Wednesday, September 27th, 2017

Walking, Not Charging

We are often asked by why our US portfolios are so overweight equities, when we are clearly late in the cycle and there is no shortage of potential risks, ranging from nuclear conflict in Korea, to financial crises in China and political dysfunction in the UK, the US and Europe. The simple answer is that the market response to these circumstances has been a significant devaluation of the dollar, which automatically boosts the return from overseas equities and boosts the earnings of US companies with significant overseas operations. But the simple answer only takes us so far, because the dollar cannot keep falling forever.

The complicated answer involves a discussion about low volatility, the projected path of US interest rates, and the Fed’s reaction function. We will leave it to others to parse the detail of Ms Yellen’s recent speeches. Our very high-level view of what she said is the following (1) US monetary policy is still accommodative and needs to be normalised (2) neither the labour market or the US inflation rate is a critical constraint and is not forecast to be in the near future (3) the Fed has never removed this much accommodation before, so it must explain its intentions well in advance and stick to the plan, unless there is a very good reason not to.

So far, so good, but this is not much use to investors trying to position their portfolios. What does it mean in practice? Regarding Message 1, the trend in US policy rates is up and the FOMC now provides the dot plot so that investors can observe the likely increase and gauge the degree of consensus. Th board’s projections for 2016 were not delivered, but those for 2017 probably will be, assuming a 25bps hike in December. The central tendency of the last dot plot suggests another 75bps during 2018. Message 2 should be taken at face value. Neither inflation, nor employment, nor (by implication) anything else in the real economy acts as a constraint at the current time. But this begs an enormous question. There must be a critical constraint; there always is. If it doesn’t originate in the real economy, it must come from within financial markets.

If you agree with this logic, there are three principal candidates, which could happen on their own or at the same time: 1) a significant sell-off in US equities; 2) an inversion of the US yield curve; 3) material strengthening of the US dollar above the level when the 2017 guidance was originally issued (i.e. 102 on the index – not the current reading of 93). Rule 3 is clearly not a constraint at the moment. Nor is Rule 2, provided the Fed can persuade the US bond market that there are no current economic constraints. This leaves us with the behaviour of the US equity market as being the critical constraint on the pace at which the Fed can raise rates. We are a long way from classical economic theory, but we have been since 2008.

Behaviour is a catch-all term which covers a lot of areas. It does not include a detailed forecast of the index level or any related valuation metric, but it does mean avoiding prolonged periods of high volatility, and if possible any short-term spikes. This in turn means responding to the threat of a correction at a far earlier stage than would have been appropriate ten years ago. On the flip side , it would probably involve leaning against any signs of excess, such as a wave of leveraged M&A. Above all, the desired behaviour requires that equities produce a better total return than government bonds over the medium term.

Before the Fed gets accused of crony-capitalism, we should be clear that it believes in the wealth effect as a way of stimulating consumption and also as a potential cause of consumer downturns when it goes into reverse. The Fed also attaches more importance than hitherto to the risk appetite of financial intermediaries like banks in the provision of credit to the real economy. When the stock market falls, loan officers tend to become more risk-averse. This mechanism is also at work on the other side of the table as company management consider their own investment intentions. It doesn’t matter which one of these transmission mechanisms you prioritise, they all benefit from a stable and rising equity market.

In the past, it would have been very difficult for the Fed to exert this level of control over the stock market, but that was when its balance sheet was $800 billion, not $4.5 trillion as it is today. It is equivalent to 20% of US stock market capitalisation as opposed to less than 5% before the crash. Although we believe that short-term rates are cumulatively important for US equities market, the sheer size of the Fed’s balance sheet helps it to suppress volatility and keep risk appetite intact.

Provided that realised volatility remains low, it is perfectly possible for investors to justify holding a high percentage of their portfolio in equities. Over the last 12 months US equity volatility has been about 9%; over the last 22 years (since our models began) the average annual Sharpe ratio has been 0.86. Put these two number together and investors only need to receive a return of 7.6% to be in line with a long run return on risk. If we allow 2.5% for dividends and share buybacks and we assume no change in p/e ratio, the index only needs to generate 5.0% earnings growth to match this target. Unless you think that a US recession is imminent, this is not difficult.

Contrast these numbers with 7-10 year Treasuries. Over the last 12 months volatility has been 4.4% while the average annual Sharpe ratio over 22 years has been 1.01. If the Fed is going to raise rates by 75bps between now and September 2018 and is successful in avoiding any inversion of the curve, it is extremely unlikely that investors will make a positive return. It is virtually impossible for them to match the risk-adjusted returns available in equities or those that they have achieved in the past.

The crucial issue for the Fed in preventing a sell-off in equities is to convince investors that the low volatility environment is sustainable well into the future. This brings us back to Message 3, which actually has two parts: (A) the Fed will raise rates gradually and (B) it will pause if there is a significant correction in US equities. There is no discussion of how long this regime will endure – that would be tempting fate – but it is clear that the Fed is in no hurry to kill this bull market. At the same time the bull will only be walking, not charging.

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