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Editor's Note: Hamish Risk | November 19, 2020
As far as technical breakouts are concerned, last week’s breach of a 30-year resistance line by the Nikkei 225 was pretty significant, yet it’s failed to get that much attention in the opinion of our inbox here at Substantive. It certainly needs to, according to CLSA and MI2 Partners, as they highlight in today’s briefing. As MI2 point out, further weakness in the US dollar could spur a wave of repatriation from Japanese investors out of US equities. They also say dollar weakness could also benefit the pound and UK assets, as Britain’s pariah status among investors has reached extreme levels. Meanwhile, HSBC explains why the equity risk premium is increasingly important to investors, MRB Partners sets out why the macro climate for US and EM financial stocks is set to improve and Goldman Sachs outlines the wider macro implications of China’s move to the frontier of sovereign digital currency development.
capital inflows Equities Japan CLSA MI2 Partners
1. Japan – the awakening equity marketNicholas Smith at CLSA has issued a note urging investors not to look at figures showing strong foreign buying of Japanese stocks and conclude this is nothing more than the usual seasonality factor. He says the resurgence could be an inflection point for Japanese equities, coming as it does after September quarterly profits beat consensus by almost 50%. Indeed, Smith says the foreign buying reflects an upturn in expectations for EPS given that Japan handled the coronavirus extremely well and is now starting to reap the benefits. That positive outlook for Japanese stocks is shared by Julian Brigden at MI2 Partners, who says that the Nikkei 225’s break above the tenacious resistance levels last week confirms the continuation of a long-term bull market that started in October 2012, with higher lows and now higher highs. He believes there may be room for further gains given the sharp decline of the US dollar in the currency markets recently, which may start to see Japanese money flowing back to Japan and out of the US equity market. Brigden points to the fact that since 2005, Japanese investors have been net buyers of overseas equities and mutual funds (including ETFs) by more than ¥50 trillion—about US$481 billion at current exchange rates—with the vast majority of that money going to the US. If the US dollar starts to break down, Japanese investors, especially retail traders, may decide to bring their money home, he says, and even a portion of that US$481 billion could have a big impact on the US dollar, US equities and Japanese equities.
Brexit UK equities MI2 Partners
2. UK two for oneIn developed markets, investors’ biggest bête noire is the UK and with it the FTSE, and it’s not hard to understand why says Julian Brigden at MI2 Partners. After all, he says, a no-deal Brexit remains a clear risk, while the response of Boris Johnson’s government to Covid has been shambolic at best, and in a world where tech and growth are beloved, he questions whether investors would want to own an index which is decidedly old school, with heavy weightings in metals, mining, oil, gas and banks. With this backdrop, Brigden says is it hardly surprising that the ratio between the Nasdaq 100 and the FTSE 100 is at historical extremes. However, he believes the bigger picture suggests the dollar is about to move lower, and given that the FTSE 100 is packed full of potential reflation trades, the index is unlikely to continue to underperform. Adding to the potential is sterling, which Brigden believes on a trade-weighted basis remains extremely cheap and, as with UK equities, unloved by institutional investors. If they chose to close their underweight positions, he says, the potential flow would be significant and would boost returns to overseas investors.
Equity risk premium Global equities HSBC
3. Forget PE, it’s about ERPIn today’s environment, the equity risk premium (ERP) is increasingly important according to Alastair Pinder at HSBC. He says unprecedented monetary stimulus, the collapse in earnings and the rise of intangible assets, means traditional valuation metrics, such as Price to Earnings and Price to Book are becoming redundant. In comparison, says Pinder, the ERP provides a more realistic assessment of market valuations. Indeed, he finds the ERP is much better at explaining future returns than Price to Earnings, a result which is consistent across regions. Pinder believes there is scope for the ERP to decline in 2021, particularly if there is greater clarity around a COVID-19 vaccine and a reduction in equity volatility. He estimates a 10ppt reduction in the VIX to 15 could pave the way for a 70bps decrease in the US ERP and 15% upside for US equities. Longer term, Pinder says increased focus on corporate governance should also reduce the riskiness of equities and put downward pressure on the ERP. Regionally, he believes the ERP looks too high for UK and South Africa. When it comes to the UK, says Pinder, Brexit has clearly driven the ERP higher, but a resolution – whatever that may be – could reduce uncertainty and allow the market to re-rate. Elsewhere, he says India looks expensive, while sector wise, he believes EM tech looks cheap relative to US tech, and EM financials and UK and European consumer goods also appear attractive.
Global financials MRB Partners
4. Global financial stocks – look for US and EM leadershipThe macro climate for financial stocks is poised to improve in the year ahead, justifying an overweight stance in a global equity portfolio, according to MRB Partners. The firm says financial sector earnings have been hit by the pandemic, as a result of the further decline in interest rates and increased loan loss provisions, but looking ahead, an economic recovery and moderate rise in interest rate points to an improvement in absolute earnings with the potential for relative earnings to also rise over the next 1-2 years. The US and emerging market financial sectors are MRB’s preferred picks within the global sector on a 6-12 month horizon. The firm says the US stands out as offering the best blend of earnings power and underlying balance sheet strength as the economy recovers from the pandemic, while EM financials should have greater leverage to improving growth than select other non-U.S. counterparts. Upside economic and interest rate surprises are needed to unlock value in eurozone financial, adds MRB, while structural risks underpin the firm’s underweight recommendations on financials in Australia, Canada, Japan and the UK.
China digital currencies Goldman Sachs
5. China’s digital yuan and its macro implicationsChina has moved to the frontier of sovereign digital currency development in 2020, says Andrew Tilton at Goldman Sachs, with the People’s Bank of China launching pilot programmes for a digital currency with four major state banks in April, and expanding this pilot in several Chinese cities, recently conducting a trial with nearly 50,000 households in Shenzhen. He says a “central bank digital currency” offers numerous potential benefits from a policymaker perspective, including improved efficiency and safety of payments, less dependence on alternative payment systems, broader financial inclusion, lower costs of management (versus cash), greater information on transactions, and potentially improved transmission of monetary policy. According to Tilton, key risks include cybersecurity and the possibility that digital central bank money could disintermediate commercial banks’ deposit function—with attendant financial stability issues. Indeed, he says in jurisdictions with weaker payments systems or poor inflation credibility, foreign digital currencies could conceivably become substitutes for local payment methods. Tilton says the macroeconomic implications of digital currencies could be significant in the longer term. Detailed real-time economic information would potentially be available to policymakers, he says, and complementary digital infrastructure could facilitate “helicopter drops” of money directly to households. Negative interest rates might be somewhat easier to implement, according to Tilton, and there is also potential for innovations in credit and payment linked to “smart contracts” technology.