Renewed trade tensions between the US and China, ships being bombed in the Strait of Hormuz, global manufacturing indices at over two year lows. Surely this quarterly update is going to be a tale of woe, volatility and falling markets.
If you shut your eyes on March 31 and woke on June 30 you would have concluded that it was smooth sailing, and a wonderful quarter for investors. For the three months the best gauge of US share market performance, the S&P 500, rose 3.8%, European markets caught a bid with the Eurostoxx 50 rallying 3.6% and the New Zealand bourse continued its high flying act up 6.8%.
But that’s not all.
Interest rates down … a lot
Investors in fixed income were healthily rewarded, with interest rates falling around the Globe.
Falling interest rates mean capital gains, particularly for those investors lucky enough to hold bonds with a long time to run to maturity. The capital gains have been solid. Investors in global fixed income enjoyed a return of 2.7% for the quarter, based on a widely used measure of fixed income performance, the Barclays Global Aggregate Index hedged into New Zealand dollars. The New Zealand fixed income market was similarly strong gaining 1.9%, based on the S&P/NZX New Zealand Government bond index. So it has been a great quarter for investors.
The strange thing is, this doesn’t seem to be translating into happy investors. In fact objective measures of investor confidence, like the amount of cash being held by hedge funds, point to caution not euphoria.
Why are investors not celebrating? Lets start off looking at some numbers. And these are big ones!
Since the middle of 2018 Investors have gone from expecting the US Federal Reserve to hike short-term interest rates three further times to now expecting the US Federal reserve to cut interest rates by over 1% in the next year. The US Federal Reserve rarely cuts rates if the economic outlook is great!
It’s a similar story in Europe where the German government bond yield reached an all-time low after European Central Bank President Mario Draghi indicated that the ECB could provide additional stimulus if economic risks increase and the current inflation outlook remains subdued.
Negative interest rates were a real theme for the quarter. All up the value of fixed income with a negative yielding exploded over the quarter and is now at a record $13 trillion market value. Yep $13 trillion of debt “earns” a negative interest rate!
It’s not just countries … now almost $1 trillion euros of corporate bonds also carry negative yields.
But that’s the secondary market for debt that has already been issued changing hands between investors. Surely a company couldn’t issue new debt at a negative rate?
Ummm no. As an example, France's LVMH raised bonds in the last quarter at sub-zero rates. Investors lapped it up. Fund managers (not Fisher Funds I will hasten to add!!) placed six times as many orders as the bond’s €300m issue size.
That’s right you now pay companies to lend money to them and people are clambering over themselves to do it!
Closer to home we are seeing similar, if not so dramatic moves, with ten year New Zealand government bonds now yielding 1.5% and markets pricing incredibly low inflation outcomes in New Zealand, sub 1%, for the foreseeable future.
The world of fixed income is sending an incredibly strong message. Market participants don’t expect much economic growth, particularly in Europe, and they don’t expect inflation any time soon, anywhere.
Shares up … a lot
This seems to be at odds with strong share markets, a conundrum that has gripped the financial market participants and led to a lot of in-depth water cooler discussions, hand wringing and column inches being written. I am going to add to that.
The value of a company is determined by two things. The future cash flow that it will generate for shareholders and the right discount rate to apply to those future cash flows to work out how much they are worth today. The discount rate is a slightly strange idea but essentially it’s a number we use to work out how much the promise of $1 in the future is worth in current dollars. The discount rate is a function of two things - interest rates and the risk of that cash flow.
This framework gives us a lens to view share market returns. Record high share prices can only be a result of changes, or perceived changes, in one of these drivers of value. Either share prices are higher because investors think cash flows or earnings are going to be sustainably higher. Or investors might believe shares are less risky to own than they were, leading to a lower discount rate. Or lastly it might be because interest rates are falling, again leading to a lower discount rate and higher prices.
So what do we think has driven recent market highs?
Well the prospect of weaker economic growth doesn’t exactly suggest that earnings are going to be a lot stronger over the next couple of years. And, with the exception of some companies, hopefully the ones that we are investing in, there has been no market-wide positive reassessment of company earnings. Analysts expect continued tepid earnings growth.
Risk in share markets doesn’t seem, at least to me, to have changed. I started this note highlighting the tensions in the markets right now. It would seem counterintuitive with all of these concerns that investors are happy pricing risk out of shares. So declining risk premia, a fancy way of saying the price for risk, are not a reason for all-time high markets.
That leaves interest rates. Interest rates have been falling, and falling dramatically, over the quarter. This can be the only reasonable rationale for higher share prices.
This assertion is supported when we dig deeper into what has worked and not worked in the market over the last quarter. To do this I have broken the market into subsets of companies that have similar characteristics. It’s not a hugely scientific but it paints a very clear picture.
For the New Zealand share market I allocated companies into four buckets, calculating the average return for the quarter for each bucket. High growth technology companies (5 firms) formed the first bucket, Listed Property companies (8 companies) the second, Utilities (11 firms), Banks (3) and so on. The balance of the market (24 firms) fell into a bucket I imaginatively called “the rest!”
As the chart shows there is a massive dispersion in returns between the more interest rate sensitive companies and more economically sensitive firms.
The interest rate sensitives - those with certain cash flows that tend to trade more like fixed income (property companies, banks and utilities) and those with very long dated cash flows that are higher risk, high growth firms - performed best.
More economically sensitive companies, like retailers or industrial firms, which, in this analysis, fall into “the rest” category, had a poor quarter actually falling in price on average. This was despite the fact that markets hit all-time highs.
It is clearly that falling interest rates, and falling interest rates alone, had boosted the market over the past quarter.
Where are today’s opportunities?
While looking into through this particular rearview mirror is interesting it may not be that helpful for working out the way forward. But it does provide context. In particular, given that investors are prone to expect the future to look like the recent past, it may provide a good steer on where not to look for the next opportunity!
As our analysis showed high yield companies, super high growth (often with no profitability) and very stable cash flow companies are the flavour of the month. The challenge for investors, looking forward, is that the valuations of these companies is beginning to look, at least to us, somewhat excessive.
Nowhere is this more evident than in New Zealand where, for instance, the listed property companies, which tick two of these boxes, high yield and stable earnings, are now trading at a 16% premium to the underlying value of the properties they own. Some caution is warranted.
Of course there are parts of the market which are less in vogue and where we see opportunities to generate healthy returns. Thankfully these areas are in the cross hairs of our time tested STEEPP investment approach.
A great example of where we see opportunity in this market is with a company like Alphabet, the owner of Google, and one of our favourite companies.
Yes I know it has some, not insignificant, regulatory challenges but it trades on a price earnings ratio of 20x almost exactly the same as Unilever, the producer of Lux soap and Surf washing powder. Unilever is a classic stable cashflow higher yielding company very much in vogue in today's market Over the next five years Unilever might, if it is lucky, grow its earnings at 7% pa. Over the same period we are confident Alphabet will grow at twice that, more than 15%pa. I know which I would rather own!
Overall our positioning remains cautious and focused on owning shares in the very highest quality companies in the world that we believe are well-positioned to grow under their own steam.
If you have any questions, thoughts or insights please share them with me.