Economic Outlook for May
At the time of writing, close to half of listed companies have reported Q1 2018 quarterly results. The pattern this quarter is once again one of strong corporate earnings results that are ahead of expectations. In the US, 279 out of the 500 companies in the S&P 500 index have reported. The average earnings result is +7% ahead of expectations and absolute growth rates are strong. Global macro data continues to be strong too. Despite recent concerns for the European economy following a slowing in some data metrics, the underlying picture remains positive. European economic growth in 2017 was the highest since 2007 and economic confidence in the region remains high. Data from China and the US also show a strong economic environment in those regions. The strong macro environment globally is feeding through into strong corporate earnings growth numbers and this is positive for equity markets.
In the short-term, however, these strong underlying data are not driving equity markets higher. Equity markets have remained directionless and erratic. This has been the case since the February sell-off and the return of volatility to more normalised levels. This market dynamic creates new risks for investors, but also new opportunities. In an environment of higher base interest rates, higher bond yields and less monetary support from central banks, equity valuations will inevitably be impacted. On one side, higher interest rates means lower equity risk premiums, which has a negative effect on equity valuations. On the other side, stronger corporate earnings should support higher equity valuations. Since the 2008-2009 crisis, unprecedented monetary support has supported stock valuations for all listed companies. The tide has risen for everyone. This is unlikely to continue to be the case. But that doesn’t mean the outlook for equities is negative. Stock picking and active management strategies are at an advantage in being able to pick stocks with upside to current valuation, while passive investing strategies are at a disadvantage in having to own stocks with weaker valuation prospects.
Everyone (Was) a Winner
The regime change in global markets towards less monetary support and higher interest rates means many stocks that previously performed well in the 2009-2018 bull market are unlikely to continue to do so. Companies whose valuations have relied on promising the market high profits and cash flows in the future, at the expense of negative cash flows today, are likely to see major negative changes in valuations. These types of ‘hype’ stories in the equity market have relied on 100% of stock value being based on distant expectations of profits, as well as relying on the market overlooking low profits today. Higher interest rates mean higher discount rates on that future value, and that will have a disproportionately negative impact on these types of equity investments. Passive investment funds will have no choice but to hold these names, which now dominate many sector indexes. Meanwhile, active investment strategies, like growth at reasonable price (GARP), which focus on strong profits and growth today, structural winners in expanding markets and stock picking, should outperform. Why wait for the promise of future profits and cash flows when you can buy them now? In the past everyone was a winner in the equity bull market, going forwards, stock picking through active management looks to be the best strategy.
Without a recession or major exogenous shock it is hard to see how or why the equity bull market would end just now. Just because the equity bull market is old that doesn’t mean it is over. The 2008-2009 global recession and market downturn was unique, the deepest since the Great Depression and 1929 market crash. It stands to reason that after such a deep recession, the business cycle will be longer than has been the case in recent decades. The simple fact that there has not been a recession since 2008-2009 appears to be enough reason for many to call the next recession as being imminent. The business cycle is certainly at a later stage than it was in the recent past. But is a recession imminent? The data says it is not. In fact the data tells us the global economy continues to expand at a solid growth rate and high corporate earnings growth is reflective of this improving environment for the economy. A recession certainly would take the wind out of the sails of the equity market, however this is not currently on the horizon. Many market watchers focus on other sources of risk as being potential catalysts for weaker markets: the prospect of a US-China trade war, North Korea, Syria. The common factor among these risks is that they have come, and then gone away again. We do not see these as being likely to impact equity markets very much. The biggest risk to any equity market is a recession, and that is where investors should be focussed in terms of any likely change in equity markets. Other risks will come and go, but it is the underlying economic cycle that will, in the end, drive markets.
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