Tougher Times Ahead
The past year has been a pretty kind to investors with most markets delivering solid gains against a backdrop of steady economic growth, easy money and low inflation. Our sense is that these fertile conditions will deteriorate slightly over the coming months. Looking ahead we expect fewer positive economic surprises and that the rate of global growth will slow from the peak achieved in 2017. Therefore, with equities already discounting the current balmy conditions a period of consolidation or higher volatility looks probable.
The US economy has led the world out of the recession following the global financial crisis and, so is the most advanced in its economic cycle. Employment levels have climbed, and the Federal Reserve was the first Central Bank to end Quantitive Easing (the process of forcing cash into the economy by buying bonds) and to raise interest rates. We expect that US interest rates will rise in December and that the pace of future rises will be faster than is currently expected. Policy makers have been happy for interest rates to rise slowly, to insure the economic recovery, but now that conditions are less fragile we expect the cost of money to rise at a faster pace.
One of the downsides of very low-cost money is that the US corporate sector has been an indiscriminate buyer of shares through company buyback schemes. This is a transaction that sees management teams replacing flexible equity financing (shares) with cheaper, but less flexible, fixed rate debt (bond) financing. There are two consequences to these transactions, the first is that it boosts the earnings per share of the company, a key objective to trigger payments to management under most long-term incentive share plans. The second is that the company has more fixed outgoings to cover in the event of a downturn. One way we can monitor this is to look at ‘interest cover’ i.e. how many times the interest payments on a company’s debt are covered by the company’s earnings. The concerning result is that the average interest cover of US corporates is the same now as it was at the depths of the global financial crisis. Our fear is that this will be a fragile starting point from which to enter any future recession and markets have, finally, started to react with companies with strong balance sheets (less debt) being rewarded by investors.
In the fixed income markets the prospects of both of higher interest rates and inflation have started to force the cost of corporate debt up from the crazily low interest rate levels of the last year. It has been bizarre how investors have been so keen to lend (other people’s) money to companies for the same small risk premium last seen in 2006, but to a corporate sector that is even more in debt than it was at that time. Our sense is that this will not end well.
The Bank of England finally reversed the post Brexit emergency interest rate cut and, well, nobody cared. The first interest rate rise in a decade and a near doubling of costs for those on an interest only mortgages has not caused Armageddon. The Bank of England’s own predictions suggest that interest rates will rise to just 1.25%pa by 2022 and if correct, then easy money, priced lower than the rate of inflation (the UK inflation target is 2%pa and it is currently at 3%pa) is here to stay. The bigger question is whether inflation is, as currently believed, a temporary phenomenon or as we fear, becoming a more persistent issue. The key variable that has not reacted so far is wage inflation and the ability of employers to cap wage rises at, or below inflation, has supported company profits since the global financial crisis. Globally, we are now seeing rising numbers of new job openings and the US is also experiencing a higher ‘quit’ rate as employees actively move employers to increase their wages. Whilst at manageable levels now, pressure is building and our concern is that firms won’t be able to suppress wage rises at the rate of inflation as the competition for talent intensifies.
As real return investors, we are sensitive about managing the next downturn in equity markets and this cycle is now over 100 months old compared to an average of 74 months and has returned circa 320%. To put this into some context, the longest ever bull market in US equities since 1871 ran from 1988 for 153 months returning 516% before ending in 2000. We suspect that this bull market will persist as the backdrop is not yet conducive for a full-blown sell off due to economic and policy trends. Whilst the valuations of most assets are an ever-present concern, underlying economic conditions are the best of the decade and Central Banks don’t yet want to cool activity, preferring instead to just remove some of the prior, excessive, stimulus.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. Investment markets and conditions can change rapidly, and as such the views and interpretations expressed should not be taken as statements of fact, nor should they be relied upon when making investment decisions. We undertake no obligation to update or revise any forward-looking statements and actual results could differ materially from those anticipated by any forward-looking statements.
Past performance is not a guide for future performance. The value of your investment can fall and you may not get back the amount invested.
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