Market report January 2020
Returns on US companies vs. aggregated earnings growth
Investors started 2020 with a large dose of good news. The FED maintains an accommodative monetary policy, trade agreements with China, Mexico and Canada are in force, Congress has reached a budget agreement. Even in the face of possible political turmoil related to the election year, the macroeconomic environment seems to be optimistic.
Have these factors already been reflected in market prices?
In the situation of shares trading of companies from the S&P 500 index above their 18.4 times the forecasted operating earnings in 2020, one could say that yes. This is well above the historical average of around 16 times earnings over the past 30 years.
Chart: American companies share prices from the last 6 years, with particular emphasis on the Price/ Forecasted Earnings end of financial year (P/FE ratio):
Until January 31, 2020
Past results and ongoing analysis do not guarantee future results. Based on estimates of operating earnings for the next 12 months.
Source: Bloomberg. S&P
The low interest rate environment has an impact on stock valuations. We see that the yield of the 10-year US Treasury Department instrument is below 2%, which is well below the long-term average of 4%. Therefore, share valuations should be higher, because investors discount cash flow with a lower interest rate.
Current valuations, given the economic environment and corporate fundamentals, are largely justified. To clarify, we can see companies whose presence in the portfolio despite aggressive valuations, can be described as a deep value investing. This is particularly applicable to companies in the exponential growth phase, with an established position and operating on high-margin markets. What is specific to the American market, however, is that we often see situations in which valuations on the private market are definitely higher than on the public market.(!) In a situation of optimistic projections, any negative revaluations will meet the need for risk revaluation and stock market repricing. This is a standard situation with market that is developing dynamically and investors’ expectations are excessive. On the other hand, as shown by historical data, the stock market is not in a positive correlation with the aggregate earnings of American enterprises (in 2018 the increase in the aggregate earnings ratio was accompanied by a decline in the stock market, in 2019 the reverse situation took place).
Signals from the broad market are not encouraging. The market consensus on corporate revenues in 2019 was overestimated from 14% at the beginning of 2019 to around 4% real growth in 2019. Of course, companies with solid foundations, low leverage and a well-prepared management team, even in more difficult macroeconomic conditions and more demanding market environment, are an interesting perspective.
Looking for investment opportunities in the face of attractive foundations
The spread between stocks presenting value (value stocks – shares whose intrinsic value is higher than market value) and growth stocks (representing growth higher than the market) is large.
On the one hand, we see a large number of attractively priced companies (US market) in the context of their current indicators. On the other hand, this is associated with a high risk, because in the face of economic uncertainty and market imbalance and the associated impact on the profitability of valuable resources, we prefer a very selective selection of companies that will defend themselves in each environment (product, business model, management). An equally attractive factor is the so-called investment catalyst, i.e. something that changes (or may change in the future) the perception of company value. It can be reorganization of the management team, beneficial changes in the industry in which the company operates, reorganization of the enterprise.
Over the past decade, we have seen very high results in most asset classes. However, in the 2020s we expect the return on assets to be lower and more difficult to manage. Looking ahead, a disciplined multi-resource approach will be particularly valuable in identifying investment opportunities and helping to mitigate any setbacks.
We start the valuation of a company by preparing an appropriate model of cash flows in the company, which should meet, among others, the indicated criteria. As in all models, model assumptions are key, which is why we try to make them rather conservative. Optionally, we prepare a model taking into account the optimistic scenario of development. The models are prepared using in-depth analysis of the current situation in a company, market environment and perspectives, taking into account the business model of the analyzed entity.
We are looking for leaders, i.e. companies that are ahead of the competition in terms of technology offered, solutions and data. A great example of such a company can be Tesla (advantage in the area of very low production costs of cylindrical batteries, AI chip created by the company – replaced the NVIDIA chip, about 2.2 billion miles of autopilot data, which are particularly valuable in the context of building autonomous networks).
The next step is to estimate the company’s 5-7 year revenue forecast, reflecting the most important factors affecting the company’s operations, including the nature of its operations, market conditions and competitive environment. Another important issue is the proper selection of the discount rate reflecting the risk-free rate (currently in the US below 2%) and the so-called risk premium. If you are interested, please refer to the presentation of our DCF model valuation of KGHM:
The above mentioned DCF model is only an example of our workshop and a sample of the set of tools we use and should be treated as such. Such a model obviously takes into account the liquidity factor of specific instruments, and is considered in the broader context of risk management, taking into account its individual elements: specification, estimation and implementation. It is also comprehensive and consistent in time.
Challenges against portfolios consisting of multiple asset classes
High rates of return in 2019 meant that strategic allocation did not matter so much to investors. Shares led the way in terms of rates of return, results were good in all asset classes and categories, from shares to bonds and real estate. This trend has continued for most of the last 10 years.
Good times have it all up that they will end sometime. We believe that markets will face profound changes in the coming decade. Challenges include unfavorable demographics in developed economies and China, slow productivity growth, reduced consumption and investment associated with servicing very high debt levels. Cyclical difficulties are associated with high asset valuations (over a decade of easy monetary policy and credit-based expansion), populist pressure and growing geopolitical risk.
We expect lower rates of return on market assets for most asset classes over the next 5 years and high volatility. Meanwhile, the risk of the situation getting worse will increase as policymakers find it difficult to present effective answers to difficult problems.
Some great tips
- Cautious exposure on stock markets – companies’ profit margins seem to have peaked, especially in the US, due to rising unit labor costs that may force companies to be more cautious when hiring and spending money. In Europe, stock valuations are attractive (in certain sectors), and low levels of the euro should support many export-oriented eurozone companies. Upward profit adjustments and improving corporate outlook also support selective exposure to emerging market shares, including Chinese A shares.
- Exposure to interest rates – once treated as a milestone in hedging the dowside of a position, in the face of negative interest rates questioned as to the amount of portfolio duration protection it offers in the face of the risk-off scenario. Uncertain outlook for growth and return on assets justify an approach to risk management that specifies certain exposure to shares with interest rate exposure.
- Alternative investment strategies for the diversification of the Beta indicator with an attractive risk /return profile.
- Main trend line – geopolitical risks and further growth may make it difficult for markets to establish sustainable trends. That is why we propose to revaluate in minus signals following the trend, such as volatility or momentum. The most likely path is a transitional period with risk in/off fluctuations. Under these conditions, it is worth placing more emphasis on signals such as valuations, corporate balance sheet quality, stimulus and inflation.
- Income horizons – generating income in a situation where more than USD 12 trillion of high-quality debt has negative yield is a big challenge. As part of fixed income, this means the need for a global, multi-sectoral approach. For example, an interesting option is exposure to high yield bonds in the US, adopting a multi-asset investment strategy that may discover opportunities in real estate investment funds (REITs), Master Limited Partnership MLP, securitized assets, or global shares.
Applying the principles in a disciplined multi-asset strategy is a good way to start a new decade. Exploiting different parts of capital markets can help investors capture swirl-resistant returns, while reducing the risks associated with new and tougher challenges that may arise in 2020 and beyond.
At the same time, it is worth being aware of many negative factors whose market presence is the subject of our observations and analyzes. I write about them in the article: https://www.linkedin.com/pulse/i-like-market-wind-any-clouds-horizon-rafa%25C5%2582-ciepielski/
Situation in Europe
We estimate growth in the European Union to be about 1.6 percent in 2020 and 1.7 percent in 2021. In the context of increased tensions in world trade (after the signed US-China Trade Agreement in Phase I, we expect an escalation of action on the US-EU line), exporters face numerous challenges, including tariffs, delayed demand, and the need to make corporate decisions in conditions of greater political uncertainty. Structural challenges and changes in such significant sectors as the car industry question the well-established business models and cause companies and decision-makers to face the need to develop new economic paradigms. Internal demand will be the basis for growth. Lower unemployment, solid wage increases and an additional monetary stimulus will form the basis of solid household consumption. A very favorable monetary policy bias will continue to drive investments in domestic market-oriented sectors such as housing, creating positive domino effects for businesses. The perspective is still subject to numerous threats and challenges that can lead to a significant slowdown in growth, with particular emphasis on the re-escalation of trade tensions, the UK’s disorderly exit from the EU and financial instability resulting from a loose monetary policy position.
A look at systemic risks
Populist politics and related geopolitical tensions are growing. The trade war between the US and China has damaged global trade, causing a decline in business confidence and a decrease in production. Trade sensitive economies such as Mexico and the euro zone have suffered the most. If we see trade wars as a tool for dividing spheres of influence, the first effects can be seen.
Can the outcome of the 2020 US election solve the problem of volatility caused by populist policies?
Probably not. Both wings of the US political spectrum support a shift towards trade protectionism, while the center remains skeptical. What’s more, the increase in populism is a global topic, as evidenced by the constant turnaround on Brexit. The global slowdown may expose the world to even greater vulnerability to adverse shocks.
Central banks have started to act and this year we can expect further loosening of monetary policy. At a time when interest rates in most of the world are already at zero or below zero, we do not expect quick effects. The next QE rounds will obviously have an impact on rising asset prices (various classes) and depreciation of savings (consumer consumption effect).
The steeper American yield curve seems to say that the risk of recession in the US has decreased. Consumers from the US and other developed markets are still spending, and the US labor market remains solid. China has set a real GDP growth rate of 6% in 2020. Achieving this goal will require further acceleration of policy easing in response to downward pressure, both internal and external. We expect the Chinese stimulus to pass on to the economies and assets of developed countries and emerging markets, thus contributing to the stabilization of the global economy in 2020.
Looking for new opportunities
It is important to maintain control over ‘duration’, that is, to maintain exposure to the risk that interest rates rise or fall, particularly important in the face of significant uncertainty on the global geopolitical scene. During periods of market turmoil, the duration of treasury bonds serves as a factor neutralizing partly the volatility on the stock and credit market, reducing the risk of portfolio value decline. Investors should also benefit from shifts in credit-sensitive sectors that offer an attractive combination of performance, quality and fall protection potential. Examples of such sectors are US securitized assets secured by commercial mortgages (Commercial Mortgage-backed securities CMBS) and subordinated debt of European banks.
Securitized assets were a good way to control the volatility of returns associated with the trade war. Commercial mortgage-backed securities (CMBS) and credit-risk-transfer (CRT) securities are more tolerant of the US-China trade war environment than US high-yield debt. They also have a low correlation with other fixed income sectors and other asset classes.
CMBS can increase portfolio income because it ensures an increase in corporate bond yields. The sector has not enjoyed popularity in recent years, partly because of fears related to the retail apocalypse – fears that may be exaggerated.
Investors can increase their income potential without incurring too much risk by allocating funds to the subordinated debt of European banks. These securities were issued in accordance with Basel III global guidelines, which required banks to accumulate capital buffers. Because they are lower in the capital structure, subordinated bonds issued by investment grade banks offer a yield similar to that of speculative securities. In fact, the yield of European Tier 1 (AT1) bonds is ahead of European and US high yield bonds.
The era of low profitability and related investment challenges will probably not end soon. Selective investment between regions and sectors, as well as an appropriate balance between interest-sensitive and credit-sensitive resources, can reduce volatility and increase the potential for return in a slowing global economy.
Global stock markets
Global stock markets, respectively in terms of 1 week (1 WEEK), 1 month (MTD), calendar year (YTD) and the last 12 months (1 YEAR), are shown in the table below:
The table includes rates of return in terms of pound sterling (GBP), local currency (Loc.) and relative (Rel.) 28/01/2020
Source: RCieSolution Research
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.