Global Investing

Easy come, easy go. A choppy October prepares to exit on a downer – just like it arrived. World equities lost about 3 percent over the past seven, mostly on Tuesday, and reversed the previous week’s surge to slither back to early September levels. Just for the record, Tuesday was a poor imitation of the lunge this week 25 years ago – it only the worst single-day percentage loss since July and only the 10th biggest drop of the past year alone. But it was a reminder how fragile sentiment remains despite an unusually bullish, if policy-driven year.

Why the wobble? t’s hard to square the still fairly rum, or at best equivocal, incoming macro data and earnings numbers alongside year-to-date western stock market gains of 10-25%. There’s more than enough room to pare back some more of that and still leave a fairly decent year given the macro activity backdrop and we now only have about 6 full trading weeks left of 2012. So it will likely remain bumpy – not least with U.S. and Chinese leadership changes into the mix as mood music. The sheer weight of a gloomy Q3 earnings season seems to have hit home this week, with revenue declines or downgraded outlooks  – particularly in “real economy” firms such as Caterpillar, Dupont,  Intel and IBM etc – worrying many despite more decent bottom line earnings. As some investors pointed out, earnings can’t continue to beat expectations if revenues continue to wither and there are still precious few signs of an convincing economic turnaround worldwide to draw a line under the latter.

The policy-driven equity boom of the past couple of months has also been suspect to many strategists given the lack of rotation from defensive stocks to cyclicals, showing little conviction in central bank reflation policies succeeding soon even though ever more ZIRP/QE has seen something of an indiscriminate dash to any fixed income yields you care to mention – from junk to ailing sovs and now even CLOs! The bond rush has swept up an awful lot of odd stuff –  not least 10-year dollar debt from countries such as Bolivia and Zambia, whatever about Spain, and corporate junk with CCC ratings and current default rates of almost 30%! As some other funds have pointed out, another weird aspect of this has been the appetite for long duration – which doesn’t fit with any belief that reflationary policies will work on a reasonable timeframe. So, is that it? Central banks will continue to wrap everything in cotton wool for the next decade without ever succeeding in boosting growth or even inflation? Hmmm. The various U.S. growth signals are not ultra-convincing, not yet at least, but they’re not to be ignored either. Thursday’s news of a bounceback in the UK economy in Q3 also shows the prevailing stagnation narrative is not without question. And everyone seems convinced Chinese growth has troughed in Q3 –and  just look at the 66% rise in Baltic Freight prices in little over a month. The rebound in super-low equity volatility in the U.S. and Europe this week is also worth watching – though it has to be said, these gauges remain historically low about 20%.

All of which brings us to US election and another potential reason to be wary of the next couple of weeks or so at least. It’s neck and neck for the White House with the debates now all done and dusted and fiscal cliff jitters firmly in the frame. Reports that Bernanke plans to step down when his 2nd term expires early in 2014 may have taken some of the sting from the Fed policy question, but Barclays strategists still think there could be a jump of 50bp or more in the implied rate on 2015 Fed funds futures in direct reaction to a victory for the Fed-sceptical Romney team. Given that they also think a Romney win, by more easily sidestepping the fiscal cliff and related growth fears, could pump 10-year Treasuries above 2 percent, that’s a considerable near-term risk to euphoric fixed income markets at least. Of course, they assume the opposite knee-jerk direction in rates on an Obama win.

On the other side of the coin, don’t forget about global monetary policy in the meantime.  The Bank of Japan meeting next week could well announce more QE from there.

Is there a change of sector leadership underway within emerging markets?

For years, commodities and energy delivered world-beating returns to emerging market investors. Yet in recent years there are signs of a shift, says Todd Henry, equity portfolio specialist at T.Rowe Price.

With the China tailwind no longer as strong as before demand for oil and metals will not be as robust as in the past decade, Henry says. But in China as well as elsewhere, disposable incomes have risen as a result of the fast economic growth these countries experienced in the past decade.

Check out the following two graphics from T.Rowe Price.

The first figure shows that in the ten years to December 2007, just before the global financial crisis erupted, emerging equities returned 300 percent in dollar terms. The two sectors that won the returns race in this period were energy and commodities, with dollar-based returns of around 650 percent. This is not surprising, given the enormous surge in Chinese demand for all manner of commodities, from oil to steel, as it fired up its exporters’ factories and embarked on a frenzy of infrastructure improvements.

Whoosh! The gloomy start to the final quarter seems to have been swept away again by the beginnings of a half decent earnings season stateside – at least against the backdrop of dire expectations – and a steady drip feed of economic data surprises from the United States and elsewhere. Moody’s not downgrading Spain to junk has helped enormously and the betting is now that the latter will now seek and get a precautionary credit line, which would not require any bailout monies up front but still unleash the ECB on its bonds should they ever even need to – and,  given Thursday’s successful sale of 4.6 billion euros of 3-, 5- and 10-year Spanish government bonds,  they clearly don’t at the moment (almost 90% of Spain’s  original 2012 borrowing target has now been raised). What’s more, Greek euro exit forecasts have been put back or reduced meantime by big euro zone debt bears such as Citi and others, again helping ease tensions and defuse perceived near-term euro tail risks. Obama’s bounceback in the presidential polls after the latest debate may be helping too by rolling back speculation that a clean sweep rather than a more likely gridlock was a possible outcome from Nov 6 polls. China Q3 GDP came in as expected with a marginal slowdown to 7.4% and signs of growth troughing — all adding to the picture of relative calm.

So, in the absence of the world ending in a puff of smoke – and the latest week of data, earnings and reports suggests not – we’re left with a view of a hobbled but stabilising world economy aided by hyper-easy monetary policy that is bolting core interest rates to zero. Tactical investors then, at least,  are being drawn into the considerable pricing anomalies/temptations across bond and credit markets as well as the giant equity risk premia and regional price skews.

The upshot has been a sharp bounceback of some 2.5% in world equities since last Wednesday, falling sovereign bond spreads in euroland and in credit and emerging markets, a higher euro and financial volatility gauges still rock bottom. Dax vol, for example, is at its lowest in well over a year. Year to date, developed market equities are now scaling 15-20%! Germany stands out with gains of some 25%, but the US too is homing in on 20%. These are extremely punchy numbers in any year, but are doubly remarkable in year of so much handringing about the future. So much so, you have to wonder if the remainder of the year will be remain so clement. That doesn’t mean another shock or run for the hills, but shaving off the extremes of that perhaps?

This week, Germany celebrated its Tag der deutschen Einheit (Day of German Unity) marking twenty-two years since the wall was torn down between East and West.

Back in the present, Frankfurt’s main share index, the DAX, has outperformed all of its European peers this year and in dollar terms has outshone almost every other global equity index. Re-unification has been painful, fostering social tensions and still huge disparities between east and west, but some analysts argue that it is precisely those disparities, not least in wages, which have underpinned the primacy of German stocks today.

There are other crucial factors of course. Germany’s high-value and high cost exports such as BMW cars are in high demand in countries such as China and India, all the more because of the weak euro.  And despite the outperformance, the market seems to price German stocks as bargains — they currently trade around 10 times forward earnings compared to over 12 times for the world index. According to fund managers at Baring Asset Management:

British investors are warming up to European equities, with the highest level of positive or rather positive views of the troubled bloc’s stocks in a year, an online survey by Baring Asset Management shows:

The biggest rise in sentiment was seen towards European equities, with over half (53%) of respondents saying they were now either ‘quite’ or ‘very’ favourable, up from 42% in the last survey and the most favourable they have been towards the European equity sector for a year.

UK investors remain more positive on stocks from emerging markets, the United States and Asia ex-Japan, but with ratings down from the previous poll three months ago, and UK equities are also viewed more favourably. The poll answered by just over 100 respondents between Aug 22-Sept 19 shows the euro zone crisis is still considered the biggest global economic challenge.

The wealthy in the United States have a reputation for being firmly on the side of the Republican Party, but maybe they shouldn’t be for the November presidential election.

According to Tom Stevenson, investment director at asset manager Fidelity Worldwide Investments, past evidence points to Democrat Barack Obama as possibly the more lucrative bet for equity  investors.  He says:

Looking at stock market performance following the last 12 elections suggests that investors should, in the short term at least, be rooting for an Obama victory. History shows that markets tend to rally after a win for the incumbent party by more than 10% on average, but fall modestly if the challenger is successful.

Jim O’ Neill, creator of the BRIC investment concept, has been exasperated by repeated calls in the past to exclude one or another country from the quartet, based on either economic growth rates, equity performance or market structure. In the early years, Brazil’s eligibility for BRIC was often questioned due to its anaemic growth; then it was the turn of oil-dependent Russia. Over the past couple of years many turned their sights on India due to its reform stupor. They have suggested removing it and including Indonesia in its place.

All these detractors should focus on China.

China’s validity in BRIC has never been questioned. Aside from the fact that BRI does not really have a ring, that’s not surprising. China’s growth rates plus undoubted political and economic clout on the international stage put  it head and shoulders above the other three. And after all, it is Chinese demand which drives a large part of the Russian and Brazilian economies.

But its equity markets have not performed for years.

This year, Russian and Indian stocks are up around 20 percent in dollar terms while China has gained 9 percent and Brazil 3 percent. In local currency terms however China is among the worst performing emerging markets, down 5 percent. Brazil has risen 9 percent.

Given almost biblical gloom about the world economy at the moment, you really have to do a double take looking at Wall Street’s so-called “Fear Index”. The ViX , which is essentially the cost of options on S&P500 equities, acts as a geiger counter for both U.S. and global financial markets.  Measuring implied volatility in the market, the index surges when the demand for options protection against sharp moves in stock prices is high and falls back when investors are sufficiently comfortable with prevailing trends to feel little need to hedge portfolios. In practice — at least over the past 10 years — high volatility typically means sharp market falls and so the ViX goes up when the market is falling and vice versa. And because it’s used in risk models the world over as a proxy for global financial risk, a rising ViX tends to shoo investors away from risky assets while a falling ViX pulls them in — feeding the metronomic risk on/risk off behaviour in world markets and, arguably, exaggerating dangerously pro-cyclical trading and investment strategies.

Well, the “Fear Index” last night hit its lowest level since the global credit crisis erupted five-years ago to the month.  Can that picture of an anxiety-free investment world really be accurate? It’s easy to dismiss it and blame a thousand “technical factors” for its recent precipitous decline.  On the other hand,  it’s also easy to forget the performance of the underlying market has been remarkable too. Year-to-date gains on Wall St this year have been the second best since 1998. And while the U.S. and world economies hit another rough patch over the second quarter, the incoming U.S. economic data is far from universally poor and many economists see activity stabilising again.

But is all that enough for the lowest level of “fear” since the fateful August of 2007? The answer is likely rooted in another sort of “put” outside the options market — the policy “put”, essentially the implied insurance the Fed has offered investors by saying it will act again to print money and buy bonds in a third round of quantitative easing (QE3) if the economy or financial market conditions deteriorate sharply again. Reflecting this “best of both worlds” thinking, the latest monthly survey of fund managers by Bank of America Merrill Lynch says a net 15% more respondents expect the world economy to improve by the end of the year than those who expect it to deteriorate but almost 50 percent still believe the Fed will deliver QE3 before 2012 is out.  In other words, things will likely improve gradually in the months ahead and if they don’t the Fed will be there to catch us.

Earlier this year it seemed that an increase in global bullishness meant the end of the road for risk-off investment strategies and, by extension, the rise in South African equities. However, 6 months later, the band is still playing, and the ship is refusing to go down.

South African equities have flourished in the face of the doomsayers, with returns this year doubling the emerging market benchmark equity performance. Both the all-shares index and the top-40 share have hit fresh all time highs this week, and prophecies of gloom for South African stocks appear to have missed the mark somewhat.

Part of the reason for this is that, when it comes to risk attitudes, much of the song remains the same. South Africa has certainly benefitted from its continued attractiveness to risk-off investors, as global bullishness has receded from whence it came. For instance, as it is relatively well sheltered from euro zone turmoil, and as major gold exporter, firms based in the gold sector are ostensibly an attractive investment for the globally cautious.

Ok, it’s a big policy week and of course it could either way for markets. An awful lot of ECB and Fed easing expectations may well be in the price already, so some delivery would appear to be important especially now that ECB chief Mario Draghi has set everyone up for fireworks in Frankfurt.

But if it’s even possible to look beyond the meetings for a moment, it’s interesting to see how the other forces are stacked up.

Perhaps the least obvious market statistic as July draws to a close is that, with gains of more than 10 percent, Wall St equities have so far had their best year-to-date since 2003. Who would have thunk it in a summer of market doom and despair.  Now that could be a blessing or a curse for those trying to parse the remainder of the year. Gloomy chartists and uber-bears such as SocGen’s Albert Edwards warn variously of either hyper-negative chart signals on the S&P500, such as the “Ultimate Death Cross”, or claims that the U.S. has already entered recession in the third quarter.