Multiple Contraction versus Earnings Strength
(this is part one of our weekly blotter, we'll publish the latter part tomorrow)
Why are US stocks and US cash the only two broad asset classes that are showing positive returns in 2018? Sovereign bonds are down on the year, as are investment grade securities and high yield. We all know what a drag emerging market assets have been on our portfolios, as have European equities and even the more illiquid parts of the average pension portfolio such as private equity, leveraged loans and real estate, on a mark to market basis, are probably exhibiting small losses on the year. While Japan is up some 4% this year, the aggregate of international equities is negative. The answer is remarkably simple and that is that interest rates have been rising and this must reduce the value of all stable cash flows versus the alternative of cash. It isn’t rocket science when you think about it like this.
Notice how I said stable cash flows. Fixed income and credit securities have stable coupons. Therefore, if the returns on cash rise, then they become marginally less attractive and the price should fall. With each 25bp increase by the Federal Reserve, the attractiveness of cash continues to rise. When you compare cash versus the yield on the SPX, then an argument can be made to allocate money away from stocks and into cash deposits. It is a war chest to a time where the valuation of other cash flows, be them US stocks, EM credit or European equities become compelling enough to re-allocate again.
However, the cashflows of stocks are not stable. They are determined by the earnings of companies all across the globe. Equity investing, in it’s simplest form, is a decision not only based on the current cashflows of a company versus the alternative but also future earnings. This is why US stocks have performed so well this year in a rising interest rate environment. We have witnessed multiple contraction in the US through the course of 2018 but the extraordinary earnings, induced in no small part due to the tax cuts / fiscal expansion policies of President Trump, has seen share prices rise. Profits have swamped the multiple contraction inherent with a rate tightening cycle.
Other markets have underperformed the United States because profit growth has lagged the US, their economies have lagged and their policies have been less market friendly. US equities do face a bigger headwind than the rest of the developed world because cash is a legitimate alternative which has made the performance of US equities even more remarkable. With cash rates negative in Europe, the incentive to own stocks should be theoretically higher implying that the sluggishness of growth and profits has been a major impediment to EU equities as an asset class. Emerging markets face the double whammy of slowing growth and corporates exposed to a higher cost of USD funding. The worst of both worlds.
US CPI is the most important data release for the week for obvious reasons.
On Monday, German Industrial Production and Singaporean GDP, Japan Current Account on Tuesday, on Wednesday UK Industrial and Manufacturing Production, and Japan Core Machine Orders, on Thursday Japanese PPI and US CPI, on Friday German and Indian CPI, Indian Industrial Production and US Sentiment by Michigan University.