Watch out for speed bumps

Harbour Asset Management's equity analysts give their forecasts for markets this year.

Friday, January 16th 2015, 10:20AM

by Harbour Asset Management

Outlook – Watch for speed bumps

We expect local equity markets to continue to ‘muddle’ through in the near term, impacted by a combination of modest earnings growth (circa 5%), reasonable corporate balance sheets and valuation levels that, while full for the New Zealand equity market, are not in a ‘redline’ danger zone (especially relative to interest rates).

But there are likely to be a few ‘speed bumps’ over the next year. There are a number of consensus views.

First the US Fed is expected to increase interest rates. Investors will need to continue to adjust expectations about interest rates at the short end of the interest rate yield curve. US growth is expected to soften slightly to a 2.75% to 3.25% pace, while core inflation pressures remain subdued. Oil price weakness, while beneficial to consumers and businesses may create some unintended consequences that can impact negatively on some sectors and may destabilise some emerging economies.

Second, Europe and Japan need both more policy stimulation and structural reform. Markets are telling us neither are expected. More over in Europe the economic situation continues to deteriorate.

Third no one expects a recovery in Australia. And markets are now betting on an interest rate cut of almost 0.5% in 2015. The Australian economy is likely to stay mired for some time, dragging on returns for NZ and Australian businesses focused on domestic Australian activity. The Australian equity market looks prepared for a poor outcome on growth. It could be that companies report better than expected earnings with strong cost controls and better capital management. In addition globally facing companies could get a lift in revenues from a lower Australian dollar.

In terms of currencies, a strong US dollar is a fourth key consensus view based around the notion of not fighting the Fed. Although in December the US Fed pledged to be patient on the timing of interest rate increases, rate increases are still on the cards for 2015. In that regard the Fed’s new policy wording in December was: “the Committee judges that it can be patient in beginning to normalise the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a  considerable time following the end of its asset purchase program in October.”

And this is where the speed bumps come. The Fed does not want to commit to a set pace of rate hikes in 2015. The Fed may not get the Fed Funds rate very high this cycle, but if wages accelerate the Fed will need to consider beginning normalisation. “Tightening with pauses,” as the data evolves, looks to be a reasonable base case. While the US growth ‘engine’ stands out versus other large global economies,  not all US data is currently universally positive, with recent durable goods and new home sales data weaker month on month and wage growth has been low, but there are signs of accelerating US wage growth.

US wage inflation is rising

Source: Strategas

The continued recovery in US economic data does make the Fed’s ‘emergency’ Zero Interest Rate Policy (ZIRP) look out of place.  The Fed does not need high interest rates, but there’s a good distance between ‘zero’ and ‘tight’ in U.S. monetary policy.  Capital markets have already started to anticipate the move. The US 2 year Treasury note yield has increased significantly since 17 December and risen 200% to 0.68% since mid-October. In the same period US 10 Year treasuries have done very little which has resulted in a flattening of the interest rate yield curve.  The 2-Year Treasury note yield is a measure of short-term interest rate expectations and is a reflection of markets pricing in a rate rise by the US Fed.

While there is potential for ‘taper tantrum’ type periods of market weakness, desynchronised global growth means economic growth and inflation rates may remain low, and interest rates are likely to remain lower for longer. Without further significant balance sheet expansion and structural reform the German and Japanese economies are moribund with recent downgrades to growth forecasts, and emerging markets leveraged to oil prices, particularly Russia, face some challenging times. Certainly further stimulus should be expected from European, Chinese and Japanese authorities. All of these actions will also support the USD, which in turn may dampen the US economic recovery as export competitiveness declines.

Energy prices appear to be staying low near term as oil prices find a new trading range. The lower oil price will provide a lagged boost to consumer and business confidence globally. While the drop in oil prices is undoubtedly positive for developed economies, the lag between the benefit of lower oil prices to consumers and business, and the instantaneous impact on market valuations of oil and gas stocks means that lower oil prices often initially leads to lower overall equity market returns. The Australian and US equity markets with their relatively large oil and gas/energy index exposures tend to fall after radical pullbacks in oil prices.

The risk is that a disorderly decline in oil prices could jeopardise one of the key drivers of the US recovery by rapidly shutting down shale and shale-related capital expenditure. Pressure on the energy sector is already being highlighted by credit rating downgrades and increasing debt costs to oil and gas exploration and production companies.

However, what lies behind the oil price crash is crucial to the investment outlook in the first half of 2015. The data are more consistent with a supply-side oil shock, with positive implications for risk assets rather than being indicative of a big slowdown in global growth.

Strong supply growth looks to be behind the oil price shock

Source: Strategas

The domestic Australian economy is likely to continue to struggle through the next 12 months. This is largely a consensus view and reflected in the most recent NAB business confidence index which dropped to a post-election low of +1. Businesses cited the inability of the Federal Government to implement policy change. The Westpac-MI consumer confidence index sank 5.7% month on month to a reading of 9. While Australian residential building activity is increasing it is not improving fast enough to offset the roll off in major capital works particularly in the resources sector. Low business confidence is contributing to an increasing unemployment rate which may reach 7% in 2015.

Federal Government spending is likely to be constrained with Federal Treasurer Joe Hockey revising the financial year 2015 deficit up by A$10.6bn to A$40.4bn. This triggered concerns in the Australian equity market about the potential impact of fiscal tightening on some sectors in May’s Federal budget. While capital markets have priced in one or two official RBA cash target cuts, the RBA continues to maintain its “period of stability” stance and at the same time jawboning the AUD exchange rate down, with RBA Governor Glenn Stevens suggesting an AUD exchange rate of US75 “probably… is better than 85c”.  We think markets are exaggerating the potential for interest rate cuts in Australia and hat the Australian dollar is oversold relative to the New Zealand dollar.

In part this is because of relative valuation but also there are some positive signs emerging in Australia. New South Wales (NSW) Government reforms are activating the NSW economy. Weakness in the AUD versus the USD may attract increased inbound tourism and result in a larger proportion of Australian household income being consumed domestically rather than spent on offshore trips and internet purchases.

Importantly the Australian investments held within the portfolio are largely focused on those companies with compelling global businesses.

While pricing of various asset classes can be described as full, they may stay at the higher end of valuation ranges in the near term. What is likely to increase over the next year is volatility. We have already seen broad commodity price volatility.  Bond market volatility should pick up in anticipation of Fed tightening in 2015.  If fixed income markets get more volatile, equity market volatility may also increase.  Market gyrations (that have picked up since October) may become more the norm rather than the exception.

Economic ‘good news’ could be ‘bad news’ for markets, if it brings Fed tightening, wakening investors from the ‘security blanket’ of low volatility.

Importantly investor positioning is less aggressive than in previous periods of potential US monetary policy tightening. Deutsche Bank has looked at US investor positioning and flows into 2015. Their six key observations are:

  1. That the post financial crisis over-allocation to bonds versus equities remains massive
  2. Bond flows moved back into longer duration in 2014;
  3. Despite their large outperformance, US equities have received relatively little in inflows
  4. Pension funds and insurance companies have been persistent sellers of equities and buyers of bonds;
  5. Elevated dollar longs in line with last dollar up cycle; and,
  6. Long positions in oil and gold also likely to be sticky.

These settings suggest that equity market weakness is likely to be cushioned.

The NZ equity market has historically handled recent US Fed tightening periods relatively well. During the 1999/2000 tightening/tech bubble period the NZ market fell 8% between December 1999 and December 2000, before rallying 16% between December 2000 and December 2001 and 3% between December 2001 and December 2002. During the US Fed’s 2004 tightening period the NZ market delivered a 9.5% return between December 2004 and December 2005.

While the New Zealand equity market continues to be priced at a 15% plus  premium to historic price to earnings multiples, underlying earning risk remains modest, with companies well capitalised. Domestic New Zealand Business sentiment remained broadly stable over December. The Business confidence index eased back by a modest 1.1 percentage points to 30.4% and remains well above its long-run average of around 11%.

Confidence remains strongest in the construction and services sectors, while the agricultural sector continues to remain the weakest reflecting the negative effect of the recent sharp weakening in dairy auction prices, together with Fonterra’s announcement of a further reduction in the forecast farm gate milk price pay-out for the 2014/15 year.

It’s been great time to own the NZ equity market over the last three years. Investors have been delivered 19% plus per annum returns over the three year period by owning the basket of stocks that makes up the NZX50 index. An unprecedented era of easy monetary policy globally has supported broader equity market performance.

Despite US Fed tightening, desynchronised growth and emerging market concerns the global financial system is in better shape to deal with shocks than it was pre GFC and equity market pricing is not at the stratospheric levels reached in the late 1990’s when monetary policy settings were changed and emerging markets imploded. However, the noise in the data can easily overwhelm the signal in the short-run – potentially creating stock pricing inefficiencies.

While relatively easy monetary conditions are likely to continue in the near term, they may become less easy as economic conditions gradually improve, potentially increasing market return volatility. After such a strong period of overall market performance reducing systematic risks from portfolios represents good investor practice, potentially reducing the impact of poor return periods. While systematic risk is difficult to completely avoid its impact can be mitigated through portfolio management strategies and asset allocation strategies. Active stock picking can mitigate the impact of market movements. Investing in businesses that offer the best long-term value creation, with a wide ‘moat’, that are being priced at a discount to their underlying value by the market ultimately we believe delivers long term high quality equity investment outcomes.

Andrew Bascand, Shane Solly, Craig Stent

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