Please note the views expressed in this bulletin are those of the author and do not necessarily reflect AMP Capital’s house view.
Theme 1: Emerging market growth under pressure
The growth advantage that emerging markets has offered appears to have diminished. This means underperformance for emerging market equities.
As noted in a previous edition, emerging market growth is under pressure. At the same time, the major developed economies have a set of positive near-term domestic growth drivers. For example, cheap energy (oil slump), QE in the EU and Japan, weaker currencies in the EU and Japan, improving labour markets, housing markets and asset prices. What this leaves us with is a notable decline in the growth advantage that emerging markets has had over developed markets during the past decade. IMF forecasts have this growth advantage returning to the 2% region towards 2020, but expect significant convergence in the year ahead. For relative performance of emerging markets versus developed market equities this has meant underperformance for the former. For more enduring emerging market outperformance, a bit of water probably needs to pass under the bridge in terms of rebalancing, reform, and deleveraging. However, on a cyclical basis it’s hard for emerging markets to stray too far if developed markets are firing up - or at least seeing stable growth. Similarly, the flows situation for emerging market equities has turned quite pessimistic. The past five years of range-trading for emerging market equities have usually been a good time to buy for the short-term. So in terms of trading the waves versus the tides, the tide still looks to be going out for emerging markets, but the waves could be positive.
Theme in pictures
Source: AMP Capital, Bloomberg. IMF
Theme 2: Economic and equity market divergence
The theme of divergent and unsynchronised growth is likely to remain relevant in the medium-term.
On a related note, it’s worth noting that within emerging market equities there have been some very good and very bad places to be in terms of investment returns (and a similar situation within developed markets). So the theme of economic and equity market divergence is still a key one. It’s clearly continuing to play through and will likely remain a theme as various parts of the world deal with the vulnerabilities and structural challenges that have developed over the past decade or so. This can be seen in the average pairwise correlations of equity returns and the OECD composite leading indicators. Markets and economies are in a period where there is very low correlation with each other i.e. growth is divergent and not synchronised. Similarly, the breadth of the OECD composite leading indicators across countries is low compared to previous cycles – but one positive is that it looks like the 2003-04 period just before global growth accelerated during the global credit boom that preceded the GFC. In any case, selectivity and country allocation is likely to continue to be an important and fruitful source of alpha in multi-asset portfolios in this environment.
Theme in pictures
Source: AMP Capital, Bloomberg, OECD
Theme 3: What about China consumer confidence?
The stock market crash has had little impact on consumer confidence because the property market has been recovering.
What impact did the stock market crash have on China consumer confidence? The answer is - very little because most Chinese have the overwhelming majority of their assets in real estate (and bank deposits). That’s why the Westpac/MNI consumer confidence survey actually rose in July – because house prices have been recovering. But then again, it doesn’t really matter as consumer confidence is not that good a guide to growth in retail sales in China, and in the past the main drivers of the economy have been investment and exports (hence why we focus on the PMI). That said, these consumption and services oriented indicators will take on increasing importance through time as the economy transitions. The other takeaway is that if you want reason to be bullish on Chinese equities, equities remain a really small part of household balance sheets so there is room to move to the upside there.
Theme in pictures
Source: AMP Capital, Thomson/Reuters Datastream, National Bureau of Statistics
Theme 4: When will the Fed go from QE to QT?
Continue to expect the Fed to hike interest rates this year, and note the prospect of QT….but it’s probably a next-year thing.
Rather than excruciate on some of the words in the latest FOMC statement, I would like to highlight an issue that admittedly won’t be relevant for some time yet, but is worth considering. We know that the Fed will probably hike rates soon - maybe September. But what we don’t quite know is when the Fed will go full circle from QE to QT. The interest rate is the old and time-tested conventional tool of monetary policy but the new tool is the balance sheet. This is because it can be expanded to attempt to ease financial conditions, and can be contracted to tighten financial conditions. At the moment the Fed has an active policy of maintaining its balance sheet:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.” FOMC statement.
The Fed can move to passive QT by allowing securities to mature and not reinvest principal - or active QT by selling its treasuries. This is one of the many reasons why the Fed can, and probably will, go slow on hiking interest rates (by undertaking QT alongside rate hikes). However, it does create the prospect of volatility in the bond market. A shift to either active or passive QT will probably cause some indigestion. So it is something worth keeping in mind as we get closer to Fed rate hikes as QT is the logical next step.
Theme in pictures
Source: AMP Capital, US Federal Reserve
Theme 5: Is US IPO activity a warning flag?
IPO (initial public offering) activity can provide clues to a top in the market and the cycle more broadly – but it’s not a perfect indicator.
As I was trawling through various datasets and trying to think up new things I thought it worthwhile comparing IPO stats to the S&P 500 index to see if it provides any clues. There are some tentative clues but before we discuss the data and charts it’s worth thinking about the logic or intuition. More IPOs mean more supply of stock (all else equal – although it’s not quite equal because strictly speaking you should look at *net* supply - IPOs and capital raisings less buybacks). IPOs also happen in greater frequency in boom times because usually in boom times the economy is going well and it’s much easier for new companies to be successful and thus go on to do IPOs. Also, the pricing is better and the greater market enthusiasm increases the likelihood that the IPO will be successful.
So we can therefore say that there will be more IPOs when the market and economy are booming, and if the economy or market stops booming it will be harder to sustain IPO activity. So, we have a supply argument and a cycle argument that says there should be information in IPO activity. In terms of the charts there is a loose link: IPO proceeds (amount of capital raised) moves in line with the market as you would expect. When it rolls over it can mean a change in trend or rolling over of the cycle – however, it is more or less a coincident indicator. The monthly pace of IPO filings is also a potentially useful indicator where a surge in filings can flag a short-term top in the market. Looking at the longer-term data for the number of IPOs, it’s a little tricky because in the past there were many more IPOs than in recent times. So in terms of its efficacy it is ‘mixed’ but it is another information point worth considering. There is a potential red flag in that there was a surge in filings and the volume and proceeds seem to have rolled over.
Theme in pictures
Source: AMP Capital, Thomson/Reuters Datastream, Renaissance Capital, Quandl
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