“Signs of weak growth overseas won’t prove large enough to have a significant impact on policy,” according to Fed Chair Janet Yellen last Thursday. “Most FOMC participants, including myself, currently anticipate an initial increase in the federal funds rate later this year”, she said.
Will underperformance of EM and Asian equities halt?
Fed caused a further increase in uncertainty…
Instead of removing the uncertainty with regard to the date of the lift-off, an additional layer of uncertainty has been created by the US central bank after the latest meeting of its Federal Open Market Committee (FOMC). By mentioning increased global growth worries sourced from emerging markets and by emphasizing the downside risks in the inflation outlook, the Fed made investors even more cautious than they already were. Of course, while neither the Fed nor the ECB has made major downgrades to their forecasts, it represents a change in direction. Better data out of emerging markets will be needed to stop this trend.
We expect that this will leave scars on earnings expectations for 2015 and 2016. Lower nominal growth is detrimental for earnings growth and in the end; earnings are the most important long-term driver of equities. Earnings momentum is already very negative and we do not expect this trend to turn around soon, with Eurozone companies in particular vulnerable due to their high emerging market exposure. We are therefore looking with more than usual anxiety to the upcoming earnings season.
…but still anticipates a first rate hike this year
In the meantime, the guessing game regarding the start of monetary policy normalization is continuing. In a speech at the University of Massachusetts last Thursday, Fed Chair Yellen tried to take away some of the uncertainty. She said she expects inflation will return to 2% over the next few years as temporary factors currently holding it down will wane. Signs of weak growth overseas won’t prove large enough to have a significant impact on policy, Yellen said. “Most FOMC participants, including myself, currently anticipate an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter,” according to Yellen. According to CME’s Fed Watch calculator, the odds of a rate hike in December currently stand at 35%.
Underweight equities for the first time since 2011
Given the increased uncertainty to the global growth outlook, we decided to move our equity exposure to a small underweight. This is quite significant, as the last time we had an underweight position in equities was in 2011. Our top-down signal continued to move lower and is currently in negative territory, not only as a result of weaker fundamental grounds but also because of a further deterioration in market dynamics. Some may argue that investors are already cautiously positioned – and we agree – but if the base case scenario shifts downwards, positioning may in reality not be that defensive relative to the new base case.
Return of the search for yield
At the same time, we upgraded spread products from a large underweight to a medium underweight. We think that the status quo of the Fed removes some of the tail risks in emerging markets. If the Fed would have hiked rates, EM policy makers would probably have been forced to tighten monetary policy to defend their currency. A second argument is the expected return of the search for yield theme, although this is potentially a stronger theme in real estate as spread products are sensitive to further declines in the oil price. Thirdly, although still very negative, the top-down signal for spread products improved over the past week. The technical picture on the other hand remains weak, with both increasing supply and weak investment flows.
Underperformance of Asia ex-Japan might come to a halt
In the equity markets, regions that may see the selling pressure abating are emerging markets and developed Asia ex-Japan. Indeed, after the Fed's decision, EM assets did outperform DM assets. The long period of underperformance of Asian ex-Japan assets may have come to a halt. The trend in fund flow data, which indicate a shift in capital flows out of Japan and the Eurozone into the rest of Asia and the US, also points to this possibility.
Of course, valuation has also come a long way for these two regions. For Asia ex-Japan, the relative trailing price/earnings ratio has fallen to the lowest level since the turn of the century. Exactly the same conclusion can be drawn based on the trend in the relative price-to-book ratio. The region also offers a more than decent dividend yield of 4.4%.
There are clear fundamental reasons for the underperformance of EM and Asia ex-Japan. The link with the boom-bust cycle in commodity prices looks obvious. The economic surprise indicators for EM are well below those in DM and also earnings momentum has been consistently weaker. However, both indicators are showing some signs of stabilization – albeit at a low level. Maybe the pendulum will switch back somewhat more in favour of EM, not because they are strengthening but due to the weakening earnings outlook in DM.
Based on these valuation arguments – combined with less pressure on EM – we closed the underweight position in Asia ex-Japan.
Market behaviour justifies a less negative stance on EM
For the broad EM universe we can also identify some behavioural dynamics to justify a less negative stance. Investor positioning in the region is very low. According to the Bank of America Merrill Lynch investor survey*, the weight of EM equities in investor portfolios has fallen to the lowest level since at least 2005. Being underweight EM is considered as the second most crowded trade (the first one being long US dollar). At the same time, EM risks are well-identified given that a Chinese recession and/or an EM debt crisis are considered as the two biggest tail risks by investors according to the survey.
Likewise, fund flows are very negative. Last week was the 15th consecutive week of EM fund redemptions. Year-to-date, EM funds have faced almost USD 50 billion in redemptions, the highest number since at least 2000. It therefore seems fair to say that a lot of bad news has been priced into EM equities and that they are bound for a relative rebound. This warrants an upgrade from a medium to a small underweight. In the meantime however, the fundamental story remains difficult with the slowdown in China, the broad weakness in Brazil and the drop in commodity prices putting pressure on the commodity producers.
*Source: BofA Merrill Lynch Fund Manager Survey, 15 September 2015