We continue to be bullish on developed world versus emerging market equities, a view we have held for nearly three years.
We have reversed our trans-Atlantic relative value play, and are now bullish eurozone versus US equities. This is a relative view, rather than a negative view on US equities.
Rising US yields - which are justified by the fundamentals, in our opinion - risk further destabilising fixed income markets globally. Though some local markets may have overshot to the downside, w e remain bearish global bond markets in general.
The US dollar bottomed in 2011 and is set to continue appreciating over the coming years . Although the euro and sterling have been resilient, further EM currency sell-offs look likely.
Macro Outlook: The shrinking differential between emerging and developed market growth continues to inform our global macro strategy . Our overall view is that while the US and eurozone are probably past the worst in their respective economic cycles, for emerging markets, the past decade of near-perfect conditions is over, and the next few years will prove to be much more challenging. This has major implications not just for global macro trends, but for our major asset class strategies, which include developed over emerging market equities, continued downside pressure on EM currencies, and higher interest rates in the developed world.
The key dynamic through which this is playing out in financial markets is the rise in real rates in the US. 10-year US Treasury yields have converged with nominal GDP growth for the first time since Q110, and the yield on 10-year Treasury Inflation Protected Securities nudged above the crucial 0% mark in June. These are signals that markets are increasingly pricing in a normalisation of economic growth, and mark a sharp reversal from the yield lows seen around the launch of QE3 in September 2012. So rather than focus on the potentially negative market impact of QE3 tapering (which we think is likely to come in September), we believe that this move higher in yields is a positive dynamic for the US - at least to the extent that optimism toward sustainable growth is rising.
For countries that have taken advantage of these unusually low yields for the past three years, the reversal of these conditions is negative. Low developed state yields have particularly helped em erging markets by keeping capital flows going to higher-yielding countries, encouraging credit growth and stimulating economic activity . The reverse of this is now happening. It is no coincidence that countries with the biggest external financing needs (India, Turkey, and South Africa, for example ) have had the sharpest market corrections in recent months. Countries coupled to the Chinese growth story via commodities and direct trade are also in trouble, but we have warned about this risk for years. There are increasing risks that the market sell-off could morph into a full-blown economic crisis, though we are not quite at that stage yet, and the relatively low level of net external debt compared with other major historical crises suggests that the risks of full-blown sovereign crises are limited to a few basket cases. Further macro pain for EM is ahead, however, and we continue to see the differential in growth between developed states and emerging markets shrinking over the next two years.
| Bottomed |
|US - 10 Year Treasury Yield (%) - Quarterly Chart|
Equities: Global stocks are likely to remain under pressure from the ongoing repricing of long-term yields. But beyond an immediate correction, stronger growth in developed states is likely to result in continued outperformance of equities over fixed income. Our three-year-old developed over emerging markets equity view remains very much in place.
Within the broader context of our developed over EM equities view, we have initiated a bullish eurozone versus US equities view. This is a reversal of our long-held and ultimately correct view that the US would outperform the eurozone, on both an equiti es and macro basis. The reversal of our view comes as improving economic data and favourable valuations suggest that eurozone equities are increasingly attractive from a risk-reward perspective. Q213 real GDP data suggest that the US growth advantage has potentially peaked. The eurozone appears to have exited recession in the same quarter, and o n a year-on-year basis, the differential in real GDP growth in the US's favour has dropped from 3.8pp in Q312 down to 2.1pp as of Q213. BMI sees the differential in growth at 2.3pp in 2013, dropping to 1. 9 pp in 2014 and 1. 1 pp in 2015. That suggests a gradual move back to relative growth conditions seen last in 2011, so this would hardly constitute a eurozone miracle. But it would be more consistent with a US to Eurozone MSCI ratio closer to the 14.0x that prevailed two years ago than to the current 17.3x.This suggests 20% upside o r more in the eurozone's favour over the coming quarters.
| Eurozone Set To Come Back |
|Spread Of US Minus Eurozone Manufacturing PMI And US Over Eurozone Equity Ratio|
As for EM stocks, most markets are a mess at present, though there has already been significant downside from the highs. A China stimulus-related bounce has failed to materialise, and several key markets are at or below significant support. For example, the MSCI Latin America index has broken below trend channel support, and we are now watching key support around 3,050, a sustained break of which could signal that a substantial correction is afoot. Our Asia team recently closed a bearish India/bullish China position, and remains concerned about stock markets that appear to be fundamentally overvalued and overstretched technically, such as the Philippines PSI and Thailand SETI, which could see sharp losses not unlike those experienced by Indonesia. The outlook is positive in some areas though: we see great potential in African stocks, especially in Kenya, and think that Polish small-cap stocks offer a way to play a recovery in German consumption.
Fixed Income: Faster growth in the developed world, leading to higher rates, keeps us wary of fixed income globally. We are especially wary of further upside moves in long-end yields, as short-end rates are likely to remain low for some time to come. Since inflation and jobs growth remain weak, policymakers will err on the side of caution and keep short-end rates low. While we are surprised at the speed and severity of the US bond market sell-off (we had expected a move to 2.75%-3.00% only toward the end of the year), we are less surprised that EM local debt markets have been repriced lower , having been outright bearish since mid-May .
| Real Yields Rising, Gold Falling |
|US - 10-Year TIPS Yield And Gold (US$/oz)|
T he long end of the yield curve has borne the brunt of the selling pressure , with the US 10-year Treasury yield looking as though it can move much higher ( our 3.0% upside target by end-201 3 may now prove to be too bullish ). We would not be worried until and unless USTs move through 25-year trendline support at around 3.50%, as this move would signal the end of the long-term secular downtrend in US interest rates. The way things are going, this scenario is becoming less and less far-fetched.
While yields have risen to the point of being potentially attractive in several EM countries after a sharp sell-off, FX and macro risks have also mounted, leaving us generally negative toward the asset class in general. There are some opportunities for differentiation, however - we maintain a bearish view on Brazilian 5-year credit default swap (CDS) , but think there could be a good entry point in Mexican local debt as government reforms come into play. When the chaos dies down, local bonds in Asia may present an attractive proposition, with real yields pushing up sharply in Indonesia, Malaysia, India and other countries -- but w e will continue to look for technical confirmation to seek out attractive entry points in the region's local debt instruments .
Currencies: Our overall view is that the dollar will continue to appreciate over a multi-year horizon . We see significant losses ahead for EM FX in particular, with other currencies such as the Australian dollar subject to many of the same downside forces. As for the euro, the eurozone's current account surplus and upturn in economic activity has put it on a fairly strong footing, particularly with capital retreating from the emerging world. While we continue to forecast EUR downside over the next five years versus the dollar, it appears to be rangebound between US$1.27-1.38/EUR for the time being.
Emerging markets that have benefited from foreign inflows to finance massive current account deficits are facing increasing pressure in the face of higher US yields and weaker domestic economic performance. The biggest worries are in countries that have seen credit booms in the past decade but which now face a choice between raising interest rates and slowing growth on the one hand, and a depreciating currency on the other . By way of confirmation, t he weakness in current account deficit currencies (INR, BRL, ZAR, TRY) has tracked UST yields closely. Though we see stability in these currencies after a major sell-off, a further spike in US yields would put these and other EM currencies under further pressure.
| Vulnerable And Weakening |
|US 10 Year Treasury Yield And EM Currencies (Rebased To May 22 = 100)|
With massive depreciation already having taken place in several EM countries, a bottom in these currencies may be near, but we are not yet convinced. We are tracking several of the most vulnerable currencies for a turning point, but we have not seen it yet. For example, the Turkish lira and Indian rupee continue to push to new all-time lows, and until central bank policy becomes clearer in both countries, it is difficult to go bullish on TRY and INR with confidence. We continue to expect the Brazilian real to remain an underperformer as economic activity continues to slow, and we are targeting a move to BRL2.4500/US$ over the coming months. Latin currencies in general remain vulnerable to weakening commodity prices, though we continue to believe that the Mexican peso remains a good long-term bet against a still-overvalued real .