An Alternative View to 2015 Themes January 2015

Al Clark

Global Head of Multi Asset

Contributions to this article have been made by Robert Samson – Senior Portfolio Manager, Tanuj Dutt – Portfolio Manager, Sebastian Mullins – Portfolio Manager, Qitian Chen – Quantitative Analyst, Salman Siddiq – Portfolio Manager and Max Amster – Analyst from the Multi Asset Team.

It is that time of year again when those in the investment business (unfairly referred to as the ‘chattering class’) share their prognostications on the path of asset classes for 2015. For the Multi-Asset team at Nikko AM this is a difficult time as our process is more founded on assessing the relative value of investments we make rather than the path they will follow over the next year. We find forecasting price levels very hard and tend not to enter the debate on whether the US S&P500 will be at 2000 or 2100 by the end of 2015. We thought it might instead be useful to highlight some investment themes that are attracting interest at the moment. For each theme that we have described as where we believe consensus expectations to currently lie and then offered an assessment of the risks that may challenge those expectations – the’ flipside’. We should point out the ‘flipside’ is not our current view, but rather a framework to assess the risks that are stacking up against market consensus. We hope you enjoy this alternate view to 2015 themes.

Consensus expectations: Commodity prices peaked in 2011, completing the restocking phase and China credit splurge following the financial crisis. Since then commodity prices have been on a steady downward trajectory, accelerating lower recently as oil prices collapsed. The consensus view has the fall in prices as mainly a response to excess supply (think OPEC and oil), with the expectation for demand to increase as the lower prices effectively act as a ‘tax cut’ for consumers. The decline in commodity prices also presents relative value opportunities within emerging markets (EM). The decline in commodity prices will be a headwind for commodity exporters, but is a strong tailwind for EM importers based on improved terms of trade and fiscal relief in the form of reduced subsidy costs. A strong consensus trade for 2015 is to be overweight EM commodity importers and underweight the EM exporters. The Flip side:

What if falling commodity prices have been more a function of weakening demand than increased supply? Since 2009, investors have mainly operated under the assumption that central bankers can defeat deflation. Still, despite best efforts, while central bankers have been largely effective in reflating equities and certain hard assets such as real estate, demand has remained lacklustre and commodity prices have continued to fall as a result. While global trade seemed to be gathering momentum to the upside in 2013, 2014 has seen growth rates roll over once again as shown below.

Theme 1: Falling commodity prices

Chart 1: Global Trade Growth

Source: BIS (YoY% changes), as of December 2014

aggregate demand the 9.2% earnings growth and 4% sales growth for the S&P500 in Q3 are key as to why US equities keep rallying. With other major regions either struggling to deliver top line growth or facing increasing headwinds to do so, the visible and consistent growth from US companies continues to attract capital. That is not to say we expect US earnings growth to remain unchallenged. Our research suggests a number of growing risks for the US earnings outlook: - Stronger USD – with 42% of S&P earnings offshore the potential translation effect is non-trivial. The step up in ‘currency wars’ look to push USD higher.

Global trade growth is partly weak due to fewer imports by the US (less consumer leveraging and more production internalized – think on-shoring manufacturing and oil shale), but it is also due to weaker demand in Europe and emerging markets. Weak demand in Europe is obvious (high unemployment and deflationary pressures), but it is perhaps less well understood how slowing trade growth and weak money supply has weighed on EM demand. While EM used to enjoy a substantial GDP growth premium over DM through most of the last decade, that premium has compressed all the way back down below levels of 2002 (see chart below).

Chart 2: EM vs. DM growth and EM vs. DM equity performance

Source: Datastream, Haver, Bloomberg, UBS, as of December 2014

Year

YoY%

Consumers will benefit from declining energy prices to increase some consumption at the margin, but it is far from clear that lower prices will spark meaningful new demand to offset the structural weakness in global demand. Moreover, recent market distress suggests that the marginal benefit of still declining energy and commodity prices has diminishing returns for the negative impact on commodity-based sectors and potentially more broadly for the impact of declining risk appetite. The second view to consider is that of underweighting EM commodity producers in favour of EM commodity consumers due to the varying impact of falling commodity prices. We are concerned this may be too simplistic a view and are actually as much if not more concerned by the debt dynamics in EM economies. Due to the aforementioned weak trade and declining demand, EM has largely filled the growth gap with credit; causing total debt to GDP ratios to rise from 125% in 2008 to 155% today (see Chart 3). Record low interest rates helped to rationalize debt accumulation as well as drive investor demand in the quest for yield. However, many who are invested in EM debt are new to the asset class and fund flows could slow (or reverse) as the dollar strengthens and the US eventually raises rates. This exposure was most clearly revealed during the so-called “taper tantrum” when EM sold off, but most severely for those countries depending on foreign flows to fund external imbalances: Turkey, South Africa, India, Indonesia and Brazil. Chart 3: EM Debt Sovereign Debt Levels

Source: BIS, as of December 2014

Since the taper tantrum, India and Indonesia elected new governments and have worked toward reform to close their imbalances. Turkey, Brazil and South Africa have done little to effect change, but since treasury yields compressed during the first half of 2014, they were allowed to muddle along on the continued demand for yield. In fact, as energy prices declined, large importers of energy such as Turkey found increased inflows on the simple premise of this benefit.

While falling energy prices may help Turkey at the margin, the economy remains imbalanced and funding the gap will become increasingly difficult in a tightening environment. It could well make sense to underweight commodity exporters based on poor fundamentals, but be selective in overweight positions and stay defensive with respect to funding risk.

Theme 2: Inflation is dead

Consensus expectation: A key theme dominating markets at the moment is the evil spectre of deflation. A cursory glance at developed government bond markets shows yields either at or near their historically lowest levels - a result of combining historically low real yields with investors falling expectations for inflation. This can be seen on the chart below where inflation expectations for US and Europe (using 5Y5Y Forward Inflation Swap as a proxy) are falling. Expectations in Japan are actually rising as the government attempts to pull Japan out of a protracted deflationary period.

Chart 4: Inflation Expectation Chart 5: 10 Yr Government Bond Yields

US

EU

Japan

US

EU

Japan

Source: Bloomberg, as of December 2014 Source: Bloomberg, as of December 2014

The consensus is for inflation expectations to continue to remain low as a litany of deflationary headwinds, cyclical and structural, keep downward pressure on prices and wages. Stronger USD, falling commodity prices, a global savings glut, low capacity utilisation, high unemployment, and the increasing use of robotics have all in some way contributed to the deflationary pulse surging through markets.

The Flipside: What if inflation is not dead? The unrelenting move lower in government bond yields (Chart 2) suggests the market views inflation as dormant. However we believe there are two possible reasons to be concerned about inflation moving higher – wages and the Fed. Wages have been subdued, particularly in real terms, for a considerable period of time. This has led to the share to labour falling for the past 30 years. As you can see in Chart 6, it appears to be bottoming at just above 42% of GDP in the US. This has led to record margin expansion for many companies in the US, helping to fuel the earnings growth for US equities. Margins appear to be topping out in the US, supporting the idea that returns to labour may be reaching a low point.

Chart 6: US Returns to Labour as %GDP

Source: Federal Reserve Economic Database, as of 31 December 2014

Wage numbers in the US are starting to surprise on the upside, albeit at the margin – real wage growth is still low. But the bright spot is in the expectations for wage growth in small businesses. A look at the NFIB Small Business Survey show Compensation Plans continuing to rise as shown in Chart 7 below. This has historically been a useful lead indicator in suggesting broader wage gains are in the pipeline.

Chart 7: US Wages

Source: Bloomberg, December 2014

Given the state of commodity prices and traded goods prices it is difficult to argue a case for goods inflation. But wages are showing signs of life having been subdued for a number of years. The current trend in wages is up and if they accelerate from here, inflation may not be as dead as the market anticipates.

Theme 3: Desynchronisation of monetary policy

Consensus expectation: Desynchronisation of monetary policy is likely to be a key driver of asset class performance in 2015. The Federal Reserve and the Bank of England are expected to hike rates while the Bank of Japan and the European Central Bank are expected to engage in further monetary easing. This expected divergence in monetary policy is being used as a key reason in support of a range of views expressed in investor portfolios. These views include some that are near consensus such as that of a stronger USD vs. the Euro and Japanese yen and also others that have gained considerable support recently even if they are not yet consensus, such as an upgrading of European equities vs. US equities despite little evidence yet of a turnaround in either economic growth or corporate profits in Europe. The Flipside: This expected divergence may not materialize for three reasons: one that is obvious, another that sounds just as controversial as it is rational and yet another that frankly borders on the conspiratorial. The obvious first reason is that the Fed has repeatedly said that policy will be data dependent. A slowdown in US growth could well keep the Fed on hold till the end of next year. In which case, 2015 will be a year of monetary policy convergence rather than divergence as the Fed and the BoJ do more of the same and the ECB joins the fray. As the chart below shows, an expanding ECB balance sheet that plays catch up with an expanding BoJ balance sheet and an already much expanded Fed balance sheet will make monetary policy appear far more in sync than it was all of this year.

Chart 8: Central Bank Balance Sheets (Local currency, Scaled to May 2006 = 100)

Source: Bloomberg, as of 31 December 2014

The second reason is controversial as no one wants to mention ‘currency wars’. However the JPY may have now weakened to a level where nothing is off the table any more for Japan’s key trade competitors. On a trade weighted basis the JPY is 40% below its level at the start of 2000 while the Chinese Renminbi has gained 40% since. Further it is also over 30% weaker relative to both the Korean Won and the Taiwan dollar over that period on a trade weighted basis. Korea is already feeling the pain from a weaker Euro and is in much need of an export revival given slower growth at home. China needs a pickup in exports to avoid a hard landing domestically. Korea and China have both lowered rates over the last few months. Hence, for Japan it will be harder to keep the foot on the monetary pedal when faced with the risk of a full-fledged currency war with its neighbours at a time when geopolitical tensions are already rather elevated.

Chart 9: Real Trade Weighted Exchange Rates

Source: Bloomberg, as of 31 December 2014

Staying with Japan, there is also a benign scenario which could prompt it to change its course of monetary policy sooner than anyone expects – success with implementation of reforms post-elections. The last risk to the monetary policy divergence theme comes from certain conspiracy theories that point to deep splits within the ECB’s governing council. Some even suggest that Mr. Mario Draghi, the President of the ECB and the largest advocate of doing whatever it takes to get the monetary juices flowing, might be planning to resign from the ECB early next year to return to his native Italy. This might still be a story better suited for conspiracy blogs but is worth paying attention to just for the fragility it points to within the broader decision making framework within European policy. With or without Mr. Draghi though, Europe will still struggle to get the political consensus required for the ECB to conduct sovereign asset purchases of the scale needed to achieve their targeted balance sheet expansion. The increase in support for euroskeptic right wing parties in the European parliament since 2009 (chart below) certainly points to the many challenges ahead. Chart 10: European Political Party Support

Source: Electionista, as of 31 December 2014

China

India

Theme 4: Buy India, Sell China

Consensus expectations: Admittedly sentiment around China is now much improved compared to a year ago. However India is the market that most investors are looking to deliver in 2015, for instance see chart below on investor positioning in the two markets at end of November which shows benchmarked global emerging market funds carrying a 3% overweight position in India vs. a -2% underweight in China.

Chart 11: Equity positioning in India and China

Source: MSCI, Datastream, as of 31 December 2014

The good news has just kept on coming for India bulls since the general elections in May this year. First there was the belief that India’s stalled reform agenda would get kick-started again by the implementation focused incoming Prime Minister Mr. Narendra Modi. Then India received another double bonanza in the form of falling commodity and oil prices. Both serve to help it balance its stubbornly high and persistent current account and budget deficits, reduce inflation, stabilize the currency and open the door to easing of real rates that would further stimulate growth. On the other hand China headlines continue to remain dogged by concerns around a potential hard landing due to further property price corrections, potential destabilization of the credit markets triggered by a deflating credit bubble and the headwinds to domestic consumption growth from ongoing reforms and to export recovery from a generally weak global trade and growth environment. The Flipside: Indian equities have outperformed HK-listed Chinese equities by 20% in 2014. How much of the above story is in the price and how much more outperformance can we reasonably expect in 2015? We look at relative valuations as a guide. As you can see from the chart below, these overwhelmingly point in favour of China.

Chart 12: India vs. China – Relative Price to Earnings Ratio

Chart 13: India vs. China – Relative Price to Book Ratio

Source: MSCI, Bloomberg, as of 31 December 2014

Source: MSCI, Bloomberg, as of 31 December 2014

However valuations are a crude gauge at the best of times. In order for China to re-rate we must be able to point to a catalyst. One that is becoming quite obvious is the willingness and ability of the leadership to do real reforms. While much has been promised in India, much reform has already been accomplished within China, and with good visibility on what more could be implemented in the near term:

a) Fiscal reform: The NPC Standing Committee passed the budget law revision in August 2013 which

formally allows local government bond issuance. This directly addresses the systemic risks emanating

from burgeoning local government debt. Further fiscal reform measures likely to be passed in 2015

include extension of sales tax to all services sectors, reform of consumption tax to boost local

government revenue and the introduction of property ownership tax

Mean

1 Std Dev

Expensive

Cheap

Mean

1 Std Dev

Expensive

Cheap

b) State owned Enterprises (SoE) reform: Central and local government enterprises are rapidly moving

toward diversifying their ownership with details expected in the guidelines from SASAC (State Asset

Administration) in 2015

c) Rural land reform/Hukou reform: The potential wealth effect from rural land reform and hukou reform

could be a significant driver of medium term growth. With the general principles around these reforms

currently under active discussion, 2015 could see the implementation of several localized policies as a

test bed before wider application

d) Capital markets reform: The government has continued with interest rate reform and will soon establish

deposit insurance. The deposit rate ceiling was raised from 1.1x to 1.2x as a means to further achieve

a more market driven setting of rates. The Shanghai-Hong Kong stock connect program is a key step

to gradually open up its capital markets and internationalize the renminbi as a reserve and trade

currency

In comparison, reforms in India will be harder going:

a) Energy reforms: The government wants to enable commercial mining of coal as a key measure to

address the acute power shortage across the country. However tackling the unions that are opposed to

the introduction of such a bill will be no mean feat. Further power distribution reforms can only be

undertaken by state governments and hence progress on that front will be slow at best

b) Land acquisition: The Modi government is proposing to make land acquisition easier to accelerate

project development. However that needs the passage of a bill to reduce the consent requirement to

50% of land owners from the 70 -80% required currently.

c) Banking reforms: Structural reforms within the Banking sector are already seen as unlikely as they

need legislative changes that are not seen as the highest priorities at present

d) GST implementation: The governments own expectation has set a target date of 1 April 2016 for GST

implementation but even that may be aggressive given the complexity associated

e) Railways: Expectations around meaningful reforms have already started diminishing

2014 was all about India equities outperforming China. But valuations are now becoming stretched and the

reform agenda is significantly more advanced in China than India. The risks are growing that the consensus

call for India to outperform China in 2015 may be challenged.

Theme 5: Africa Unloved Consensus Expectations: Investors have shunned Africa in the second half of 2014. The fluid political situation of the North, the impact of falling commodity prices on the largest economies revenues and the Ebola outbreak in the West have all contributed to Africa performing poorly over the last 6 months. Expectations are for the ‘Dark continent’ to remain under pressure.

Chart 14: Equity Index Performance

Flipside: From an investment perspective African equities have two major positives – they are not as commodity dependent as first thought and they have a low correlation to other equity markets, even EM equities. A look at the sectoral breakdown of African equities shows it is not skewed toward Energy (5%) and Materials (9%) but more toward Financials (53%), Telcos (11%) and Consumer Staples (18%) (Bloomberg, December 2014). These sectors will benefit substantially as the African working age population swells over the next decade. Ernst & Young have suggested the African ‘middle class’ already exceeds the Indian ‘middle class’ and with 45% of the population under 15 years old, this dynamic will only strengthen. African equities also demonstrate a low correlation to other equity markets as shown on the chart below. With the IMF expecting growth in Africa to remain around 5-7% for the next few years, equities offer a path to accessing this growth in a diversified manner.

Source: Bloomberg, December 2014

Chart 15: African equity correlations

Source: MSCI, December 2014

The other often overlooked tailwind for African equities is the advances that have been made in infrastructure and technology. Africa is currently experiencing an infrastructure boom. Between 2001 and 2012, FDI has increased nearly fivefold (see chart 16). While FDI flows have slowed in some parts of the world, FDI in Africa continues to gather pace. Chart 16: Sub-Saharan Africa Foreign Direct Investment

Source: United Nations Conference on Trade and Development, Bilateral FDI Statistics, 2014. “FDI flows” refer to each Partner Country’s “FDI flows abroad” to countries in SSA from 2001-2012. “FDI stock” refers to each Partner Country’s “FDI stock abroad” to countries in SSA in 2001 and 2012. See UNCTAD for its definition of these terms.

Improved productivity through infrastructure and technology, demographic tailwinds and a diversified exposure suggest the consensus expectations for African equities to fall with commodities may be too pessimistic. This may not be a story for 2015 but the structural tailwinds are growing for African equities to shed some light in the ‘Dark continent’.

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