Macro Outlook September 2014 Interest Rate Markets The sharp increase in government debt in the world s major developed economies, as a consequence of the financial crisis, remains a key driver of monetary policy in our view. Table 1: Debt to GDP and Inflation United States GDP $ (2013) Gross Government Debt: GDP 2008 Gross Government Debt: GDP 2014 Government Budget 2014 e Current CPI Inflation Rate 16,800 64.8% 101.5% -3.10% 2.00% Euro Area 12,750 66.2% 92.6% -3.00% 0.40% Japan 4,902 167% 227.0% -6.70% 3.40% UK 2,522 44.5% 90.6% -5.80% 1.50% World 74,900 Source: Trading Economics, Bloomberg Given historically elevated and still rising debt to GDP ratios, a central policy objective is to keep the cost of servicing this debt low. Central banks have succeeded in this objective to date. The charts below put the increase in government debt to GDP ratios, post 2008 into a historical context. Chart 1: US Government Debt
Chart 2: Euro Area Government Debt Chart 3: Japan Government Debt Chart 4: UK Government Debt
A second policy objective, to reduce the real burden of the debt over time through generating inflation, has proved more difficult. CPI has been stable around 2% in the US, has fallen sharply in the Euro Area and is falling in the UK albeit from a higher level. Japan has had more success by encouraging a devaluation of the Yen, a policy the Euro Area is now attempting to replicate. Chart 5: US CPI Chart 6: Euro Area CPI Chart 7: UK CPI
S&P 500 Chart 8: Japan CPI At current yield levels the prospects for capital gains in government bond markets are limited. That said, we believe central banks will continue to be supportive until debt to GDP ratios are trending downward. In the United States, most advanced in its recovery and set to be begin a modest tightening cycle in 2015, we think 10Yr yields will likely be capped in the 2.75-3.00 area in the next six months. We expect the Euro-Bund to continue its recent outperformance versus the US 10Yr Note. Equity Indices We are structurally bullish of equities on the basis of earnings. Chart 9: S&P 500 Price and Earnings Annual EPS S&P 500 Closing Price 2200 2000 1800 1600 1400 1200 1000 800 600 400 200 0 2015e 2014e 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 $140 $120 $100 $80 $60 $40 $20 $0 EPS Between 1997 and 2001 the S&P 500 was clearly stretched relative to earnings. Assuming current expectations for earnings in 2014 and 2015 are met, it is hard to say the index is currently overvalued.
Medium and long term structural trends exist which reinforce earnings capacity. Ongoing support from monetary policy, discussed earlier, is one such trend. Some others that we believe continue to be very powerful are: Employment Costs and Flexibility Employment costs are typically the largest cost in a business and in this area the landscape has shifted dramatically in the favour of corporations in the last twenty years. As a result of globalisation and the integration of China, India, Indonesia, Eastern Europe, Brazil, Mexico etc. into the global economy, the supply of labour available to multinational firms has increased by hundreds of millions. Cheap labour can be accessed in ways that were not possible even 15 years ago. The cost savings for firms are enormous. With regard to employment flexibility, historically if revenue growth was weak employment costs were sticky so margins narrowed. Today, employment law is more flexible so costs adjust more quickly. Margins can be maintained or even expanded in times of weak revenue growth, something evident since the financial crisis. Influence on Public Policy As a result of the employment they are in a position to offer, multinational corporations are in a powerful position to influence public policy around taxation, employment law and grants for example. National governments compete on these terms to present their countries as attractive locations for multinationals to operate from. Ireland has done it very successfully. New Markets The capacity to grow revenues has expanded as new markets with huge populations and potential have opened up in the last decade. The near term outlook for emerging market growth has deteriorated this year, as China slows, commodity prices decline and Russia retreats from the globalised order. These forces will wax and wane but structurally the long term trend of an increasingly integrated global economy driven by technological development is intact. Taxation of Profits Profits are shifted legally but artificially between jurisdictions in order to minimise taxation. Going forward the capacity of firms to pursue this activity may be reduced. We will see how that issue develops. A major change in the international landscape in this respect would undoubtedly be a negative for earnings but ultimately we will be surprised if the landscape shifts dramatically. Share buybacks and dividends Activist investors are increasingly pressing for excess cash to be given back to shareholders through dividend payments and share buybacks. In addition, managements are incentivised in the direction of share buybacks to achieve a higher EPS and share price. This will be an on-going source of support for stocks.
% The Great Rotation After a 30 plus year bull market in bonds and two stock market crashes since 2000 many institutional investor portfolios are overweight bonds and underweight equities. The earnings yield on the S&P 500 is currently 5.5% versus a 10 year US bond yield of 2.5%. Prospects for capital gains in bond markets are limited relative to the period from 1982. Both capital gains and yield are to be found in the equity market. Many of the structural trends we have identified are not new, most were in place prior to the financial crisis. The financial crisis caused earnings to crash but, in our view, the structural trends in place ensured it was temporary. Foreign Exchange After months of declining volatility in foreign exchange markets we are encouraged by the recent trend of USD strength. We expect this to continue. Chart 10: 60day Volatility in EURUSD and USDJPY Euro Jpy 30 25 20 15 10 5 0 From late 2012 the Bank of Japan successfully encouraged the market to weaken the Yen. CPI inflation has reversed its decline and printed at +3.4% year-on-year in July. After a prolonged period of consolidation USDJPY has recently broken above 105 and begun the next leg of what we believe is a multi-year appreciation. We feel 125 is a realistic target. We interpret the ECB policy announcement on September 4 th as an attempt to replicate the Bank of Japan s success in generating positive inflation through a substantial weakening of the currency. The BOJ balance sheet has increased in size by almost 80% since November 2012. The ECB indicated an intention to increase the size of its balance sheet by roughly 50%. The size is smaller but the desired outcome the same.
CCI usd Index Yen TWI CPI % Chart 11: Yen trade weighted and Japan Inflation Yen Trade Weighted Japan CPI YoY 150 145 140 135 130 125 120 115 110 105 4.50 3.50 2.50 1.50 0.50-0.50-1.50 Jul-14 Apr-14 Jan-14 Oct-13 Jul-13 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 In response to a question relating to his speech at Jackson Hole, asked at the press conference following the September 4 th ECB meeting, Mario Draghi commented: The idea is that there are, I would say, three instruments for revamping growth. Structural reforms, fiscal policy and monetary policy. We suspect this is a nod to Japan s Three Arrows. Draghi has previously shown an acute understanding of market psychology and we suspect he wants to create a link in the mind of market participants between Euro Area policy and Japanese policy since Abe and Kuroda came into office. The comparison is not perfect. Policy direction in Europe is not as cohesive as in Japan. All the actors are not pulling in the same direction so the effect is diluted but we feel that the thrust of European policy is shifting. The trade weighted yen fell 25% between November 2012 and December 2013. We believe EURUSD will weaken toward 1.15. Between 2002 and 2011 the commodity sector soared and the USD weakened. This dynamic is now in reverse. We expect the commodity currencies - AUD, NZD and CAD - to continue to weaken over the medium term. Chart 12: Commodity Prices and the USD Continuous Commodity Index USD Index 700 650 600 550 500 450 400 350 300 250 200 150 125 120 115 110 105 100 95 90 85 80 75 70 Jan-14 Jan-13 Jan-12 Jan-11 Jan-10 Jan-09 Jan-08 Jan-07 Jan-06 Jan-05 Jan-04 Jan-03 Jan-02 Jan-01
Precious Metals Against the backdrop of what we believe to be a commodity bear market, and bull markets in the USD and equities we feel gold and silver are likely to continue to weaken. Investment demand for gold continues to wane. Silver has recently pushed down out of a range in which it had consolidated since June 2013. We interpret this as a renewal of the downtrend and expect it to move toward USD15 and ultimately USD10. Gold, at USD1220, is still above its June 2013 low of USD1182 but we expect it to weaken towards USD1000 in due course. Chart 13: SPDR Gold Trust Holdings 80000 SPDR GOLD TRUST HOLDINGS 70000 T o n n e s 60000 50000 40000 30000 20000 10000 0 13 12 11 10 09 08 07 06 05 04 Conor O Mara Investment Director Three Rock Capital Management Limited conor.omara@threerockcapital.com www.threerockcapital.com PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS The information contained within this document is for information purposes only and is subject to change without notice. It is not an invitation to buy or sell a particular financial product or service and it should not be regarded as such. Three Rock Capital Management Limited (TRCM) does not represent that the information contained here-in is complete, fair or accurate. The opinions and views expressed are those of the creator and may not reflect those of TRCM. Futures are risky and leveraged financial instruments and should only be considered by investors who fully understand the risks and potential losses involved. Past performance figures contained in this document are not necessarily indicative of future results. This document should not be supplied, presented or distributed to retail investors. It should not be redistributed, supplied or presented in jurisdictions where the investments described may be restricted or prohibited by law and TRCM cannot accept any responsibility for such actions. Three Rock Capital Management is regulated by the Central Bank of Ireland. The firm is registered with the CFTC as a CTA and a CPO and is a member of the NFA.