Tuesday 22 November 2016 by Opinion

The running of the bulls – time to get defensive

The “Trump rally” over the past two weeks has highlighted the irrational behaviour of equity markets compared to bond markets, meaning investors can no longer grab the bull by the horns

Running of the bull

Bond markets have responded to Trump’s inflationary policies in a rational way – by increasing rates sharply on the expectation of higher inflation from fiscal stimulus and trade policies.  Bond markets have had their sharpest fall in price since 2001, losing around 4.1% since the election.

Trump’s inflationary policies has impacted bond markets – with the Bloomberg Barclays Global Aggregate Bond Index’s sharpest fall in price since 2001, losing around 4.1% since he was elected. However the very same policies should create far more concern for equity investors.  Likely losers include: heavy importers such as Ford and Apple, or businesses that are reliant on trade such as FedEx or shipping companies, and utility stocks that are highly leveraged, which should face higher costs from Trump’s expected policies and higher interest rates.

Yet equity markets continue to push upward. Importers, utilities and companies with little to gain from Trump’s policies are being dragged higher by the Trump rally.  This is not on the back of rising earnings, but on the expectation of rising earnings from Trump’s spending policies. 

The problem is equity valuations were already at historic peaks

As we have been reporting in the Smart Income seminars and annual guides, US equity prices have been inflated well beyond historic norms by years of cheap debt.  As shown in Figure 1, the US market was already at valuation levels only seen previously in 1929, 1999 and 2007 – but it has shot higher in the past two weeks.

Source: FIIG Securities

The average cyclically adjusted price to earnings (CAPE) ratio since 1885 has been 16.7x.  In the post WWII period, it was been 18.6x. The current CAPE ratio is 27.1x.  As the CAPE ratio takes into account inflation and bond yields, even the best arguments for why “it is different this time” can only justify ratios of 22x – the average ratio since the death of inflation in the early 1980s.  This means that US equities are between 19% overvalued if 22x is “fair value” and 39% overvalued using the long term average at present. 

To simplify the argument for getting defensive, let’s use the post WWII ratio 18.6x as “fair value”. That level suggests US equities are 31% overvalued.  This means that either share prices need to fall by an average of 31%, or earnings need to climb by 45% – the increase in earnings required to reduce the price/earnings ratio by 31%. 

US company real earnings have fallen by 19% in the past two years and are lower now than they were ten years ago.  Earnings growth was achieved through cost cutting post GFC, but revenue growth has been very slow, down 15% in real terms in the past ten years, and 4.5% in the past two years. 

To believe that current equity valuations are justified, you need to believe that revenue growth will suddenly pick up, on average, by more than enough to cover the increase in costs that will come from inflationary pressure.

It is not a case of them rising enough to justify the recent Trump rally – revenues need to climb enough to justify the already high valuation levels and the Trump rally too.

Get defensive

If you are in the strong equity bulls camp, the below should probably be ignored.  But even if you are slightly wary about the level of valuations and euphoria in equity markets at present, you need to consider how to position your portfolio to hedge against the risks of sudden drop in valuations.  Here are the top five defensive strategies posted by us over the past few years, in order of what we think is more relevant today.

Top five defensive strategies in the new economy

  1. Prepare for a bumpy ride thanks to protectionist politics and the related shift to fiscal stimulus
    Trump’s fiscal stimulus approach and his anti trade stance will probably strengthen in the US economy in the next few years, but at the cost of the global economy.  The EU and Japan have not yet successfully stimulated their economies despite massive quantitative easing (QE) stimulus programs, and they certainly cannot cope with lower demand from US imports right now.  China has stimulated its economy with debt, so it too cannot cope with much lower demand from the US despite being better positioned than Europe and Japan.  This divergence in fortunes will impact currency markets and bond markets. We will see US rates pulling away from EU, Japanese and other global rates, pushing the USD up – causing more volatility as markets try to guess what a higher USD will do to US rates beyond that.  We must consider the increasingly likely global switch from monetary to fiscal stimulus, and protectionist trade policies.  First Brexit then Trump, but the next wave could be even more destabilising.  Europe enters an election cycle over the next 12 months that is likely to see all parties shift toward anti trade, anti immigration, anti austerity policies, inspired by Brexit and Trump.  Such moves will create uncertainty and increased volatility for financial markets.
    Strategy – derisk your whole portfolio; reduce European exposures; increase US exposures

  2. Deflate your overall portfolio
    Bubbles or not, valuation levels on US equities and global sovereign bonds exceed historic norms on many valuations.  Sovereign bonds have fallen in price recently, but only to what could be considered moderate value. US equities on the other hand continue to inflate, without earnings evidence. 
    Strategy – reduce US equities relative to other countries; switch higher risk equities for corporate bonds

  3. Deflate your equities portfolio
    When the tide goes out we find out who is wearing pants and who isn’t, or so goes the old expression.  In investment markets this means when markets correct, companies valued on hype rather than substance will fall the hardest.  In the GFC, high dividend payout ratio stocks, such as property and infrastructure stocks, fell by 70% or more.  While major banks fell by 50%, they recovered as they had earnings substance.  Since then, dividend payout ratios have risen across the whole market, creating new risks for investors chasing yield.  Dividends have already started to fall globally and in Australia – so high dividend stocks with earnings risk in an economic downturn will be harshly treated in a correction.
    Strategy – reduce high dividend payout ratio equities and switch to corporate bonds

  4. Reduce exposure to the global economic cycle
    Trump may be good for the US economy, at least in the short term, but the upside for the global economy is limited.  This has yet to be priced into global equity markets and in particular Australia’s market.  Commodity prices remain inflated following Trump’s win on the basis of his infrastructure promises, yet US imports source very little of its commodities from Australia, and Trump’s anti Chinese steel stance creates far more downside for our commodity prices than infrastructure projects.  He has also promised to open up more oil exploration sites, meaning lower oil prices in the medium term. 
    Strategy – reduce exposure to growth assets, particularly resource equities, the AUD and high valuation equities

  5. Hedge against China slowdown
    Our ‘base case’ for China remains an assumption that they safely navigate their economic slowdown without a hard landing.  But the risks of a hard landing are certainly heightened by Trump’s anti trade positions, particularly the pressure he intends to apply on the highly leveraged Chinese steel industry.  Trump is very likely to soften his pre election stance, but with the extraordinary increase in Chinese corporate debt, mostly in the steel, coal and property sectors, any reduction in revenues for this sector risks a jump in defaults, and a knock on effect for the Chinese economy as a whole.  A weaker China is clearly a poor outcome for Australia and even the perceptions of higher risks will likely push the AUD downwards. 
    Strategy – reduce China exposure by lowering AUD positions and lowering resource equity positions