Swimming Up the NILE
• We believe U.S. equities will likely end the year higher and once again outperform government bonds.
• Despite its age, the U.S. economic expansion may have room for more growth.
• Corrections should represent buying opportunities, and stocks could quickly retest prior nominal highs.
• Emerging market opportunities are not about to disappear but they are likely to change significantly.
Mervyn King, the former Governor of the Bank of England, once described the decade from the early 1990’s to the early 2000’s as “NICE,” that is Non-Inflationary Consistently Expansionary. The subsequent decade in the developed world was, well, less NICE and the global economy is still suffering from the hangover. And yet as we embark on 2014, a synchronized global expansion of sorts has taken hold—albeit with less familiar characteristics. Growth in the U.S. is Non-Inflationary but Lackluster (NILE?) while in Europe and Japan long awaited recoveries—albeit with fits and starts—are materializing. The emerging world, for its part, is now coming to grips with the end of its own NICE decade.
While NILE in the U.S. has buoyed financial markets and has kept the Fed at bay, it’s sufficiently uninspiring that some Americans are in denial of its very existence. One in three Americans believes that the U.S. economy is still in recession,1 and investors have generally treated domestic stock markets’ appreciation with considerable skepticism. In fact, while many waited in cash or high quality bonds for their worst fears to be realized, the S&P 500 Index in current dollars rose over 193% from its March 2009 bottom,2 151% if adjusted for inflation. Only in the second half of this year have retail dollars returned to domestic equity mutual funds in significant numbers. Growing appetites for equities extended beyond the U.S. as investors benefited from massive monetary policy accommodations in Japan, and from improving macro conditions and a stronger commitment to the common currency in Europe. Markets are trading at higher valuations than at the start of 2013. But on most metrics, including the Cyclically Adjusted Price to Earnings Ratio, markets are either trading in line with long-term average valuations (U.S., for example) or in the case of select emerging markets and peripheral Europe, at discounts.
Source: Ned Davis Research as of 11/30/13. *Historical median P/E is calculated by taking the historical averages based on availability and sufficiency of data in the case of the United States this historical median is derived from a starting date of 1979. The Cyclically Adjusted Price to Earnings Ratio (CAPE) is a measure of the price of a country’s index divided by the 10-year rolling average of earnings, which provides a more stable measurement of current valuation. Each country is represented by the corresponding MSCI country index. Past performance does not guarantee future results. See index definitions at bottom of page.
Has the Rally Run Its Course?
Now the questions begin. Does the return of the individual investor portend the end of an impressive run up in markets? Since S&P 500 Index valuations have already climbed from a February 2009 low of 11 times trailing earnings to past more than 17 times,3 are stocks too expensive to buy? Is the market fully reflecting Europe’s sluggish recovery? If we’ve held appreciating stocks, is it time to sell? If we’ve stayed on the sidelines, is it too late for this go ‘round?
I’ve regarded investor skepticism as a bullish indicator—stock markets climb a wall of worry, but now with many market indicators at all-time nominal highs, and many near-term sentiment indicators flashing warning signals, I acknowledge that there will likely be more of a churn in the markets in the year ahead than there was in 2013. But market cycles generally end not when valuations rise but when recessions are in the offing or when inflation accelerates. A look around the world reveals little evidence of these lethal developments, save some inflation concerns in a few emerging economies. Global manufacturing surveys suggest an improving macro backdrop, often a harbinger for strong global equity market performance.
Source: Bloomberg. 9/30/13. Past performance does not guarantee future results. MSCI ACWI Index definition at end of page.
The classic corporate hubris, overinvestment road to recession, appears as distant as the inflation/monetary policy road to recession. Businesses are generally operating with lean inventories, commodity prices and wages are largely weak, and measures of inflation are below the target levels of central banks in most developed economies. Through 2014 the Fed will likely curtail its large scale asset-purchase program, but it has no intention of raising interest rates, perhaps not for years. Among major central banks, the Fed, the European Central Bank, and the Bank of Japan are all on policy paths characteristic of a business cycle’s early days.
U.S.: Swimming with the NILE
Compared to the historical five- to seven- year average life of the U.S. business cycle, today’s four-and-a-half year old expansion might appear to be turning a bit grey. But this cycle has the highly unusual characteristics that followed from the bursting of a major financial bubble. As economic historians have confirmed across time and place,4 something like the biblical seven lean years must pass before the effects fully fade. The de-leveraging process has retarded the current U.S. expansion but has left it room to run.
Source: Haver Analytics. The Economist and National Bureau of Economic Research, 9/30/13. Past performance does not guarantee future results.
Consider three key indicators, each of which is more characteristic of a cycle’s youth than its dotage:
With modestly positive population growth—almost unique among advanced economies—and a maturing echo-boom generation, housing demand has probably yet to peak and inventories remain too low.5 For the sixth year in a row, the U.S. has built fewer than 1 million new homes; we need about 1.6 million new homes annually to keep pace with population growth.6
2. Capital Expenditures
Recessions usually result from excessive inventories, hiring and capital investment. With shelves overflowing businesses pull back and the overall economy declines. In this cycle, companies have been more likely to hold unusually large amounts of cash or to use their cash to buy back their own stock—almost $1 trillion since 2009—than to invest and expand their businesses. The current cost-averaged age of fixed assets in the United States is 21.8 years, a level last seen in 1949.7 There’s room to expand.
The post-World War II average monthly increase in nonfarm payrolls 51 months into a business cycle has been 266,000 jobs per month.8 Through October of 2013 the average was only 204,0009 –a level that’s even less impressive given a population that’s far larger today than it was during many of those earlier expansions.
Combine pent-up housing and business demand with generally improving trends in small business hiring plans,10 and surging energy production11 and you have a recipe for improved growth in 2014. The likelihood of a smaller fiscal drag in 2014 and a still very accommodative central bank helps paint an even better picture.
U.S. equities will likely end this year higher and once again outperform government bonds. But importantly 2013’s winners are unlikely to repeat the feat in 2014. Smaller capitalization benchmarks trade at premiums to large-cap indices. Within the large-cap space, the high dividend- yielding sectors like telecom and utilities appear rich to higher quality companies that typically offer smaller dividends but offer greater growth potential.
Europe: “Green Shoots” in Spanish?
Across the pond in Europe, a fragile recovery has emerged. Aggregate household consumption growth is positive for the first time in nearly two years12 and renewed export growth in many of the hardest-hit peripheral countries has market participants learning how to say “green shoots” in Irish, Italian, Portuguese, and Spanish.13 Yes, there’s still a long ways to go. Much of the Continent’s economic prospects are weak, and true competitiveness for many of the countries of Europe would only come with the unlikely return of national currencies. Austerity is not completely over, the banking sector is still fragile, and further bailouts (see Greece) are likely. However, markets trade on whether things are getting better or worse, not on the absolutes of good and bad. Much of Europe is getting better.
Investors should be wary of European companies that, as my colleague George Evans so eloquently puts it, “need European GDP oomph to create shareholder value.” Many will likely prove to be value traps. Instead, focus on companies poised to benefit from enduring global growth themes including growing world affluence, new technologies, changing market structures, and aging populations. Valuations are not as attractive as they were a few years ago when the so-called easy money was made but remain well below levels that cause concern.
Emerging Markets: Not as NICE
As for the world’s (still) emerging economies, the long-term structural story is still intact but will not play out as nicely as it once did. The easier work has been done, but the credit bonanza, the commodity super-cycle and all its trimmings are now likely behind us. The receding tide exposes those swimming with less clothing. During 2013 the markets battered state- owned enterprises and companies with significant exposure to countries with sticky inflation and/or large current account deficits. Policymakers cannot take their eyes of the ball. I believe the ability and willingness of policymakers in the emerging markets to tame inflation, temper credit growth, eliminate misallocations of wealth, improve infrastructure, and reward innovations will be the most important factors in the growth of the global economy over the next decade and beyond.
China offers the most visible example of how these shifts can proceed—or perhaps fail. Policy initiatives from relaxing restrictions on family size, to facilitating the growth of smaller cities, to improving social services, to easing financial controls, are all aimed at transforming the Chinese economy from an investment and export-driven model to an economy that encourages and satisfies domestic demand for goods and services. No one can say how far and how fast these reforms can be carried out. What we can say with some certainty is that the ability to profit from Chinese economic growth will change considerably. And it’s not just China.
The challenge of evolving from an export-driven to a sustainably domestic-demand- driven economy is one that any emerging economy must either meet or stagnate. The U.S. succeeded in the second half of the 19th century; Argentina, which a century ago was among the world’s largest economies, has never done so.
To the extent that this transformation does occur, the winners and losers both in the emerging markets are among those who sell to those markets will shift markedly. For investors, the opportunity to profit from expanding prosperity in the emerging markets is not about to disappear but it is likely to change significantly. Commodity-driven economies particularly will feel the impact, but lower commodity prices will also boost consumers’ ability to enjoy a few more of life’s material comforts.
This transformation will nowhere be smooth, somewhere fail, and everywhere disrupt. In particular, a shift away from massive investment in production of goods and commodities threatens countries and institutions that have either borrowed or lent too much to finance the old model. The implications reach residential and commercial real estate, Chinese off-balance sheet lenders, and Brazilian state banks. While none of these institutions has the global connections of the North Atlantic banks that collapsed in 2008, credit contractions will likely occur in various emerging markets with the potential for short-term damage. Investors should be wary of over-levered firms and of especially high valuations.
Growing economies are a necessary but not sufficient condition for favorable financial markets. Expanding production of goods and services means someone is selling something and has the potential to turn a profit. Markets, however, tend to anticipate economies and then look for confirmation as the results transpire. Broad developed market indices have largely forecast sustained, even improved, growth during 2013. While I believe those expectations are likely to be realized, the 2013 rally leaves little room for error, and potential shocks such as a spike in inflation expectations, renewed currency fears in Europe, or a credit contraction in an important emerging economy could roil markets.
I believe, however, that corrections will represent buying opportunities. Stocks, if true to form, will quickly retest prior nominal highs as long as those shocks don’t result in widespread recessions or severe monetary policy tightening. Don’t be too surprised. A cyclical bear market occurs on average once every 4.4 years, and technically we just missed counting a bear market in the third quarter of 2011 when stocks contracted by over 19% during the debt ceiling battle.14 If 2011 doesn’t technically count as a cyclical bear market because stocks weren’t down by over 20%, does that mean we are due for one in 2014? If it does count, are we spared until sometime in early 2016? These are pertinent questions for traders but significantly less important for investors with a longer horizon. For selective investors the NILE should provide a nice long swim in tepid waters.
- Source: Bloomberg Businessweek and Absolute Strategy Research, September 9, 2013.
- Source: Lipper. Represents returns from March 9, 2009 to November 22, 2013.
- Source: Bloomberg as of 12/2/13
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "The Aftermath of Financial Crises," American Economic Review, American Economic Association, vol. 99(2), pages 466-72, May.
- I often hear that student debt and skepticism about real estate will make these echo boomers renters rather than buyers. Perhaps, but someone has to own, maybe build, the place you rent, and you’re not going to live in mom’s basement forever.
- Source: national Association of Realtors, as of December 2013
- Source: Bureau of Economic Analysis as of 10/13. Average is measured by the current cost method which allows comparisons across time periods.
- Source: Bureau of Labor Statistics
- Source: Bureau of Labor Statistics
- Source: National Federation of Independent Business Small Business Hiring Plans Index, September 30, 2013.
- Source: U.S. Department of Energy, October 18, 2013.
- Source: Eurostat, June 30, 2013.
- Source: Eurostat, June 30, 2013.
- Source: Bloomberg
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