Equities unbound: when will the bull market end?

Wall Street is setting new records against a backdrop of so-so economic data. What is going on? Central banks are cranking up the money presses again. While they’ve proven unable to generate inflation they can still inflate asset prices, writes Victor Hill.

Soaring higher

On Wednesday (20 November) the Dow Jones closed at 27,819.80, the S&P 500 at 3,108.38 and the NASDAQ at 8,526.73. These are all at or very near record highs.

The US markets have been heading remorselessly upwards for about a month. On 28 October the S&P index hit a new all-time high of 3,039, closing up 0.5 percent on the day. That exceeded the previous high of 3,025 achieved on 26 July. The Dow Jones industrial average and NASDAQ composite indices were close behind, sending stocks upward in what is often a volatile month for stock markets.

It is natural to ask what lies behind this market euphoria. Earnings expectations have been revised downwards of late in line with the overall slowdown in global economic growth, although relatively few analysts expect a full-on recession next year. This view is supported by the dis-inversion of the US yield curve which I discussed in late August. The rhetoric around the US-China trade war is less shrill than before though there is still little sign of its definitive resolution. But the real driver behind these toppy markets is that central banks are turning the money taps back on. It seems that the markets are buoyed up not by fundamentals but rather by liquidity.

According to a recent report by Citi Group[i], aggregate rolling 12-month security purchases by central banks, having hit a 10-year low earlier this year, are now rebounding. The Citi report argues that central banks tend to underestimate the impact of monetary policy on asset prices and that, for that reason (in my own words, not Citi’s) they have been over-egging the pudding. At the same time, other sources of credit creation and liquidity within the banking system have dried up. This makes global markets uniquely sensitive to central bank policy.

For now, Citi (and others) remain bullish on the market outlook. So long as the drugged-up markets continue to get their liquidity fix they will continue to defy gravity. But how much longer can this continue? That is a question that I have been asking in these pages for some years now.

Fundamentals versus monetary policy

The outlook on the global trade front has improved somewhat. The Trump administration is now likely to postpone or even abandon proposals to slap new tariffs on Chinese goods and on European automobiles, come December. For this reason the automotive sector and industrials have fared well in this rally – although in the UK the outlook is blurred by fears about the outcome of the general election on 12 December. (On that, more below.) Of course, positive sentiment on the trade front could be undermined at any moment by a presidential Tweet or another drone attack in the Gulf.

And Germany is not in recession – the country managed growth of 0.1 percent in Q3 2019 rebounding from a revised 0.2 percent fall in the previous quarter and beating market expectations of a 0.1 percent contraction. That is hardly a cause for elation. Taking a glass-half-full approach, Citi reflects that at least global data is no longer deteriorating at an accelerating rate.

On corporate earnings, analysts’ estimates have been revised downwards almost every week so far this year. Interest rate cuts in mid-summer cannot explain the current rally. What has changed is that the ECB has resumed its programme of asset purchases and the Federal Reserve has abandoned its programme of balance sheet reduction. Citi cites research to the effect that QE in one region spills over into another; thus the impact of monetary policy should be analysed globally.

Currently, the Fed is purchasing $60 billion a month of US T-bills. But because these securities are all short-term (that is less than one year, and many less than one month) this activity is not even classified as QE. Yet these purchases all reduce the supply of risk-free assets available to investors.

The Bank of Japan’s purchases of equities through exchange traded funds is a much more aggressive form of QE. The Bank of England, for its part, prefers buying corporate bonds to buying gilts. The ECB, meanwhile, is promiscuous in the REPO markets over all maturities, from overnight REPOs to infinite-maturity REPOs (mind-boggling as that sounds to non-central bankers like you and me). This multiplicity of unconventional monetary policy tools (known as UMPTs by the cognoscenti) makes the total amount of QE going on globally difficult to estimate precisely.

In practice, institutional investors are not poring over the numbers; rather they are feeling the prevailing sentiment. Just as when the now retired Signor Draghi vowed to do whatever it takes – and government bond yields in fiscally stressed EU states magically fell. In this way, a wall of money instinctively follows what I have termed the priestly caste of central bankers.

But look below the surface, as the team at Citi Research has. Profligate monetary policy by central banks has been matched by attenuated credit creation in the private sector via bank lending. Decelerating lending implies decelerating future growth. There is now a valuation gap as between price to policy and price to fundamentals. We have been warned.

Investment styles

Most professional investors believe that the pendulum will swing back: that, in time, the bulls will be outrun by the bears. The first question, then, is when will a market correction come? But no one really knows the answer to that. The second question, however, for investors like Fidelity’s Tom Stevenson, is which investment style will fare best when that correction comes[ii]? Growth or value?

Growth shares are those of companies that can be expected to deliver rising profits regardless of how the overall economy is performing. These are often businesses that sell products that we cannot live without (smartphones, then). Because they tend to have low sales and earnings volatility, investors are normally prepared to pay over the odds, especially if the economic outlook is poor.

Value shares, in contrast, are shares of companies in sectors which may be out of favour and which trade at lower multiples than growth stocks. But if their valuations fall to below a certain level they will become of interest to contrarian investors – especially if market conditions are improving.

Over the last decade since the financial crisis, much of the smart money has been on growth stocks as investors have favoured consumer staples and technology stocks that have promised faster profit growth. According to Tom Stevenson, however, we have reached a tipping point. Growth shares have become excessively expensive while value shares are cheaper than ever. The valuation gap (that term again) between the two, he thinks, has widened to an unprecedented level. As a result, there has been a change of sentiment since the late summer away from growth stocks and towards value stocks. Banks and industrials have done particularly well.

Overall this looks like good news. Tom says that the best times for investors are when value is outperforming growth. In this new environment active managers are likely to be able to generate alpha again – and that will take the shine off the universe of passive funds.

UK-specific factors

The UK market has been held back for three-and-a-half years now by the uncertainty around Brexit. A Tory majority government after 13 December would allay these concerns for the short-term at least as it would become overwhelmingly probable that the UK would leave the EU on 31 January 2020 under the terms of Mr Johnson’s Withdrawal Agreement. That would mean that absolutely nothing changes during the transition period over 2020. Towards, the latter end of 2020, however, the uncertainty will recur when and if the post-Brexit UK-EU trade deal runs into the sand. (As I predict it will – more on that in due course.)

But there is an additional layer of fear and uncertainty surrounding the possibility that Mr Corbyn might emerge as Prime Minister on or after 13 December (though the probability of a Labour majority government is slight). Shares in utilities on the London market dipped last week in view of the Labour Party’s privatisation plans but have more or less held their ground this week. United Utilities (LON:UU.) is down very marginally on the month but is still up by 10 percent on a 12-month basis.

More significantly, the BT (LON:BT.A) share price was hit by Labour’s announcement that it would provide free broadband for all further to a forced take-over of BT’s fixed-line cable business, BT Openreach. BT’s share price has fallen 10 percent in the last 30 days and 26 percent over the last 12 months.

Labour’s policy on broadband is the most audacious and eye-catching policy initiative of the general election campaign – something which everyone understood. It is also entirely unworkable. It arises from the fact that, having been ahead of the curve in the first phase of the roll-out of internet connectivity, the UK has fallen well behind its peers. Outside the major conurbations few people and businesses get access to the internet via fibre-optic cable but rely on legacy copper cable connections which are unequal to modern broadband speeds.

Labour is right to say that the current network is failing the British economy. People cannot efficiently work from home or run small businesses with low broadband connection speeds. And Labour has a point that BT inherited the old legacy cable network from the long-forgotten GPO; and while it has updated that network it has not sufficiently extended it. When you order a new broadband connection in rural areas in the UK from TalkTalk (LON:TALK) a BT Openreach van shows up about two weeks later.

So why am I sceptical of Labour’s big idea?

First of all, it will be very difficult for a Labour government to agree a fair market value for Openreach with BT without protracted litigation. (At least the lawyers will get rich.)

Second, I could not imagine that even Mr Corbyn’s Labour will set up a new government department to maintain and operate the unit. Rather, they will de facto outsource the running of the new government entity to a telecoms giant – such as BT. Thus the running costs would just be absorbed by government without any evident improvement in service levels.

Thirdly, there will be huge issues surrounding the use and ownership of data generated within the UK broadband network. Although some opinion polls showed that “free internet” was popular, others revealed that most people area appalled at the idea that a (Labour) government might have access to our search data.

Fourth, most of us get our broadband internet connection via a “bundle” with a major media provider such as Virgin Media(owned by Liberty Global (NASDAQ:LBTYA)) or Sky (owned by Comcast (NASDAQ:CMCSA)). The bundle normally includes satellite or cable TV, a fixed phone line and possibly a mobile connection in addition to broadband internet. If you take broadband out of the bundle the cost of the remaining bundle will go up. So free broadband will not be free after all.

For all that, I think that BTmight actually be a leaner, meaner telecoms outfit without its labour and capital-intensive operations unit. It would still most likely provide maintenance services, charging more-or-less what it wants to the new government-owned network company. I suspect the sell-off in BT shares has been overdone.

The end point of QE

QE started out after the global financial crisis of 2008-09 as a temporary measure to provide sufficient liquidity in the financial system to forestall a systemic banking crash. When that crash was averted but the global economy became mired in stagnation, it was used as a tool to stimulate the economy overall – a role previously dominated by fiscal policy. But, having become mainstream, it has proven politically and economically impossible to desist from further QE. It is now the principal means by which the global economy sustains demand, pushing up asset prices as it does so. If the money presses were halted overnight global markets would splutter and the global economy would probably be plunged into recession.

But there is a theoretical limit to the role of QE. That is that the stock of financial assets in the global economy – investment papers, bonds and equities – is finite. In some dystopian monetary policy-dominated future the world’s central banks might end up owning all the financial assets outstanding. Thus, private property would be abolished and capitalism would perish: not, as Marx predicted, by succumbing to its own inherent contradictions; but rather it would disappear like the legendary Oozlum bird by flying up its own orifice.

***

The Tories are proclaiming that they are well ahead in this election – and the opinion polls still show a double-digit lead over Labour. But closer scrutiny of the polls shows that Labour is trending upwards at the expense of the Liberal Democrats. Mr Corbyn probably outdid Mr Johnson in Tuesday’s ITV debate – despite his pitifully equivocal stance on Brexit. (His core supporters actually admire his constructive ambiguity.) But Ms Swinson is performing poorly, at least where she performs at all. Strategists at Lib Dem HQ may now regret making her the focus of their campaign (just as Tory High Command put Mrs May centre-stage in 2017 – a kind of Mussolini in leopard-skin boots).

Meanwhile, Mr Johnson has repeated his leadership campaign strategy by studiously avoiding controversy of any kind and keeping a straight face. But BoJo without the clowning is like a Jaffa Cake without the jammy filling. There is something missing. And there is so much that could go wrong.

I warned readers two weeks ago that there would be wildcards in this election. One more poorly-alleviated natural disaster (another flood? snowmageddon?) and one more health crisis (a flu epidemic on top of the existing chaos in our A&E departments?) will see Messrs Corbyn and McDonnell waddling down Downing Street like a pair of wild ducks.

[i]Citi Global Credit View, 15 November 2019

[ii]See An upswing for value shares is good for markets, Daily Telegraph, 18 November 2019. See: https://www.pressreader.com/uk/the-daily-telegraph-business/20191118/281599537332259