This March marks the 10-year anniversary of the longest bull market in history that has been ploughing on in the US since early March 2009. The S&P 500 Index has delivered a staggering 400% in total returns over the decade. In addition, the US economic cycle is the second longest on record since WW2. However, the narrative has moved on from 2017’s synchronised global growth to a 2018 characterised by volatility, the revising down of expectations on economic growth, concerns around peak earnings and the path and pace of monetary policy.
It’s also worth noting this is not your typical recovery, the pace of cumulative US GDP growth has been the weakest compared to previous post-war expansions. Slowing global growth, trade tariff concerns and the removal of liquidity are all potential causes of market jitters across the globe. However, what stood out in 2018 was the decoupling of the US from the rest of the world, not only in the divergence of growth, but also in policy and stock market performance.
A year on from the $1.5 trillion tax reduction package, that aimed to boost economic growth, the key question now is ‘how sustainable is this growth?’ Particularly given the record amounts of debt in the system, on both corporate and government balance sheets. As seen in 2018, the hiking cycle has precipitated a global economic slowdown, with the stimulus from tax cuts and deregulation in the US starting to wane. However, the recently more dovish stance of the Federal Reserve, adopting a more patient approach to interest rate hikes this year, has helped risk assets to rally in 2019, unwinding the losses of the final quarter of 2018.
The shifting focus of the Fed
It can be argued that central bank policy is acting as a pendulum capable of driving market swings. The focus of recent debate is around the Federal Reserve’s policy of targeting inflation and the validity of such an approach.
As my colleague Jim Leaviss, Head of Wholesale Fixed Income, observed at a recent roundtable, a central bank “regime change”, potentially allowing for greater tolerance and flexibility, could be on the horizon. In early June, the Federal Reserve’s Chicago conference could be the starting point for a change in direction. He thinks they will stick to an inflation target but perhaps discuss what a 2% inflation target looks like, such as whether it is a long-term average or maybe they target nominal GDP, so GDP plus inflation or a range target. As a bond investor, Leaviss says, this makes a case for inflation protection in your portfolio. However, he prefers 10-year government bonds over Treasury Inflation-Protected Securities (TIPS), where the 5-year US inflation breakeven rate, a market proxy for short-term inflation expectations, is below the Fed’s 2% inflation target. In a recent blog published on our sister blog Bond Vigilantes, a closer look is taken on the diverging fortunes of inflation in the US and Europe and the relative attractiveness of TIPs versus German Bund Linkers.
What does this mean for debt issuance? Leaviss noted Olivier Blanchard, former IMF Chief Economist, talked about public debt having no fiscal cost, as long as the nominal interest rate paid on issued government bonds is below the nominal growth rate of the economy. The proxy for interest rates, the US 10-year bond yield, currently stands around 2.75%, compared to around 4% US nominal GDP growth in the US last year. He noted there is plenty of room for growth in debt assuming everything else stays the same. However, US Debt-to-GDP is likely to rise with increased government spending on healthcare, for instance, due to rising demographic pressures, which could drive up government bond yields by a few basis points. Levels much above 3% could push interest rates beyond the rate of growth, making debt less attractive. Looking longer-term, Leaviss is nervous and in the short term he says that central banks can’t do much about the cycle at this stage, while in a populist world, politics can drive central bank policy. So, the relative attractiveness of government bonds depends, to some extent, on our viewpoint and on the time horizon under review. In a scenario where debt piles are growing at a faster pace than economic growth, you could make a fairly bearish case for government bonds.
Is inflation a good economic indicator?
When considering the reflectiveness of inflation as an economic indicator, my multi asset colleague and fund manager, Eric Lonergan, perceives this as much more of a structural assessment. What he finds most curious is why it has taken so long for the Federal Reserve to realise it doesn’t have an inflation problem. Many of the factors that were expected to cause a spike in this measure in the post-financial crisis era, such as oil moving to $150 a barrel and a tripling of its monetary base, have had a minimal impact. He points to Turkey as being similar to an economy in the 1970s when, for example, oil prices and inflation were more strongly correlated. Turkey has generated inflation as markets are not de-regulated, prices are controlled by oligopolies and monopolists and inflation-indexed contracts are prevalent. This is not comparable to the dynamics in developed economies.
For Leaviss when he considers inflation expectations, he echoes the sentiment of economist Danny Blanchflower who claimed that headline employment figures are misleading, as they exclude discouraged workers and the impact of the rising gig economy, hiding a waning in cyclical demand. The Phillips curve, which proposes that inflation will go up as the labour market tightens, could therefore be alive and kicking, but room for further strength in employment disguises this.
Finding opportunities amidst the noise
Rather than focusing on economic prognostications, for Lonergan it is better to concentrate on valuations and where investor bias throws up opportunities. Notwithstanding its premium to other global markets, the S&P 500 index has de-rated over the last 18 months. When looking at the equity risk premium, similar levels of compensation are available that were seen in times of distress, this is very much the legacy of 2008, where we saw the highest levels of volatility since the depression. Lonergan refers to volatility as an “intellectual virus” creating a willingness to forgo returns for no volatility. What is priced into the premium? The volatility aversion and worries about a recession, but as Lonergan believes this probability is low, he thinks equities look attractive versus cash and many areas in fixed income.
Looking closer at equities, my colleague and US fund manager, John Weavers, believes there are still many good opportunities to uncover in the US market. There are huge tailwinds to healthcare spending, not just in the US but globally, given ageing populations and increasing life expectancies in developed economies. Despite this, the market is worried about drug pricing and the possibility that regulation will tighten. This has led some areas to slip to price levels not seen since 2016 when markets worried over a potential Hillary Clinton Government clamping down. Weavers believes these fears have been overdone and this provides selective opportunities within the healthcare sector. One sub-sector he likes is managed healthcare. It’s an area unique to the US with firms, like UnitedHealth, Anthem and Humana, managing individuals’ private healthcare needs. Forward earnings multiples in managed healthcare companies are back down to 12.8 times; perhaps over concerns about public healthcare being introduced for all in the US. However, Weavers thinks the ’Medicare for All’ bill (introduced last week by the Democrats) is unlikely to find enough country-wide support to get passed. This creates an extremely attractive emerging opportunity, from a valuation point of view, in a sub-sector where there are clear long-term growth prospects.
Weavers has also been focused on finding companies with lower debt-to-EBITDA levels given the current macro environment. He explains that half of the debt on corporate balance sheets needs to be renewed on a two- to five-year cycle, which could cause headwinds for levered businesses if debt is repriced in the next two to three years. Companies exposed to this risk will have less cash available to reinvest in the business or grow the dividend, which in Weaver’s view would make them less attractive investments.
An apparent cause for concern in the bond market is the growing number of BBB bonds, the lowest rank of investment grade debt, which makes up 50% of the US public debt market. Leaviss believes such concern is overblown, as the Global Financial Crisis (GFC) has driven caution within the rating agencies. While some banks were clearly too highly rated prior to the GFC, arguably now some are rated too low given better regulation and more capital on balance sheets. There may, however, be downgrades to high yield.
It is clear that sentiment and volatility are likely to create market opportunities in 2019, as they did in 2018. While changing monetary policy can impact companies and consumers directly, it can also shift perception and subsequent behavioural trends. The metrics by which we understand the economic cycle could be different from what came before and in the same way, we cannot judge the current bull market run in the US in the same light as previous bull markets. What we can, however, turn back to as a reliable indicator is fundamentals, to look through market noise and economic cycles and deliver returns over the long term.
 Source: ICE Data Services, 31st December 2018.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.