Stephen Jones
A few weeks ago in this column I suggested that while equity markets were likely to enjoy a nice run into Christmas, the prospect is that highs reached will not be breached for some time.
With investors generally wary of chasing stock markets – they have been so all year - it’s hard to know which view is more contentious.
Global equities, however, returned a handsome 2.3 per cent in October and have started November in a good mood so I’m going to look beyond this early Santa rally to expand on the tougher longer-term outlook.
Importantly, I’m not looking for dramatic falls akin to 2008/09 or even last winter, when equities slumped 17% over the fourth quarter into Christmas Eve.
My concerns relate to the ongoing slowing of the global economy and the increasing cost of responding to populist pressures, the lack of monetary policy options and a narrowing ownership base for stocks.
These should be interpreted as strong headwinds, though, as opposed to sink holes.
Since last Christmas, the US equity market, which accounts for more than half, by value, the world stock market, has returned more than 30%.
While dividends have contributed just over 2%, valuation multiples have surged 26%.
Earnings, meanwhile, have grown, although only by a modest 3%.
Equity gains have come from a rerating driven by the slide in long-term US bond yields - which fell from 3% to 2.2%, which is a big deal for bond investors.
This, in turn, reflects that there have been three cuts in US policy rates.
All the while consensus forecasts for economic growth this year and next have fallen, validating the weakness in bond yields.
Not for the first time, bond markets have had the clearer vision of the future.
Significantly, these downbeat projections come even as global central bankers are easing policy – either in practice or against prior intentions.
While everywhere looks set to avoid the recession that blighted equities late last year, nowhere is activity likely to prove vibrant.
Together with the populist drive to cut a bigger slice of the cake for the man in the street – and the UK electorate may yet vote for a transformation of the modern capitalist model not reflected in UK asset prices (a Corbyn-led government) - it is simply going to get a lot harder to grow company profits.
Meanwhile, the ownership base of equities continues to narrow.
Nothing, it seems, could make large institutional pension funds buy stocks and major investors continue to reduce weightings.
Yale’s $30 billion endowment fund, for example, currently has a target allocation of less than 3% of its assets in US equities.
Combine this with the challenges that individual investors face in holding onto volatile equities – and they typically hold too much cash - and it is easy to understand why equities are having to fall before they will appeal to investors.
Traditional valuation multiples on world stocks may be around long-term averages, but that probably isn’t sufficiently compelling.
So, who has been buying? Well, for the most part either official central banks and their satellites - the Bank of Japan most notably - or companies themselves.
Unfortunately, the support from company buybacks looks likely to sour. Not only, as Forbes reports, does the data suggest that companies are poor stock investors – buying high and selling low - but Goldman Sachs observe that the value of US corporate buybacks has recently been falling badly and that the outlook is poor.
That is hardly a surprise given economic forecasts.
The change in monetary conditions over the past year has been dramatic but, increasingly, the fear is of policy exhaustion, with policymakers powerless to respond when - not if - we enter a recession.
There are new tricks to try, but these represent dramatic departures from the standard economic model and are only likely to be embraced in adversity.
Some positive feedback to lower interest rates is likely to be visible in the hard economic data over the winter, which risk markets will celebrate.
It appears that permanently lower long-term discount rates are reflective of a more austere economic outlook.
While equities have enjoyed the adjustment from higher bond yields, it looks likely that from next year - and beyond - the hard work is going to have to start.
Stephen Jones is chief investment officer at Kames Capital.
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