The economic and financial environment is dominated by a host of uncertainties. The unpredictable nature of the new US President and the uncertainties surrounding measures taken by his administration as well as by other governments and the central banks mean that any attempt to forecast the markets is likely to need rapid revision or adjustment. This is true as much for asset classes as a whole as for the potential winners/losers by sector or region.
The optimism being shown by the equity markets (particularly cyclical stocks) in a rapid acceleration of economic growth seems premature to say the least. The fact is that the brakes dampening the global economy are predominately structural. The United States' growth outlook (in real terms) remains more or less constrained by the rather immutable trends of slow growth in the available workforce and weak productivity. The measures taken by the new US administration will only be felt in the longer term, assuming that these measures are conceived intelligently enough to have a positive multiplier effect on growth. But if poorly conceived, these measures could have the inverse effect and exacerbate the slowdown in global trade and geopolitical instability.
Pending clarity in this regard, there is a risk of the economy slowing further. Although economic data have undeniably produced positive surprises recently, some of the latest developments could put this progress in jeopardy. The currently improved economic indicators are in fact the direct consequence of the substantial stimulus measures put in place 12 months ago. These measures are now turning into reverse. The upturn in oil prices is eroding consumer purchasing power and higher inflation will put the central banks under pressure to trim their ultra-accomodative monetary policies. The US economy could be progressively impacted by the rise in bond yields and the strength of the dollar, especially after seven years of expansion. Its historic sensitivity to long-term interest rates is only being reinforced by the significant amount of excess debt present in practically all sectors.
Bond yields and sector allocation
A potential slowdown in the US economy (and hence in the global economy) would inevitably lead to a new decline in US bond yields. There is therefore still a place for long-term US government bonds in a diversified portfolio, if only as a hedge against a risk of such a slowdown, which could wrong-foot the financial markets. Bond markets in the Eurozone and Japan continue to offer an unappealing risk/reward profile.
If the economy slows further and bond yields decline, the sector rotation in favour of value stocks at the expense of quality stocks will come to an end and go into reverse. Independently of this, the economic uncertainties and the asymmetric risk / reward profile of value stocks continue to advocate investing in companies with low debt, that have good earnings visibility and are capable of maintaining a competitive advantage in their sector, even if this might mean enduring periodic phases of underperformance. Companies in sectors typically grouped under the term 'value' simply do not generally have the characteristics that would make them good long-term investments.
Regional considerations
At a regional level, the US market’s long phase of outperformance could come to an end. This outperformance has primarily been due to a much more favourable trend for US corporate earnings, a trend which has resulted in large part from the capacity of these companies to improve their profit margins. The strength of the dollar and the increase in wage costs and interest expense are now in danger of hampering US companies’ margins.
Underperformance of Europe due to poor earnings
Source: Barclays Research, DataStream, MSCI, IBES
US and European profit margins
Source: Barclays Research, DataStream
The US market is also quite expensive, irrespective of how it is valued.
More compelling valuations, more favorable liquidity conditions and currencies acting as a tailwind for earnings revisions would seem to favor European equities. One should however be aware that more than half the margin (and valuation) gap between Europe and the US reflects the different sector composition of the two markets.
On the other hand, numerous factors continue to argue in favour of the Japanese market. Fund flows are favorable with the Bank of Japan's announcement that it is going to double its equity purchases, pension funds increasing their equity allocation and foreign investors being under-invested in Japanese stocks. The valuation of the market remains attractive and businesses are in a good financial shape, 50% of the non-financial companies having net cash.
The consensus on the end of the 'lower for longer' interest rate regime and fears of Trump instigated protectionism is perceived as a negative for Asian and emerging markets, the more so since many companies in these regions have built up large US dollar debts. From a contrarian point of view, these markets offer the potential for positive surprises.
Ultimately, in what might become a very difficult year for equity investors, the focus should be on company fundamentals, even though the trend towards passive investment styles has never been stronger. The foundations behind the recent rise in stock prices are very weak and one needs to be highly sensitive to signs that conditions are deteriorating. Price-to-earnings ratios are modestly high for world indices, but enterprise value - to - EBITDA ratios show exceptionally high valuations. And valuations always matter ultimately. Using ultra-low interest rates as a rationale to justify these multiples no longer makes much sense. Earnings need to rise significantly to justify current valuations. In an environment where companies’ revenue growth is constrained by weak economic growth and where profit margins are compressing rather than expanding, a strong surge in earnings seems a remote possibility however. A mentioned above, the focus should therefore be on industry leaders that can grow sustainably, generate solid and consistent returns on capital and maintain an edge in quality.
Peak dollar?
The dollar’s rise is coming to an end, at least against the euro. The US dollar trade-weighted index has appreciated by over 30% since September 2014. A further move higher could be damaging for trade and capital flows at a time when the international system is very dollarised and sensitive to US interest rates. History tells us that significant appreciations of the dollar have often been a source of global instability, especially when they are accompanied by a rise in US interest rates.The principal factor that could lead to further appreciation of the dollar is linked to possible changes in the US tax regime, especially where imports and exports are concerned. The potential changes that are being discussed amount to a form of protectionism if they eliminate tax deductibility on imports and allow income from exports to be tax-exempt in the United States. All else being equal, they would lead to a reduction in the US current account deficit and, in so doing, reduce the flow of dollars to the rest of the world. The dollar-funding shortage would be reinforced if US companies are incentivised to repatriate overseas cash.
In the absence of such changes to the US tax regime, the dollar’s rise, at least against the euro, will come to an end. The consensus on the dollar seems almost unanimously positive, with most observers estimating that it is only a question of time before the dollar reaches parity with the euro. Their optimism is partly due to the general enthusiasm surrounding the US economy since the election of Donald Trump and, more concretely, to the divergence in monetary policies and the resulting yield differential. Given that these factors are known, they have already been priced in. Among the considerations that could cause investors to change their mind are a potential slowing of the US economy, the danger of disillusionment with the new US administration or a change in the expectations regarding the ECB's monetary policy, a change that could come for example from the cyclical upturn in inflation mentioned above
Gold continues to have a place in a diversified portfolio given the numerous economic and political uncertainties and the fragility of the financial system. Gold-mining companies remain a geared way of betting on an increase in the gold price.
