An irrationally angry bear?

ECONOMICS & MARKETS
Garry Laurence

Garry Laurence

Global Equities Portfolio Manager
Global sharemarkets are off to a bad start in 2016 – but are things as bad as they appear? Gary Laurence runs his eye over the US economy and the earnings potential of key holdings in the Perpetual Global Share Fund. 
As I sit here today, the MSCI World Index has officially entered a bear market, with the index down 20% from its May 2015 high. Banks are amongst the hardest hit in this current sell off with Credit Suisse hitting a 27-year low and many European banks hitting levels not seen since 2009. 

The panic in global share markets started with Chinese A-shares falling heavily in the early days of January. As the price of oil slipped below $30 a barrel, the panic started to flow through to the banking sector as markets started to worry about their loans to energy companies.

The fear has also spread to industrial companies where the stronger (more expensive) US dollar is making it harder for US exporters. Now the fear has reached levels where people are expecting a global recession.

Personally, I am a lot less bearish than the markets – but that may simply be because the markets vote on prices every day whereas at Perpetual we buy for the longer term. I don’t have the same level of concern about the real economy – and more importantly, about the earnings of the companies we own. Let me share some of my reasoning.

The banks don’t have much energy

Crucially, most major banks around the world only have about 2-3% of their loan books exposed to the energy sector, so this is not like the GFC where loan books were completely overexposed to falling house prices and a weaker consumer sector. 

Indeed, we currently have 13% of the portfolio in banks. Interestingly, the bank executives we’re hearing from seem as perplexed as I am about the slide in their stock prices. Jamie Dimon, the CEO of JP Morgan, said on their earnings call, “We are not forecasting a recession. We think the US economy looks pretty good at this point.”  He said this on January 14th – and it was then announced that he bought $26m worth of shares!

We also spoke to Paul Donofrio, the chief financial officer of Bank of America. He was at pains to emphasise how different the bank’s balance sheet is to what it was during the GFC. They have shrunk the mortgage and credit card books and the quality of their loans has dramatically improved. Indeed, their loan book is growing again, with commercial loans up 12% year-on-year in Q415. This is not a sign of a weak US economy.

On our earnings call with Wells Fargo they also emphasised that their energy book represented a miniscule proportion of their loan book. All these banks are expected to grow their earnings into 2016 and are trading at attractive valuations. They have the largest and lowest cost share of retail deposits in the US – which is why they represent the majority of our bank holdings. We like owning banks when interest rates are rising – as they are, albeit slowly, in the US.
  

The economy is not catering

Given the weakness in equity markets, you would think the US economy is entering a recession. This is not the case.

  • We still expect GDP growth of 2% driven by improved consumption – that represents around 70% of US GDP and it continues to grow. 
  • Retail sales were up 3.4% in January because Americans have heavier hip pockets thanks to cheaper petrol and rising wages (up 2.5% recently).
  • The US unemployment rate is now down to 4.9%

None of these numbers are usually associated with a weaker economy

Chart 1: US unemployment rate

Global Share FundSource: Deutsche Bank

The media sends a positive message

US media companies have also been positive, with big advertising companies, Omnicom and Publicis, posting strong growth. 21st Century Fox also spoke about a strong television advertising market - their Fox News cable channel is benefiting from political advertising as the US party primaries hit full swing. Lastly, Google – a significant Fund holding – had one of their best quarters in a while, with constant currency revenue growing 24% in the fourth quarter of 2015. They’re benefiting from the continued migration of advertising spend to web search and from growth in their YouTube franchise. 

"I am genuinely excited about the opportunities currently being thrown up by these market conditions."

On the industrial side of the US economy, there were more mixed results, some of which affected our portfolio.

  • The stronger US dollar is hurting agricultural exports and dragged down CSX Corp, a railroad operator which we own and which has seen weaker numbers in coal and agricultural shipping.
  • Dick’s Sporting Goods had to downgrade earnings forecasts due to weather affected hunting and winter wear sales. Temperatures on the East Coast and in the centre of the country were more like summer than winter in December.

We look for value – and now there’s more on offer

The last observation I have about global markets is the difference in performance of growth stocks versus value stocks over the past few years. Growth stocks have outperformed over the past few years as their valuations have hit historical highs, whereas value stocks have actually become cheaper. 

Chart 2: S&P500 growth versus value stocks 

Global Share FundSource: UBS

We have not been immune to this downdraft in value stocks and our performance has suffered over the past six months as companies have become even cheaper. We still have conviction that the collection of businesses we own are worth more than the market is paying for them today.

We will wait patiently for the market to value these stocks more appropriately. While I have been worried about valuations over the past few years, and have mentioned this in my past newsletters, I am genuinely excited about the opportunities currently being thrown up by these market conditions.

As a wise man once said, “be greedy when others are fearful”. I can see a lot of fear around at the moment. 

 

The views in this article express the opinion of the author and may contain general advice. It has been prepared without taking into account your objectives, financial situation or needs and because of that, you should consider the appropriateness of the advice before acting, having regard to your objectives, financial situation or needs. Any information referenced in the article is believed to be accurate at the time of compilation and is provided in good faith. The author is an employee representative of Perpetual Investment Management Limited (PIML) ABN 18 000 866 535 AFSL 234426.

 

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