2015 Economic OutlookStill too early to call an end to the global economic expansion
- Alongside a strengthening US economy, there remains plenty of room for growth to bounce back in Japan (after slipping into recession in 3Q 14) and in Europe (which posted a marginal quarterly expansion in 3Q 14); growth engines in both Japan and Europe have spluttered for much of 2014, and 2015 is likely to be a year of recovery for both economies. In addition, China’s multiyear rebalancing act has brought growth to the 7% range, a more sustainable level and down from the double digit growth rates seen prior to the Global Financial Crisis, entailing a stabilisation of growth rates for Asia.
- Divergent rates of economic growth globally also means the risk of synchronised “overheating” is considerably low; receding global inflationary pressures suggests that the process of interest rate normalisation in the US could be a little slower than anticipated, while the fragile growth environment in a large part of the developed world means looser monetary policy for longer. With these factors in mind, we think that it is premature to call an end to the current global economic expansion, with both developed and developing economies geared for more growth in 2015 – we expect to see economic expansion continue well into 2015 and beyond that, albeit at varying paces for different regions. 2014 global GDP remains on track for 2.47% growth, up from 2.18% in 2013; growth is seen accelerating to 2.93% and 3.12% in 2015 and 2016.
- Growth in Europe has disappointed in 2014, but a low base for capital expenditures and improving household spending should see the region avoid slipping back into recession after a near-scare in 2Q 14. Also, the ECB remains highly accommodative, while fairly positive bank stress tests results should quell banking sector concerns, which could finally give anaemic credit growth a boost.
- While the consensus largely expects rate hikes from the US Fed in mid-2015, an environment of sub-par global growth coupled with muted inflationary risks (thanks to the decline in commodity and energy prices) means the Fed may not be in a hurry to raise rates. An initial interest rate hike in 2015 is widely expected of the Fed, but this would probably be more symbolic (marking the start of a gradual return to normalisation), with subsequent rate hikes likely to be measured carefully against both US economic progress and the global economic environment. Lower energy prices may even provide a boost to personal consumption expenditures, as real discretionary incomes rise, a positive for economic growth in consumption – dominated economies like the US. For economies like Europe and Japan, price declines remain a risk, although their respective central banks have already committed to asset purchases to quell deflationary risks in both markets.
Investment ThemesDisappointing earnings forecasts to reverse course
- Outside of the US and Japan, earnings momentum has been fairly weak across various markets in 2014. Asia ex-Japan equities have seen earnings downgrades since 2011, with 2014 marking a fourth consecutive year where corporate profits have come in weaker than initially-expected. This has also coincided with a period of weakness in Asian/Chinese GDP estimates; with the region's economic growth forecasts stabilising, we believe that the Asia ex-Japan earnings revision cycle will finally be on the mend.
- With returns for developed markets like the US, Europe and Japan over the past few years outpacing the rate of earnings growth, valuations have already normalised to fair levels, which means stock markets will require earnings to continue growing to post a reasonable rate of return for investors. As in our outlook for 2014, investors looking for strong double digit returns in 2015 from a well-diversified portfolio of global equities (with a fairly large allocation to developed markets) may be disappointed, with stock returns expected to track earnings growth much more closely going forward. In the fixed income space, historically-low yields mean return expectations are low, although stabilising risk-free rates mean investors could see decent returns from credit spreads, like in the case of high yield debt, Asian bonds as well as Emerging Market debt.
- Following strong returns for both stock and bond markets over the past few years, investors have gravitated towards passively-managed investments, with Morningstar data suggesting that passive mutual funds in the US have taken a 75% share of net flows over the past year (ending September 2014). With bond yields at historically-low levels and selected equity markets trading at or near all-time highs, we think actively-managed investments are more appropriate, with active stock-pickers able to shun more expensive stocks in favour of more attractive ones, while interest rate uncertainty coupled with historically-low rates means credit selection, currency expertise and a more flexible positioning should aid in driving fixed income strategy returns to a greater degree going forward.
- Commodity prices and the USD have become increasingly negatively-correlated in recent years, with the recent strength in the USD coinciding with the lowest commodity prices since early-2009. Commodity prices have declined -50.5% from their 2008 all-time highs (as of end-October 2014), and with the consensus already expecting a stronger USD, it may appear that commodity prices could remain under pressure going forward.
- However, investors should note that just like forecasting currency movements, guessing which way commodity prices are likely to move is an incredibly difficult art; we refrain from doing both, and would prefer to focus on the positives of lower current commodity and energy prices - this should boost consumer spending and ease budget and fiscal deficits for countries which have significant fuel subsidies and substantial energy imports. Just as importantly, we would caution against mounting expectations of an ever-strengthening USD – the currency has already posted strong appreciation in 2H 14 while selected Asian and EM currencies are already trading at multi-year lows against the greenback.
- As a part of the commodities basket, gold prices have declined nearly -40% since their 2011 peak on easing inflationary concerns and diminishing investor risk aversion. Having highlighted our cautious stance on gold in our 2011 outlook, we have reiterated that view over the past 4 years and have also maintained that rising interest rates are likely to pose headwinds for gold prices, given the higher opportunity cost of gold ownership (given its lack of yield and holding costs). Just as identifying the peak of an asset price bubble is near-impossible, accurately pinpointing the bottom for gold prices is not something within our expertise. For 2015, higher US rates are likely to present continued headwinds for gold, although supply could be curbed somewhat as gold prices fluctuate below the marginal cost of production for selected gold mining companies. However, lower energy costs may help to bring down the cost of gold production, which could see more downside risks for gold in 2015.
What should investors do?Overweight equities vis-à-vis bonds
- For a seventh year in a row, we think investors should favour equities over bonds. Our preference for equities is predicated on continued earnings growth amidst fairly modest inflation and generally accommodative monetary policy which should be supportive of economic growth.
- Bond yields still remain near historical lows, an indication of the low expected returns which characterise the asset class. With interest rates yet to normalise, we think that it is still too early in the cycle to turn positive on fixed income, despite low anticipated inflationary risk.
- Admittedly, valuations for selected developed markets have normalised, although we expect earnings growth to drive the majority of returns for these equity markets; cheaper EM and Asian equity markets may provide heftier gains as their valuations mean-revert.
- Corporate earnings disappointments have been a feature of Asian equity markets since 2011, which has weighed on stock performance in the region . The stabilisation in China/Asian GDP growth alongside marginal improvements in developed market growth rates should promote a recovery in Asian earnings and forecasts; 2015 could finally be a year of upward-revisions for Asian earnings
- With a 5.4% total return (in USD terms, as of 17 November 2014), Asia ex-Japan equities have kept pace with global equities so far in 2014, although tepid gains are reflective of the disappointing earnings growth the region’s stocks are expected to deliver in 2014 (presently running at about 3%). Nevertheless, at just 12.7X 2014 earnings, Asian equities remain undervalued at this juncture, and we believe that a recovery in the earnings revisions cycle for Asia ex-Japan equities will be a key catalyst for Asian equity valuations to mean-revert higher. A normalisation to 14.5X PE would see the market deliver a 21% annualised return by end-2016 (or nearly 50% upside on a cumulative basis, including dividends).
- Our forecasted returns for developed markets like the US and Europe have fallen in 2014 on higher valuations, which has seen us lower our ratings on both markets to “neutral” in mid-2014. Despite the lower potential upside for both markets, we still expect both markets to deliver fairly reasonable (single-digit) returns for investors, in line with the pace of earnings growth in the absence of valuation gains. Also, both markets remain home to some of the largest companies which have global businesses with operations spanning across the world, allowing them to benefit from growth outside of their respective regions while diversifying revenue and profits geographically. We continue to advocate an allocation to developed markets for portfolio diversification purposes, with the expectation that 2015 should be another year of positive earnings growth for developed market companies.
- We had perhaps called for a rebound in China a little too early, as the world's second largest economy remains in a transitory stage of "rebalancing" from a more export/investment-driven economy towards a consumption-led economy. From a peak of 14.2% GDP growth in 2007, China's economy has moderated to 7.3% growth in 3Q 14, while the consensus has now adjusted down 2015 and 2016 estimates to a 7% rate. Such a drastic moderation in growth rates alongside the ongoing anti-corruption crackdown has had profound effects on the corporate sector; like Asian earnings, China's corporate earnings have been on a trend of disappointment in recent years.
- Critically, the pace of earnings downgrades for China equities has slowed in 2014 alongside a moderation in GDP forecasts, which sets the stage for 2015 to be a year of outperformance for the China equity market. Valuations remain very undemanding at this juncture; China equities trade at just 9.2X 2014 earnings (as of 17 November 2014), a long distance away from the 13X fair PE we attribute to the market. On our estimates, the China equity market is on track to deliver a 33.6% annualised return by end-2016, driven primarily by an expansion of the market’s PE ratio.
- With a 24.7% year-to-date return (in THB terms, including dividends as of 17 November 2014), Thailand has certainly surprised us with its strong performance in 2014. These returns have come on the back of a military coup (the first since the 2006 coup d'état) in May, while both GDP and corporate earnings forecasts have headed south since mid-2013 (see Update on Thailand: Looking Beyond the Coup D'état) – the country's 2014 GDP growth forecast was revised down from a high of 5.3% to just 1.5% presently, while earnings for 2014 and 2015 have been lowered by -14.2% and -10.8% year-to-date (as of 17 November 2014).
- With economic growth and earnings revisions trending downwards while the stock market trends higher, there appears to be a disconnect between investor sentiment and reality, which has (in our opinion, unjustifiably) sent valuations for the Thai equity market higher so far in 2014. At 16.5X 2014 earnings, we think the market is now priced to deliver disappointing returns for investors and would suggest that investors underweight the market in their portfolios.
- Despite our suggestion to underweight fixed income, we maintain that fixed income remains an integral and relevant part of an investor's portfolio. While uncertainty surrounds the actual timing of Fed rate hikes in 2015, we expect muted inflation to contribute to a more gradual rate hike cycle, which could contribute to more stability in bond yields in 2015.
- Nevertheless, yields on safer fixed income instruments like G7 sovereign bonds remain unattractive at this juncture (and are also expected to be hurt more should the Fed hike rates quicker-than-anticipated). In the current environment, we prefer High Yield bonds, which now sport a fairly attractive spread over similar maturity Treasuries (the spreads have widened since our cautious note on the sector early this year. Asian and EM debt have had a decent run in 2014, but still sport rather decent spread levels over risk-free securities, while Asian High Yield bonds still offer some of the highest potential returns in fixed income today, albeit with higher credit risk.
- For investors seeking lower risk alternatives in fixed income, we think our long-standing preference for short duration bond funds still makes sense, despite the asset class now becoming a consensus favourite. While we expect a gradual hike in rates in 2015, longer duration risk-free bond yields still offer little in terms of an additional yield to offset the possibility that rates may rise quicker-than-anticipated, making the short duration space a far more desirable fixed income segment to be in.
- Investors may feel that commodity-related equities are cheap at this juncture; as an example, gold miners in the NYSE Acra Exchange Gold BUGS index have declined -73% from their 2011 highs, and presently trade at a PB ratio of just 0.77X (as of 17 November 2014), down significantly from a PB ratio of 4X back in 2006. However, pricing commodity companies remains difficult given the inability to forecast commodity price changes; unless investors have a strong conviction on the future direction in commodity prices, it can be difficult to assess the attractiveness of these companies.
- This is also evident in our view on Russia, which has been hammered by EU and US sanctions following Putin's "exploits" in Ukraine. A weaker rouble has hurt returns for investors so far in 2014, although Russian exporters are likely to benefit from rouble depreciation. At a PE ratio of just 4.9X 2014 estimated earnings, the Russian market is one of the cheapest markets anywhere in the world. However, Materials and Energy companies have a fairly large representation within the Russian index, which adds significantly to the uncertainty in Russian corporate earnings forecasts; we have thus elected to keep our 4.0 star "very attractive" rating on the market as opposed to upgrading the market on performance weakness.