The chicken or the egg?
If you ever needed proof that economic indicators are very poor predictors of market returns then you need to look no further than the last twelve months or so. Despite GDP growth rates indicating slowing economies in the US, UK and Europe (including Germany), all risk assets are trading at multi-year highs.
Why? The rally is largely the result of some of the most unusual steps to support a financial system in the history of the modern world. If, at any time in the past four or five years, there were signs of fragility, the world’s governments and central banks charged in with seemingly endless amounts of money to support the system. Markets are supposed to be forward looking and so logically these measures, which are designed to stave off disaster, have been rewarded by improved sentiment and therefore higher asset prices.
Akin to the famous debate about which came first – the chicken or the egg – we can also debate whether the recovery is purely the effect of the unusual monetary and fiscal stimulus measures or whether the recovery can ultimately create the environment for us to survive the imbalances caused by these unusual stimulus measures. Is the pain of past excesses ultimately unavoidable and is this a harsh lesson we will learn as stimulus measures fail to be sustained indefinitely?
I would suggest current asset prices imply that the recovery is sustainable and that the excesses can be managed as these stimulus measures are withdrawn. I remain scepticle of this goldilocks-type-scenario playing out but acknowledge that we can consider the same evidence and come to opposing conclusions and portfolio positions.
THE BULL CASE:
The balance sheet or the financial health of companies and households is generally much stronger. This is perfectly true in many cases – default rates are lower and corporate and household deleveraging has taken place as money has been injected into the system through central bank interventions and policy decisions. Interest rates are at the lowest levels on record, making servicing debt a much easier proposition from available income. Things are so good that some companies like APPLE are under pressure to return some of their cash pile to investors because cash makes up something like 30% of the market cap of the company. Sounds quite rosy.
Corporate earnings are strong and around 72% of S&P500 firms have beaten estimates in the latest quarterly review. This is another very positive sign that goes some way to justifying the recent equity market gains. Paying more for shares in companies you expect to receive a higher earnings yield from makes sense.
Economic data points are indicating a recovery. Again this is true in many cases. Forward looking indicators like the PMI services data out of the UK and Europe last week have moved above 50, indicating expansion. Consumer and business sentiment surveys are also generally more positive on future prospects. China is apparently successfully navigating its way to a soft landing and will once again be a huge driver of global economic growth.
Equity markets are one of the few assets classes offering real returns these days. For savers and those already in retirement, the idea of yet another year of negative real returns from their bond and cash positions is getting untenable. The pressure to take on risk via equities is growing as nothing else is delivering the required returns. Equities, while potentially not attractive on an absolute basis, are attractive relative to all the other options out there. Money is flowing into equities and the Bloomberg survey taken at Davos in January, revealed that 66% of respondents expect to add to their equity holdings in the next 6 months.
THE BEAR CASE:
The balance sheets or the financial health of companies and households is generally much stronger. APPLE is not deploying their large cash reserves into new investments, which could be a sign that they are not that confident about the prospects for the future. Lots of uncertainty over the fiscal cliff and US policy initiatives may be to blame. On the other side of the Atlantic last week we saw that PEUGOT may need the support of the French government to survive – Obviously not all is quite so rosy out there.
It is also worth noting that the corporate deleveraging that has taken place is not due to the problems having been resolved. A lot of the debt excesses that led to the financial crisis have simply been moved to the Government’s balance sheet and will still need to be addressed in the fullness of time.
Corporate earnings are strong and around 72% of S&P500 firms have beaten estimates in the latest quarterly review. This kind of statistic can be meaningless. Earnings ‘beats’ are frequently measured against estimates that have already been revised lower. What if I were to tell you at the start of the year that your salary would be R100 000.00, but by March I estimate that it will only be R98 000.00 and by September I have revised my guidance to R85 000.00 for the year. Then, at the end of the December, you receive your final pay-check which shows that your total income for the year was R90 000.00. Do you go out and celebrate because it was better than the 85 grand last estimated or do you feel aggrieved that it was 10% less than I initially told you at the start of the year?
Economic data points are indicating a recovery. You can pick economic data points to support or refute any theory if you really want to. In reality the reaction to single data releases is more an indicator of market sentiment rather than any actual statistical relevance. UK GDP for the fourth quarter fell -0.3% versus an expected fall of -0.1%; US GDP fell -0.1% versus an expectation for a rise; and Germany, Europe’s biggest economy, saw GDP fall by -0.5%. The US unemployment rate also ticked back up to 7.8% last month but the markets shrugged off all these negative data points and continued to rally.
Even if the positive news is sustainable and central banks have engineered a recovery, inflation will surely follow. The stimulus will have to be retracted at some point. Interest rates will have to go up, and money supply will need to be removed from the system. Can the real economy actually stand on its own without the support of central banks? How solid will real earnings remain and how healthy will balance sheets look when the inevitable process of ‘normalisation’ begins?
If the answer to any of these questions is uncertain, then any strong signs of recovery, accompanied by the likelihood of sharp gains in the inflation rate, could lead to a reduction in stimulus measures which in turn could be the catalyst for profit taking in risk assets.
Equity markets are one of the few assets classes offering real returns these days. This is the one bull case statement that I have sympathy with because it is a fact. However, having acknowledged that, it is not wise to chase returns on the basis of short-term market moves. If equity markets are not your natural asset class, given your age or ability to take on risk, then I would strongly urge you not to capitulate and enter equity markets at these levels out of fear of another year of lowly returns elsewhere. Your investment strategy should be in place for the right reasons and making short term adjustments may seem right for the next 6 to 12 months but you could suffer significant falls in your capital value if equity markets give up some of their recent gains.
So what am I doing right now?
The funds I run with a long-term objective (my retirement savings and child’s education investments) will maintain their equity market exposures,despite my misgivings over current valuations, as I expect equities to deliver the best real returns over time.
On the other hand, my trading strategies have a more short-term focus on capital preservation and are currently very heavily weighted in cash and equivalents. This has cost me when I compare my returns to equity markets in recent months but I am okay with that short-term. I remind myself that it is my strategy to protect this capital from downside risks and not to succumb to ‘what-if’ emotions.
Many may perceive my defensive position as being a bit chicken, but I remain concerned with the price of risk assets (equities and bonds) and the low level of volatility, given some of the major global uncertainties that still prevail. Added to which, I think if the recovery is sustained, central banks will have little option but to withdraw some of the stimulus measures and the equity markets may take this as a signal to sell given how the stimulus measures have driven up prices in recent years.
Please note this write-up does not constitute advice. Contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.