September – An 'Indian Summer' for global markets!

Market Views And Insights | October 13, 2017

Geoff Lewis, Senior Strategist (Asia), Capital Markets & Strategy Team

Global markets posted a strong performance in September driven primarily by economic fundamentals, with developed markets (DM) taking the lead. China’s markets have remained stable ahead of the upcoming Communist Party congress.

That said, the North Korea crisis may continue offsetting strong economic data for now. There have been surprising leadership movements in Japan and Germany. More worrying, however, is the complacent market response to the Catalonian referendum issue in Spain. With more risks on the horizon (e.g. Italian elections), we remind investors that populism in Europe is not over. Panic is not the appropriate response to political risk, but neither is complacency.

The current macroeconomic situation could prove complex to navigate. In this edition of Monthly Macro View, Manulife Asset Management’s Senior Asia Strategist Geoff Lewis explains how to interpret these events and proceed accordingly.

Review of markets in September1

In what is usually one of the seasonally weaker months, global stock markets put on another strong performance in September, chalking up new heights. The MSCI World equity index rose 2.3% in September, the eleventh successive month of positive returns. This marked the second-longest string of increases since the index began in 1969.2 Since mid-August the rally has broadened out to include some of the previously lagging sectors, supported by strong economic data and renewed hopes of tax cuts in America.

Developed markets lead the way

Developed markets (DM) took the lead in September, as MSCI US rose 2.0%, MSCI Europe 3.3% and MSCI Japan 2.01%). Emerging markets (EM) slipped a little, with a negative 0.4% return. But they remained firmly in the lead for the third quarter overall, with a gain of 8.0% for EM versus 5.0% for DM. A stronger world economy is being reflected in more optimistic consensus forecasts of the medium-term earnings outlook for companies (See Figure 1), which we see as having played a large role in the current rally.

The near-term earnings outlook is also promising, as 43 S&P 500 companies have issued positive earnings guidance well above the 5-year average of 27, and the third-highest number for a quarter since FactSet began tracking earnings-per-share (EPS) guidance in 2006. At the sector level, companies in the information technology, healthcare, and consumer discretionary sectors account for 39 of the 43 companies issuing positive EPS guidance for the third quarter.

Figure 1: Look to the medium-term (5-yr) forecasts for a clue to current market strength3

Turning to home, Hong Kong stocks rose another 8.6% in the third quarter of 2017 and are up 30% year-to-date, making Hong Kong's Hang Seng the world's top-performing major index,4 beating Asia ex-Japan, the US, Europe and EM. A Chinese internet giant accounts for 30% of the Hang Seng's rise this year. The Boston Consulting Group estimates that China's 710 million internet users spent almost US$1 trillion online last year, with no sign of growth slowing.5 With internet penetration only 52% in China, there is still plenty of room for the market to grow. Chinese IT giants have established network advantages that will make it difficult for foreign competitors to make significant inroads in the near term.

In Mainland China, the Shanghai Composite Index rose 6.2% in the third quarter, its strongest rise since the fourth quarter of 2015. Consumer stocks performed well in the third quarter. Mainland stock markets are closed for the Golden Week public holiday (2 to 6 October) and on re-opening are expected to be in a 'wait-and-see' mode ahead of the CCP’s 19th National Congress which begins on 18 October.

Equities by sector and fixed income trends

By global MSCI sector, energy performed best in September, as the sector responded to the 6% move up in the price of crude oil,6 while industrials and financials also performed well. In the "risk-on, reflation-trade" environment that prevailed for most of September, defensive stocks like utilities, consumer staples and real estate were shunned by investors, posting negative monthly returns. Global financials ─ a sector that we like in both Europe and North America – continues to perform well, supporting our positive view. Historically, a surge in new highs among US financial stocks has been consistent with stronger-than-average forward returns for the sector, so investors may wish to continue to add exposure.7

In Asia, defensive sectors also fell in September, while the strongest returns came from the consumer discretionary and IT sectors. By investment style, September saw a modest victory for value, though for the third quarter overall growth factors (momentum and forecast earnings) and high beta performed best in DM. In Asia and EM, momentum, forecast earnings and net upgrades did well.

In fixed income markets there was only a small price to pay for stronger economic data and renewed hopes of US tax cuts. The US Treasury yield curve marginally steepened. Structural trends support low government yields in DM bond markets, and we think US Treasury yields can remain in their present trading range even as the Fed starts to reverse quantitative easing (QE) along the lines set out at the September Fed meeting.

The North Korea crisis

The North Korea crisis is one new factor that has possibly acted to offset strong economic data and keep DM yields low over the summer. US economist Carmen Reinhart suggested this possibility in a recent Project Syndicate article.8 She thinks we may learn something from the economic theory relating to very rare events or catastrophic disasters, defined as events that are far removed from the much smoother probability distributions of base case and alternative macro scenarios. It is an underdeveloped field, but early work by Robert Barro concluded that anticipation of such an event by investors, although given only a very small probability, could still be enough to trigger significant portfolio flows into safe-haven assets like US Treasuries or German Bunds.

If this factor has been playing a part in suppressing yields over the summer, it will likely prove temporary. Investors will tire of the political posturing between the leaders of the US and North Korea, switching their focus to other issues. When that happens, DM bond yields, especially US Treasuries, may rise relatively sharply as North Korea begins to fade from view and the competition for safe assets subsides.

Asian credit, commodity prices, and foreign currency exchange

Asian credits were mixed in the third quarter, with India returning 1.5%, China 0.75% and Taiwan 0.71%, with other markets close to zero or slightly negative (S&P Government Bond Index returns). Asian and EM debt markets have generally held up well, all things considered, as large inflows into exchange-traded funds (ETF) and institutional funds supported EM debt in September. Even during political risk events that a few years back would surely have triggered knee-jerk outflows from EM debt, we have continued to see investors keep faith. There is still solid demand for Asian and EM fixed income, and the carry trade is not about to disappear just yet, especially as fundamentals in most cases remain sound via a recovery in commodity prices and terms of trade, external surpluses, and greater fiscal discipline. In the most recent reporting week (to 27 September) there were decent inflows into Colombia, India and, somewhat surprisingly, South Korea.9

Commodity prices advanced in September in line with the strengthening global economy. The International Monetary Fund's broad commodity price index rose 3% month-on-month, taking the third quarter's gain to a solid 7%.10 Commodity price strength was widespread, with 68% of individual commodities posting higher prices last month. Oil took the lead with a 6% rise.11 Brent's late-September peak of US$59.5 per barrel is the highest price for crude oil since mid-2015, reflecting the declining trend in global inventories, OPEC (Organization of the Petroleum Exporting Countries) production discipline, and doubts over the ability of US shale output to sustain upward momentum in coming months.

Metals prices in September retained much of their August move up (except for iron ore, which fell month-on-month but which remained 25% above the August 2016 price).10 Strength in both the metals and energy subsectors reinforces the positive message for global activity given by the commodity complex.

For foreign exchange, September saw some significant changes in positioning, with more currency traders short the US Dollar index (DXY) than long for the first time in three years. The opposing view is that we will experience a technical dollar rally into year end, with US tax cuts, strong economic data and only 70% of a December rate hike priced in as key underlying supports. Politics is also playing a key role: the advance of the German right in the last month's elections and the growing crisis in Spain over Catalonia are euro-negative, dollar-positive.

Also, dollar positive are the rumours that Kevin Warsh may succeed Janet Yellen as the next Fed Chairman in February, as Warsh is known to be highly critical of sustained QE. Thus, some further retracement in the euro's year-to-date gains is in the cards. The single currency fell 1.2% versus the dollar in September, but remains 12% higher year-to-date. The yen also weakened against the US dollar, while the sterling continued its recovery. For nimble currency investors, the fourth quarter might indeed offer a trading opportunity in the form of a dollar bounce. Re-energised dollar bulls might add some momentum to a technical rally, though we still see a weaker dollar as the primary trend for 2018.

Cyclically-adjusted equity valuations (CAPE)

Those who worry most about equity valuations often point to the elevated levels of the cyclically-adjusted price-to-earnings (PE) ratio, or CAPE (See Figure 2). Also known as the “Shiller PE” after its originator, US economist Robert Shiller, the CAPE takes a 10-year average of trailing earnings as the denominator of the PE ratio to get a better measure of the earnings-per-share trend.

In a recent Project Syndicate article,12 Professor Shiller pointed out that bear markets in US equities have usually been preceded by high CAPE valuations, with a 32% average premium to the long run mean of 16.8 times. Today, the premium on the Shiller PE is 79%, a level that has only been surpassed in 1929 and 1997-2002.

Figure 2: S&P 500 Shiller (cyclically-adjusted) Price/Earnings, Price/Cash Flow & Price/Free Cash Flow (times) 13

To the more bearish equity strategists, this richness in the CAPE has become a major source of worry. But the CAPE is not without its own problems. Three key weaknesses in the CAPE are: (i) any 10-year period that includes the Global Financial Crisis (GFC) years 2007 and 2008 will include a big hit to earnings; (ii) it will be distorted by the late 1990's accounting rule changes where capital write downs flow through to the income statement; and (iii) the growing weight of the giant internet stocks with high value-added per employee justifies a PE ratio that is higher than in the pre-internet age.

We would also prefer to look at a price-to-cash flow or price-to-free cash flow (P/FCF) metric, using the same 10-year trailing average. These measures also appear in Figure 2, and show much less cause for alarm than the standard Shiller PE. The P/FCF measure, in particular, looks much less expensive than CAPE relative to its average for the shorter period over which we have data. The much reduced capex by US corporates in the past 10 years are a key driver for the S&P 500's higher free cash flows.

Looking at the same metric by sector results in some interesting observations (Figures 3 and 4). Cyclically adjusted P/FCFs for financials and IT appear to be quite attractive, in that investors are not being asked to pay excessively for their FCFs. Thus, US IT stocks may appear pricey on a sales or earnings multiple, but not for their cash flows, which is what should matter more to investors.

In contrast, energy's P/FCF (not shown) is still very elevated owing to the massive capex invested before the oil price plunge in 2014, which is still reflected in the sector's FCFs on a rolling 10-year basis. The current trailing 12m P/FCF for energy is at a much more reasonable level, making energy look attractive on a cash flow basis.

Figure 3: MSCI US Financials - Cyclically-adjusted Price/Earnings, Price/Cash Flow, Price/Free Cash Flow and Price/Sales (times)13

Figure 4: MSCI US Info Tech - Cyclically-adjusted Price/Earnings, Price/Cash Flow, Price/Free Cash Flow and Price/Sales (times)13

Global Politics in September

German elections – Less boring than expected?

In Germany Angela Merkel beat her rivals last month to win her fourth term in an election that will also bring a far-right party into Germany's parliament for the first time in more than half a century. After shock election results last year, from Britain's vote to leave the European Union to the election of US President Donald Trump, many look to Mrs. Merkel to rally a bruised liberal Western order, tasking her with leading a post-Brexit Europe. She must now form a coalition government - an arduous process that could take time. Merkel's conservative bloc won 32.5% of the vote, making them the largest parliamentary group. However, that was down from 41.5% in the last election, in 2013.

Support for their closest rivals, the centre-left Social Democrats (SPD) which are currently junior partners in a so-called "grand coalition" with Merkel, slumped to 20.0% ─ a new post-war low. The SPD said the party would go into opposition, ruling out a repeat of the previous Christian Democratic Union of Germany (CDU)/SPD alliance. The far-right Alternative for Germany (AfD) stunned the establishment by finishing third and entering parliament for the first time with 13.5% of the vote.

Abe calls snap election in Japan – Readies US$18 billion fiscal package

On 28 September, Japan’s Prime Minister Shinzo Abe dissolved the Lower House of parliament to hold a general election on 22 October, while also announcing an US$18 billion economic package. Abe unveiled a slew of economic measures including more education spending in areas like preschool and higher education, as well as improving conditions for people working in elderly care. Abe pledged to pay for them with funds from a consumption tax increase originally intended to rein in the nation’s swollen debt. He also spoke about the need to maintain pressure on North Korea after Kim Jong Un’s regime fired two missiles over Japan in recent months. Heightened tensions with North Korea have boosted Abe’s approval rating after a series of scandals, and may help him retain his coalition’s two-thirds majority in the lower house of parliament.

Ahead of Abe’s remarks, Tokyo Governor Yuriko Koike announced that she would form a new national party to challenge him. Koike, a former member of Abe’s Liberal Democratic Party (LDP), said Monday that her "Party of Hope" would run candidates across the nation. A poll published in the Nikkei newspaper on 9 October said Abe’s LDP received 44% of support, compared to 8% for both Koike’s group and the main opposition Democratic Party. Another survey by Kyodo News published on 24 September showed the LDP with a more than three-to-one margin against its closest rival, with 42% of respondents still undecided.

Spain: Catalonian independence referendum was not handled well

Recent political events in Spain are a reminder to investors that "populism" in Europe has not gone away. The "hardball" tactics employed by Spanish Prime Minister Rajoy against the Catalan pro-independence vote on 1 October backfired, serving only to increase the political divide. Rajoy indicated Madrid would not rule out using its constitutional powers to remove Catalonia’s autonomous status if the region presses ahead with independence plans. For now, markets are treating Catalonia as a local risk – in the week after the referendum, the IBEX fell 1.9%, while eurozone stocks and government bonds were unchanged and VSTOXX barely rose. This seems an extraordinary degree of complacency. Catalonia is a pressing issue with potential to deteriorate much further before a compromise solution can be found. Investors should stay focused, as there are a number of other key European political risks looming, notably elections in Italy early next year.

The Federal Reserve's balance sheet reduction

Is the Fed's run-off rate reasonable?

One question to ask is: whether the Fed’s planned runoff rate is reasonable, ie achievable, without disrupting yields? About 50% of the Fed’s Treasury holdings mature in the next four years, while the month-over-month prepayments of Mortgage Backed Securities (MBS) are difficult to project and could be erratic. We regard the Fed's "autopilot" runoff with monthly caps as a sensible approach, much preferable to a full runoff. According to the Fed's projections, in the first year, the runoff for US Treasuries would be US$180 billion (or around 1.5% of the Treasury market, 0.9% of US GDP and 40% of fiscal year 2018’s fiscal deficit). The first-year runoff for MBS would be US$ 120 billion (or 2.4% of the total MBS market). If the caps stay at US$ 30 billion per month for Treasuries and US$20 billion per month for MBS, the annual runoff increases to US$360 billion (or 3.0% of the market) and US$240 billion (or 4.8% of the market), respectively.

Such a pace of balance sheet reduction would require approximately three years to let Treasuries and MBS run off by US$1.5 trillion, to achieve the "target" balance sheet size of US$3 trillion. Overall, this appears to be a reasonable "glide path" towards a long-term balance sheet target of around US$ 3.0 trillion. It should not cause major disruption to either the US government bond or MBS markets.

What will be the likely impact on Treasury yields?

The general expectation is that there will be a very gradual rise in bond yields over the next several years, as the analysis above shows the expected runoff to be orderly and manageable. Quantitative estimates of balance sheet reduction suggest increases of around.15 to 20 basis points (bps) in the US Treasury 10-year yield over 2018 to 2020, with some degree of front-end loading likely.

On this basis, rates appear set to ultimately rise to 3.0% plus, which may not leave enough conventional easing capacity to sufficiently address the next recession when it arrives. Thus some foresee a return to balance sheet expansion at some point. Possibly, the expectation that QE could be redeployed in the future could keep some downward pressure on the term premium.

The historic evidence for QE lowering long term rates is not conclusive. The US 10-year’s nominal yield and term premium appear to be only weakly linked to asset purchases during the three QE programmes (Figure 5). It was in the periods between QE programmes that the Treasury nominal yields and the term premium declined most distinctly. History over the past ten years does, however, suggest that the S&P’s price level and equity risk premium were positively associated with the Fed’s asset purchases during QE 2 and QE 3 i.e. higher share price levels and a lower equity risk premium (ERP, see Figures 6 and 7).

Figure 5: Fed Balance Sheet & 10-yr US Treasury yields14

Figure 6: Fed QE, S&P500 & equity risk premium16

Figure 7: QE2 and QE3 associated with falling ERP (orange & grey regression lines)14

China A-shares share in the tranquillity

An unusual degree of tranquillity ─reflected in the record-low level of VIX ─ has been a much discussed feature of DM equities in 2017. Perhaps less commented on is that Mainland China equities – regarded by most western investors as inherently volatile – has also been enjoying a period of unusually low volatility (Figure 8). Look at the chart and visually exclude or "take out" the peak in volatility in mid-2015 that accompanied the sharp “patriotic” rally in stocks. What you see then is a broadly flat volatility trend in Chinese A-shares (SH Composite Index) for almost 20 years (from 1996 to 2015) averaging around. 20% 3-month annualised. Most recently there has been a move lower (inline with VIX, VDAX etc), to levels not seen since 1992.

One explanation is that the current exceptionally low volatility in Chinese equities reflects the efforts of Chinese regulators ahead of the key Communist Party congress in mid-October when there will be a reshuffle of the top leadership. The China Securities Regulatory Commission (CSRC) stated that they will strive to ensure "stable operations of the capital market" and create a congenial, sound atmosphere for the meeting. We prefer to attribute the low volatility in A-shares to the same benign economic prospects facing non-China stock markets.

Overall we remain positive and overweight China in our Asia and global emerging market (GEM) portfolios, which is a view that a growing number of foreign investors have begun to share with us since 2016 (See Figure 9). Finally, regarding the Congress itself, we have very little to say. With China equities, we believe it is a case of "WYSYWYG", or "what-you-see-is-what-you-get." Post-Congress, we expect to see few major changes to the economic and financial policies that China has been employing with some considerable success throughout 2017.

Figure 8: Shanghai Composite Index 90-day Volatility 15

Figure 9: Investors are increasingly returning to China 16

1 Manulife Asset Management, FactSet, as of 29 September 2017. Societe Generale Cross Asset Research, 2 October 2017. Equity indices are calculated in total returns in US dollar.
2 See Societe Generale, Global Equity Market Arithmetic, 2 October 2017.
3 FactSet, Manulife Asset Management calculations, October 2017.
4 See SCMP, 'Hang Seng Index Cuts Above Rivals in Nine Months,' 30 September 2017.
5 SCMP, page B4, 30 September 2017.
6 Average of Brent, WTI and Dubai spot prices.
7 See Strategas "Technical Analysis," 3 October 2017.
8 See Carmen Reinhart, 'The Fear Factor in Today's Interest Rates,' Project Syndicate, 25 September 2017.
9 See HSBC Global Research, 'GEMs funds flows,' 2 October 2017.
10 See HSBC Global Research, 'Commodity Prices Snapshot,' 3 October 2017.
11 Average of Brent, WTI and Dubai spot prices.
12 Robert Shiller, 'The Coming Bear Market,' Project Syndicate, September 2017.
13 Bloomberg and Manulife Asset Management’s calculations. 3 October 2017.
14 Bloomberg and Manulife Asset Management’s calculations, September 2017.
15 Bloomberg, SCMP, 30 September 2017.
16 MRB Partners, 26 September 2017.

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