The de­ci­sion tree from here

Financial Mirror (Cyprus) - - FRONT PAGE - By Louis Gave

For months, I have ar­gued that the MSCI World’s push to within a cou­ple of per­cent­age points of its all time high was driven by two pow­er­ful forces: the ex­tremely low level of global bond yields, and the con­tin­ued com­pres­sion of for­eign ex­change volatil­ity. I went as far as to ar­gue that this en­vi­ron­ment was rem­i­nis­cent of 1986-87, and the Lou­vre Ac­cord, whose break­down ul­ti­mately trig­gered the 1987 crash. Yet, here we stand to­day with bond yields mov­ing rapidly higher and forex volatil­ity spik­ing — and risk as­sets are lap­ping it all up. So are th­ese new mar­ket trends sus­tain­able and self-re­in­forc­ing? Or will they ul­ti­mately prove con­tra­dic­tory?

As I write, it seems that the mar­ket’s per­cep­tion has evolved rapidly from Pres­i­dent Trump be­ing a mas­sive li­a­bil­ity, to Pres­i­dent Trump be­ing a mas­sive cat­a­lyst for faster growth. If the past three trad­ing days of mar­ket moves are to be be­lieved, in our near fu­ture lies a haven of faster nom­i­nal growth based on in­creased in­fra­struc­ture spend­ing and wider govern­ment deficits, an end to Wash­ing­ton DC’s grid­lock, higher in­fla­tion etc... All of this may in­deed come to pass. But if it does, will it re­ally be as bullish for US eq­uity mar­kets as most in­vestors seem to be­lieve? After all:

1) Does higher govern­ment spend­ing lead to higher P/E ra­tios?

Over the past decade, Charles Gave has re­peat­edly demon­strated the in­verse cor­re­la­tion be­tween P/E ra­tios and govern­ment spend­ing. Sim­ply put, past a cer­tain point, the more money a govern­ment mis­al­lo­cates, the lower the P/E ra­tio. The ques­tion is whether the US is now at that point. Put an­other way, is there re­ally a bunch of lowhang­ing-fruit cap­i­tal spend­ing pro­grammes that the fed­eral govern­ment can de­ploy cap­i­tal to in short or­der and, over time, be re­warded with large pro­duc­tiv­ity gains? On this ques­tion, colour me scep­ti­cal.

2) Would higher in­fla­tion stronger eq­uity mar­ket re­turns?

lead

to

Here, the an­swer is a sim­ple no. His­tory has shown time and again that ac­cel­er­at­ing in­fla­tion leads to lower P/E ra­tios, and vice versa. The best en­vi­ron­ment for eq­uity mar­kets tends to be a de­fla­tion­ary boom, not an in­fla­tion­ary boom. Higher in­fla­tion forces man­agers to waste time con­stantly rene­go­ti­at­ing prices and wages. It en­cour­ages the stock­pil­ing of commodities, in­ter­me­di­ate goods and in­ven­to­ries, which in turn adds tremen­dously to the volatil­ity of the busi­ness cy­cle.

As all of us were taught in Fi­nance 101, an eq­uity price is noth­ing but a stream of fu­ture earn­ings dis­counted by an in­ter­est rate onto which one tacks on a risk pre­mium.

Our con­tention in re­cent months was that the in­ter­est rates used to dis­count eq­uity risk were ridicu­lously low, as were the risk pre­mi­ums. As a re­sult, we ad­vised in­vestors to be wary of pil­ing into any “carry trade” or “mo­men­tum trade” de­pen­dent on the con­tin­ued com­pres­sion of in­ter­est rates and risk pre­mi­ums. Now, in re­cent weeks (pre­dat­ing the US elec­tion, and ac­cel­er­at­ing since then), volatil­ity and in­ter­est rates have both moved higher. But eq­uity mar­kets have broadly held on to their gains. Is this sus­tain­able?

The an­swer will be pro­vided by the earn­ings com­po­nent of the equa­tion. In­vestors who be­lieve that Don­ald Trump will be suc­cess­ful in jump-start­ing a mori­bund US econ­omy with a com­bi­na­tion of fis­cal re­form, fis­cal stim­u­lus, in­fra­struc­ture spend­ing, and whole­sale dereg­u­la­tory loos­en­ing will likely con­clude that US eq­ui­ties re­main the best place to be. On the other hand are those in­vestors who fear the im­pact of a strong US dol­lar on cor­po­rate earn­ings, that pro­tec­tion­ist mea­sures will cause se­ri­ous dis­rup­tions in sup­ply chains, that ris­ing min­i­mum wages will crush mar­gins, and that shift­ing in­cen­tives will push cor­po­rates to move full steam ahead to­wards the au­toma­tion of all sim­ple — and many com­pli­cated — tasks, fur­ther de­press­ing the pur­chas­ing power of blue-col­lar work­ers. Th­ese in­vestors are likely to con­clude that any rise in over­all US cor­po­rate earn­ings will fail to make up for the in­creased in­ter­est rates.

Now as Charles Gave al­ways says, in pe­ri­ods of un­cer­tainty, one should not try to be a hero, but should in­stead tar­get the as­set classes that seem to of­fer the best “heads I win, tails I don’t lose” propo­si­tion. And in to­day’s mar­ket, whether one be­lieves that Trump’s pol­icy pre­scrip­tions will lead to stronger US growth, or not, we can pos­si­bly con­clude the fol­low­ing:

- We have prob­a­bly seen the lows in in­ter­est rates for a while, and the steep­en­ing of yield curves around the world will pro­vide a solid back­drop for “re­turn to the mean” trades ev­ery­where. As I see it, the most ob­vi­ous re­turn to the mean trades are fi­nan­cials ev­ery­where, com­mod­ity stocks ev­ery­where, and value stocks in emerg­ing mar­kets. More­over, both fi­nan­cials and com­mod­ity stocks will likely ben­e­fit from a looser reg­u­la­tory en­vi­ron­ment un­der a GOP­con­trolled Wash­ing­ton DC.

- In­creases in govern­ment spend­ing are usu­ally good for commodities—as are in­creases in in­fla­tion and in­creases in geopo­lit­i­cal un­cer­tainty. In that re­spect, the re­bound in com­mod­ity stocks over re­cent days makes per­fect sense. Less clear is whether com­mod­ity prices (gold, cop­per, sil­ver etc...) can con­tinue to rise along­side a ris­ing US dol­lar?

- The UK could ac­tu­ally be one of the big ben­e­fi­cia­ries of last Tues­day’s vote. While Barack Obama threat­ened to send the UK to “the back of the queue” in trade ne­go­ti­a­tions should the Bri­tish elec­torate dare to choose

risk

pre­mi­ums

and

higher Brexit (a threat that promptly re­vived the Brexit camp’s for­tunes), Don­ald Trump wel­comed Brexit and has re­peat­edly de­clared his in­ter­est in work­ing more closely with his mother’s coun­try of birth (in spite of all the an­tiTrump grand­stand­ing by Bri­tish mem­bers of par­lia­ment). In­ter­est­ingly, while the volatil­ity of most currencies has spiked in re­cent days, ster­ling volatil­ity has re­main muted. This adds a level of com­fort to our opin­ion that most of the bad news about the UK is now in the mar­ket, and that ster­ling is a new safe haven in this un­cer­tain world.

- China is an­other win­ner from last week’s vote. Com­bine China’s ac­cel­er­at­ing re­gional in­flu­ence with the muted volatil­ity of the ren­minbi and it is hard to see how more in­vestors will not want to join the grow­ing band of Asian cen­tral banks shift­ing some of their re­serves into ren­minbi bonds. Even if that is only be­cause, in a year of po­lit­i­cal tran­si­tion, China of­fers those most prized at­tributes: pre­dictabil­ity and bore­dom.

- Ro­bot­ics are likely to be even more of a prom­i­nent theme go­ing for­ward. After all, the com­bi­na­tion of pro­tec­tion­ism and ris­ing min­i­mum wages will push ever more com­pa­nies into au­tomat­ing their pro­duc­tion.

Putting it all to­gether, we would over­weight the pound, the ren­minbi and com­mod­ity currencies, along with fi­nan­cials, com­mod­ity stocks and au­toma­tion stocks. As I have ar­gued all year, in­ter­est rate­sen­si­tive stocks (util­i­ties, tele­coms, etc.) and sta­ble growth stocks (health­care, sta­ples, etc.) will con­tinue to face the sig­nif­i­cant head­wind of ris­ing in­ter­est rates. For how­ever one cuts it, it is hard to avoid the con­clu­sion that ris­ing in­ter­est rates and ris­ing volatil­ity are a sig­nif­i­cant hur­dle for a very ex­pen­sive eq­uity mar­ket to clear. Throw in an over­val­ued cur­rency on top of that, and an over­weight bet on US eq­ui­ties re­ally comes down to the be­lief that the US econ­omy is like a coiled spring, ready to re­bound in re­sponse to the mag­i­cal wand of fis­cal re­form, ramped up govern­ment spend­ing, and reg­u­la­tory eas­ing. I hope that this is the case; but in­vestors should be pre­pared in the event that it isn’t.

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