There is much debate about the start date and impact of the first US tightening cycle in nine years. Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset, says investors should be concerned about the US sharemarket - not US Fed policy.
There is much debate about the start date and impact of the first US tightening cycle in nine years. Matt Sherwood, Perpetual’s Head of Investment Strategy, Multi Asset examines this and concludes that while the US Fed will not implement policy that will endanger the US sharemarket, but investors should be cautious of its weak internals as the recent rise has had been an increasingly narrow base, governed by heightened valuations and overly optimistic earnings expectations. With the US economy performing weaker than expected in 2015 and the US dollar rising, it is hard to see how any rate hike will be associated with an environment which boosts expected US earnings growth. This is important as some of the largest losses in history occur when optimism is high, valuations are elevated and EPS expectations are lofty, and all of those boxes are being ticked at present. As such, investors should be concerned about the US sharemarket, not US Fed policy.
Introduction – It’s a strange world
The world has changed a lot in 200 years – life expectancy has more than doubled, only one in five people live in poverty (relative to 19 out of 20 in 1820), more people live under democracy and global economic output, income and wealth are at record levels. But the world also remains hugely indebted, working age ratios are approaching century lows, half of the advanced economies are growing less than +1.5% y/y and 4 out of 5 have negative real rates. In other words, the world has massive debt, but the risk premiums demanded to own this debt are at all-time lows.
Global growth downgrades
Any one of debt, ageing and inequality can slow a recovery, but a combination of all three slows it with a high degree of predictability. With USD56 trillion (the US, Europe, Japan, China and parts of South America) of the USD78 trillion global economy affected by a majority of the three issues, it is not surprising that the global economy continues to be downgraded by all and sundry. Indeed for the past four years forecasts for the global economy have begun with a four handle in front of it, but have on average been downgraded by one percentage point over the subsequent 18 months (see Chart 1).
The US Fed and near-term sentiment
At present, medium term views about the global economy and global equity markets are broadly in line with where they were a year ago, which seems justified by continued policy support in Europe, Japan and China and a consolidating recovery in the US. However, the near-term views are less constructive with heightened uncertainty given unresolved concerns in Europe and China and the uncertainty about the timing and effect of changes to US Fed policy. Given the lack of material newsflow in the coming weeks this situation is unlikely to change until the FOMC meets in mid-September 2015. Until then, US rate speculation is likely to dominate market trends and investment returns.
Rate hikes shouldn’t back up bond yields
Although economists say a September rate hike is likely, the market is saying that the first Fed rate hike is unlikely until December 2015 and I maintain this latter view. However, even if the Fed hikes earlier than I expect, any move upwards is unlikely to spark a major spike in US bond yields like that which occurred in 1994 and more recently the taper tantrum of 2013. The rationale for this is that commodity prices (especially oil) are declining sharply, the USD is rallying (and tightening financial conditions), global inflation remains low, emerging market growth is declining and the policy change is unlikely to be a surprise, even if the timing is a touch early.
More like 2004 than 1994
In 1994, the market ignored US Fed suggestions about rising rates, and heightened prepayment risk in US mortgage- backed bonds saw investors sell duration which added to the upward pressure on yields and US treasuries lost -6.1% that year, which was the first US bond market loss for eight years and the worst annual loss for US Treasuries in over a century. In 2004, which was the start of the last US tightening cycle, the bond sell-off was well telegraphed and inflation remained low, so bond returns (+4.9%) were more constructive for portfolios. While over the past year, US bond yields have had higher highs and higher lows, a longer-term analysis suggests that there is resistance level around 2.75%. Accordingly, if this remains the case, the portfolio risk in FY16 appears to be more of a US equity market story than a bond market concern , but investors should fear the US sharemarket more than the US Fed.
Chart 1: Global growth has been consistently downgraded for four years
An increasingly narrow US sharemarkets
While the US sharemarket has continued to make fresh record highs for the past three years, the rises have become narrower in a manner similar to what was seen in 2007. In the past two years, the US S&P 500 has recorded 93 fresh record highs, but only four sectors have contributed to the rising share index (financials, IT, consumer discretionary and healthcare). In the past three months that number has declined to three sectors (IT has declined since May). In contrast, the other sectors have collectively declined (see Chart 2), which suggests that US sharemarket leadership is not broad-based and is more fragile than record prices may suggest. Fewer sectors are rising and small cap stocks are being downgraded, which is bad sign for the short-term health of the US sharemarket, especially with US Fed rate hikes potentially around the corner.
Goldilocks doesn’t exist
While the long-running US equity bull market has been supported by a long period of slumbering bond yields, it is wrong to say that US shares since 2010 have only risen because of US Fed policy. Over this period total US sharemarket returns has been a cumulative +84%, with earnings up +39% over the period, dividends contributing +17% and valuations have added another +28%. The rise in valuations has primarily reflected the impact of lower bond yields as US Fed policy sparked a search for yield and the US equity bull market at this stage looks mature. Now that US Fed policy has troughed and rates will be raised soon, that will place increased pressure on corporate profits to drive returns, but it is hard to find a ‘goldilocks’ growth rate that is good for the economy and constructive for the US sharemarket. Profit margins are already at record levels, which means that any economic acceleration may lead to declining margins as costs rise, and any economic moderation is likely to weigh on revenue and overall EPS growth which will be a problem for a market trading on 18 times earnings.
Chart 2: A narrow US sharemarket rise
… And US EPS growth is weak
Indeed, the only way to engineer US EPS growth near full-employment is by resurrecting US productivity growth but this is unlikely given the lack of investment spending over the past five years. The problem for the market is that there is little confidence that rate hikes in 2015/16 will be associated with macro improvements that will generate higher US earnings growth. The post-GFC economic recovery remains the weakest in US history and so far in 2015, the US economy is annualising at 1.5% growth and US earnings per share have risen just +0.98% YTD, relative to +7%, +6% and +6% in the prior three years, respectively. Clearly declining energy prices and the rising US dollar are weighing on corporate performance and this is likely to continue, yet forecasts EPS one year forward is +7.4% and has been upgraded every month since January. The fact that the Fed will be hiking without a clear uptrend in earnings, is a more dangerous environment for stocks and investors should manage stocks accordingly.
Implications to investors
The US Fed is likely to remain at the forefront of investors’ concerns for the remainder of 2015. In the last ten cycles US rate hikes have killed four bull markets within two years and if the Fed hikes in September, market bears may be concerned that the tightening cycle is starting with a higher than average valuation (18.0x relative to an average of 17.3x in the past ten tightening cycles), but the bulls may say that two of the four loses had higher starting valuations than today (18.3x in 1972 and 27.5x in 1999) and rates are much lower today. Regardless of whether you are in the September, December or 2016 camp for rates lift-off, investors should not fret US Fed hikes as they are likely to be tame affairs, but they should worry about the market’s internals and its increasingly narrow base. While few seem concerned about it, investors just need to ask whether they believe the US economy will prompt rising corporate earnings growth in FY16. This is important as some of the largest losses in history occur when optimism is high, valuations are elevated and EPS expectations are lofty, and all of those boxes are being ticked at present.
- In the past two years, the US S&P 500 has recorded 93 fresh record highs, but only four sectors have contributed to the rise. The other six sectors have collectively declined. This suggests that US sharemarket leadership is increasingly narrow and with small cap stocks being downgraded, the short-term health of the US market appears clouded, especially with the mixed growth picture around the rest of world.
- The US Fed will hike rates soon and this move will place pressure on corporate profits to drive returns, but it is hard to find a ‘goldilocks’ growth rate that is good for the economy and constructive for US shares. The problem for the market is not higher rates, but that there is little confidence that rate hikes in 2015/16 will be associated with macro improvements that will boost US earnings growth. Combining the narrow market rise and the Fed hiking rates without a clear uptrend in earnings, FY16 implies a more dangerous environment for US stocks. Better value exists elsewhere.