Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Equity Monthly: Has Asia finally turned?
Peter Garnry
Chief Investment Strategist
Summary: As we've previously observed, in any given business cycle, South Korea tends to be the first to buck the trend. With the country's leading indicators now again turning higher, it might be assumed that where South Korea goes, others will follow.
In last month’s Equity Monthly our main message was: ”Our view is still that investors should still play equity markets defensively. Many signs indicate that the business cycle is turning, but this may take several months. Be patient.”. Since then more evidence has shown that the business cycle has maybe already turned in Asia and this will likely spread globally within the next few months. China’s PMI figures from March suggest that China is seeing positive momentum after slowing down for more than a year. We have covered this development extensively on our morning calls and China’s improving numbers are the key driver of equity markets right now.
South Korea has turned higher
In March we got confirmation that South Korea’s leading indicators already turned higher in December and have continued to expand in January. OECD releases February figures on 8 April and we expect further confirmation that South Korea has turned in terms of the business cycle, demonstrating that Chinese stimulus has indeed proved to be enough once again to lift growth in Asia. As the months pass the effects will trickle into Europe and North America. This is likely also why the market was quite relaxed this morning when Germany Factory Orders in February hit -8.4% which is the worst growth since 2009 and at the 7th percentile of observations since 1992.
South Korea has turned higher
In March we got confirmation that South Korea’s leading indicators already turned higher in December and have continued to expand in January. OECD releases February figures on 8 April and we expect further confirmation that South Korea has turned in terms of the business cycle, demonstrating that Chinese stimulus has indeed proved to be enough once again to lift growth in Asia. As the months pass the effects will trickle into Europe and North America. This is likely also why the market was quite relaxed this morning when Germany Factory Orders in February hit -8.4% which is the worst growth since 2009 and at the 7th percentile of observations since 1992.
What does the business cycle means for equities and how should investors be thinking about their equity exposure? The table below shows the four phases in the business cycle measured by the OECD’s leading indicators and their coincident equity returns in USD for each equity market.
The global economy is currently in the fourth column (economic activity below trend and contracting) but if South Korea once again proves to be the first country to lead the world then global leading indicators will soon turn into the first column which is often called the recovery phase. In this phase investors should be overweight Asia Pacific (and in particularly China, Taiwan and Singapore) and North America. European equities are not worth being overweight until later into the business cycle.
The global economy is currently in the fourth column (economic activity below trend and contracting) but if South Korea once again proves to be the first country to lead the world then global leading indicators will soon turn into the first column which is often called the recovery phase. In this phase investors should be overweight Asia Pacific (and in particularly China, Taiwan and Singapore) and North America. European equities are not worth being overweight until later into the business cycle.
The devil’s advocate: US yield curve inversion
In our latest equity presentation (which can viewed in a recorded version here) we draw parallels between now and 1998. As in 1998 the US 3M/10Y spread went negative at around the same time as a major crash in global equities and a policy panic by the Fed. Typically a US yield curve inversion has spelled trouble for investors with S&P 500 returns being negative -8% over the next 18 months. However, two recent cases go against this pattern: 1998 and 2006.
In our latest equity presentation (which can viewed in a recorded version here) we draw parallels between now and 1998. As in 1998 the US 3M/10Y spread went negative at around the same time as a major crash in global equities and a policy panic by the Fed. Typically a US yield curve inversion has spelled trouble for investors with S&P 500 returns being negative -8% over the next 18 months. However, two recent cases go against this pattern: 1998 and 2006.
The 1998 US yield curve inversion and subsequent performance in the S&P 500 is illustrated below. The Fed managed to ease monetary policy and the global economy was able to shrug off the Russian default, carrying equities much higher into the big dot-com bang. Another interesting parallel to 1998 is that back then the US technology sector was driving a lot of the gains in the overall equity index such as we have seen in this cycle. While many things back up a cautious outlook on equities we cannot completely rule out that investors might again underestimate China’s ability to reignite global growth, thus extending this rally for some time more.
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