The year 2017 marked a major turning point for world economies. They finally appear to be sustaining growth after many years of extraordinary levels of central bank/monetary stimulus. Unlike past cycles, the recession/stimulus/recovery cycle that began in 2008 has been drawn out. By comparison, the recession was deep, the stimulus aggressive, and the recovery lackluster. The lackluster recovery meant that aggressive stimulus had to be kept in place much longer than in the past. As 2017 unfolded, we saw evidence of sustainable growth. Particularly in Europe and Japan, economic growth gained momentum and accelerating company profits began to reflect it. By mid-year 2017, rates of growth in Europe were exceeding US growth – even while the ECB (European Central Bank) continues to stimulate more than the Fed.
The phases of the economic cycle remain in place despite their lengths being drawn out. Growth is becoming more self-sustaining and less reliant on ultra-low interest rates. This means we are at the point where growth rates pressure inflation higher and stimulus will need to be reduced. The US cycle is ahead of cycles in Europe and Japan, but not too far ahead.
Equity market pricing (the values of companies), like economies, is also becoming less reliant on interest rates and more reliant on sustained growth. All else being equal, lower interest rates will always push the value of a unit of earnings up. In response to recession, central banks and markets reduce the cost of debt (yield) and equity capital (high P/E) for companies. This capital is then accessed by companies for investment that eventually results in higher earnings. We saw this progression in 2017. Equity returns were driven by growing earnings rather than growing prices for those earnings. The 22% price appreciation of global equities in 2017, for example, can be entirely explained by growth in company earnings (sales 6%/profit margins 16%), while prices for those earnings (P/Es) were flat during the year.
Over the past five years, various attempts by the Federal Reserve to “taper” its bond buying were met by market panic, famously starting with the “taper tantrum” in 2013. Markets repeatedly signaled the Fed that the recovery was still too fragile to withstand a reduction in Fed support. Convinced by the recent strength of the recovery, the Fed has been slowly raising rates, gradually removing its stimulus, while carefully watching market and economic indicators. The Fed has orchestrated the transition very gracefully thus far.
By historical comparison, the drawn out transition period has produced a very long economic recovery and equity market run. Since the 2008 downturn, the US equity market has recorded nine straight years of positive returns. As of this writing, we have had an unprecedented 15 straight positive months since the 2016 election. These lengthy streaks have led to talk of “recessions” and “bubbles.” Recessions and bubbles are caused by human nature, characterized by excesses, overconfidence and fearlessness. Major world central banks continue to provide unprecedented stimulus and their economies are struggling to break out of sub-2% inflation and sub 3% growth. This implied lack of confidence by central banks sends a message that we are still far from seeing the economic excesses, overconfidence and fearlessness that typically precede a recession. Despite lengthy “bull” runs in the US and other equity markets, trailing ten year annual returns in the US market remain below average and in Non-US markets are nearer to historical lows. This is hardly the fearless risk-taking environment, nor excess return windfall, that characterizes market bubbles. The more plausible explanation is that developed economies and markets are slowly transitioning to the second phase of recovery, the post stimulus, momentum sustaining phase.
Where are the valuation opportunities? Which are most likely to benefit investors near term?
The extended economic and market cycles have resulted in extended valuation cycles – markets remaining over/undervalued for long periods. Since 2008, major central bank bond buying programs and the zero interest rate policies (ZIRPs) have kept interest rates from rising. As a result, bond yields, today, remain below normal and bonds remain overvalued. With the Fed expected to unwind its bond buying support and further lift short term rates in 2018, interest rates should continue to move higher. The yield on the ten year US Treasury note, which has been below 2.5% for some time, should be heading up towards 4-5%, a level in line with today’s inflation and growth expectations.
In recent years, emerging market and high yield bonds have been great beneficiaries of investor hunger for yield. New issuer credit quality has deteriorated and the additional yield they offer today is well below normal. This indicates late cycle (low quality/narrow spread) overvalued credit conditions. Even though weak borrowers will be supported by improving growth, the low additional yield will limit investor protection against rising rates.
In a typical global economic slowdown, risk averse global investors buy lower risk US equities and the US dollar while selling higher risk Non-US equities and currencies. US equities and the US dollar eventually become relatively overvalued and Non-US equities and currencies relatively undervalued. As global economies eventually recover, global investors become less risk averse and began to sell US equities and the US dollar and buy more risky Non-US equities and Non-US currencies. This reduces the relative overvaluation of US equities and the US dollar and the relative undervaluation of Non-US equities and currencies.
The fragile nature of the global recovery, less fragile in the US, has caused global investors to remain risk averse longer, preferring to hold safe US equities and the US dollar. This has led to a prolonged US equity market relative overvaluation, which has begun to reverse in 2017 and is expected to continue do so in 2018. Continued reversal will favor still undervalued Non-US markets and their currencies.
What to expect in 2018
Expect equities to increasingly be driven by growth and earnings momentum. The positive impact of growth participation should outweigh the negative impact of rising rates, as it normally does at this stage in the cycle. Greater confidence in risk-taking among global investors will favor higher risk, and undervalued Non-US markets and their currencies at the expense of safer, and overpriced US equities and the US dollar. Bond investors will be hurt by falling bond demand from home central banks, other central banks, major banks, risk-averse investors and others who could not get enough income since the Great Recession. Those taking credit risk will do better, although low recent credit spreads will limit their advantage.
Investors face two significant risks in 2018. The greatest is that stronger than expected growth and/or inflation indicators may prompt the Fed and other major central banks to act sooner or more aggressively than they had planned. This would be trouble for bond and bond-like income product investors. Such shocks will disrupt equity market momentum. The next greatest risk is that growth slows and the Fed is forced to abandon plans for taking rates back towards normal. In this case, current mis-valuations will persist and the adjustment process will slow back down.