Markets, especially in the US, still look robust. However, investors suspect a turning point is on the way and are beginning to rethink their strategy.
US equities defied logic in August by climbing 3 per cent, despite the rise in the federal funds rate. The S&P 500 index has now risen by 230 per cent since 2009 – the longest bull run in history – and has a price/earnings ratio more than 50 per cent higher than its historic average.
Some of the speed bumps that preoccupied investors earlier in the year appeared to have been circumvented. Rising inflation was widely seen as a threat to economic prosperity, but it is edging along benignly; corporate earnings have held up surprisingly well and international trade wars have had a muted impact so far.
Credit Suisse equity strategist Jonathan Golub has forecast that the S&P 500 will reach 3350 in 2019, implying that there is more than 15 per cent to come. He argues that the economy is solid, earnings per share are still growing strongly, and investors are underestimating the market’s potential upside and over-estimating its risks.
However markets have certainly become more volatile and investors are nervous. There was much talk of a correction when traders returned to their desks after the summer break, and many have been offloading tech stocks and replacing them with utilities and other defensive plays, noticing that the market’s gains have largely been driven by a few technology companies, notably the FAANGs (Facebook, Amazon, Apple, Netflix and Google). Without these, the S&P 500 would have been in negative territory in the first half of the year.
Moreover, global trade negotiations are up in the air. Mysteriously, trade fears have spurred selling across Asia and Europe, but the US has remained relatively unaffected, creating potential for an asymmetrical shock.
Few doubt that the US bull run has been driven by the extremely low interest rates maintained by the US Federal Reserve for the past decade. Rates did not rise above 1 per cent until 2017, and the Fed has promised a parade of slow and steady hikes to try to exert control over the market. The Fed’s Open Market Committee has projected that the federal funds rate will climb to 3.1 per cent by the end of 2019 and to 3.4 per cent by the end of 2020.
However, the CME’s futures market – normally a better predictor of where rates are going – suggests the federal funds rate will be much lower, at about 2.6 per cent at the end of 2019. This means the market is concerned that central banks will hike rates too far, too fast over the next year, choking off economic growth.
The tightening in US rates for the first time in a decade could prove a turning point as investors reconsider the style of stocks they go for. Since 2008 growth stocks have off offered better returns than value stocks, with the meteoric rise of the FAANGs demonstrating just how eagerly investors have seized on any earnings growth.
However, anyone waiting for the cycle to turn cleanly back to value stocks is going to be disappointed. Stocks that represent good value have become difficult to find as the market as a whole has climbed higher. Reliable dividends have been easy to locate, but that is not the same thing, and against the backdrop of low interest rates, high-yielding stocks have become expensive.
Right now, the investment world is a topsy-turvy place. Equities are hugely volatile on a day-to-day basis, yet gold and other precious metals that have traditionally been considered a store of value have scarcely responded. Gilts and Treasuries have climbed in recent months – but at the same time, so have commodity prices, which normally rise in line with improving economic activity. US trade data is beginning to weaken, but it is being ignored as everyone looks to the fiscal stimulus still expected from the Trump tax cuts. Other stock-specific factors will also exert greater influence in the months ahead, such as ESG factors, reputational risk and how companies are positioned for the next technological revolution.
Meanwhile, the clear beacon of opportunity is emerging markets – in particular countries traditionally considered weak, such as Indonesia, India, South Africa and Brazil. These have been sold down as Turkey and China weigh on investors’ minds, but are now far less fragile than in the past, following the implementation of remedial monetary policy and reforms. These markets currently trade at a 27 per cent discount to developed markets, a larger discount than the 10-year average of around 20 per cent.
The impact has been felt on funds such as Aberdeen Asian Smaller Companies Investment Trust, which allocates around 14 per cent to each of Thailand, India, Malaysia and Hong Kong and has tumbled 3 per cent over three months.
Those with greater allocations to China have fared even worse. Templeton Emerging Market Trust, for example, with 20 per cent in China, is down 8 per cent over the past six months. Our portfolio is already well stocked with similar holdings, but there’s still a window for anyone with a US- or UK-centric portfolio looking to diversify into these markets with their strong potential to bounce back in the mid-term.