Edison Investment Research

Market outlook: balanced but still biased to upside.

Impact of lower rates, China tax cuts and political progress likely to be evident by mid-2019

Weak incoming data, both in respect of profits forecasts and the global economy is in sharp contrast to the strong performance of risk assets such as equities and corporate credit during 2019. Conflicting narratives can certainly create angst but in this case reflect investors’ belief that central banks have acknowledged the slowing global economy. We would concur that easier financial conditions means relief from negative economic surprises may be in sight by mid-year. Despite having risen sharply in the first few weeks of the year, on balance we believe global equities now have the prospect of volatile but still upward progress, as political events unfold.

Brexit: Prepare for a confrontation.

No-deal preparations on both sides represent a predictable escalation in tensions

UK PM Theresa May has survived the confidence vote triggered by her own party. A further proposed House of Commons confidence vote is also destined to be defeated. However, PM May’s continued premiership does not mean there will be no change in Brexit tactics. She faces the same unresolved conflicts as before. In order to deliver her deal, she may shift towards a more confrontational position with the EU in order to obtain increased leverage. Investors should not confuse this with actively seeking a no-deal Brexit. However, the road to amending the Withdrawal Agreement and winning UK Parliamentary approval now seems paved with market volatility. While UK markets are now trading at valuation levels which discount a significant degree of Brexit disruption, declining earnings forecasts in both the eurozone and UK suggest that it is too early to materially increase equity exposure to these markets.

2019 Earnings forecasts softening.

October market declines coincide with falls in non-US 2019 profits outlook

In recent consensus earnings revisions, we see a modest acceleration of downgrades to 2019 UK and continental European profits forecasts which have been drifting lower since August. In contrast, US forecasts have been revised only fractionally lower. The real action is in emerging markets, where 2019 forecast profits growth has fallen from 15% as recently as August to only 11% today. Finally we note that the typical upward trends in analysts’ target prices has stalled during 2018. This in our view confirms our top-down perspective that higher interest rates have been feeding through to company valuations, even as profits continue to grow.

Market valuations improving in UK and Europe.

There are risks, but valuation risk is slowly receding, with the exception of the US

October’s equity market volatility may already be in the rear-view mirror despite the evident risks of Brexit and lingering concerns over Italian debt sustainability. If markets stabilise close to current levels, the recent volatility may in hindsight be seen as a helpful correction towards aligning equity market prices to normalised interest rates and bond yields. Following the recent market declines, but following solid earnings growth and ROE in 2018 to date, median non-financial price/book levels, with the notable exception of the US, are now close to long-term averages. While there may be concerns over the sustainability of current profit margins, rising bond yields or geopolitical events, valuations can now move down from the top of investors’ lists of risks.

Rising US bond yields spark volatility breakout.

Synchronised declines in global equity markets may help stockpickers

October’s sharp declines in equity markets are being attributed to rising US bond yields. However, the surge in volatility is similar to that seen in January and raises questions about an underlying weakness in equity market depth rather than any radical change in fundamentals. It was hardly a secret that bond yields were likely to rise further over time given the strength of the US economy. Furthermore, a quarter-point increase in US 10y rates to 3.25% is not an especially large move. Recent increases in the US 2y rate perhaps went against the grain of Powell’s August comments but again were not especially noteworthy. We believe investors should first ensure that portfolios are appropriately positioned from a risk perspective, given the likelihood of a higher volatility trading environment.  Second, investors should be actively looking for securities which have been unfairly discounted in what has been an indiscriminate sell-off. However, we do not feel it is time to change our cautious stance on developed equity markets in general.

Choose your narrative with care for 2019.

Trade, politics or tighter US monetary policy? One may have a light at the end of the tunnel

In the 10 years since the global financial crisis of 2007-2008 there has been a perennial fear that the withdrawal of central bank support would lead to a collapse in asset values, which had been artificially inflated by ultra-low interest rates and asset purchases. With equity markets outside the US now having fallen by 13% in US dollar terms since the peak in Q1 18 as US interest rates have risen, it is very easy to become convinced this is the start of something bigger. While experience is in general an advantage, investors should beware of the risk of being too quick to make emotive links with the run-up to the 2008 financial crisis and emerging market crises of the 1990s. Notwithstanding the recent market declines, when we look ahead into 2019 we can see scenarios which imply a continued, albeit slower, global GDP and profits expansion - and a pause or slowing in Fed rate increases.

Guaranteed security? Investment implications of US foreign policy.

North Korea summit opens the way to an easing of sanctions and international recognition – while G7 allies are left reeling

North Korea has recently made enormous progress towards re-integration with the world economy on its own terms, and in particular security guarantees for its incumbent administration. Development of nuclear missile capability in 2017, followed by the willingness to discuss the destruction of this same capability only a year later does indeed highlight that Kim Jong-un may be, in Trump’s words, a very worthy and smart negotiator. Potentially, the prize is as large as a return to the world community of nations. The contrast with the disarray at the meeting of the traditional G7 allies days earlier was striking - and these trade disagreements are the greater risk for markets in our view.

High equity valuations face macro headwinds.

Factors behind record run of corporate profitability may be fading

We have had a cautious view on global equities for longer than has been comfortable. In truth, over the last 12 months this view has been 50% right at best. European markets, including the UK, have delivered relatively little capital growth. However the US and emerging markets have moved significantly higher. When the headlines are focussed on geopolitical events, it is also easy to lose sight of the anchor of equity valuations. We have updated our equity valuation measures and find that the US market in particular remains notably expensive while European markets still appear overvalued. We recognise that this has in part been justified by the record run of corporate profitability but the factors driving this phenomenon may now be going into reverse.

Social Media’s Dieselgate?.

The risks include fines, increased regulation and a change in consumer preferences

The recent controversy over social media and the use of its user data is likely to persist. Many users may not understand that researchers can accurately profile individuals on something as simple as their Facebook “likes”. The potential for influencing in subtle ways both consumption and more controversially political behaviours through targeted advertising should be clear. Multiple investigations across jurisdictions may now cast a harsh light on business practices which may otherwise have continued under the radar. Global digital titans which have become in effect brokers of user data are therefore under threat on another front, in addition to a recently proposed digital revenue tax.

Volatility spike: Investors have only themselves to blame.

The only mystery is why markets were so placid in the first place

Perhaps controversially, we view the intellectual horsepower being consumed by the legions of writers commenting on every second’s movement in markets over the last few days not dissimilar to the wasted electricity consumed to validate speculative bitcoin transactions. Both activities are in our view of relatively modest economic value, even if there is currently heightened demand. There have been, in a historical context, only modest declines from the highs for major stock markets, albeit concentrated in the stronger local currency year to date performers of the US and Japan. In volatile times, investors must remain focused on the long-term outlook.

Rising bond yields: Mini-drama perhaps, but not a crisis.

Rising yields a ‘known’ risk – declining economic momentum would be a bigger concern

This week’s modest declines in equity markets may be the largest of the last nine months but that is only an illustration of just how far equity market volatility has fallen. The narrative of rising bond yields and inflation expectations is being used to explain the market declines. This is understandable and we ourselves have previously highlighted the anomalously low level of global bond yields. However, rising yields are a known risk for 2018 and unlikely to create a major sell-off in equity markets by themselves. We would be more concerned if there was firm evidence of a meaningful slowdown in economic momentum. Such evidence is - for now - largely absent in either Europe, the US or China.

Canaries in the monetary coal mine?.

High profile difficulties in a hot corporate debt market are intriguing

Steinhoff and HNA Group are from different regions and sectors. Yet they are making the headlines for the wrong reasons as the market raises questions over their debt sustainability. What these firms do have in common is that have pursued a policy of debt-financed acquisitions during this cycle. Now, LIBOR rates are pushing markedly higher. These signals of tightening credit bear watching in our view, even if they are presently not a cause for immediate alarm. It is however our important to be alert to early signs of a turn in credit availability. This is likely to first occur at the margin of the credit risk spectrum, as in 2007/8.

Market volatility unsustainably low as bonds and equities diverge.

Bonds and equities appear to be simultaneously pricing two scenarios – so why is volatility so low?

There is now a growing disconnect between low global government bond yields which appear to indicate that the global recovery of 2017 may prove transient and high equity market valuations which discount an extended period of strong profits growth. In addition, starting from Q1 17 there has been an astonishing and sustained decline in equity market volatility. While there is nothing which suggests a market regime change is imminent, we continue to believe that re-normalisation of monetary policy is likely to result in the re-normalisation of volatility, bond yields and equity valuations over the 2018-19 period. This is not in our view a good time to be seeking to maintain returns by increasing portfolio risk.

Valuations: An important part of the puzzle.

Price/book multiples highlight worrying trend in risk appetite

In this cycle valuations have been, so far, the dog that did not bark. Globally, the median sector price/book multiple has risen from the trough of 2008 to a new peak. Such an expansion in market valuations is similar to that seen in the 1980-1987 period. Between 2012 and today we have come full circle in terms of tactical asset allocation. Earlier, we could not understand why investors were so uninterested in adding risk to portfolios despite such high expected returns in equities. Now, equity valuations suggest only modest long-term returns are on offer and there is greater prospect of short-term disappointment. It is however proving equally difficult to attract investors’ interest in this signal for caution. Perhaps the metaphorical - and silent - valuation dog knows the psychology of the current marginal investor rather too well.

Interesting times for central bankers.

If growth is picking up, why are bond yields still so low?

It appears the low volatility/high valuation regime in equity and credit markets is continuing into the autumn. This is despite an important and imminent US Fed balance sheet reduction announcement. Furthermore, October brings details of the ECB’s plans to reduce the net purchases of its own QE program. While central bankers are quick to claim credit for any improvement in economic conditions, the decline in long-term bond yields over the summer questions the durability of the expansion as the yield curve flattens. It also remains to be seen if investors will re-appraise the low level of risk premia in global markets as QE is withdrawn.

Earnings momentum remains stable for now.

Economic surprise driving EUR v USD but no FX hit to eurozone profits estimates

It may be the perfect environment for passive strategies as the lack of catalysts during 2017 has led to a continuation of the low volatility yet highly-valued equity market regime. In particular, it has been a robust year for corporate profitability. 2017 earnings growth forecasts remain pinned around 10%. Even while the medium-term outlook for markets looks challenging on valuation grounds as extraordinary monetary stimulus is unwound, those looking for a significant correction in the short-term should beware as corporate earnings trends remain robust at present.

Fed rate decision: One and done - or not done?.

One and not done would spook markets in our view

On Wednesday 14 June, we believe the US Fed is highly likely to raise the target range for the federal funds rate by a further 0.25%. We believe the opportunity the move policy rates further away from the zero “lower bound” will not easily be passed-up as US unemployment figures improve and as importantly without spooking markets, which have priced this move in. However, a signal of “one and done” for 2017 – or at least “one and wait and see” will be critical to keep markets buoyant. In addition, investors will be watching for benign comments in respect of any adjustments to the Fed’s balance sheet policy.

Volatility: Low, but downside protection in demand.

We struggle to understand why market volatility has fallen so far in 2017

One of the notable aspects of equity market performance during 2017 has been the rapid fall in market volatility. Trailing 90-day realised volatility for the S&P 500 has reached 7% in recent weeks. Over the last 20 years, these are levels are matched only during a brief period over 2005-2006. We do not see an especially strong parallel with 2005 as at that point US equities were still moderately valued and the US economy was expanding after a mild recession. We believe investors are once again becoming complacent; but also note the skew towards higher priced put options suggesting within the options market at least that downside protection is at a premium.

Earnings forecasts: a short-term support for markets.

Rising estimates notable in continental Europe

While economic surprise indices may now be rolling over, US earnings forecasts for 2017 are effectively unchanged since January. In the UK and continental Europe forecasts have risen relatively sharply since the start of the year, reflecting in the UK a continued tailwind from sterling weakness and in continental Europe the long-awaited improvement in economic activity.

Sector view: Boring old insurance.

In a fully valued market, a defensive sector priced sensibly

Our view that developed market valuations remain somewhat extended remains place. However, there is one sector which does not appear overvalued or compromised by legacy liabilities and questions over the future sustainable return on equity. Nor does it appear directly in the line of fire of technology’s advance like retail, or subject to on/off policy switches in China which have contributed to the de-rating of the resources sectors. European insurers appear from a top-down perspective to offer sensible valuations, reasonable returns on equity and high dividend yields in a low interest rate environment.

Market wobble? Still time to re-position portfolios.

No clear trigger for recent market declines

Even if some calm has now returned, the market declines this week are perhaps a little more disconcerting than usual as they have occurred with no obvious trigger and followed an extended period of very low volatility. This makes the situation a little more uncertain, as specific triggers can often be analysed, quantified and discounted. There is therefore the danger of investors becoming fearful of the unknown - and risk averse - should the declines become more serious.

Market indices riding on political outcomes.

Is now really the time to throw in the towel on active management?

When Trump addresses Congress this evening, global investors will be looking for more than promises. US equity investors are now waiting to price in the delivery of markedly higher US corporate profits. Market indices look expensive and thus the fortunes of passive investors seem unusually reliant on political outcomes; is it really the time to throw in the towel on active management?

Yellen’s hawkish testimony: Rate increases ahead.

The strong performance of asset prices in the post-2008 era remains in our view largely attributable to lower than expected growth rates being offset by much looser than expected monetary policy. However, as expressed recently by Bank of England Governor Mark Carney “..we’re coming to the last seconds of central bankers’ fifteen minutes of fame”. If, as we believe, central banks are in the early stages of stepping back from unconventional monetary policy this is likely to have significant implications for asset prices.

Implicit forward guidance on asset prices?.

Outside Japan, global inflation measures have over the last 8 months been rising as fast as at any time in the previous 25 years on a headline basis. The US Fed has kept real interest rates much lower for much longer than in previous cycles and the orthodoxy in central bank circles still appears to be that interest rates should stay accommodative in order to avoid the risk of deflation with rates still close to zero. Keeping rates low as inflation and growth accelerates may feel pleasant for now but also runs the risk of Fed Chair Yellen’s “nasty surprise”.

Valuations trump noisy narratives: increased caution on global equities.

Price/book valuations point to sub-par equity returns over the next 12m

Judging only by current equity market valuations, global equity investors are significantly more likely than usual to achieve only below average returns over the next 12 months, if prior correlations remain a guide to the future. Average price/book multiples for world equities are once again at peak levels, similar to those prevailing in 2007 and 2000, and this is reinforced by a similar picture for P/E ratios. We believe investors should factor in the possibility that broad equity market exposure may result in weak or negative returns and stock-pickers cannot rely on a tailwind of benign markets over the next 12m.

Trump’s double surprise.

It is quite clear that in the days leading up to the U.S. Presidential election, both markets and surveys got it wrong. Traditional polling once again failed to spot the depth of support for radical political change. This was after all the U.S., which has delivered the strongest post-crisis economic performance of any developed nation. 

UK economy and corporate profits: Refusing to follow forecasts.

Since July, there have been over 250 UK corporate earnings reports or trading statements, which we have been tracking for any sign of Brexit-related weakness. Within these corporate filings we can find little evidence, in either outlook statements or in managements’ referendum commentary, to suggest a slowdown in trading is underway.

On the contrary, over 80% of company earnings reports indicate that trading is in-line with earlier expectations. Furthermore, 16% of companies report that trading is ahead of expectations against only 3% reporting that trading has fallen below expectations. In addition, recent data on house prices and manufacturing surveys seem to confirm that fears of a Brexit-induced slowdown in the UK have proved overblown, over the summer at least.

Equity valuations – party like it’s 1999… and 2007?.

Amidst something approaching a euphoric relief rally in global markets following the UK’s vote to leave the EU, investors should not overlook equity valuation metrics, which have historically provided an excellent guide to returns over the long term. As Exhibit 1 shows, relatively low valuations preceded the bull markets in 1994-1999, 2002-2007 and 2009-2013. However, valuation metrics rarely form part of a market narrative and if they feature at all are often dismissed, usually as “it’s different this time”.

UK earnings trends - stable and few surprises.

There has been much speculation in regard to the economic and market impact of the UK’s vote to exit the EU. However, even four weeks after the date of the referendum, there is no hard data to rely on. In the circumstances, survey data may also be misleading, with the risk that it reflects a projection of the personal views of respondents rather than a cold analysis of future prospects.  However, early indications are that 2016 UK consensus earnings forecasts have remained stable, a continuation of the trend seen since February.

Brexit, Fed: a short squeeze.

If in the short-run the market is a voting machine, as attributed to value investor Benjamin Graham, yesterday’s 3% rise in European markets represents a vote of confidence in the Remain campaign winning the UK’s referendum on Thursday and a consistently more dovish US Fed for the remainder of the summer.

Fed boxed in by yield curve.

It is looking increasingly likely the US Federal Reserve has missed its chance to engage in a meaningful interest rate tightening cycle. Globally, 10-year government bond yields have fallen sharply – in many cases to new record lows, in part due to the recent US jobs data and in part the increasing uncertainty over Brexit. This flattening of the yield curve is a strong indicator for a period of sub-par US growth, even if survey data has, for now, improved somewhat during Q2. Whether or not we are looking at a technical US recession is perhaps, technical, as in any case a period of even weak growth is inconsistent with positive surprises for corporate profits and equities.

Beware of buy and hold.

The last few decades of the 20th century represented a golden era for equity investment with an average compound annual return, including dividends, of 14% pa in the period 1973-2000 for the US, UK and Europe. In this century to date, the annualised rate of return has fallen to 5%.

M&A in the UK - is Brexit opening a (relative) value opportunity?.

Whether down to the potential for Brexit or a widening current account deficit the decline in sterling over the last 6m has been substantial. On a quarter-on-quarter basis the trade-weighted value of sterling has fallen by 7%, representing a move of more than 2 standard deviations away from the mean.