Extracts from the chaos theory international bestseller, “The (Mis)Behaviour of Markets” by Benoit B Mandelbrot and Richard L Hudson
Last Quarter Review
As largely anticipated by the market, the Federal Reserve (Fed) raised the US base interest rate by a further 0.25% to 2.25%, at its September Federal Open Market Committee (FOMC) meeting, citing increased growth forecasts for 2018, and forecasting one more rate hike this year, and three more in 2019. Meanwhile the price of crude oil climbed again to more than $80 a barrel (Brent contract), the US dollar remained resiliently strong, while trade war tensions especially between the US and China continued to rise.
US stock indices powered to new record highs during the quarter with the S&P 500 ending up more than 7% over the three months, while the Dow Jones Industrial Average (DJIA), which has for most of 2018 lagged the other major US indices due to the absence of four of the five popular FAANG companies (Apple being the one exception) did even better rising almost 10%, and suggesting the broader market (and not just the tech sector) is now fully participating in the latest equity bull phase on Wall Street. Elsewhere equity markets were decidedly lacklustre with most moving sideways or falling, with the exception of Japan where stocks rose more than 8% as measured by the Nikkei 225 index.
The Bank of England (BOE)’s Monetary Policy Committee (MPC) decided unanimously (9-0) to raise UK interest rates from 0.5% to 0.75% at its meeting on the 1st August. At the same meeting, the Committee also voted unanimously to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.
At the subsequent MPC meeting on the 12th September, no monetary changes were made, while arguably the key observation from the BOE minutes was as follows, “At this meeting, the Committee judged that the current stance of monetary policy remained appropriate. Any future increases in Bank Rate are likely to be at a gradual pace and to a limited extent.”
The Eurozone economy expanded 0.4 percent during the three months to June 2018, the same pace as in the previous quarter, while the ECB left the base interest rate at 0% at its meeting on September 13th, and said it expects key interest rates to remain at record low levels at least through the summer of 2019. Policymakers reiterated that the monthly pace of the net asset purchases will be reduced to €15 billion from September to December 2018, and will then end.
China’s central bank, the People’s Bank of China (PBOC) left interest rates unchanged, while the Chinese economy grew by 1.8 percent in the second quarter, providing the strongest quarterly expansion since the September quarter of 2017. However Chinese stocks continued to fall on the back of growing concerns regarding the trade war with the Trump administration, which was also reflected in the yuan (or renminbi) weakening further against the US dollar.
While growth in most emerging markets, and especially Asia, has remained strong, many have suffered worrying exchange rate devaluations against the dollar during 2018, thanks to a combination of higher oil prices (which of course are priced in $) and the Fed’s remorseless monetary tightening. This has resulted in those countries with extensive external debt (priced in $) such as Argentina and Turkey suffering severe exchange rate devaluations (the peso has fallen more than 50% and the lira 40%).
|Key Economic & Market Data||2018 Q2 GDP||12 month GDP||Base Interest Rate - End Sep 2018||Equity Index - Last Quarter||Equity Index - Last 12 Months||Sovereign Bond Index - Last 12 Months|
|NB. GDP Data shown are to the 30th June 2018; Interest Rate, Equity & Bond Index Data are to the 30th September 2018; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.|
The Wall Street equity bull market is now officially the longest in history, with the S&P 500 index, which ended September at 2914, up 337% since March 2009 (when the index bottomed at 666), but it remains a distant second from a performance perspective to the October 1990 - March 2000 equity bull, which saw the S&P 500 rise 419%. During the last quarter, we witnessed not just one but two companies reach an extraordinary $1 trillion valuation, as first Apple and then Amazon achieved the remarkable milestone, with the latter’s share price climbing more than 70% since the beginning of 2018!
Understandably in light of such developments, and as is to be expected in the latter stages of any equity bull market, there is increasing concern regarding valuations, and whether they are sustainable. To complicate matters, the unprecedented monetary action undertaken by the Fed following the sub prime credit crisis in 2008, of both its zero interest rate policy (ZIRP) and quantitative easing (QE), which resulted in sustained artificially suppressed real interest rates have made it much more difficult to compare valuations relative to previous economic expansions.
On September 14th, marking the tenth anniversary of the financial crisis, Nobel Laureate Robert Shiller and Wharton’s Jeremy Siegel debated whether the equity market is overpriced. Robert Shiller’s famous valuation metric, namely CAPE (cyclically adjusted price earnings, which uses real earnings per share over a ten year period to smooth out fluctuations in corporate profits during the business cycle), suggests that US stocks are now more expensive that at any time in history other than just before the crash of 1929 and in the immediate run up to the tech driven crash of 2000.
Jeremy Siegel contends that stocks while modestly overvalued, are attractive relative to excessive bond valuations, and that over the past 140 years, the price earnings (PE) ratio averaged about 15, which corresponds to U.S. stocks having had real (inflation-adjusted) annual returns of 6.7%, compared to bonds of just 3.5%. He suggests that earnings yield is a very good predictor of long-term returns, and that with the S&P at its current level, stocks are selling for about 18 times 2018, and just over 16 times 2019 estimated operating earnings.
Meanwhile on the back of falling unemployment, rising wages, and continued economic growth expectations, consumer confidence according to the Conference Board Consumer Confidence index in the US recently hit its highest level since September 2000. More importantly, an indicator that has a 100% accuracy record in terms of anticipating every US recession over the past fifty years, namely the Conference Board's Leading Economic Indicator (LEI, which is a composite of ten different economic indicators, including employment, housing, and interest rates), suggests the American economy is in rude health.
“The leading indicators are consistent with a solid growth scenario in the second half of 2018 and at this stage of a maturing business cycle in the US, it doesn’t get much better than this. The strengths among the LEI’s components were very widespread, further supporting an outlook of above 3.0 percent growth for the remainder of 2018” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board at the press release in August.
Naturally, the older the Wall Street bull becomes, the more alert investors must remain for any signs of a turning point, and an eventual bear market. The adage, “a bull market climbs a wall of worry” comes to mind as we observe all the factors currently occupying investors’ focus.
These include the worrying economic developments in several emerging markets such as Turkey and Argentina, which have been exacerbated by the strength of the dollar and rising American interest rates, as well as the added strain that a prolonged period of high and rising oil prices places on most countries in the global economy. Additionally, markets are concerned that the Trump administration’s aggressive trade policy, will adversely impact global economic growth, while arguably the biggest worry is the Fed’s monetary actions.
Jerome Powell, the Fed Chair made some interesting remarks at the Jackson Hole symposium for central bankers in August, that highlighted the dilemma he and his fellow FOMC members face every time they meet. Acknowledging the dangers of both acting too quickly and too slowly when it comes to raising interest rates, Powell explained that, “the job of avoiding these errors is made challenging today because the economy has been changing in ways that are difficult to detect and measure in real time.”
After explaining how the central bank analyses and assesses the three key considerations of its policy making approach, namely inflation, unemployment and GDP growth, Jerome remarked, “I see the current path of gradually raising interest rates as the FOMC's approach to taking seriously both of these risks. While the unemployment rate is below the Committee's estimate of the longer-run natural rate, estimates of this rate are quite uncertain.”
The Fed Chairman concludes, “The economy is strong. Inflation is near our 2 percent objective, and most people who want a job are finding one. My colleagues and I are carefully monitoring incoming data, and we are setting policy to do what monetary policy can do to support continued growth, a strong labor market, and inflation near 2 percent.”
Arguably the global economy has never been harder to discern in the last decade since the Fed first enacted ZIRP and QE to empower the post credit crunch recovery, and since then we have seen several phases of reflation followed by deflation. The Fed’s own conviction level that we are finally in the throes of sustained reflation appears high based upon its monetary strategy over the last couple of years, and its forecast that it will continue normalising interest rates throughout 2019.
Yet there are plenty of signs to suggest that deflation will once more prevail including the reluctance of US long term interest rates to definitively rise. The yield on the benchmark 10 year US treasury has thus far failed to rise above the all important 3.15% believed by many as necessary to confirm the economic inflation anticipated by the central bank, while the Chinese yuan’s decline in 2018 against the US dollar is another indicator of deflationary pressures remaining strong.
Of course every cloud has a silver lining and if the deflationary trend that has prevailed post Lehman, and arguably has been in place since the Dotcom collapse of 2000, continues, then the long bull market in Treasury bonds that was born in the early eighties still has life in it. The downside is that should this be true, and Jerome Powell and his colleagues at the Fed continue to raise short term US interest rates, then the yield curve will invert, signalling an almost certain recession in the American economy, and a bear market on Wall Street.
For now the yield curve is flattening but has not inverted, suggesting that valuations in American stocks, while expensive have the potential to become even more expensive before this bull market is finally over. Additionally we shall shortly enter the third year of the presidential cycle (November 1st 2018 to October 31st 2019), which has historically tended to be the best of the four on a relative basis for stocks.
This positive omen comes from data in an article that appeared in the Wall Street Journal showing that since 1896, when the DJIA was created, the Dow has produced an average fiscal-year gain of 7.1%, but this increases to almost 11.5% (excluding dividends) during the third year of a presidential cycle. No guarantees of course, as some third years have seen declines in stock prices, but most cycles, this twelve month period in the presidential term has comfortably exceeded the long term average, and proved most rewarding.
As ever, monitoring and determining the macro picture including the likely direction of key indicators such as the dollar and Treasury yields will play a key role in advised portfolio asset allocations going forward.If and when a more defensive investment strategy becomes necessary, we shall of course advice accordingly. For now, we remain positive towards markets and sectors where we believe relative value exists.
Despite the lack of definitive evidence of increasing inflation either side of the Atlantic, we remain cautious on both UK gilts and US Treasuries, along with corporate debt, where the low additional yields over government bonds suggest we are not being adequately rewarded for the inherent risk. We also retain some exposure to commercial property where appropriate for diversification purposes.
As always, investment risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our client’s needs.