Be cautious of bond markets [outside of SA], switch from high growth stocks into value and dividend paying stocks, and hold some cash. This is the advice from Guy Monson, the chief investment officer at Sarasin & Partners in a presentation to attendees at the recent Morningstar Investment Conference in Cape Town.
The world is a volatile place at the moment, thanks in part to an extraordinary economic experiment dubbed Trumponomics; but also thanks to Brexit uncertainty, the rise of populism around the world and China’s slowing economy.
In particular, US events are impacting the rest of the world. The US economy is growing at a blistering rate and may touch 4% economic growth this year. Assuming this can be sustained it will put US president Donald Trump in a super-league along with the likes of John F. Kennedy and Lyndon Johnson, who achieved annualised real GDP of 5.5% and 5.2% during their terms.
US unemployment is at a 90-year low, consumer confidence at an 18-year high, and small business confidence is at a 50-year high. All of this has been achieved while core inflation is still at 2%. This is a far cry from the backdrop of ‘secular stagnation’ that characterised the last years of the Obama administration. “These numbers are extremely robust,” says Monson.
This renaissance has been fuelled by fiscal spending nine years into the economic upcycle and on a far greater scale (currently 0.75-1% of GDP) than any economic textbook would ever advise. “It seems that the president is deliberately running the US economy ‘hot’ by injecting, over a decade, $1.5 trillion of tax cuts, and $250 billion of fiscal stimulus. It’s an extraordinary economic experiment. We have never seen anything like it outside of wartime,” he says.
Is there something to it?
This has triggered a surge in US domestic investment (running at a robust 7.1% rate) and should, over time, contribute to improved profits and taxes – making the programme ultimately self-financing, or so the story goes.
However the US is not an island and investors are watching these developments with some concern.
The bond market vs Donald Trump
While the eight US rate rises since 2015 have drawn capital into US dollar assets, this may not be enough to keep the bond market happy. “In our view, the US economy is simply too robust for so gentle a Fed normalisation path – couple this with strongly positive net supply of treasuries [treasury bonds] and you have steeper yield curves,” Monson says. “To date, the sell-off has been concentrated in the US, Canada, and the UK with Europe (except Italy) showing only a modest back-up in yields. With ECB [European Central Bank] bond purchases set to end this year we expect European bond yields to rise and start to narrow the gap with US treasuries. This would likely be accelerated if either the EU versus Italian budget stand-off was resolved and/or there is a negotiated Brexit agreement.”
More generally, bond investors are uniquely sensitive to inflation rates – in this respect, the US president’s decision to impose sanctions on Iran has helped trigger a rise in oil prices of more than 25% this year. Nervous foreign investors and rising oil prices have not often been good for treasuries …
What does this mean for investors?
Be wary of the bond market, hold some cash (even a little sterling if you are brave) and pay attention to value stocks, says Monson
Returns to growth investing have exceeded those to value investing for the better part of four years, with tech stocks like Facebook, Alphabet, Amazon and Netflix leading the charge.
However, the price-earnings ratios of the Russell 1000 Growth Index (29.21) and Value Index (16.39) are diverging to a point not seen since 2012. While the forecasts suggest similar levels of earnings gains for growth and value stocks, Monson says, “even if you do still like the growth stocks, you must expect a reversion at some point.”
What would start the reversion? “If financials do better, this could be the inflection point that we’ve been looking for since all the factors that benefit financials such as rising interest rates are now in place. And if the technology sector slightly underperforms the market, you’ll see some meaningful outperformance by value stocks.”
Look at energy, it is only 0.7% of the Russell 1000 Growth Index and 11.4% of the Value Index, but as a result of the rise in oil prices, the sector was the biggest gainer in the second quarter, he says. Royal Dutch Shell is generating so much cash that gearing will come from 20% to 10% in the next two years and by 2022 it goes debt free. “I can’t remember when we saw an oil company with no debt.” Rio Tinto is another cash-flush company that is opting to return cash to shareholders rather than engage in M&A activity. “It has $15 billion in share buy-backs and has recently announced another $4.3 billion. So if you missed out on the Fangs [Facebook, Amazon, Netflix and Google], don’t worry.”
Meanwhile, research shows that macro factors for value investors are positive when corporate earnings are strong, GDP growth is above 2%, and interest rates are rising.
However, while stocks in the UK, Japan and possibly Latin America are showing value, Monson notes that the sheer strength of US profit growth suggests investors should not be cutting positions wholesale just yet.