It's Groundhog Day for the MarketsLearn more about this firm
- The likelihood of subdued economic growth means that interest rates will be lower for longer.
- There will no longer be a rising tide of U.S.-led QE that lifts all boats.
- We think that a selective approach in equities will pay off as investors focus more on valuations and fundamentals.
Financial markets have endured their own version of Groundhog Day in recent months: the issues that troubled investors earlier in the year – namely the timing of the Fed’s first rate rise, the subdued pace of global growth and the ongoing macroeconomic uncertainties in China – are no closer to being resolved now than they were back in the summer. So perhaps it is worth considering what has changed in markets, and what hasn’t.
The Fed, for its part, has worked very hard to try to keep the December policy meeting alive (and current odds suggest the probability of a hike in December is greater than 50%, having been less than 30% prior to the October meeting). Critics of the Fed would argue that the FOMC has simply been too transparent and that policymakers have painted themselves into a corner. If the FOMC itself is not sure about what it should do, it is impossible for anyone else to predict what the Fed will do with any accuracy.
While the Fed’s moves (or non-moves) have occupied the lion’s share of the column inches in recent weeks, it is the muted tone of global economic data that is perhaps most vexing. The Lehman crisis took place well over seven years ago, and yet signs of a traditional cyclical recovery in developed economies remain very hard to find. If anything, the current concern in markets now is the overcapacity in China and what it will mean not only for commodities and energy producers but also industrial profitability in general. While we do not expect a recession, life for a number of global industries is very difficult and likely to get worse. Talk of a recession in industrial profits may sound alarmist, but is probably not too wide of the mark if you happen to be a maker of mining equipment or agricultural equipment, areas where there is significant global oversupply. If you produce a commoditized, undifferentiated product – such as steel plate, for example – life is incredibly tough and companies are failing.
Why has global growth been so subdued? While QE has created the conditions (i.e. near-zero interest rates) for companies to invest, it only makes sense for companies to invest if they think that there is demand for what they will then produce. Post crisis, that demand has been notable by its absence, outside of emerging markets. Of course, emerging markets are now under significant pressure, particularly the ones that have built their economies to feed Chinese demand for commodities, meaning that the global consumption outlook is muted at best. In that context, it is perhaps not surprising that companies have chosen to cut costs and use spare cash to pay dividends and buy back shares. In a world where organic growth is very hard to find, it makes much more sense to buy back shares than committing to expensive, long-term projects involving huge amounts of capital expenditure and uncertain payoffs – as many mining companies have found to their cost over the past year or so.
A lack of corporate confidence to invest is, however, only part of the story. When oil prices slumped, we expected consumers to benefit from a “cheap energy” dividend, but that simply has not emerged in the way that we expected. Rather like corporations who are reluctant to spend on large-scale investment projects, we believe that many consumers are simply thankful to have a job in the post-crisis world and are therefore banking rather than spending their gains from low energy prices. Perhaps more significantly, and despite tightening labor markets in countries such as the U.S. and UK, wage gains have been very modest. We should also not forget that a generation of people who left school or college in the late noughties will have grown up without ever knowing the cheap and abundant finance that was available pre-Lehman. Leveraged consumption is not returning in the U.S. or elsewhere, and this will have a material impact on the level of GDP growth we will see next year and in the coming years. In other words, the unholy trinity of tighter regulation, higher legal costs and tougher capital requirements will mean that retail banks will increasingly look like utility companies in the future.
What does this mean for investors? In our estimation, organic growth will be hard to find and this perhaps explains the pick-up in M&A. Companies who have already shrunk their cost bases and used financial engineering to lift their share price have few other options left in the locker. Indeed, increased M&A and the fact that companies have become more creative with their balance sheets has driven the recent deterioration in credit fundamentals in the U.S., and this is creating a further headwind for markets.
The likelihood of subdued economic growth means that interest rates will be lower for longer. Indeed, the terminal fed funds rate for this cycle could be as low as 2%. On paper, this is positive for bonds but it is hard to get excited about government bonds given where yields are and the fact that the Fed will be raising rates. European high yield does, however, look interesting, given a meaningful yield spread over governments and the fact that the asset class is usually a beneficiary of M&A, unlike investment grade.
A low discount rate is, in theory, a major positive for equities, but all the issues discussed above suggest that economic growth – and therefore earnings – are likely to be weaker than they would have been if some of the excess global productive capacity had been burnt off. The process of creative destruction and elimination of excess capacity that usually follows a recession has simply not occurred this time, and we think this could have a meaningful impact on the investment landscape. We think that a selective approach in equities will pay off, particularly as China growth concerns are unlikely to abate anytime soon. We also think that investors will focus more on valuations and fundamentals as global liquidity continues to ebb, and in that world investors should be ready for more stock-specific disappointments. In the future, the Fed will no longer be underwriting equity markets and despite the likelihood of further policy action by the ECB, there will no longer be a rising tide of U.S.-led QE that lifts all boats.