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Markets are facing a renewed bout of turmoil. Bond yields are surging, equities sliding. Two strategists who called the turn in the market with unusually canny timing are Teun Draaisma and Joachim Fels of Morgan Stanley.
Mr Draaisma, head of Morgan Stanley’s European Equity strategy team, issued a strategy note last Tuesday warning of ”sell” signals from equity markets, partly because of the risk that interest rates are rising to critical levels. His note warned of a ”full house” of sell indicators including higher bond yields, increasing manufacturing orders in the US, valuation concerns and risk barometers.
He said such such a ”full house” sell signal had occurred only five times since 1980. Equities have always been down in the next 6 months, on average by 15 per cent Previous occasions include September 1987 and April 2002.
Mr Fels, chief global fixed income strategist at Morgan Stanley, made a similarly prescient call. In late May, he warned the bubble in bonds may be deflating . He said the overwhelmingly negative recent newsflow for bonds is only the beginning of a major bear market for the asset class.
The two strategists will answer your questions in a live Q&A this Monday from 2.30pm BST. They will talk about the outlook for bond and equity markets and whether last week’s sell-off was overdone. They can also answer questions on such issues as how investors should be positioning themselves, whether the credit cycle is turning, where the investment opportunities are, how big a risk global inflation is and what sectors are likely to outperform.
To me it looks like the tighter labour markets in the US and Europe are due to a negative factor, low productivity growth, rather than high economic growth. Comments?
Jan Andreassen, Oslo, Norway
Joachim Fels: True for the US, where the productivity boom that started in 1995 has ebbed in recent years. Not true, in my view, for Europe, where productivity growth has started to pick up. Europe has had impressive employment growth (relative to its disappointing GDP growth) for much of this decade. The reason: labour market reforms and wage restraint. The newly integrated workers, initially not so productive, are now becoming more productive through learning-by-doing, IT, and new investment in machinery and equipment. Somewhat belatedly, Glodilocks is arriving in Europe.
How would you describe the role of hedge funds on the securities market. Do they stabilise or destabalise the market? Which of them would you find as the best and why? What are your criteria of assessment?
Krzysztof Szlichcinski, Warsaw, Poland
Teun Draaisma: It is tempting to generalise when making statements about hedge funds, but the reality is that there are many different types of hedge funds, some long-term, some short-term, some high risk, some low risk, some with high leverage, some with low leverage. The more efficient markets are, the better the allocation of capital can be. Hedge funds have more flexibility in terms of the type of investments they can make. The growth of hedge funds has allowed markets to become more liquid and more efficient in my view, not in the least because the growth of derivatives markets allows financial risks to be spread over many different players. However, risks still - and will always - remain, and when there is more leverage there is more overall risk. Possibly, hedge funds have made markets more stable during the vast majority of times, but potentially more unstable in a four or six sigma event, because of the higher leverage in the system, overall.
How do you see the US economy performing over the next two to three years?
Joachim Fels: The US economy is just emerging from a mid-cycle slowdown, with business investment and inventories propelling output in Q2. Construction should bottom out later this year, and consumer spending should slow somewhat from its heady pace in response to the landing of house prices. Taken together, I think the US economy will grow at or slightly above the growth rate of potential output, which I believe to have slowed from 3 per cent plus to only about 2.5 per cent. Hence, inflation should remain sticky above the Fed’s comfort zone, and further rate hikes by the Fed cannot be ruled out.
Sitting in Stockholm, it seems like Swedish stocks were hit harder than elsewhere last week. Do you have theory on why this was?
Teun Draaisma: The Swedish economy is quite cyclical and has a well developed industrial and technology sector, and its equity market has a higher cyclical and beta component than other markets, through their engineering and technology sector most of all. Whenever markets get hit Sweden tends to be hit harder. Sweden is one of the best global equity markets for the last 25 years though!
Is the recent rise is interest rates and the creation of ‘Sovereign Wealth Funds’ threatening to put an end to what has been called Bretton Woods II? If so, what might be the implications?
Donald Benson, Johannesburg, South Africa
Joachim Fels: I don’t think the end of Bretton-Woods II is near. The system still makes economic sense for China and most other dollar-peggers. It gives their goods access to a large consumer market and provides an anchor for monetary policy. The US in turn benefits from cheap imports and high asset prices. SWFs may buy fewer bonds and bond yields may therefore rise, but the bulk of their assets are likely to remain in the US dollars. They will merely buy other assets, for example big-cap stocks. Rumours of BW II’s death are greatly exaggerated, in my view.
Has the US Treasury market been oversold? I wanted your view on what this means for the equity market, M&A activity and investor risk appetite.
Rajiv Ahuja, Boston
Teun Draaisma: Bond yields are crucially important for equity markets. Rising US bond yields is good for equities initially, up to 5 per cent, as it denotes a better growth outlook. Beyond 5 per cent it becomes a problem though, as it hurts the relative valuation case for equities, as well as the growth outlook. Rising rates across the curve from current levels would be a big further problem for equities, that is why inflation releases such as CPI and PPI in the US later this week are really important. Food inflation is going through the roof, commodity prices are high too, so watch this space.
If rates can stabilise and slowly come down from here that would be the best news for equities. If inflation and growth slows down that would be best, while higher growth inflation and rates would be the worst case scenario. We prefer to be in cash than in equities for the next 6 months, and we are overweight cash, neutral equities and underweight bonds.
What is your view on how far the ECB will raise rates? Do you think they are like to go too far and damage the economy?
Roger Thornton, Sussex
Joachim Fels: Our ECB Watcher Elga Bartsch thinks the ECB will hike two more times, taking the refi rate to 4.5 per cent by the end of this year. The underlying growth momentum appears to strong enough for the economy to stomach higher rates. To be sure, interest rate sensitive sectors such as construction are likely to slow. But solid global demand and decent consumer demand should keep growth on track.
What is your view on energy stocks? Do you think an investor should be investing in this area at the moment?
Elizabeth McKenzie, Scotland
Teun Draaisma: I am very positive on energy stocks, they represent very good value. First, I think the oil price is much more likely to go up then down, in part because hurricane season has just started, and the supply situation is tight. Second, the stocks are quite cheap now, after having lagged behind the market for 20 months. Third, they have strong balance sheets, and they could benefit from using more debt to create value. We like most large oil companies, and quite a few of the smaller oil services companies too, although the valuation case as well as the risk-reward for the latter category is less compelling.
Mega caps have been dogs for so long I can’t remember. Is there any chance that we might be starting to see them start to bounce back a little if risk aversion and bond yields start to rise? Do you favour any particular sectors for meg-caps?
John Butters, New York
Teun Draaisma: Mega caps have underperformed for seven years now. Now is the time to buy them relative to the rest of the market. They have never been cheaper relative to the rest of the market, while merger and acquisition activity, as well as private equity, is increasingly going after larger caps. Balance sheets are also strongest. Finally, the past few years of bull markets tend to be great for mega caps, as asset allocation flows and retail money favour big and well known names, such as Nifty Fifty between 1968 and 1973, and TMT between 1997 and 2000.
There has been a lot of talk about sovereign wealth funds may be diversifying official reserves away from US Treasuries? Do you think that has been a factor in the recent rise in bond yields? Surely it cannot be a coincidence. Maybe the markets are pricing in reduced inflows into bonds.
Vijay Patel, Hong Kong
Joachim Fels: I agree the talk about SWF’s reallocation away from bonds into higher-return assets – whether true or not – has played a role. Bond yields have been kept artificially low in recent years due to heavy buying by the reserve accumulators. Any signs that they turn to other assets should help deflate the bond bubble. But I believe that the main reason for the bonds sell-off has been robust global growth and the apparent rebound of the US economy, which has changed the outlook for short rates.
Why is Morgan Stanley neutral on equities when you have issued a sell note on the market?
Patrick O’Brien, London
Teun Draaisma: Our approach is based on a combination of quant models and logic. We never wish to contradict our quant models, but we do not need to follow them precisely. Our quant model says: ”on a six-month view, sell equities as there is a 15 per cent correction coming and rates are breaking through critical levels”. Our quant models also say: ”on a multi-year view, this is still a bull market and we will go to new highs before this bull market is over”. Finally, our quant models say that consensus sentiment is quite cautious. Real big corrections tend to happen when sentiment is overly optimistic, or when recessions hit. Therefore, we expect sideways to down equity markets for the next six months, we prefer cash over equities, we are overweight cash, neutral equities and underweight bonds. We are positioned in such a way that we would perform well during a correction in equities.
How far do you think bond yields will rise over coming months?
Tony Tassell, London
Joachim Fels: Following last week’s sharp sell-off, we may enter a consolidation phase near-term or even stage a short bear market rally if risky assets correct further. But eventually I expect 10-year US Treasury yields to break above 5.5 per cent and perhaps reach 6 per cent during the second half of the year on rising inflation concerns. In such an environment, 10-year Bund yields would probably pierce the 5 per cent level.
Before taking on his current job in January 2005, Mr Fels co-headed Morgan Stanley’s European Economics Team. He also served as co-head of currency economics, lead UK economist and senior German economist during his career at Morgan Stanley. Mr Fels has been the firm’s European Central Bank watcher since its inception in 1998.
Mr Fels is also member of the Shadow ECB Council, of the German Banking Association’s Economic and Monetary Committee, and of the Volkswagen Foundation Asset Allocation Advisory Board. Since 1999, he has been advising the German Finance Minister on international economic policy and financial market issues.
Mr Draaisma joined Morgan Stanley’s equity strategy team in 1997 and is a member of Morgan Stanley’s Asset Allocation Committee of the firm. The Strategy Team has been voted number 1 in 6 out of the last 8 years in the Institutional Investor polls among investors, currently second. The strategy team also runs the Morgan Stanley European Model Portfolio, which has outperformed its benchmark by an average of over 3 per cent a year since inception in 1994, outperforming in 11 of the 13 years. Prior to joining Morgan Stanley, Mr Draaisma worked in the economics department of the Organisation for Economic Cooperation and Development.