Why investors should pay attention to financial cycles.

Transcription

1 Investment Insights Financial cycles and asset prices April 2017 FOR PROFESSIONAL INVESTORS ONLY Why investors should pay attention to financial cycles. Much analysis is devoted to looking at inflation and growth data to assess where economies are in their business cycles. Less attention is paid to credit and house price developments and an analysis of how economies move through their financial cycles. We think financial cycles can be useful to investors, providing insights into the possible trajectories of asset prices. My outlook for the US financial cycle supports my view that the dollar s bull run is nearing an end. The US Federal Reserve may be unlikely to aggressively raise interest rates in 2017 given softer economic conditions in China and elsewhere. A bottoming of China s financial cycle could be a bullish signal for the global economy, but remains out of sight. US and euro area set to peak as China heads lower Financial cycles in the US, euro area and China 0.20 United States Index 1 Euro Area China Forecast 0.15 Jens Søndergaard Currency analyst Based in London 11 years of investment experience (as at 31 December 2016) For illustrative purposes only. Past results are not a guarantee of future results. 1. Indexes rebased to zero as of their first data points (not shown): 1986 for China and 1971 for the US and euro area. Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. All market forecasts are subject to a wide margin of error, including our own. Analysis performed using economic modeling, historical comparisons and subjective judgments. Hypothetical financial cycle forecasts were developed using an economic model, historical data through 30 June 2016, and our judgment. Sources: BIS, Capital Group, Haver Analytics, OECD, Capital Strategy Research (CSR) estimates, UK National Institute of Economic and Social Research thecapitalgroup.com/europe 1

2 Financial cycles 101: what they are, why they matter Put simply, a financial cycle tracks the combined evolution of house prices and the amount of private-sector debt in an economy. Financial cycles are one approach to studying the relationship between house prices, private sector credit growth and economic growth. The concept and methodology has been developed by the Bank for International Settlements (BIS). The conceptual foundation rests on one simple observation: trends in house prices and private sector credit develop slowly, with the progress of each trend influenced by the other in a positive feedback loop. It is important to emphasise that the financial cycle is credit-oriented and, therefore, quite distinct from the business cycle (which looks at output). This different focus has meant that, on average, financial cycles last at least twice as long as typical business cycles. Building on the pioneering work of the BIS, I have found that financial cycles are of great practical use. They are, in my view, a powerful tool that investors can use to assess the outlook for economies and asset class returns. Four phases, four investment environments How equities and bonds have typically fared (for illustrative purposes only) Bonds Equities Equities Bonds Leverage declines at an accelerating rate Leverage grows at an accelerating rate Leverage growth decelerates Leverage declines decelerate Phase 1 Phase Phase 3 Phase 4 Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. Financial cycles were developed using an economic model, historical data through 30 June 2016, and our judgment. Source: Capital Group 2

3 Debt s growth rate (not its absolute level) is key Importantly, it s not absolute debt levels that matter for financial cycles. In other words, whether the financial cycle is rising or falling is of limited importance. Rather, it s the rate of change in the growth of debt that appears to be crucial: whether the cycle is accelerating or decelerating. For investors, it s reasonable to leave the debate over the precise nature of the relationship between debt, house prices and the real economy to the academics. What s of greater practical interest is the observation that turning points in financial cycles are infrequent and have often coincided with changing fortunes for equity and bond markets. A financial cycle has four distinct phases. Each phase is marked by a particular combination of slope (whether the cycle is headed upward or downward), and steepness (whether the cycle is accelerating or decelerating). We have looked at asset returns across 17 different cycles covering 40 years of data. Based on this empirical work, bonds have tended to fare better relative to equities around cycle peaks (phases 1 and 4), while equity returns have typically been strongest around troughs (phases 2 and 3): Phase 1 is the initial decline after a peak: credit growth slows significantly, house prices fall sharply. Phase 2 is the second leg of the downturn, when the cycle decelerates into a trough. Deleveraging continues, though there are signs that is ending. Put differently, the growth rate of house prices and credit remains negative, but is becoming less and less negative. Phase 3 begins as the cycle reaches a turning point and moves upward as house price inflation and credit growth turns positive. Phase 4 leads up to the cycle peak. Sometimes the cycle slows and appears to be headed for a turning point, only to regain momentum and return to phase 3. We have often observed cycles that alternate between phases 3 and 4. If history is any guide, the framework we use (pioneered by economists at the BIS) tends to work best in the US and other countries with larger autonomous economies that include significant banking sectors. On the flipside, there are countries where the connection between turns in the cycle and asset prices is sometimes weaker. In Germany, for instance, the equity prices of many larger companies are less tied to domestic conditions and more dependent on cycles in emerging markets (major export destinations). Developed economies experience upturn; emerging market cycles headed lower When we observe the evolution of financial cycles across the globe, they are clearly out of sync. This is actually good news for active investors (who can be selective). At a high level, the cycles of most developed markets is progressing nicely at an upturn: phases 3 and 4 predominate. Many emerging markets have passed their cycle peaks and the downward slope of phase 1 looms. The latest data we re able to incorporate into the framework is from the second quarter of That means our forecasts do not reflect policy changes and other economic developments since November s US presidential election. Furthermore, while history gives us a measure of confidence in our forecasts, it cannot be emphasied enough that the future can confound current expectations. 3

4 Recall that: phase 1 marks the initial decline of leverage after a peak; the downturn moderates in phase 2 as the cycle reaches its trough; in phase 3 leverage growth accelerates; and phase 4 leads up to the cycle peak amid decelerating leverage growth. Four key observations in early 2017: The US financial cycle is heading up Germany and Japan have moved very close to their peaks China remains firmly in phase 1 Brazil (which transitioned from phase 1 in the first quarter of 2016) still seems to be in the early days of its time in phase 2 Financial cycles around the world are a mixed bag Select developed and developing economies Malaysia, Thailand Indonesia Switzerand France China South Korea, Russia, India Finland, Norway Turkey, Mexico United States United Kingdom Australia, New Zealand Sweden South Africa Ireland Japan Germany Canada Brazil Phase Portugal Poland, Belgium Hungary Greece The Netherlands Italy Spain, Denmark 1 Phase Phase 3 Phase 4 For illustrative purposes only. Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. Financial cycles were developed using an economic model, historical data through 30 June 2016, and our judgment. Source: Capital Group US cycle appears headed for a 2019 peak Let us consider more closely the current state of the US financial cycle. It entered phase 2 in 2011, and then bottomed out at the end of One simple interpretation of where we stand now is: the housing correction is in the rear-view mirror, deleveraging is over and the cycle will accelerate prompting faster GDP growth and higher inflation. Clearly, this is an optimistic outlook in comparison to the secular stagnation story that has been widely discussed in recent years (especially before the US presidential election). Looking ahead, our latest forecast for the US financial cycle suggests a more nuanced view. The US financial cycle s upturn could continue for the next year or so, before rolling over. That said, the cycle s deceleration may soon become much more pronounced why? One possible answer is that the deleveraging process in the US was never really over, it merely paused. US households may simply resume deleveraging if the Fed embarks on a more aggressive interest rate hiking cycle and the housing market loses momentum as a result. 4

5 Peaking US cycle, fading dollar bull? Looking at past data, the value of the dollar appears to be related to the US financial cycle. In particular, the dollar often seems to have led the US financial cycle. To be clear, we are not suggesting cause and effect. That being said, past peaks in the US financial cycle have tended to come on the heels of peaks in dollar strength. Given that the financial cycle is expected to top out in 2019, the currency s recent plateau could very well mark the end of the dollar bull run that began in A continued slowing of credit growth rates from here would offer further evidence of moderating momentum in the US cycle, and add support to my view that dollar strength has indeed reached the high point of the recent market cycle. On the other hand, the possibility that unexpectedly rapid economic growth prolongs dollar strength cannot be discounted. So, if you think that house prices and credit growth are about to reaccelerate, then you should probably also expect meaningful dollar appreciation to resume. In my view, the bottom line for dollar-based investors is that the US financial cycle suggests currency translation may present less of a headwind to international market returns than in recent years. As an aside, the dollar appears overvalued according to our own measures of currency fair value. Most currencies are undervalued against the dollar, especially the British pound, the euro and the Swedish krona, as well as various emerging currencies like the Mexican peso. US financial cycle expected to peak in 2019 Financial cycle and dollar trade-weighted real exchange rate USD Trade-Weighted Real Effective Exchange Rate (left axis) US Financial Cycle (right axis) US Financial Cycle Projection (right axis) Exchange Rate (rebased to 100 in 2010) Index 1 (rebased to 0 in 1971) Forecast For illustrative purposes only. Past results are not a guarantee of future results. 1. Index is whether credit and property prices are growing faster or slower than their mediumterm trends and is rebased to zero as of the first data point, which is 1971 for the US. Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. All market forecasts are subject to a wide margin of error, including our own. Analysis performed using economic modeling, historical comparisons and subjective judgments. Hypothetical financial cycle forecasts were developed using an economic model, historical data through 30 June 2016, and our judgment. Sources: Capital Group, JPMorgan 5

6 Euro zone s muted cycles offer silver lining For the first time since the euro area s creation in 1999, the financial cycles of Germany and some of the peripheral economies have converged. This could be a significant development suggesting less stress from economies pulling in different directions. For many years, it was the case that Germany would boom when the euro area periphery was deleveraging (and vice-versa). This created a headache for policymakers. The European Central Bank struggled to set interest rates that were appropriate for both Germany and the periphery. In the run-up to the Global Financial Crisis, interest rates were too high for a slowgrowing Germany but too low for the fast-growing economies in the periphery, fuelling a significant rise in lending there. The fallout from this unsustainable credit boom were the banking and sovereign debt crises that erupted over the past decade. Ultimately, our latest financial cycle forecasts suggest more muted economic growth prospects for the euro area. However, this might just be a price worth paying if the outcome is more consistent growth across individual economies in the near term, and more sustainable growth for the entire region in the long term. Will core and peripheral European economies align as financial cycles converge? Financial cycles in the euro area Germany France Italy Spain 0.35 Index (rebased to 0 in 1971) Forecast For illustrative purposes only. Past results are not a guarantee of future results. 1. Index is whether credit and property prices are growing faster or slower than their mediumterm trends and is rebased to zero as of the first data point, which is 1971 for the euro area (or the earliest possible data point). Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. All market forecasts are subject to a wide margin of error, including our own. Analysis performed using economic modeling, historical comparisons and subjective judgments. Hypothetical financial cycle forecasts were developed using an economic model, historical data through 30 June 2016, and our judgment. Sources: BIS, Capital Group, Haver Analytics, OECD, CSR estimates, UK National Institute of Economic and Social Research 6

7 China upturn could be significant for equities, but there s no sign yet China is widely perceived to have significantly increased leverage in recent years. The reasoning is simple: the ratio of debt to GDP keeps climbing. A look at the financial cycle, however, offers a very different perspective. The cycle peaked in China s housing market has been growing less quickly since 2012, a deceleration that has more than offset the increasing ratio of debt to GDP. Authorities appear to be successfully engineering a gradual downturn in China s financial cycle. This is no mean feat. When we first constructed a financial cycle for China back in 2014, the possibility of an ugly banking crisis had loomed especially large. Three years later, no crisis has erupted, as the government has addressed the problem in part by allowing debt levels to increase. That said, downside risks to the economy and currency haven t disappeared. A steadying of the financial cycle will require the ratio of credit to GDP to stabilize and, ultimately, decline. Unfortunately, the pace of debt creation has accelerated in the last couple of years. Even though China s debt-to-gdp ratio hasn t turned yet, the Chinese housing market is rolling over a bearish signal for the Chinese financial cycle. When will China s financial cycle bottom out? Unfortunately, the timing of the turn appears to be outside the scope of our current forecast. In past cycles, phase 2 has generally been a positive period for equities, hence we re keeping a very close eye on developments. A transition from phase 1 to phase 2 could highly benefit the many emerging markets whose fortunes are closely entwined with China, as well as the broader global economy. China s gentle financial cycle downturn Components of China s financial cycle Credit Contribution Leverage Ratio Contribution House Prices Contribution Financial Cycle 0.22 Index (rebased to 0 in 1986) 1 Forecast For illustrative purposes only. Past results are not a guarantee of future results. 1. Index is whether credit and property prices are growing faster or slower than their mediumterm trends and is rebased to zero as of the first data point, which is 1986 for China. Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. All market forecasts are subject to a wide margin of error, including our own. Analysis performed using economic modeling, historical comparisons and subjective judgments. Hypothetical financial cycle forecasts were developed using an economic model, historical data through 30 June 2016, and our judgment. Source: Capital Group 7

8 China adds to the Fed s dilemma in 2017 In recent times, the Fed has paid a lot of attention to global conditions when deliberating over domestic policy. Consequently, the timing of the downturn in China s financial cycle could give US policymakers pause even if domestic conditions argue for rate hikes. The global economy could be unsettled by much tighter US monetary policy at a time when China one of the world s primary economic engines is in the downward leg of its financial cycle. Intriguing signals in an uncertain world When I first presented work on financial cycles back in 2013, I highlighted the fact that the US appeared to be transitioning to phase 3 (often associated with especially strong equity returns). Over the three-year span ended 31 December 2016, the US equity market gained around 20% double the return notched by US bonds. With the financial cycle in phase 4, the outlook for equities may not be as bright. At a time of fragile global growth and an uncertain outlook for economies and policies, financial cycles represent an especially intriguing source of information. My approach to financial cycles is to be pragmatic. We should let the data speak for itself, while acknowledging that the future is unknown and no forecast can be correct all the time. Nevertheless, past turning points in financial cycles have often coincided with changing fortunes for equities and bonds. For investors looking to make long-term active decisions on asset allocation to specific countries or regions, that observation alone should offer real food for thought. Key takeaways Financial cycle analysis helps investors understand the possible trajectories of asset prices. My outlook for the US financial cycle supports my view that the dollar s bull run is nearing an end. The Fed may be unlikely to aggressively raise rates in 2017 given softer economic conditions in China and elsewhere. Among emerging markets, financial cycles appear most supportive of equities in Brazil, Hungary and Poland. A bottoming of China s financial cycle could be a bullish signal for the global economy, but remains out of sight. Past results are not a guarantee of future results. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is intended to highlight issues and not to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. This communication is issued by Capital International Limited (authorised and regulated by the UK Financial Conduct Authority), a subsidiary of the Capital Group Companies, Inc. (Capital Group). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice Capital Group. All rights reserved. CR ACEXCH