Thursday, May 31st, 2018
With equity markets recovering steadily after the February correction, many investors keep looking for bearish narratives and reasons to sell. This is despite observable and reported strong US company earnings in the recent March quarter. In our view, current earnings of US companies are supportive of US equity market valuations.
More importantly, and as we outlined at our Mid-Year Investor Briefings, the world is in a long growth cycle and the investment and economic outlook remains positive.
Events since our presentations have already confirmed some of our predictions. At the briefings, we suggested that the trade friction between China and the US may in fact lead to collaboration rather than trade war. We have seen the first step towards that with President Trump suspending his threats to impose tariffs on some $US150 billion of Chinese goods. Further, we note that US Treasury Secretary Steven Munchkin (yeah, I know) has declared “we’re putting the trade war on hold”. Seemingly both the US and China realise that each has too much to lose from a trade war.
US Secretary of the Treasury, Steven Mnuchin
Importantly, it is the events that develop and evolve after the initial escalation (the usual Trump midnight tweet) that supports our broader thesis of a steady market and economic outlook. Such a backdrop is conducive to achieving the investment goal of 6% to 8% per annum returns this year and over the next few years.
Benign inflation and bond yields
At the heart of our thesis is the benign outlook for inflation. Many continue to predict an outbreak of inflation, but the fact is that inflation around the world is under control. We expect ongoing rates of inflation of 1% in Western Europe and Japan; around 2% for North America; and a little higher in Australia.
With inflation well under control, bond yields, whilst correcting, haven’t got too far to go. We believe that bond prices will correct, or normalise, a little more over the next few years, which will see five to ten-year bond yields match, or slightly exceed inflation rates.
US bonds have already had a correction, pushing ten-year yields to 3%, and they may rise a further quarter or half of a percent in the next year, but those levels are still well below historic averages and we are not overly concerned by that.
Certainly, bond yields must move significantly higher in Europe and Japan. If markets were QE free, we would expect a serious correction. But with QE anticipated to remain for the foreseeable future, bond yields will climb slowly. Indeed, while we predict that German ten-year bond yields will reach 1% in 2019, we do not see this as a major impediment to either the German, European or the world’s equity markets.
Of more pressing concern is that cash rates in Europe and Japan are being held at negative levels by their Central Banks. While the maintenance of these rates is not sustainable, we do not see the negative rates adjusting in the next 12 months. However, we do perceive that the maintenance of negative rates is corrosive to growth and this will become more widely understood as growth in Europe slips again in 2019.
A thought that we continue to entertain is that the US Federal Reserve may stall at some point on its path to normalise cash rates. Markets are pricing in two to three 0.25% adjustments before Christmas, but we wonder if President Trump may soon tweet that this policy is anti US and of no benefit when its trading partners are holding cash rates at negative levels. This will put new Fed chair Jay Powell’s independence to the test.
On any scenario, the outlook is for bond yields to rise over the next 12 months, but not significantly; and probably not enough to upset equity markets.
Equity market ballasts
US markets have risen strongly since the GFC, and many are calling them overvalued. But the benign outlook for inflation and bond yields are generally supportive of current valuations.
Inflation and bond yields are clearly very important for equity markets. Indeed, in a crazy world of manipulation, the enduring relationship between inflation/bond yields and equity PERs is the only thing that can give investors some rational guidance.
To begin with logic, if inflation and bond yields rise, then equity PERs should fall (and vice versa). But the relationship also provides a rule of thumb: equity markets are fair value when the 10-year bond yield in the US plus the market PER approximates 20 (the so-called “rule of 20”).
Given our prognosis for inflation and bond yields to sit around 2% and 3%, with current US equity PERs of 18 times earnings, this gives a total of 20 to 21. This suggests that equity values are slightly elevated, not excessive and in individual cases fair.
Higher bond yields will mean that higher market PERs are unlikely to occur in the next few years. PER contraction is a risk, but higher earnings are a clear offset to this.
Recent US company earnings are also supportive of current valuations. Over 90% of US companies have now reported their March quarter results. Overall S&P500 reported earnings grew by over 20% (on the March 2017 quarter) and exceeded analyst expectations. Not only were earnings strong, but so were revenues, up by an average 10%.
We know a portion of earnings growth was driven by the Trump tax cuts, on average explaining about 30% of earnings growth. The energy sector, benefiting from high oil and gas prices, also helped drive overall corporate earnings. But outside energy and tax cuts, underlying industrial earnings were reasonably strong.
However, while broad 20% earnings growth is not sustainable, there remain some tailwinds. The tax cuts will continue to benefit earnings for the next three quarters and oil prices will likely remain elevated with OPEC supply constraints in place.
Thus, while we do not declare the US market as cheap – it sits around fair value based on the rule of 20 mentioned above – the outlook for earnings growth and the benefits of a trade settlement supporting US exporters underpins an investment allocation.
Against this generally positive outlook, there are some risks that investors need to be aware of.
One risk we highlighted at our briefing, and which continues to concern us, is the strength in oil prices. Oil prices at $80 or higher must lead to an upswing in inflation, and this is the greatest risk to our inflation and investment outlook.
That risk is heightened by the actions of Russia. We have already seen Russia infiltrate and disrupt the US political system and ongoing disturbance to oil markets seems another strategic intent.
Russia exports more than 5 million barrels per day (b/d) of crude oil and condensate and more than 2 million b/d of petroleum products, mostly to countries in Europe. Exports of crude oil and petroleum products represent around 70% of total Russian petroleum production. Russia’s oil and natural gas industry is a key component of Russia’s economy, with revenues from oil and natural gas activities—including exports—making up more than a third of Russia’s federal budget revenues.
We expect that Russia may use its new-found alliance with OPEC to stir up energy-based inflation. This could become a weapon to trigger a rise in US bond yields and add to US budget stress. Thus, the strategic imperative for the US to become self-sufficient in oil and gas is clear. Importantly, it has done so in the last year or so and trade discussions with China have flagged the potential of US exports of LNG to China.
US fiscal deficit
Another risk to our growth thesis is the fiscal situation in the US. While tax cuts are benefiting corporate earnings, the corollary is a burgeoning fiscal deterioration. US Government debt continues to grow at an alarming rate.
Various commentators and forecasters project the US will have a US$1 trillion deficit, or 5% of GDP, which is clearly unsustainable. It means the US Government will have to come back to bond markets consistently to raise debt.
That observation gives us a key insight into why the US/China trade olive branch was offered: the US, as we flagged at our Mid-Year Briefing, needs the support of China’s vast capital reserves for its bond market.
Turning to Australia, we believe the outlook is similarly positive to the global picture. We enjoy record-low interest rates, a growing economy and a trade surplus. Indeed, our biggest challenge is to not get bogged down by the inane commentary and noise emanating from Canberra or the Royal Commission.
The Federal Budget was handed down after our May 1 briefing, but it revealed a solid fiscal position. We will have a projected surplus in a few years and the deficit is just 0.8% of GDP, one sixth the size of the projected US fiscal deficit.
Our economic growth is steady to moderate and there are several tailwinds supporting the economy, including massive infrastructure projects that will be rolled out across the East Coast in the next decade.
We are also benefiting from the Chinese tourism boom, with visitor numbers compounding at around 10 to 12% per annum, and the Chinese visitors spending over $10 billion per annum. Significant economic growth is being generated through the tourism trade.
There are, of course, some ongoing issues around the Financial Services Royal Commission. Australian investors have traditionally been heavily weighted in the financials, telcos and retailers in a bid to generate franked income, but they are now realising the risks of overexposure to equities and have been suffering market losses.
But if we look through the Royal Commission and consider the prospect that many of the problems are historical, and that the banks likely have programs underway to remediate them, some of these stocks have and will become oversold.
Outside the ASX 50 and the ASX 100, there are growing numbers of growth opportunities in the Australian equity market. This is presenting Australian equity investors with a solution – segment the Australian equity market into yield (the top 100) and growth (ex 100).
A case for confidence
After strong investment gains, some investors are looking for reasons to sell the market. Yes, there are some risks including high oil prices and the US fiscal deficit, and investors should expect a little more market price volatility.
But overall, the story that inflation, bond yields, earnings and economic growth (both in the US and Australia) is telling us, continues to be a positive one, and investors should continue to invest with confidence that the market will deliver reasonable investment returns for the foreseeable future.
The conclusions that we presented to investors at our May presentations are outlined below.