15 January 2015

Macro Strategy Update

The Long Run, In the Short Term

Executive Summary: We maintain our view that the world is not headed for a recession and growth will continue. Long term trends are changing and we must be aware and capitalise on it. Commodity importers and exporters will experience very different growth trends, whilst the US looks set to lead the world economy once again. In the short term, be ready for higher volatility as financial markets grapple with asset re-pricing once the Fed hikes rates. Looking across asset classes, there is no better place to be than in equities, but be ready for downdrafts this year.


Global Economics.
In our previous article, we touched on diverging global growth trends and posited that the world as a whole would likely not enter a recession but instead get stuck in second or third gear. So far, macroeconomic data suggests that this remains the case, Composite PMI numbers which are currently slowing from the levels achieved in mid-2014 but still above 50 (Fig 1). Global GDP growth is still below long term trends but we expect it to gradually pick up given a potential consumption boost from lower commodity prices (Fig 2).

Fig 1: Composite PMI Of The Various Economic Regions Remain Expansionary

Fig 2: Global GDP Growth To Slowly Grind Higher

In our 16 Dec 14 article, we alluded that cheap oil was beneficial for the majority of countries in the world. The chart below shows the inverse correlation between growth and oil prices. The effect should start to filter into the various economies by the second half of the year and this would contribute to the growth tailwinds (Fig 3).

Fig 3: Positive Growth Effects From Cheap Oil

We would like to point out some important long term trend changes which strengthen the case for US ascendancy in the world economy once again. There is no denying that key EM countries exhibited stellar growth in the 2000’s. On a relative basis however, US growth has been increasing significantly since the 2008 financial crisis such that the growth differential of EM countries during the past decade has declined and is expected to shrink further (Fig 4).

Fig 4: Shrinking EM vs US Growth Differential – It Last Crossed In 1999

The US continues to lead the world in productivity and technological innovation, benefiting from favourable demographics including immigration and quality of education, and the lion’s share of world R&D spending. With this advantage and coupled with the relatively slow wage growth of the past 5 years, the US is second only to China in terms of manufacturing cost competitiveness (Fig 5). This is obviously not a fluke or one time occurrence, but a long term structural shift which will benefit the US economy for many more years to come.

Fig 5: US Productivity and Cost Competitiveness Is A Structural Shift

With the divergence in growth paths and subsequent divergence in monetary policy between the US and the rest of the world, it is likely that the cycle of US dollar appreciation continues for a few more years (Fig 6). The consequence is a negative view on commodities and volatility in both currencies and markets of weaker EM countries.

Fig 6: Dollar Strength Due To Trend Change And Diverging Monetary Policy

Expectations for Europe remain relatively muted as the positive effect of a cyclical rebound is likely offset by headwinds arising from uncoordinated reforms and political uncertainty. Near term political risks arise from the Greek parliamentary elections in late Jan, and other elections in UK, Portugal and Spain in 2015 could hinder structural reform if populist parties gain more vote share. On a positive note, there are signs that the drag from austerity measures are slowly waning (Fig 7), and hope that the ECB’s QE program will provide the necessary kick-start that the Eurozone needs (Fig 8).

Fig 7: The Drag From Fiscal Austerity In the Eurozone Is Waning

Fig 8: ECB QE Program And The Likely Effects

Looking at EM and in particular emerging Asia, we expect these economies to continue to perform well in relation to global peers. The central government in China appears content to accept slower reform to ensure greater stability in the economy, as shown by small stimulus measures throughout the past two years (Fig 9). South Korea and Taiwan which are tech-heavy economies with strong export links to US should also benefit from US strength. For the majority of the economies, lower commodity prices will help consumption and investment and lower inflation.

Fig 9: Expect China To Continue To Guide And Moderate The Economy Through Targeted Stimulus

Market Implications.
We raise the prospect that 2015 brings an era of more volatile equity, fixed income and currency markets. With the Fed expected to start rate hikes in July, the resulting shift in the yield curve and across the board asset re-pricing will definitely introduce more volatility into markets (Fig 10). Re-pricing in bonds would likely lead to rising yields which would result in an unpalatable negative return especially for investment grade issues (Fig 11).

Fig 10: Equity Option Implied Volatility and Fixed Income Volatility Have Been Increasing

Fig 11: At Present Yields, Fixed Income Provides No Buffer Against A Small Rate Rise

We see no reason not to hold equities. With bond yields at current levels, equity risk premiums for many markets are elevated and are above 1 standard deviation from long term averages. This means that despite above average valuations for some markets, we are sufficiently compensated for taking on equity risk (Fig 12).

Fig 12: Equity Risk Premiums Are Elevated. High Risk Premium Means More Compensation For Taking On Equity Risk

We wrap up this update by reiterating that we see growth continuing at an incrementally higher pace than last year. We should see boosts to consumption coming from lower oil which would benefit oil importing countries. The US could take over the lead in global growth once again which represents a structural shift in the world economy. Be mindful that we will face higher volatility in markets this year as a result of Fed policy but there should be ample liquidity given divergent monetary policy from the various central banks.

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