Now we are a few trading days in after the horrific events in Paris over the weekend, it is perhaps worth reflecting on where it all leaves us. Most market participants had been expecting a big sell off in the face of terror, but so far that has not materialised. There have been some predictable individual sector effects – mainly defence stocks such as British Aerospace strengthening, and Travel & Leisure (Tui for example) selling off; overall, however, the market is up on its Friday evening close.
Why this calm? Well of course, it is still early days and the fact that the atrocities occurred after the close of European and US markets on Friday, giving some time for reflection, may have helped. There is usually never one easy answer to why markets react in the way they do: one reason may be that, prior to the massacres in Paris, they had already sold off quite appreciably, with the FTSE 100 having fallen by 3.8% from the end of October to 13.11.15. Some better news from China may have also soothed investors: ‘China economy fears ease after capital inflows boost – Foreign Exchange reserves also rise $11bn, ending five months of decline’ (FT 16.11.15). There may have been some impact that further uncertainty in the Middle East threatens oil supplies, giving a boost to the oil majors that still make up a significant part of stockmarket indices.
Or are investors just becoming more enured to these shocking events, in light of the view that they often seem to have little lasting economic impact. This time could be different of course and the European Central Bank has already warned about the danger of potential weakening consumer spending and investment in the face of the Paris slaughter. Consumer and business confidence remain fragile.
The world is a risky place certainly; but it has always been so to a greater or lesser extent. So ultimately we have to come back to fundamentals. The case against equities was well made in a recent Investec Asset Management piece, citing three major concerns: valuation (principally of US equities), levels of debt and the uncertain outcome of Quantitative Easing (QE), or so called printing of money.
The Three Bears
Taking these in turn, valuation is naturally the biggest concern for us; it is true that US equities with the S&P 500 at c. 2066 as I write, just up for the year to date, are not cheap, but an assessment of how expensive they are depends on with what one is comparing. Certainly, if the measure is the Shiller CAPE (P/e) ratio (which is based on real earnings over the previous ten years) which averages 16.6 times over all time (in this case all time being since 1871), the current ratio of 26 times looks expensive. However, over the last twenty years the average has been 26.8. Equally, the current dividend yield of 2.06% suggests an over-valuation compared to the all time average of 4.4%, but not against the average of the last 20 years, of 1.86%.
My point is that while US equities may be expensive, they are not obviously so compared to the more recent past, at least on fundamentals. It depends where we are in the economic cycle – if we are about to see a bust after five years of ‘boom’, then clearly 26 times earnings is too much. If, however, we are still crawling out of a deep hole and just beginning to peep over the top, then it may not be.
Caution is of course warranted, in the face of this uncertainty – but then uncertainty is always there. In terms of valuation, the UK market is in any case much cheaper than the US, with a dividend yield of 3.9%.
Too Much Debt?
In this slot we can only deal briefly (and probably too superficially) with the other two concerns; too much debt can be a problem, but it depends who has the debt and what assets they have. Clearly the world as a whole – unless we are borrowing from Mars – cannot have ‘too much debt’, ie. for every debtor there must be a creditor. It may matter who are the creditors; but according to a Barclays investment review in 2014: ‘It is likely that future increases in productivity, historically the most significant contributor to long-term output growth, could easily coincide with one or more segments of the economy paying down debt. There simply doesn’t have to be a strong relationship between the two.’ In other words de-leveraging (paying down debts) need not impact economic growth. And again: ‘A population whose living standards and tangible assets are growing steadily may have greater uses for the flexibility facilitated by debt and use disproportionately more of it.’
What About Printing Money?
As to the outcome of QE, many critics appear to be frustrated that QE has not yet resulted in the rampant inflation their theories predicted. There may indeed be difficulties in Central Banks reducing the size of their balance sheet (reversing QE), although some of these are simply accounting issues, but most problems should be overcome if real economic growth is strong. In our view the world has been suffering from demand being too weak (worrying about too much debt is starting in the wrong place); in this regard we still expect low oil and energy prices to give a good boost to demand in the US and Europe, once the dampening effect of reduced investment in the oil & gas sectors has worked its way through.