Read the full IMS Bulletin Q3 2017
We find ourselves in the eighth year of the post-2008 crisis economic recovery and equity markets are robust, as the macroeconomic background is improving. This is already the third longest economic expansion cycle since WWII, the first two being the decade following 1991 and the nine years following 1961. Year to date global equity markets have returned 10.7%, with emerging market stocks gaining 18.4%, US stocks rising 9.3%, European equities adding 8.7% and UK shares lagging, but still positive, at 4.7%. Some valuations are ‘rich’, especially in the US market, where the Federal Reserve has made further steps towards interest rate normalisation, hiking rates for the fourth time since 2015. However in other regions, such as Europe, valuations are closer to historical averages, in no way suggesting the bout of “irrational exuberance” usually concomitant with the end of the cycle.
The question on many investors’ minds is “as we are already eight years into the cycle, is the proverbial end nigh?” The most common term for this fear is “acrophobia”, a fear of extremities, which we considered in the previous quarter’s bulletin. What we have to ask ourselves is whether this fear is rational. After all, an already elongated cycle and above average valuations, along with a sometimes toxic political climate, certainly do not help investor confidence. While we cannot predict how long the rally will last, we believe that it is well supported by a confluence of positive factors.
1. Cycle Length: Advanced But Mind The History
There’s an old joke amongst economists about the statistician who drowned in three feet of water, on average. Conventional economists usually adhere to the theory of a 5-6 year business cycle. Hyman Minsky identified such occurrences in which a period of stability encourages risk taking, which leads to a period of instability, which causes more conservative and risk-averse (de-leveraging) behavior, until stability is restored, renewing the cycle. In the US, the world’s leading capitalist economy, the average cycle since 1949 has lasted around 5.5 years, so it is natural that investors may feel fatigued after 8 long years.
However if we study the cycles more closely, it is apparent that in the 1950s they tended to last for 3-4 years, yielding above 4% growth. Conversely, the more recent cycles have tended to last much longer, 6-10 years, with average growth closer to 2%. Why cycle dynamics have changed is the subject of much debate, mostly pointing towards the way central banks and regulatory authorities intervene. However, the fact is that fundamental change has occurred. Therefore the length of the cycle may be a warning sign of maturing asset prices, but it does not in and by itself precipitate its end.
2. Earnings Growth Supporting Valuations
The magic number in the investment world is 15. The valuation of a company is deemed fair when the Price/Expected Earnings ratio does not surpass 15-16 times. In the US the ratio is currently 18.5x, while it is closer to 15x in the UK and Europe, 13x in emerging markets and 14x in Japan. The number is used freely and has little importance when valuing banks or technology companies, for example. At the time of writing Amazon, one of the world’s biggest companies, was trading at $1000 per share, more than 170x current earnings and 75x expected earnings for this year, meaning that the company needs to significantly grow its future earnings in order to justify the current valuation. If analysts were to use 15x as the benchmark and valued Amazon at 75x this year’s expected earnings, the company would need to generate five times this year’s expected earnings (75/15) indeterminately for its current price to be a deemed ‘fair’.
Nevertheless for the S&P 500, which is currently dominated by technology companies such as Amazon, analysts get fearful over 15-16x P/E, i.e. the historical index average. First and foremost, the dominance of technology companies helps explain some of the higher valuations based on traditional metrics in the US. As they often have high growth rates, analysts can underestimate future earnings. Then there is the matter of profitability. In the US earnings grew 15% for the year to Q2, up from -15% in April of 2016 and a few years of 0% to 10% growth. EU companies also improved their profitability, growing earnings by 25%, up from -20% in the same quarter last year. UK companies also saw a rapid increase in profitability, but in the case of firms with large overseas operations, profitability is skewed higher by the weaker Pound. We feel that current valuations are not overly demanding on aggregate and that the acceleration in earnings supports them.
3. Improving Macroeconomic Backdrop
Overall the global macroeconomic backdrop has been improving since mid-2016. Growth rates for the US and Europe accelerated on the back of stronger manufacturing, a robust service sector and increasing consumer confidence. In Europe particularly we have also seen a significant improvement in credit conditions, which has allowed Spain to grow by 3% on average and reduce unemployment levels. Key trade and productivity indicators have improved and inflation has edged down after oil fell from a $55 high to near $46 at the time of writing, allowing producers to maintain their prices. Meanwhile important emerging markets, such as China and India, have maintained their growth rates and are willing to go forward with substantial reform to face the challenges of the 21st century. The Chinese have taken steps to curb debt levels and shadow banking, while planning for the “Belt and Road” initiative, a massive infrastructure plan to improve trade, spanning across the whole Eurasian continent. In India, the PM has taken steps to decrease corruption and increase government control over the tax base with an all-encompassing demonetisation, a general sales tax (an equivalent of VAT) and the institution of a national ID system. There are of course pockets of weakness, especially in the UK and some European periphery countries. The former has seen growth and consumption slow down post-referendum, a trend which could accelerate. The latter includes countries such as Italy, which is barely growing at 1%, and Greece, where capital controls and unemployment continue to hamper economic growth. In Q2 2017 we did see some more mixed figures which are considered further below.
4. Equity Momentum
Global equity momentum has picked up in 2017. After three years of little growth for equities (MSCI World returned 3% in 2014, lost 3% in 2015 and gained 5% in 2016, mostly during the later months) global equities have gained 10.7%. The rise has been very broad-based with almost all regions contributing positively. Meanwhile volatility is near all-time lows. Global markets have not experienced a major 5%+ correction since February 2016. More importantly, retrenchments are usually short-lived and lack depth. Especially in the US, which tends to lead global equities, we have noticed that stocks tend to rebound very quickly following a 2%-3% drop. This momentum could be attributed to several factors including:
- central banks encouraging risk taking, with a lot of liquidity chasing few opportunities as equity supply has decreased.
- the rise of algorithmic trading.
- equity underwriting has been falling in the last two years and share buybacks have been taking stocks out of circulation
- so long as systemic risks remain in check and borrowing costs are low, the so-called ’fast money’, i.e. hedge funds and high frequency traders, can pursue fast-trading strategies which may provide support in case of market retrenchments.
- an increased supply of confidence towards the new US President’s economic agenda.
5. The Central Bank ’Put’
For three decades the heads of the world’s largest (some say the world’s de facto) central bank, the US Federal Reserve, have assured markets that they would take equity prices into account when considering liquidity conditions. This stance effectively subsidises risk taking, allowing markets to leverage the liquidity offered and augment returns for risk assets. Central banks may now be reducing liquidity levels and the retraction of the Fed’s balance sheet (in essence a reverse QE) is a medium-tern concern. However, as long as investors trust that they will be bailed out by central bankers when needed, and as long as the economy is functioning well, we believe that we will remain in a secular bull market, one where equities will gain over the longer term and from one cycle to another. While the ’Put’ holds, that longer term view may well remain unaffected by various central bank activities of gradually retracting liquidity.
6. US: Anticipation of Stimulus, Reform and Capex
President Trump’s election in the US had a surprising effect. Far from the systemic risk predicted, Mr. Trump’s elevation to the highest echelons of office, in conjuncture with the Republican dominance in the Senate, have allowed for the breaking of gridlock in Washington, as the GOP now controls both chambers of Congress and the White House. This development has been touted as a catalyst to go forward with a range of issues which could stimulate the US, and subsequently the global economy.
Obamacare: The repeal of the Affordable Care Act has been at the top of the Republican legislative agenda for most of the decade. After a couple of false starts, the resolution passed the House only to be stopped at the Senate door, where it became apparent that the proposal needs to be debated and scored before it is approved. To be fair, healthcare reform is a titanic undertaking. Successfully tackled within the year, it could boost market confidence that other projects, like tax reform or infrastructure spending, will also be implemented.
Infrastructure spending: Mr. Trump’s promise of $1tr in infrastructure spending, also featuring $26bn for the great Mexican Wall, has hit a roadblock as Democrats remain sceptical and Republicans deeply divided and questioning the numbers.
Tax reform and investment incentive: The Treasury secretary presented the broad framework for his tax plan last month:
a) the seven tax brackets will be revised to three, with rates of 10%, 25% and 35%
b) companies are going to be offered a 10% tax on repatriation of overseas cash
c) corporate taxes are to be cut from 35% to 15%. The plan is ambitious and would pose the biggest tax reform since 1986, but lawmakers are unconvinced that the effect on public finances will not damage the economy. Tax reform could also bring a 50% bonus depreciation for companies, i.e. allow them to depreciate fixed assets faster. It allows businesses to take an immediate first year deduction of 50% on the purchase of eligible business property. This, in theory, should incentivise companies to accelerate investment in fixed assets. It is also notable that these developments might come at a juncture when US CEO confidence is at its highest level since 2007, which could finally drive profits more towards investments rather than high dividends and buybacks.
Risks
There are plenty of reasons that support the continuation of the current cycle. However there is also a litany of negative catalysts which could upend the cycle. First and foremost are the signs that the world is transforming. We stand at the cusp of a great technological revolution, by some accounts tantamount to a new industrial revolution. Apart from the standard 5 year cycle, economic theory also looks at a 50-60 year cycle, also known as a ’Kondratiev wave’. Russian economist Nikolai Kondratiev first identified these cycles which supposedly affect all sectors of an economy and are driven by big (i.e. not marginal) technological advancements that influence all of society. For our age, this could be the advent of robotics and AI which are already disrupting many industries, from car makers to banks. Anatole Kaletsky identified the post-2008 period as a new era for western capitalism which he dubbed ’Capitalism 4.0’. Kaletsky posited that the western capitalist system must reinvent itself or witness the rise of China as the next economic paradigm. Although central banks have prevented the consequences of non-adjustment materialisingso far, as central bank liquidity is slowly withdrawn, the global economic and financial system will be tested. Coupled together these theories suggest that we may find ourselves at a precipice of momentous change. However, we have no way of knowing if the theories hold or how long the transition will take. The old saying that “markets can stay liquid longer than you can stay solvent” serves as a warning for asset allocators who might want to short the market.
A further significant risk is the process of interest rate normalisation. For close to a decade, global interest rates have been kept at ultra-low levels, accommodating investors and rekindling risk taking. While we have evidence that this risk-taking has somewhat spilled over from Wall Street to Main Street, i.e. from stocks and bonds to real businesses, we must acknowledge the pervasive effect that low rates have had on savers and pensioners. As the western world (China and Japan as well for that matter) grows older in a profound demographic shift, savers and pensioners are becoming an increasingly important demographic. Additionally, as people find it harder to retire frustration grows against a system that doesn’t seem to work for them. This anger turns into protest votes, some of which we have already seen: Brexit, the US election and the strong backing for populist parties in recent European elections. Interest rate normalisation should help pension funds to match their liabilities and quell some disappointment against the establishment, but it could also risk derailing the recovery. It is a process which pits some groups against others. The young against the old, the industrial sector versus the financial sector, consumers and investors versus savers. As interest rates normalise, we are also conscious of valuation differentials. So far, companies with high levels of debt have enjoyed a valuation discount versus their peers, as debt is considered a cheaper form of financing than equities. Higher interest rates mean higher interest payments, which should reduce the valuation discounts for stocks of highly leveraged companies.
Fears and Flows 