There’s plenty of room for more growth, says our Burning Issues panel
This year’s impressive performance from US financial markets has got analysts on this side of the Pond worried. Stateside experts assure us that a prospective price/earnings of 25 on the S&P 500 – and a cyclically adjusted p/e of 28 – is nothing to worry about.
Why not? Because America’s core strengths are coming through, they say. A healthy population structure and a high level of policy stability are combining to set America aside from the worries that are now clouding the horizon in Europe or in Asia.
Meet the Panel:
Tom Elliott, Group International Investment Strategist at deVere
Wouter Volckaert, fund manager of Henderson Global Trust
Kerry Craig, Global Market Strategist at JP Morgan Asset Management
Jaisal Pastakia, Investment Manager at Heartwood Investment Management
1. Some Wall Street traders are calling this “the most hated rally in history”. By which they presumably mean that they feel February’s boom in equity values is being driven by something other than corporate fundamentals. Your thoughts?
February’s rally was perfectly rational. Against a background of Janet Yellen’s assurance that the Fed would be ‘patient’ in introducing its long-awaited hike in interest rates, the equity bulls could enjoy the good growth data coming from the US and the UK, and signs of improving business confidence in the beleaguered euro zone. To cap it all, the ECB was set to launch QE, putting pressure on the euro and boosting euro zone exporters and stock markets in general.
Other market participants were nervous of this rally, warning that the Fed’s statements on monetary policy were not as clear as the bulls would have us believe. Their chief exhibit was the minutes of the last Fed meeting, that showed the average forecast amongst Fed monetary policy committee members for interest rates at the end of 2016 was 3.5%. This contrasted with the market pricing in just 2% by end 2016.
As Simon and Garfunkel said, ‘A man hears what he wants to hear and disregards the rest’. This week we have seen the penny drop, triggered by last Friday’s strong non-farm payrolls.
There certainly isn’t a lot of euphoria surrounding the US equity market at present. It is natural for investors to question how much juice can be squeezed out of a market that has just entered its seventh year of a bull market run, and is up over 220% during that time.
However, both economic and corporate fundamentals remain strong in the US relative to other regions and while the valuations are no longer as attractive as they once were neither are they screamingly expensive. A combination of earnings growth, share buy backs, M&A activity and higher consumer confidence will continue to support the market.
All the same, investors should temper their return expectations in a market this elevated, and should focus on the attractive sectors and companies rather than the broad market while expecting higher levels of volatility.
The S&P500 has gone up threefold in USD terms since bottoming on 9 March 2009 and is trading near an all-time-high level. We are six years into a market rally, and by now you would expect your mother-in-law to be bragging about her latest investment triumphs and your cab driver to be a source of hot trading tips.
However, none of that is happening. We are seeing some behaviour that is associated with being well into a market cycle – for example a burger chain with less than 100 stores coming to the market with a value of over $1bn – but we are not hearing many people talk about newfound riches in the stock market. That is why I would call it the most unloved bull market I have ever witnessed.
The disparity between share price returns and investor sentiment can largely be explained by the fact that the stock market has mainly gone up on the back of multiple expansion.
I like to think of the stock market as a mathematical formula: P = P/E x E. The market (P) can go up on the back of growth in the earnings generated by the companies listed on the stock market (E), and on the back of the multiple that investors are willing to pay for this (P/E). The E is correlated to the economy, and therefore hasn’t expanded that much over the past six years. Instead, the market has gone up on the P/E going up, or so called multiple expansion. The key driver for this multiple expansion has been excess liquidity. Quantitative easing and low interest rates have created surplus capital which chased asset classes worldwide – from equities to bonds, London property, vintage cars and fine wines.
So excess liquidity leading to multiple expansion has been the key driver behind equities. That doesn’t feel as comfortable to people as a booming economy, big salary increases and rosy newspaper headlines. And we’ve had quite the contrary – austerity talk, the threat of deflation and the possibility of a break-up of the European. That explains why this is the most hated rally in history.
We do not believe that the US market is fully pricing in declining earnings expectations. The speed and the severity of the fall in earnings expectations since the start of 2015 have been unusal (EPS growth estimates have fallen from 9% to 2%.) Of those companies that have announced disappointing earnings results, almost all have highlighted the strong dollar as the main factor holding back earnings.
It is important to remember that, at a market level, in the short term, there is little correlation between earnings growth and market performance. However, at some point earnings do have to come through to support higher valuation multiples, which are moving up to levels last seen in 2007.
2. The numbers suggest that the US economy has shown remarkable resilience recently: the Q4 GDP growth of 2.5% was better than expected, and it seems to indicate an even stronger 2015. Industrial production was up 4.8% year-on-year in January. Isn’t there genuine reason for optimism there?
We are cautiously optimistic on economic growth. The US economy is growing but only at a moderate pace relative to previous recovery cycles. In fact, data releases in the first quarter have been mixed. Regional manufacturing survey reports have disappointed and retail sales have been weak. The bright spot has been the labour market, which is showing robust job creation.
February capped a one year period of successive monthly job gains exceeding 200,000. A tighter labour market bodes well for wage growth, which has been lagging (around 2% year-on-year), and should support consumption, already benefiting from as lower oil price. Headline inflation remains very low, although core inflation (excluding food and energy) had its strongest increase in January since October (+0.2% month-on-month). Over the longer term, we expect inflation pressures to reach the Fed’s target of around 2%.
The end of quantitative easing in the US and the outlook for interest rate hikes means that excess liquidity will gradually disappear, and so the years of multiple expansion driving equity markets are over.
Economic momentum and corporate earnings growth now need to take over as a market driver. Fortunately the latter is recovering and therefore there is indeed genuine reason for optimism.
After five moderate years, we are finally seeing a more meaningful pick-up in corporate investment and credit growth. Unemployment has fallen to the level where we are starting to see wage growth. And a lower oil price should provide a nice tailwind for oil importing countries such as the US.
US economic growth looks robust. But the headwinds from higher US interest rates threaten sock markets in two ways.
First, high dividend ‘bond proxies’ such as utilities, pharma and other sectors associated with generous dividend yields but slow profits growth, may suffer as investors look for income from less risky sources. A dividend yield of, say, 2.5% may look good if you can only get 0.01% on your bank deposit account and a 10 year government bond yields 2% but with no opportunity of capital growth. But what if the bank account cash, or the 10 yr Treasury yield, goes to 3.5%? We can almost hear the sucking sound of cash leaving the ‘bond proxy’ part of the stock market, with large, mature defensive sectors particularly badly hit.
The second headwind caused by higher US rates will be on currency, as the USD rallies in response and hurts export earnngs from US companies.
The recent economic data from the US has come in below expectations and forecasts for first quarter economic growth have been revised down. Some of this is due to one off weather impacts, but also concerns about weaker than expected consumer spending even with lower energy costs.
Despite this, the economy should see respectable growth at close to 3% this year, largely driven by the consumer. The labour market continues to tighten and on average 288,000 jobs have been added each month for the past three months and the unemployment rate has fallen to 5.5%. Wage growth has been stubbornly slow to increase, but as the labour market tightens wages should start to increase – and, more importantly real wages will rise because inflation is at low levels providing a consumption boost.
Fed chairman Janet Yellen has strongly intimated that US interest rates are likely to head upward in the next nine months. The markets seem to have taken that as good news, since they were expecting the tightening to come earlier. Is that fair comment? And are they just setting themselves up for a bigger downturn when it eventually comes?
At the start of the year, all the focus was on the European Central Bank, but in early March that has started to shift back toward the Fed. The ending of the Fed’s zero interest rate policy is nearing reality as we approach mid-year, and it is being most prominently played out in the foreign exchange markets with the rise of the US dollar. While Fed tightening is not a surprise, the ramifications of a strong dollar are undermining the profitability of some of the larger US-based global corporates, as well as creating uncertainties across asset classes, particularly in emerging ,markets and commodities.
The equity market always takes a break when the interest rate cycle turns, but the break tends to be short and the correction not that large (less than 10% on average). Once we move past the initial uncertainty, the market tends to focus on the fact that the interest rate hike happened because the economy has strengthened and equities resume their upward path.
The bigger risk would be if the FED tighten too much too quickly, which I would define as anything more than 150bp tightening in the first 18 months of the cycle.
The timing of the first rate hike by the Federal Reserve is the most anticipated event of the year. There will be increasing speculation and market volatility as we get closer to any potential lift of date around the middle of the year but the exact date will be very much dependent on how the economic data develops over the coming months.
Markets hate uncertainty and history shows us that in the lead up to the start of the interest rate cycle equities have not performed well. However, once the uncertainty is removed and the hurdle of the first rate increase since 2006 is past the focus will once again be on an economy that is healthy and no longer needs a zero interest rate policy. This should see equities continue to move higher.
OPEC is currently working on ways to improve the oil price. Although its efforts are not guaranteed to succeed, how vulnerable do you feel that the US might be to a rapid rise in prices?
Consumption accounts for nearly 70% of the US economy, so any factor which influences consumption will impact the economic outlook and drastically higher oil prices would act as a brake on economic growth through higher fuel prices.
However, with a global excess supply and the long lead times to reduce production a sharp rise in price is less of a threat than a drastically higher US dollar in the near term. A strengthening currency will create disinflationary pressures in the economy and has the potential to undermine corporate earnings outlook deflating equity markets.
I see USD 60 a barrel by year end, in response to closure of some shale production in the US and increased demand from the euro zone as economic recovery continues. The Saudis are unlikely to cut production to boost the oil price, any rise will be market forces at work – exactly as intended by the Saudis when they began raising output last summer.
We don’t worry about this. The supply of oil continues to outstrip the demand and the worldwide storage capacity for oil is now close to being full. Once the excess capacity hits the market rather than storage, we actually expect the oil price to take another leg down. OPEC requires unanimity in its decisions and Saudi Arabia is keen not to subsidise the development of a US energy market, so we don’t expect OPEC to step in and cut production. Saudi Arabia is willing to take a short-term hit if it might benefit them over the long term.
The US economy is much more insulated from the oil price, with the shale oil and gas revolution significantly reducing the country’s dependence on foreign oil since 2005. Imports are at their lowest level (around 30%) since 1985.