27 April 2016 /
After the tumultuous start to the year financial markets recovered somewhat in March and have so far remained stable in April. Not for the first time the key issues discussed by the Investment Committee were expectations for future corporate profit growth, whether the efficacy of liquidity to continue lifting financial asset prices had finally run its course, and what might be the implications for markets in that eventuality. Whilst developments in the US featured prominently in our discussion, the group also addressed certain developments that had occurred since the March meeting and which had not been entirely expected. In particular, performances of Japanese and European equity markets and the remarkable recent strength of the Japanese yen, but also the significant downgrades to analysts’ earnings estimates.
Given the overall gloomy picture, the decision was taken to lighten portfolio equity positions to below Central Risk Positions, with the proceeds to be held in cash for now. The deciding factor was that we felt equity markets were walking a tightrope whilst the two opposing forces of economic growth and liquidity were becoming increasingly imbalanced. To us, the range of possible outcomes for the many market scenarios currently seems skewed to the downside and thus we judged it to be prudent to reduce some portfolio risk. The reduction in equity holdings will generally be expressed through sales of European and Japanese ETFs or index-like holdings, while retaining more active exposures that we hope will be able to find value in increasingly divergent stock valuations. The purpose of selling, of course, is that we anticipate lower prices in the short to medium term, and that reinvesting at these lower levels should afford an opportunity to add value to portfolios in an environment of generally low investment returns.
The outlook for US corporate earnings looks somewhat disconcerting at present. Now that the US equity market no longer benefits from the palliative effects of quantitative easing, fundamentals are likely to return to the fore as the driver of future returns. US corporate profits reached an all-time high as a percentage of the economy in 2012 (see chart 1), whereupon they have begun to sharply deteriorate, most notably due to the substantial falls in earnings from energy and resources companies.
Chart 1: Corporate Profitability and Employee Compensation as a share of GDP
During the course of 2015 profit margins have started to fall as wages accelerate. Without a pick-up in top-line (revenue) growth, which requires generally faster economic growth, the outlook for corporate earnings is likely to be poor.
This is not just the case for the US, and, with markets being reasonably efficient, nor is a weak earnings outlook a complete surprise. Chart 2 shows the current speed with which analysts are downgrading the earnings per share (EPS) forecasts:
Chart 2: Analyst earnings revisions (current year vs 10yr average)
The question for the Committee was, given the speed with which analysts are downgrading their earnings expectations, how far has this already been factored into share prices? This seems to have occurred to a certain extent. However, the Price/Earnings ratio of the S&P 500 remains above its long term historical average and the US remains expensive relative to other markets.
The biggest disappointment however is not so much the US but the paltry earnings growth in the rest of the world. A year ago we were anticipating a pick-up in European and Japanese profits and tilted portfolios towards Japan and Europe and away from the US to capture this trend. While Japan, in particular, has been a tremendous positive outlier in terms of future earnings growth expectations for the last few years, it has now returned to somewhere near the middle of the, fairly unexciting, pack. Estimates put top-down profit growth in 2016 for the US at 10%, Japan at 9% and Europe at only 4%.
In our undoubted opinion, the cause of the slow profit growth is a general lack of economic growth. We, along with many others, have written before about why global trend growth is weakening (namely demographics and technology); however, the increased regulatory burden borne by the financial system may be an additional cause of this.
There has been a two stage monetary response to the slow pace of economic growth. First was the introduction of zero interest rates and then quantitative easing in the form of the purchasing of government and corporate bonds by central banks to reduce long term interest rates and increase cash in the economy. Some economies have introduced a third initiative which is negative interest rates. Initially thought to be an economic stimulus, the consequence of negative interest rates is now coming under sharp scrutiny.
From an investing perspective, we envisioned these ever looser conditions — if accompanied by weak corporate demand for credit — would result in additional demand for financial assets. Whilst this is still likely to be one of the consequences, the behaviour of financial markets indicates that this can no longer be taken for granted, particularly if the price of the assets is not seen as attractive or investors lose faith that economic growth will pick-up. This seems to be the situation we are increasingly finding ourselves in, which implies that incremental changes in liquidity will be held in precautionary balances until prospective returns on non-cash financial instruments increase, either because of faster growth or because prices fall (when equity prices fall it is generally the case that their expected future return increases).
We have maintained our barbell approach with the equities we hold, which involves combining on one side a selection of ‘quality’ equity managers, and on the other growth managers or individual stocks. The latter were marked down sharply in price during January and February as investors worried about economic growth, and the possibility of another recession in the US. We are not in that camp yet, and whilst we are not expecting any significant acceleration in the pace of economic growth, we do still envisage a (potentially drawn-out) period of slowly improving GDP. In such an environment we think our returns from the growth strategy will outpace quality equity. However, with fixed income assets currently an unreliable risk diversifier, we feel it is prudent to retain this diversified equity strategy. In any event, were there to be a recession in the US, we believe it would likely be a brief technical recession (two quarters of negative GDP growth), rather than the severe downturn we experienced in 2008/9.
Given prolonged weakness in Japanese equities, we carefully assessed the market’s prospects. We noted the continued progress domestic companies have shown in striving to enhance returns on capital and rewarding shareholders through record stock buybacks and much improved dividends over recent years. From a corporate perspective this has yielded results to the benefit of shareholders. However, despite this positive internal change, we concluded that the Japanese economy is unlikely to display strengthening economic growth and investors are becoming increasingly disillusioned with Prime Minister Abe’s structural reform programme. In our view, the Bank of Japan has been somewhat unfortunate, in the sense that global macro events have conspired to push the yen higher, both through general market risk aversion (which traditionally sees investors buying yen as a ‘safe haven currency’) and the recently weaker US dollar, as the Fed appears to be displaying another bout of dovishness. Nevertheless, a strong yen is unwelcome for Japanese assets, although we would expect some further measures to cool its rise in due course.
The investment case for Japan based on domestic trends has been compelling, and whilst the yen’s value should not undermine these developments in the mind of the foreign investor, the result has been the significant selling of equity by foreigners. We continue to see a profitable landscape in Japan and we are invested in local mangers seeking to benefit from the domestic changes. We moderated our views on the yen earlier in the year, and as a result most of our Japanese positions are either entirely, or at least partially, unhedged, which has dampened some losses on these positions.
In Europe the economic picture continues to improve, albeit from a very low base, with signs of renewed demand for credit, improving consumer confidence and stronger retail sales. Against this more positive backdrop European equities have been somewhat disappointing. Having been significantly undervalued relative to the US in 2012, they have rerated to trade at a historically normal level of Price/Earnings relative to other equity markets. Disappointingly, in aggregate European companies have failed to produce an earnings recovery to match the tentative economic recovery in the region, with profits still significantly lower than their pre-crisis peak. Accordingly the region looks less attractive now, although we are hopeful that stronger corporate performance will be generated as the economic recovery continues. As with Japan we have removed some of the broad market holdings to concentrate on more targeted exposure.
Our fixed income views remained unchanged, although as ever we challenged our belief that there is little value in government bonds other than inflation linked bonds. The dominant buyer continues to be central banks in Europe and Japan.
The Federal Reserve in the US is no longer increasing its balance sheet, and we watch to see how the market unfolds as it begins to unwind its vast stock of these assets.
In general it should be stressed that while we have chosen to reduce risk, this is not because we expect some kind of market or economic meltdown. The big picture remains that we are in the midst of a long and slow global economic expansion following the extreme shock and contraction of the Financial Crisis. In this environment financial markets are likely to remain underpinned. However, having experienced strong returns over the last few years that have pushed up valuations, and with continued uncertainty regarding policy responses (not to mention a number of febrile geo-political situations), the balance of risks makes a more cautious stance appropriate at this juncture. It also gives us the fire power to invest at more attractive levels when inevitable bouts of volatility occur.
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