Volatility is up, but talk of the end of the equity bull is premature

Analysis - 7/6/2018

In short
  • Relatively benign macro conditions are still supportive for equities
  • Corporates remain in good shape – we see limited signs of peak market CEO exhuberance
  • However, peak cycle earnings growth is behind us and exogenous risks are significant

Following a year like 2017 in which the average volatility for the S&P 500 was just 11.1, it was a pretty easy call to predict that equity market volatility would pick up this year, which it has.

In January, we were reasonably sanguine about the equity outlook, believing that the strong economic and corporate fundamentals would lead to higher prices. We thought that European shares would have the opportunity to do better and that EM assets were vulnerable to global FX risks, which they have certainly proved to be. Whilst global equities are up so far this year by over 3% at the time of writing, European shares have lagged the strongest global markets so far this year, despite patches of outperformance. In part, this is due to the difference in the sectoral composition of the bourses, with the market leading technology sector in the US, for example, representing approximately 25% of that market vs a mere 5% in Europe. It is also true that momentum as a factor has proved powerful in explaining performance and that many of the current vogue stocks are US listed.

The Europe – US sector difference is not small. In fact, at current prices, the market capitalisation of Google, Amazon, Apple and Facebook combined with Tencent, Baidu and Alibaba (the last three being Asian tech giants) is bigger than the entire Eurozone market. That seven technology (or related) companies can be worth more than an entire region’s stock market tells a story that either equates to an over valuation of some shares on a scale not seen since the late 1990s or one where technological development and innovation is now so rapid and widespread that it is disrupting and influencing traditional business models and thereby propelling growth to levels significantly and sustainably ahead of other sectors.

Inevitably, the answer is a bit of both, but there is little doubt as to the impact of technological development on both the improvement to and destruction of traditional business models across a very wide swathe of industries. Moreover, such is the pace of change that identifying the winners and losers has become increasingly important in determining the outcome for equity investors.

Europe has also had to contend with a near 20% in financial shares. Whilst this percentage is not wildly different to other countries including the US, the latter’s banking sector is benefiting from three growth catalysts which European companies do not have. These are tax cuts, the winding back of burdensome regulation and a gradual rise in interest rates (albeit that the US yield curve is still very flat). In contrast, at its 14th June meeting the ECB announced that it would keep interest rates on hold until the summer of 2019. Having an extended period of effectively ‘emergency’ interest rates is not a healthy backdrop and reflects a stubborn lack of belief in self-sustaining growth and inflation, which is not helping the banks. Combined with renewed concerns around the political situation in Italy (and the knock-on consequences for Italian banks and other holders of Italian debt) as well as idiosyncratic worries over Deutsche Bank and other bell-weather names, it is not surprising that the sector is down over 10% this year, which has certainly contributed to the region’s weaker performance. 

Arguably, financials and technology are two of the most important market sectors and in that context investors need to understand whether the prevailing conditions above are likely to persist. We think it would take a large upwards shift in inflation expectations to drive a number of the global ‘value’ stocks sustainably higher. Currently, the bond market doesn’t think this is very likely and nor do we. This doesn’t mean that we can’t see good progress in industrials and capital goods names, for example, as business investment picks up, but it probably leaves the door still open for technology stocks to keep performing nicely.

Late cycle doesn't necessarily mean end of cycle

We are often asked whether late-cycle basically mean end-of-cycle. The answer is important since equity returns at the end of the cycle have typically been harder to attain (weak breadth) and below the average returns of the entire cycle. Some data including US PPI and PMI certainly point to ‘late-cycle’, but several signals we monitor are at odds with the end of a bull market. First, we have earnings continuing to rise AND net earnings surprises in the top decile (suggesting that analysts haven’t yet got overly optimistic). Second, despite interest rate rises, US 2yr yields remain above the Fed Funds rate implying the Fed remains accommodative, also not typical at cycle ends. CEO exhuberance is far from levels associated with end of cycles. Certainly, we are seeing healthy levels of share repurchases and M&A activity, but the sales to capex ratio is low by historic standards, reflecting  the lack of confidence CEO’s have to reinvest in their businesses.

Many of the evident trends and themes will continue and may become more acute



On markets, copper remains in an uptrend, US transport stocks (road and rail) are near relative strength highs for the cycle and staples and utilities which typically start to improve as we enter the last innings of the cycle, continue to lag on a relative basis.

We believe that we’re in an extended cycle and that many of the evident trends and themes will continue and may become more acute. Technological change is one of them and it will continue to bring pain to companies not using it to adapt their businesses. IT has already transformed diverse segments of the economy including communications, retailing, medical therapies and many other. Mankind is addicted to data and instant access to it (wifi/mobiles). If you had bought shares in every App on your smartphone home screen a few years ago you would have done pretty well.

Longer term, IT will transform much of what it hasn’t yet touched. Humans will be liberated from the chore of owning or driving their own cars and robots and AI will cause seismic alterations to our way of life over the next few decades.

Thanks to the capex required to keep up with the demand and the desire for many of these IT revolutions, company shares will continue to be floated by the rising tide. But for all the positive effects such as productivity gains, increasing standards of living and life expectancy, IT’s negative effects occur because it enables the rise of corporate monopoly power which help those companies maintain market leadership. This already appears to be the case and there has been little reaction by authorities to contain it. Moreover, this has occurred after several decades during which the distribution of added value moved towards capital and away from labour. It doesn’t take much to explain worker/voter disillusionment which, if left unchecked could be extremely damaging to an already unstable social state in our democracies.

There is little debate that the period since 2009 has been kind to investors. As we look forward though, we should not lose sight of the factors behind the truly extraordinary equity bull market that has been in place since 1981. These include the rise in the level of aggregate earnings as a share of GDP, the growth rate of aggregate earnings and of earnings per share, the stunning decline in the level of interest rates (market discount rate) over the period and the de-equitisation of the market courtesy of corporate stock repurchases. That all these ‘equity positive’ factors have been in evidence together is historically remarkable. However, just as the joint probability of such an event is very small, the likelihood of a repeat from here is equally small, if for no other reason that we are likely to witness some sort of mean reversion in these fundamentals in the future. If true, then indexing could prove to be as problematic during the next few decades as it has been successful in the past few. Moreover, with the pace of business model obsolescence accelerating, there are likely to be more losers than winners, so in theory it should be easier to beat the index. Index investing through ETFs may have had its best days.

Richard Beggs
Global head of investment strategy


 

This analysis is an extract from the first House View published by Edmond de Rothschild. 

This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes. 

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