New article from Tatton Investment Management: Now we know it's risky!

23 March 2018

Equity markets have taken a turn for the worse following the US’ probable imposition of “section 301” tariffs on China.

Undoubtedly, events that increase uncertainty about the likely path of profits are bad news for any company’s share price. In a sense, given that the likelihood of President Trump’s action was high and much-discussed particularly in the last two weeks, some might say that this path should have been discounted by the market already.

Of course, markets can be influenced by an incredibly large number of related but constantly shifting factors and “knock-on” effects. Even when the next event can be reasonably clear, the fact that it happens triggers other events. It’s that creation of new paths and possibilities which can destabilise markets through increasing uncertainty.

Even when events occur which have equally positive or negative future impacts, if the likelihood of extreme outcomes rises, investors tend to want to insure against the bad ones. Some investors buy options to sell their assets, an explicit insurance contract. As a whole, the market builds in an implicit insurance.

That insurance is the risk premium, the extra expected pay-out an investor estimates that they need to make it worthwhile to hold a risky asset (in comparison to a non-risky asset like a bank deposit or short-term government bond). An event which has balanced outcomes (upside and downside) for a company’s earnings shouldn’t change analysts’ forecasts for earnings. However, because an investor needs a greater return in order to take the risk, the share price they’ll pay to buy some more of the company goes down. The “valuation” of the company, (such as the price-to-earnings or P/E ratio) falls.

Most investors are in for the long-term and don’t sell. That’s because (we would say) the main point of long-term investing is to get paid a diverse portfolio of risk premia on a pretty constant basis. Also, because investors (generally) get information at the same time as everybody else, prices move quickly to discount everybody’s worries. One would have to have good reason to believe that one had better information or analysis than others to justify selling. And then, at some point in the future, one would have to decide when to buy.

What matters for each investor is getting the long-term holdings aligned with their risk appetite. A useful working definition of long-term is “not needing the money for a number of years”. If one’s savings aren’t needed in the nearer-term, then history shows that the best strategy is to get the asset allocation aligned to the risk appetite and then leave it that way through thick and thin.

What can happen is that an investor realises that they’ve taken on more risk than they really wanted. Often, it's because their circumstances have changed but, because investments have been good, they haven’t got around to thinking about it. When the environment changes, they’re left having to decide while feeling uncomfortable and possibly fearful. (As an aside, this is why clients are asked to review their risks at least annually, hopefully when market moves aren’t influencing their perceptions of risk).

Here at Tatton, we accept we probably don’t have more information than others, but we do believe that good analysis can be rewarding. So let’s delve a bit further…

The rise of trade tensions may have been clear for some time. Meanwhile, as John Authers in the FT says, Trump’s move to enact now has come at the same time as expectations of company earnings growth are strong:

In the US, the tax cuts and fiscal boosts were announced first, and analysts upgraded earnings growth expectations to 20% for 2018.

After a strong 2017, UK, earnings expectations have settled at 7%. Europe’s earnings growth is at a similar level.

Asia expectations jumped sharply driven by the US and a strong China. Japan’s 2018 earnings are expected to rise a whopping 34%.

These expectations have been weighted towards cyclical sectors; industrials, energy and materials on the back of strong economic growth. Growth indicators have been slipping somewhat since January, particularly in Europe, less so in the US. This week’s business survey indicators (the preliminary “Purchasing Manager Indices” or PMIs) were generally a bit lower than economist expectations and lower than February’s (which had been lower than January’s).

Alongside the Trump policy impacts, US strength could well be down to a weaker dollar at the start of 2018. Europe’s relative weakening is probably the mirror of that – a stronger euro. Overall, global economic indicators are now generally in line with economist expectations, after exceeding them for over four months. The graph below is the Citi economic data “surprise” indices:


Final sales growth has been robust globally because of strong economic growth. Those revenues (rather than expanding margins) have underpinned earnings growth. However, if the world is “late cycle” (the growth peak is near or possibly even in the past), equity valuations shouldn’t embed lots of earnings growth in the next couple of years. Indeed, P/Es should be relatively low.

Generally, markets do not have very extended P/Es but only Japanese stocks are below their 10-year average. When comparing each equity market to its bond yield, the US is the one that stands out as expensive. If earnings growth in later years is much stronger than elsewhere, it could be justified. However, if there is reason to doubt later growth, it starts to look vulnerable.

That’s the rub. In the US especially, despite being a long way through the economic cycle, optimism probably led to an under-appreciation of risk among retail investors, with huge inflows into equity exchange-traded funds in December and January, taking valuations to extended levels. The underpinning of strong economic data had started to wane before the tariff issues came into immediate view, leaving markets in a vulnerable position.

The imposition of tariffs is a problem then. Even if it were a balanced risk to earnings, one would expect cheaper P/Es. It’s highly likely to not be balanced. It’s not easy to envisage a scenario in which the outcome is greater economic growth at the global level, nor even at any regional level.

However, growth has been good, is good, and tariffs might not have much impact. Trump’s removal of the metals tariffs on Europe shows the situation is very flexible, and that the administration is honest when it says it’s open to negotiations.

Other good news got rather buried this week. The Bank of England kept rates on hold and showed it recognised that economic data was mixed. It is still probable that rates will rise in May but only if the data doesn’t soften further.

Likewise, while the Fed raised rates, it seems that the Powell-led Fed differs little from the Yellen’s. The fear was that policy would become more rigid, with a greater commitment to raising rates in the future. While the members’ expectations of the path for rates were a little higher, there was no insertion of a fourth rate rise for 2018 – another two remain the expectation. The commentary acknowledged the more mixed data, important because being data-led reassures market participants that the Fed is still mindful of downside risks.

Longer-dated bond yields fell somewhat on that news and then a little bit more under pressure from equity markets. Perhaps one can draw a positive conclusion; the equity market decline is not sparking a flight from risk to non-risk assets. Investors may be less perky but they’re not exactly panicking.

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