10 July 2013

Macro Strategy Update

Mid-year review and 2nd half outlook

It is now a good time to take stock of how markets have fared and consider the potential outcomes in the next six months. Overall it was a mixed picture, with some markets making new highs while others struggled. As economies and monetary policy go out of sync with each other, so does the performance of different markets. It seems to appear that emerging markets are losing their lustre in the next six months with developed markets looking more appealing.

Global market performance - 1st half

By asset class, it is clear that commodities and fixed income were the losers while global equities managed to stay positive. The fact that the US dollar index made strong gains in the first six month is indicative of the change in asset class performance, as commodities were negatively affected by a stronger US dollar while expectations of higher dollar rates hit bonds.

In equities, developed markets outperformed emerging markets. In some markets like Japan or the US, the outperformance was massive (see Figure 1). Within emerging markets, it was the commodity biased Latin American and emerging European equities that suffered the most. By sector, the materials sector led the declines while healthcare and consumer led the gainers (Figure 2).

Figure 1: European financials have begun to outperform

Figure 2: Equity Market Performance by Sector % (1st half 2013)

In the fixed income space, the performance of bonds was quite uniform. Fears of monetary tightening sent government, corporate, emerging market and Asian bonds into negative territory. US high yield bonds were the exception, ending the first six months flat, although its peak to trough loss was 7%. Given the intensity of the sell off over the past month, a fair amount of speculative positions would have been removed in these markets.

Figure 3: Bond Market Performance by Sector % (1st half 2013)

Global Economic Performance

The performance in the major economies was also not in sync. The US continued to confound skeptics with its “muddle-along” growth, where consumer spending and housing remain key pillars of economic growth. Japan surprised with a solid Q1 GDP report where the annualised growth rate came in at 4.1%. A substantially weaker yen has yielded benefits as business and consumer confidence improved on the back of rising corporate profits. Meanwhile Europe continues to offer hope that the worst is behind them, with the latest manufacturing PMI data showing signs of improvement, especially in the peripheral European countries.

The BRIC economies were not meeting growth expectations. China, the powerhouse among the developing economies, continues to disappoint with key economic indicators like industrial output, retail sales and fixed asset investments experiencing slowing growth rates (Figure 4). The resolve of the Chinese leadership to reform the economy is having an impact on growth. Given that Chinese officials are now graded not just on GDP growth but also on improvement in the people’s livelihood, social development and the environment, expectations on economic growth will have to be reduced.

Figure 4: China Economic Indicators

Global Monetary Policies

Monetary policies also differ in the developed and the emerging economies. While much of the developed economies are involved in quantitative easing or have monetary policies to encourage credit growth, policies in the emerging world were targeted at containing credit growth, which had grown excessively, risking a misallocation of capital. China is a prime example where policy makers were active in curtailing the banking sector, targeting the real estate market specifically. The recent sell off in emerging market debt and currencies also led some central banks like Brazil and Indonesia to tighten policies further, in an effort to stem the rapid decline of their currencies.

Market Outlook

Looking ahead the next six months, it seems likely that markets will continue to diverge in performance. Global economies are no longer in sync with markets and thus monetary policies are also likely to diverge. Hence it is reasonable to expect correlations in markets to breakdown in the months ahead.

The sustainability of US and Japanese economic growth will likely lead to continued outperformance by their equity markets. For the US, markets continue to signal that the growth cycle remains intact. Consumer discretionary and financial sectors continue to lead the market even after the most recent correction. Even in the junk bond universe, the credit spread between the riskiest and the safest bonds continues to narrow, indicating a lower probability of default (Figure 5). The odds are that the US economy is getting better.

Figure 5: Spreads Narrowing Between CCC-rated and BB-rated bonds

In Japan, we are also seeing tentative signs of sustainable growth as credit demand makes a comeback1. Abenomics is beginning to turn the Japanese household from a hoarder of cash to spenders and borrowers. Rising property prices and increasing home sales have increased the odds that the economic expansion can continue, providing some tailwind for the Japanese stock market. If reforms can be carried through after the elections, it would cement the sustainability of Japan’s newfound growth cycle.

Over in Europe, despite renewed fears that bailout recipients Portugal and Greece are in trouble, the equity and bond markets are more stable, as compared with emerging markets. Signs that the recession is ebbing are giving investors more confidence that the worst is over for Europe. Coupled with the ECB’s new forward guidance that monetary policy will stay loose for an extended period of time, the odds have fallen that the ECB may prematurely tighten (as they did in 2011). We continue to see Spanish and Italian bond yields falling with European financial stocks holding up, despite the recent correction.

It is the developing world where the risk reward looks unfavourable. First, the potential for more capital outflow from the region is threatening to affect the real economy as financing becomes scarce and expensive. As the US dollar continues to strengthen on a resurgent US economy, illiquid markets in the developing world may face rapid depreciation in their currencies, which again affects the real economy. Volatility in currencies is never good for businesses as it makes it difficult to plan for future investments.

Second, economic growth in the developing world over the past few years coincided with rapid credit growth. Take Asia as an example. Using data from the Asian Development Bank, credit intensity of Asian economies has risen, meaning that an additional dollar of credit extended resulted in less than a dollar of economic growth generated (Figure 6). In such a situation, the risk of misallocation of capital is high. Thus it is not surprising that policy makers in Asia have taken steps to restrict borrowing, especially for real estate loans where rising prices have encouraged more speculation and less prudent borrowing.

Figure 6: Domestic Bank Credit to GDP

Third, US growth may not benefit the developing world. As wages increase, the rising cost of inputs in the developing world has led to a trend for more manufacturing to be done in the US. Furthermore, US domestic energy prices have fallen due to more efficient production of domestic shale gas. This trend is negative for developing economies as the importing of goods from the US fails to match up despite a strong US economy. Since the middle of 2011, US import of goods have stagnated (Figure 7) even as the economy and consumer spending continue to grow (Figure 8).

Figure 7: US Imports

Figure 8: US Consumption

It is likely that going forward, the previously high growth rates in Asia, and even the other parts of the developing world, would have to be lowered. This presents a headwind for equities, since earnings growth will be challenged.

In the fixed income market, investors’ action will be driven by both real and perceived Fed tapering. As long as the US economy continues to surprise to the upside, the chances that markets will discount Fed tapering are likely to rise. The tide has turned for bond markets as increasingly we get more evidence that the US economy is on a firmer footing. That said, the plunge in fixed income markets are overdone in the short term, sending many markets into oversold territory. This makes them vulnerable to a bounce whenever a soft patch of economic data is released or if the Fed comes out more forcefully to reinforce that low interest rates is here to stay for an extended period of time despite a scaling back of the quantitative easing program. Nonetheless, investors should take any opportunity to reduce risk in their bond portfolios by shortening duration to the minimum. Illiquid markets like emerging market and high yield bonds should be avoided as price discovery will be challenging when investors all start heading for the exit at the same time.


The second half of 2013 will be more challenging than the first. Changes in US monetary policy and economic headwinds in the developing world will bring about volatility in asset prices. Nonetheless, there are still places for investors to park their money where growth remains intact and could even surprise on the upside. The US and Japanese equity markets remain our favourite picks.

Portfolio Positions

Following our last rebalancing exercise to take tactical positions in Japanese equities and global REITs for our cash portfolios, we are now reviewing our longer term CPF portfolios. For CPF portfolios we had already recommended moving all our fixed income positions to short duration bonds. In line with our views above, we will shortly be recommending underweighting emerging market and Asian equities in favor of US and global equities.

1. Japan Bank Lending Hits 4-Year High as BOJ Pumps Money. 7 July 2013. Reuters.

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