The prospects for 2017 are likely to be heavily informed by what we have seen in the years since the financial crisis. Since 2008/2009, economic policy has focused almost exclusively on austerity measures and loose monetary conditions, such as ultra-low (and even negative) interest rates and quantitative easing (QE) programs. These measures were intended to slow the growth of debt relative to gross domestic product, to lower-risk free interest rates and stimulate economic activity. Whilst they have been successful to the extent that they have averted a 1929-style depression and a collapse of the banking system, they have been largely ineffective in engendering significant growth in the real economy.
In addition, there has also been the unintended consequence of significant asset-price inflation that, in most economies, has not benefitted the broad population. That has been reflected in political developments in 2016. The surprise outcomes of the U.K. Brexit referendum and the U.S. presidential election are clear examples of electorates pushing back against the income and wealth inequality that they have experienced in recent years. There is scope for this to continue in Europe with French and German elections next year. This pressure on governments and central banks is likely to accelerate the much anticipated shift away from monetary policy towards a more pro-growth fiscal policy.
What does fiscal policy mean for markets?
A global shift to expansionary fiscal policy, such as the tax cuts and infrastructure spending proposed by U.S. President-Elect Donald Trump, would likely mean a boost to the supply of bonds and also to expectations of future inflation. In such a scenario, investors would no longer see falling bond yields as the norm, which would have profound implications for the yield curve in fixed-income markets, and by extension for perceived ‘safer’ bond-like segments (i.e., ‘bond proxies’) of the equity market.
In recent years, valuation has taken a back seat as stocks characterized by low levels of volatility have outperformed their more cyclical counterparts, not because of their fundamentals but because of their bond-like qualities. This outperformance has meant that many assets that are perceived to be ‘defensive’ are now very expensive. For example, as of October 31, 2016 global consumer staples traded at around 20 times next year’s earnings, which is higher than their previous peak in 2007.1 Such valuations are unsustainable in my view and render these parts of the equity market vulnerable to the resurgence of valuation as a key driver of returns. A shift to fiscal stimulus would support that resurgence and serve as a shot in the arm to those parts of the market that have lagged the considerable outperformance of ’safe haven’ assets.
Where are the valuation opportunities?
In aggregate, markets appear quite expensive to me. Despite recent spikes in yields, it is still difficult to find any value in the bond markets. At first glance, equity-market valuations also appear expensive, albeit less so than bonds. However, these high equity valuations mask extreme valuation disparities amongst both regions and sectors. If you dig deeper, I believe there is still value to be found in certain parts of the market.
In regional terms, I think that Europe is the stand-out opportunity, especially when compared to the U.S. equity market. European companies have not re-leveraged to the same degree as their U.S. counterparts, benefit from supportive financial conditions and still have significant scope to improve their earnings, which are a long way below their prior peak. To put the valuation disparity between these markets in context, the U.S. equity market hasn’t been this expensive relative to Europe for decades.
In sector terms, the cyclical areas of the market, particularly banks, should in my view continue to perform well. Banks are much better capitalized entities now than they were in the immediate aftermath of the financial crisis. They have significantly improved their capital structures and reduced the volatility of their earnings streams in recent years whilst operating in an extreme environment of tight regulations and ultra-low interest rates that have depressed returns. I believe that there is potential for the interest rate and regulatory backdrop to improve throughout 2017.
Can the great rotation continue?
As we have seen in recent years, unforeseen risk-off events have the potential to shake investor confidence and render valuation a backseat driver in market movements. In those circumstances, ‘defensive’ assets could outperform again, particularly over short periods. However, we remain resolute in our belief that over the long term, valuation is the most reliable driver of returns. Many of the ’safe haven’ assets that have performed well are now overvalued to the extent that they no longer necessarily offer the protection that investors have come to expect of them. Meanwhile, areas of the market, such as Europe and some of the more cyclical sectors, are pricing in an outlook that is much worse than the one that I envisage. That disparity is not sustainable. A shift in thinking amongst policy makers towards expansive fiscal measures should support further positive (even if only moderate) economic growth and an uptick in inflation. In my opinion, this would provide the right environment for the normalization of valuations across markets.