With declining revenue and lower global growth it seems irrational that equity prices are rising. Forecasters are still optimistic that “next year will be different” and US earnings will rise by 8.5% in 2016 - but they have been wrong before – this year is an example. Logic dictates that the risk of a correction is rising rapidly
Irrational exuberance is amongst us again, at least amongst equity markets. US equities are now at a historic one year PE ratio of 23.0 times, well above their long-term average of 15.5 times. In the last 12 months, earnings fell 13% while the S&P500 has rose by 5%. Wall Street’s analysts expected an average increase in earnings per share of 7.5% in 2015, so they were out by 20%, a massive margin of error.
On the other hand, economic growth is being continually reforecast downwards. As we expected, the OECD came out last night revising their forecast for 2015 global GDP growth to 2.9%. Their forecast at the start of the year was 3.6%, reduced to 3.1% in June, and then 3.0% in September. The world economy continues to be far more sluggish than most economists believe.
Safe harbour investment strategy
This strategy was first introduced a few months ago, designed for investors seeking an investment strategy that will protect wealth even in the event of a global sharemarket correction or economic slowdown. The Safe Harbour strategy comprises Investment Grade corporate bonds, and in particular infrastructure sector bonds. For wholesale investors, it also includes US Dollar and Great British Pound denominated investment grade bonds. These bonds typically hold their value in such conditions, notably holding or rising in value during the GFC years of 2008 and 2009.
Several months has passed since then, so it’s timely to update the reasons investors might consider when assessing this strategy. The main reason remains sharemarket over-valuation, particularly in the US. Similarly, the other reasons we cited at the time remain strong arguments for being conservative at the moment, that is weakness in the EU, China and Japan, the 2nd, 3rd and 4th largest economies in the world after the US; and the declining outlook for the Australian economy.
US sharemarket valuations remain too high
We’ve reported in recent seminars and in The WIRE that our preferred long-term PE ratio measure, Yale University’s CAPE measure, has been higher than its current level of 26.5 times on three occasions: 1929; 1999 and 2007, followed by the three largest corrections in the past 100 years.
Source: FIIG Securities, Standard & Poor's, Robert Shiller
For those that prefer the shorter PE ratio metric, the Dow Jones is now at a PE ratio of 23x, compared to its historic 15.5x.
These sorts of valuation levels can be justified if earnings are expected to rise, but the problem is that no-one is forecasting large rises. In fact, revenues are actually falling at the moment. In 2015, corporate revenues will fall by 3.3%, with cost-cutting being the driver of any earnings increase. This is not sustainable.
Either revenue needs to grow dramatically, or the Dow is set for a fall of around 20-30% to see it come back to near long-term averages. This is clearly illustrated in Figure 1, showing that over the past 12 months earnings have fallen by more than 10%, while the S&P500 has actually risen.
The main argument by those forecasting a rising sharemarket - ironically is that the world’s central banks have committed to keep interest rates low for as long as it takes to see the world economy strengthen. The problem with this argument is that current PE ratios need a lot of earnings growth to be justifiable. The earnings growth needed to justify these levels would be a sign of a strengthening economy and support a return to historic interest rate levels.
So, at best, the ultra-loose monetary policy, leads to low interest rates, which successfully leads to earnings growth of the 40% or so required to justify current share prices. But if this low interest rate approach doesn’t successfully increase earnings, it doesn’t matter how low rates are, the current PE ratio of 23x is not justifiable and must correct.
The world economy is neither strong nor weak, just dull
The US economy continues to recover slowly from the impact of the GFC. It is one of very few strong economies globally, perhaps joined only by the UK amongst those expected to maintain momentum into 2016. The next three largest economies; the EU, China and Japan; all face building headwinds:
- Japan was just showing some signs of life when China’s trade started to slow dramatically. Japan’s economy is likely to slow for the second quarter in a row in 3Q15, marking an official recession.
- The EU is showing hopeful signs of recovery, albeit still muted. Unemployment is back down to January 2012 levels, but still 10.8% which is around 2.0% higher than pre-GFC levels and with a massive 35 million people still unemployed or seeking more work. The southern economies of France, Italy and Spain need to show signs of growth, without continually needing government stimulus. Italy’s debt to GDP ratio for example is now second only to Greece’s, but the Italian government just passed next year’s budget which included tax cuts and spending stimulus. France and Spain are similarly increasing their debt piles in an attempt to further stimulate their economies, but as we saw with Greece, this is not sustainable.
- China really holds the key for the global recovery now. Japan and the EU are doing all that they can reasonably be expected to and are unlikely to surprise on the upside. China on the other hand has a large element of uncertainty still, and the risks are on the downside. China’s imports have fallen 18.8% over the past year in value terms.
- The OECD just lowered its forecast for global growth, the 3rd time this year they have had to revise their forecast, and bringing them to seven years in a row of overly optimistic forecasts for the global economy.
Source: FIIG Securities, Bloomberg
Australia is highly leveraged to world growth
Over 30% of Australia’s exports now go to China, up from just 8% in 2004. Most of this growth has come from iron ore and coal export growth. In fact iron ore and coal have risen from an average 17% of Australia’s total exports in 2001 to a peak of 40% in 2013. Since then, this figure has declined to 31.5%, still well above the level in the early 2000s. This phenomenal growth has been the backbone of Australia’s remarkable economic growth over the past twenty years, but is now our greatest threat.
China’s demand for steel has plummeted, and expected to fall another 20% according to China’s own experts and Macquarie Group analysis. Iron ore production in China is expected to offset this drop in demand, so the global iron ore price shouldn’t be impacted in the medium term, but will face volatility. Our iron ore producers are amongst the lowest cost producers in the world, but to keep costs competitive will hurt the local economy, particularly Western Australia.
The other concerning trend for Australia is the early signs of a very steep property slowdown in the eastern capitals. Auction clearance rates, a strong early indicator of a change in demand, have fallen from 84% to 61% in Sydney in the last two months.
Moves by the major banks to first increase rates on investor loans and then on all loans has clearly started to dampen demand. Lower demand impacts the economy in two ways: Firstly, lower demand for property means lower construction, and construction has been an important driver of the Australian economy for the past 2-3 years. Secondly, higher property prices, instils higher consumer confidence, which in turn drives consumer spending and business confidence. If prices slow too quickly or even decline, there will be an impact on the overall economy which has not yet been factored into earnings for Australian equities.
Enter the safe harbour to avoid the storm
The whole point of the Safe Harbour investment strategy is for those investors that are concerned about the outlook for the riskier asset classes like equities and property. This strategy invests in corporate bonds with very high credit ratings and just as importantly in assets with little to no exposure to the economic cycle. Infrastructure assets are not reliant on economic growth to achieve their revenue growth, nor do they suffer large falls in revenue when the economy slides.
We believe that the best time to execute the Safe Harbour strategy is when equities are at recent peaks, and when bond yields are also at their peaks. This means buying into Australian bonds when the 10 year government bond yield is above 2.6%p.a. or in the case of US bonds, when the 10 year treasury yield is above 2.0%p.a..
Yields in both markets have jumped recently due to bullish equity market activity driving a switch from bonds to equities. This rally has occurred in spite of disappointing earnings growth, as above, and will eventually run its course. Executing the Safe Harbour strategy ahead of that time will allow an investor to lock in higher yields than will be available after the end of this rally.