Post the Global Financial Crisis (GFC), there has been an enormous rise in asset prices that has largely been driven by various stimulus of one form or another. Although this has been a worldwide phenomenon, a closer look reveals that US equity returns have contributed more than their share and have surpassed other developed as well as emerging markets. In this article, we explore why.
Since the GFC, US equity markets have thoroughly
outperformed their counterparts in developed and emerging markets owing to strong earnings and benign monetary and fiscal conditions. This shows that understanding US markets is key to understanding global markets, especially post the GFC.
There has not been a single down year in the S&P 500 since 2009 which begs the questions: how long will it keep going and whether the end is nigh? These stellar returns could be attributed to the following:
Unprecedented liquidity by the Fed and other major central banks
Strong corporate earnings, predominantly in the technology sector
Over the past 24 months, there has been a common consensus amongst most market practitioners that the world economy is experiencing a ‘Goldilocks scenario’ with inflation under control and strong economic growth. The good news is that has been largely true, the bad news is that this is going to end, signs of which are already apparent.
To understand where the market cycle is going, we need to figure out where are we in the cycle, how did we get here and what plausible turns it could now take. Although we do not claim to predict the future, it certainly helps to know the factors driving the market and make your investment decisions accordingly.
We are in a market cycle that has been prolonged by fiscal stimulus (Tax cuts and Jobs Act 2017) to the tune of 275 bn USD resulting in strong earnings over the past 18 months.
Global synchronised growth has been the theme amidst investors cheering for one of the strongest rallies in US equity markets while ignoring the quiet divergence that has been underway across Europe and Emerging markets.
This does not mean that we are calling the end of the bull market anytime soon. Various indicators suggest that the first half of 2019 would most likely be a continuation of the trends seen over the past 2 years, the strength of which will be decided by earnings guidance, further tax cuts and a possible infrastructure spending bill.
Short-term : Presidential Cycle
Recently there have been signs of caution settling into the market with deceleration of earnings, a US trade war with China threatening to escalate, monetary tightening and commitment to normalising interest rates
by rate hikes.
Historical analysis suggests that midterm years tend to be volatile which could be partially attributed to the fact that investors tend to lock in the returns garnered over the first 18 months of a presidential cycle and wait for the political uncertainty to roll out during Q3. Add to that, the fact that historically October has been the most volatile month of the year, the recent bout of volatility is not at all surprising.
As shown in Figure 3, the period of Q4 Y2 and Q1-Q2 Y3 promise to be a strong period for equities. Bear in mind that these are historical numbers and hence should be taken within the right context of earnings and
We believe the extended market cycle could continue to the end of 2019 and might even accelerate, the extent of which could be determined by a possible infrastructure bill in 2019 and a US-China trade deal, with possible signs of exhaustion becoming
Having made the case for a favourable short term period for equities, we caution investors towards weakening of certain key drivers and possible worsening of conditions that have been the underpinning of the recent surge in asset prices across the spectrum. Investors need to be on the lookout for an inevitable (economic) regime change with major global central banks pulling the plug on liquidity.
Close to a Trillion USD will be taken out of the system within the next year with the Fed selling 30bn USD and the ECB pledging to unload 50bn USD on a monthly basis. Added to that the fact that Treasury yields have shot up to the highest level since 2011 could force investors to re-evaluate the attractiveness of equities.
2017 saw one of the lowest VIX readings in history with the year ending in close to 20% appreciation for the benchmark S&P 500 index. The rally added another 8% until deep into January 2018 and by many accounts, 2017 was the least volatile year since 1964. That changed quickly when volatility spiked and investors saw a rapid correction of more than 10%.
Although it is impossible to single out a factor responsible for the correction, a hawkish Fed coupled with a strong surge in short term treasury yields (2 year) to the range of 2.10 – 2.20 % (a level not seen since 2009 and the GFC ) did contribute.
A closer look at interest rates, volatility and systemic liquidity tells us that we are in a new market regime that has started to transition itself away from low volatility, low rates and accommodative monetary policy. As noted earlier, fiscal policy is still expansionary and coupled with corporate earnings may still provide strong tailwinds for equities and other risky assets.
3-Month rates have surpassed the S&P 500 dividends for the first time signalling the end of the low rate environment that has favoured equities since the GFC.
It’s always hard to time the market and we believe investors should refrain from doing that. Rather, we should be on the lookout for worsening of key factors that have supported this unprecedented rally. We believe the following underlying factors are worth monitoring closely:
Fed hawkishness: Liquidity
Trade war: Inflation
Higher rates along with balance sheet reduction will weaken one of the key drivers of risky assets i.e. Liquidity while at the same time rising wages and tariffs will only exacerbate the problem of inflation.
Besides these two, there are other potential concerns that could roil the market in the short term such as political gridlock in the US pertaining to a divided Congress and possible investigations targeting the current administration, a full blown trade war, and contagion from Emerging markets. These concerns are valid and potentially can take some steam off but unless there is a strong deterrent for corporate earnings, long term investors should not fret. Rather, historically political shocks are good buying opportunities as long as earnings and liquidity support the market.
Smart Beta : Factors to Watch
Fed fund rates have increased from 0% to 2% (lower bound) in a span of 2 years and are on upward trajectory in coming years. This calls for adjustment of asset prices across the spectrum owing to higher discount rates. With tepid growth expectations coupled with higher rates and liquidity being pulled out of the system, we think Value as a factor could be more attractive than Growth into equities.
Besides the theoretical reasoning that higher rates adversely affect Growth stocks relative to Value stocks, the most recent rate hike cycle shows that Value did outperform Growth as a factor as depicted in Figure 5.
Data for Figure 1, 3, 4 and 5 in this article were sourced from Bloomberg.
Data for Figure 2 was sourced from CBO (congressional budget office) US
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