Thursday, December 13th, 2018
Prior to the post-G20 weekend meeting, 2018 was tracking to be the worst year for investment returns in USD terms on record.
With just one month to complete, the chart below presents the unsavoury truth that returns right across the spectrum of asset markets have produced negative turns. Over 90% of USD asset classes have produced negative returns leaving large overseas institutional and pension funds with nowhere to hide this year.
From an Australian perspective, this widespread negative performance of mainly international asset classes has been offset by a weakening AUD. However, this benefit has recently been tested by burgeoning LNG export income leading to a sustained trade surplus. Further, the weekend trade truce announced by the US and China at the G20 Summit has buoyed risk asset markets including the AUD.
The above chart shows the extraordinary contrast between last years and this year’s returns. 2017 was an extraordinary year where virtually no asset class produced a negative return – indeed the best ever year over the last 100 years on this measure. A slightly weaker international bond market index was probably the worst asset class.
By contrast, 2018 is an awful year. Indeed, subject to a post-G20 and/or a Santa Clause equity market rally in December, this year will be the worst for US asset returns since 1920.
A closer look at some of the components is shown in the next chart which highlights the negative returns for equities, bonds, corporate credit, commodities and energy.
The chart below shows that US equities have so far this year outperformed the very weak international indices (see FTSE ex-US returns). In world indices, the US index represents some 60% of attribution due to its immense size (about US$24 trillion market capitalisation). In contrast, the smaller emerging market indices have been battered as trade tensions and a rising USD destabilises their economies.
The weakening world equity markets have reflected the reality of the economic growth position. Outside the US the synchronised growth of 2017 has now stalled. During the recent September quarter, we have seen negative economic growth recorded in the major economies of Japan, Germany and Italy.
Equity market analysts have begun to downgrade earnings expectations for 2019 as major economies slow and the trade dispute between the US and China intensified.
The chart below shows the eps sugar hit of US corporate tax cuts that are flowing in 2018. These were correctly anticipated by the lifting US equity market in 2017 – remember that the market constantly projects forward in pricing equities. However, the outlook for 2019 is now coming under sober reflection as world earnings growth (dominated by the US market) is forecast to slow.
In Australia we are seeing a similar adjustment to forecast earnings in FY19 as bank earnings stall, the residential building cycle corrects and slowing wages growth checks consumption. Concurrently a weaker commodity price cycle, emanating from China as it battles Donald Trump on trade, creates a further headwind. The downward adjustments to projected earnings have led the Australian market to -11% decline from its recent peak in September.
For Australian investors, particularly SMSFs, the above charts emphasise the importance of diversification in investment assets. Also, it is important to remember that world asset market indices have a low weighting to Australian direct property which has remained a solid performing asset in 2018.
Another significant observation from the above charts is that earnings growth can be offset by PER compression driven by higher bond yields and/or inflationary expectations. Thus, while earnings have and are expected to increase into 2019, equity markets have pulled back.
The interplay between earnings growth and PERs is shown in the next chart that decomposes the factors that deliver the performance of the US equity market. While eps growth is normally supportive for equity market performance it is not always so.
2018 is now looking very similar to 2011 when earnings growth was offset by PER contraction. Similar but less significant interplays can be observed in 2005 and 2007.
The decline in PERs is normally caused by higher bond yields. However, slowing earnings growth will also cause a downward price adjustment if earnings growth is well below the PER of the market. This is known as the PEG ratio for it compares PERs to earnings growth. A PEG ratio well above “one” is a heightened concern if bond yields are rising or are projected to rise.
To this point, the chart below is instructive as it compares the makeup of the debt of the US economy compared to the period at the onset of the GFC – ten years earlier.
It is interesting to observe that total debt as a percentage of US GDP has not risen since the GFC. It has remained at 330% of GDP which means that as the economy has grown by about 40% since 2007 so too has total debt. However, it is the composition of the debt that is more important in determining the outlook for US government bond yields and the pressures on PERs that will flow.
We can see that financial institution debt (bank balance sheet leverage) and thus household debt has declined as a percentage of GDP. US banks have reduced their leverage in their balance sheets by constraining asset growth and bolstering capital.
Meanwhile, corporate (non-financial) debt has grown faster than GDP suggesting increased borrowings funded from inside the US financial system – probably through the corporate bond market. This increased debt is indicative of heightened buyback and corporate activity. Major US multinationals tend to leave cash offshore (low tax income) and borrow in the US (low rates and tax deductible).
However, of paramount significance is the growing US government debt which has grown at twice the rate of GDP. Thus US government debt has grown from 50% to 100% of GDP over ten years and it will get worse in coming years due to the Tump Administration’s fiscal policy.
We expect that bond supply will exceed demand and bond prices will fall and yields rise. This is subject of course to the absence of monetary policy interference. For instance, a QE4 policy if introduced would again upset economic logic and we note that just last week the US Federal Reserve indicated that it may now slow the upward adjustment of interbank interest rates.
The Federal Reserve is ready to support the US Government should bond interest rates rise or the economy falter.￼
Today US Federal debt is estimated at US$21.7 trillion; it has grown by $2 trillion under the Trump Administration. In FY19 the US Administration will issue $1.3 trillion in new debt or twice the amount issued in FY18.
Our final chart tracks the yield journey of ten-year US bonds since the end of the GFC. The full US QE policy effectively ended in mid-2016 when US ten-year yields traded at 1.4% yield.
The retracing of yields back to 3% has been orderly in an era of low inflation. The process was well underway under President Obama as yields lifted above 2.5% in 2016.
However, the extraordinary rally in yields in 2017 stands out as nonsensical given Trump’s clearly stated growth policy through a massive fiscal deficit.
So where to from here for US bond markets and the risk-free rate of return?
The longer-term is more predictable than the shorter-term. Thus whilst we are confident that world bond yields are heading higher over the next two to three years, we cannot confidently predict that this will begin over the next 6 months.
The worlds bond markets have been destroyed by QE as a viable indicator of risk with ten-year yields below one per cent across major economies of Europe and Japan.
Therefore, it is best that we restrict our forecast to the long game. Consequently, we maintain a healthy weighting to assets that generate meaningful yield and have some leverage to growth or are floating rate securities. As for equity market growth, we remain attracted to smaller Australian companies and international exposures to emerging economies that will recover after the recent downturns.