Newton’s Iain Stewart: Market enthusiasm has its bounds
The US economy and profits need to pick up soon if the enthusiasm built into share price valuations is to be validated, warns Iain Stewart, manager of the Newton Real Return Fund.
US policy continues to set the tone for financial markets globally. Consensus expectations for the economy are overwhelmingly bullish; expectations for equities are, if anything, even more bullish as, despite the tapering of the current QE programme, the monetary authorities continue to provide a ‘put’ in the form of more stimulus, should the economy falter.
Given the increased linkages between the financial markets and the real economy, the steps taken by the Fed – most notably QE – are seen as putting a floor under asset prices.
In defence of US central bankers, there does seem to be a definable change in the new Yellen-run Fed with regard to the destabilising effects that their policies might be having on the financial system. This is likely to be contributing to their desire to continue ‘tapering’ their asset-purchase programme.
That said, the economic orthodoxy that drives Fed thinking spends little or no time worrying about the unintended consequences of unconventional policy – despite the fact that financial stability is included in US policymakers’ mandate.
Fed officials believe the key problem is a lack of jobs and that this ‘slack’ in the labour market can be tackled with monetary policy for as long as is necessary – and they see the lack of CPI and wage inflation as confirming this view.
It is clear the Fed expects official interest rates to stay low in the foreseeable future as it sees its job as incomplete. Euphoria in equity markets seems, by contrast, to be discounting a return to robust economic growth (consensus forecasts for the US now expect an acceleration from 1.8% annualised GDP growth in the first quarter to 3% in the fourth quarter of 20141) and some ‘normalisation’ of interest rates.
Tapering of asset purchases is tending to reinforce this view, despite the Fed’s protestations that tapering is not tightening.
Although economy ‘bulls’ see the tapering of bond-buying by the Fed as a clear negative for US Treasury bonds, it can also be seen as a withdrawal of stimulus from an economy which has become reliant on a constant flow of cheap money.
We remain broadly positive on US long bonds in the expectation that rates will not rise in a parallel fashion along a yield curve which is already very steep. Moreover, in multi-asset funds, we see long Treasuries as a useful (and cost-effective) hedge against risk asset positions, rising geopolitical risks and the deflationary risks which we continue to see.
Fed tightening or not, any perception of a withdrawal of liquidity could present problems for what has become an expensive momentum-driven equity market, in some ways reminiscent of the late-1990s boom – ‘story stocks’, technological miracles, IPOs and stratospheric valuations.
What’s more, reported earnings for the MSCI US Index have declined in the last 12 months and the downward trend in corporate cash flows doesn’t bode well for US capital spending levels2. A pick-up is required soon if the enthusiasm built into valuations is to be validated.
As in the late 1990s, the investment opportunities of today are likely to lie away from the current areas of market obsession. We continue to believe that emphasising ‘haven’ qualities – stability, balance sheet strength, low leverage, high barriers to entry, global diversification, low beta to economic activity – is appropriate.
We are not just looking for securities in which we can shelter from potential financial market volatility; indeed, Newton’s technology related themes ‘Net effects’ and ‘Smart’ reflect powerful trends that may transform or disrupt incumbent business structures.
We must, of course, resist overpaying for quality, but where these ideas pass our fundamental and valuation screens, we believe they continue to offer the best risk/ reward potential against a challenging backdrop.