging-economy assets greeted the announcement with a rebound. Emerging equities actually outperformed their developed-world counterparts in September: +6.2% on the MSCI Emerging Markets index in dollars vs. +4.8% on the MSCI Developed Markets benchmark. Moreover, indices, expressed in dollars, for emerging equity markets most heavily penalised over the summer (India, Indonesia, Thailand, Turkey, Brazil and South Africa) on account of worsening economic fundamentals and depreciating currencies bounced back with great verve in September: +9% for the MSCI India, +11.9% for the MSCI Turkey and +9.6% for the MSCI Thailand. South-East Asian markets, which had been so eagerly sought after by investors in the last couple of years, are still trading at premiums to the equity markets of northern Asia. That state of affairs is hardly likely to be tenable for long, especially as the austerity belt-tightening (hikes in interest rates) which the nations of South-East Asia will have to submit themselves to will cause their growth to slacken in tempo. Moving forward, we would expect valuation multiples for equity markets in South-East Asia to decline.
Conversely, shares traded on markets in northern Asia (South Korea or Taiwan) stand to benefit from an upsurge in export growth in response to strengthening demand from the US and, to a lesser degree, Europe.
Euro at its highest against the dollar since February
The Fed’s decision to postpone its QE3 tapering sent the dollar sliding, its exchange rate against the euro moving from around USD1.33 on the eve of the Federal Open Market Committee (FOMC) meeting to USD1.35 more recently. News of the Fed deferring its turning-off of the liquidity taps did, however, give cyclical currencies, those of both emerging and developed nations, a timely boost.
This appreciating trend enjoyed by cyclical currencies should run on for a few more months until the Fed does indeed make a move to rein in its asset buying, most likely in December according to our revised time-line. Most economies in the developed and, above all, emerging world have seen their cycles turning upwards recently, throwing up some attractive buying opportunities after the steep drops in their currencies since May this year.
The euro/dollar exchange rate should hold fairly steady or the dollar might even edge gently higher between now and December as the underlying uptrend we are forecasting for the dollar is conditional on the Fed tapering its quantitative easing.
Breathing-space for commodities The Fed’s decision, coupled with the cyclical upturn in China, also pushed prices of most commodities upwards. Their falls since the start of 2013 had, however, been so steep that this recent rebound has still not been strong enough to push them back into the black for the year, the sole exceptions being energy and palladium. The Fed’s decision to postpone its QE tapering would seem to herald a few more encouraging months for commodity prices against the ongoing backdrop of a rebounding global economy.
The rise in commodity prices is, however, likely to be pretty modest, partly because uncertainties surrounding the global economic cycle are still high and partly if the dollar does start to climbing before December. Energy prices should hold fairly steady though. We continue to forecast a price for Brent crude oil of USD115 a barrel for the end of the year, equating to an increase of roughly 5% from current levels.