2014 Global Macro Outlook - Nov 2013

Sean Maher

Strategist

[email protected]

+ 44 207 687 2213

Nov 2013

Fed Switch From QE to Forward Guidance, as China Starts Belated

Deleveraging in 2014

mailto:[email protected]

Sean Maher

Given Scale of Fed Balance Sheet, Delaying Exit Much Longer Dangerous $3.9trn into GEM Debt and Equities Since Crisis, $2.2trn to Asia

Almost $2.4trn in Excess Bank Reserves at Fed – Over 60% of Balance Sheet by Year End

Q1 Economic & Strategy Outlook 2

Ma

rket

Ove

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• Global broad money M2 up $3trn YTD to end September (annualised 6% growth) of which

$2trn in GEM; global CPI inflation index up by only 2% - excess liquidity driving asset prices

• Late stage bull market? – watch for frenzied US momentum tech trades on 100-200x PERs

reversing (Tesla, Amazon, Netflix)

• PCE inflation well under 2%, real risk of delay is growing market dysfunction, disruptive credit

spread volatility - $4trn balance sheet makes Fed solvency questionable on normalization

- IMF estimates Fed losses in most likely rate normalization scenario would amount to

about 3% of GDP, or $500bn.

• 2% interest by 2015 on current excess reserves is $44bn annually i.e. slowing down money

velocity will be expensive once inflation expectations rise above 3% - interest payments plus

capital losses on LT bond holdings would require Fed recapitalisation, a huge political problem

• One strategy would be to reduce duration of bond portfolio with a ‘reverse Operation Twist’,

using the short-term bonds obtained to mop up excess reserves, much like the BOJ did in

2006 - average maturity on Fed balance sheet about 10 years – versus 6 years for overall

market.

• Blurring of lines between central banks and governments, led by Japan – shift globally to

Nominal GDP targeting? ECB and BOJ likely to ease further in 2014, to counter inflation

target undershoot - short JPY/Long Topix trade to resume in Q1

• Fed likely to shift to rules based forward guidance from QE as policy focus in early 2014,

to cap LT rate expectations while diminishing near-term asset bubble risks

Sean Maher

Markets Face Pivotal Moment by Mid 2014 – Does QE Work in Real Economy? US Credit Spreads at Post Crisis Lows, USD Biggest Loser from Debt Ceiling Scare

Gold Weakness Driven by ETF Liquidation, EM Demand Pressured from India to Turkey

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1050

1150

1250

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1450

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1850

1950

Junk/IG Spread At Lows, Gold Struggles

Gold Spot Price ($) (lhs) Junk/IG Yield Spread (bps) (rhs)

10

14

18

22

1.21.31.41.51.61.71.81.9

2

VIX Spike Reversed by QE For Longer

Barclays US Agg Credit Option Adjusted Spread % (lhs)

VIX Index (rhs)


Ma

cro

Ove

rvie

w

106

110

114

118

122

Will USD Strength Resume in 2014?

JPM Asian Dollar Index

0

5

10

15

20

ROE % EarningsReinvestment

Rate %

FCFReinvestment

Rate %

Sales Growth% (annualised)

S&P 500 Companies Boosting ROE Via Buybacks Rather than Capex

(4Q through Q2 13)

Sean Maher

Investor/Corporate Liquidity Preference Has Peaked –1990s Style Asset Bubbles? Technology Absorbing CPI Pressures by Suppressing Labour ULC as well as Investment Costs

YTD Equity Inflows Outpacing Bond for first time since 2007 ($350bn versus $170bn)

• Bubble risks advanced in corporate credit (esp. Europe), US social networking stocks, prime Asian real estate – US HY net leverage at 3.8x, over 10% above LY average

• Fed obsession with employment/output gap framework misguided – structural shifts in income distribution, demographics and employment intensity of growth being ignored

• Further equity re-rating above LT CAPE trend likely if liquidity preference declines further – US liquid assets rose from 9% to almost 13% of total household assets, now declining and flowing into markets, combined with excess global liquidity

• S&P 500 revenue growth running at just 3.5% annualised – yet consensus 15.4% operating EPS growth in 2014

• Market Cap./GDP at 1.12x, price/sales ratio at 1.6x, EV/sales 2.3x – latter only exceeded in 1999; margin debt over $400bn, testing July 2007 highs

4.0 5.1

5.6 5.8 5.7

3.9 4.6 4.7

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10.7

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013YTD

Buyout Median EBITDA Multiples Above 2008 Highs

Debt/EBITDA (x) Equity/EBITDA (x)

Valuation/EBITDA (x)


Bu

bb

le T

rou

ble

?

Sean Maher

How Much of Falling US Participation Rate is Structural? Full-time employment/population ratio bottomed at 46% in January 2010, 47.7% now

Lower Immigration, Retiree Surge and Later Workforce Entry Supply Side Factors

72%

73%

74%

75%

76%

77%

78%

79%

57%

59%

61%

63%

65%

67%

69%

Weak US Workforce Participation Rate Complicates Fed Exit Strategy

Employment-Population Ratio 12mma (lhs)

Civilian Participation Rate 12mma (lhs)

Civilian Participation Rate of Men Over 20 Years Old12mma (rhs)

-2%

-1%

0%

1%

2%

3%

4%

US Workforce Growth Declining on Demographics/Slower Immigration

Total Civilian Labour Force (3yr % growth saar)

Total Civilian Employment (3yr % growth saar)


US

La

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ur

Ma

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Sean Maher

Fiscal Deficit Sub 2% of GDP in FY2015 – State/Local Hiring Budgets Growing Inequality Key Structural Theme Globally - Share of US employees earning sub $15k in real terms

at 13% up 2ppts since 2000 - share making less than $35k grew 4ppts to 35.4%

3%

5%

7%

9%

11%

42%

44%

46%

48%

50%

Wage Share of GDP at Record Lows

Wage and Salary Disbursements (% GDP 12mma) (lhs)

Corporate Profits After Tax (% GDP 12mma) (rhs)

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Healthcare Inflation Slowing to 1-2%

Overall Urban CPI Index (1982-84 = 100)

Healthcare CPI Index (1982-84 = 100)


US

Str

uc

tura

l T

he

me

s 30%

35%

40%

45%

50%

55%

Top 10% Income Share at Record High

Top 10% Income Share (Excluding capital gains)

Top 10% Income Share (Including capital gains)

Sean Maher

Korea Vs. ASEAN Bet in Q3 Paid Off, as Did China Banks and AXJ Tech Global Cyclical/Defensive Mean Reversion as ‘Low Volatility Anomaly’ Sectors Overshot

GEM Investors Rediscover Relative Macro Risks in Portfolio Differentiation – Bet on Capex Rebound?

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

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Defensive Yield to Cyclical Switch Has Legs, GEM Volatility to Resume

Global Cyclical - Def Spread (RHS)

Emerging Markets (Jan 1 2013 = 100) (LHS)


Se

cto

r/S

tyle

Ro

tati

on

World

US

Eurozone

UK

Japan

Australia

Sing

HK

GEM

0.8

1.2

1.6

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2.4

2.8

3 7 11 15

Pri

ce t

o B

oo

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Trailing ROE %

S&P 500 Stretched Vs. Japan, Europe

Sean Maher

Favour GEM to DM Exporters Over Domestic Consumer , Strong USD Beneficiaries

Japan and Europe Equities Over US, GEM Inflow/FX Volatility to Resume Low Volatility Has Hit Macro Hedge Funds, Particularly in Commodities/Bonds – Volatility Looks Cheap

• Citi US surprise index rolling over, but truck tonnage in September hit all-time high, up 8.4% y/y - US corporate credit option adjusted spread at post-crisis lows

• Large portion of EM portfolio flows this cycle from dedicated global EM funds and large ‘Total Return’ style global bond strategies, rather than banks – total inflows 5% of EM GDP

• Risks highly correlated ‘risk off’ episode when Fed finally tightens - EMD has recouped about half summer losses – EM feedback to Fed policy via S&P earnings/exports complicates monetary policy further

• Underweight commodity terms of trade losers – deteriorating external balances combined with consumption/real estate booms a risk from Brazil to Indonesia and Australia, potential banking sector funding cost if inflows reverse

• Trend strengthening in USD will draw capital out of Asia, Japanese AXJ reallocation sufficient to offset?

• Scale and timing of RMB convertibility key factor – early opening of capital account could add further excess liquidity to regional markets

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Excess Returns by Asset Class

1 year 3 years 5 years


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Sean Maher

Weak US Corporate Investment a Drag on Recovery, But Acceleration Looms

High Correlation With Employment Growth – Surveys/Replacement Cycle Positive Capex 53% of NIPA Profits in 2012, 68% Average Since 2002 – Mean Reversion on Replacement Cycle?

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US Corporate Net Cash Flow as % GDP Has Surged, Led by Tech Sector

Corporate Net Cash Flow as % GDP 12mma

8%

10%

12%

14%

16%

2%

3%

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5%

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% G

DP

But Corporate Investment Still Weak…

Private Residential Fixed Investment

Government Fixed Investment

Private Nonresidential Fixed Investment - rhs


US

Ca

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US Corporate Investment Intentions and Job Openings Turn Higher

Non-Residential Fixed Investment (% y/y SAAR)

Total Nonfarm Job Openings % y/y 3mma

Philly Fed Future Corporate Capex Diffusion Index (6mma)

Sean Maher

US/Europe Fiscal Drag Eases in 2014, Boosting Global Trade GEM Underperformance on loss of GDP and Earnings/Margin Momentum, Reform Paralysis

FX Reserve Growth Just 5% in 2012 - BOP Focus as Terms of Trade for Commodity Exporters Slump

• GEM EBITDA margin at 16% now sub DM - 3 and 6mth GEM earnings revisions still negative as is revision breadth, but improving at margin – P/B at 1.4x and CAPE at 16.5 x (versus US at 23x) offers support – Europe cheaper but limited LT growth

• Historically high return on EM labour vs. capital undermined productivity growth, which has been falling everywhere, while earnings driven by top-line growth rather than by expanding margins has created poor capital discipline.

• Resources account for 40% of GEM equity earnings – secular bull market now over, driving soft earnings momentum

• Sustained QE destabilising EM economies with pegs to the USD, BOJ action hasn’t added to portfolio inflows yet – bank credit quality deteriorating

• Net $28bn in EM debt outflows since May, resumed in recent weeks – 5% correction in GEM real exchange YTD only beginning of trend


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-0.7%

-0.2%

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1.3%

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2.3%

DM Structural Budget Balance Adjustment Easing in 2014 ex Japan

(% GDP)

2013 2014 2015

Sean Maher

BOJ Injecting 16% of Annual GDP into Asset Markets, 3x More than Fed Wage Inflation Critical or ‘Abenomics’ Will Backfire – Cash Wages Down 0.6% y/y

LT MSCI World Relative PER Premium on Topix Normalised at 16-17k – 110 JPY Target end Q1

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Will Japanese Investors Return to Foreign Markets?

Stocks Net Flow 12 Week MA - JPY Bn

Bonds Net Flow 12 Week MA - JPY Bn

55.2%

14.6%

35.8%

2.1%

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7.0%

4.0%

11.8%

7.2%

6.8%

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14.4%

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31.7%

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3.2%

3.9%

0% 20% 40% 60% 80% 100%

Japan(JPY 1,547trn)

United States($54.4trn

Euro Area (€19.3trn)

Households Invested for Deflation

Currency and Deposits Bonds

Investment Trusts Shares and Equities

Insurance and Pension Reserves Others


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• Cash Wage Growth of +0.5% y/y Probably Requires Unemployment Sub 3.5%

• Female Participation Rate Rising, Still Sub 49% – Key To Reducing Demographic Drag

• Bank lending at 4-year high but limited credit demand; key measure of success is whether private

investment accelerates into 2014

Sean Maher

Modest 1-1.5% Recovery in 2014 – Credible Stress Tests Crucial, New LTRO? Loan to Deposit Ratios Unsustainable – Credit Contracting at 4% y/y

Bank Assets 375% of GDP Vs. 160% in Japan, 75% in US, Bad Debts 8% of Loans in Italy, 12% in Spain

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German Trade Surplus Near Record

China US Germany


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• Bank Loan to Deposit Ratios 120% in Italy/Spain, vs. 70% in Asia/US – Eurozone GDP Almost 3% Below

Pre-Crisis Peak, but 1-1.25% Growth in 2014

• German ‘Grand Coalition’ Unlikely to See Austerity Relaxation, But Fiscal Drag Peaking; Bundesbank

wants removal of zero risk weighting on sovereign debt

• Political Risks Receding – Backlash versus Golden Dawn in Greece/Berlusconi in Italy

• French Spreads Over Bunds to Widen by 50-100bps in 2014?

-450-350-250-150

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150250350450550650750

Spanish Eurosystem Liabilities Down Over €160bn Since mid-2012

Finland France Germany

Greece Ireland Italy

Netherlands Portugal Spain

Sean Maher

Plenum Marked Decisive Shift in Pro-Market Direction, RMB Overvalued? Pressure to Accelerate Convertibility – But Needs Deeper Bond Markets (only 45% of GDP)

Investment 56% of GDP Growth in Q3 as House Prices Accelerated in Tier 1 Cities

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20% RMB Real Appreciation Since 2010 a Drag on Growth

China Indonesia India

Korea Malaysia Singapore

Thailand Brazil Russia

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Property Price Boom Destabilizing

Big 5 Average Tianjin Guangzhou

Shenzhen Beijing Shanghai


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• Average Price/income ratios from 12x (Shenzhen) to 15x (Shanghai) and 22x (Beijing) versus 5x in Singapore, 7x in

London/NY and 9x in Sydney - real estate 25% of fixed investment

• Leverage heading toward 250% of GDP by 2016/17 on current trend, pace of domestic investment growth must slow 5-

7ppts to mid-teens; external demand pick-up key to deliver even 6-7% growth during the transition

Sean Maher

Productivity Growth Falls to 7-8% as Investment/Output Ratio Soars Boosting Productivity From 17% of US Levels Key - SOE Capex/Sales Ratio at 10% Peaking

45% of Debt ST Vs. 33% in non China AXJ – 50% of Listed Stocks Have Sub IG Credit Profile

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2009-2012 1961-1970 1981-1990 1981-1990 1991-2012

China Japan S. Korea Taiwan China

Collapsing Investment Returns Force Growth Model Shift

Investment Ratio (%GDP)GDP Growth %Investment/Output Ratio x

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China AxJ ex China Europe US

China FCF/Debt Cover A Third of AXJ

Median Gross Leverage (x, lhs) Median FCF/Total Debt (%, rhs)


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Industrials

Materials

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Cyclicals Remain Vulnerable to Reform Led Slowdown in 2014/15

China GDP Drivers (% Growth)

1997-2002 2003-7 2008-11 2012-17

Capital 3.5 4.3 3.9 2.5 - 3

Labour (Quality

Adjusted) 1.6 1.3 1 0 - 0.5

TFP 2.5 6.6 4.8 2.5 - 3

GDP 7.6 12.1 11.5 6 - 7.5

TFP as % of GDP

Growth 33 54 51 35 - 40

Sean Maher

External Balances and ‘Stickiness’ of Capital Flows Matter Again for GEM $3.9trn in GEM Inflows Since 2009, Largely in Debt – EM FX Volatility to Resume in Q1

Indian and Indonesian Current Account Rebalancing in 2014?

• Since 2008 bank inventories of EM assets have shrunk more than 70% to about one day’s trading volume - combined with ‘one click’ ETF flows, makes risk-off episodes inherently more violent and correlated

• Markets with trend credit/GDP ratio rising, inflation above trend are going to face sustained volatility i.e. Turkey, India, South Africa, Indonesia, and Brazil

• Thailand, Malaysia adjustment to be absorbed mostly by currency depreciation rather than by broader economic and asset market disruption.

• Negative feedback loop focuses on currency weakness driving inflation dynamics and challenging the credibility of central banks – stagflation environment persists from India to Indonesia and Brazil

• Moderate improvement in EM PMIs in recent months, but level remains relatively low and China has disappointed - watch for improving Indian/Indonesian trade data to offer INR/IDR support in Q1

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FX Investors Fled Funding Vulnerability

Current Account Q213 (%GDP, 4Q sum)

Net International Position % GDP


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Sean Maher

US Biggest Non-OPEC Oil/NGL Producer by mid-2014 at 11m bpd Over Past Decade, 50% of US Trade Deficit Was Energy Imports – Long Term Trend USD Positive

China Now Biggest Importer - Needs Urgent Energy Pricing Reforms To Curb Pollution

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Net Oil Imports Halve Since 2007

Balance (lhs) Imports (lhs) Exports (rhs)

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China's Energy Intensity Unsustainable

Energy Intensity (mt oil equivalent/$m GDP)


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• US Oil Production at 8.2m bpd next year – Rising Auto Fuel Efficiency Reducing Consumption

• China consumes about 35-40% more energy than Korea, 2x Brazil at comparable income levels

• Iranian crude exports halved after the EU/US sanctions in mid-2012, cutting revenues by over $35bn a

year – return to market by mid-2014?

Sean Maher

Stagflation Trend Until Post Election - INR Fair Value 60 on Productivity Adjusted Basis Key is Private Investment Rebound and Current Account – Gold Imports Have Collapsed Since May

Corporate Capex 11% of GDP from 17% in 2008 – Modest Growth Rebound to 5% in FY2014

-3%

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11%

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Industrial Output Growth Weak, and Inflation Persistent

Manufacturing PMI (LHS) WPI (% y/y) (RHS)

IIP 3mma (% y/y) (RHS)

60%

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100%

110%

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130%

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Low Indian FX Reserves Underline Funding Risks

Total External Debt (USDbn)

Current Account (USDbn)

Reserves as % of Debt + CA (RHS)


Ind

ia

• Chronic Supply Side Inflation Bottlenecks Remain – Vulnerable to renewed USD Rally

• State banks Risk 15% Peak NPLs – Restructured Debt Over 6% of Loans

• Rajan Strategy Cheered by Markets But Will Backfire if Capital Goods Output Trend Remains Dire

• After 15% rally, Sensex at 10-yr avg. 15x forward PER – ROE under pressure; Corporate Debt Better Bet

Sean Maher

Structural Investment Themes Intelligent Machines, Mobile Web, Safe Food, and Chinese Wealth Dispersal

Cost of capital to Rise Globally as GEM Reserve Accumulation Peaks at $9trn on Demographics

• ‘Internet of Things’ boom – Smartphone market

maturing (c2bn globally by end 2013), but smartphone

technology embedded in consumer durables and

industrial machines, MEMS (micro engineered

machines) – Samsung and TSMC– chip prices rising

on supply discipline (DRAM, NAND)

• ASEAN Investment over Consumption exposure –

flipside of China rebalancing is higher fixed investment

share of GDP in Philippines/Indonesia/Thailand

• Global Internet Traffic Shift to Mobile – Currently

only 15% - e.g. Baidu’s mobile search app downloads

up 50% q/q, Facebook ad revenue

• Chinese Food Safety - Baby Formula panic likely to

widen as middle class favour imported/local organic

food over domestic, after spate of scandals – a third of

arable land contaminated with heavy metals/pesticides

• China Pollution Crisis – PV solar cycle is turning

after overcapacity price crash as alternative share of

China/Japan energy mix surges – wind and solar 3-4%

of China energy mix by 2020, global PV glut easing

and prices stabilising. Global PV industry to install 42

GW this year, up 40% y/y

• Long China Asset Gatherers/Wealth Management

– capital market deepening (bonds), opening of

capital account as liquidity is redirected from real

estate

• China R&D spend – target to add 1% of GDP by

2015 or $60-70bn - recent weak manufacturing

investment trend should reverse, suppliers of

instrumentation, testing, laboratory equipment etc.

• China Industrial Automation/Robotics – driven by

rapid decline in school leavers entering factory

workforce, 15% compound wage growth and

weakening productivity ex FDI sectors

• US Consumer Revival – record low debt service

costs and rising net worth will offset still weak real

income growth, pockets of skill shortages from

industry to IT already driving a wage pick-up

• Short Asian Petrochem Industry - impact from US

energy boom – gas 5-8x more expensive in Asia,

feedstock margins far higher for US processing –

excess capacity in Asia?


Inve

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Sean Maher

Lower US/Europe Fiscal Drag in 2014, Low US Energy Costs Underpin Growth Global Growth to Accelerate Toward 3.5%, 3% in US if Capex Recovers

EM Export Pick-Up, But Domestic Demand Constrained by Slowing Credit Growth

• A global resynchronization in growth plausible in 2014: the easing in fiscal drag next year alone will add 0.6 ppts to growth for G7, including more than 1.5% in the US (IMF). Business surveys suggest that ‘animal spirits’ are gradually returning from depressed levels. From the Tankan survey, to the IFO, to the Philly Fed survey, capital spending plans are being revised up.

• Repeated central-bank intervention has repressed market volatility, lowered correlations and given the illusion of systemic stability – but can’t tackle structural trends including technology shifts driving inequality/weak aggregate demand - ‘Financial Repression’ via QE driving asset bubbles from Asian real estate to US high yield corporate debt – but inflation still well contained globally

• China’s growth transition implies huge wealth transfer from state/SOEs and opening capital account - liberalising interest rates and deepening domestic bond markets key reforms – 7% GDP trend growth with downside if reforms delayed

• US GDP and productivity growth look set to accelerate versus Europe/Japan as share of global economy generated online soars - energy competiveness/low unit labour costs boost ‘on shoring’ trend – positive for USD on current account

• Japan taking huge risk with belated monetary stimulus – will ultimately backfire unless wage growth/productivity and lending also accelerate

• Global online economy growing 5-8x faster than offline – but China productivity can benefit in telecom, finance, retail, and education from domestic internet giants

• Cost of capital globally likely to rise structurally from mid-decade, as demographic dividend from China reverses, shortage of domestic deposits

• USD looks very cheap on LT fundamentals – test of 100 on DXY in 2014? Both ECB and particularly BOJ likely to be expanding stimulus to pre-empt disinflationary risks


Su

mm

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Sean Maher

Macro Summary Recommendations as Tilt Versus Strategic Benchmark/Single Class Limits or Long/Short

For Absolute Return Investors


Su

mm

ary

As

se

t V

iew

Investment View Trading View

Asset class (3-6 months) (1-3 months)

Equities Bullish

US Neutral Neutral Testing 1800 ERP based fair value target despite earnings downgrades - cyclical top in Q1?

Europe Bullish BullishRecession easing, Target 2 balances improving - prefer European large caps over US but getting

expensive

UK Neutral Neutral Domestic earnings exposure preferred, resource weighting a drag on valuation and momentum

Japan Bullish Neutral 110 JPY/$ by end Q1 on portfolio rebalancing, structural reforms key for equity break out on ROE boost

Asia Pacific Bearish Neutral O/W late-cycle sectors (e.g. Industrials), Chinese banks, Korea, Taiwan - close Thailand/Ppns short

GEM Equities Neutral Bullish Valuations discount negative earnings momentum, particularly GEM materials - O/W China, Korea, CEE

Fixed Income Bearish

Government Bearish Bearish 10yr Treasury in 2.5-3% range until Fed timetable clear

Investment Grade Bearish Bearish Prefer HY to IG. US Financial bonds within IG.

High Yield Bullish Neutral Default rate at record lows offers support

EM debt Neutral Neutral EMBI tapering led correction was overdue, value in Indonesia, India as CA deficits peak in coming months

Commodities Neutral

Energy Neutral Bearish Brent fair value $90-95/bbl on oversupply, geopolitical premium should reverse in Q4

Industrial Metals Neutral Neutral Copper near marginal cost support, China data and low inventories supporting iron ore at $100/mt

Precious Metals Neutral NeutralGold in $1100 - $1400 range - ETF adjustment over but India likely to turn net seller so re-test of lows

feasible

Agriculture Bearish Neutral Oversupply near term (esp. rice on Thailand) - LT bull case intact on China food quality crisis

FX

USD Bullish BullishBearish sentiment prevails on tapering delay but breakout to 100 on DXY in 2014 feasible - cheap on LT

fundamentals

GBP Bearish Neutral New housing boom underway and GDP likely to grow 1.5% this year, but UK fiscal outlook challenging

JPY Bearish Neutral Consolidating as expected sub 100, target productivity adjusted fair value 110 vs USD

Europe Bearish Neutral Recession easing, but ECB will ease in 2014 as Fed exits - target 1.25

Asia Pacific Neutral Neutral Long peso, INR fair value at 60, IDR still high risk but cheap - KRW, SGD LT bets

Rationale

2014 Global Macro Outlook - Nov 2013

Economy & Finance

Transcript of 2014 Global Macro Outlook - Nov 2013