Goodbye to all that

After almost 18 months without a setback, investors forgot what volatility felt like. That complacency has now been shattered, but sound underlying business conditions remain intact. That’s no bad thing. 

Finger pointing to graph - Rathbone Investment Management

Investors were ebullient when the year began. Complacent even. That is no longer the case.

As of late January, the global equity benchmark hadn’t suffered a daily setback greater than 1.5% since September 2016 – a run unprecedented since 2006. After a tumultuous February and March, much of that complacency has been washed away. At the time of writing, most equity markets in the developed world have fallen about 10% from their peaks. Over half of the companies listed on the major US and UK indices have stock prices which have fallen below the price they averaged over the last 150 days. This may seem like a rather obscure statistic, but it is a significant technical indicator. It’s indicative of a broad-based loss of momentum, and momentum can be a powerful force in stock markets. It comes down to simple human behaviour: people don’t like buying what everyone else is selling. 

For that reason, a sharp recovery may not be around the corner. But we do believe that markets will recover. We don’t think this tumult will precipitate a thunderous crash. 

Stock market falls much greater than 10% are very rare at a time like this, when business is booming and the economy is growing steadily. And our framework for assessing the ‘business cycle’ – in cruder terms the flow from boom to bust – suggests that the US and global economies are still solidly in the expansion phase. Unemployment, personal income and industrial production are running better than their recent history. More technically, we say that they are accelerating away from the trend, and it’s this concept which underpins the best barometers of where we are in the business cycle.
In short, economic growth remains strong and inflation is still relatively low. A recession is unlikely within the next six months and you don’t tend to see sustained share price falls without one.  

With this in mind, we think UK stocks – which have underperformed other major developed markets so far this year – could offer value. The FTSE 100, with its foreign earnings and bias to faster-growing Asian markets, is particularly interesting. UK shares have significantly underperformed the MSCI World Index since the end of 2011. This was due to a number of factors: the UK’s high exposure to poorly performing sectors such as banking, oil and mining; a relative lack of exposure to higher-growth areas such as technology; and more latterly concerns about the potential for Brexit to impact the UK economy. At the time of writing, the FTSE 100’s closing price was 13.1 times the index’s expected earnings for the next 12 months. That’s roughly a 20% discount compares to the S&P 500’s 16.5 times. On another good valuation measure – free cash flow as a percentage of the value of all shares – the FTSE 100 has also become more attractive. This has risen from 4.8% at the time of the vote to leave the European Union to 6.6% today – better than the S&P 500. 

The UK has challenges ahead, but we think the FTSE is being judged too harshly by the market.  

Anatomy of a fall

During the worst stock market tumbles, investors tend to lose all appetite for risk. By this we mean companies making luxury consumer goods, commodity miners and banks – all those businesses most affected when people try to cut spending fast. Or on a more global view, investors abandon emerging markets in favour of home. Investors instead flock towards more defensive parts of the market, whether the utilities or soap and cereal manufacturers no-one can do without, or government debt. This ‘flight to quality’ exacerbates falls in riskier segments. Pleasingly that hasn’t happened this year: emerging markets have outperformed developed ones; UK small-caps have outperformed the FTSE 100; those riskier stocks haven’t underperformed those that are more steady and stable. Equity investors that focus on profitability – such as return on assets – and long-term growth have been rewarded. Our stock selection process centres on these very attributes.

The sell-off started in early February when investors started to fret about rising inflation leading to tighter monetary policy from the US Federal Reserve (Fed) and higher bond yields. Higher bond yields, all other things being equal, mean lower equity prices because bond yields are used to determine the value of future earnings today. The higher the yield, the less you value cash you will get in the future. This is because if you can earn a higher return on something as near to risk-free as a government bond, then riskier investments become less attractive. 

That’s why we told you in January that we were especially vigilant for signs that economic growth wouldn’t be strong enough to offset the negative impact of higher bond yields on stock prices. At the moment, our analysis suggests that bond yields will not rise too far too fast, and global growth will be sufficient for equity markets to continue to satisfy most investors’ required returns.

Valuing a Treasury 

We have done a lot of work on assessing the likely path of bond yields. In trying to answer how far and how fast yields will rise, we first estimate the US economy’s ‘neutral real interest rate’. This is the bedrock of bond yields. Interest rates are dictated by desired net savings: If more people want to save than invest, rates will fall to the point where they encourage people to invest; if investment overwhelms saving, then rates will rise until bank deposits become more alluring than risky projects. The neutral interest rate is what brings saving and investment into balance.

One approach is to assume that this neutral interest rate is related to potential GDP growth, which is the growth rate an economy can sustain without pushing inflation higher. From there was can build up our estimate of what the 10-year Treasury yield should be –roughly 3.25%.

We tested this against other calculation methods and analysis by third parties, including the Fed, and found a range of 2.75-3.25% was most robust for the 10-year Treasury yield (for more detail, see our latest InvestmentInsights).
Changes in inflation and cyclical deviations in growth expectations as well as other factors such as the impact of quantitative easing (QE), cause oscillations around the neutral real interest rate. But it’s the neutral real interest rate that establishes an anchor around which bond yields are unlikely to stray too far. At the time of writing, the 10-year Treasury yield was 2.75%. So will inflation push the yield out of our estimated band over the next six months or so?

Inflation could move higher, driven by greater wage increases, President Donald Trump’s fiscal stimulus and tax cuts, the weakened dollar and high oil prices. However, we believe it isn’t headed for the moon. If we are correct, slightly higher inflation would push the 10-year yield closer to the middle of our estimated 2.75-3.25% band.

To err is human

Perhaps the biggest risk to our assumption comes from the Fed itself. The central bank’s closely watched ‘dot plot’ – which traces all voting and non-voting members’ estimates of interest rates for the next few years – suggests that interest rates will rise to around 3% by the end of 2020 and beyond. Adding the average spread of the 10-year bond, it implies a Treasury yield above 4%. This seems at odds with our calculation of the neutral rate and the model produced by the Fed’s own economists. Notably, it increases the risk of a monetary policy mistake somewhere down the line (such as the Fed increasing rates too far), which may start to put greater upward pressure on bond yields today. We noticed this some time ago, but we are comfortable watching how the Fed proceeds for now.

Another slow-burning risk has flared up in the past month: trade war. Mr Trump campaigned on a stridently anti-free trade platform. On his first day in office he dragged the US out of the Trans-Pacific Partnership, torpedoing what would have been the largest regional free trade agreement in history. (The remaining nations subsequently ratified the deal under a new name.) He followed that up by pushing Mexico and Canada to renegotiate the terms of NAFTA. He also levied stiff tariffs on some minor imports.

All this didn’t really capture the market’s attention. Perhaps because investors were focused on Mr Trump’s battles to get healthcare and tax reform through Congress. But when Mr Trump announced punchy tariffs on steel and aluminium imports that were blatantly aimed at China, investors took notice. And when he followed it up with more tariffs on a wider array of Chinese products, investors took fright. The S&P 500 fell almost 6% in a week. 

When Donald Trump won the presidency in November 2016, we believed he would struggle to make headway on virtually all of his flagship policies. However, our scepticism about Mr Trump’s ability to tame Congress didn’t extend to thinking he would be completely ineffectual in the White House – and it still doesn’t. There is plenty that Mr Trump can do by executive fiat, especially in matters of trade.

We detailed the benefits of free trade and the potential for a trade war that could come from tit-for-tat tariffs in our Trade of the century report of October 2016. So far, China’s response has been relatively modest, boosting tariffs on US pork, fruit, wine and some other products. If it really wanted to send a message it would have included soybeans, aircraft and sorghum. 

It’s hard to tell how much further Mr Trump will go with tariffs and trade. As his rhetoric reached fever pitch, his Treasury Secretary, Steven Mnuchin, was in China hammering out a deal that would scrap the metal tariffs before they are even enforced. The two countries are apparently trying to rebalance the US trade deficit with China by reducing Chinese tariffs and improving intellectual property laws to entice American businesses to export more to the Middle Kingdom.

If it comes off, the bargain would probably rank as one of the best deals Mr Trump has ever brokered. But it’s a massive gamble.  


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