Economic analysis by Filipe R. Costa
While investors became euphoric in 2008 with the launch of the first QE programme in the US, such emotion does not hold when comparing the event with the first QE announcement in the Eurozone.
Investors reacted positively to Mario Draghi’s QE package announcement and the programme is, in fact, large enough to be noticed, but the euphoric uptrend that guided US markets higher in the past may be much more limited this time, as the global geo-political environment and economic conditions are on balance worse (albeit comparatively better in the US). While investing in Europe may be a good option (at least while QE is still a top headline), the risk factors that must be considered are so multifarious that an investor should look carefully at them before blindly jumping into equities.
In his newsletter to investors, Daniel Loeb, the hedge fund manager and founder of Third Point LLC, recently pointed out some important factors that have been “haunting” investors. Loeb refers to the current market as resembling a “haunted house…where a new scary event lurks around each corner” and declares his hedge fund is preparing for “inevitable sell-offs” by lowering equity exposures. He still sees opportunities at the individual stock level but market-wise bullishness may be behind us already. Stock picking abilities will be more valuable than ever, as replicating the market portfolio won’t be enough and volatility has been increasing.
Even though I don’t agree in full with Loeb’s views and explanations, there are a few points he highlights in his newsletter that are worth mentioning here as a starting point to identify the risks investors may face in the near future. So, let’s look at the following points, or possible “scary events”, as he puts them:
- Lower overall growth
- De-pegging of the Swiss franc
- Declining currencies in Europe and Japan
- Disconnect between when the Federal Reserve expects to raise rates and what the market is forecasting
- Rise of populism across Europe
- Russian-Ukrainian conflict
Despite the large-scale asset purchase programmes deployed in the US, UK and Japan, and the global reductions in interest rates, the world is not recovering at a decent pace from recession.
Even in the US, where growth exists, it has been lower than one would expect after a recession. The US economy has traditionally put in strong GDP growth rates after recession years, which is not the case now. The latest jobs data was highly acclaimed last week, but I am still relatively unimpressed, as I believe they hide problems with construction. If the real unemployment rate in the country was 5.7%, then the US economy would be operating really near its NAIRU (non accelerating inflation rate of unemployment) and acceleration in prices would be expected, particularly in wages. The BLS recorded a 12 cents per hour gain in the jobs report, but that is not really enough to use the world “acceleration” with confidence is it?
To put it differently: do you believe the US economy is operating near full employment? I don’t. Recorded unemployment rates understate the real numbers by counting people that are marginally attached to the workforce, people that are seeking employment for too long, and people that are working part-time against their own will. But I don’t want to bore the reader with such a discussion, which would be enough for an entire magazine issue. The point here is that growth is still not strong enough to justify the uptrend we are seeing in the US equity market.
Loeb points to the de-pegging of the Swiss franc from the euro and the declining values of the euro and the yen as a problem in terms of US corporate profits. A few months ago I highlighted the declining euro against the dollar as a problem to come over the next few earnings seasons. That time has now come. While Draghi was very helpful for corporate America in July 2012 when he said he would do “whatever it takes” to save the euro, Bernanke ended the party when he left the Fed at the end of 2013 by scheduling the end of QE to occur at mid 2014.
The euro is down more than 18% since mid 2014. With European QE set to last for almost two years, corporate America will find troubled waters this side of the pond, which will be reflected in the next profit statements. David Kostin from Goldman Sachs goes as far as predicting 0% sales growth for the S&P 500 constituents in 2015. If that comes true, it will weigh heavily on the current near all-time record level the S&P 500 currently shows. Janet Yellen faces a tough time ahead. Her data are pushing for the first rate increase, while global conditions threaten to punish US companies if that happens, through the exchange rate channel.
Loeb points out the disconnect between investors’ expectations (the market) and those of Fed officials regarding the interest rate path. The market is rescheduling to 2016 what the Fed is scheduling for mid 2015 – the first interest rate rise. Why is this a problem? Because the market is not pricing correctly the probability of a rate increase occurring this year. This adds downside risk to the current S&P 500 level.
The European situation is also a concern at the political level. After many years of relatively unsuccessful austerity measures in peripheral Eurozone countries, people are seeking massive political changes, with the current Syriza win at the Greek general election being the most salient example of such a will. While there’s nothing wrong with people seeking an improvement in living conditions and replacing their leaders in order for that to happen, the rise in populism may lead to added uncertainty for the future of not only Greece but also the Eurozone as a whole. I believe Alexis Tsipras is right in realising Greece is broke and that it is better to deal with it now than to extend borrowing and face it in the future. But if the core European countries play hard ball here to the point of Greece having to exit the euro, I believe they will merely succeed in engendering an increase in populism – in Greece and elsewhere. The euro would then find it hard to survive. One way or another the risk is there and we should carefully take it into consideration.
My last point concerns the Russian-Ukrainian conflict. While many may believe this is contained in the region, there is a lot of potential for collateral damage which is indexed to how the international community deals with it. Obama’s idea to arm Ukraine is a senseless one. It is time for the EU to clearly detach from the US in terms of action regarding this conflict, as any harsh measures taken against Russia would not help solve the conflict and could harm the EU’s future potential in terms of building a bigger economic bloc. Cracking Europe means cracking the current EU construction. It is in the political interests of the EU to keep Russia more to the West than to the East, which may not be in line with the US Government’s agenda. For now, the EU has retreated on sanctions applied to Russia, which is a positive development, but we should monitor how EU’s external policy develops on this matter for any added risk to European markets and the euro.
With all this in mind, 2015 will no longer be a free-riding year for hedge funds. This year they will have to seek for real active management, as passive strategies may not derive positive results. With sentiment having already hit a high in the US, finance theory says we should look for value instead of growth. Those larger stocks, with a good record of dividend growth, and with solid cash flows, will eventually outperform those high P/E companies that promise more than they can ever deliver. Investors must prepare for a time when income will outperform capital appreciation. With that in mind, our February edition of Spreadbet Magazine is fully dedicated to income and to finding solid yields in difficult times.