Will The Rally In Cheap Markets Continue?

 
Stock markets around the world have appreciated significantly from their late March lows but the rebound has not been even. Since the lows, US equity markets have rebounded more than most developed market countries during Q2 2020, but continue to trade at much higher valuations that other markets.

Current Global Stock Market Valuations
 
 US Markets[1]Non-US Markets[2]Emerging Markets[3]
Price/Earnings23.4918.9413.28
Price/Book2.991.391.34
Price/Sales2.171.071.08
Price/Cash Flow11.766.234.82
 
Source: Morningstar
[1] SPDR S& P500 ETF Fund (SPY) as of July 10th, 2020
[2] iShares EAFA Index Fund (EFA) as of July 7th, 2020
[3] Vanguard FTSE Emerging Market ETF (VWO) as of May 31st, 2020

This is important because there is a strong long-term correlation between current equity valuations and future expected returns.
 
Correlation of CAPE Ratio with S&P 500 Index Real Return

 
Source: Research Affiliates, LLC, based on data from the Robert Shiller database. 1881 – October 2017
 
CAPE: Also known as the Shiller P/E, the Cyclically Adjusted Price to Earnings Ratio (CAPE) is a measure of price divided by an average of 10-year earnings, all adjusted for inflation. The objective of the CAPE is to provide a measure of price to earnings that is independent of short-term fluctuations in the business cycle.
 
During a recent interview with one of the Co-Founders and Managing Partners of our sister firm MASECO Private Wealth in London, Nobel Laureate Robert Shiller reiterated how non-US markets appear to be inexpensive with higher expected returns. Click here for the full interview. 
 
On a relative basis, non-US markets are also trading at inexpensive valuations compared to their own historical valuations. Emerging Market equities are cheaper than 88% of history and non-US Developed Market equities are cheaper than 77% of history while the US is only cheaper than 5% of history.[4]  
Current and Historical Market Valuations.[5] 
 
 
Source: Research Affiliates, June 30th 2020

As you might recall from our recent article on valuations released in April, the long term valuation differences between regions has led to our relative overweight of Emerging Markets versus US stocks. This decision has started to pay off for investors and recently Emerging Market equities have outperformed US equities. In the past month, Emerging Market equities have outperformed the US and non-US Developed Market equities by circa 10% respectively.

Emerging Markets Outperformed US and Non-US Developed Markets in the Past Month [6] 
 
 
Source: Morningstar, June 8th to July 8th 2020

To summarize, investors need to decide where to take risk in their pursuit of returns. In equities, we currently favour International and Emerging Markets over the US because of their inexpensive valuations in both absolute and relative terms and because there is a high correlation between current valuations and future expected returns.
 
 
 

[4] Based on CAPE valuation as of May 31st, 2020 source: Research Affiliates
 
[5]
 
[6] SPDR S&P 500 ETF Fund (SPY), iShares EAFA Index Fund (EFA) & Vanguard FTSE Emerging Market ETF (VWO)
 
 
 
Accessing Your Accounts

If you wish to find out the current value of your investment portfolio, you can do so the following ways:
  • log on to the client portal provided by your platform provider; or
  • contact your Wealth Manager.

Main Street vs. Wall Street

Main Street and Wall Street seem to have decoupled in the last few weeks. It appears that investors are ignoring any future negative financial impact of the COVID-19 pandemic. They seem to expect global economies and corporate profits to return  to lastear’s level (V-shaped recovery) and that a vaccine will be found before a new wave of infection hits. However, most of the recent economic data released paints a different picture , for example, unemployment is still at very high levels.

Risky assets had a rapid recovery
Returns of global equities and investment grade bonds are now positive for the first time since the start of March 2020 and high yield and emerging market debt have recovered much of their losses.

Source: Morningstar, own calculations, data as at 22nd June 2020

From a behavioral angle, hope and greed have overcome fear. The most commonly quoted fear gauge, the VIX, has receded significantly from its March high:

Source: Yahoo.com, data as at 22 June 2020

Many people still suffer
Many people have lost their jobs over the course of the pandemic and its rapid spread across the world. In the US, unemployment has increased to record levels:

Source: US Bureau Labor of Statistics, data as at 01 May 2020

Some leading US economic indicators like The Purchasing Managers’ Index (PMI) have bounced back from recent lows, but a turn in US corporate profits has not yet been reported:

Source: U.S. Bureau of Economic Analysis, National income: Corporate profits before tax (without IVA and CCAdj), retrieved from Federal Reserve Bank of St. Louis, data as at 01 January 2020

For 2020 the Fed projects that US real GDP will shrink by 7.6% to -5.5%. Two months ago, the IMF urged governments tto provide further economic stimulus to avoid a steeper recession; both the European and US governments are in discussions to do just that.

Wall of Money
In March, the Fed went beyond decreasing interest rates and started buying assets on an unprecedented scale and scope. The Fed has continued to take significant actions. Only this month it announced that it is expanding its asset purchase program from buying exchange-traded funds of investment-grade bonds to purchasing individual bonds. Consequently, the below chart shows that its balance sheet has almost doubled to over $7tn.

Source: Federal Reserve Bank of St. Louis, data as at 17 June 2020

Equally remarkable, growth in U.S. M2, a broad measure of money supply, has been its strongest since the Federal Reserve’s records began in 1960. Such huge liquidity is trying to find good investments, and part of it supported the recent stock market rallies.

Source: Federal Reserve Bank of St. Louis, data as at 01 May 2020

Mr. Market: An expert in assessing the future
Mr. Market was introduced by Benjamin Graham in his book “The Intelligent Investor” published in 1949. Graham is often referred to as the “father of value investing” and was the teacher of Warren Buffet at Columbia University.

Mr. Market is always a step ahead of the economy, as he prices in future economic developments. Therefore, he reacts positively to news on government stimulus, low interest rates and other central bank actions, as well as progress on developing a vaccine against the COVID-19 virus, because all of these are positive for economies and future corporate profits. Therefore, it is fair to expect economic developments to become positive in the not too distant future. The big questions such as “when?” and “by how much?” may have different answers from what Mr. Market currently prices in, as Mr. Market cannot assess known unknowns. , equally, nor can anyone else. Mr. Market is also influenced by broad investor opinion and sentiment, as well as excess liquidity.

However, doubting whether Mr. Market is right and betting against him takes exceptional skill and expertise to successfully assess vast amounts of data. Many famous investment voices from Graham to Buffet, Bogle to Fama advise investors against trying to time the market, just as we advised our clients only three months ago not to give in to fear and sell equities. We now caution them not to follow feelings of “missing out” and buy into the recent rally, proactively increasing equity exposure. Instead, following Mr. Market within your current strategy should be the better approach, versus hoping to be lucky. This article is authored by Helge Kostka,
Chief Investment Officer of MASECO Private Wealth, and Investment Committee member for MASECO Asia.

The Government Shutdown: There’s more at stake than just a wall

When the President of the United States opted not to sign into law a bipartisan bill to fund several government agencies (a bill which was overwhelmingly supported in both the House of Representatives and the Senate), the US Government entered a partial shutdown at midnight on the 22nd of December.    A government shutdown isn’t a unique event anymore.  Shutdowns go all the way back to President Carter, and the only period in which there wasn’t a shutdown was during the George W Bush Administration. Now in its third week, the current shutdown is the longest in US history.

What is the real impact of a shutdown from an economic perspective?

Let’s start with the actual employees that are impacted by the shutdown. The current shutdown impacts roughly 800,000 federal employees comprised of nine federal departments:

  1. Department of Treasury
  2. Department of Agriculture
  3. Homeland Security Department
  4. Department of the Interior
  5. Department of State
  6. Department of Housing and Urban Development
  7. Department of Transportation
  8. Department of Commerce
  9. Department of Justice

Many of these employees, such as the Transportation Security Administration, will have to work without pay. These are the individuals that help protect the US and travellers to the US at airports around the country.  So how does this impact them?  According to Northwestern Mutual’s 2017 Planning and Progress Study[1], roughly 70% of US workers  live pay check-to-pay check.  This statistic inevitably includes a (significant) portion of the TSA workers.  Credit card bills, mortgages, utilities, rents, etc. are likely to become delinquent due to the cash flow constraints of these workers.  And these are just some of the knock-on effects.  In some states, the federal government is the major employer.  In cases such, there is a further erosion of the supporting community, such as restaurants, shops and banks, as patronage will be lower due to the federal workers having limited resources to put back into local commerce.

There are also more macro-related issues surrounding shutdowns. In the US, for instance, interest rates have been rising due primarily to the strong economy and the increasing level of inflation.  This has already made borrowing money more expensive with regard to mortgage repayments (those that have a variability aspect to them), consumer debt, auto leasing, etc.  The shutdown exacerbates the situation by making the economy more unstable.  The US hasn’t been in a recession since June 2009, which marked the end of the Great Recession or better known as the Global Financial Crisis.  Shocks to the economic system such as a government shutdown could be a catalyst for propelling the US into a correction or recession. We saw some of these fears play out in the US stock market in late December/early January.

Credit concerns are another aspect to the government shutdown. According to Standard & Poor’s, the US credit rating stands at AA+.  Both Moody’s and Fitch have the US at Aaa and AAA respectively.  A protracted shutdown could lead to a downgrade of that rating.  If that happens, interest rates will rise, bond debt will worsen, and the dollar could potentially see a real weakening against the global market basket of currencies.  This would result in a higher cost for imports.

Investing globally will help soften the blow of any negative impacts from the government shutdown. But, as the old adage goes “When General Motors sneezes, the stock market catches a cold.”  Now simply replace General Motors with the United States and the stock market with the global economy, and you have a recipe that isn’t very appealing.

[1] https://news.northwesternmutual.com/planning-and-progress-2017

What’s Going on in Emerging Markets?

After 2017, a year in which emerging markets gained more than 35%, investors are very concerned about the performance in 2018. Year-to-date, emerging markets are down nearly 8%.  If valuations in the space are at multi-decade lows, what can explain this seeming discrepancy?  It turns out there are several factors contributing to weak performance so far this year.  First, although it is easy to assume it has little effect, the US dollar has strengthened significantly in 2018.  In local EM currency terms, the dollar has rallied nearly 10% in some instances (compared to 4% in dollar terms)[1].  Some of these countries (e.g., Turkey, Argentina, and others) are actually seeing bear market territory for their securities in US dollar terms.  Emerging markets tend to underperform historically when the US dollar gains strength.

The next factor is the move towards protectionist policies on an international scale, and in particular, by the US. Further exacerbating the situation, Trump, has instituted a non-systematic trade war with multiple countries, some of which are emerging market economies.  As an example, Trump has targeted Turkey which is a key EM economy and is intricately connected to many other emerging market economies in the vicinity.  The threat of tariffs has had a detrimental impact on EM economies that sell to the US (i.e., EM exports will decrease causing an increase in unemployment in these countries).

A third factor is the rebound in commodities, particularly oil. If you look at current oil prices (Brent, WTI) compared to last year over the same time, oil has moved nearly 50% higher.  This has a more negative impact on emerging markets because it makes manufacturing costs higher.

Although the above points paint a not-so-rosy outlook on emerging markets as an asset class, many emerging market economies have improved their current account deficits and strengthened their overall financial position. It is also important to view EM in a worldwide context.  From a CAPE (cyclically adjusted price earnings) perspective, emerging market countries are poised to outpace the rest of the world over the next 10 to 15 years.  The United States has had its longest bull market in history, and prices haven’t yet receded.  The last recession in the US ended in June 2009.  This means the US is on its nearly 37th quarter (111th month) without a recession.  With the average economic cycle lasting between 5 – 7 years, the US is poised not only for a recession, but its equity market has and continues to be highly, if not, fully valued with a CAPE near 40%.

From a long-term investment view, attempting to call the top of the US market (or the low of emerging markets, for that matter) is a fool’s errand, likely amounting to nothing more than a blip over the long haul. As history and academia teach us, it’s very important to never attempt to time markets; it is a losing proposition. Where we are in the current business cycle is no different.  Emerging markets remain an important part of a global asset allocation strategy, but investors must expect higher than average volatility in this asset class since it is less stable than other developed markets.

[1] http://www.morningstar.co.uk/uk/news/170562/2018-a-very-tough-year-for-emerging-markets.aspx/

 

What is the Reconstitution Effect and How Does it Impact my Portfolio?

Exchange Traded Funds or ETFs, came into existence in the early 1990’s. They have grown tremendously in popularity by institutional and retail investors alike. As a refresher, ETFs are marketable securities that typically track an index, a commodity, bonds or a basket of assets. One of the major differences between mutual funds and ETFs is that the latter trades like a stock, meaning you can use limit orders, use margins, short positions, and trade throughout the trading session. In addition, like stocks, one of the most likable characteristics of an ETF is that it’s usually very inexpensive. ETFs offer a diverse range of options for investors seeking investments with low fees. From the days of Benjamin Graham to the present, value investors have always touted investments that are broad-based and low cost; ETFs fit the bill.  However, the benefits of ETFs do not come without trade-offs. In order to replicate the index, an ETF fund manager must sacrifice trading flexibility.

Why do we care about falling prices?

Why should we care that prices are falling?  Isn’t it better for consumers to pay less for goods?  The prospect of deflation is so scary to economists and central banks alike, that it is causing the latter to pour trillions of dollars into their respective economies to prevent these drops in prices.  Just recently, the European Central Bank (ECB) pledged to buy government bonds as part of yet another quantitative easing to the tune of €1.1 trillion.  Many consumers do not understand the concept.  This is why everyone is concerned: