Fear and Promise and the Equity Risk Premium: 2016
Relax; that is, become less taut. A recent survey by Credit Suisse has found that investors are far too fearful. While the world is awash with many reasons to be fearful, the equities market continues to sport an equity risk premium of a bit less than six percent annually. In a world of low-to-negative returns on bonds and fixed investments, that’s great. All one has to do to earn this risk premium is to endure the day to day volatility inherent in the stock market. Meanwhile, relative valuations on stocks should remain favorable until the 10-year bond provides a competitive risk-oriented yield of some 3.5%, according to Credit Suisse analysts. For this to happen, the Federal Reserve Board must create inflation, the kryptonite of bond values.
It’s just like me to list the current boogeymen driving the markets. This letter is no different. Fear of the unknown is one thing. But fear of the known is manageable and right now there are so many reasons to manage the negative. My comments here will therefore first summarize the many paths to uncertainty, inclusive of societal decay, social upheaval, economic recession and protectionism in the form of politics of the absurd. Secondarily, I will use quantitative data and reality to realign one’s thinking toward hope.
This strategic discourse, however, should not be seen as a consistent approach to my communication to you. I hate public optimism. I even hate institutional optimism. Show me a long-term bull market that doesn’t concern me. After all, the markets are safest immediately after a recession, not before. As evidence, I gave, in January of 2009, a public lecture entitled “The Future is Bright”. Few people found my message plausible. The reaction to my lecture enhanced my confidence. The market bottomed the following month when the S&P 500 hit 666. As of this writing the S&P500 now stands at roughly 2,174. That’s progress. That said, why then (after so much progress) would I continue to expect the economic cycle to offer significant upside? After all, consider the following boogeymen:
• U.S. corporate earnings appear to have peaked as the cost of labor is increasing, both by political edict as well as due to a tight labor market.
• Equities are not cheap. The trailing 12 month Price to Earnings ratio (P/E) of the S&P500, 18.7, is roughly 28% above its 50-year average.
• The Chinese economy is slowing and their currency is declining relative to the dollar, making their products cheap relative to U.S. made products.
• If the next recession were to hit, real interest rates would have to fall by 5%, on average, to stimulate an economic rebound. With rates so low now, that cannot happen. Only fiscal policy would be left as a policy weapon. This literally takes an act of Congress.
• Abnormally high political risk may be at hand. That is, both U.S. political parties are moving toward protectionism, inclusive of boosting minimum wages, rebalancing the economic reward of corporate profits toward labor, reducing immigration, changing tax policy, and realigning entitlement benefits.
• Significant business model risk exists. Disruptive technology is creating price visibility and reducing inventory asset life. In addition, corporations are facing growing competition from Chinese exporters.
Nevertheless, in the face of these challenges the following context exists:
• TINA: There Is No Alternative to equities from a competitive standpoint. Money goes where it is treated best. And now that money from around the world has crowed into government bonds, corporate bonds, and real estate, these asset classes appear very expensive. As a result, although the cost of equities is a little high, stock values are still within a normal range, according to CS analysts. For this reason, Credit Suisse analysis now identifies the current U.S. ERP (equity risk premium) at roughly 5.7% annually vs. a warranted level of 5.3%, a long run average of 4.2% and an ERP at market peaks of some 2.6 percent.
• Meanwhile the riskless return on bonds is becoming a return-less risk. This is driving investors into cash in the short term, with the likelihood being the next leg up in this economic cycle will be driven by investments seeking ERP- comparable returns.
• Positioning must change. In total, since the first quarter of 2009, households have sold a net sum of $62 billion in stocks. During the same time frame, Institutional investors sold roughly $1.1 trillion of equities. Meanwhile, U.S. corporations (minus financial institutions) purchased $2.6 trillion of U.S. equities; approximately 15% of all U.S. market capitalization.
Central banks around the world continue to push investors toward equities in order to support economic growth. Yet, as the benefits of monetary policy have begun to ebb, hints of fiscal policy are now being considered in Japan, the U.K. and the U.S. To illustrate, Donald Trump has called for a package of infrastructure spending fiscal policy and tax cuts (fiscal policy) while Hillary Clinton’s campaign website states that were she to win the Presidency she would increase infrastructure funding (fiscal policy) by $275bn over a five year period.
If the benefits of monetary policy continue to decline and U.S. Gross Domestic Product (GDP) continues to come in quarterly below 1.5%, fiscal policy programs would most certainly be put before Congress for approval. Credit Suisse analysts report that such policies would drive down bond yields and increase inflation. This would mute the appreciation of lower bond yields while creating a financial environment that causes investors to need to buy inflation hedges (stocks) rather than deflation hedges (bonds). With inflation expectations on the rise, from very low levels, equities have historically rerated pushing price/earnings multiples higher, to around 20 times earnings, according to Credit Suisse research.
Per StatBureau.org, the rate of inflation in 2015 was 0.73% and for the twelve month period ending June 30, 2016 was 1.01%. The following chart, going back to 1871 describes the relationship between P/E multiples and inflation. On July 22nd, the Financial Times reported that Jack Lew, the U.S. Treasury Secretary, stated that ‘There was a debate when I came in between growth and austerity…that debate is pretty much over…fiscal policy taking an equal billing is a significant move forward.’
According to a recent Credit Suisse survey of investors, it’s almost impossible to find a bear of bonds, unlike the start of this year when it was impossible to find a bull of bonds. If China faces a hard landing and dramatically devalues its currency, thereby exporting deflation, bond investors may yet see a peak. However, it would be a mistake for bond investors to take the current theme, lower-for-longer to mean lower forever. This perspective assumes the world’s central banks will win this war on deflation.
Taking a shorter term perspective, bond yields have reached such a low point that only further deflation and rate cuts could bolster annualized returns. However, in this same short-term assessment, inflation has risen marginally in recent months. Moreover, around 60% of inflation comes from the labor market and U.S. wage growth is rising, even before accounting for a huge increase in the minimum wage, expected to hit in 2017 and beyond.
In summary, inflation is starting to increase from very low levels. This is good. Inflation is necessary to defeat deflation and move equity price multiples higher. Wages are increasing, though U.S. GDP remains below 2 percent. This has caused the negative speculation on U.S. bonds to subside for now. This current low interest rate environment is allowing companies to refinance the cost of outstanding debt and thereby exceed market earnings expectations. This sets the stage for increased hope since better times ahead for equities are correlated to increased earnings and increased price/earnings multiples. Of course, there will be volatility in getting into a world of higher inflation. It could take years until inflation becomes a problem. For now, deflation is the ebbing boogeyman, leaving equities as the only alternative available to promise equity risk premium comparable returns.
Vaughn Woods, CFP, MBA
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0216
Credit Suisse, Global Economic Strategy, July 28, 2016. Researchers for Equity Research Investment Strategy: A. Garthwaite, M. Pronina, R. Grffiths, N. Wylenzek, A. Hymers and M. Yuan.
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