The decision tree from here
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?
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
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.