GSFM unpacks how advisers can best maintain a global equity exposure in a ‘cautiously constructive’ environment.
Late last month John Tobin, managing director and portfolio manager with Epoch Investment Partners, visited Australia. He came prepared to share Epoch’s macro outlook with financial advisers around the country, an outlook he summed up in two words – ‘cautiously constructive’. In this article, GSFM unpacks what this means and how advisers can best maintain a global equity exposure in a ‘cautiously constructive’ environment.
Global growth is slowing, but a recession is not on the immediate horizon. This is Epoch’s base case, which John Tobin acknowledged, is shrouded in uncertainty and risk. Any one of a myriad of factors could impact the base case and markedly change the outlook.
In the US there’s the ongoing trade spat with China, the looming trillion dollar deficit and a tsunami of government and corporate bonds to be rolled over. On the other side of the world, there’s the uncertainty around Brexit, the global unwind of quantitative easing (QE) and political unrest.
As illustrated in figure one, the international monetary fund (IMF) expects weak GDP growth throughout this year and next.
Slowdown versus recession
Why not a slowdown that accelerates and tips into a global recession? Mostly it has to do with labour markets; employment and wages are growing, and this supports spending that that both provides and underpins growth.
As illustrated in figure two, the US is experiencing an extremely tight labour market (a), which has led to wage growth, and in Europe (b), there are favourable employment trends in both the European Union (EU) and the broader Euro area spanning 18 countries.
The downside is that tight labour markets and wages growth often herald inflationary pressures which in turn put upward pressure on interest rates.
According to the IMF’s World Economic Outlook released in January 2019, the are four factors contributing to the subdued global outlook base case:
- Risks to global growth tilt to the downside
- An escalation of trade tensions beyond those already incorporated in the forecast remains a key source of risk to the outlook
- Financial conditions have already tightened since the (northern hemisphere) fall
- The main shared policy priority is for countries to resolve cooperatively and quickly their trade disagreements and the resulting policy uncertainty.
Risks to the base case
Risk one: US-China trade issues
It’s not just the trade conflict with China that needs to be resolved; what’s going on in the background is far bigger. China has clearly articulated an ambitious agenda – ‘Made in China 2025’ – which identifies specific goals and ambitions to be achieved by that year.
The Chinese government is providing massive subsidies across a range of industries, which serves to reaffirm Beijing’s central role in the Chinese economy. Figure three provides a non-exhaustive list of the funds established to support a range of industries in which China aims to become the dominant global supplier.
The aim for domestic Chinese producers by 2025 is summarised in figure four. Import substitution is a major aim for Beijing; implicit in this is an ambition to be a global champion in each of these sectors.
Whatever the deal struck between the Trump administration and China, it won’t address the ambition and agenda set by the Chinese government for the next decade and beyond.
With all the attention on China, it’s worth mentioning that President Trump has picked trade fights with nearly all of the US’s trade partners; for example, tariffs on aluminium imports from Canada, the EU and Mexico are still in place, impacting an estimated 150,000 US-based jobs.
Risk two: Transition from QE to QT
The transition from quantitative easing (QE) to quantitative tightening (QT) isn’t solely a US problem; it effects the balance sheets of a number of central banks.
QE expands the balance sheet of a central bank as it acquires securities in the open market to generate liquidity and support economic activity. Figure five shows the balance sheets of the G4 nations – Japan, US, UK and the European Central Bank (ECB). Each embarked on a QE program in response to the global financial crisis and in 2018, each (except Japan) has commenced the transition from QE to QT.
In the US, the Federal Reserve has stopped buying bonds in the open market and stopped allowing bonds to run off as they mature; it is now a net seller of bonds.
This is a significant regime change when you consider what happened from 2009 to 2017 – the QE strategy was bold and novel and had not been done before. There is no historical precedent to point to, so there’s no roadmap to suggest what might happen as QE is unwound.
Figure six shows the expansion of the same four balance sheets vs the S&P500. There is a strong correlation between the two.
The central bank action has lowered interest rates around the world to unprecedented levels, with zero or near zero interest rates. When you look at the math around price/earnings (PE) ratios, it’s easy to see why this correlation exists – if you lower the discount rate, the PE ratio rises.
A significant part of the equity market growth over the past decade can be attributed to expansion in PE ratios. To the extent that central banks are now moving in the other direction, there’s a strong likelihood that further multiple expansion is stifled and, at the very least, it represents a headwind for equity market performance going forward.
Risk three: The US trillion dollar deficit
In 2017, President Trump introduced tax cuts that blew a big hole in the US budget deficit – and as illustrated in figure seven, from 2019, the US will be running one trillion dollar deficits.
The blue line in figure eight represents the US deficit as a percentage of GDP – Epoch believes this is a problem that will come back to haunt the US government and markets. From 2019, the treasury will have to roll over debt, and take on new debt, to the tune of US$ one trillion, which is not sustainable.
Risk four: Corporate credit
Corporate credit as a percentage of GDP is at an all-time high in the US, particularly given the time of the economic cycle. Typically, peaks tend to coincide with recessionary periods (figure nine).
At the same time, there’s a ‘wall of maturity’ looming; 62 percent of investment grade debt matures within the next five years and 45 percent of high yield debt is expected to mature by 2023. This represents hundreds of millions of dollars of corporate debt that will need to be rolled over – or in other words, refinanced – in the next few years.
The BBB index has grown enormously this decade and is now two and a half times the size of the high yield index. Historically, one third of the BBB index is downgraded during a downturn.
This need for corporate debt to be refinanced will coincide with the US Treasury trying to fund its enormous deficit. That, according to Epoch, sounds like a traffic jam about to happen.
There are a number of binary issues facing capital markets – this is positive, that is negative. Brexit is one of them; if the UK does not have a ‘clean’ Brexit, which is looking less likely by the day, there are severe consequences for the UK which will be felt in other economies across Europe and more broadly.
There is a rising risk of a trade war. Key issues include asymmetric market access, alleged IP theft, forced IP transfers and China’s 2025 policy. Trade tensions will remain a market theme in 2019 and a source of volatility for years to come. Epoch is particularly concerned about a bifurcation in global supply chains.
The looming trifecta of QT, soaring US budget deficits and the upcoming wall of maturities in both Treasuries and corporate debt could drive both interest rates and volatility higher. Corporate debt is likely to be at the epicentre of upcoming market dislocations as debt issuance soared with QE and spreads remain dangerously tight.
Technology will continue to have an impact; Epoch believes it is a positive for all three components of ROE. Technology is a positive for higher profit margins, asset utilisation and leverage, suggesting companies can return a higher proportion of cash to shareholders.
Technology changes the way businesses operate, in particular, the way it impacts the capital required to run a business. The implication is there will be more free cash flow to distribute to shareholders, which is a long term structural trend and one that is favourable for a shareholder yield strategy.
Shareholder yield strategy – designed to navigate volatile markets
Going forward, equity investors are going to have to be more selective because expansion won’t be pushing up prices universally. A shareholder yield strategy is a total portfolio diversifier, offering low correlation with traditional equity styles due to the strategy’s emphasis on capital allocation and free cash flow.
Unlike a growth or value investment strategy, a shareholder yield strategy is not based on accounting metrics such as price/earnings or price/book ratios. Instead, it’s underpinned by shareholder distributions and capital growth based on free cash flow; historically, both are a source of consistently high income within an equity allocation and the most stable driver of long-term returns.
A shareholder yield strategy focuses on companies that are growing their dividends based upon growing underlying cash flows. This approach typically results in lower than market volatility, low beta and drawdown protection. With the headwinds likely to face capital markets in the coming months, it’s a strategy worth considering for your clients’ portfolios.
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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.
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