Playing in extra time

Playing in extra time

09-11-2017 | 年次アウトルック
The market rally seems to be never-ending – but the whistle may be about to be blown on this high-scoring game.
  • Lukas Daalder
    Lukas
    Daalder
    Chief Investment Officer

There could be any number of metaphors to describe the current state of financial markets. Living on borrowed time. Enjoy it while it lasts. Into the third half. How much porridge is still left in Goldilocks’ bowl? It ain’t over till the fat lady sings. We struggled a lot to come up with the right description of the 2018 outlook.

We were looking for a phrase that would warn that the current bliss in the financial markets is not sustainable, but that this is not necessarily an ominous sign for 2018. Financial markets tend to overshoot, and with growth momentum picking up and inflation nowhere in sight, why should markets suddenly come to their senses?

We eventually settled for ‘Playing in extra time’. The best part of the game is over, but the outcome is still undecided. The players are tired, the game is looking less dynamic, but that does not exclude the possibility of there being some surprising last minute goals and ‘plot twists’.

Investment outlook 2018
Investment outlook 2018

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Looking at the state of the world economy and financial markets, there is no denying that we are now in a late stage cycle, with all the associated signs of wear and tear. For one thing, the quality of the global credit market has steadily weakened. The overall creditworthiness is declining and covenant-lite financing is on the rise, while the number of so-called zombie companies − whose very survival depends on receiving even more credit − has steadily risen. We have not yet reached critical levels, but the outlook has clearly weakened.

The same applies to China’s private sector debt, which has risen to more than 220% of GDP. That’s almost twice the level of ten years ago. Granted, China probably holds the world record when it comes to ‘kicking the can down the road’ and it may be capable of adding another year or two to its record, but it is clearly approaching an inflection point. A third factor that confirms we are in the late stage of the cycle is the steady decline in unemployment rates around the world.

Mind you, we are not complaining. Low unemployment is always a welcome development. However, historically, tight labor markets are not normally conducive to economic stability. Wages start to rise, the economy starts to overheat, and central banks react. And, yes, we have seen the obituaries of the Phillips curve as well and heard the rumors regarding the death of the link between unemployment and wages, so maybe the economy will take longer to overheat this time. To simply expect that we can continue going down the current path for another eight years, however, is not realistic.

The final, and probably most important, sign that we are currently into extra time is the fact that almost all financial markets have become so expensive. The S&P 500 is now trading at a Shiller PE of 30.7 times, a level only ever seen before in 1929 and 2000; global high yield spreads are at the 15% richest levels on record; while the German ten-year yield (0.4%) is still completely out of line with the nominal trend growth of the German economy (2.5% over the past five years).

To make the situation with the S&P 500 a bit more tangible: over the past six years, reported earnings per share have risen by 30%, while the S&P 500 has risen four times as much (120%). We freely admit that we have carefully chosen this timeframe to maximize the gap, but even so, there is no denying that during the past years the S&P 500 has structurally outpaced the underlying economy, pushing valuations up.

So how much longer can this party last? The honest answer is that valuation plays an important role in the longer run (a five- to ten-year timeframe), but it is pretty useless for predicting for the near future. The classic example is the dot-com rally. Greenspan gave his “irrational exuberance” speech at the end of 1996, which was followed by another three years of additional stock market gains.

Not that we think that the current situation is comparable to the 1996-2000 era − the current stock market rally has been dubbed “the most hated rally ever” for a reason, but it does serve as a clear example that momentum-driven rallies can last a long time. The same applies to high yield spreads: the last time we saw these levels of tight spreads was in early 2006; it took another year and a half for problems to arise.

Extra time can still be pretty fun to watch. As a general rule though, the longer the party lasts, the bigger the crash once the normalization process sets in. As such, we would prefer to see the dancers take a break in 2018. That would mean a bit more volatility in equities, higher bond yields and a return of credit risk premiums. While this might not make for a brilliant investment year, it would be a logical effect of the overly positive returns we have seen over the past five years. Reculer pour mieux sauter, as the French saying goes.

If we have learned anything over the years, it is that financial markets do not follow the ‘preferred’ scenario. Growth momentum is picking up, earnings momentum is strengthening and, notably, a rise in inflation is nowhere in sight. Central banks are not acting like party poopers just yet. Sure, debt is too high and credit is too loose, but as long as sentiment stays high, financial markets can easily ignore such concerns.

Keep an eye on the clock though.

Investment outlook 2018
Investment outlook 2018

Playing in extra time

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