25 Aug 2017 Review and Forecast
In the beginning of the year, BigSur’s Investment Committee forecasted that 2017 would usher in the higher probability for a “boom and bust” in financial markets. Our reasons were that this economic cycle had just entered its ninth year of expansion (the second longest expansion in history), the political landscape in both the U.S. and Europe remained uncertain, and equity valuations were already extended.
Markets have continued pushing up, breaking record after record throughout the first half of the year given the extensive pro-growth policy agenda that was set forth by President Trump, which included: deregulation in the financial and healthcare industries, tax reform for individuals and corporations, and increased infrastructure spending. Expectations for these reforms persist, yet none of the policy agenda items have materialized. Hopes of a significant boost to the economy from a change in policy have been discounted by the market, except for tax reform, which we believe could catalyze the markets.
Weakness in the economic policy agenda has been counterbalanced by stronger than expected earnings growth, both domestically and abroad. The U.S. is currently experiencing a “Goldilocks” economy, driven primarily by accommodative central bank policies, rising corporate profits and historically low volatility. Slow and steady growth has produced a long stretch of job creation, leaving the economy on mostly stable footing. In July, the U.S. posted a record 82nd straight month of job creation and an unemployment rate at a 16-year low.
These positive numbers have pushed volatility indexes down to their lowest levels in over 30 years, but we believe there exists a great deal of uncertainty that is not being priced into markets. An example of this uncertainty was recently witnessed when tensions between the U.S. and North Korea caused the VIX to spike almost 45%. Within the next two trading days though, markets recovered their losses, and volatility quickly fell back to lower levels. This move reflects investors’ tendency to buy stocks following any pullbacks – a mentality that has helped limit both the scale and duration of stock downturns.
The leading global investment banks have pegged the probability of a recession at a mere 15%, according to a recent survey conducted by the Wall Street Journal. Although stocks may be fully valued, this stock boom lacks other booms’ fervor and overlook of companies’ fundamentals. The U.S. equity market
currently trades at about 18x future earnings, which is higher than the average historical multiple; however, on a relative basis to bonds, they remain attractive. History has shown that valuation indicators such as price/earnings, price-to-book, price-to-sales, or price-to-dividends ratios are notoriously poor at identifying market tops.
Our view is that an inflection point is still a year or so away, and that it is therefore too soon to de-risk portfolios. This view is in line with that of BCA Research: “Our best guess is that a recession is at least 18 months away, and that corporate earnings will continue to grow at a robust rate over the rest of the year. Conditions do not yet merit a retreat from equities, and investors who de-risk too soon risk lagging their benchmarks and their peers.”
We believe the stock market still has room to run primarily because of earnings. Investors were pleasantly surprised by the strength of earnings results in the U.S. and Europe, shrugging off political uncertainty and placing their faith in continued global growth.
The U.S. experienced consecutive double-digit profit growth in the first two quarters of 2017, with the S&P 500 increasing 15% in Q1 and 11% in Q2. These strong earnings results are the product of years of cost-cutting, a weaker USD and stronger consumer spending. Corporate managers have been creative in expanding what was considered toppish profit margins, and the weaker dollar has helped propel revenues.
Since the presidential election, the S&P 500 has risen over 16%. It can be argued that investors overestimated Trump’s ability to implement policy, but greatly underestimated earnings growth. The strong corporate results are coming amid political gridlock in Washington, as policies that were expected to help companies’ bottom line have not been passed. Political uncertainty continues to make companies reluctant to invest until there is more clarity on specific policies. Tax reform is clearly what the future requires for earnings to continue their same pace, and for corporate investments to rise. A tax overhaul will be very difficult to pass in the current political environment. However, there is a strong possibility that within the next six months, the administration can reduce the corporate tax rate and introduce a business-friendly plan for repatriating assets. These events can be very meaningful to earnings, especially if the corporate tax cuts go from the current 35% level to the low 20s.
In Europe, the equities rally was reignited by improvements in both the economic and political environments. It has been easier for European companies to expand profit margins relative to their American counterparts given that the region is in an earlier stage of the economic cycle, translating into more room for growth. European earnings grew 25% in Q1 and 16% in Q2, propelling the Eurozone to experience its first full year of earnings expansion in six years. Many analysts believe earnings growth in the Eurozone will continue to surpass that of the U.S. for the remainder of 2017, and all of 2018. This turning point in market leadership is driven by lower valuations, aggressive monetary accommodation, improving labor markets and economies.
In regards to the political environment, what was expected to be a series of volatile elections driven by the rise in nationalism ended up being “non-events” for markets. Of these elections, the most important was the victory of Emmanuel Macron in France, which eased fears about the spread of populism across the continent, as well as an exit from the common currency. Another major concern across Europe was the dangerous leverage ratio present in Italian banks, which have improved.
Global Monetary Policy
We are beginning to see a further global shift to a “normalization” of interest rates and monetary policy, removed from the crutches of central banks that have helped prop up markets. Favorable monetary and fiscal policies substantially reduce the probability of a recession in key developed and emerging market countries. The direction and magnitude of change of yield curves may provide early signs of building overtightening risk, with the U.S. curve most critical. The flattening of the U.S. curve this year indicates overtightening risks may be rising. However, with the curve still well in positive territory, it is flashing amber rather than red in our view. We believe that equities can continue supporting higher valuations, even if the 10-year Treasury bond yield was to rise 150 basis points to 3.75%.
Global equities have benefited from suppressing bond yields and from a very supportive tide of liquidity caused by central bank’s $14 trillion of quantitative easing (QE). As central banks begin to sell assets in order to normalize markets, there could potentially be a repricing in the bond market which could carry on to affect equities. Many analysts predict that the next market correction will be caused by the bond market. We believe that a pop in the “bond market bubble” will only occur given strong inflationary pressures, which have yet to be seen. Soft U.S. inflation readings for the past four months have even caused analysts to ratchet back expectations for future Fed rate hikes.
Given the fact that central banks will likely take their time withdrawing stimulus, there could potentially be further room for equities to run higher until then. Since inflation has been so contained, central banks can manage normalization on an extended time frame, withdrawing liquidity very carefully. Central banks will need to be ahead of the markets when announcing hikes if they want to avoid crashing the markets and the global economy.
There are many key indicators that are presenting mixed signals in terms of where the market is headed. We believe one of the top causes of divergence is the negative view investors have towards the ability of governments to implement business-friendly policies, while maintaining a bullish view on global growth continuing its push forward.
Diverging Economic Indicators
The trend lines clearly show that consumers have become increasingly confident about both their current and future prospects. Confidence levels are currently sitting at a 16-year high, with Americans drawing encouragement from an economy that continues to provide jobs, rising stock and home prices and steady pay gains. That confidence though has not yet translated into increased consumer spending and business investment, meaning they are not putting “their money where their mouths are”. Spending and investment will likely remain on the sidelines until policy is clearer.
Diverging Risk Indicators
The market seems to be signaling a period of unusual stability, with volatility measures in both the U.S. and Europe reaching historic lows, yet if you turn on the news, the world seems to always be on the brink of chaos. On the other hand, policy uncertainty indexes have spiked multiple times, breaking records set during the 2008 crisis. They seem to be warning of a period of high volatility for global economies.
Diverging Technical Indicators
Fund flows have historically been one of the best measures of how comfortable investors feel about risk. More money has flowed into equity and bond funds, on a monthly basis, since November 2016 than in the first ten months of 2016. This is consistent with the drop in volatility. However, money is leaving U.S. stocks and moving into European stocks. Money going into U.S. stocks is at a 9-year low, while inflows into European stocks recently hit a 5-year high.
Our Base Case
We believe markets still have some room to run, therefore it is important to remain invested in the short-term. Our reasoning for markets continuing their upward momentum is the fact that that fundamentals remain strong, even in this late stage of the economic cycle. We are carefully monitoring data points that could signal exuberance in financial markets, primarily the risk in rising valuations, the loss of momentum in U.S. reforms, and the rise in geopolitical risk that has been overlooked by investors for far too long. We recommend the following investment advice in coordination and consideration of individual investor characteristics:
- Being patient is important. Investors should have at a minimum a 10% cash allocation
- It is more important than ever to review each individual security in a portfolio. Top quality assets, or “blue-chips” are the most resilient. We recommend holding only those stocks that are “triple plays”, meaning companies that beat both earnings and revenue estimates in Q2’17, and guided future earnings estimates higher
- Diversification continues to be the only “free lunch” in financial markets. We believe clients should increase alternative investment exposure, particularly by building a portfolio of illiquid and uncorrelated “niche” private investments that can continue to perform well even through a market downturn
- The only cheap security available to investors has been volatility. We recommend, when appropriate, creating a hedging portfolio to take advantage of these historically low levels, primarily buying put spreads on SPX
- Prudence is the best approach to navigate this market. The smartest move is to identify areas of instability and stay far away from them. We are believers in avoiding areas of turmoil – market sectors under “tsunamis” – such as retailers, supermarkets and automakers.