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The Challenge For Equity Markets

Rendered to its bare bones, an equity price is a stream of future earnings, discounted by both a risk-free rate and an appropriate risk premium. And at its core, this simple equation summarizes the challenge confronting investors in US equities for it is clear that the risk-free rate will struggle to move much lower, while current valuations point to a risk premium that is near its floor (the P/E ratio for MSCI US stands at 21.5x, or almost one standard deviation above its historical average).


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Hence, for any investor operating on the basis that US equity prices will move higher, logic dictates that they must expect a very solid stream of future US corporate earnings. And herein lies the rub: US earnings have lately been pointing in the wrong direction.


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What can turn US earnings?

So what can turn US earnings around? The strong US dollar means it is unlikely that many American exporters will generate a fresh surge in profits from overseas operations. Meanwhile, the recent roll-over in earnings may simultaneously indicate that, after seven years of zero interest rate policies and massive share buy-backs, corporate America has no more scope to financially engineer its way to profitability (note that 2016 has so far witnessed a large drop in share buybacks).

This means that any rise in US corporate earnings in the coming quarters will have to be the result of improved US economic activity. And this is where things gets challenging, for over the past 18 months US data has disappointed on a fairly reliable basis.


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An argument can, of course, be made that the US economy has lots of pent-up demand and is primed to rebound. Perhaps, but the next question is whether the current political environment in the US is conducive to the unleashing of such a coiled spring. Put yourself in the shoes of a US businessman today: on the left, Hillary Clinton is promising the greater business community a higher minimum wage, potentially increased medical coverage costs, more capital gains taxes and possibly higher tariffs (rejection of the Trans-Pacific Partnership free trade deal and all that). On the right, Donald Trump is (definitely) promising higher tariffs, along with a rise in the minimum wage, greater difficulty in hiring foreign talent, increased capital gains taxes and potentially higher medical costs.

With this kind of uncertainty, who is going to hire workers or break ground on a new factory? Simply put, could the uncertainty surrounding a potential Trump presidency, along with the Clinton campaign being forced to the left by the Bernie Saunders insurgency, be one of the reasons for the recent disappointing US jobs numbers? And, if so, will the situation really change in the coming months? Moreover, is the Federal Reserve really going to raise rates in such an uncertain political environment? Surely, the better Trump does in the polls, the more likely the Fed is to delay any rate hike until after the election (of course, should Trump get elected, there may not be another rate hike for years!).

The rest of the world has a different dynamic

Before we fall prey to excessive pessimism, it should be remembered that conditions outside of the US are somewhat different. Specifically:

  • In Europe, like the US, it is hard to imagine the risk-free rate or the risk premium contracting meaningfully. Therefore, any equity gains will also have to come through an expansion in corporate earnings. The key difference between Europe and the US is that after five years of very little growth, the European economy is arguably more of a coiled spring and will benefit from an undervalued exchange rate.
     
  • In Japan, the same picture can be painted with the added bonus of a potential start to financial engineering and share-buybacks (see A New Marginal Buyer Of Japanese Equities).
     
  • In Asia, the picture is different as the risk-free rate in most countries (whether China, Indonesia, Philippines, India, Malaysia, Australia) is now falling. Thus, Asia is the one major economic region where equity markets could rise without a big bump in the numerator (i.e. the stream of future earnings), but simply through the continued contraction of the denominator (risk-free rate + risk premium).


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This latter point brings us to the final challenge confronting equity investors. On the one hand everything seems to favor an overweight in Asian equities: attractive valuations, easier fiscal and monetary policies, a broad lack of political uncertainty, falling interest rates, a US dollar that is no longer rising and highly conservative foreign investor positioning. Yet on the other hand, the highly cyclical nature of Asian corporate earnings means that its markets have historically fared poorly in periods of weak US market performance. And hence today’s quandary: can US equity markets withstand an uncertain domestic political environment and stretched valuations and thereby allow the unfolding of a bull market elsewhere?

6 Comments

  • >Anonymous

    Anonymous

    23/05/16

    The answer comes in part deux?

    Reply
  • >Anonymous

    Anonymous

    23/05/16

    USD has been rising consistently for 3 weeks...........

    Reply
    • Dear Reader,

      USD has indeed been stronger the past few weeks... but by and large, it has been on the marginally weaker side for the past twelve months and it currently stands at the same level as February 2015. In other words, the US$ bull market which was such a determining factor of the investment environment of the post GFC years up to 2015 now seems to have stalled:

      Interactive chart

      Which brings me to the belief that the US$ is increasingly acting like a stock that is no longer going up on good news... usually a sure sign that everyone's portfolio is loaded with that stock.

      After all, let’s face it: everything that could have gone RIGHT for the US$ over the course of the past year pretty much happened… and yet the US$ fell marginally:

      • ECB much much easier than anyone in their right mind could have expected
      • Immigrant crisis in Europe and rise of far right
      • Brexit debate
      • Terrorism in Europe triggering re-introduction of borders and increases in European defense spending
      • BOJ much much easier than anyone in their right mind could have expected
      • China becoming much more assertive geopolitically
      • Brazil completely imploding
      • South Africa not far behind…
      • Fed being the only central bank to hike rates this year

      And if everyone is already long the US$, then when the bad news comes around, the USD risks getting sold off aggressively. So what could be the bad news ahead (for the US$):

      • Poor US capex and job creation as most entrepreneurs decide to wait out the political circus in the US
      • A Fed that does little (honestly, as Trump keeps going up in the polls, do you really think that the fed will take the risk of hiking rates? Imagine for a split second that Trump gets elected: we likely will never see another rate hike for the rest of our careers!)
      • Trump continues to go up in the polls, leading most investors to reconsider their overweight US equities allocations
      • Even if Hillary wins, we still end up with higher minimum wage, no TPP, and a likely big increase in healthcare spending and wider deficits… dollar bullish?
      • Meanwhile, US trade balance continues to deteriorate fast
      • Central bank reserves, which had been shrinking (indicating a global shortage of US$) are now growing once again (indicating no more US$ shortage).

      Reply
  • >Anonymous

    Anonymous

    23/05/16

    Part der...
    Until now

    Reply
  • >Anonymous

    Anonymous

    23/05/16

    Add to these worries the huge build up in inventories and the answer becomes clearer

    Reply
  • >Anonymous

    Anonymous

    23/05/16

    according to BAML, share buybacks are tracking above 2015 levels year to date...

    Reply