It is not often that signs of economic strength trigger a market sell-off. Slightly higher than expected wage growth was perceived as presaging significant inflationary pressures, leading to a market correction. Volatility accelerated faster than during the Lehman collapse. Our inboxes were inundated with emails proclaiming various shades of “buy the dip” from banks.
We take a largely sanguine view regarding recent economic data. There was nothing extraordinary about the wage numbers. Unemployment is exceptionally low, and businesses are struggling to find qualified staff. Low inflation expectations, however, remain very well entrenched. Core PCE inflation (one of the key measures targeted by the Fed) is at 1.5% and not expected to reach 2% until 2019.
If inflationary pressures are more benign than some fear, why did markets react as violently? There are two explanations. The first is “technical”, and relates to some high profile short volatility investment products, as well as automatic selling by risk parity funds. The second is fundamental. The market is only just beginning to adjust to the reality of increasing interest rates, following an exceptionally long period of low rates and low volatility. It is this latter explanation that we find more persuasive.
We believe there are two factors that are likely to dominate the trajectory of US equities for the year. The first is relative valuations. The second is the risk that interest rates may rise at a faster pace than foreseen.
The US equity market is currently valued at a price to earnings ratio of about 20. While this level is relatively high by historical standards, it can be justified by earnings growth. With reasonable GDP growth and a boost from tax cuts, earnings growth is likely to remain robust for the foreseeable future.
A price to earnings ratio of 20, however, implies that the earnings yield is 5%. This type of level is attractive when interest rates are very low. But when short term rates move from near zero to well over 2% (assuming all the Fed hikes currently expected in 2018), this level of earnings yield is far less attractive. Unless earnings accelerate significantly from current levels, investors need to adjust their expectations to lower returns. This is because while earnings can grow, valuation multiples will decline.
It is our expectation that US equity returns will be about 5% in 2018. This may still be attractive compared to many fixed income assets, but is well below the long term historical average.
It is also unlikely that the market trajectory can be as smooth, or volatility as low, as we have witnessed in the past few years. This is in part because of fiscal risks, and its implications for interest rates, as well as developments in international trade.
Because of the recent tax reform, the Congressional Budget Office foresees an increase in the fiscal deficit by about $300 bn this year, and over $400 bn in 2019. This will push the fiscal deficit to well over $1 trillion next year, or over 6% of potential GDP.
The sustainability of fiscal expansion depends on whether tax reforms accelerate investment and productivity, leading to meaningfully higher potential growth. In the short term, a rising deficit increases upward pressure on long term rates, while in the medium term rising growth does the same. While this strategy entails considerable risks, these can be ameliorated if deregulation sufficiently raises potential GDP growth.
The bigger cloud to the outlook, in our view, emanates from international trade. Trade and fiscal deficits move hand in hand, as they are two sides of the same basic economic calculation. As a result, reducing the trade deficit is a key policy objective of the Administration which cannot be achieved under current fiscal plans. This increases the likelihood of trade frictions, as we have already seen by the recent imposition of tariffs on various goods, including Chinese solar panels, Korean washing machines, and the potential for punitive duties on imported steel. A trade “war” has not erupted, but it would be naïve to underestimate its likelihood.
Against this background, we see recent market volatility as foreshadowing further volatility throughout the year. With valuations at current levels, we are not inclined to follow the “buy the dip” advice of many strategists. Rather, this is an environment where we prefer to remain overweight markets where valuations remain low – Europe and Japan – and to underweight the US markets where we see the potential for valuation multiples to decline. In allocating assets in today’s market, it is also good to recall that cash no longer has a zero return.
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