Three years ago the European Union was about to fracture under the weight of its own debt - currency, bond and equity prices in the highly indebted periphery were plunging as risk premiums blew out and then Mario Draghi said he would do whatever it takes to keep things united. After this, risk markets rallied in line with the currency and delivered strong returns for investors as asset prices recovered. After its October 2015 meeting the ECB President hinted about more policy stimulus in December which has once again sparked a rise-on rally. However, Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset finds that any policy delivery in December is likely to spark a risk rally of much shorter duration given prevailing low bond rates, high equity valuations and a lack of corporate performance, with 2015 real EPS growth negative in nearly every region.
- The world is older, more indebted and has a wider socioeconomic divide than ever, which means global growth and inflation will be weaker for longer and that low rates are here to stay. This environment has handicapped the corporate sector’s ability to deliver on optimistic EPS growth with only Japan recording positive real EPS growth in 2015. Accordingly, the fully invested bear market remains alive with few investors having deep conviction about the foundations of the latest recovery as growth concerns reign supreme amid elevated valuations.
- US valuations are back to recent highs (17x forward earnings) and investors are expecting +8% EPS growth in the next 12 months, even though US corporate performance so far this year has delivered next to zero. While the current US reporting season has had a +68% beat rate which is around the historical average, it is against heavily downgraded numbers. The recent underwhelming US corporate performance suggests that it will be very difficult for the US market to drive multiple expansion from here, which should cap the recovery. Europe and Japan offer more value but central banks and corporations have to deliver on expectations, or else the recovery could rapidly unwind.
For central banks, it is the best of times and it is the worst of times. The world is more indebted so their ability to impact growth through changes to financial conditions should be at its zenith. However, the population is older, wealth is more unequal and balance sheets are so overleveraged that central bank power is now asymmetric – they can’t boost growth by cutting rates to stimulate more leverage, but they can curb growth by not providing stimulus or worse still, raising rates too early. Data shows this has been the case since 2009 with nine central banks hiking rates and all nine having to reverse that move within 18 months, as financial conditions tightened too much.
CENTRAL BANK POWER – REPUTATION OR REALITY?
Many investors (including myself) over recent months have been writing about central banks having less policy ammunition. With rates at zero these organisations have many less bows in their policy quiver, but at present, the enemy (namely the market and growth bears) still seem to be fearful of going to war against increased liquidity. There has been nearly a quarter of a century of data to show that you don’t fight the Fed or any other ‘QEing’ central bank, but even a superficial look at announcements and the growth impact suggests that central bank power is more to do with reputation, than reality.
CENTRAL BANKS DON’T MAKE ‘CONVERSATION’.
Much of the attention of investors in late October was on Mario Draghi and the People’s Bank of China who suggested and implemented more policy easing, respectively. Super Mario did not disappoint waning investors, delivering a well-received message of impending boosts to ECB policy support. While the statement suggests that this is still six weeks away and that certain hurdles have to be leapt to be implemented, central banks do not make statements like he did to simply fill in an empty void. Central banks leaders are very well aware of the power of markets and are very deliberate in what they say and do.
… BUT ARE LIMITED IN WHAT THEY CAN DO
In the end, the trigger for easier ECB policy comes from an appreciating Euro, which drives inflation and growth lower and lowers inflation expectations. The policy support is likely to involve an extension of the current QE program to June 2017, a broadening of eligible securities (to include more than just sovereign bonds) and also a further 10 basis point reduction in the deposit rate (to -0.3%). Quantitative easing is targeted towards reducing long-term premium of bonds in core countries and lowering the yield spread between the core and the periphery, whereas the more negative deposit rate is geared towards weakening the currency and boosting exports, growth and inflation. Mario showed investors that he still has the ability to wave a big stick, even if it’s brittle and hollow inside. It’s the same ineffective stick waved several years ago with growth and inflation today still too low to address government balance sheet issues, but financial markets are much higher.
THE OCTOBER RECOVERY LACKS CONVICTION
Since the US Fed baulked at tightening rates in September, China, Taiwan, India and Norway have eased rates, indicating that policy support has become more global. Nevertheless, few investors are likely to have much conviction about the October recovery as it has been underpinned by a ‘scarce yield’ story and has driven earnings multiples back to recent highs. Indeed, uncertainly about the global growth dynamics reign supreme yet analysts are expecting +8% US EPS growth in the next 12 months, even though US corporate performance in 2015 has delivered next to zero. While the current reporting season has had a +68% beat rate which is close to the historic average (+66%), that is against heavily downgraded numbers, and suggests that corporations are struggling in the low growth and low inflation world. Waning corporate delivery suggests that it will be very difficult for most markets to drive a P/E expansion from here, which should cap the recovery unless EPS improves.
… BECAUSE 2015 EPS GROWTH IS NEGATIVE
Interestingly, only Japan has delivered earnings growth in 2015 (+12% EPS growth – see Chart 1) worthy of lofty valuations, but that is the advanced market that is trading at the cheapest valuation (14x forward earnings). Indeed, Japan is the only market to deliver positive real EPS growth this year with the US dependent on inflation to underpin higher EPS and EM deep in negative territory reflecting declining commodity prices and a slowing China. As such it is easy to conclude that the fully invested bear market remains alive and well.CHART 1: EPS IS LOWER IN NEARLY EVERY MARKET
SO WHERE IS THE PROTECTION?
If EPS is too low and valuations too high given the cloudy macro picture, a key question for investors is how to manage risk. Periods of heightened stress in financial markets is the stage of the cycle where portfolios are doing their most important work, namely protecting capital. Traditionally investors have held bonds to offset equity volatility, but bonds are more overvalued than equities given extremely low government yields, which suggest that the normal bond price rally as growth stalls is unlikely to materialise if volatility suddenly ramps up again.
... NOT IN THE USUAL PLACES
Many of the sectors that share investors typically look to as a proxy for solid defensive growth such as healthcare, energy and utilities recorded larger losses in August and September than their US ‘growth’ counterparts (see Chart2), with the former also recording a smaller recovery in October. This has added to investor confusion about managing portfolios in today’s investment terrain. However, examining the performance of defensive and growth sectors over the past two months indicates that a company’s ability to deliver earnings growth is what matters – those than can are rewarded and those which don’t are punished. Indeed, US stocks which have beaten both revenue and profit forecasts have risen +3% on average, whereasCHART 2: DEFENSIVE STOCKS UNDERPERFORMED
RESPONSE TO EUROPE’S QEII WILL BE MODEST
Examining asset price behaviour after previous QE announcements indicates that strong price gains for both credit and equities are the most consistent result. However, the macro backdrop is vastly different from the first QE announcement in both Europe and the US in three key ways: financial conditions have become more constructive, the economic cycle has already turned (in Europe) and valuations are higher. This is likely to limit any price gain until the earnings outlook improves.
IMPLICATIONS TO INVESTORS
Mario hasn’t done it again, and investors should be wary of expecting too much risk market upside in response to recent policy easings. In the end, balance sheets continue to limit growth and weigh on inflation, and corporations are struggling to deliver on upbeat earnings per share forecasts. Central banks are limited in what they can do as most of the problems in the global economy are not monetary in their nature and therefore the central bank quiver is close to empty regardless of what short-term risk market reactions may suggest. The key for central banks is knowing that they can’t improve the growth dynamics by easing policy, but they can make things worse by not easing, even worst still tightening too early. Accordingly, the global sharemarket is unlikely to have another major leg up until earnings per share accelerate, but this would require a stronger economy which would be associated with less policy support. Even if economies here win, investors lose.
This analysis has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for the use of financial advisers only, it is general information and is not intended to provide you with financial advice. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.