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 1. Home
 2. Investment news
 3. Market Pulse – Are equities disconnected from reality?

Market news - 7 minute read


JANUARY MARKET PULSE – ARE EQUITIES DISCONNECTED FROM REALITY?

Despite the slowdown in economic growth in 2019 and disturbing global events
since the beginning of this year, equity markets have been remarkably robust

Written by Chris Godding
Published on 29 January 2020


Since our last publication of the Pulse in December, the US Embassy in Iraq has
been attacked, Qasem Soleimani assassinated, a passenger jet shot down by the
IRGC, fires have devastated parts of Australia and the deadly Coronavirus has
emerged in China, yet equity markets have held up remarkably well. 

This disconnect of equities from the real world was a source of torment for
investors throughout 2019 and it appears set to continue.

During 2019, company earnings declined by just under 8% and emerging market
earnings by close to 15%. MSCI UK earnings dropped by 8.6% and in the US, where
a fiscal sugar rush helped to boost activity, corporate earnings still fell by
over 5% on average. In the same year, the MSCI World Index rose 26.24% in local
currency terms.



One of the principal reasons behind this disconnect was the broad easing of
monetary conditions as it became clear during the latter part of last year that
the Federal Reserve would, until further notice, not try to pre-empt inflation.
Taking the pre-emptive rate rise off the table removed a major external risk for
equity investors. It also suggests that if inflation does gather momentum, the
reactive Fed and the policy lag will create its own set of new problems. If the
current relative economic resonance, or stability, is disturbed by inflation,
the risk of a return of boom and bust are higher. The corrective action is
exponentially more difficult to get right and analogous to driving a car using
the rear view mirror.

The slowdown in investment and trade last year meant that the change in interest
rate policy at the Fed was essential to stabilising growth. The result was an
improvement in investor sentiment that drove P/Es higher through 2019. The phase
1 trade deal between the US and China last December provided a fitting finale to
equities.  The performance of markets in 2019 reminds us, once again, that in
the short term, the change in the market multiple or P/E is frequently the
dominant driver of returns rather than earnings.

In 2020, we expect the global monetary accommodation to continue to be a
tailwind at least until the fourth quarter but expect that incremental equity
appreciation will be more dependent on actual earnings growth as opposed to
further P/E expansion.  



Since Fed policy remains one of the most significant levers in financial
markets, the key questions for investors now are whether the stimulus in the US
will achieve the inflation desired and what is the potential for overshoot.

For the moment, with a projected US deficit in excess of US $900 billion and
total debt at 105% of GDP, inflation remains an aspiration.  However, labour
shortages are becoming a problem, wages are rising and any election driven
fiscal boost may tip the scales enough for the Fed to move. In our view, the
structural deflationary forces of technology and demographics remain quite
powerful and will help keep inflation in check, at least until later in 2020 or
even 2021.  However, markets and investors are notoriously bad at forecasting
inflation and it remains a key tail risk for equities via higher interest rates
and lower valuation multiples.

 

Ask any monetarist and the outlook for earnings should be good given the
stimulus and, as you would expect, the consensus of analyst agrees with a 10%
rise in earnings on average across the MSCI forecast for 2020. These estimates
suggest an earnings yield of 6% for global equities compared to 1.6% on a US ten
year Treasury bond or 0.53% on a ten year UK gilt. The long run average is
around 3.5%, which implies room for further significant equity appreciation at
current bond yields. The small caveat is that the accuracy of the analyst
estimates is not particularly good, which is of no surprise given the variables
involved. History suggests that earnings estimates at the start of the year are
cut by 50% – analysts tend to be too optimistic – which would reduce 2020
earnings growth to around 5%. However, even assuming the lower 4.5% growth would
leave the earnings yield at 5.7%, which is a comfortable premium of 4% over
Treasuries.   

If sustained over ten years, that 4% excess return would compound to a total
return of 48% and we would only normally start to get concerned if it went below
3%, either via US ten year bond yields rising above 2.5%, or a recession. Both
of which appear unlikely.

The Coronavirus could challenge this rather optimistic view and will clearly
impact the current fragile economic recovery. Coming during Chinese New Year is
a mixed blessing with most factories closed for the holiday but domestic
consumption in China and the region will undoubtedly be hit quite hard. External
and transitory shocks are normally good buying opportunities but, on this
occasion, short term investor sentiment is already quite positive and patience
for some exuberance to be flushed out may be warranted.

 

Investor sentiment is particularly enthused in the technology sector and
continues to favour growth over value. While the global aggregate of the MSCI
technology sector trailing 12 month earnings multiple is a ‘reasonable’ 11x, the
S&P Technology sector in the US is trading at 60x (average 38x) and a hefty 23x
forward earnings.  Technology is the best performing sector by far over the past
12 months, returning over 43% while the energy sector is the worst at 3.3%. 

Investors are clearly expressing the view that tech is the future and oil is a
stranded asset of the past. They also appear to believe that we are in a world
of low interest rates, low cyclical growth and structural change. While we don’t
expect market leadership to change until the end of this market cycle, it is
worth noting that the risk premium investors are being offered in the US tech
sector is now -1.5% (on forward estimates!) and paying to take risk rarely works
out well in the long run so caveat emptor.

In the UK, there appears to be a significant post-election bounce flowing
through the economy. This was recently reflected in a bounce in the sentiment
indicators in both services and manufacturing. Anecdotal evidence, including
client activity at Tilney, the property market and elsewhere suggests the
release of a substantial pent up demand and we, like the Bank of England will
look to see if it is sustainable. Our pre-election forecast of a healthy
Conservative majority (we predicted 84 seats) was met with natural scepticism
but it is good to see the relief rally in stocks being repeated in the real
economy. However, given low core inflation and the structural headwinds facing
the UK as it prepares to leave the EU there seems to be little reason why the
Bank of England should not cut rates and, like the Fed, err on the side of too
much stimulus rather than too little. Central banks are very well trained in
slowing an economy and have plenty of policy tools to do so if required. The
currency is likely to weaken if they do cut rates and also help move core
inflation back toward the 2% target.



The US /Sino trade dispute had a material negative impact on investment and
trade volumes during 2019. The Fed, the ECB and the PBOC have sown the seeds of
stimulus and we were beginning to see a reaction and recovery. However, trade is
the truncheon of the Trump administration and there are risks of a further
reversal of globalisation as the focus now moves toward Europe.

The Coronavirus could also not have come at a worse time in terms of stalling
momentum and could materially challenge the earnings growth assumptions for this
year depending on the duration of the problem. It is a dynamic situation and it
is too early to know the global implications and how the UK will be impacted.
The good news in that investors are already bearish about the UK and
underweight.


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