As summer rolls on, are there risks of investor complacency about markets, given the role played in recent years by central banks' use of quantitative easing?
Calling the turning point on when macro-economic policy and the asset allocation stance of wealth managers becomes “normal” again might be a fool’s errand, but there appears to be a growing sense that while the era of ultra-low interest rates is not yet over we are nearing the end. And that end is going to be a challenge for a market almost a decade into a bull run.
A commentary from R Christopher Whalen – whose comments have appeared in these pages before – is instructive about how some financial experts are thinking. Writing on his website, www.theinstitutionalriskanalyst.com, Whalen ponders the example of new era auto company Tesla (NASDAQ code is TSLA), which took a hit on the NASDAQ exchange last week. Whalen said the move highlights the fragility of a market that has been boosted by the US Federal Reserve’s quantitative easing program, likening this to “a leveraged buyout of the US equity markets”. He goes on to write: “How else can we explain TSLA, a firm whose financial performance is measured by free cash outflow, being more valuable than far larger car companies that actually earn profits?”
Warming to his theme, Whalen goes on: “Think of it: TSLA is a LBO without any cash flow. Of course, the global equity markets are all about discounting future earnings or, in the case of TSLA, the next capital raise. With $7 billion in debt and a voracious appetite for other peoples’ money, TSLA embodies the new era notion that it is acceptable for companies to lose money until they grow large enough to be profitable - maybe.”
What such comments suggest is that certain parts of the US equity market could be vulnerable if the Fed were to tighten the monetary screws by more than is being discounted in the markets. Interestingly enough, at press briefing last week that your correspondent attended, Psigma Investment Management, a UK-based firm, said that a more defensive asset allocation strategy makes sense. And that firm also pointed out that if one tracks the comments of Fed members, and compares these against expected interest rate moves as implied by market prices, markets are under-estimating what policymakers predict will happen. At some point, there is going to be a shock.
The US is home to the world’s largest equity market, and for some time now that market hasn’t provided many pockets of value. The US S&P 500 Schiller Price To Earnings Ratio is almost 30 - the same level exactly as it was when equities started their crash in 1929 and not far from where they started sliding in the 2008 financial panic (source: Psigma). A number on its own should be read carefully, but the warning lights seem to be flashing. What this all means is that active management, rather than simply riding the coat-tails of a market rally in a passive fashion, as has been the case for almost a decade now, looks perhaps due for a return. There will be a need for selective focus: The US P/E ratio for next year is given by Psigma at 18 times, with a dividend yield of 2.1 per cent; that compares to 14.7 and 3.2 per cent, respectively, for Europe; 14.7 and 4.2 per cent for the year UK, and 12.1 and 2.7 per cent for emerging markets.
Shift in emphasis
One of the most succinct descriptions of a change of tone and focus from central banks comes from Graham Bishop, investment director at Heartwood Investment Management, a UK firm. “While central banks are likely to proceed carefully to avoid any disorderly market disruption, we have to acknowledge that policy risk is rising. Balance sheet reduction in the US, tapering in Europe and further targeted tightening measures in China could all impact market liquidity and sentiment, despite overall financial conditions still remaining accommodative. These potential outcomes also come at a time when the growth momentum appears to be softening in the US and UK, albeit at the margin. By implication, in the future, the onus would fall to governments to support growth as central banks step back from financial markets,” he writes.
“It remains early days and for now, at least, economic fundamentals continue to support risk asset markets. Nonetheless, more policy uncertainty is likely to add to market volatility and higher bond yields to reflect a less dovish posture taken by many central banks. The marked rise in the 10-year German bund yield at the start of July is a clear symptom of this shifting narrative. We may now be entering a period which is not so much characterised around the ‘reflation’ trade, but rather the ‘higher yield’ trade,” he said.
Some wealth managers appear to remain fairly sanguine, even if they are becoming impatient about a presumed inability of the Trump administration to deliver on the sort of corporate tax cuts that were cited earlier in the year as a reason why US equities went on a tear. For example, Didier Saint-Georges, managing director and member of the investment committee at Carmignac, a European investment house, writes: “The US central bank has gone about tightening its monetary policy with sufficient caution to allow markets to painlessly price in the shift taking place. The result has been that, after a few fits and starts, US Treasury yields have settled in roughly halfway between those two recent extremes. Meanwhile, the S&P 500 has continued to climb - to the point that it now stands 30 per cent higher than where it was in early 2014."
“Trump’s reforms have come to a standstill and the business cycle is peaking. We therefore infer that monetary policy will be tightened only very gradually. The risk of a surge in long-term yields seems limited and growth stocks could soon start outperforming once again,” Saint-Georges writes.
The drumbeat of noise around a return to “normality” and an end to an extraordinary period of monetary policy activism does appear to be getting louder. Perhaps we should leave the last word to R Christopher Whalen: “The notion that five years of market manipulation by the FOMC (and other central banks, to be fair) can end happily seems rather childish, especially when you consider that the other great accomplishment by the Fed during this period is a massive increase in public and private debt. Once the hopeful souls who’ve driven bellwethers such as TSLA and AMZN [Amazon] into the stratosphere realize that the debt-driven game of stock repurchases really is over, then we’ll see a panic rotation back into fixed income and defensive stocks.”