Ignore the chatter; take the long-term view

Harbour Asset Management portfolio Shane Solly looks at the reasons why have equity markets been weak, and what it means for investors going forward.

Wednesday, January 9th 2019, 7:00AM

by Harbour Asset Management

Shane Solly, CFA Harbour Asset Management

Key points

Equity markets have re-traced and become more volatile over the second half of 2018.

Tighter monetary policy has sapped liquidity
Lower liquidity has contributed to higher volatility
Investors have become more bearish

History reminds us that those investors who take a long-term view and invest when equity markets become overly negative are generally well-rewarded when overall market risk tolerance stabilises.

Why have equity markets become more volatile in the last half of 2018?

Equity markets have fallen in the second half of 2018, moving on from the previous three years of abnormally low volatility when global quantitative easing flooded the capital markets with low-cost capital. They are now exhibiting higher volatility (ups and downs) and have, on average, been trending lower.

Why have equity markets pulled back?

We would point to three factors – tighter monetary policy, lower earnings growth and a pull-back in “animal spirits” in part reflecting policy uncertainty.

1. Tighter monetary policy to normal levels

Money flowing into capital markets has shrunk as the US Federal Reserve has tightened monetary policy. Lower growth in liquidity has removed support for high equity valuations. As capital markets rebase to lower levels of monetary growth, investors ration scarcer capital. This is exhibited in the form of higher-risk premia required to invest in higher growth, higher risk and long-term assets such as companies listed on stock markets. Price to earnings multiples (years of future earnings investors are prepared to pay) have fallen for equity markets, led by a pull-back in cyclical and higher growth sectors, back to average levels (some market valuations are lower than average while other valuations, such as New Zealand’s, remain elevated).

Figure 1. US financial conditions have tightened notably over the last year

Source: Bloomberg, Haver, UBS. 20 December 2018

2. The rate of earnings growth is slowing to normal levels

The rate of earnings growth, whilst positive, is slowing from high levels. Strong global economic growth and flat input costs characterised the early part of 2018, however, more recently, growth expectations have moderated, and some input prices have risen. While global economic activity is likely to remain in expansion mode through 2019, growth may continue to slow as the US central bank tightens policy. Declining activity is likely to reduce cyclical support for company profitability and earnings per share growth. Already, expectations are for US earnings growth to moderate towards 5% in 2019.

Some investors are also anticipating an increased probability of a recession in 2020, with surveys by independent research groups Strategas and ASR pointing to circa 20-35% probabilities. Investors are likely to continue to be nervous, despite underlying global demand conditions remaining currently solid. More importantly, inflation is under control and potentially limits the need for the US to further aggressively tighten policy.

Against this backdrop, we are well into a long-term global economic cycle and mature cyclesgenerally have a history of higher volatility. As illustrated in Figure 2, global economic uncertainty has increased significantly over the last year, which may be influencing investors’ confidence in future company earnings growth potential.

Some companies also face higher input costs, impacting on near-term earnings growth, that may require them to restructure their businesses. Longer term, technology change and new business practices may continue to enhance underlying company earnings for those companies that can utilise them to strengthen their competitive position.

Figure 2. Global economic uncertainty has risen potentially impacting on earnings confidence

Source: Policyuncertainty.com. December 2018

3. Weaker animal spirits

Capital markets are made up of individuals – but their behaviour can be group-like. Just like a herd, investors’ confidence can trend, hence the term animal spirits. Market confidence has gone from being optimistic to pessimistic over the last six months. Perhaps this reflects a particularly noisy and unusual period of geopolitical change and may also be associated with a change in direction of US monetary policy. This change in animal spirits highlights two behavioural issues that can amplify confidence – recency bias and risk aversion bias. Humans tend to overemphasise the most recent data they receive and undervalue long-term data trends - investors may be overemphasising recent negative returns against historical long-term positive returns from equity markets. When faced with uncertainty, investors generally attempt to lower the uncertainty by accepting a more predictable but lower expected payoff investment. As illustrated in Figure 3, global risk aversion indicators have shifted sharply higher.

Certainly, while geopolitics has become unpredictable, the underlying global economic framework remains intact. Animal spirits or investor confidence can contribute to equity markets overshooting both positively and negatively before markets reset at a new level.

Figure 3. Global risk aversion has risen to elevated levels

Source: Bloomberg, Haver, UBS. 20 December 2018

Will equity markets remain volatile?

Equity markets will likely continue to exhibit a higher level of volatility than they have over the last three years.

In the near term, we may see higher than average levels of volatility – the behavioural issues discussed above, and a reduction in the use of leverage/gearing may see volatility remain elevated. While we may have already seen the bulk of the equity markets pricing response to tighter US financial conditions and lower expectations of economic growth, markets don’t generally adjust to change quietly. Some investors, such as risk parity funds, borrow as volatility falls to enhance equity market returns. These risk parity funds have been significant sellers of the equity market recently as they reduce leverage.

Not all volatility is bad – markets can be volatile in both an upward and downward direction. But generally, equity markets fall by the elevator (fast) and go up by the stairs (grinding and slower).

What may contribute to markets stabilising?

There are a number of ‘circuit breakers’ that may contribute to equity markets stabilising such as:

Lower growth and inflation are giving central banks room to maintain easier, growth-supportive monetary policy. The US Federal Reserve, while continuing to increase official interest rates is getting to the end of its current tightening cycle. Expectations for higher interest rates keep reducing.
While earnings growth may slow from recent high levels, company earnings remain robust, with the potential to meet or beat consensus expectations. Robust earnings reflect structural reasons such as the application of new technology and cyclical reasons such as economic growth and profit conditions remaining broadly supportive.
Company debt levels are generally modest and balance sheets are relatively conservative meaning companies can sustain a slower level of activity for some time.
While access to debt capital has tightened for some, other companies have good access to debt or are sitting on cash. These companies may grow via merger and acquisition of listed companies as equity investors lose sight of long-term return potential, reducing the investment universe for share market investors and underpinning market valuations. We are seeing an increasing number of takeover announcements.
New equity issuance is likely to decline as lower share price valuations increase the cost of companies raising new equity capital, further reducing the supply of new investments to absorb the growing pool of investment funds.
Overall equity market risk premia are elevated relative to historical levels, and price-to-earnings multiples are back to or below average levels for many equity markets. Patient long-term investors are likely to see the opportunities ahead.

It is reasonable to foresee a lower growth “not too hot, not too cold” environment emerging where equity markets generate returns consistent with long-run return over the next twelve months.

The return profile may remain more volatile than average over the next twelve months and geopolitics will continue to test investor confidence. Additionally, the slowdown in growth may place pressure on more leveraged companies so some cyclical companies may face some downside risk as global economic activity slows.

How should investors be considering investing in equity markets?

Given the pull-back, equity markets are back to levels that may prove attractive entry levels for long-term investors. Depending upon investor investment risk objectives and risk tolerance strategies worth considering include:

More active investors may consider building up cash levels to invest into equity markets on weaker days (over time we think equity markets will provide better returns than cash);
Less active investors and those that are less willing to pick the timing in investing may want to consider dollar-cost averaging and regular investing, which allows investors to gradually increase investment to growth assets over time rather than attempting to pick a market low;
For more risk-tolerant investors, investing in a highly selective portfolio of growth companies that grow wealth over time regardless of underlying economic activity has proven to boost returns in periods when markets are overly negative. Companies within growing industries with strong industry positions, particularly those that benefit from changing technology and business practices, tend to deliver above-average returns to investors through time; and
Investing in a portfolio of defensive growth companies with lower volatility may provide a lower risk, lower return investment for more cautious investors that need to invest in growth assets to meet their investment objectives.

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