Political Risk
We generally worry more about economic risks (a China
slowdown, rapid Fed rate hikes, deflation in the eurozone)
than political risks. Yet the world is a very unstable place,
characterized by a large number of regional “zero-sum
conflicts.” These are disputes that are unlikely to be resolved
by diplomacy; it is hard to imagine anybody negotiating peace
treaties with the Islamic State or Boko Haram.
The conflict between Russia and the West over Ukraine and
other former Soviet states is perhaps the greatest threat.
President Vladimir Putin has proven he’s willing to cut off
the nose (and more) to spite the face.
Our Risk and Quantitative Analysis group has a framework to
assess political risks and their potential impact on economies,
markets and our portfolios. See an example below for our key
scenarios on the Ukraine conflict (minus portfolio impact).
The status quo—frozen conflict—is already reflected in deeply
discounted Russian equity markets. Yet an (unlikely) escalation
of the conflict would reverberate beyond Russia and hit risk
assets hard globally, we believe.
Japan
Japan is all in—on a high-stakes bet that monetary stimulus
will jump-start the country’s economy. The central bank’s
balance sheet has swollen to almost 60% the size of Japan’s
GDP, roughly three times the ECB ’s balance sheet as a share
of the eurozone’s economy.
The BoJ is even buying equities. This is a big boon to asset
markets, especially as Japan’s bellwether $1.2 trillion
Government Pension Investment Fund (GPIF) is wading in.
The fund aims to more than double its benchmark allocation
to Japanese and foreign equities to 25% each—and slash its
allocation to Japanese government bonds (JGBs).
The BoJ is effectively printing money to buy the Japanese
pension fund’s government bonds—and finance its equity
buying. The path of least resistance is likely to be up (further)
for Japanese equities and down for the yen. A collapse in the
trade-weighted yen has been mirrored by a rally in Japanese
equities since 2012.
Other pension funds and households may start mirroring the
GPIF’s move and shift some of their cash piles into stocks.
Beyond the Boj's Bazooka
The case for Japanese equities is not just about the BoJ’s
bazooka. Japan Inc. is changing (really). Consider:
} Almost 45% of Japanese companies announced dividend
hikes in 2014, according to SMBC Nikko, the highest
percentage since data became available in 1995. Dividends
and buybacks have risen to the highest level in six years—
and are poised to climb further, Goldman Sachs forecasts.
See the chart on the right.
} C orporate reforms are a key driver. These include the
creation and adoption of corporate governance and
stewardship codes. The new JPX-Nikkei 400 Index—
which only includes companies with high returns on
equity (ROE)—provides an incentive for Japanese CEOs
to become more shareholder friendly. Nobody wants to
be on the other side of this (admittingly long) velvet rope.
The GPIF and other large domestic investors are already
tracking the index.
} Japanese equities are the cheapest in the developed world
(page 6). Yet these numbers understate Japan’s cheapness.
Japanese accounting standards are more conservative than
elsewhere (thanks to differences such as higher depreciation
charges). We like both beneficiaries of a weak yen (exporters)
and of domestic reflation (financials).The biggest near-term risk for Japan is a loss of momentum
for “Abenomics,” Prime Minister Shinzo Abe’s three-pronged
plan to revitalize the economy and drag Japan out of a
two-decade economic funk. Abenomics could give way to
“Kurodanomics”—with BoJ Governor Kuroda pressing harder
and harder on the monetary accelerator, but structural reforms
going nowhere. This would likely end in tears.
PLAYING WITH FIRE
Being bullish on Japanese equities has become somewhat
mainstream in the last two years. Foreign investors dominate
trading, with a 60% share of volume on the Tokyo Stock
Exchange. A loss of confidence in Abenomics could cause
market gyrations. Reforms to develop a stronger equity culture
would reduce Japan’s vulnerability to the mood swings of global
investors, but this will take time.
The BoJ is playing with fire. What if the central bank actually
succeeds and inflation starts to take off quickly? The nightmare
scenario would be a spike in JGB rates leading to a fiscal
crisis. Japan’s public debt load stands at almost 250% of
GDP, according to the IMF, the highest in the G7.
United States
The U.S. economy is in a cyclical upswing—and is one of the
world’s few major economies expected to accelerate in 2015.
Steady growth in employment, a moderate (yet patchy) housing
recovery and rising capital expenditures (capex) all point to a
sustainable recovery. So much for “secular stagnation” or
any other catch phrases to denote a long-term growth decline.
A rise in household wealth and falling oil prices bode well for
consumer spending, which accounts for about 70% of the U.S.
economy. (Wealthier consumers are happier—and spend more.)
Ultra-loose monetary policy has inflated U.S. equity and home
values, boosting the net worth of U.S. households by $23.1
trillion, U.S. Federal Reserve data show. Other positives include:
} R ock-bottom interest rates have helped households reduce
debt levels, and debt servicing payments have fallen to the
lowest level in decades. Another boon for consumers:
falling energy prices. The average hourly paycheck now
buys 7.5 gallons of gasoline versus just over four in 2008,
our calculations show.
} C ompanies are hiring, with payrolls expanding at a pace
of around 240,000 a month in 2014, according to the
Bureau of Labor Statistics. They are investing, too: Capex
jumped almost 11% in the third quarter, the latest quarterly
GDP scorecard shows.
} Fiscal challenges are subsiding. The impact of rises in
payroll taxes and government spending cuts—a drag on
the economy in 2013—has largely faded. Even state and
local governments are starting to spend again.
} Monetary policy should remain highly stimulatory. Even if
the Fed were to hike by a full percentage point, real shortterm
interest rates would still be negative.
So when will the Fed raise rates—and by how much? It depends
on the pace of recovery in the labor market, and on how soon
wage growth starts to feed into higher inflation.
The headline U.S. unemployment rate stands at 5.8%, and is
falling by around 0.1% per month. That means by mid-2015
unemployment could be homing in on 5%. This is the Fed’s
rough estimate of the non-accelerating inflation rate of
unemployment (NAIRU)—the threshold for inflationary
pressures to build up.
What really matters for inflation is short-term unemployment,
a study by Brookings Institute shows. Wages tend to rise rapidly
when this rate falls below 4.5%. The rate today? Just 4%.
History suggests wages should be rising at a 3%-plus annual
pace given today’s jobless rate. See the chart below. Structural
trends such as innovation and globalization, however, could
keep a lid on wage growth (as they have done for some time).
How high will U.S. rates rise in 2015? The median projection
of Fed members points to a federal funds rate of around
1.4% by the end of the year. Markets are pricing in a rate of
just under 0.5%. Short-term yields could rise a lot faster
than expected if the Fed’s projections are on the mark.
We expect rates to drift higher, but only moderately. The U.S.
dollar should strengthen and the yield curve flatten. Credit
and long bonds should do fine as yield-hungry insurers and
pension funds dampen any yield spikes. Our model—which
takes into account factors such as inflation and policy
expectations—points to a fair value of around 2.7% for the
U.S. 10-year Treasury yield, some 0.4% above current levels.
Yet U.S. Treasuries today look like good value compared with
ultra-low-yielding Japanese and European bonds in depreciating
currencies. German Bund yields have become a big driver of
Treasury yields over the past year, our research shows. This
means the biggest risk for U.S. Treasuries in 2015 may not be
the Fed—but European growth. Fiscal stimulus in Germany,
unlikely as it may seem currently, would be a game-changer.
Every 10-basis-point increase in the 10-year Bund yield
would boost U.S. yields by five basis points, we estimate.
The other side of the rate puzzle is supply. Net issuance of
U.S. fixed income is expected to rise to the highest level in six
years in 2015, driven by a halt in the Fed’s bond buying and
increased corporate issuance. Yet total issuance should
remain well short of pre-crisis years. See the chart above.
What would higher rates mean for U.S. equities? If history is
any guide, there is likely to be a big difference between the
performance of low-beta stocks (defensives) and high-beta
stocks (cyclicals). U.S. defensives usually do well when interest
rates are falling (and vice versa), as detailed in Risk and
Resilience of September 2013. They tend to lose money when
the 10-year yield rises more than 15 basis points in a month,
our research shows. See the chart below.
U.S. cyclicals do best when rates rise—but only when the rise
is mild. Returns start to taper off when yields rise more than
around 10 basis points in a month. This bodes well for cyclical
stocks in 2015 (if history repeats itself). Even if the Fed hikes
rates sharply, solid demand for longer-term bonds should
dampen the rise in 10-year yields.
Corporate earnings are a key risk. Analysts predict doubledigit
growth in 2015, yet such high expectations will be tough
to meet. Companies have picked the low-hanging fruit by
slashing costs since the financial crisis. How do you generate
10% earnings-per-share growth when nominal GDP growth is
just 4%?
It becomes tempting to take on too much leverage, use
financial wizardry to reward shareholders or even stretch
accounting principles. S&P 500 profits are 86% higher than
they would be if accounting standards of the national accounts
were used, Pelham Smithers Associates notes. And the gap
between the two measures is widening, the research firm finds.
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