Introduction
October was a bad month for shares with global shares losing 6.8% in local currency terms and Australian shares losing 6.1%. It’s possible that following top to bottom falls of 9% for global shares, 11% for Australian shares, 21% in emerging markets and 31% in Chinese shares we have now seen the low in the share market rout. Shares were due a bounce and from their October lows and Australian shares have risen around 4% since. But it’s impossible to be definitive and with the worry list around US interest rates, trade, politics, etc, there could still be another leg down. However, our view remains that recent turbulence in share markets is a correction or a mild bear market at worst (like 2015-16) rather than the start of a deep bear market like the global financial crisis. This note reviews the key recent worries for shares and why they are unlikely to be terminal.

US inflation & interest rates

The US economy is very strong as evidenced by consumer confidence at an 18-year high, unemployment at a 49-year low and strong economic growth. With spare capacity being used up wages growth is edging higher as shown in the next chart.

Against this backdrop it makes sense for the Fed to continue the process of returning monetary policy and interest rates to something more normal. Naturally, the ongoing removal of monetary stimulus in the US creates consternation and has been periodically occurring ever since former Fed Chair Bernanke started talking about slowing or “tapering” quantitative easing in 2013. In short, investors continue to fear a return to the GFC and so any move to remove monetary support creates periodic bouts of fear. Several points are worth noting about this though. First, the Fed can afford to remain gradual in raising rates. Inflation is at the 2% target, wages growth is a long way from the 4% plus level that preceded past recessions and productivity growth is rising so this will keep growth in unit labour costs down. Meanwhile, intense competition and technological innovation are also continuing to help keep inflation constrained.

Second, on any measure US monetary policy is a long way from being tight. The Fed Funds rate is zero in real terms, it’s well below nominal growth and the yield curve is still positive.

Finally, a return to more normal interest rates is a good thing because it reflects a stronger, more normal economy.

In short, expect gradual 0.25% Fed rate hikes to continue, with the next hike coming in December, and this will cause bouts of market volatility but it’s a long way from crunching the economy in a way that would bring on a deep bear market in shares.

The US/China trade conflict

This issue has been periodically worrying markets since around March. It stepped up a notch after last month’s speech by US Vice President Mike Pence indicating that US gripes with China extend beyond trade which led many to talk of a new Cold War – the implication of which is less trade and occasional military tensions which implies lower economic growth and lower price to earnings multiples. However, it’s still not as bad as it looks.

First, so far only 12% of US imports have been subject to a tariff hike averaging 15%, which is equivalent to an average tariff hike of 1.8% across all imports. So it’s a non-event compared to 1930 which saw a 20% tariff hike on all imports.

Second, while initially the US seemed to be picking trade fights with all major countries it has since renegotiated trade agreements with South Korea and Canada/Mexico and is negotiating with Europe and Japan. This tells us Trump is not interested in trade wars with everyone and that he is not anti-trade per se but wants “fairer trade” for the US.

Third, while Trump has threatened more tariff hikes on China if it retaliates it’s noteworthy that China has not fully retaliated and has been cutting tariffs and announcing more protections for intellectual property. This may help defuse the tensions a bit.

Fourth, while Trump’s comments expressing optimism about a deal with China should be treated with scepticism as they came just before the US midterm elections, they do highlight cause for optimism that a deal will be reached eventually. At least Trump and Xi are talking and Trump’s optimistic comments ahead of the midterms effectively tells us that he is aware that the trade issue is harming the stock market and potentially the economy. The latter in turn suggests that he wants a deal well before he faces re-election in 2020. So, while it may be premature to expect a deal when Xi and Trump meet later this month, a deal is likely well ahead of the 2020 elections. With China already lowering tariffs, improving intellectual property protections and softening joint venture requirements the outlines of a deal are starting to become apparent and Chinese Vice President Wang has indicated China is ready to negotiate with the US.

The US midterm elections – no surprises

The US midterm elections saw the Democrats win control of the House and Republicans retain the Senate which was what had been indicated by the polls and betting markets. So, it provided no surprises – in contrast to Brexit and Trump’s 2016 win! While the Democrat House is likely to prevent Trump from cutting taxes any further it won’t be able wind back last year’s tax cuts, reverse Trump’s deregulation of the economy or change his trade policy. But there is some chance that Trump and the Democrats may agree on infrastructure spending. While the Democrat House will likely set up committees to investigate Trump and consider impeachment charges, it’s very unlikely to get the required 67 out of 100 senate votes to remove him from office unless he is shown to have done something really bad. All up, while there may be some skirmishes around shutdowns and debt ceilings, the midterm outcome could be positive because it means less policy uncertainty.

On average, US Presidents have lost 29 House seats in their first midterm election. Clinton lost 54 and Obama lost 63. Trump looks to have lost around 34 but only needed to lose 23 to lose control of the House so what has happened is not unusual. What’s more the Republicans look to have increased their Senate majority so it’s not all bad for Trump. More broadly, it should be noted that “divided government” is the norm in the US. Perhaps the biggest risk is that Trump takes it personally and ramps up the populism, but if he wants to get re-elected in 2020 (which he does) then he won’t want to do anything that damages the economy and amongst other things this points to cutting a deal with China and getting the tariffs removed. Since 1946 the US S&P 500 has risen in the 12 months after all midterm elections – probably because the president starts to focus on re-election and so tries to boost the economy.

US tech stocks
Having accounted for a big chunk of US share market gains this year the US tech sector has corrected around 13%, but that still leaves it vulnerable to relatively high valuations (Nasdaq is on a PE of 42 times), sales growth slowing down for some of them and the prospect of increasing regulation. However, we have not seen anything like the tech boom euphoria of around 1999/2000 so a crash like back then is unlikely. Our base case is that the US share market will start to see a rotation from expensive tech to cheap cyclical stocks (with many trading on forward PE’s of less than ten times).

Eurozone worries – German and Italy

Fears that the Eurozone is about to blow apart causing financial mayhem and threatening global growth have been with us since the Eurozone crisis that started in 2010. Lately the fear is that populist governments will take countries out of the Euro. This started with Greece in 2015. It was an issue last year but then pro-Euro parties and candidates won in various elections. This year it’s been an issue with Italy particularly, as its populist government sought a wider budget deficit, and Germany with Angela Merkel indicating she will step down as Chancellor in 2021. In terms of Italy, there will no doubt be a conflict between the European Commission and Italy over the size of its planned budget deficit but don’t expect it to go too far as the deficit is not outlandish and German and France won’t want to embolden the Eurosceptics in Italy by pushing back too hard.

In terms of Germany, the poor performances of the governing German grand coalition parties the Christian Democratic Union (CDU), the Christian Social Union and the Social Democrat Party (SPD) at state elections do not signal a threat to the Euro. First, comments by SPD leader Nahles indicate the grand coalition is not under imminent threat. Second, Germany’s budget surplus and falling public debt indicate plenty of scope to provide fiscal stimulus, which would be positive for Germany and the Eurozone and provide an electoral boost for the grand coalition partners. Thirdly, German Euroscepticism is not on the rise. In fact, support for the Euro in Germany has risen to 83% and it was support for the pro-Euro Greens that surprised in Bavaria and Hesse, not support for the Alternative for Deutschland. Finally, a new election is unlikely as both the CDU and SPD have seen a loss of support, so they aren’t going to back an early election. So those looking for a breakup of the Euro can keep looking.

Oil prices – back down again

In early October world oil prices reached their highest since 2014 with West Texas Intermediate topping $US76/barrel with talk it was on its way to $US100 on the back of strong demand and supply threats including impending US sanctions on Iran. This in turn was adding to concerns about the impact on global economic growth and rising inflation. However, since then the oil price has fallen by nearly 19%. US sanctions on Iran have started but with little new impact as Iranian oil exports had already fallen and the US granted waivers to allow eight countries – including Japan, China, India, Taiwan and South Korea – to continuing importing Iranian oil. The Iranian export cutbacks at a time of threats to production from Venezuela and Libya leaves a now-tight global oil market at risk of higher prices, but for now the threat has receded a bit.

SOURCE: https://www.ampcapital.com/au/en/insights-hub/articles/2018/November/Rising-US-interest-rates-trade-wards-the-US-midterm-election-results-etc-should-investors-be-worried

Introduction

Some commentators claim shares are way overvalued and so a crash is inevitable. As always, it’s a lot more complicated, but given the current turbulence in share markets it’s worth having a look at whether share markets are expensive or not as a guide to how vulnerable we are to further falls. More broadly, valuation measures provide a guide to future return potential.

Why valuation matters – the cheaper the better

First a bit of background on valuation. A valuation measure for an asset is basically a guide to whether it’s expensive or cheap compared to the income it generates. Simple valuation measures are price to earnings ratios (PEs) for shares (the lower the better) and yields, ie the ratio of dividends, rents or interest payments to the value of the asset (the higher the better). An obvious example of where the starting point valuation matters critically is cash. For some years now, bank term deposit rates have been historically low meaning returns are low and value is poor.

For government bonds the yield is similarly a good guide to value. Over the medium term the main driver of the return a bond investor will get is what bond yields were when they invested. While the relationship is not perfect, it can be seen in the next chart – which shows a scatter plot of Australian 10-year bond yields (horizontal axis) against subsequent 10-year returns from Australian bonds based on the Composite All Maturities Bond index (vertical axis) – that the higher the bond yield, the higher the subsequent 10-year return from bonds.

Again, despite rising a bit in the last two years, bond yields remain low so low returns should be expected from bonds.

For shares a similar relationship holds. The following chart shows a scatter plot of the PE ratio for US shares since 1900 (horizontal axis) against subsequent 10-year total returns (ie dividends and capital growth) from shares. While it is not as smooth as with bonds as there is more involved in shares, it indicates a negative relationship, ie when share prices are relatively high compared to earnings subsequent returns tend to be relatively low.

The next chart shows the same for Australian shares. Again, there is the expected negative relationship between the level of the PE and subsequent total returns (based on the All Ords Accumulation index).

The key is that the starting point valuation matters. The higher the yield (or the lower the PE) the better.

Complications to be aware of

Of course, there are several pitfalls with valuation measures that investors should be aware of:

• Sometimes assets are cheap for a reason (value traps). This is more often associated with individual shares, eg, a tobacco company subject to an impending law suit. These traps can really only be picked up by thorough research.
• Valuation measures are a poor guide to timing. Eg, if an investor sold shares short in 1996 when Fed Chair Greenspan warned of “irrational exuberance” they would have lost out as shares rose for another four years. Australian residential property has been overvalued for almost 15 years but that’s been no guide to timing a fall in home prices. The key is to have a thorough investment process that depends on more than just valuations.
• There is a huge range of share market valuation measures. For example, the “earnings” in the PE calculation can be earnings reported over the last 12 months, consensus earnings expectations for the year ahead or earnings that have been smoothed to remove cyclical distortions. All have their pros and cons. For example, the historic PE is based on actual data with no forecasting, but it can give the wrong signal during a recession as earnings may collapse more than share prices and so the PE may not give a buy signal.
• Finally, the appropriate level of valuation can vary depending on the environment. For example, in a period of low inflation and low interest rates it’s well-known that assets can trade on lower yields as the interest rate/yield structure in the economy falls. This in turn means higher PEs. So low inflation, say down to around 2%, can be good for shares via higher PEs. But if inflation goes from “low” to deflation it can be bad as it tends to be associated with poor growth and so shares trade on lower PEs.

The message from all this is that share market valuation is important, but you ideally need to assess it along with other indicators if you are trying to time market moves. The key is to acknowledge that when a range of valuations measures are at an extreme then they are probably providing a signal that should not be ignored.

So what are current share market valuations signalling?

Let’s start with price to earnings ratios using historic earnings, ie, earnings reported for the last 12 months. In the US, this PE is currently around 21 times which is consistent with subdued medium-term returns going by the second scatter plot on the previous page. But in Australia at around 15.3 times it’s consistent with reasonable medium term returns according to the third scatter plot on the previous page. Of course, current levels for historic PEs in the US and Australia have both been associated with a very wide range in terms of subsequent returns historically. Furthermore, PEs based on historic earnings are not totally reliable given the cyclical volatility in reported earnings.

Given this, calculating the price to earnings ratio using 12 month ahead projected earnings are arguably more useful. These are shown in the next chart for global shares, the US and Australia. None are way out of line with their averages since the early 1990s but in a relative sense US shares on a forward PE of 16.1 times remain a bit expensive albeit less so than earlier this year, and global shares are a bit cheap trading on a forward PE of 14.2 times thanks to cheap markets outside the US.

In emerging countries, the average forward PE is quite low at around 10 times.

The next chart looks at price to earnings ratios calculated using a 10-year moving average of earnings, which is often referred to as the Shiller PE (after economist Robert Shiller) or the cyclically adjusted PE. On this measure US shares are clearly more expensive than since the tech boom. However, markets outside the US, including Europe and Australia, are not expensive at all. It should also be allowed that the 10-year moving average earnings calculation is distorted by the earnings slump a decade ago. As the 2008 and 2009 earnings slump starts to fall out of the calculation, the US Shiller PE will start to fall. But still there is better value elsewhere.

Finally, it’s worth looking at share market valuations that allow for the fact we are still in an environment of relatively low interest rates and bond yields. The next chart subtracts the 10-year bond yield for the US and Australia from their earnings yield (using forward earnings). This basically gives a sort of a proxy for the equity risk premium – the higher the better. While this gap is well down from its post GFC highs, it’s still reasonable, suggesting shares are still more attractive than bonds. Of course, this will change as bond yields drift higher, but as we have seen over the last two years since bond yields bottomed, this is likely to remain a relatively slow process.

The overall impression is that measured against their own history developed country share markets are not dirt cheap, but they haven’t been for several years now and they are not at overvalued extremes. The main risk relates to the US share market, but other markets’ valuations are reasonable. So while the pull back in shares we have seen over the last few weeks could go further yet – as worries around the US interest rates, US/China trade, rising oil prices, problems in the emerging world, President Trump and the US mid-term elections and the Italian budget remain – at least most share markets are not trading at overvalued extremes which would potentially accentuate downside risks.

SOURCE: https://www.ampcapital.com/au/en/insights-hub/articles/2018/October/Are-shares-expensive

Introduction

Every so often shares go through rough patches. We saw this most recently around February on the back of US inflation and interest rate concerns and the start of US tariffs which saw US shares and global shares fall roughly 10% and Australian shares fall 6%. Shares mostly recovered – even getting through the seasonally weak months of August and September surprisingly well – with US shares making new records and Australian shares hitting a ten-year high, but the worry list has returned again with US, global shares and Australian shares now down around 7% from their recent high. This note looks at the issues for investors and puts the falls into context.

What’s driving the latest plunge?

The recent plunge reflects a range of factors.

• Investors have started to worry again that the very strong US economy will push the Fed into tightening a lot more and that this will cause a further sharp rise in bond yields which will threaten growth and share market valuations.
• The trade conflict between the US and China is continuing to intensify and spilling over into other areas.
• Technology shares, which have been key drivers of the US share markets rally (and outperformance) have been vulnerable – being somewhat overvalued and facing increased regulation in the US (which is something that President Trump has been threatening).
• Rising oil prices due to strong global demand and threats to supply have added to concerns about inflation and growth.
• Problems in the emerging world partly due to rising US interest rates poses a threat to global growth as reflected in a recent downgrade to the IMF’s global growth forecasts.
• Nervousness remains in the US around President Trump and the Mueller inquiry and the upcoming US mid-term Congressional elections.
• Tensions in the Eurozone regarding the Italian budget are weighing on European shares.
• October is also known for share market volatility and this October is the 31st anniversary of the 1987 crash which often seems to create a bit of apprehension.

Because shares have fallen rapidly they are technically oversold and so could have a short-term bounce. But given that many of these issues could get worse before they get better the risk is that the pullback has further to go.

Considerations for investors

Sharp market falls with headlines screaming that billions of dollars have been wiped off the share market (funny that you never see the same headlines on the way up!) are stressful for investors as no one likes to see the value of their investments decline. However, several things are worth bearing in mind:
First, periodic corrections in share markets of the order of 5-15% are healthy and normal. For example, during the tech/dot. com boom from 1995 to early 2000, the US share market had seven pull backs greater than 5% ranging from 6% up to 19% with an average decline of 10%. During the same period, the Australian share market had eight pullbacks ranging from 5% to 16% with an average fall of 8%. All against a backdrop of strong returns every year. During the 2003 to 2007 bull market, the Australian share market had five 5% plus corrections ranging from 7% to 12%, again with strong positive returns every year. More recently, the Australian share market had a 10% pullback in 2012, an 11% fall in 2013 (the taper tantrum), an 8% fall in 2014, a 20% fall between April 2015 and February 2016 and a 7% fall earlier this year all in the context of a gradual rising trend. And it has been similar for global shares, but against a strongly rising trend. See the next chart. While they can be painful, share market corrections are healthy because they help limit a build-up in complacency and excessive risk taking.

Related to this, shares climb a wall of worry over many years with numerous events dragging them down periodically, but with the long-term trend ultimately up & providing higher returns than other more stable assets. Bouts of volatility are the price we pay for the higher longer-term returns from shares.

Second, the main driver of whether we see a correction (a fall 5% to 15%) or even a mild bear market (with say a 20% decline that turns around relatively quickly like we saw in 2015-2016) as opposed to a major bear market (like that seen in the global financial crisis (GFC)) is whether we see a recession or not – notably in the US. The next table shows US share market falls greater than 10% since the 1970s. I know it’s a bit heavy – but I like this table! The first column shows the period of the fall, the second shows the decline in months, the third shows the percentage decline from top to bottom, the fourth shows whether the decline was associated with a recession or not, the fifth shows the gains in the share market one year after the low and the final column shows the decline in the calendar year associated with the share market fall. Falls associated with recessions are highlighted in red. Averages are shown for the whole period and for falls associated with recession at the bottom of the table.

Several points stand out. First, share market falls associated with recession tend to be longer and deeper. Second, falls associated with recessions are more likely to be associated with negative total returns (ie capital growth plus dividends) in the associated calendar year as a whole. Finally, as would be expected the share market rebound in the year after the low is much greater following falls associated with recession.

So whether a recession is imminent or not in the US is critically important in terms of whether we will see a major bear market or not. In fact, the same applies to Australian shares. Our assessment remains that US/global recession is not imminent:

• Still high levels of business and consumer confidence globally are only just starting to help drive stronger consumer spending and business investment.
• While US monetary conditions have tightened they are far from tight and they are still very easy globally and in Australia (with monetary tightening still a fair way off in Europe, Japan and Australia). We are a long way from the sort of monetary tightening that leads into recession.
• Fiscal stimulus will boost US growth into next year, partly offsetting Fed rate hikes.
• We have not seen the excesses – in terms of debt growth, overinvestment, capacity constraints and inflation – that normally precede recessions in the US, globally or Australia.

Reflecting this, global earnings growth is likely to remain reasonable providing underlying support for shares. So, for all these reasons its likely that the current pull back is more likely to be a correction rather than a major bear market.

Third, selling shares or switching to a more conservative investment strategy or superannuation option after a major fall just locks in a loss. With all the talk of billions being wiped off the share market, it may be tempting to sell. But this just turns a paper loss into a real loss with no hope of recovering.

Fourth, when shares and growth assets fall they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities the pullback provides. It’s impossible to time the bottom but one way to do it is to average in over time.

Fifth, while shares may have fallen, dividends from the market haven’t. So the income flow you are receiving from a well-diversified portfolio of shares remains attractive, particularly against bank deposits.

Sixth, shares and other related assets often bottom at the point of maximum bearishness, ie just when you and everyone else feel most negative towards them. So the trick is to buck the crowd. “Be fearful when others are greedy. Be greedy when others are fearful,” as Warren Buffett has said.

Finally, turn down the noise. At times like this, negative news reaches fever pitch. Talk of billions wiped off share markets and warnings of disaster help sell copy and generate clicks and views. But such headlines are often just a distortion. We are never told of the billions that market rebounds and the rising long-term trend in share prices adds to the share market. Moreover, they provide no perspective and only add to the sense of panic. All of this makes it harder to stick to an appropriate long-term strategy let alone see the opportunities that are thrown up. So best to turn down the noise and chill out – yeah, I agree it’s sometimes easier said than done, but still!

SOURCE: https://www.ampcapital.com/au/en/insights-hub/articles/2018/October/the-pullback-in-shares-seven-things-investors-need-to-keep-in-mind