Initial selling has nothing to do with valuations, and that is why it is always so difficult to judge the extent of any short term correction. With a bit of space from the immediate marker volatility, what did it tell us about the long term position of debt and equity markets?
Having watched this sort of thing far more than perhaps I’d like, my summary is this: it was an interesting but not unexpected week with a technical adjustment in markets. It was investors finally reacting to the fact that interest rates are adjusting to the reality of stronger economic growth and a US central bank that has begun the process of removing excess liquidity from the system.
Eighteen months ago I thought that we had turned an a corner not yet visible to the broader market - interest rates had inflected. Few people thought the same, particularly given the lack of wages growth in the US and the fact that rates were still negative in parts of Europe.
Scaling the wall of Fed money
In September 2016 I expressed a view in our quarterly report that it is important for investors to keep in mind how abnormal rates are (and remain so now) and not to allow the gyrations of the market hide the fact that the tide may be well and truly changing. We thought the inflection point had occurred in July, 2016 and that there would be a different set of long term opportunities going forward.
Our expectation was that economic growth and earnings would be better than most were expecting and that the short term price action risk would now more likely come from inflation scares and subsequent upward moves in interest rates.
Between then and now, we have invested with an eye firmly on our belief that markets were beginning to underestimate just how tight labour markets were, with the most common complaint from CEOs in the US being the ability to find workers. Coupled with the passage of Trump’s tax cuts late last year, which in theory will create significant pent up demand in the economy, interest rate markets have begun to take notice that the inflection point had already been reached.
Money has continued to flow into bonds at the expense of equities
But investors, particularly passive ones, have been still piling into bonds at the expense of equities.
What was interesting though, was that until very recently, the most common topic of conversation was still around the lack of wage growth- looking in the rear view mirror. Then we get the strongest year on year increase in US wages for some time and market sentiment turns on its head and interest rates appear to trigger technical reaction in equity markets.
I suspect it is just further confirmation that excess liquidity is starting to leave the system (most high profile being through VIX funds and even bitcoin). In such an environment investment, opportunities will now be in those companies that can grow their earnings, as opposed to those that historically benefited from a re-rating on the back of lower interest rates.
When you do look at forecast valuation multiples, they seem reasonable. As examples, home builders are trading at less than 10x forecast earnings, banks and alternative asset managers at 10-12x and Pfizer is 11x. So 50%+ of our global portfolio is on an average price to earnings ratio of approximately 11. Other large sectors/ stocks - monopolistic and high growth businesses like the financial exchanges, Mastercard/ Visa and Google - range from 18-24x, which seem quite reasonable for the nature of their businesses. So we continue to believe that these types of businesses will give us a satisfactory return in a general market environment of lower returns and choppier price action.
So over the week, with the pullback in the market, we marginally reduced some of our futures hedges, closed out short REIT positions and will, in all likelihood, marginally increase some of our existing positions. This will all be done within an overall framework that rates have inflected, markets have done well, and a an invested position of approximately 85-90% is prudent.
