Look Out Above!: Equity Markets Will Continue To Grow In 2013
Since the "Great Recession" the Fed has committed itself to an extremely aggressive monetary policy. The Fed's policy -- to keep interest rates low in order to spur capital flows into riskier assets -- has thus far been successful. This past Friday (Feb 1) the Dow Jones reached 14,000 for the first time since 2007. Considering this return to historic highs, we should look both backwards and forwards to examine the long term prospects of the equity markets, and see what lies ahead for investors. Interestingly, the Fed’s policies have remained consistent over the past year -- 10 year treasuries have held steady at about 2%. If so, we need to examine why the continued low interest rate environment should continue to push equity markets higher.
What Has Changed: The Macro Landscape
As I see it, last year equity markets grappled with three major macro issues, since solved, that kept full investor enthusiasm at bay.
1. European Debt Crisis
2. USA political and economic issues
3. China’s economic downturn -- soft or hard landing
European Debt Crisis
Last year, Europe basically teetered on the brink of total collapse. Greece restructured its debts, Portugal, Ireland, Spain and Italy looked like basket cases, and the stronger powers in the EU didn’t seem to have to appetite to help out their weaker brethren. However, two significant events changed the course Europe set for itself last year. Firstly, the ECB began their Outright Monetary Transaction (OMT) program where they committed to buy sovereign debt of troubled nations, thereby driving down borrowing costs. Nations wanting to participate in this program need to ask the ECB for help, and agree to ECB austerity guidelines. Granted, no country has availed itself of this mechanism, but the mere promise of help has tamed the bond vigilantes, and kept the borrowing costs of troubled nations at more reasonable rates.
Second, the ECB has opened up the possibility of lowering their deposit rate below 0%, i.e. they will charge banks to park their money at the ECB. This will obviously encourage banks to lend out money to borrowers, and thereby stimulate the economy. Though the ECB has not taken this dramatic step, and they will still have to grapple with the technical issues of going into negative rates, they have left the door open to undertaking this option.
The upshot of these moves, along with statements made by Mario Draghi, has been a reassured global market not worried about a full or partial breakup of the EU and the possible significant collateral damages on the global economy. These actions have comforted investors worldwide, and put them at ease to continue to invest in riskier assets, such as equities.
Last year, investors felt uneasy about the uncertainty surrounding the US elections, and the attending economic issues. Simply put, the US has a $16tn national debt, and legislative and executive branches that cannot seem to agree on anything. A lot of this stonewalling on the Republican side has been an outgrowth of their desire to paint Barack Obama as an incompetent leader, unable to tackle the major fiscal issues of the day. With the Republicans humbling defeat in November, and the mandate that they received from the American people they seem more willing to negotiate on the major fiscal issues of the day. Witness the fiscal cliff debate, Republicans backed away from their “no tax increase pledge”, and have given into the White House on that front. Additionally, Republicans and Democrats have come together on major domestic issues such as immigration and gun control -- a cautiously optimistic spirit has descended upon Washington. With these developments in hand, investors can have hope that Washington can get its fiscal house in order, and take the necessary decisions to reduce long term debt. These extremely important developments of the last three months -- the settling of political uncertainty -- will prove extremely positive for world markets, and give investors the confidence to invest in the equity markets.
China’s GDP has shrunk every quarter since Q2 2010.
This troubling trend caused many to fear that China will not sustain its long term growth, and will make a “hard landing” -- a continued drop in GDP growth. This belief has been driven by the fact that China’s labor market has gotten too expensive, and will destroy China’s export driven economy. Furthermore, the argument goes, China does not have the domestic demand to grow its economy on the back of internal consumption. However, recent figures have debunked this claim both from an export competitiveness perspective and an internal consumption perspective.
From an export competitiveness perspective, China still has a $150bn trade surplus, or 2.5% of GDP. While their exporting power will weaken over time, as everyone expects, they still have the strongest manufacturing infrastructure in the world, and will maintain their global position in this realm for the foreseeable future. From an internal consumption basis, China’s retail sales grew 14.2% in the most recent quarter (significantly higher than expected), and the MNI China Business Sentiment rose from 51.35 to 51.52. These two factors both strongly contributed to China’s reversing their string of declining quarter over quarter GDP growth in the most recent quarter (see chart above).
China does have lingering problems in smoothing the transition from a primarily export driven economy to a more internally driven one, but we see from the latest numbers leadership seems to have a handle on the situation. We should also note that China had their once a decade leadership change late last year, and this fresh perspective has further given investors confidence that China will ably make sensible economic decisions during this transition period.
Europe (25%), the USA (25%), and China (10%) collectively make up around 60% of the global economy. In order for investors to have confidence to shift into riskier assets, it is essential to ensure the continued stability of these major economies. Finally, we should note, the world’s fourth largest economy, Japan, which has been in an economic downturn for the past 15 years, recently adopted a more accommodating monetary policy that should move capital flows into riskier assets. This “cherry on top” will provide a further catalyst for strong worldwide equity growth.
The US Specific Landscape
Using historical and relative metrics we come must come to one conclusion -- US equities are cheap. On a historical basis, in the late 90’s, right before the internet bubble, US equities traded at 40-50x P/E, in 2007, right before the subprime bubble US equities traded at 16x P/E. Currently, US equities trade at 14x P/E. On a relative basis, junk bonds currently yield 6%, and the 10 year treasury could yield negative real rates depending on inflation. These factors drove investors into equities in the past year, and will continue to do so in the upcoming year.
On top of all this, whereas in 2007 the US economy began suffering from the first effects of the subprime mortgage crisis, and a precipitous drop in auto sales, today we have the exact opposite situation. The Case Schiller home price index has steadily increased over the past year, and auto sales have begun to pick up in a major way. Lastly, corporations have dramatically cut down on leverage, and have extremely strong cash positions that they can put to work. Taken altogether -- the historical and relative “cheapness”, and the positive macro headwinds, US equities should see an extremely positive move higher
How To Play This
Investors wanting to play this theory could simply buy an S&P Index fund -- take your pick. Those seeking a more aggressive approach could buy a levered index fund, and increasing the leverage depending on your level of conviction.
However, some might remain skeptical over the arguments I made above, because of the underlying weakness in the US economy. Last quarter the US economy contracted by -0.1%, the first contraction in a long time. The economy probably won’t grow much faster than 2.5% this year, a long ways away from the 3.5-4% growth the economy needs to really take off. Additionally, the Fed's loose monetary policy leaves us with significant inflation risks. Therefore, in addition to the above, I would recommend the following hedges. First, as I argued above, I don’t think investors will flock to bonds or cash in the event of a continued downturn. However, TIPS and gold could both offer investors very nice protection in the event of a continued downdraft in the US economy. TIPS, especially, with the potential for capital appreciation and yield could serve investors nicely in hedging their overall portfolio.
Lastly, the threat of a nuclear Iran still casts a shadow on geopolitics. More to the point, a total lockdown of Iranian oil flows, and/or the halting of transports along the Straits of Hormuz remain a primary worry of investors. Though I think ultimately the world can pick up the slack in the event of an Iranian conflict, we must take this issue into consideration.