Four reasons for caution on a market in transition
“At its core, investment is about valuation. It’s about purchasing a stream of expected future cash flows at a price that’s low enough to result in desirable total returns, at an acceptable level of risk, as those cash flows are delivered over time. At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation.” – John Hussman.
The exercise of buying low and selling high is the single most fundamental discipline in investment. Intuitively it makes perfect sense, is theoretically straightforward and has the benefit of working wonderfully well over the long-term. Unfortunately in practice, executing such a discipline is often fraught with difficulty, as in the short-term valuations are frequently overwhelmed by sentiment and momentum.
This quarter’s opening quote captures the essence of today’s market environment perfectly in our view. Reassured by recent gains and the perception of safety and resilience that follows an extended market rise, investors are mostly optimistic and seemingly confident of sizable future gains, in spite of historically unfavourable valuations. This is nothing new. In every cycle investors demonstrate a costly inclination to buy securities at elevated valuations because things feel comfortable, only to sell them again when valuations are depressed and things feel very uncomfortable.
Today’s sense of comfort is the consequence of a nine-year bull market in pretty much everything, underpinned by uber-low or negative interest rates, suppressed volatility, endless rounds of quantitative easing (QE), and central banks having your back at all times. Volatility has picked up since the turn of the year due to the unsustainability of such late-cycle accommodation at a time when capacity constraints in the economy are becoming evermore apparent.
In hindsight, our shift in emphasis towards capital preservation last year was premature.
As many of the risks we on the Schroders Multi-Manager team had safeguarded our portfolios against were put on the backburner, we had to endure much of the market’s advance as outsiders. This year, many of these risks have started to re-emerge, and are briefly discussed below.
1) Central banks are behind the curve
“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” – Warren Buffett.
At 3.76%, the US unemployment rate has just reached its lowest level since 1969, and is now marginally below the Federal Reserve’s (Fed) year-end forecast. It has also been sat below its estimate of the level consistent with a neutral policy setting for well over a year. With inflation also now more or less at its target of 2%, the Fed is in catch-up mode.
As things stand, the funds rate is at least 100 basis points below the Fed’s estimate of neutral, and remains negative in real terms. With Congress and a pro-business president aggravating inflationary pressures by borrowing trillions of dollars to stimulate a late-cycle economy, it’s difficult to see how the Fed can justify suspending its efforts to normalise.
Bond yields have been in a secular downtrend since 1981. For a long time, 10-year Treasuries traded more-or-less in line with nominal GDP growth (4.1% last year). This relationship broke down in 2010 when the Fed began distorting the yield curve through quantitative easing – a policy that is now being unwound.
The combination of higher inflation, rising short-term interest rates, quantitative tightening (QT) and massive new debt issuance leaves the bond market looking cyclically challenged in our view.
In Germany, where QE is still underway and nominal interest rates are still negative, the situation appears even more unstable. 10-year Bunds recently traded as low as 0.25%. These are yields for a fully-employed economy (lowest unemployment rate in 38 years) that has consistently been averaging just over 3.5% GDP growth in recent years.
The bottom line is that the Fed is not done raising rates and we suspect the European Central Bank will not be far behind in removing its titanic footprint from global bond markets. Quantitative tightening (QT) has scarcely begun and the big spike in government borrowing is yet to unfold. Both are going to accelerate together over coming quarters. This amounts to an intensifying withdrawal of liquidity from financial markets and a growing headwind for a highly leveraged global economy.
2) Leverage is once again at a record high
“There can be few fields of human endeavour in which history counts for so little as in the world of finance.” – John Kenneth Galbraith.
The main thrust of our argument in recent times has essentially been that the state of the global economy, although not booming, has been sufficiently robust to no longer warrant a monetary policy stance fit for a depression.
Sadly, by waiting so long to recalibrate policy, central banks have once again encouraged record amounts of leverage to build throughout the system, making it more reliant than ever on continued low rates. Consumers have borrowed to boost their insufficient wages, governments run ever-larger fiscal deficits so they can cut corporate taxes and companies pile on cheap debt to fund the buybacks, dividends and M&A activity that has helped take equity valuations close to record highs.
While this all feels very comfortable in the short-term, it has been based on the notion of a prolonged period of low inflation and low rates, which is now changing. As cost-of-capital assumptions increase and credit stress intensifies, risk premiums should rise - which is a polite way of saying asset valuations ought to contract.
Corporate debt has been a chief beneficiary of the QE distortion. It has been the destination for many investors forced out along the risk curve to generate a yield commensurate to what they could previously earn from risk-free securities like T-bills or government bonds. After a long bull market, investors in this asset class now assume a great level of risk for very little reward. Not only has interest rate risk risen, but credit risk also.
Although the corporate default rate ended 2017 at a record low of 3.3%, this is plainly a backward-looking measure of risk. Moody’s recently declared that the number of global non-financial companies rated speculative (or junk) has jumped by 58% since 2009 to the highest proportion in history. Furthermore, the share of leveraged loans considered “covenant-lite” (ie those that lack the usual protective covenants) hit a record-high 82% in April, up from 20% in 2011. This has occurred at a point where the level of US non-financial corporate debt has itself hit a record 45% of GDP.
These three issues are far more relevant when assessing future risks for investors. Sure, they may only become important during the next phase of economic stress, but as Moody’s pointed out, expect a “particularly large” wave of defaults when that does occur.
3) We are late-cycle
“I’ve been in the business for over 30 years and not once have I ever found a time when rising oil prices and rising interest rates provided a tonic for a bull market in risk assets.” – David Rosenberg, Gluskin Sheff.
In 2017, investors enjoyed positive surprises for both growth and inflation. This year, the trade-off between the two has deteriorated. The global manufacturing PMI currently sits at a 10-month low, while years of disinflation have given way to a period of moderately higher inflation. Strictly defined, this is a classic case of late-cycle stagflation – a historically unfavourable condition for both stocks and bonds.
Other late-cycle signposts include buybacks, which this quarter hit their highest level since…Q3 2007. And M&A, which has totalled close to $2 trillion globally year-to-date – an increase on last year of about two-thirds. Both are indicative of a perceived lack of organic investment opportunities.
While late-cycle does not necessarily imply end-cycle, it does indicate pressure on profit margins as capacity constraints lift input prices (labour and raw materials) and aggravate generalised inflationary pressures. To prolong the expansion, we ultimately need to see either an eleventh-hour productivity boost or an increase in the supply of skilled labour. Neither appears to be immediately on the cards. Indeed, the latest data suggests capital spending plans are now fading. Maybe Trump should shift the incentive structure for companies and start taxing buybacks!
4) Valuations are generally unattractive
If you run a long-term trend line through a series of completed market cycles, you will find that although it is positively sloped, the fluctuations around the trend can be enormous. In practice, this means that the gains accrued in the later stages of a bull market are only really captured by those who sell. For the rest, these gains are merely transitory.
During a meeting last year, our visitor pronounced that “my valuation work versus anybody else’s is no basis for an investment process.” Of course, in the short-term when valuations often prove frustratingly meaningless, this can often appear correct. In the long-term however, valuations are hugely informative, not only for establishing long-term return expectations, but also the potential vulnerability of an asset class over the balance of a particular cycle.
Share buybacks, while beneficial to shareholders during an expansion, have muddied valuation analysis this cycle and distorted several popular metrics. To quote Chris Cole of Artemis Capital Management LP:
“Share buybacks financed by debt issuance are a valuation magic trick. The technique optically reduces the price-to-earnings multiple (Market Value per Share/Earnings per Share) because the denominator doesn’t adjust for the reduced share count.
"The buyback phenomenon explains why the stock market can look fairly valued by the popular price-to-earnings ratio, while appearing dramatically overvalued by other metrics. Valuation metrics less manipulated by share buybacks (EV/EBITDA, P/S, P/B, Cyclically Adjusted P/E) are at highs achieved before market crashes in 1928, 2000, and 2007.”
To return full-circle to the theme of our initial observations, we think that most investors today not only feel reasonably optimistic about the economy and corporate earnings, but believe valuations are reasonable and that there remains little threat from the bond market.
Our concern is that this is overly complacent, particularly in respect of valuations. Indeed, we judge this to be a window of opportunity where, from a full-cycle perspective, harvesting gains and de-risking portfolios makes generally good sense.
How this all affects our positioning
“Change of a long term or secular nature is usually gradual enough that it is obscured by the noise caused by short-term volatility” – Bob Farrell, Merrill Lynch.
Our portfolios currently have three distinct attributes that differentiate them relative to others:
- We are overweight cash relative to bonds primarily, but equities also. While the overvaluation of bonds appears pretty unilateral, there are areas of the equity market that offer good long-term value
- We are overweight the value style, which has underperformed significantly this cycle, and underweight the outperforming growth and momentum styles
- We are well hedged against the late-cycle emergence of inflation
In our view, many major economies - like the US, Japan, Germany and even the UK - are later cycle than the market appears willing to concede. Although globalisation has relieved many of the domestic bottlenecks that historically generated inflationary pressures, we are now two years on from when deflation anxiety peaked, leaving many central banks behind the curve.
The switch in investment leadership that we felt would accompany this fundamental shift from deflation to inflation has - thus far - emerged only intermittently. While frustrating, we ultimately believe the rewards on offer once this shift becomes more apparent will prove worthy of the wait.