Note May 30,2019: Assessing the Valuation Weave- Unspecific developments that could suddenly flare are reasons for safety margins in industries from engineered products to food. That need for risk premiums appears currently skimmed over in capital markets. Central bank activity in general and especially quantitative ease have directly affected valuation in fixed income. Yet, we see tentativeness in the latest Federal Reserve statements and from other central banks. Fixed income yields currently range downwards and even negative in both Germany and Japan for government bonds. In addition, there exist low premiums well into the low quality corporate debt. Despite foreign exchange being perennially the most heavily traded capital instrument, unusual calm appears between the major trading currencies of the U.S. dollar, Yen and the Euro as well as the Renminbi. Sudden flaring is a risk as is the pushing of volatility into emerging or smaller currencies.
Typically, an equity valuation weave has amalgamated yields in fixed income and buoyancy in company, sector or whole equity market index prices due to future business growth expectations. At present, overemphasized has become the competitive prevailing yield component, not least via momentum. Consequently currently even among even large companies, substantive air pockets are seen that which would otherwise be associated with smaller companies due to disappointments in necessarily less seasoned businesses.
In the present continuum of political, central bank, business and market performance, diversification including alternate assets seems called for. We stress equity diversification to include quality, not as commonly used as a euphemism for size but instead classically of growth at a reasonable price.
For companies, sectors and geographically, equities have not necessarily had a lock step relationship with interest rates when considered over time or in cross section at a point in time. The reasons for dissonance are clear enough. Administered interest rates can be lowered or held low for a variety of concerns, including currency flux, economic growth, domestic business mismatch and as seen since 2008, financial intermediation weaknesses. It seems to us that in the present long lasting momentum phase of capital markets, over emphasized has become one aspect of price discovery, namely the paucity of returns in alternates. A common disposition in this cycle has been to look at equities as mere risk on/off momentum tools versus prevailing interest rates. Such a disposition underestimates the importance of aspects like the ability to service debt especially as leverage rises in fixed income and in equities, of the age-old role of valuation as it relates to business growth prospects. Lately however, these assumptions behind a momentum push have appeared to fray of low rates as being reason enough to purchase equities or engage in activities like favor for sector indices or factor investing as antidote to volatility. Over the long term and across many interest rate regimes as benchmark, the S&P 500 has been able to deliver around 7% earnings growth on a valuation of 16x.
Since 2009 in this cycle and as is classical subsequent to earnings bottoms, periods of double digit recovery have been recorded in earnings for the S&P 500. Still and significantly so in this cycle, market participants appear to have been willing to overlook sharp cutbacks in consensus expectations during quarterly reporting release after release – as long as the actual release exceeded the most recent consensus for earnings. Reports of revenue stress also appear to have been accorded less importance. As markets in equities appeared momentum oriented, valuation expansion garnered another boost in 2018 in the form of U.S. corporate tax cuts. Still, a 2% or even less year-over-year quarterly earnings growth rate is meaningfully lower than the annual earnings growth rate of around 7% over the long term for the S&P 500. Internationally, actual business commentary accompanying releases has continued to highlight the sharp level of business competition accompanying the paucity of revenue growth. Furthermore and not limited to small or unseasoned companies or even acorn divisions within companies, several large companies have one after another and globally been reporting shortfalls and/or the need for urgent restructuring. As well and despite 2019 being close to a decade since the global GDP growth bottom as well as the present long period of low interest rates in many jurisdictions, management difficulties have been flaring internationally across industries. Currently from august institutions like the IMF and the OECD have been recorded reductions in global GDP growth expectations towards 3% annually, compared to 4-4 ½% before the flareup of credit crisis in 2008. We believe that at the aggregate corporate, industry sector and company level, the evidence jars against common place assumptions of momentum and of comparisons with the levels of ambient fixed income yields as being the dominant considerations. We expect quality of delivery and of balance sheet strength to be more important for equities, not as commonly used as a euphemism for size but instead in the old fashioned sense of growth at a reasonable price. It could also override the hypothesizes behind sector and factor investing as antidote to volatility.
Much more than market participants have been willing to countenance in their fervor for quantitative ease as balm for valuation excess, political matters also loom at present. Minority parliamentary government or divided control of the administration and Congress in the case of the United States have often been held up as productive, unless gridlock results instead. In domestic U.S. politics and ahead of its 2020 elections, rancor has already become fast raged. Political belligerence internationally appears expanded with respect to Latin America, east Asia and the Levant, now including confrontation between Iran and the United States over a broad range of issues, compounded by nuclear positioning. Internationally today, the United States has appeared willing to distance itself from nurturing consensus with allies and instead appeared to be confrontational with them. In trade, confrontation instead of agreement appears even more so between the United States and China replete with tariff and counter tariff measures that could easily broaden into tests of strength from military to capital market issues. The belt and road initiative has received great emphasis from China in it presenting itself as second largest currently but rising major power. India may have had a decisive election based on defense but economic and credit challenges loom in its fastest growing major economy. The European Union elections and the breakdown of government in Britain demonstrate latent stresses within the large economic footprint of Europe. Challenges to revenue growth and indeed profit margins do remain for many companies.
Unspecific developments that could suddenly flare are reasons for safety margins in a diverse ranges of industries from engineered products to food. That need for risk premiums appears currently skimmed over in capital markets. Yet, we see the latest Federal Reserve statements to be indicating tentativeness and even uncertainty about appropriate policy. Tentativeness seems also being reflected in statements from other central banks. The present global and internal political environment in many major countries is likely to make policy making more difficult for the central banks than was the case for years after the eruption of credit crisis from 2008.
Central bank activity in general and especially quantitative ease have directly affected valuation in fixed income. Fixed income yields currently range downwards and even negative in both Germany and Japan for government bonds. In addition, there exist low premiums well into the low quality corporate debt. Despite foreign exchange being perennially the most heavily traded capital instrument and a harbinger of change, unusual calm appears between the major trading currencies of the U.S. dollar, Yen and the Euro as well as the Renminbi. Sudden flaring is a risk as is the pushing of volatility in major and into emerging or smaller currencies.
In the present continuum of political, central bank, business and market performance, diversification including alternate assets seems called for. We stress equity diversification to include quality, not as commonly used as a euphemism for size but instead classically of growth at a reasonable price. StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e