Bears emerging from the undergrowth

Since Labor Day in the US on 2nd September, the global equity market has adapted a juxtaposition rather than an arguably short-sighted one of focusing on the Twitter volatility surrounding the US-China trade talks. This has been represented by a counter-intuitive notion that lower bond yields, emanating from a weaker global growth outlook in 2020, are being bolstered by a perceived coordinated relaxing of fiscal and monetary policy amongst the G7, as highlighted by the ECB narrative on the 12th September presented by Mario Draghi, now in his final year as the president of the European Central Bank.

The facts and the background make interesting reading. Global bond yields were widely forecast to rise in 2019, as a long-awaited rise in US rates, from rock bottom levels, that prevailed since 2009, seemed to be finally taking hold at the end of last year. In November 2018, the US 10-year Treasury yield was up to nearly 3.25%, and equity markets in tandem were having their worst quarter in many years. However, slowing growth expectations, fuelled by President Trump’s destabilising trade policy shifts have sent the same yield down to below 1.80%, as at earlier this month.

Global bond yields followed in sync; nowhere was that more prevalent than with the German 10-year Bund yield that currently languishes at minus 0.49%. That is below the ECB’s deposit rate of 0.5%. Such a development has not been seen since the financial crisis of 2009. This causes disquiet amongst investors and bears have been starting to emerge from the undergrowth. In reality, a historically low, arguably excessively low, interest rate environment has now been sustained for over ten years. This extended period of increased reliance on monetary policy may not have been in the minds of the central bankers, led by US fed governor, Bernanke, when they led a coordinated response to the collapse in investment confidence globally in 2009.

Of course, lower bond yields, driven by quantitative valuation models at the very least, provide a safety net, if you will, to equity valuations. In fact, at the beginning of September, equities stood at their cheapest level versus bonds in over five years. In simple terms, The S&P500 yields 1.86% currently on or near par with the 10-year US Treasury. It is dramatically more pronounced in the UK, driven partly by Brexit uncertainty, with the FTSE100 yielding 4% versus the 10-year Gilt at 0.75% (up sharply this week on a lower probability of a no-deal Brexit). These circumstances have led to a plethora of perfectly valid arguments around owning high yielding, dividend growth stocks given the paucity of income on offer elsewhere.

Interestingly with the advent of a more relaxed approach to fiscal policy emerging within the G7 the equity market has been heavily rotating and enjoying new leadership in the past two weeks, coming out of long-term growth stocks, like the technology sector, into value plays, led by financials that have been largely sidelined in a falling rate environment throughout 2019. This coupled with a perceived more supportive commentary around the ongoing saga of the US-China trade talks running into the key date of the 1st October, the 70th Anniversary of the founding of the People’s Republic of China, has driven equities higher this month.

It is worth analysing the commentary from Mario Draghi that he made on the 12th September. Seven years ago, in the middle of the eurozone sovereign debt crisis, the president of the European Central Bank (ECB) promised to do ‘whatever it takes’ to preserve the euro and promote economic prosperity for the region. He added this week that the policy will be continued for as long as is necessary. This should be noted in light of the jobless rate in Germany – the main engine of economic growth in the eurozone – starting to rise for the first time in over five years. What measures were introduced by Draghi? The deposit rate was cut to minus 0.5%, meaning that banks will be forced to pay more for leaving bank deposits overnight with the ECB. The ECB also announced a restarting of quantitative easing at a monthly rate of EUR 20 billion as of the 1st November. All these measures are intended to stimulate inflation, which is well below the ECB target of 2% and ultimately to support growth in the region, which is now forecast to slow down to 1.1% this year and 1.2% next year.

Draghi himself said: “These risks mainly pertain to the prolonged presence of uncertainties related to geopolitical factors, the rising threat of protectionism, and vulnerabilities in emerging markets.” The response was a weaker euro and a tweet from the US President that the ECB is trying, and succeeding in depreciating the euro against the US dollar. He wants the Fed to respond with lower rates in kind. A race to the bottom in the currency markets is in full flow as each of the major developed countries are seeking, if not actively, a weaker currency to bolster their exports and therefore their growth dynamics. After 10 years of excessively low-interest rates globally, the reality is that economic growth is below historical norms and there is no guarantee that a further round of easing will have the desired effect. In the meantime, Mario Draghi steps down on November 1st leaving the incoming president of the ECB, Christine Lagarde, with little option but to continue with a stimulus package to support economic growth in the eurozone. Inevitably, some forecasters are now pointing to an almost permanent life support mechanism being required to bolster growth in Europe and beyond. That is what might be tempting a more negative commentary to the global equity markets.

So, what are some of these economic forecasters suggesting? And what could be the consequences if they are right? A US Recession in the first half of 2020 is one potential outcome, with US unemployment likely to rise in tandem to around 4.5%, even if the Fed cuts rates to 0.25%. This would fly in the face of the new normal of ‘muted’ economic cycles and lower market volatility, backed by excess liquidity, that has become a permanent feature of the past 10 years. The implications for the equity market would be unquestionably negative if there was an unwinding of the ‘new normal’.

US equities have enjoyed a long-term historical relationship with US unemployment. A slow fall in unemployment has proved positive for equities. However, when unemployment rises, and that tends to be more quickly as corporates shed jobs, then equities fall sharply. To quantify, if you take into account the last 10 recessions for the US economy, since 1950, equities have typically lost 20% on average each time. The pushback would be to argue that there are no visible excesses in the system to drive the major economy in the world into recession. The response being that the simple mathematics around an excessive reliance on a loose monetary policy to extend the economic cycle has led to excessive use of US dollar debt and reliance upon access to global capital, markets and supply chains. The blame game would focus on the central banks for promoting a semi-permanent strategy of excess use of monetary policy and QE.

Once the central banks are challenged the economic dream of a ‘new normal growth environment’ will come crashing down. Governments themselves are now largely addicted to a low-interest rate environment and have preferred to refinance debt rather than reform their economies or capital environment. Arguably, as in 2012 when the eurozone was in the midst of a debt crisis, when global growth slows, debt sustainability questions emerge, at a corporate and government level, even in a world of low rates. Any slowdown in the US economy should be treated very seriously as a risk in this suspended scenario where global business models are now assuming that the new normal world of growth supported by loose monetary policy is permanent.

Let’s look at the impact of the economic environment we are considering on corporate earnings and equity valuations in the recent past and going forward. In this new normal world of muted but consistent economic growth, the ability for corporates to easily refinance at cheap rates has become a key factor in the rise of cross-currency corporate debt. It is a form of financial engineering as the large corporates have been able to minimise the volatility of their earnings and thereby appear more ‘bond-like’ as an investment. This should be aligned with a rise in equity share buybacks and dividend pay-outs, since 2010, that has grown to over 70% from 30%) of operating cash flow for the constituents of the S&P500. In sharp contrast, Corporate Capital Expenditure has barely shifted over the same period as a percentage of operating cash flow, running at between 30 to 40%. Investment into the economy has just not been happening at a rate to support stronger more stable economic growth. This has contributed to historically high equity valuations both for the US and global equity markets (ex-UK) as we move into 2020. This has been the case for some time, but when you paint a picture of slowing growth and therefore earnings, against a backdrop of a reliance on a relaxed monetary environment, then US, and thus global, equities do not appear as attractive.

Global and US ‘bottom-up’ earnings forecasts are currently running close to 10% growth for 2020 and 2021, despite the risk of a recession at some point over the next 18 months. Even when you take out the large US technology companies that are expected to grow their earnings by closer to 20%, you are still left with an 8-9% earnings growth forecast for the S&P500 next year. This expectation is likely to be a challenge as the reliance on low rates, and the central banks themselves, starts to abate.

The last two US recessions saw US earnings fall 30 to 40% on a six month annualised basis. If this scenario were to play out, then US equities and the broader global indices could fall by 15 to 20% through 2020. The problem is that absolute valuations of equities globally are not discounting any stress in the economic cycle. US trailing price/earnings ratios could fall by six to eight points as corporate profits fall. Of course, as profits and therefore cash flow comes under pressure in a recession scenario, then liquidity becomes far more critical.

Aggressive rate cuts by the Fed or the ECB, from already low levels, may not be sufficient to offset an economic growth downdraft. One positive factor for the more bullish equity investor is that the bond/equity yield ratio is more supportive to equities than at any time in the past five years. And bond yields would undoubtedly fall further should US unemployment start to rise, thus indicating a possible recession in the US. In this environment of underperforming equities, we would want to favour defensive bond sensitive sectors (like utilities and telecoms) and quality at the expense of cyclicals that would suffer at the hands of a recession.

One way in which investors may consider the current valuation of equities by country is to look at the measure of the current market capitalisation over gross domestic product (GDP). It is a macro data point that removes the potential volatility in earnings as highlighted above. For the United States, going back over 50 years of data, the total market capitalisation/GDP ratio is 144% incorporating US$21.34 trillion for GDP. This is within the touching point of the all-time high of 149%. Interestingly other markets are not so richly valued versus historical comparison. The UK, for example, is currently standing at a total market capitalisation/GDP ratio of 115% versus a high of 201% based on 47 years of data. The UK’s GDP is at US$2.58 trillion. China’s nascent equity market, interestingly, using the data point of US$11.8 trillion of GDP, is trading at a ratio of just 42%, against a high of 662% over 29 years of data.

The fact remains, that if the United States were to endure an economic slowdown in 2020, at a time when its equity market is arguably fully valued, then it would drag the rest of the world, in equity terms, down with it.

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