Q3 Outlook: managing through the frustratingly slow recovery

On a dramatic day for UK, European, and the global financial markets, Eoin Fahy, Chief  Economist, takes a look at the Brexit issue and in particular at five 'Myths’, that have arisen about what happens next.

Myth 1: As the UK is now set to leave the European Union, governments will now move quickly to introduce border controls on trade between the UK and the EU.

Reality: The UK’s vote to leave the EU is the start – not the end - of the exit process. It is likely that it will be late 2018, at the earliest, before the UK could legally exit, and it could in fact be considerably later than that. The exit mechanism in European law states that once the UK formally informs the EU of its intention to leave, under the terms of Article 50 of the European Treaty, a two-year period of negotiations begins, at the end of which the UK would legally leave. This period could only be extended by unanimous agreement of all 28 countries involved.  However, there have been some suggestions that the UK might opt not to invoke this particular article of the Treaty, as it puts inconvenient time limits and restrictions on the exit process.  Instead it may start a more informal set of negotiations to facilitate the exit.

Either way, however, it is very clear that barriers to trade between the UK and the EU will not be in place in the immediate future.

Myth 2: The European Union is falling apart.

Reality: The Brexit vote is a real blow to the EU, but it cannot be said to be “falling apart”. The fact that one country has voted to leave should be seen in the context of the growth (not decline) of the number of countries in the EU in recent years. Prior to 1973, there were only six countries in the EU. That grew to 12 in 1986, 15 in 1995, 25 in 2004, 27 in 2007 and 28 in 2013. The departure of one country, even the UK which is the third-largest member with about 13% of the EU population, does not mean that the union is falling apart. This is perhaps especially the case for the UK, which has always been seen as somewhat “semi-detached” from the EU, with much less enthusiasm for the EU at official and general public level than in most other EU member states.

To be fair, while it’s wrong to say that the EU is falling apart, it is not impossible to make the case that the UK’s departure could (note could, not will) lead to further departures over the next few years. The EU is unpopular in some countries such as Denmark, and the Dutch electorate recently voted against an EU agreement with Ukraine in a sign, perhaps, of its disaffection with the EU. In Greece, to date the electorate appear to continue to favour EU membership notwithstanding the extreme difficulties there, but further austerity measures and social unrest could change that picture. And there is always the possibility that the UK will lead to populist parties in other countries organising similar referenda, potentially with similar results. But this does seem unlikely at this stage, and certainly not a “done deal”.

Myth 3: Brexit will inevitably lead to a recession in the UK, and probably in Europe as well.

Reality: There can be little doubt that Brexit is negative for the UK economy, as has already been stated by a myriad of independent institutions and economists, inside and outside the UK.  But we need to be careful not to confuse “slow growth” with “recession”. A recession is a possibility; there is no doubt about that, particularly if the UK’s exit is badly handled. A scenario where negotiations failed to achieve an agreement to allow reasonably tariff-free access to each other’s markets could lead to a recession if it had a very negative effect on trade. 

But it’s much more likely that the negative impact would be felt over several years, keeping growth to a much lower level than would otherwise have been the case, and could well push up the unemployment rate, perhaps.

Turning to the impact on the rest of Europe, the negative impact on trade, and business confidence, is most unlikely – in its own right – to be big enough to cause a recession. While trade with the UK is important, the UK is just not important enough to cause a recession for a trading bloc as large as the eurozone. 

That said, a recession in Europe is nonetheless possible (though not probable) as a result of a different channel, i.e. a repeat of the European sovereign debt crisis. One conceivable scenario is that investors become concerned that other countries will leave the EU and it will eventually break up completely. In that scenario, weaker countries could no longer expect financial support from wealthy countries like Germany, or from the European Central Bank, and so in an extreme case they might be forced to default on their debts. 

Bond yields for peripheral, high-debt countries like Portugal, Greece, Spain and Italy would soar, and the damage to business confidence, combined with an inevitable credit crunch, would cause a sharp recession in Europe.

This scenario is unlikely and certainly not our base forecast, however.

Myth 4: The result of the referendum means that the issue is now closed. The electorate has spoken and the UK will certainly now leave the EU.

Reality: While it is certainly very likely that the UK will leave, it is not a certainty. As mentioned above, it will probably be at least two years before the UK could legally leave the EU, which gives plenty of time for UK and European politicians to reach an agreement on revised terms for UK membership of the EU, allowing a second referendum to be held, this time – potentially - resulting in a vote to Remain in the EU. We should not forget that a substantial majority of the members of the UK Parliament are in favour of remaining in the EU – approximately half of the ruling Conservative Party, as well as the considerable majority of the various opposition parties.

That said, a reversal of the decision would not be easy to achieve. Outgoing Prime Minister David Cameron has explicitly said that another referendum is not a possibility, and he or any other politician trying to overturn the referendum result could be seen to be defying the vote of the people, so they would need to be able to argue that circumstances have changed so much that a second vote is necessary.  This is possible, but unlikely.

Myth 5: Protest parties now dominate European politics.

Reality: It is easy to look at the UK electorate’s vote to leave the EU, combined with the strong showing of many other protest/populist parties across Europe, and conclude that these protest parties are about to take power in Europe. But the facts say otherwise. In the most recent general or Presidential elections, most of these parties obtained support ranging from about 15% to 25%. In Spain, Podemos took 21% of the vote in its most recent general election, while the Five Star movement in Italy got 26%, Syriza in Greece reached 35%, Sinn Fein in Ireland took 14%, the National Front in France took 18%, and the UK Independence Party (UKIP) took 13%. The exception is Greece, where Syriza took about 35% of the votes (but due to an unusual voting system, came very close to forming a majority government). These vote shares show a high level of support, certainly, but far below majority status.

The bottom line: populist/protest parties are now an important political bloc in many European countries, but they certainly do not dominate parliaments and they seem unlikely to take power anywhere other than Greece.

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The early weeks of 2016 were dominated by a very nervous and negative market environment, with headlines at the time being dominated by talk of the potential for global recession and persistent fears about deflation. The quarter ended on a much more confident note, with risk assets including equities rallying strongly and confidence restored in the global economic recovery and the health of the corporate sector. This ‘tug-of-war’ between for example; growth or recession, inflation or deflation, rate rises or rate cuts is something we as investors are now well accustomed to. As for outlook, we at KBI remain in the ‘glass half full’ camp as we have done since the global economic and market recovery commenced after the 2008 global crisis. Market volatility remains a constant feature as do the supportive actions of central banks, which once again came to the fore during the second half of the quarter. As such the first quarter of 2016 in many ways was a quarter of two halves, finishing on a more upbeat note. I continue to see equity market dips as a buying opportunity.

The more recent Federal Reserve comments have moved to reassure markets that interest rates would not be raised excessively, quickly or without regard to financial market fragility, have provided this strong underpinning to markets.  Meanwhile, the European Central Bank measures to boost bank lending and growth, including an expansion of its bond-buying programme, is also a positive. The central banks I believe will continue to support slow but steady economic growth. This growth while positive is unlikely to be robust at any time soon as we work through debt and other global overhangs.

Equities

As stated above, I regard market setbacks as an opportunity and not a threat. We are not as yet calling an end to the bull market that commenced during 2009 and I believe we have more years to run. A global economic and earnings expansion (albeit modest), supports higher equity markets from here. Equity markets in aggregate remain fairly valued and attractive versus other competing asset classes. 

During the latter half of 2015 and at the beginning of 2016 I highlighted material dislocations within equity markets and felt strongly these couldn’t be sustained. I highlighted the following dislocations which concerned us:

• Growth stocks that were showing a significant outperformance over value stocks at magnitudes not seen since the early  2000s TMT levels.
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• I noted a major polarisation in relation to dividend yield, where for example in North America over the prior 15 months the lowest yielding quintile of stocks had outperformed the highest yielding quintile by in excess of 20%.

• Significant industry group performance divergences. For example healthcare (biotechnology) and IT significantly outperforming industrial sectors.
   
• The strong outperformance of Developed Markets over Emerging Markets.

These trends in all cases had resulted in major valuation gaps well beyond historic norms, which made us very uncomfortable.

At that point, I was anticipating a rotation from many of these extreme positions as I believed it would lead to a healthier overall stock market. Happily and interestingly there has been a relatively noticeable change in the first 5 months of 2016, with sector relative performance rotation; higher yield outperforming zero yielding stocks for example and a generally less defensive undertone helping value stocks and outperforming Emerging markets. We have also experienced a much better tone to commodity markets and to the surprise of many (not including us at KBI) a weakening dollar and some strength in Emerging market currencies. While the style shift year-to-date has been helpful, it has been modest from a mean reversion perspective, with potentially much more outperformance to be achieved from here I believe.

Fundamentals do always matter in the end and our concerns during 2016 was that in a risk-off/defensive mindset investors were almost investing for ‘growth at any cost’ and on the other side better valued companies or industries that were perceived as more pro-cyclical/less defensive were sold despite valuation. This is the big rotation I highlight year to date which can continue.

Meanwhile the corporate sector is in good health, with plenty of cash on its balance sheet and relatively little debt. A key driver for markets will be continued positive earnings growth over the next few quarters. I expect an increase in Merger and Acquisition activity, but also a focus on dividend yield and growth and other ways of returning cash to shareholders.

Bonds

Global government bond yields remain close to and increasingly in many cases below historic low levels.  A more confident world economy and increased inflation expectations over coming quarters should again not be positive for bond yields and I would expect yields to trend higher.

To conclude, I remain positive on the outlook for the global recovery and believe equities will continue to be beneficiaries of this. In contrast, while short term central bank behaviour is seen to underpin bond markets, I remain very bearish on a more medium term horizon.

Noel O’ Halloran, Chief Investment Officer 


KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. KBI Global Investors (North America) Ltd. is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd. is a majority-owned subsidiary of KBI Global Investors Dublin Ltd. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors (North America) Ltd, or any of its affiliates, (collectively, “KBI Global Investors”). The views expressed are those of KBI Global Investors and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such.  Opinions expressed herein are subject to change without notice.  

Noel O’Halloran, CIO of KBI Global Investors got off to a flying start as an aeronautical engineer. The scientific approach this experience engendered has paid off in his current role.  By Mark Battersby

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Where to from here...can equity markets keep going?
Despite the strong returns achieved last quarter, for euro investors in particular, I continue to take the ‘glass half full’ view and believe that equities can make further progress over the next 12 -18 months. It’s worth highlighting that in absolute valuation terms, equities are no longer cheap, as the MSCI World equity index is now on a P/E ratio (using 12 month trailing earnings) of 18 versus the 16.9 times historic average, and so equities are now above fair value relative to history. My core expectation from here is that further upward progress will be in line with earnings and dividend growth rather than by further P/E expansion. The slow-but-sure economic recovery we forecast will support this.

I could go further and highlight that there is perhaps a 20% chance that equities continue to perform strongly and continue to rerate even further upwards to a P/E of say 20. In a world where many major central banks continue to make strong efforts to boost growth (and inflation) through Quantitative Easing (QE) and other means, bountiful liquidity continues to flow into the financial system which can first drive asset prices strongly upwards, with the real economy responding with a lag. That abundant liquidity has already had a strong impact on government bond markets – with many eurozone government bonds yields being below zero for periods out to 5-7 years, or longer in some cases.

Those low bond yields, and very low deposit rates (negative in many cases) also support equities as they make bonds and deposits, the traditional alternatives to equities, extremely unattractive relative to equities, particularly equity strategies with appealing dividend yields of say 4%.

Where can it go wrong.....the key remains growth?

This equity bull market is now six years old and probably one of the few in history where investors have worried the whole way up. For me there are no signs of exuberance, such as we saw for example during the ‘TMT’ bubble of the early 2000s, as for every positive I can highlight, there can be a corresponding concern or worry.

For me THE key issues to watch will be:

1)   The US economy.  Growth in the US has been quite weak during the first months of 2015 with events such as severe weather being blamed. A rebound is expected by the markets and by most economists over coming quarters. If this does not happen, it would be a material unexpected negative as the US remains THE engine of the global recovery. This would have negative implications for the earnings and dividend growth I highlight above.

2)   Chinese growth. The Chinese government has been directing and managing a slowdown in their economy, towards or slightly below the 7% growth level. This has been achieved without any significant dislocations to markets or society. Any further significant slowdown from here to say 3 or 4% growth would be a significant negative for global equities

3)   The impact of ‘QE’ in Europe.  An obvious issue to watch is whether the ECB's QE programme will bear fruit. It's early days but there has been a more positive tone and indeed an economic pickup in Europe over recent months. A relapse would be provide a meaningful challenge and, at the least, a meaningful setback to equity markets. Greece will also remain in the European headlines

4)   Market breadth in the US.  While I remain generally relaxed, I am not relaxed with what I perceive to be quite a narrow and unhealthy US stock market. Over recent months in particular the market has been hitting new highs but led by a very narrow list of stocks in high-momentum, high-valuation sectors such as biotechnology and new-economy technology stocks. Large parts of the market aren't participating in these new highs. I would look to see the leadership in the market rotate and broaden out over coming quarters as if it doesn't, for me it would begin to echo the early 2000s market which would not be positive.

5)   Strange bond markets! To fundamentally rationalise bond yields at current yield levels is pretty impossible. The distortion created by central banks buying is seemingly very apparent. When I see for example that Danish home buyers now get paid by their bank to take out a mortgage or the Mexican government launches a 100 year bond denominated in Euros at a yield of just 4%, it’s not normal. Similarly when I was told that wealthy Swiss savers are now taking the money from their local Swiss bank account and lodging it in security company vaults and paying them 15 basis points per annum for the privilege because it’s cheaper than the negative rates the banks are paying, it’s certainly not normal! At some point just as with the TMT bubble, this bond bubble will burst. To pinpoint when or how is the difficult bit.

To conclude, despite strong returns to date, equities remain the asset class of choice against pretty much zero returns on cash and bond markets which are fundamentally unattractive in our scenario. From a macro perspective, the main change we expect to see over the next couple of months is confirmation of improved growth and activity in Europe, where a combination of the lower euro, much lower energy prices, and QE by the European Central Bank is expected to boost consumer and business spending, as well as exports.  Other economies are also expected to grow at a reasonable rate.  Globally, we expect to see further cuts in interest rates, particularly in Emerging Markets, but in contrast US interest rates are likely to rise (for the first time in many years) in the autumn.

Meanwhile the corporate sector is in good health, with plenty of cash on its balance sheet and relatively little debt.  We expect an increase in Merger and Acquisition activity, but also a focus on dividend growth and other ways of returning cash to shareholders.  Against this background in our portfolio construction we continue to emphasise stocks with strong cash flows, attractive balance sheets and strong and attractively positioned businesses. In a world of zero or negative cash rates, I expect equities with attractive and growing dividends to remain winners. 

Noel O'Halloran, Chief Investment Officer

During 2014 we recorded new highs for global equity indices as well as recording the sixth year in a row of positive returns from global equities. This was achieved despite many headline challenges be they geo-political or simply the ongoing challenges of the muddle through growth struggle for many of the world’s economies. From my general perspective, this constant ‘barrage of challenges’ to the recovery scenario was to be expected and has been a feature of the global equity recovery since March 2009. Global bond markets have also continued to hit new highs confounding all negative predictions (including yours truly) once again.

For 2015, I believe we can expect more of the same, albeit with more volatility than recent years. While the global equities have been in a bull market now for six years and is therefore quite mature, I don’t believe the bull market is over but do believe investors should expect more modest single digit returns for 2015. The lesson from recent years have been that while ‘hits’ have been many and frequent they are transient and eventually overcome by improving fundamentals and central banks that keep the recovery underpinned....so buy the equity dips!

Why more modest returns?

• The key reason is that equity valuations are no longer cheap and I believe that returns should be more in line with global earnings growth – which I expect to grow by 6%. Over recent years strong double digit returns were driven both by earnings growth and an upward revaluation of P/E multiples. Although this re-rating could continue, it’s not my central expectation. This also underpins my strong preference for high but sustainable dividend yields as a component of total return.
• Earnings themselves have become more dependent on top line growth as the impact of significant margin improvements over recent years lessens. In a muddle through growth environment for many economies, robust top line growth is not to be expected
• One key reason to expect higher bonds and equity volatility is that the Federal Reserve (Fed) will change course and commence raising US interest rates this year. The US itself has been a strong driver of the market and economic recovery and low US interest rates have underpinned this. We don’t expect the Fed will make a policy mistake but that’s not to say that markets won’t experience another one of their ‘transient wobbles’ when it happens

What will we be watching?

• Top of the list over the first quarter will be the euro (again). Click here to see our separate blog of Jan 7 for our views re same  
• The dramatic oil price fall of late has been a significant market feature. I expect the majority of the fall is now complete and my running assumption is that the oil price stabilises around current levels in a range, perhaps for a number of quarters
• Global central banks have remained the bedrock of the global recovery and while the Fed may change direction in 2015, I don’t expect the global central bank underpinning to change. While much negative energy will likely be expended worrying about the Fed, a corresponding positive may emerge in the form of the ECB embarking on a more radical quantitative easing programme, the Bank of Japan continuing to stimulate and many Emerging Market economies may surprise with more stimulative policies (both fiscal and monetary easing).

What could surprise?

• The markets to date have had a very nervous and negative reaction to the rapid oil price fall. They haven’t yet however put enough emphasis on the positive benefits of this fall.Over coming quarters, I expect we will see improved consumer spending, enhanced profitability in sectors such as transportation, and improved growth in countries (often Asian) which are large importers of oil. Lower inflation from lower oil prices will be written up as ‘deflationary’, but it is a benign deflation that actually benefits rather than hurts the beneficiaries. So while the damage to certain sectors such as oil stocks or countries such as Russia has been immediate, I think the beneficiaries haven’t yet been properly rewarded. Indeed, from our perspective many sectors with little direct exposure to oil have been severely overly-punished we would argue, and provide opportunity for investors.

• At a regional level, having been hit with many concerns over recent years, Emerging Markets are increasingly off the radar of global investors.  I feel that they are becoming a forgotten asset class. Against a background of attractive valuations, reasonable fundamentals and a real possibility of interest rate cuts, Emerging Markets could be a surprise winner for 2015.
   
• Another beaten up asset class for the contrarian investor to consider is broad commodity investments once more. They certainly could perform much better in an environment of increasing confidence surrounding global growth and a move to a more ‘risk-on’ environment. I’m not convinced at this point but perhaps one to revisit through the year.

To conclude, I believe that 2015 will be a positive year but one with more modest returns and with more volatility to be expected. Equities remain the asset class of choice against pretty much zero returns on cash and bond markets fundamentally unattractive in our scenario. Central banks will remain central actors on the stage, although their roles will change with the Fed likely to become more the ‘bad’ guy and the ECB and others to become increasingly centre stage. 

Noel O' Halloran, Chief Investment Officer