Frontier’s Capital Markets and Asset Allocation Team International Research Trip Insights. ABN: 21 074 287 406 l AFS Licence No. 241266
What the trip entailed • We conduct this trip annually, at around the same time each year • Meetings were held in New York, Washington, Paris, Frankfurt, Berlin, London and Hong Kong with a range of economic, policy and industry representatives including: − Central banks (France, Germany, England) − Treasuries (UK, Germany) − Supra-national bodies – International Monetary Fund, World Bank − Industry bodies (banking and broad-based industry) − Political and policy analysts − Government officials and politicians − Economic and financial market research organisations/institutes − Fund managers (top-down macroeconomic styled managers in London and New York) − Broking strategists/economists/quantitative analysts • We also attended a conference in Hong Kong which included sessions addressed by Asian central bank representatives, policy makers and industry representatives 1
Key themes • Global disinflationary/deflationary forces − The impact of a broadly-based global growth slowdown − Continued slow growth recovery • Long term “equilibrium” real and nominal interest rates − The impact of leverage and demographics • Eurozone Issues − Impact of ECB QE and the importance of keeping Greece in the Euro • Key macroeconomic themes − US economy − Oil − Market factors − Portfolio strategy issues 2
Key conclusions • The unanimous consensus that global inflation and growth will remain muted − This is a universal re- evaluation (“capitulation”) − This suggests that any change to this view would cause significant ructions in market pricing − Relatively limited liquidity in interest rate markets suggests a change in view would cause significant volatility − But for now, the ECB’s QE policy is dragging global rates lower • Long term “equilibrium” interest rates and global growth potential are expected to be lower − The impact of leverage and demographics • Greece will not be forced out of the Euro currency system − Due to geopolitical considerations • Global policy conditions remain overwhelming growth-supportive − This remains a generally positive environment for growth asset markets − But long term prospective returns are likely to be lower reflecting secular forces • Key uncertainties − Why has productivity (and growth) and capex growth been weaker than expected? − Why haven’t improvements in labour markets (in the US and UK) not led to wage increases? − Why have inflation forecasts been serially downgraded? 3
Compared with last year’s trip – what’s different, what’s the same? • What’s different: − Investor positioning with regard to sovereign bond duration • Accompanying investor expectations about growth and inflation prospects − European (ECB) policy as important (maybe more so than Fed policy) in driving asset class performance • Less focus on Japanese Abenomics too − Policy settings are more accommodative (policy rates are lower) • Inflation lower (oil) and growth continually undershooting expectations • What’s the same − Global central bank policy still the key driver of asset class performances • And likely to pause as long as possible before tightening conditions − Global capex spending still underperforming − Investors are still waiting for convincing signs of global growth recovery − Fiscal deficits causing less angst − Growth assets still likely to outperform − Chinese economic “rebalancing” ongoing and success still unknown 4
Global disinflationary/deflationary forces • All investors seem to agree on the overwhelming global disinflationary/deflationary forces − Most bond investors are now square (some even long) on international fixed interest duration (all were short duration last year) − Inflationary pressures seem to be consistently surprising on the downside globally − Investors and central banks see relatively small likelihood of inflation surprise • Asset price inflation seen as more likely • This is the biggest area of investor agreement, closely followed by bullishness on the USD − Therefore both areas are where consensus could be most wrong − A faster-than-expected rise in inflation expectations (and interest rates) is the overwhelmingly key risk • Simultaneous global growth slowdown • Inflation-hedging assets have de-rated relative to disinflation-loving assets • Yield is more prized than it was last year, and last year it was already the only game in town • A deterioration in liquidity (given current Central Bank attempts to supply liquidity) would also be a big shock • Deleveraging hasn’t really occurred given the increase in government debt − Potential for growth upside where deleveraging has occurred, but still a substantial drag elsewhere 5
US sovereign yield components suggest low nominal growth Breakdown of UST10Y yield % 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 Breakeven Rate Nominal Yield Real Yield Source: Bloomberg, Frontier • Nominal US sovereign bond yields appear unsustainably low − The fall in yields to current levels has been driven in recent years primarily by a decline in growth expectations (real yields). More recently, lower oil prices have caused inflation expectations to move very slightly lower − Real yields still look unsustainably low − In sum, nominal growth expectations appear very low 6
US forward rates 10Y10Y yield vs subsequent UST10Y yield US 10Y10Y nominal rates 5.0 9.0% The purple line shows what the market is pricing UST10Y yields to 1.4 The purple line shows what the market was pricing UST10Y yields 8.0% be in 10 years’ time. The shaded grey region shows the difference to be in 10 years time. The orange line shows that the actual 4.5 1.2 between this forward yield and the current UST10Y yield UST10Y yield turned out to be 10 years later 7.0% 4.0 1.0 6.0% 0.8 3.5 5.0% 0.6 3.0 4.0% 0.4 3.0% 2.5 0.2 2.0% 2.0 0.0 1.0% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 14 14 14 14 14 14 14 14 14 14 14 14 15 15 15 15 10Y Change in 10Y Yield (RHS) 10Y10Y 10Y10Y Actual UST10Y 10 Years Later Source: DataStream, Frontier Source: DataStream, Frontier • Market-implied forward rates for US government bonds have continued to fall, in line with expectations for a lower for longer official policy rate • However, previous experience suggests there may be an element of “anchoring bias” at play − Until this episode, historical forward rates consistently overestimated future bond yields − The opposite may now be occurring 7
Leverage has increased post the GFC • In a typical business cycle, it takes Change in Debt/GDP ratio, 2007-2014 approximately 7 years for a country to de-lever • However, post the Global Financial Crisis, most countries have increased rather than reduced debt Source: Amundi 8
Continued increase in global liquidity Aggregate balance sheets of BoJ, ECB, Fed and BofE (USD trillion) Source: Commerzbank • The stimulus impact of QE operations continues to rise − Driving yield-seeking and rising asset prices 9
Economic growth among OCED countries has slowed down significantly OECD Real GDP growth (10 year moving average) 4.0 3.5 3.0 (Percent) 2.5 2.0 1.5 1.0 Source: DataStream/Frontier • Post the GFC, economic growth has slowed down simultaneously across most OECD countries − This is significant, as in most business cycles, usually only a few countries are affected while overall global growth generally remains robust 10
Sub-par recovery continues • Continued very slow global growth recovery − Output across DM and EM economies remains much lower than was expected in 2008, just before the onset of the global financial crisis, and its growth path has also been lower − Medium-term (five-year-ahead) growth expectations have been steadily revised downward since 2011 for both − Impact of leverage in the system • Due to the subdued performance of “total factor productivity” (TFP) − TFP peaked ahead of the GFC (in 2003). Subsequent decline seems to reflect the waning of the exceptional growth effects of information and communications technology and a shift of resources away from sectors with high productivity • This decline may have spilled over from the US to other advanced economies − Softer employment growth (demographics, structural unemployment, participation rate) − Lack of capex recovery • The collapse in economic activity during the global financial crisis, and the long and deep recession following • Financial factors are also an important transmission channel • Less advantageous financing terms and tighter lending standards • Risks and uncertainty about expected returns have tended to increase • Investment-to-capital ratios remain depressed for longer after large shocks • Increasing structural unemployment, a persistent or even a permanent reduction in participation rates Source: IMF World Economic Outlook April 2015 11
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