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Dear Madam, Dear Sir,
Dear Investor,
Markets have wrong-footed many
investors this year; attentions are not
only turned to up or down and asset
classes, but also sectors. We noted
recently that less than 18% of US mutual
funds outperformed the S&P500 in the
first quarter. Opacity prevails and as
a result of market participants being
divided in their outlook, markets continue
to move in waves; it is either risk-on or
risk-off and the frequency of change is
weeks, not months. Growth is simply too
low and valuations are too high to ignore
worsening financial conditions.
We are here to assist you with your
investments. We draw on our impartial
expertise to offer you transparent advice
and investment services. Please do not
hesitate to contact your BIL adviser or
any of our investment management
experts for assistance.
Yves Kuhn
Chief Investment Officer
Spring 2016
07/12
How to deal with a slowing
economy
The first days of a year are usually considered to be stockmarket friendly, but there was a massive price drop in
risky asset classes this year. Sentiment among investors
has clearly become pessimistic. In this climate, emotional
pressure on investors mounts. Should they sell their
shares? Or is it better not to?
For many Investors, there is a feeling
that a foggy outlook keeps them from
enjoying spring. Opacity is still the
watchword for 2016. Investors continue
to be at the mercy of oil prices and the
Chinese slowdown.
- An oil price below USD 35 per barrel will
destroy capital to the tune of some USD 1
trillion according to the Swiss investment
bank UBS. Note that the subprime debacle
of 2008 destroyed approximately USD 5
trillion in capital. It is interesting to note that
the oil price and risky credits (high yields)
are inversely correlated. The cost of capital
to companies currently seems to be set not
only by the central banks but also by oil
producing nations.
- Fears that the Chinese economic slowdown
is too abrupt and that China will devalue its
currency, the renminbi, add to the global
deflationary forces. Risk assets have
already suffered but will continue to do so
until we see some light through increasing
global inflation.
The good news is that one major fear has
faded away. Any US recessionary fears have
been staved off, as the latest macro data
from the US gives no reason to believe that
the US will face a recession over the next
six months. The Fed communicated that
rather than the four rate hikes suggested at
the end of 2015, they might see two rate
hikes in 2016. More specifically, Fed Chair
Janet Yellen recently noted that “the US job
market and housing recovery have lifted
the US economy close to full health despite
the risks that remain, including a global
economic slump”.
Why are major central bankers afraid of
an economic slump?
According to the Bank for International
Settlements (the central bank of the central
banks), there is too much debt for the given
Yves Kuhn
Olivier Goemans
Chief Investment Officer
Head of Portfolio Management
rate of economic growth. Economists like to
speak about a global recession and according
to their definitions, the threshold lies between
2.5% and 3% global economic growth. Whatever
the definition is, we can probably conclude that
global industrial production has been dropping
by 2% and it is forecasted to drop by 4% by 2017.
The threat of deflation in Western economies
has spurred central banks into action. The Bank
of Japan and, more recently, the European Central
Bank have slashed rates into negative territory
in a bid to revive economic growth. However,
there are growing doubts within the investment
community about central banks and the impact
of negative rates. In simple terms, when interest
rates are negative, money has more value today
than it will tomorrow. According to Larry Fink,
CEO of BlackRock, an asset manager, negative
interest rates risk hitting consumer spending
and undermine economic growth. This is clearly
evidenced by lower global demand for goods,
especially in emerging markets. According to
Mr Fink, the toll that these low rates are taking
on investors’ ability to save for the future is
significant: a typical 35-year-old has to save
more than three times as much to make the same
retirement income when long-term interest rates
are at 2% as when they are at 5%.
In addition, negative rates are flattening the
returns of financial institutions, especially
banks: the relative price-to-earnings ratio has
dropped to the lowest level for euro zone banks
since 2000. The main explanation for banks’
underperformance is the flattening of the yield
curve putting pressure on net interest margins, a
key factor for bank profitability.
Global Industrial Production
(as at 29 February 2016, deviation from 3.1% trend)
10
1
8
6
0,8
4
2
0
80
-2
0,6
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
0,4
-4
-6
0,2
-8
-10
-12
0
Slowdown of industrial production
Global industrial production
Estimate
Source: Crédit Suisse, BIL
So how can we get out of this circle of low nominal growth and negative rates?
In the absence of structural changes, growth and inflation can be stimulated by
weakening the euro. The European Central Bank has tried this and found that a
strongly appreciating USD puts downward pressure on core consumer price inflation
in developed market economies. A weaker USD would provide some kind of boost
to global economic growth, as commodities will increase and demand may return in
emerging markets. We consider it mainly helpful for emerging markets, but rather less
so or at least mixed for developed market assets.
At some point, demand for capital needs to be stimulated by the governments and
not by just the central bank, something ECB President Mario Draghi has repeatedly
stressed. More concrete action from governments is needed. There is even talk that
politicians may opt for a helicopter money approach whereby central banks print
money for finance ministries to hand out to citizens in the hope that they will spend
the unexpected windfall.
BIL’s macro outlook for the next six months
There has been a loss of growth momentum.
According to Christine Lagarde, Managing
Director of the International Monetary Fund,
the global outlook has weakened further over
the past six months, exacerbated by China’s
relative slowdown, lower commodity prices
and the prospect of financial tightening for
many countries. Until now the recovery has
largely been driven by emerging markets
2
and the expectation was that advanced economies would pick up the “growth
baton”.
There are signs of improvement. According to Bloomberg, the real GDP growth forecast
for the global economy in 2016 is 3%, accelerating to 3.3% in 2017. Economists tend to
lean towards a lower figure: a low of 1.8% and a high of 3.4%. Several projections for
2016 economic growth in the US put it at 2%, with the second half growing stronger
than the first half on average.
“
Global inflation is low, driven by lower energy
prices and weak economic growth
Elsewhere growth looks set to come in below par.
Low investment, high unemployment and weak
balance sheets weigh on the euro zone; growth
for 2016 is predicted to be 1.5%, with similar
growth projected for 2017. It is worthwhile
highlighting that the Japanese recovery has been
particularly weak. Japanese growth forecasts are
0.7% for 2016, moving sideways to 0.6% for
2017. Japan’s economy is highly dependent on its
exchange rate. Last but not least, 2016 Chinese
growth is 6.5%, slowing to 6.3% in 2017. The
Chinese authorities continue to ease monetary
and fiscal policies.
Global inflation is low, driven by lower energy
prices and weak economic growth. US service
sector inflation has reached 3.1%, with US core
inflation above its 20-year average. Consumer
price inflation ex-food and energy was 2.3%. The Federal Reserve Bank’s favourite
inflation gauge, the Personal Consumption Expenditures index (PCE), is expected to be
1.8%. The year-on-year Employment Cost Index (ECI) recently fell back to 2%.
Euro zone inflation is also faring slightly better thanks to services, which saw a
substantial pick-up to 1.3% on a year-on-year basis from 0.9% previously. Overall
consumer price inflation is -0.2% for the euro zone. Headline inflation has been
restrained by energy prices (core inflation will obviously be less impacted by the
plunge in energy prices). This is disguising growing inflation pressures in economies
for local reasons.
Our outlook for the next 12 months takes into consideration the fact that core inflation
has been high in over half of the world’s economies, while the cross-country correlation
of core inflation remains very low. This suggests that apart from oil inflation, this
is becoming an increasingly local issue rather than a global concept. Local forces,
principally labour costs and administered prices, are expected to continue to influence
underlying inflation.
US Equities
Both dollar and oil rates of change tend to
influence the evolution of forward earnings,
as nearly half of S&P 500 earnings are exportrelated, while exports represent only 13% of US
GDP. The underlying pace of forward earnings
growth in the US remains weak and not seen to
change much by the consensus in the first half of
2016. Negative earnings revisions for the 2016
full year have increased since Q4 2015 results.
Earnings are seen falling 9.8% year-on-year in
3
2016 earnings growth outlook in US (%)
Latest data
Start of the earnings season
20
0
-20
-40
-60
Energy
Materials
Utilities
Financials
MSCI USA
Industrials
IT
Consumer staples
Healthcare
-80
Telecoms
The cyclical outlook for US equities is still
challenging. Consensus US expected earnings
growth stands at 1.7% with 3.4% sales growth,
while corporate profits appear to have peaked in
2014 and have been on a downtrend ever since.
At the same time, productivity has not improved
while operating costs are on the rise, driven by
wage pressure. This has led to deterioration in
corporate profit margins.
the first quarter of 2016, which would be the sharpest fall since the third quarter
of 2009 and the fourth consecutive quarter of negative earnings growth. Excluding
energy, US profits are expected to fall 5.1%, with only 3 out of 10 sectors to report
earnings growth in the first quarter of 2016.
Consumer disc.
The US equity market is off to a volatile start
this year. Having slid by close to 15% by the
middle of February, it quickly rebounded
14% in euro terms by the beginning of March
as we saw some of the earlier headwinds
facing US equities easing. The dollar has
weakened, oil has rebounded, the Fed has
come out with a softer tone against rate hikes
and global economic data has shown some
improvements.
Source: Thomson Reuters datastream, BIL
Meanwhile, the market is priced at 17.6x forward earnings vs. 15.0x 10-year historical
average, which does not offer much room for error, as the potential for price/earnings
(P/E) multiple expansion is coming from the “E” side of the equation. We believe the
underlying fundamentals still warrant a cautious stance on US equities and a sustained
rally in the broad equity market is, in our view, limited in the current environment.
We continue to like sectors and styles of strength, preferring reasonably priced secular
growth stories – industries with strong sales growth and sustainable margins. Sectors
most exposed to these factors in the US are technology, healthcare and consumer
discretionary.
European Equities
The fourth quarter 2015 earnings season and
pressure on consensus expectations did little
to reassure investors.
More importantly, the dynamics for 2016
earnings expectations in Europe are still on
the downside, but seem to have bottomed
out. All sectors in Europe have seen their
consensus forecast for 2016 cut except for the
telecommunications sector, highlighting the
cautious tone adopted by companies during
the results season. On a brighter side, massive
downgrades are concentrated on commodityrelated sectors (energy and materials); the
downgrades in the other sectors are mild on
aggregate and most of them are still expected
to post decent growth rates going forward.
The earnings growth in Europe (now seen at
+0.5%) has been mostly dragged down by the
energy sector (energy companies’ earnings are
expected to be down 31% this year). Analysts
are on average forecasting an oil price of
USD 40-45, meaning that we are unlikely to see
more massive downgrades should the oil price
stay around current levels.
Investors’ relief to see commodity prices rising
was a driver of the rally seen since mid-February.
However, despite the rally, most of the major
European indices still post negative returns
year-to-date, pushing valuations down slightly
to 14.8x 12 months forward price/earnings
ratio, a 10-15% discount to the US. Whilst the
valuation gap is broadly in line with history,
European earnings have stagnated since the
end of the financial crisis, leaving more upside
should the macro momentum return to normal
conditions.
Our preference has been for defensive
sectors as a way to be relatively insulated
from macroeconomic opacity and potential oil
price weakness. We like the healthcare sector,
which offers high quality, growth-oriented
companies. High return on equity and strongly
predictable cash flows should attract investors
in the current environment, despite the recent
weakness of the USD versus the EUR. We also
continue to favour the telecommunication
services sector for its European exposure and
on-going market repair, which should support
positive earnings momentum.
Solid balance sheets and superior cash
generation should support increased dividends
(the dividend yield of the sector is 4.8%). The
sector’s price-to-cash flow stands at 5.3x,
which appears cheap compared with history.
Mergers & Acquisitions (M&A) appears to be
on hold in both sectors (due to regulation for
healthcare, the small number of targets and lack
of compromise for telecommunications), but we
believe companies still offer attractive profiles
even on a standalone basis.
2016 earnings growth outlook in Europe (%)
Latest data
Start of the earnings season
Source: Thomson Reuters datastream, BIL
4
Energy
Materials
Utilities
Financials
MSCI Europe
Industrials
IT
Consumer staples
Healthcare
Telecoms
Consumer disc.
20
10
0
-10
-20
-30
-40
“
Commodity
prices rising
was a driver
of the rally
A stronger
yen
represents
a huge
obstacle
to higher
equity
prices
Japan
A stronger yen has significant implications
for the Japanese economy and equity market.
Since the adoption of negative interest rates
by the Bank of Japan at the end of January
2016, the yen has appreciated by more than
10%. This was unexpected! There is a strong
argument that negative interest rates lower
the speed at which money circulates through
the economy, commonly referred to as the
velocity of money. In Japan, citizens are
clamouring for 10,000 yen notes (and home
safes to store them in) – clearly an unintended
consequence of negative interest rates.
A decline in the velocity of money increases
deflationary pressures and in turn strengthens
the currency, which runs counter to the BOJ’s
stated goal of 2% inflation as measured by the
core inflation index (including energy). If the
BOJ was using CPI inflation ex-energy, which is
running at 1%, it could at least declare a partial
victory.
a stronger yen represents a huge obstacle
to higher equity prices due to the adverse
impact on profits of big export-oriented blue
chip companies. Yen strength also fuels the
unwinding of the yen carry trade, as foreign
investors who had taken positions in Japanese
equities very often hedged their yen exposure
by selling yen. A stronger yen feeds the reversal
of this trade.
On the positive side, a stronger yen increases
the purchasing power of Japanese consumers,
thus boosting an area of the economy that has
been lagging significantly. Furthermore, if the
Bank of Japan decides to ease policy further
through asset purchases, it could include ETFs,
which would in turn be supportive of equities.
While we recognise that on balance a stronger
yen is a drag on Japanese equity prices, we
continue to analyse investment opportunities,
especially in domestic-oriented sectors.
The implications of a stronger yen are mixed.
Given the extremely high correlation of the
USD/JPY exchange rate with the equity market,
Fixed Income
The ECB has invented a new measure to
revive the economy; not only do assets now
earn negative interests, but the same could
also apply to liabilities. In general, we think
the ECB's recent policy measures represent
a more meaningful shift in the emphasis of
policy: away from sensitivity to the exchange
rate and towards supporting easy domestic
financial conditions.
As Deutsche Bank notes, as special factors
such as extreme flows, valuations and oil
moves naturally dissipate, the lower quality
credit finds it difficult to keep pushing
spreads materially tighter even when faced
with an upcoming ECB purchase programme.
Correlation to oil is beginning to break down,
which we also find to be a natural going
forward, exposing high yield more to its own
valuations and fundamentals.
Heading into the second quarter, we see a
supportive backdrop for bonds from dovish
central banks and a modestly improving growth
outlook with a risk bias for higher rates. As
the search for yield is again underway, we see
tumbling yields in Europe. Year-to-date, the best
performing indices in euro were the euro high
yield (3.2%), euro investment grade (2.7%) and
global developed sovereign markets (2.5%). The
yield of the German 10-year-Bund stands at 15
basis points, while its Italian counterpart is at
135 basis points (1.35%).
5
In Europe, core and peripheral spreads continue
to tighten versus Germany over the medium
term as the economic recovery continues. Bund
yields have fallen sharply since the beginning
of the year. However, they have failed to rise
meaningfully with the bounce-back in risk
assets over the last month.
US investors’ attention is slowly turning to
inflation and the expected rise in headline
inflation over the remainder of 2016 as energy
base effects fade. The dovish outcome of the
March FOMC meeting has lowered yields but
also diminished policy uncertainty in our view.
The gap between the lowered FOMC projected
rate path and the market has now narrowed
significantly. The narrow gap signals lower
volatility and positive sentiment for risk assets.
Following the subsequent fall in US yields
and reduction in volatilities, we expect lower
front-end yields and a steeper curve. We think
this dynamic will provide broad support for US
inflation break-evens.
In terms of euro zone outlook, there is a
chance that inflation and growth data have
the potential to push Bund yields higher over
the coming months, but the current drivers
seem strong and may remain so over the short
term, even if sentiment in risk markets remains
benign. It may be that the market is to some
extent pricing in the flow effect from an extra
EUR 20 billion per month of ECB bond purchases,
even though in April 2015, the fundamental
The strength of the dollar has
significant bearing
effect can quickly undo that through higher
growth and inflation expectations. When Bund
yields were last at current levels, however,
investors seemed convinced that the ECB would
squeeze them ever lower. That conviction is
missing in this move and lower yields seem
mostly to be causing investors pain.
If we are proved wrong about Bund yields
moving higher in the coming months, we think
it would be because inflation expectations
continue to be supressed, in turn likely the
result of continued very low spot inflation.
Nevertheless, this already looks priced in to a
significant extent.
Conclusions
As predicted, we have seen a relief rally and central banks’ actions have helped to
put risk back on. So why do we still have a lot of cash? We are positioned to harness
volatility to our advantage. Markets are currently driven by fears rather than greed.
We saw a rebound in risk assets; however, the negative prediction of the Bank for
International Settlements and the IMF’s economic downgrades do not help. On the
other side, it looks like oil is stabilising and the US recession risk has faded for now.
Recent macro data from China has improved. However, global industrial production
and global demand continue to fall so panic-selling remains on the cards.
Equities are exposed to the continuous whipsaw of risk-on and risk-off. Bonds,
especially in Europe, yield very little and the risks of losing money on those become
more real by the day. In terms of equities:
-We prefer Europe, as cyclical growth and accommodative policy support earnings
growth. We prefer selected emerging markets and are willing to reduce Japan at
this stage in order to finance potentially these new positions.
-
The weakening US dollar has helped US equities to show relative good
performance. We are aware that current high US valuations reduce the buffer
for shocks and increase risks of drawdowns in particular. Key is what happens to
earnings over the coming quarters.
With regard to fixed income, the world is very relaxed about inflation. Whereas this
might be the right behaviour in many regions, we are slightly more cautious about
how US investors price in inflation. We expect that the underlying wage and price
dynamics will eventually lead to an awakening about US rates. A weaker US dollar
will accentuate the probability that this awakening will not be soft. We consider
inflation break-evens in the US.
With regard to emerging markets and commodities, we expect that both asset
classes will find a bottom during 2016. We have seen a rebound in those asset
classes, but it is probably too early to say whether the recent bottom of these
markets has been relative or absolute. The strength of the dollar has significant
bearing on how that question is answered.
Yves Kuhn
Chief Investment Officer
As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of April 15, 2016. This publication is based on data available to
the public and upon information that is considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the accuracy
or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information expressed herein. This document has been prepared
only for information purposes and does not constitute an offer or invitation to make investments. It is up to investors themselves to consider whether the information contained herein is
appropriate to their needs and objectives or to seek advice before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability
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DM0209900-EN-05/16
-We view lower-for-longer oil prices as the top risk for credit, particularly for high
yield. With a weaker US dollar, we become more interested in local emerging
market debt. From a sector approach, we realise that the corporate debt of
material/steel companies rebounds from very low levels.