A GLOBAL MARKETS TEMPERATURE GAUGE
Foord has always advocated the importance of staying invested through cycles for the long term. But as the market cycle progresses, risks rise. In this article, portfolio manager NICHOLAS BALKIN takes a temperature gauge of global markets.
We’ve all heard that it is time in the markets that counts, not timing the market. But as we know, market cycles do exist. They are very difficult to predict accurately, but they can and should be assessed in broad terms. We can do this because we know that they are driven by interest rate cycles and business cycles, which affect earnings.
Assessing the stage of the market cycle allows us to build conviction in the direction of the most important variables in the global economy. In turn, these variables are key to our forecasts for economic growth and the earnings and income streams we can reasonably expect from different asset classes. It also clarifies the key risks that we need to be managing.
We look at four simple factors to gauge the temperature of global markets and inform our assessment of the stage of the market cycle. I have already mentioned two — interest rates and earnings. Money available for the market and confidence levels are the other factors. We will look at each in turn.
An assessment of the money available for the markets includes an analysis of the aggregate money flow into and out of global markets. Quite simply, lots of money flowing into markets implies structural support for market price levels because we would expect there to be more buying than selling. The opposite results when liquidity is withdrawn.
In the ten years since the 2008/2009 global financial crisis, central banks have injected unprecedented liquidity (money) into global markets. Extremely supportive monetary policy in all corners of the globe resulted in $2.5 trillion per year flowing into capital markets. Most of this money landed up in financial assets and not the real economy.
The US Federal Reserve is now reversing the flow of dollars as quantitative easing ends. The ECB is about to begin its own reversal and the Bank of Japan should soon follow. So, we are in the midst of a reversal in money for the market after a decade of excess liquidity. In the years ahead, there will be less money for the markets. What does this mean for portfolio positioning?
The second factor, the interest rate cycle, is simply the cost of borrowing. Economic expansions usually end with rising interest rates. Since 2008, central bank policy was focused on avoiding a deflationary depression and interest rates were reduced to zero. Low interest rates support companies to grow earnings (through cheap borrowing and by spurring consumption in the broader economy).
Interest rates also have a direct, positive impact on valuations via the discount rate — as the discount rate falls, the current value of future income streams of all assets goes up. The developed world, led by the US, is now firmly into a rising interest rate cycle. So, interest rates, like money for the markets, is another indicator of the late stage of the market cycle.
Confidence is the third factor. This is where we assess the markets’ animal spirits, so to speak. Because fear and greed drive markets, gauging confidence is important in judging the market cycle. By almost any metric, confidence is comfortably above pre-crisis levels. This is not surprising after one of the longest bull markets in history, combined with global economic growth, especially in the US. Confidence levels are high, but where do they go from here? In our view, it is more likely that they will decline rather than rise further.
Finally, we assess earnings. In the fullness of time, company earnings drive share prices. And like the first three temperature gauges, earnings appear to be nearing cyclical highs, particularly in the ever-important US economy. Years of monetary stimulus, robust economic growth and late-cycle fiscal stimulus from the Trump government have caused US company earnings to surge well above pre-crisis levels. For now, rising earnings support market valuations but there is little room for error.
So, we have four amber warning lights flashing when we filter the current market cycle through our mnemonic MICE trap. This supports our cautious and defensive investment strategy. But readers will take note that our balanced portfolios still hold 60% in equities, despite our worries for the late stage of the market cycle — because investing in quality companies through these cycles is the most important driver of long-term return outcomes.