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15 January 2015

Macro Strategy Update

The Long Run, In the Short Term

Executive Summary: We maintain our view that the world is not headed for a recession andgrowth will continue. Long term trends are changing and we must be aware and capitaliseon it. Commodity importers and exporters will experience very different growth trends, whilstthe US looks set to lead the world economy once again. In the short term, be ready for higher volatility as financial markets grapple with asset re-pricing once the Fed hikes rates. Looking

across asset classes, there is no better place to be than in equities, but be ready for downdrafts this year.

Article

Global Economics.In our previous article, we touched on diverging global growth trends and posited that theworld as a whole would likely not enter a recession but instead get stuck in second or thirdgear. So far, macroeconomic data suggests that this remains the case, Composite PMInumbers which are currently slowing from the levels achieved in mid-2014 but still above 50(Fig 1). Global GDP growth is still below long term trends but we expect it to gradually pick upgiven a potential consumption boost from lower commodity prices (Fig 2).

Fig 1: Composite PMI Of The Various Economic Regions Remain Expansionary

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Fig 2: Global GDP Growth To Slowly Grind Higher

In our 16 Dec 14 article, we alluded that cheap oil was beneficial for the majority of countriesin the world. The chart below shows the inverse correlation between growth and oil prices.The effect should start to filter into the various economies by the second half of the year andthis would contribute to the growth tailwinds (Fig 3).

Fig 3: Positive Growth Effects From Cheap Oil

We would like to point out some important long term trend changes which strengthen thecase for US ascendancy in the world economy once again. There is no denying that key EMcountries exhibited stellar growth in the 2000’s. On a relative basis however, US growth hasbeen increasing significantly since the 2008 financial crisis such that the growth differential ofEM countries during the past decade has declined and is expected to shrink further (Fig 4).

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Fig 4: Shrinking EM vs US Growth Differential – It Last Crossed In 1999

The US continues to lead the world in productivity and technological innovation, benefitingfrom favourable demographics including immigration and quality of education, and thelion’s share of world R&D spending. With this advantage and coupled with the relatively slowwage growth of the past 5 years, the US is second only to China in terms of manufacturingcost competitiveness (Fig 5). This is obviously not a fluke or one time occurrence, but a longterm structural shift which will benefit the US economy for many more years to come.

Fig 5: US Productivity and Cost Competitiveness Is A Structural Shift

With the divergence in growth paths and subsequent divergence in monetary policybetween the US and the rest of the world, it is likely that the cycle of US dollar appreciationcontinues for a few more years (Fig 6). The consequence is a negative view on commodities

and volatility in both currencies and markets of weaker EM countries.

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Fig 6: Dollar Strength Due To Trend Change And Diverging Monetary Policy

Expectations for Europe remain relatively muted as the positive effect of a cyclical rebound islikely offset by headwinds arising from uncoordinated reforms and political uncertainty. Near term political risks arise from the Greek parliamentary elections in late Jan, and other elections in UK, Portugal and Spain in 2015 could hinder structural reform if populist partiesgain more vote share. On a positive note, there are signs that the drag from austeritymeasures are slowly waning (Fig 7), and hope that the ECB’s QE program will provide thenecessary kick-start that the Eurozone needs (Fig 8).

Fig 7: The Drag From Fiscal Austerity In the Eurozone Is Waning

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Fig 8: ECB QE Program And The Likely Effects

Looking at EM and in particular emerging Asia, we expect these economies to continue toperform well in relation to global peers. The central government in China appears content toaccept slower reform to ensure greater stability in the economy, as shown by small stimulusmeasures throughout the past two years (Fig 9). South Korea and Taiwan which are tech-heavy economies with strong export links to US should also benefit from US strength. For themajority of the economies, lower commodity prices will help consumption and investmentand lower inflation.

Fig 9: Expect China To Continue To Guide And Moderate The Economy Through TargetedStimulus

Market Implications.We raise the prospect that 2015 brings an era of more volatile equity, fixed income andcurrency markets. With the Fed expected to start rate hikes in July, the resulting shift in theyield curve and across the board asset re-pricing will definitely introduce more volatility into

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markets (Fig 10). Re-pricing in bonds would likely lead to rising yields which would result in anunpalatable negative return especially for investment grade issues (Fig 11).

Fig 10: Equity Option Implied Volatility and Fixed Income Volatility Have Been Increasing

Fig 11: At Present Yields, Fixed Income Provides No Buffer Against A Small Rate Rise

We see no reason not to hold equities. With bond yields at current levels, equity risk premiumsfor many markets are elevated and are above 1 standard deviation from long termaverages. This means that despite above average valuations for some markets, we aresufficiently compensated for taking on equity risk (Fig 12).

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Fig 12: Equity Risk Premiums Are Elevated. High Risk Premium Means More Compensation For Taking On Equity Risk

Conclusion.We wrap up this update by reiterating that we see growth continuing at an incrementallyhigher pace than last year. We should see boosts to consumption coming from lower oilwhich would benefit oil importing countries. The US could take over the lead in global growthonce again which represents a structural shift in the world economy. Be mindful that we willface higher volatility in markets this year as a result of Fed policy but there should be ampleliquidity given divergent monetary policy from the various central banks.

IMPORTANT NOTES: This report is provided for the information of the intended recipient only and should not bereproduced, published, circulated or disclosed to any other person without the prior written consent of GYC. Theinformation and opinions expressed herein reflect a judgment of the markets at its original date of publication and aresubject to change without notice. GYC does not warrant the accuracy, adequacy or completeness of the informationherein and expressly disclaims liability for any errors or omissions. The information is given on a general basis withoutobligation and on the understanding that any person acting upon or in reliance on it, does so entirely at his or her ownrisk. Any projections or other forward-looking statements regarding future events or performance of countries, markets or companies are not necessarily indicative of, and may differ from, actual events or results. Neither is past performancenecessarily indicative of future performance. You should make your own assessment of the relevance, accuracy andadequacy of the information contained in the information provided and make such independent investigations as youmay consider necessary or appropriate. Accordingly, neither GYC nor any of our directors, employees or Representatives can accept any liability whatsoever for any loss, whether direct or indirect, or consequential loss, thatmay arise from the use of information or opinions provided.

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