As has been widely reported, the key risk as we enter the new year remains the US-China trade war, which, since it kicked off just short of a year ago, has disrupted "classic" economic cycle-based analysis and which, combined with the age-old alibi of tightening monetary conditions, is a ready-made and reassuring explanation for the equity-market counter-performance in 2018.

Let’s just take a moment to ponder this, starting with a look at the S&P 500, labelled below with comments on the aforementioned trade war.

What’s to be made of this? Ask someone not well acquainted with the financial markets to analyse the graph and he? probably won’t correlate the Sino-US trade war with the US equity slump. The index hit a high in September, when the trade war was at its nastiest, and only started going south in early December, when tensions had abated.

From where we stand, the truth lies elsewhere, and is based on re-rating/de-rating cycles, i.e., on expectations cycles. The graphs further below show the S&P 500 PER: the one on the left shows the standard PER, calculated on actual profits; the one on the right shows a PER calculated on actual smoothed profits.

The background to this cycle is one of continuous equity re-rating leading to … the great unknown. Starting with a P/E of 10 in late 2008 (or early 2009 depending on the retained PER), it was difficult to know ex-ante just when this PER spike was going to end. Valuation models have their limits and tend to use historical averages as equilibrium values, which doesn’t really make sense, as markets rarely stop at averages. What really preoccupied investors was – knowing whether the PER was going to end up at 15.2, 17.3 or 21.7.

As a rule, one way of grasping the question is to identify the macro context and to suppose that this influences the equity valuation scheme. In such a case, an understanding as to whether the context is improving or worsening can offer an understanding of the valuation dynamic.

From that point of view, 2018 was a great year, as it fit neatly into this scenario. The PER did not hit its peak in September (unlike the S&P 500) but rather in January, upon news of Donald Trump’s fiscal stimulus plan. Lesson learned! It’s only when the icing is on the cake and when the planets (macro, micro, financial conditions) align that US equities stop re-rating.

It’s now clear that POTUS’ fiscal gift was a poisoned chalice, as things looked too good to be true: eternally low rates, robust economic growth (revised upwards) and rocketing profits following the tax cuts. Total asymmetry: how to improve on such a situation further? In fact, it’s because critical mass had been reached that it was actually the beginning of the end.

After the alarm bells that sounded in February, the index rebound that continued through the summer was a test. Could those optimal year-begin conditions be reproduced? All attempts to do so were in vain, with the PER only feebly rebounding and another index correction taking place as of October.

Don’t pay too much attention to the graph above. Growth expectations, although an important variable for equities, are not the only one. This cycle saw a combination of highly favourable factors that will be difficult to replicate – indeed, that’s why the cycle was so successful. The 4 most notable factors:

1)       synchronised developed-country growth,

2)       spread of the technological revolution (internet 2.0, steepening of the adoption curve to its maximum) benefiting US oligopolies,

3)       very loose monetary conditions,

4)       declining volatility in macro and micro cycles.

US tech-stock is this cycle’s theme. US Tech drove it and US Tech ended it. To give you an idea of the exceptional nature of this leadership, we compare below the operating margins of this segment of the S&P 500 with margins for other stocks. 


Clearly, the macro cycle doesn’t explain everything. The internet 2.0 thematic is the stuff of dreams and an extrapolation of present conditions has also helped substantially raise index PERs. This trend is on the way out, with its main practitioners attracting suspicious looks and many questions being asked. Monopoly revenues from these stocks are about to be challenged by states, putting an end to investor extrapolations.

Where are we in the de-rating cycle, and where will it all end?

History shows that this can take time. It’s also interesting to see how the psychology has changed in the space of a few weeks. The reasons for the great financial crisis are manifold but it would appear that inadequate monetary policies helped, in general, stoke investors’ and economic agents’ greed. Although central banks therefore have to shoulder some of the blame for the last crisis, few hold this against them, as it was those same central banks that brought it to an end. By implementing totally unprecedented policies (negative rates – Who’da thunk it!), developed-country central banks rescued the global economy and, in fine, investors. Here, we find ourselves in the heart of Stockholm syndrome territory, with investors developing a growing fondness for those who took them to the brink, as perpetrator turned into saviour. Then Goldilocks arrived, in the shape of robust and non-inflationary economic growth beyond investors’ wildest dreams, transporting the investment world to seventh heaven.

Today, even though monetary conditions remain accommodating, economic growth is not yet inflationary and Google has not yet been dismantled, nagging doubts remain. These factors now seem ineffective. That’s why investment risk remains high. In 2016-2017, that risk was low because of the overriding uncertainties and markets climbing the wall of worries. In 2018, investment risk was high because no further risks had been identified, it was just too good to be true. In 2019, investment risk remains high, as the context is worsening and – even though hope springs eternal – there is no tangible proof of that changing in the near term.

We are constantly reminding people that financial markets are expectations machines and that nothing can be extrapolated from the past or even from the present. Contrariwise, we could be forgiven for thinking that our views are outdated, that "the worsening context" was all played out by end-December and that it’s now time to look ahead. What’s stopping us …?

The difference, this time, is that it’s no longer – as we’ve said – just a question of "cycles": it’s a whole set of support factors that are being eroded day after day. That’s why things are different this time and why we shouldn’t be obsessed by economic cycles, especially those of the transatlantic variety. 


The comments and opinions expressed in this article are those of the authors and not necessarily those of Candriam.




 

Tristan Abet

Senior Fund Manager




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