US

Key considerations for fixed income investing

The Federal Reserve has continued to partially remove stimulus via further reductions in quantitative easing (QE) this year. Despite this reduction, US 10 year treasury yields have fallen from 3% in January to approximately 2.5%. We are not particularly concerned about the risk of inflation, which is usually the key driver of higher interest rates. There is too much excess capacity and structural unemployment in the global economy (especially in Europe) for us to be overly concerned of an inflation spike. However, The US Federal Reserve owns close to 35% of all US Treasuries with more than 5 years of duration remaining. There is a risk that rates could rise with the removal of Federal Reserve buying. As a result, we recommend investors allocate a significant proportion of their defensive assets to credit funds with minimal duration exposure, to reduce the risk of loss of capital if US 10 year government bond yields do indeed rise significantly.

Will stronger GDP growth lead to strong earnings growth and market gains?

Despite slow growth in the first quarter which was largely weather related, we believe US GDP growth in 2014 is likely to be in the vicinity of 2.5-3%, which is higher than the growth rates of 2013. Importantly, public sector revenues have improved due to stronger consumption and higher asset prices, which has led to higher tax receipts. The budget deficit is likely to decline to 3 to 4% of GDP, negating the need for major expenditure reductions or tax increases. The outlook for corporate capital expenditure is positive, and consumer confidence is robust due to recent gains in housing and equity prices as well as employment growth.

While the outlook for US GDP growth is reasonably positive, the outlook for corporate earnings is not particularly promising. First quarter earnings grew at close to 2%, and we are doubtful that consensus expectations for 8% earnings growth this year will be achieved. Tailwinds of reduced interest expenses, no real wages growth, productivity gains and US dollar weakness have been key drivers of US corporate margin expansion in recent years. A number of these earnings tailwinds have abated. Corporate margins may hover at their current historically high levels, but further margin expansion is unlikely to be significant. The U.S. dollar has strengthened against most major foreign currencies over the past year, which is a headwind for earnings growth (earnings from subsidiaries are worth less in US dollar terms and exports priced in local currencies are also worth less in US dollar terms).  Interest rates are likely to gradually increase in the years ahead, providing a further headwind to earnings per share growth. The consequences of this is not necessarily poor share market performance – but further price earnings multiple expansion is likely to be a prerequisite for any further equity market appreciation of considerable magnitude.

Europe

Expect slow growth and diversity in GDP growth rates

We expect Europe to exhibit slow, albeit positive GDP growth throughout 2014. Business and consumer confidence have improved, and this could lead to more robust business and consumer spending. The medium term inflation outlook in Europe is low, and is likely to fluctuate around 1% or less. Given the very high unemployment rate of close to 12% (with significant disparity between countries), and low workforce participation rates, wage inflation pressures are minimal. The output gap is also wide in Europe, with significant excess capacity. As such, with nominal GDP likely to grow at about 2%, European nations are less able to inflate their way out of their high net debt levels.

Banks remain in deleveraging mode, and credit conditions remain relatively tight. Growth rates between European nations are likely to remain varied – Germany is likely to exhibit more positive growth, with Spain and Italy continuing to lag.

The outlook for UK GDP growth is more promising – consumer spending is growing and business investment has finally started to exhibit some robustness. Inflation is also higher, equating to significantly higher nominal GDP growth than continental Europe.

Japan

Japan is likely to experience slower growth this year, mainly due to the sales tax increase in April 2014 from 5% to 8%, which is likely to dampen consumption, and also due to more constrained government expenditure post extraordinary stimulus in 2013. GDP growth is likely to be in the vicinity of only 1%.

Source: IOOF, May 2014

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However, it is not clear whether the recovery is sustainable and structural problems remain hidden below the surface.

Global growth forecasts have continually been revised down during 2013, with the IMF recently reducing its 2013 growth forecast to 2.9% from 3.2%. A new trend of slowing growth in emerging economies and recovering growth in developed economies has emerged.

Despite the global slowdown, there is growing optimism that the US is gaining momentum and that Europe is showing the first signs of recovery. In addition it seems China has stopped slowing and has stabilised at around 7.5% growth. Indeed, it is expected that emerging economies will soon benefit from a recovery in the developed world and hence global growth should rebound in 2014 to around 3.6%, according to IMF forecasts.

Structural issues

Despite increased momentum leading into 2014, there remains structural problems in each region.

In the US, the recovery is patchy and requires extraordinary monetary stimulus from the US Federal Reserve (the Fed) to keep interest rates very low and the USD weak. The tricky part for the Fed will be exiting this program. We have already seen markets ‘front-running’ the Fed when it indicated mid-year that it was considering tapering its bond purchasing program. Bond yields rose aggressively, the USD rallied and capital began to flow out of emerging markets and back into the US. The Fed seemed to be alarmed at the sharp market reaction and subsequently delayed plans to taper in September 2013.

In addition, the issue of reducing the US budget deficit and public debt without harming economic growth remains a divisive issue for Congress. The public debt has grown to US$16.7bn, or 100% of GDP, while the budget deficit is around US$650bn, or 4% of GDP. To be fair, the budget deficit is the lowest deficit in 5 years and has been reduced from around US$1.2 trillion in the years immediately following the GFC.

However, the public debt will continue to grow unless the deficit is returned to surplus and hence the Republican controlled lower house is becoming increasingly active over the budget and the self-imposed US$16.7bn debt ceiling. The recent budget stand-off in Congress forced a government shutdown that may hurt the US recovery but financial markets remained calm on the assumption that the budget and extension of the debt ceiling would eventually be approved, which indeed it was.

In Europe, the recovery is fragile and there still remains sovereign debt and bank solvency issues in the southern countries. There is also the larger question:  can the European monetary union succeed without a proper fiscal, banking and political union (of the kind that we see in the United Kingdom or the US)? Lonsec suspects not but we expect the EU to forge closer integration over the long term.

In China, its economic model for the past 40 years of export and investment led growth is becoming unbalanced and unsustainable. There is a concern that property and infrastructure development has become too large at 50% of the economy and has run ahead of income growth. More wealth needs to be distributed to its citizens to boost incomes and hence consumption.

China’s new leaders recognise the need for reform to drive the economy towards more sustainable and diversified growth across consumption, business investment, housing, government spending and net exports.

In Japan, the new Abe government is trying to get the country out of a debt deflation trap that has existed since the 1990 property bubble burst. Japan’s sovereign debt is very high at 240% of GDP and the central bank has a substantial money printing program aimed at keeping interest rates low and encouraging inflation but also keeping the currency weak. In addition, Japan is also dealing with an ageing population and increased competition from South Korea and China.

The structural issues mentioned above are all major issues and are not going to be solved overnight. It will take many years for each issue to be resolved or in the worst case, emerge as a crisis. We can’t know how they will all turn out but it pays to be aware of them when investing.

Australia

Compared to the US, Europe and Asia, Australia has relatively few issues. The budget deficit and public debt are low to moderate, the banking system is strong, the economy is diversified and the government should be more functional, after the recent election. The issues in Australia are more around encouraging growth outside of the mining sector and improving productivity.

However, one structural weakness could be the build-up of housing debt which is relatively high at around 100% of GDP. But the debt is being serviced and impairments are very low. Household debt is not likely to be an issue unless unemployment rises and/or credit becomes much more expensive, both of which seem unlikely given the economy continues to grow, inflation remains subdued and the banks are well capitalised.

Conclusion

A recovery in the US and Europe should lead to a rebound in global growth in 2014. However, we remain wary that the recovery is still fragile and there are still some major problems below the surface.

At this stage, we are retaining our largely neutral growth, underweight bonds and overweight cash stance. If we can gain greater comfort on the sustainability of the global recovery, we will look to increase growth weightings and reduce cash.

Source: Lonsec, October 2013

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