Last week New York wobbled and the London market retreated to 7,000. European equities look fragile and emerging markets look tubercular. Is this the beginning of a global market correction or a bout of passing jitters?
The US equity markets: reasons to be cheerful?
Things may not be that bad, after all.
The current US bull market began in Q1 2009 – nine and a half years ago –since when the S&P 500 has risen by over 330 percent. On 09 March 2009 the forward P/E ratio on the S&P 500 (at a level of 677) was a multiple of 10.3. On 30 September 2018 (at a level of 2,914) the multiple was 16.8.
That is not stratospheric. Consider that at the inflection point of 24 March 2000 (the dot.com bubble) the forward P/E was at 27.2 times. Further to that the market fell by 49 percent before reaching its nadir on 09 October 2002.
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Moreover, the dividend yield on the S&P 500 has risen significantly. In March 2000 it was 1.1 percent. In October 2007, just as the banks started to tumble, it was 1.8 percent. On 30 September it was 2.0 percent – as compared with the 10-year Treasury bond yield of 3.1 percent. So the opportunity cost of investing in the US market, even if you think the market has no upside at all, is only just over one percent.
For income investors, the best dividend yields can be found with utilities (4.4 percent) and commercial services (4.0 percent) – so both offer better income than Treasuries. Technology stocks, overall, pay the lowest dividends though Apple Corporation (NASDAQ:AAPL) is an exception.
Corporate profits in the USA are still on the up. In Q2 2018 JP Morgan estimates that earnings-per-share across the market was $38.65 – and the consensus amongst analysts is that that will increase in Q3 and Q4. That arises both from continued increases in revenues plus increased margins, not least amongst the tech giants (the FAANGs plus Microsoft (NASDAQ:MSFT)), which largely account for the outperformance of the US market relative to Europe.
Much of this additional profit has been used to conduct share buy-backs which are now at record levels, amounting to over $700 billion in September. This obviously puts pronounced upward pressure on valuations.
In terms of company size, small companies have experienced better stock market returns than mid-size and large companies. In terms of sectors, one of the winners is, of course, technology companies which, overall, are up 655.8 percent since the market low of March 2009. But don’t overlook consumer discretionary stocks which are up 765.1 percent; financials – up 548.8 percent; and health care, up 422.2 percent. In the ongoing dance between cyclicals and defensives, currently JP Morgan thinks that cyclicals look relatively cheap.
Even if investors in US equities should not rush to the exit, there may be an argument to reduce exposure to the US market in favour of other markets. In a recent newsletter, Morgan Stanley recommended that global equity investors who wish to reduce their US exposure should accumulate Japan. One reason for this is that return on equity (ROE) for Japanese companies has been consistently rising in recent years.
Before the inception of Abenomics six years ago the ROE for the Japan MSCI stood at just 4.4 percent – 8.6 percent less than Emerging Market stocks. Now it is at 9.8 percent, only 2.4 percent less than the Emerging Markets. What accounts for this massive uptick in ROE?
Firstly, the Japanese economy is no longer suffering from deflation. Secondly, capital expenditure, not least in the robotics arena, is well up, driving improvements in productivity. Thirdly, as in the USA, cuts in corporate profit taxes have fed through into higher retained earnings. Fourthly, Japan has at last achieved huge improvements in the quality of its corporate governance – the revelations from the Olympus scandal of 2017 were a massive wake-up call.
Collectively, these factors determine that the Japanese economy is no longer as sensitive to the value of the yen as in the past. Furthermore, Japan’s growth is entirely self-funded and therefore the Japanese economy is not exposed to increases in US rates. Morgan Stanley thinks that Japanese ROE could rise to 12 percent by 2025, further stimulating the Japanese stock market’s trailing P/E ratio.
The Japanese economy was growing at a clip of 1.3 percent in Q2 2018. In August unemployment stood at 2.4 percent. Wage growth, after years of stagnation, is robust. Japan’s lost decade is but a distant memory – though still a salutary lesson.
This has not been a great year for European investors. The Euronext 100 peaked in May – behind Germany’s DAX which peaked in January, and which is now down by around 15 percent. Switzerland has gone in a similar direction, though it’s only down by around 10 percent from its January peak.
The eurozone economy is still growing, but the rate of growth is declining – it was down to just above 2 percent in Q2. It looks like growth in Italy may have altogether stalled in Q3. On the jobs front, eurozone unemployment is down to 8.1 percent – just a smidgen above the Q4 2007 low. But confidence is waning.
China and Emerging Markets
The Chinese market has fared horribly this year. The Shanghai Composite peaked at the same time as Germany’s DAX (the two countries are huge trading partners) and is now down almost 30 percent. Hong Kong’s Hang Seng index has a similar story to tell.
Yet Chinese GDP was still growing at an amazing 6.7 percent in Q2 2018. What is worrying about China is that debt levels have soared. Chinese government and household debt are still well below those of the USA – but non-bank corporate debt has risen to exorbitant levels. It is 164.1 percent of GDP in China, compared with 73.5 percent in the USA.
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Emerging markets have been heading south this year, with a few exceptions. The Brazilian index has recovered somewhat since the first round of the presidential election on 07 October. (The second round will take place on 28 October: it looks like it will be Mr Bolsonaro of the Social Liberal Party – even though he is not at all socially liberal.) The Russian and Indian markets, however, have both been poor performers.
BRICS was an acronym coined by a Goldman Sachs economist who was then put into the House of Lords as a minister by Mr Cameron – but then lost his political address. It is a useless coinage. But then so is Emerging Markets (markets are either emergent or dormant). A much more useful measure of advancement is to quantify what percentage of a population belongs to the middle class. I know that for my class-obsessed British readers that might sound a bit snobbish – but there are robust IMF-World Bank metrics to gauge this.
Last year, 12 percent of India’s population was “middle class”. China scored at 30 percent, Brazil at 52 percent; Mexico at 70 percent; and South Korea at 90 percent (probably more than the UK). I’d love to know what the figure is for Russia – but it must be similar to Brazil’s. Once we know how much of a population is middle class we can surmise how much they value education, travel and services – we get an insight into their aspirations.
India – a land I love and to which I shall be returning in early 2019 – is a most peculiar country. It has world-clout culture and a rapidly evolving financial system; it is a technology powerhouse; it is a vibrant democracy with a space programme. Yet, after 71 years of proud independence, half of its population (that’s 600 million people) have no toilets. Standards of public health in China are much higher.
In terms of currencies, the headline disasters are the Turkish lira (down 50 percent against the dollar this year) and the Argentinian peso. But overall, pretty much all EM currencies have lost ground against the dollar, and as such their poor stock market returns have been exacerbated in dollar terms. The Indian rupee, the Russian rouble, The South African rand and the Brazilian real have all fallen.
The London Market
Back in late May this year I penned a piece entitled Footsie 8000 – What’s not to like? It seemed that the FTSE had finally broken out of its long-term range boundary and was heading north at last. But it was not to be. Despite the glorious summer in the UK, the fog of Brexit never lifted in the financial markets.
The FTSE-100 index, it must be said, is an extremely odd one in that it is very detached from the economic fundamentals of its host economy. This is for two reasons. Firstly, there are a lot of constituent listings there – miners, oil majors, commodity traders (think of BHP Billiton (LON:BLT) and Glencore (LON:GLEN) – which conduct only very small proportion or even none of their business in the UK. Second, there are UK-domiciled companies which generate much of their income overseas. When the pound falls against the dollar their sterling income stream rises. That was partly why the post-Brexit devaluation of sterling had only an attenuated impact on the London market.
It is sobering to reflect that the FTSE-100 brushed 7,000 on Millennium Eve (31 December 1999) and it is at a pretty identical level as I write this nearly 19 years later. (Of course that does not reflect dividend pay-outs which are currently running at over 4 percent – so much better than cash). That is why UK-based equity investors should focus on the FTSE-250 or the FTSE-All Share indices rather than the weirdo FTSE-100.
The FTSE-All Share has fared much better in the 21st century – up from 3,000 to 3,876 as I write – so up by 30 percent in 19 years. But that’s still not very impressive. It’s really time for UK wealth managers, like our very own Ranjeet Singh, to justify why investors should be in UK equities at all.
The “doom loop”
In the first week of October the IMF warned that the world’s banks are highly exposed to risky government debt which it calls the doom loop. In many countries – Italy is an extreme example – most government bonds are snapped up by domestic banks because they qualify as secondary capital under the Basel III capital adequacy regime. Italy’s banks hold nearly 10 percent of the country’s approximately €2 trillion of debt – which stands at 132 percent of GDP.
As yields on unloved government debt rises – currently the case in Italy – so the mark-to-market value of those bonds diminishes and the banks that hold those bonds have to mark down their capital. This comes at a time when Italian banks are carrying massive portfolios of non-performing loans.
If the Italian government defaults on its obligations then the entire Italian banking system would collapse overnight. As I have written recently, Europe’s French and German masters will move Heaven and Earth to stop that from happening. Italy is now looking like the weak link in the eurozone chain, as Greece was in 2010-12. I have expressed the view that, come the hour, the Italians will prefer to remain in the eurozone rather than launch some experimental digital currency. But Italy, the eurozone’s third largest economy, has the heft to put the entire eurozone under economic strain for some time to come.
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In fiscal 2018 the government of the USA will borrow $1 to finance every $5 that is spends. (It will spend about $4.1 trillion). Last year the US budget deficit amounted to 3.5 percent of GDP. In 2028, according to JP Morgan, it will be 5.1 percent of GDP.
What is worrying when economists look at the debt profiles of rich developed nations is that sustained fiscal deficits have led to rising levels of national debt – even during relatively benign economic conditions. The consensus amongst mainstream Keynesian economists from the 1930s to the Credit Crunch of 2007 was that governments should borrow in times of recession in order to spend and thus to stimulate the economy. Keynesians (there are still some of them left) believe in the multiplier effect whereby every $1 of government expenditure flows through the economy from the worker to the shopkeeper to the supplier…Curiously, classic Keynesians do not hold that investment from the private sector has the same effect.
But classic Keynesians also believed that governments should sustain fiscal surpluses during upturns. That is not what has happened since 2009, with minor exceptions (of which, Sweden). Instead, since the financial crisis, governments – most notably that of the biggest economy in the world – have continued to return, compulsively, to the cash machine called the sovereign debt markets.
During the week of 04 October, the S&P 500 fell by more than 4 percent. That is actually quite a modest decline – though an unwelcome one. Of course, the younger generation of investors are not used to this kind of turbulence.
2018 has been a year of relatively flat markets – though the US market has continued to benefit from the strong performance of the tech giants. Volatility has returned – we have now had several bouts of extreme volatility, of which one in February and one in October. In the credit markets bond yields are increasing and credit spreads are rising. The cost of debt is likely to continue to rise in 2019 suggesting that the default rate may increase. That is bad news for mature, indebted companies.
What to do? Morgan Stanley has produced a pretty eclectic list of asset classes to avoid. These include cryptocurrencies, European banks, EM equities and bonds, Italian bonds, consumer staples, airlines and base metals. The fund manager still prefers equities to debt, however. It favours pure defensives right now: utilities, staples, telecoms and energy.
Euphoria is just so last year. A financial writer whom I admire, John Stepek of MoneyWeek, said on 16 October[I] that, on the basis of reading the analysis of technical traders, the tone of the market has changed.
We are still enjoying the cruise in relatively benign waters – but there are increasing whispers in the first class lounge that the crew have spotted an iceberg. Or was it a whale?
Meanwhile, the dance floor is full.
Some people look at two-dimensional maps of the world – usually Mercator’s projection which has been in use since 1569. In fact it is still, 450 years later, the standard two-dimensional view of the world, even though it distorts reality. I prefer three dimensions: I’ve got a globe on my desk.
In the November edition of Master Investor Magazine I’ll show why investors need to examine the world three-dimensionally in order to determine where the inflexion points are likely to be. The three dimensions of global analysis are: global financial markets, underlying economic fundamentals (GDP growth etc.) and geopolitics. It’s a heady mix – but I think you might find it interesting.
There is, of course, a fourth dimension. As we have known since the beginning of the 20th century, thanks to the work of the genius Albert Einstein (1879-1955), the fourth dimension is time. We know there will be a market correction sometime – but when? That is the trickiest one to pin down.
My answer today is: not yet. Markets follow sentiment around economic fundamentals, perceptions of which are imprecise. Growth is likely to slow next year – but that does not mean that the world will fall into recession. It is more likely that the bull market will be curtailed within two years or so by a conflation of certain critical geopolitical events.
You can see these thunderbolts coming if you carry good binoculars. And I’ll share with readers what these events will be very soon.