25 Feb 2020
The length of the current US bull market is the second longest on record and the economic cycle has broken records for the length of its upturn, with the last decade being the first since the 1850’s without a recession. Not surprisingly, investors are concerned that a cyclical reverse in both the economy and the stock market is close at hand. Academic research suggests that cycles don’t typically end of old age, but when some form of excess develops (over heating in the economy or over valuation to a significant degree in the market), or as a result of an exogenous shock that affects either of these. Looking at the macroeconomic fundamentals and market valuation, there is little sign of the excess required to de-rail either the economic or market cycles in 2020 and the US remains the dominant influence on markets globally. A buoyant start to the year led to overbought territory by mid-January but overall neither sentiment indicators or valuation are at dangerous extremes in the States.
In a complex world dominated by short-term news flow and “noise”, investors can easily be overcome with news and commentary, some of which can be ill informed and over complicated. We’ve always believed that the merits of simplicity are under rated and that asset markets are driven by just three factors – fundamentals (economic and political/geopolitical), valuation and sentiment.
Perhaps the principal threat to the global economy and stock markets is an exogenous shock such as a political/geopolitical event which would affect growth. The markets are currently pricing in a second term for Trump with a pro-business administration in the States and Iran may retaliate for the killing of Soleimani, which would disrupt oil supplies to the West. Either of these expectations could be called into question during 2020, which would result in bouts of volatility over the short-term, but it’s unlikely that a serious downturn will be driven by either of these factors this year.
Investors are also concerned about the market impact of an event such as the Coronavirus. Analysis of Sars (November 2002 to July 2003), Swine Flu (March 2009 to August 2010), Ebola (December 2013 to June 2016) and the Zika virus (March 2015 to November 2016) show common reactions. As investors are uncertain how badly economic growth/markets will be affected, there is typically an initial sell off during the early days of an epidemic. During the Sars crisis, luxury, leisure and travel were the most affected. In each of these events, a sharp initial stock market decline quickly gave way to recovery. For example, during the Sars outbreak, the Chinese stock market initially fell but rebounded by more than 30% in the three months after April 2003. In fact, history shows that the more equities fall initially, the more they subsequently re-bound and this type of event has historically been a buying opportunity rather than a sign that investors should exit stocks.
Central banks have recognised that, to a large extent, monetary policy has run its course, and it remains to be seen whether increased fiscal policy will result in better performance of value type stocks in certain sectors. The most highly valued parts of the market today are some of the high growth disruptive equities that have been the best performers over the last five years. Again, this will also be driven by whether higher levels of fiscal stimulus by governments, even if limited, cause inflation expectations to rise. If inflation starts to rise, this is more likely to lead to a renaissance for value type stocks.
Observers of the US election should concentrate on some of the key battle ground states unexpectedly won by Trump. Michigan, Ohio and Pennsylvania, the importance of these local economies and their dependence on trade, suggests that, in the short-term, Trump is likely to ease back on his hard line rhetoric on trade. The most negative enduring impact on markets would be the victory of a leftist Democrat candidate ushering in less business-friendly policies in the States.
Something for investors to watch this year is whether established trends within markets change. Once again, there has been commentary about the possibility of a weaker US$. The rationale behind this is that relative growth rates between the US on the one hand and Europe/Japan on the other may shift. There is election uncertainty in the States and Trump has pressured the Fed to some degree into an easier monetary stance. In Europe, any indication of a shift away from negative interest rates by the ECB under Lagarde could be positive for the Euro. A weaker US$, or certainly one that is not showing excessive strength, would be a positive for emerging markets and Asia.
Markets have been dominated on a day to day basis by short term news flow and what is often called ‘market noise’, but the medium-term direction of asset markets will continue to be driven by the three factors of fundamentals, valuation and sentiment. The macroeconomic fundamentals point to the persistence globally of a “goldilocks” (not too hot, not too cold) economic climate. Equities have been favoured over the last few years, but valuations are mixed with those in the States above historical averages. Extreme levels haven’t been reached though, certainly when factoring in a persistently lower discount rate for equities.
Volatility in the global economy is low both in terms of GDP and inflation and with relatively high levels of profit margins, markets should continue to be able to live with higher than average valuations. The Shiller cyclically adjusted earnings number will improve as the financial crisis period drops out of data and sentiment is elevated but not yet dangerously bullish. Overall the combination is positive for equities generally with the greatest risks of a bear market in 2020 being from exogenous events. Investors can put in place some hedging of equity risks, perhaps through gold ETFs or US treasuries. If these instruments suffer a price setback and markets become technically overbought, trimming equity exposure could be an option. Overall investors look likely to be rewarded for taking equity exposure in 2020 although they need to be aware that after a particularly long bull market, when setbacks occur, they are likely to be swift and sharp.
Graham O'Neill, Senior Investment Consultant, RSMR
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