One way or another - investment update

Stock markets continue to take an optimistic view of the risks to future earnings, but we remain gently cautious and note that there are plenty of reasons not to be complacent.

Three months ago, we wrote that global macroeconomic developments offered investors several reasons to be cheerful, but we believed that they had become too sanguine, too quickly about the remaining risks to future earnings. This was reflected in higher valuations. In particular, we felt that the unpredictable height of the political hurdles to be cleared in 2017 left financial assets more susceptible than usual to a sharp correction, that is to say a fall of c.10%. 

Since then the run of good macroeconomic data has continued, spurring on investors who appear to have put politics and uncertainty to one side. Global equities returned c.3.5% in a ‘hope’-based rally, unusual for this later stage in the business cycle. By ‘hope’ we mean that valuations have risen without significant earnings momentum. Indeed we have noted persistently negative earnings ‘breadth’ in the US over the period, meaning that there are fewer companies for which earnings expectations are being revised up than there are companies with diminishing prospects. That said, overall quarterly earnings reported by companies were robust enough in aggregate, with a healthy amount of earnings – though not revenue – growth.

Such incongruities mean that investors face the same dilemma as we enter the second quarter. On the one hand, our global leading economic indicator suggests output growth is set to reach 3.75-4.0% by the end of June, a rate not reached since the initial bounce-back from the financial crisis in 2009/10. Higher bond yields and higher inflation are likely to curtail growth in the second half of the year, but it seems unlikely this will be to the extent that growth will revert to anaemic levels.

On the other hand, the equity risk premium has plunged over the last four months: in the US it is now near five-year lows, in Europe it is near three-year lows. As we have said, investors are demanding less and less compensation for tomorrow’s uncertainties. Some analysts argue that this reflects receding fears of ‘secular stagnation’ – a theory revived from the 1930s to describe a chronic shortfall of demand as companies stop investing and demographic changes alter consumption habits. But if investors were putting to rest the secular stagnation thesis, one would expect to see upgrades to medium- and long-term growth expectations. There has been little evidence of this. Indeed, the component of US government bond yields that reflect expectations of economic growth has actually fallen in recent months.

This by itself requires caution. Historically, equity markets struggle as bond yields are driven higher by expectations of inflation, but not growth. Added to the equity risk premium, bond yields are used to ‘discount’ tomorrow’s earnings into today’s price. A higher discount rate applies to every firm’s future earnings, lowering their present value. But some may lack the pricing power to pass on higher inflation to their customers and so the future value of their earnings may come under pressure too. The ongoing economic expansion may help companies to navigate this threat, but our equity selection is focusing more and more on ‘pricing power’ – the ability of firms to pass on rising costs to their customers.

The ongoing expansion suggests investors should remain invested – remember that bear markets very rarely occur without recessions – but our fundamental analysis warns not to become too complacent. Indeed, our ‘risk-on/risk-off indicator’ tells us that more cautious sub-strategies are again outperforming the more gung-ho, even though markets are rising overall. For example, high volatility stocks have started to underperform low volatility stocks. Growth stocks are outperforming value stocks again. In short, despite low volatility, markets are not rewarding higher levels of risk-taking.

Furthermore, in the short run, the overall level of macroeconomic data tends to matter less to markets than how these data compare to expectations. The difference is tracked by the Citi economic surprise indices; the index aggregating the G10 nations has risen to its highest reading in over five years. After strong runs of positive ‘surprises’ the consensus tends to rise, making future positive surprises less likely. This results in a ‘mean-reverting’ tendency that suggests the capacity for macroeconomic momentum to spur markets may be about to wane.

Political risk

Markets appear unaffected this year by the ongoing political uncertainty. In the US, surveys of CEO and CFO confidence, which historically correlate with capital expenditure, have rebounded, while stock markets appear to be pricing for President Trump as Ronald Reagan reincarnate. But even Reagan, who governed with a much more cohesive Republican party, took two years to implement tax reform – let’s just say there’s scope for disappointment.

When we hear about political risk in the eurozone, it’s really shorthand for the risk that the euro breaks apart. The disintegration of the eurozone would be one of the largest financial shocks in modern history. Currency unions have broken apart before, but none in recent decades compare with the size, global significance and level of cross-border financial integration of the eurozone. Firms and financial institutions have transacted trillions of euros on the assumption of zero exchange-rate risk. Within the eurozone alone, the cross-border exposure of firms’ and banks’ balance sheets could be as high as €46 trillion, according to Deutsche Bank. The dislocation that would ensue if this risk needed to be repriced would swiftly cause a sclerosis of the real economy.

We do not pretend to be experts in election forecasting. After last year, who is? Geert Wilders, the far-right, anti-EU candidate unnerving investors in the Netherlands, in the end won only 13% of the vote. We have tended to be a little more sanguine about France, due to its two-stage election process in which mainstream voters from both sides of the aisle have the opportunity to rally together against an extremist candidate if one should get through the first stage – as they did against Jean-Marie Le Pen, the current pretender’s father. The core pillars of the EU and euro also have considerable popular support in France: 80% of people view the free movement of EU citizens positively; and 68% support the euro and the monetary union. That said, we are a little concerned that in the Eurobarometer survey – one of the few polls that suggested the UK would vote for Brexit – the number of French respondents for whom the EU ‘conjures up a positive image’ has dipped below those with a negative impression for the first time.

We are keeping a very close eye on market-based indications that the political uncertainty is starting to spill over into the contagious, dislocating scramble to reprice risk that, as discussed above, could segue into economic crisis. For example, we look at the costs banks have to pay from various sources to fund their activities, as well as the cost holders of bank bonds would have to pay to insure against default. The cost of insurance has been falling since November and is now just 25-30% of the cost commanded in 2011, when we had a taster of what a eurozone break-up might be like for investors before the European Central Bank (eventually) pledged to do “whatever it takes” to prevent investors from forcing the break-up of the single currency. The cost of bank borrowing has fallen even further and is now just 20% of the maximum borrowing cost in 2011 and less than 10% of the cost commanded in 2008/09. In summary, the financial markets that really matter are rather cool on the political risk that really matters, but we must remain vigilant. The ‘read across’ is that we do not expect a large rally as and when political hurdles in the EU are cleared.

UK economy in 2017

Back home, it seems many forecasters may have been guilty of letting politics get in the way of science. The consensus now expects the UK economy to grow at 1.5% (inflation-adjusted) in 2017, a very large upward revision to what we have always viewed as a more realistic rate from the overly pessimistic forecasts declared last year (although consensus is now well below the OBR’s very optimistic 2.0% announced for the March Budget).

Nevertheless, 1.5% is nothing to be excited about, and despite a decent six months since the referendum, there are a number of factors that are likely to weigh on growth in the first two or three quarters of 2017. First, there is a clear negative correlation between consumer confidence and household inflation expectations. As the latter rises, further consumer spending – which has been the backbone of economic growth over the last two years – could falter, particularly after drawing down on savings and taking out an alarming amount of consumer credit in 2016.

Second, business investment is still weak and surveys do not give grounds for optimism. Third, net trade should help, but companies are only passing on c.50% of the fall in sterling, using the rest to rebuild margins. Fourth, our modelling work would suggest that an ‘uncertainty shock’ only really starts to drag on growth six months after the initial event.

Our analysis suggests the performance of the FTSE 100 relative to global equities has been consistent with the devaluation of sterling, the recovering oil price and better Asian macroeconomics. However, sterling is unlikely to offer much of a tailwind in the immediate future; the outlook for the oil price is now more evenly balanced; and Asian economics are unlikely to surge ahead while Chinese policymakers look to rein in last year’s accommodative policies.

On the other hand, the FTSE 100 equity risk premium has not experienced the plunge that has left us more cautious about US or European equities in the near term. It is one of the few regional indices (along with Japan and some of its neighbours) that trades at a valuation meaningfully below the multiple ‘justified’ by our long-term fundamental assumptions. That said, as a global bellwether, it is unlikely to be immune if investors reassess the level of economic uncertainty as political events unfold and decide to discount tomorrow’s earnings a little more cautiously.

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