Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett considers whether the recent market rally will prove sustainable, while Tom Mansley argues that US consumer credit remains resilient, supporting mortgage-backed securities. Ernst Glanzmann reflects on the ongoing pendulum-like effect of the pandemic on Japanese equities and how a stronger yen and easing commodity prices could be supportive of the asset class going forward.

08 December 2022

David Dowsett – Global Head of Investments

Overall, markets remained positive over the last week, for which I believe there are two key drivers. First, during his speech last Wednesday, Federal Reserve (Fed) Chair Jerome Powell said he would be conscious not to overtighten. Second, we are seeing continued evidence that the Chinese authorities are reopening the country, with relaxed requirements for PCR tests for public events in Shanghai announced over the weekend. Both events have been positively received by the market. Markets are therefore still experiencing end-of-year rally conditions but we should maintain some caution given how far and how fast markets have rallied.

The payrolls data released on Friday showed a resilient labour market in the US. This led Larry Summers, former US Secretary of the Treasury, to state that we might need a higher end point for Fed funds again. This is still to be determined but I think the evidence is there in the resilience of the US economy; even if supply side constraints are easing somewhat, demand still remains strong in the US and there is no evidence that this will slow with average hourly earnings looking fairly strong. I therefore do not expect this to be a continued, open-ended rally back to the levels previously experienced before the sell-off began. Rather, I think there will be some back and forth.

The FOMC meeting next week will be the final key event for the year, but we are in reduced liquidity conditions into year end. This can lead to some volatility associated with the fact that investment banks have little interest in providing any inventory into year end given how challenging 2022 has been.

Tom Mansley – Mortgage Backed Securities

The Fed has been very loose in terms of monetary policy for a long time and now it needs to tighten by raising rates and shrinking its balance sheet. However, not only does the central bank have to compensate for its own overshoot in policy but it also must account for government fiscal policy which was also very stimulative. When Fed monetary policy and government fiscal policy are simultaneously stimulative, they are very powerful and have caused high inflation which the Fed now has to counter. Alongside rate hikes, Fed Chairman Jerome Powell has maintained a hawkish rhetoric in order to break the psychological inflation spiral as when people believe there will be inflation, it is self-reinforcing. With inflation slowly ticking down, investors are wondering when the Fed will pivot and so we have seen a rally in risk assets and the dollar selling off slightly.

We believe the US consumer is in a strong position to withstand Fed rate rises. The household debt-to-income ratio has fallen significantly over the last 15 years, meaning there is less debt versus income. As a result, consumer credit looks relatively strong compared to corporate and sovereign credit. Debt to income today has returned to where it was prior to the early 2000s. The other factor to consider is that consumers took advantage of a period of low rates to refinance debt and lock in low rates. For example, many in the US have 3% 30-year fixed rate mortgages, meaning they have locked in a low interest rate on a low debt level. We can see this through the debt service ratio, the proportion of income that services debts, which is sitting near all time lows. Additionally, the savings rate spiked to 30% during the pandemic. According to the Fed, households have accumulated USD 1.7 trillion in excess savings since the beginning of Covid through a combination of government stimulus programs and reduced expenditures. This will likely give consumers a lot of power to get through a recession. The combination of low debt levels, low debt servicing payments and excess savings mean that consumer credit will likely remain strong through a downturn. It also means the Fed recognises it can be more aggressive and cause a recession without significantly harming the consumer. We are also coming off a very low unemployment rate, currently at 3.7%, slightly above the recent 3.5% 60 year record low. Again, this means the Fed can raise rates and if the unemployment rate goes up even 2%, it only brings it up to a normal long-term average.

There are two big powers fighting each other in the housing market right now. One is the supply versus demand imbalance which puts upward pressure on prices. The other is that home prices have risen and mortgage rates are high so it is difficult for new home buyers to afford houses which puts downward pressure on prices.

Regarding supply in the housing market, there are very few vacant homes in the US. We can also look at available supply in terms of months of supply, which refers to the number of months it would take for the current inventory of homes on the market to sell given the current sales pace. Months of supply is currently around three months, where the norm is approximately five months. There is a shortage of homes and an overall shortage of supply versus demand. Prior to 2009, there was more supply than demand, but we have since had an extended period of a lot more demand than supply.

Regarding the demand side, millennials tend to have waited longer before getting married and having their first child, which is acting as a delay mechanism in our society. Traditionally when a household was formed, they bought a house. However, about 15 years ago, that model broke and when people formed households they would rent, rather than buy. However, around 2016-2017, millennials started to buy houses, a trend that accelerated during the Covid pandemic. But this delay meant that there was 10 years of pent-up demand. The millennial generation is enormous and has a large influence on what goes on in the economy and society. The sudden switch from renting to buying meant a lot of homes were needed and the market was consequently very short of homes.

The big question is where do house prices go from here, considering those two powerful forces of rising prices and decreasing affordability. The last time we saw a steep increase in prices, they started to go down following the Global Financial Crisis (GFC). However, there were too many homes at that time and the home ownership rate was high so that there was more supply than demand. Today, it is very different. As soon as prices decrease, there are a lot of millennials that missed out previously who will likely look to buy. We believe we may see home prices go down 10%, increasing their affordability so that millennials can again purchase homes. Underwriting is currently very tight, very different to 2005 when we saw loose credit standards. Since then, it has been harder to get a mortgage and if you get one, you have proven that you can afford it.

We prefer seasoned mortgages. With 15-year-old mortgages, prices would have to decrease a lot more than during the GFC to get back to the cost basis in terms of home price. Additionally, home prices are far higher, but the mortgage balances are lower. A 15-year-old mortgage therefore has a large equity buffer, and the borrower has demonstrated an ability to pay, which only gets easier as time goes on. Therefore, these types of mortgages will be resilient to a recession and to home prices falling, in our view.

Spreads of these mortgages are generally stable. However, during Covid, spreads widened across the world in all sectors. In the seasoned mortgage space, spreads never returned to where they were pre-Covid before they started widening out again this year, driven by recession fear. The 2020 event, synonymous with 1998, was a liquidity crisis with too much leverage in the system. However, today we are experiencing a standard recession widening. It is important to consider what is widening out because of a risk premium being attached to everything and what is widening out because of a risk premium plus an expectation of actual loss. We believe the seasoned mortgages have widened but not out of expectations of real underlying losses. We believe consumers can pay, as outlined above. They have large excess savings and large amounts of equity in their homes. Furthermore, there are programmes that were designed during the last crisis to help people through recessions specifically, such as forbearance, which is essentially a payment holiday, or temporary modifications to interest rates. Given the current strength of consumer credit, a vast majority will not need those programmes but their existence is important because they will limit foreclosures, which should minimise any losses. The programmes maximise cash flow for the investor and at the same time leave the homeowner in the house and allows them to get through a recession. This is why we did not see many foreclosures during Covid, even though the unemployment rate hit 14%.

Spreads are currently at almost the Covid peak, which could make for a great entry point, in our view. When Covid occurred, it was difficult to discern between actual loss and risk premium across markets, but we now have a much better understanding of what is going on as we enter this downturn. We believe that consumer credit will be resilient going forward.

Ernst Glanzmann – Japanese Equities

A central topic we are currently dealing with is the pendulum-like effect of the Covid pandemic, where companies that initially benefited are now reversing their gains, while those that suffered initially are benefiting from the reopening. This is an ongoing process and we believe it could continue into 2023. It has created a multi-layer dynamic that is playing through Japanese equity markets.

We see this effect in the IT industry. We clearly see a downtrend in this sector, for instance PC demand is petering off. This is an area which was an early beneficiary in the pandemic and is now reversing. Similarly, mobile businesses have seen a slackening in demand which also feeds through into demand for dynamic random-access memory (DRAM) and NAND, a type of memory chip. Furthermore, reduced demand for PC and mobiles also feeds into reducing fixed investments, such as the equipment needed to produce DRAM and NANDs. We expect that by mid-2023, this process of correction will start to slow and could pivot going into 2024, so while this is a short-term set back, we believe we will return to a more solid growth pattern.

Going into next year, we expect to have a smoother flow of global goods and better supply chain processes. We will also certainly see recovering tourism, leisure and business travel. We have seen growing private consumption following the reopening of the nation after the pandemic. We also believe that the Chinese economy is on a recovering track and it is starting to look more optimistic in terms of its zero-Covid strategy which would be a tailwind for Japanese equities. Earnings-wise, we may have a tougher period ahead, especially in the first half of the next year. We would expect a single digit net profit decline - nothing dramatic but more of a stagnation. In the short-term, we would expect that earnings will start to recoup and return to growth towards the end of 2023 and into 2024. Some of this will be due to the yen appreciation that we expect once the Fed slows down its hiking cycle. This would be good news for all input prices that go into end products sold in Japan which will protect, and even improve, margins. We also expect cost pressures to ease. Both the commodity price index and the copper price are easing and while oil is still at historical high levels, the price is stagnating at best. Easing commodity prices, especially combined with a stronger yen, are supportive of margins.

A positive note is an increase in building orders for factories and power plants in Japan. There is substantial activity building new facilities in Japan. This dramatic growth could be seen as onshoring or it could mean that capacity is expanding. During the pandemic, we faced major supply chain issues and strong demand so capacity was limited in many areas. If we look at the IT industry and the long-term forecast for data processing and what is needed to facilitate this then it makes sense to onshore and build new factories. This activity will require new parts, machinery and factory floors, most of which will be automated as much as possible, so this is good news for Japan’s robotics and related parts industries.

While we believe we may see a slowdown in the US economy in the next few months, we do not believe that we will hit a major recession as the World Export Index does not currently indicate a major slowdown. We believe robotics are still on a sustainable growth path despite the gyrations around the incremental growth pace. The same is true for numerical control machines, which are automated machines, which could be argued are at a peaking point but we do not expect a major fall. Semiconductor sales have seen drawdown in the Asia Pacific region, but we believe this could be short term as there is still pandemic-related drawdown in that region.

In terms of valuations, similar to many other markets, Japan is at bottom levels and even in some cases at historic low levels. It could be argued that these earnings setbacks we expect to see a few months from now should be priced in already to some extent and should not influence the market too much going forward.

TOPIX companies have achieved net profit growth of 8% per year for 10 years on a rolling 10-year calculation. That achievement measures well with other regions. At present, we see little to argue against a repeat of this growth rate over the medium to longer term. More and more Japanese companies are involved in global businesses and opportunities. These companies have major positions in global markets and they benefit from global trends. Japan is home to companies with clear exposure in niche, growth areas, such as air conditioning, heat pump businesses, factory automation, semiconductor manufacturing equipment and medical devices, just to name a few.