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1QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
BLUE QUADRANTC A P I T A L M A N A G E M E N T
FSP 42165
QUARTERLY REVIEW Q1 2016
Compiled between Apr 1 - 3, 2016
2QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
FINANCIAL MARKET AND GLOBAL ECONOMIC OVERVIEW
GLOBAL OUTLOOK
US GROWTH WILL REMAIN RESILIENT IN 2016 AS CONSUMER SPENDING SUPPORTS OVERALL GROWTH
US economic growth slowed further to an annualised growth
rate of 1.4% (q/q) in the fourth quarter of 2015 from the 2%
reported in the third. As in the prior quarter, the slowdown
was driven by a further contraction in private domestic
investment due to slowing non-residential fixed investment
growth and a reduction in inventory levels for the second
consecutive quarter.
The collapse in energy prices and a stronger US Dollar
have acted as key headwinds for the US economy, having
an adverse effect on the US manufacturing sector and
broader exports. A faster pace of inventory accumulation
and consequent de-stocking have also impacted
negatively, particularly in the latter half of 2015. The chart
below illustrates that inventory levels in nominal terms
have risen to the highest levels since the last recession.
Real Inventories/Sales Ratio
Nominal Inventory/Sales Ratio
1.55
1.50
1.45
1.40
1.35
1.30
1.25
1.202000 2003 2006 2009
Dec
Nov
2012 2015
Nevertheless, despite these headwinds, the US economy still
managed to grow by 2.4% in 2015, an unchanged rate when
compared to 2014.
On the positive side, household consumption has remained
buoyant supported by strong job growth, historically low
debt servicing burdens and the further decline in energy
prices. Personal consumption expenditures grew by 3.1% in
2015, accelerating from a growth rate of 2.7% reported in
2014. Personal consumption contributed 2.11% out of 2.4%
of the annual growth recorded in 2015, increasing from a
contribution of 1.84% in the prior quarter. This largely offset
the increased negative contribution from the widening in the
US trade deficit, which subtracted 0.64% from calendar 2015
GDP, up from 0.18% in 2014.
As discussed in prior publications, sustained job growth and
accelerating wage growth amid a generally accommodative
monetary backdrop, are likely to remain key tailwinds for the
US consumer and the overall economy by implication. With
consumption accounting for over 70% of the US economy, a
recession without a retrenchment in consumer spending is a
very unlikely prospect.
More notably perhaps, recent data on the manufacturing
sector in the US has shown indications of an incipient recovery,
which could gain further traction as the year unfolds.
60
55
50
45
40
35
302006
(Inde
x)
ISM MANUFACTURING: PMI COMPOSITE INDEX
2008 2010 2012 2014 2016
reserach..stlouisfed.orgSource: Institute for supply Managementreserach..stlouisfed.org
3QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
The systemic risks created by the bursting of the US housing
bubble was mainly caused by the defaulting mortgage debt
as a % of bank and insurance capital being a multiple of
this capital figure and thus a real threat to the solvency of
important financial institutions. The systemic risk associated
with rising defaults in the US is almost zero pertaining to the
high yield and mining sectors.
The chart below shows how high yield bonds have already
staged a fairly significant recovery, with yields declining by
nearly 200bps since reaching a multi-year high in the final
quarter of 2015. This retracement in yields should ease some
of the strains placed on companies with higher debt levels in
their capital structure.
The US economy is set to adjust from the twin negative
shocks following the collapse in energy prices (impact on
the US shale energy industry) and the appreciation in the US
Dollar. The headwinds from these factors should dissipate
as the year unfolds and point to the potential for continued
robust growth in 2016 relative to other developed economies.
In the last quarterly publication, we noted the recent negative
development regarding the sharp rise in corporate bond yields
and specifically high-yield bonds issued by non-investment
grade companies. A large portion of the rise in yields was due
to a widening in the spread between high quality investment
grade bonds and lower quality bonds, specifically those
issued by energy and commodity companies.
We further noted how the rise in yields across other unrelated
sectors was probably an overreaction and partly related to
a ‘contagion’ effect spilling over into other sectors, due to
the attendant liquidity effects. Funds facing redemptions
are forced into selling more liquid bonds, even if the issuer
companies are at little risk of defaulting, in order to meet
redemption requests.
Outside of specific sectors such as energy and mining, default
rates remain near historically low levels, while the outlook
for growth in the US itself remains positive. It should be
remembered that low bond yields and favourable corporate
bond spreads have also allowed many corporates to extend
the redemption profile of their outstanding debt issues.
Finally, the actual size of the high yield bond market is small
relative to other sectors of the capital market, both in an
absolute sense as well as and, importantly, relative to bank
and insurance capital.
Mortgage debt outstanding as share of total debt outstanding (ls)
Source: FRB, DB US Credit Strategy, Haver Analytics, DB Global Markets Research
0%
5%
30%
30% vs 2%
25%
20%
15%
10%
0%
-5%
-10%
-15%
-20%
-25%
-30%
2000 2002 2004 2006 2008 2010 2012 2014
HY bonds outstanding as share of total debt outstanding (rs)
TODAY IS VERY DIFFERENT FROM 2006
11
10
9
8
7
6
5
(Per
cent
)
BOFA MERRILL LYNCH US HIGH YIELD EFFECTIVE YIELD
2012-01-01
reserach..stlouisfed.orgSource: BofA Merrill Lynch
2013-01-01 2014-01-01 2015-01-01 2016-01-01
4QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
The general re-pricing of equity valuations, particularly in
these aforementioned companies was a likely key factor
driving the equity market sell-off in December and January.
The chart above reflects that outflows from equity funds
reached their highest levels in the first seven weeks of the year
since 2008. This data is also consistent with various market
sentiment indicators, which reached extremely oversold
levels in January and February and set the stage for the recent
rebound. Given that we do not expect a ‘2008-type’ economic
environment this year, the recent negativity and fund flows
away from risk assets should provide a reasonable platform
for further strength in equities. Their attraction as an asset
class is especially supported by the still very accommodative
monetary backdrop.
This backdrop received an additional boost in March, when
the ECB expanded both the size and scope of its current QE
program. The Federal Reserve further stepped back from prior plans to raise benchmark rates by 100bps this year.
Many now see the Fed only raising interest rates further in the second-half of the year and possibly by no more than 50bps
or in two equal increments of 25bps each.
As discussed, we expect positive real income growth to
continue to support overall consumer spending in 2016.
Buoyant activity in the housing market and the broader
construction sector will also lend some support to the overall
economy. Following several years of narrowing budget
deficits, the US budget deficit is expected to widen once again
in 2016. Fiscal consolidation at both the federal and state/
local levels have acted as a notable drag on US economic
performance since at least 2011. This dynamic will now shift
from a headwind to an additional tailwind from 2016 onwards.
BUDGET DEFICIT FORECAST W/NEW STIMULUS, $BN
2015-439Nominal-2.5%% of GDP -3.4% -3.9%
-634 -7502016 2017
-80
IN $BN. GLOBAL EQUITY FLOWS (MF +ETF) FOR THE FIRST SEVEN WEEKS OF THE YEAR.
Source: Bloomberg, ICI, J.P. Morgan.
-60
07-65
-19-8
-36
232319
3851
08 09 10 11 12 13 14 15 16
-40
-20
0
20
40
60
80
100
US GOVERNMENT SPENDING GROWTH HAS UPSIDE
US government consumption &investment, real, year-on-year
1996
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
2000 2004 2008 2012 2016
Source: Soberlook
5QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
EUROPEAN OUTLOOK STILL POSITIVE, JAPAN BATTLES CHINA “GROWTH” HEADWINDS
Growth in the broader Eurozone, although likely to have
slowed somewhat in the first quarter of 2016, is expected to
have remained positive. Following a modest decline in activity
in the manufacturing sector, notably in France and Germany,
recent data for March is pointing to some stabilisation. The
European Manufacturing PMI for March ticked higher to 51.6
from 51.2 in February, which was a multi-month low.
Notably, PMI readings outside the two ‘core’ economies of France and Germany were actually much higher and in some cases continue to print at multi-month highs.
US economic growth appears set to remain fairly resilient
over the next 24 months. We detail below how the real
longer-term risk is an under-appreciation for a potential
acceleration in inflation during the year, rather than a return
to a deflationary ‘quagmire’.
The chart below further details how the potential for a further
acceleration in wage growth in the US remains a key upside
risk. Given that the labour force in the US is only growing by
around 100,000 to 125,000 per month, average job gains of
around 200,000, as has been the case in the past 5 years,
suggests that the unemployment rate will continue to
decline in 2016. This obviously creates the risk of a further,
perhaps meaningful acceleration in wage growth as the year
progresses.
Quits Rate (LHS)
Source: Haver Analytics, Renaissance Macro Research
17.0
WHEN QUITS RISE, WAGE GROWTH TENDS TO FOLLOW
15.0
11.0
9.0
7.0
5.095 97 99 01 03 05 07 09 11 13 15
Average Hourly Earnings (RHS)
13.0 3.5%
4.5%
4.0%
3.0%
2.5%
2.0%
1.5%
Unit Labour Costs
6
US UNIT LABOUR COSTS RIDING MORE QUICKLY THAN OUTPUT PRICES
5544
33
22
1100
-1-1
-2-2
-3-3
-4-496 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
6corporate output prices
Source: Soberlook
Eurozone Manufacturing PMI, sa, 50 = no change
65
60
1998
55
50
45
40
35
30
MANUFACTURING PMI (OVERALL BUSINESS CONDITIONS)
Source: Markit
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
COUNTRIES RANKED BY MANUFACTURING PMI : MAR.
Ireland 8-month high
5-month high3-month high
3-month low5-month high
2-month high7-month low
2-month high
Netherlands
Italy
Spain
Australia
GermanyFrance
Greece 49.0
49.6 (flash: 49.6)50.7 (flash: 50.4)
52.853.4
53.5
53.6
54.9
6QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
France is still battling the headwinds created by the election
of the more socialist Hollande government and a lack of
serious reform. In Germany, growth remains very sensitive
to export developments and this economy with its large
manufacturing sector has been negatively affected by the
decline in global fixed investment. The weakness in emerging
market economies also impacted as they have become an
important export market for Germany over the past decade.
With evidence of some stabilisation in key emerging
economies such as China, accommodative central bank policy
and rising German property prices, growth in this economy
will possibly remain positive in 2016. As improved conditions
in the periphery feed through into the core over the course of
the year, an acceleration is a realistic expectation.
In particular, the recent underperformance of European
equities relative to US equities has created an opportunity for
some geographical re-balancing in investment portfolios.
More notably, given the renewed decline in European bond
yields and the German 10-year yield trading back below 20bps,
there is some emerging evidence that inflation in Europe may
actually surprise to the upside during 2016. Although headline
inflation in Europe and the US remains close to zero, inflation
gauges continue to be pulled lower by the transitory effect of
the decline in oil and broader commodity prices in 2015.
Core inflation, although currently lower than the 2.3%y/y in
US at present, has accelerated in recent months to reach 1% y/y.
Should oil and commodity prices stabilize or rebound to
some extent this year, overall inflation in Europe is likely to
accelerate markedly in tandem with a general rise in headline
inflation in developed economies. This is a negative for global
bond yields, particularly those in Europe, which remain well
below corresponding yields for US bonds across similar
durations.
Recent data from Japan has disappointed to the downside.
The manufacturing PMI for March showed a renewed decline
to below the key 50 level and suggests a renewed contraction
in the Japanese manufacturing sector. Like Germany, the
Japanese economy remains far more sensitive to export
demand. In this case, Japan has severely felt the slowdown in
China and other regional Asian emerging economies.
1.7
1.5
1.3
1.1
0.9
0.7
0.5‘49 ‘52 ‘55 ‘58 ‘61 ‘64 ‘67 ‘70 ‘73 ‘76 ‘79 ‘82 ‘85 ‘88 ‘91 ‘94 ‘97 ‘00 ‘03 ‘06 ‘09 ‘12 ‘15 ‘18
US/Europe, relative price perf (USD)
+1 St Dev
-1 St Dev
US VS EUROPEAN EQUITIES, RELATIVE PRICE PERFORMANCE (USD)
Monthly data. GFD Europe index & reconstituresnthe MSCI Europe estimate pre-1970,includes a 12% UK weighing until 1970, after is actual MSCI Europe weighings; latest UK weight is approx. 31%Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg, Global Financial Data (GFD)
Apr ‘09 Oct ‘10 Apr‘12 Apr‘15 Jan‘160.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
Oct‘13 Jul‘14
EUROZONE CORE CONSUMER PRICE INDEX (CPI) YOY
Actual1.0%
Forecast0.9%
Source: Trading Economics
7QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
There nevertheless remains a strong likelihood that the Japanese economy will still show positive growth this year, driven by resilient or improving growth in the US and Europe. Further contributory factors are a prospective rebound in China and a stabilisation in other key emerging economies such as Russia and Brazil.
STIMULUS EFFORTS IN CHINA GAIN TRACTION, POINTING TO REACCELERATION IN GROWTH
The slowdown in Chinese growth has inevitably prompted the
local authorities to embark on more aggressive policy stimulus.
The chart below outlines that the central government fiscal
deficit has widened significantly over the past year and could
reach 4% of GDP this year. This positive fiscal impulse should
support overall growth, at least over the short-term.
In fact, the most recent PMI data for March is already showing
signs of a potential recovery in the country’s manufacturing
sector.
As Chinese property prices are far more impactful than
any movement in Chinese equity prices, it is perhaps more
encouraging to note that the former has also shown some
signs of stabilization and evolving upward price trends.
60
55
50
45
40
30
30
25
Source: Nikkei, Market
2002 2003 2004 2005 2006 2007 2008 2009 2010
Increasing rate of contraction
Increasing rate of expantion50 = no change on previous month, S. Adj.
NIKKEI JAPAN MANUFACTURING PMI
2011 2012 2013 2014 2015
Jul-0
9
Jul-1
0
Jul-1
1
Jul-1
2
Jul-1
3
Jul-1
4
Jul-1
5
Source: Bloomberg
48 50
52
54
56
58
50
52
54
56
China PMI ManufacturingChina PMI Non-Manufacturing (RHS)
CHINA PMI MANUFACTURING & PMI NON-MANUFACTURING
100-CITY AVERAGE PROPERTY PRICE MOM CHANGE (SA)
2.0% 2.0%
1.5% 1.5%
1.0% 1.0%
1.0% 1.0%
0.0% 0.0%
-0.5% -0.5%
-1.0% -1.0%
-1.5%Jan-12 Jan-13 Jan-14 Jan-15Jul-12 Jul-13 Jul-14 Jul-15 Jan-16
-1.5%
Source: Goldman
0% 0%0.5%1%
2009 2010 2011China Annual Fiscal Budget Deficit (RHS)
China Annual GDP Growth Rate
Source: Bloomberg and iFast Compilations; data as of 23 March 2016
2012 2013 2014 2015 2016
1.5%2%2.5%3%3% E3.5%
2%
4%
6%
8%
10%
CHINA ANNUAL FISCAL BUDGET DEFICIT VSCHINA ANNUAL ECONOMY GROWTH (%)12%
8QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
Chinese private sector credit growth of loans extended by the
Chinese financial system further accelerated to 15.3% y/y in
January from 14.3% in December. This is the highest rate of
credit growth recorded since early 2013 and provides another
indication that a ‘hard landing’ in the Chinese economy is an
unlikely scenario for 2016.
Central Bank 1-year lending rates of around 4.5% also have
room to move lower, while reserve requirement ratios are
also far higher than the statutory ratios prevalent prior to
the global financial crisis in 2008. Given that the central
government also still has substantial room for fiscal stimulus,
the tools available to Chinese policymakers to avoid a hard-
landing in the short-term are substantial. A return to the
double-digit growth rates recorded over the past decade is
also unlikely, but the Chinese economy will possibly continue
to grow overall, supported by stimulus and consumption
growth.
There nevertheless remain substantial longer-term risks.
China’s now ageing demography suggests that the total
number of employed workers in the economy is likely to
remain flat going forward, while scope for the kind of robust
wage growth seen over the past decade also appears limited.
China has lost substantial competiveness as wages increased
and its currency, which is nominally pegged to the US Dollar,
gained when compared to regional competitors.
The major risk for China is stagnant job and wage growth,
along with a political system that is unsustainable in the long-
term, at least if China wishes to move to even higher levels
of income per capita. As USD liquidity continues to tighten
over the next few years, the Chinese currency will possibly be
forced to further devalue before the end of the decade.
At present, China still has a large trade surplus and foreign
exchange holdings, so it is probable that policymakers will be
able to control the exchange rate for some time to come. At
some point before the end of the decade, not likely this year,
Chinese growth will weaken or slow further. When coupled
with possible rising social and political tensions, the risk of
an acceleration in capital outflows could ultimately lead to
an even more pronounced devaluation in the currency at
some point. This will be the key or pivotal moment for China,
related financial markets and regional economies as regards
specific event risks.
We have noted in past publications that one of the major
‘fault lines’ that would be exposed to a hard-landing in China
is Hong Kong. Hong Kong has experienced an enormous
property bubble and prices have risen significantly in recent
years, partly driven by investment from Mainland Chinese
investors.
Hong Kong as a banking centre is additionally at risk, given the
large growth in loans to mainland China entities from Hong
Kong. Hong Kong banks also rely on cross-border funding
in order to sustain their own foreign currency denominated
lending activities.
Source: www.tradeeconomics.com / peoples bank of china
2012 2014 201612
14
16
18
20
CHINA OUTSTANDING LOAN GROWTH
CHINA CASH REVERSE RATIO BIG BANKS
2006 2008 2010 2012 2014 20166
8
10
12
14
16
percent
18
20
22
Source: www.tradeeconomics.com / peoples bank of china
9QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
true of the oil market which has been influenced by the rapid increase in US oil supply since 2011. Lower prices will eventually result in some kind rebalancing as new supply growth stalls or even contracts. In certain segments of the commodity market where the lead time to new production is shorter, this rebalancing may happen quicker.
The energy sector at the margin now has an increasingly shorter lead time than in the past. US energy producers exploiting unconventional shale reserves can now drill and bring new oil wells to production in a matter of weeks. This timeframe is in contrast to the lengthy lead times normally associated with major oil projects in the past. As the US energy sector increasingly becomes the worlds swing producer, oil production may respond more quickly to price changes than was previously the case.
There exists a scope for a general recovery in commodity prices over the next two years, but it is our opinion that it will be more nuanced and narrowed than was the case in the great commodity bull market of the last decade. Despite the potential for a temporary recovery in Chinese investment spending, that economy remains substantially unbalanced as investment spending still accounts for nearly 50% of overall GDP.
There thus remains significant downside risk in respect of Chinese investment spending growth over the next five years. The demand for commodities more sensitive to fixed investment or infrastructure spending, such as iron ore and
copper, will also be affected by implication.
Recent data has shown a notable weakening in the Hong Kong
economy, as evidenced by the sharp decline in retail sales in
recent months.
A temporary or cyclical recovery in the Chinese economy
should however also lend some support to the Hong Kong
economy over the near-term. With property prices already
having dropped somewhat from the recent peak reached in
2015, developments in this important region will be worth
monitoring as the year unfolds.
COMMODITY MARKET REBALANCING LIKELY TO BEGIN IN EARNEST IN 2016
We believe that the large-scale price declines in a range of
mining and resource companies are creating opportunities
in these sectors. As already highlighted, there remains scope
for a renewed cyclical upturn in Chinese investment spending
and the associated demand for various commodities. Volume
data from China in fact shows little if any real decline over the
past year, with the exception of coal volumes, in spite of the
recent fall in commodity prices.
This suggests that the weakening in commodity prices over the past few years have mainly been driven by increased supply rather than collapsing demand. This is particularly
2008 2009 2010 2011 2012 2013 2014 2015 2016-30
-20
-10
0
10
20
30
40
HONG KONG RETAIL SALES YOY
400 000350 000300 000250 000200 000150 000100 000 50 000 0210 000180 000150 000120 000 90 000 60 000 30 000
400 000350 000300 000250 000200 000150 000100 000 50 0000210 000180 000150 000120 000 90 000 60 000 30 000
STOCKS OF COPPER AND COPPER WARRANTS IN CHINA
31-12-99 31-12-01 31-12-03 31-12-05 31-12-07 31-12-09 31-12-11 31-12-13 31-12-15
Data Source: Wind Info
Clothing Stock on Warrant CopperStock Subtotal Copper. Closing Stock on Warrant Copper
Stock Subtotal Copper: Total
Source: Soberlook
10QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
The chart below shows how inventory levels of copper in
China have reached their highest recorded levels, despite the
recent recovery in copper prices.
On the other hand, demand for commodities more tied to consumption such as oil and also possibly metals such as platinum and aluminium may fare somewhat better. The large reduction in oil sector capital investment over the past year will limit oil supply growth over the medium-term. The outlined shorter lead time associated with US energy production could also lead to a much faster rebalancing in this market than is generally anticipated at present.
As previously detailed ,oil is in many ways a unique commodity, given the inherent natural decline in production rates that most oil fields exhibit over time. When a specific oilfield is first tapped, the pressure in the field is obviously very high. As the resource is depleted by outflows from the trapped reservoir, the pressure decrease causes the rate of flow out of the field to taper off.
This decline rate can vary depending on the type of field but the rate is very steep for shale fields. The rate of production from a typical shale oil well can fall by as much as 50% in one year. The industry consequently has to invest an enormous amount of capital annually in order to bring new fields or resources on stream. This is necessary to maintain global supply at existing levels, let alone increase production. At oil prices below $50 and certainly below $40, new investment simply does not make economic sense. As a result the industry has sharply reduced capital expenditures over the past two years or in some cases players have been forced smaller to stay afloat. These levels are not sufficient to address the natural declining rate of all oil fields currently in global production.
The International Energy Association (IEA) reported in its most recent monthly Oil Market Report (OMR) for February, that global oil supply declined by 180,000 barrels per day (b/d) in February to 96.5mn b/d. More notably, the IEA also said that preliminary data for February suggested that OECD commercial inventories had declined during the month, marking the first such decline in just over a year. The IEA said
that it expected total non-OPEC supply to decline by 750,000 b/d in 2016, chiefly driven by a decline of 530,000 b/d in the
US market.
On the negative side, total oil inventories remain high. Despite
the improving dynamics reported by the IEA in February, there
remains a gap between existing demand and supply. The IEA
estimates place global oil demand for Q1 2016 at around
94.7mn to 95mn b/d, which is still some 1.5mn b/d below
current supply levels. However, Q1 2016 saw seasonally lower
demand for oil. Based on the IEA’s estimate for an increase
in global demand of 1.2mn b/d in 2016, total demand should
rise above 96mn b/d by the second-half of the year. Based
on the current rate of decline and assuming 100,000 b/d per
month, supply will also have declined to around 96mn b/d
by this time. This would suggest that the oil market could in
fact rebalance well ahead of recent consensus expectations
and may partly explain the recent rebound in oil prices from
below the $30 mark reached in January.
WORLD OIL DEMAND
1Q201385
90
95
87.5
92.5
97.5
mb/
d
3Q2013 1Q2014 3Q2014 1Q2015 3Q2015 1Q2016 3Q2016
Source: IEA
11QUARTERLY REVIEW Q1 2016BLUE QUADRANT
C A P I T A L M A N A G E M E N T
QUARTERLY REVIEWQ1 2016
SOUTH AFRICA OUTLOOKRecent data covering the manufacturing and mining sectors as well as new vehicle sales all suggest that the economy slowed further in the first quarter of 2016. This is not unexpected given the headwinds faced by the local mining sector after the slump in international commodity prices. More recently
the further increase in domestic interest rates have also had an impact.
The SARB has now increased its key benchmark lending rate by 200bps since the first hike in the current cycle in January 2014. The hike from 5% to 7% takes the prime lending rate to 10.5%. This is the highest level for short-term lending rates since early 2010 and not unsurprisingly, the economy will struggle to gain any meaningful traction in this environment. Consensus growth estimates for 2016 have been revised lower to just 0.5%.
The key question for many local investors is whether further rate hikes are likely and at what point will the level of interest rates finally lead to a recession in consumer spending and the broader economy by implication. After the reappointment of Pravin Gordhan as finance minister, political uncertainty eased. Terms of trade have improved as the prices of precious metals outperform that of oil. When coupled with a possible recovery in sentiment towards emerging market currencies, these factors could pave the way for the SARB to consider pausing its current tightening cycle, despite inflation projected to remain elevated for the rest of the year. Despite the poor economic backdrop and recent increase in interest rates, South African households generally still appear to be in reasonably healthy shape, particularly those in the middle to high income groups. Elevated wage and salary growth and waning demand for credit has helped keep nominal growth in disposable incomes above that of household indebtedness since the last recession in 2008/9.
This trend has been particularly noticeable as regards
outstanding residential mortgage debt. Demand for mortgage
credit has only recently picked up, following several years of
sluggish growth in the aftermath of the 2008/9 recession. The ratio of household sector mortgage credit outstanding
relative to disposable income has declined further in recent
quarters, from a peak of 49.2% in Q1 2008 to 34.8% in Q4
2015. Household mortgage advances grew rapidly from a
trough of just below 30% of household disposable income in
2002/3 while residential property prices rose to a peak level
of 49.2% in Q1 2008. The ratio had declined mainly due to
sluggish household mortgage credit growth and elevated
nominal, not specifically real, wage growth since 2008.
As interest rates still remain below prior historical highs, one could advocate that the scope for severe stress in the residential mortgage sector remains limited at this time. Despite the poor economic backdrop, a sharp rise in delinquency rates may not occur. A reflection of this is the fact that the household sector debt service ratio remains lower than the prior peak levels associated with a sharp rise in delinquency rates. According to FNB data, the number of residential property sellers due to financial pressure remains at or near a decade-low of around 14% as opposed to the 34% high experienced in 2008.
Household Mortgage Debt-to-disposable Income Ratio (Left Axis)
Household Sector Debt -to-Disposable Income Ratio
HOUSEHOLD MORTGAGE DEBT TO DISPOSABLE INCOME RATIO
1994 1997 2000 2003 2006 2009 2012 2015 10% 20% 30% 40% 50% 60% 70% 80%
90% 88.80%
77.8%
31.85%
49.20%
34.8%
18%
15%
12%
9%
6%
3%
0%2008 2010 2012 2014
Household Disposable Income-year-on -year % change
Household Sector Debt -year-on-year % change
HOUSEHOLD SECTOR DISPOSABLE INCOME VS DEBT
Source: FNB
Source: FNB
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The Q4 SARB bulletin reports that the latest debt service ratio
stood at 9.7% of disposable income. This is higher than the
recent cyclical trough of 8.5% recorded in 2012/1, but still
somewhat lower than the 2008 peak of 14.4%.
All of this suggests that, should the SARB indeed opt to pause
its tightening cycle, conceivably at its next meeting in May,
consumer spending growth should remain positive. The
broader economy should consequently avoid a technical
recession this year. With latent political uncertainty and the
prospect of a rebound in international oil prices, inflation will
remain a key risk. As such, the outlook for further interest
rate hikes remains quite good over the longer term, beyond
2016.
The sharp rise in electricity and associated administered
prices since 2008 suggests that available disposable is
probably much lower than generally thought. After adjusting
for these items and including the more the recent food prices
hikes, income and therefore the debt service obligation ratio
as a % of disposable income, is probably much higher than
that reflected in the official data.
This would suggest that although mortgage debt and in
general household debt serviceability remains reasonable at
present, it would likely take a smaller rise in interest rates to
recreate the same level of consumer stress. Rates would not
specifically have to rise back to the levels seen in 2008 and
the late 1990s in order for delinquency rates to increase. It
is worth noting that the prime rate reached a level of 15% in
2008 compared to its current level of 10.5%.
Sellers downselling due to financial pressure - % of total sellers
Trendline
Q1-20080%0%
10%15%20%
25%
30%
35%40%
34%
% o
f Tot
al H
ome
Sal
es
% of R
ental Tenants in good G
ood Standing
40%
50%
14%
Q1-2010 Q1-2012 Q1-2014
DOWNSCALING DUE TO FINANCIAL PRESSURE
Source: FNB
% o
f Dis
posa
l Inc
ome
HOUSEHOLD SECTOR DEBT-SERVICE RATIO VS INTEREST RATES
19950%
10%
5%7%9%
11%13%
9.7% 15%17%19%21%23%25%20%
1998 2001 2004 2007 2010 2013 2016
Prime Rate - Right AxisHousehold Sector Debt-Service Ratio (Interest Only)
Average Interest Rate on Household Debt
8.5%10.3%12.5%
Source: FNB
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MAJOR INVESTMENT THEMESBlue Quadrant Capital Management clients invested in one
or more funds listed below can refer to the client portal at
www.blueqcm.com for more detail regarding each major
investment theme listed in this publication.
US DOLLAR TO OUTPERFORM AS GLOBAL YIELD TRADE UNWINDS
SUMMARY
• US current account deficit will narrow and possibly move
to surplus as US energy production and net imports
decrease.
• Accelerating US economic growth will lead to gradual rate
normalization. Coupled with less global dollar liquidity
and a smaller US current account deficit, the fundamental
underpin for the global ‘carry’ yield trade will become
progressively less favourable.
• These dynamics will attract capital flows back to the US,
supporting sustained US Dollar bull market.
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid asset classes such as fixed-income and higher risk
yield-bearing counters and securities that have benefited
from this trade.
• Remain overweight in the US Dollar in respect of our
overall currency exposure.
THE CASE FOR A SECULAR BEAR MARKET IN FIXED INCOME
SUMMARY
• Current consensus expects continued disinflation in the global economy. US and global labour market dynamics do, however, point to a threat of the return of sustained wage inflation over the next 5 to 10 years.
• Additional potential risks to the medium-term inflation outlook could include:1 Fundamental dynamics such as lack of infrastructure investment in major developed economies.2 The end of ‘Moore’s’ law and geopolitical-induced disruption to global energy supplies.
• Memories of the 2008 financial crisis create the risk that policymakers will be slow to react and respond to a return
to elevated global inflation.
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid asset classes such as fixed-income and higher risk yield-bearing asset classes, where rising interest rates and yields erode capital principal.
• Remain overweight the US Dollar in terms of overall currency exposure, which will benefit from rising long-term US bond yields
• Build and maintain an exposure to physical gold and specific gold producers as a form of portfolio insurance.
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NEGATIVE ON OUTLOOK FOR SOUTH AFRICAN ECONOMY AND FINANCIAL ASSETS
SUMMARY
• Supply-side structural constraints, such as a persistent power deficit and a fractious labour environment, will constrain the country’s ability to expand export capacity
• Current government policy favours substantial state involvement in the economy. This will continue to result in substantial capital misallocation.
• These dynamics will ensure that the country’s two key economic imbalances, namely the fiscal and current account deficits, will remain large and entrenched as a feature of the country’s economic fundamentals.
• A depressed commodity price environment, with possible exception of gold, will lead to a deterioration in terms of trade, and create additional external headwinds for the economy.
• Rising global interest rates and a reduction in US Dollar liquidity will make it difficult for South Africa to fund its current account deficit resulting in a sustained depreciation
in the currency.
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid domestic asset classes such as fixed-income and higher risk yield-bearing asset classes, particularly commercial property.
• Retain a large offshore exposure and minimize Rand currency risk in portfolios.
• Retain a minimal exposure towards interest-rate sensitive domestic sectors.
• Seek to invest in companies that are able to generate
export revenues or will benefit from import substitution
NEGATIVE ON OUTLOOK FOR CHINESE ECONOMY, FIXED INVESTMENT AND GLOBAL LINKAGES
SUMMARY
• The large growth in credit over the past five years has led to a massive capital misallocation. There exists widespread evidence of a significant capital stock surplus in certain sectors, such as residential- and commercial property.
• Chinese fixed investment has averaged 50% of GDP over the past five years, an unprecedented level relative to other economies both past and present.
• Chinese fixed investment spending has been a major driver of global demand for industrial commodities, particularly steel and iron-ore. A substantial slowing in Chinese fixed investment spending creates substantial downside risks for industrial metals
• Low global interest rates and access to cheap US Dollar funding has led to large-scale use of cheap US Dollar funding to finance risky investment projects in China. Unwind of this trade could lead to systemic risks in certain key banking centres, such as Hong Kong and Singapore and Australia by association. All three banking centres
remain heavily reliant on wholesale funding.
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid those economies which have benefited from both elevated commodity prices and ample global liquidity, such as Australia. Substantial risks over the next several years to commodity-sensitive currencies that have also benefited from the global ‘yield’ trade.
• Build and maintain a short exposure in commodity or
‘yield’ currencies, as well as the financial assets of these
economies. • Avoid exposure to industrial metals and also mining
companies focused on the production of commodities tied to fixed investment or infrastructure, particularly
steel and iron ore.
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THE US ENERGY REVOLUTION – IMPLICATIONS AND THE SCOPE FOR ENERGY PRICE VOLATILITY
SUMMARY
• US oil and gas production is expected to increase
significantly over the next five years due to the use of new
technologies able to unlock vast previously inaccessible oil
and gas (shale) reserve formations
• Increasing US energy production and decreasing net
energy imports have important implications for global US
dollar liquidity going forward.
• Increasing US oil and gas production may depress
global energy prices, creating substantial risks for major
‘petrostates’. Inherent political vulnerabilities may be
exposed, leading to heightened geopolitical risks and risk
of major energy supply disruptions.
• The current disparity in pricing between US natural gas
prices and global gas- and oil prices will gradually be
narrowed.
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid major energy companies, particularly those with operations in geopolitical regions with heightened risks.
• Focus on maintaining an exposure to US-centric energy companies, and in particular companies focused on natural gas production, with substantial gas and liquids reserves. The inevitable narrowing in US gas prices relative to global oil and gas prices will favour these companies.
• Focus and maintain an exposure to companies that will benefit from rising US oil and gas production as a second derivative of this dynamic. Energy infrastructure companies able to remove logistical bottleneck and take advantage of existing energy price differentials will benefit.
THE CASE FOR A NEW GROWTH CYCYLE IN US FIXED INVESTMENT
SUMMARY
• US fixed investment expenditures (as % of GDP) have
declined to a multi-decade low in the aftermath of the
Great Recession in 2007 to 2009
• The US capital stock and in particular public infrastructure
is ageing and will require renewal or productivity will
continue to lag, creating upside risks to the medium-term
inflation outlook
• An upturn in the US housing market and sustained job
and income growth will boost federal, state and local
taxes, which coupled with reduced military spending, will
create fiscal space for an increase in public investment
expenditures.
• As the “millennials”, the largest demographic generation by
number enter the key 34 to 44 age segment, they will drive
household formation and demand for housing
• The rise of the millennials will drive inflation higher, as
demand for credit increases in the context of significant
supply-side and productivity challenges
IMPACT ON OUR INVESTMENT STRATEGY AND FUND POSITIONING
• Avoid asset classes such as fixed-income and higher risk yield-bearing asset classes, where rising interest rates (as inflation trends upwards) and yields erode capital principal.
• Remain overweight the US Dollar in terms of overall currency exposure, which will benefit from rising long-term US bond yields and relative growth outperformance
• Build and maintain an exposure to equities expected to benefit from an upturn in US fixed investment spending as well as a general upward trend in housing activity, prices
and mortgage demand.
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