By Jay Pelosky (via Itau Global Connections).
Summer’s last days are upon us, and as we prepare for a change in season we should also consider a change in financial asset leadership. The long run of US equity outperformance may be coming to an end, spurred by headwinds at home and a sense of stabilization if not recovery abroad. Leadership may be passing to the non-US developed markets, namely Europe, the UK and Japan. Prior writings have discussed the positive feedback loops developing in Japan and the UK; Europe is now knocking on the door.
From a near-term perspective, the risk asset retracement off the June lows seems to have run its course as those investors not on vacation begin to nervously contemplate a very busy Fall. There is plenty to be nervous about: the beginning of the Fed’s taper process and the search for a new Chairman (an unfortunate combination); US spending and debt-ceiling talks set against a backdrop of 2014 midterms making compromise a dirty word in D.C.; German elections and the follow-on coalition-building necessary to deal with continued debt struggles in Greece and Portugal; Japan’s fiscal talks; and China’s economic policy meetings – these are just some of Fall’s focal points.
In the US, we may be entering a period where not losing money replaces making money, as taper talk leads to both stock and bond weakness. Ten-year UST yields over 2.80% when set against a steady state economy, docile inflation and a well-anchored yield curve that is twice the 20-year average would seem to suggest that a gradual tapering process is in the price. Yet the price action in bonds is poor and could feed on itself as the 3% round figure looms ahead. Stocks seem fearful (and perhaps with good reason) of operating with a reduced Fed safety net while the USD seems caught between taper talk (bullish) and better news abroad (bearish). The prime concern remains the initiation of tapering and an economy that fails to accelerate, leading to mutually reinforcing downside direction in the economy, stocks and bonds.
The Big Picture
The big-picture focus remains the search for economic growth and corporate earnings power. Widespread hope that US consumers, having repaired their balance sheets, are poised to re-enter the consumption business as a global locomotive seems overblown, as low savings rates, high energy prices and weak income growth limit that optimism. The US remains in search of economic acceleration; given the prospect of dollar strength as tapering begins, the external sector is not likely to be a source of demand as demonstrated by 2Q13 net exports. Within the domestic economy, business spending could help but requires a better demand picture. Housing, autos, and credit have all been mainstays to date, but recent evidence suggests possible cooling in housing and autos, leaving one to wonder what will provide the economic acceleration already built into 2014 economic growth and earnings expectations.
Outside the US, China continues to deleverage, with broad measures of credit growth approaching two year lows. China is in the very early stages of a significant slowdown in its growth rate. The other emerging economies face growth model transitions complicated by stagflationary environments made worse by weakening currencies and rising oil prices. Asian economies in particular face an iron triangle of a more competitive Japan, a slowing China and capital flows shifting back to the developed markets. Recent market action in India and Indonesia reflect these challenges. In Europe there is a growing sense of positive change at the margin, with the economy bottoming and growing prospects for the ECB to become more active. A tapering Fed and a deleveraging China may require the ECB and other major central banks to do more to sustain the global economy.
Positive Feedback Loops
The three positive feedback loops noted in the past – Japan, the UK and Mexico – continue to develop, and weakness here should be bought. The Abe government’s recent election victory provides the political runway for significant structural changes. From an economic perspective, deflation is easing, exports are picking up and consumption is rising. Policy-wise, the government is floating a number of policy initiatives including minimum wage hikes, corporate tax cuts and flexibility on the imposition of expected sales tax hikes. On the market side, earnings have been quite good, though the investor response has been muted at best. Japanese corporates remain cash-rich (more so than even their US counterparts), and the prospects for rising dividends and stock buybacks are quite good. The JGB market remains well-anchored as the megabanks offload their holdings to the BOJ while the long mooted prospects for foreign debt-buying appear underway. The yen has been (surprisingly) strong, shaking many out of their short yen positions and providing opportunity for others to reset trades at more advantageous levels. While tapering seems to be in the price of US fixed income, it does not seem to be so in the currency space, spelling opportunity.
The UK economy has surprised with its recent robustness across both domestic and external sectors. The UK will also be a major beneficiary of EU economic stabilization as close to 50% of its trade is with the EU. Finally the BoE remains in place to support any faltering of the economy should it become necessary. In Mexico, the recently proposed energy reforms seem like a good first step, setting in place the possible increase in FDI from external energy companies to go along with the world’s auto producers, who are increasingly making a home for themselves in Mexico.
Europe – The Main Story
The main story, though, is Europe. Having been quite cautious on Europe for some time, both in terms of its economic growth outlook as well as the opportunity in its financial assets, it is now time to be long European risk and short US risk. This is the opposite positioning of the past few years and suggests a possible sea change for global equity markets. The US, global equity market leader for the past two years, is likely to make way for the non-US developed markets to lead, at least in the short term and possibly for the next several years.
Recent economic data out of Europe, including a positive 2Q13 GDP print, export growth, the first year-over-year increase in industrial production in nearly two years, and even rising car sales – all support the idea that the European economy is bottoming. A dramatic pickup is unlikely, given very high unemployment and debt concerns, but sometimes the news just has to get less bad, as my former colleague Barton Biggs used to say, and that would seem to be the case for Europe.
Economic bottoming has led to a pretty sharp rally across European debt and equity markets over the past several weeks. A key question thus becomes how sustainable is the move?
Supporting the case for sustainable outperformance is a combination of:
1) Very low expectations amid cycle low earnings,
2) Light positioning, attractive valuation and significant underperformance,
3) Better economic news at the margin amid an easing of austerity headwinds,
4) Banks that are in better shape, and
5) The small but not insignificant chance that the ECB could swing into action.
The lack of appealing alternatives also supports a more positive view towards Europe. The US has been the global equity leader (US/EAFE relative performance is at multi-decade wides) but faces numerous headwinds going forward, from tapering and rising rates to D.C. talk and lack of visible economic acceleration, to full valuation, overly positive sentiment readings, slowing and poor-quality earnings and margin compression (are we approaching the crunch point between corporate profit margins and compressed labor wage rates?). Japan has been a home run this year but has lagged recently. The UK is interesting, as noted above, but is not big enough to capture all the attention. Emerging market equities appear cheap and have been big underperformers, but their economic challenges weigh too heavily for us to expect them to lead. Investors are searching for a new story, and Europe is it.
Recent solid EU equity performance in the face of a struggling S&P index suggests a leadership transition may already be underway. Europe’s ability to stay positive amid US equity weakness is new, and if sustained it should bring in additional buyers. Should the S&P sell off by 5%-10%, one could expect the EU markets to be relative outperformers and in a flat S&P world to be absolute outperformers.
The principal European equity opportunity seems to be centered in the financials, as the major European banks have made progress cleaning up their balance sheets (not true of their smaller brethren), have dramatically underperformed their US counterparts over the past three years, are attractively valued and are geared to any economic stabilization and modest recovery into 2014. A steepening yield curve may also support equity price appreciation in Europe’s financial sector, as it has in the US.
The US money center banks have been a leadership sector; one approach may be to take profits here and replay the hand in Europe. Looking at the recent performance between XLF, representing US financials and EUFN, representing European financials, suggests some early birds are already on this worm. It is true that the major European banks are not in as good a shape as their US counterparts and that the EU recovery is not likely to be as strong as the US, but it is change at the margin that counts, and Europe has it. Core European banks have also insulated themselves from the woes of the periphery – their price action on further debt-restructuring news out of Greece and Portugal should be observed for confirmation.
European fixed income is tougher to call, as peripheral yields have come in considerably and the risk of further debt blowups loom as we move through the Fall. Core bond yields are rising as safe haven trades unwind. Within the corporate debt space, High Yield looks appealing, with very low default rates and 5% plus yields. Europe is in the midst of a funding transition from bank loans to bond issuance; developing expertise here should pay off over the next several years. The euro itself remains a toss-up; the ECB’s shrinking balance sheet has been a major support – should that change, then the euro’s value would as well.
Given that both European equity and high yield have rallied of late, one should be cautious in entering positions, looking to buy on (S&P inspired) weakness and add into uncertainty around the German elections while buying in large size, should it become clear that the ECB will shift to expanding its balance sheet. There are numerous ways to invest, including equity ETFs such as FEZ, EZU and high yield ETFs such as IHY. A play on non-US developed markets outperforming the US would be VEA, which has a 60/40 split between Europe and Asia and a near 25% allocation to financials.
Other, more aggressive opportunities include looking to add duration to fixed income portfolios. A steep yield curve anchored by a Fed that has made the distinction between tapering and tightening, a steady state economy, and real fear in the bond market all suggest it is worth a look. Two possible ideas stand out: US MBS investments and EM debt. Both these investments have been hit very hard by rising UST rates and have recovered modestly (EM debt) to not at all (M-REITS) from their early summer swoons. As tapering becomes priced in between 2.75%-3.0% on the US 10-year Treasury, these instruments could do well, thought timing is tricky. The clearing out of retail positions leaves the field clear for institutional investors to re-enter, and as one enters others will follow. Mortgage originations have fallen to two-year lows while Fed purchases far outweigh net supply. In the case of emerging market debt, net outflows have occurred for twelve straight weeks, the longest stretch since 2008-2009.
Other contrarian opportunities might exist in the commodity space, including both industrial metals such as copper and precious metals such as gold. Copper seems to have found some support near the $3 level, rallying back to $3.30 on significant short covering. Should the global growth story prove more vibrant, a long copper position should do well. Gold, loved then hated, seems to be finding its footing somewhat and in a world struggling for direction could build on physical demand from rising wealth in the emerging economies as well as financial investors seeking safety from falling stocks and rising yields. The gold miners (GDX) look like they are trying to make a bottom and represent a geared play on a gold price rally.
A busy Fall awaits; US equity struggles could be the trumpet call for European equity to come out of the bullpen and onto the field. Sell US equity strength, buy European equity weakness is the call.
Jay Pelosky is Principal of J2Z Advisory, LLC, a global asset allocation and portfolio strategy consultancy for institutional investors. Jay advises clients and invests personally based on insights gained from 30 years of financial market experience in over 45 countries. For the past decade, he has invested his own capital in a global, multi-asset, ETF-based Asset Allocation strategy. He sits on the board of Franklin Holdings (Bermuda) Ltd. and serves on the advisory board of Carmel Asset Management. Jay teaches a graduate level course, The Art and Practice of Global Investing, at The George Washington University and is a founding member of the New America Foundation’s World Economic Roundtable. His formal Wall Street career spanned twenty years and included positions on both the buy-side and sell-side. At Morgan Stanley, he launched the Firm’s global asset allocation and global equity strategy research products. He also formed and co-chaired the research department’s asset allocation committee. Jay created the firm’s Global Emerging Market Strategy (GEMS) product and initiated its equity investment, research, and strategy efforts in Latin America.