May 2014

It has been a solid start for US equities after a strong 2013. Their resilience has been particularly impressive given investors had ample opportunity to take fright. Despite much uncertainty over the crisis in Ukraine and the fact that US economic readings were weak (largely due to bad weather), equity investors shrugged off these issues. It was striking how resilient equities proved to be and how contained volatility stayed during this period.

Equity-market volatility is being anchored at low levels by confidence in the positive structural outlook for the US economy. When implied volatility (as shown in the Chicago Board of Exchange’s Volatility Index or VIX) falls below 20 (its long-term average since 1990), we have a favourable environment that allows valuations to expand. Lower volatility was a pre-requisite for the rerating in US equities that we saw in 2013 (since when volatility has averaged 14.3). While many investors became accustomed to elevated volatility through 2008 to 2012, it looks like volatility can stay low for a sustained period, much as it did in the 1990s. Investors should be wary of looking only at the recent past.

In terms of what might trigger volatility, the interest-rate cycle has become the key focus. US Federal Reserve President Janet Yellen recently let slip at a media conference the phrase “six months” in response to how soon the interest-rate cycle could start after tapering is completed. While there was a small spike in volatility and equities fell on the news, there was no reaction from US 10-year Treasuries, indicating the lack of concern among bond investors about inflation risk. Inflation is benign with little prospect of pressure building. Tapering is now well understood. Yellen is doveish on the US unemployment market. We will continue to have a supportive Fed for equities.

In the US, the news is only going to get brighter – we are at an inflection point in the US economy. Yet equity investors are not fully recognising how rapidly the US economy is strengthening. The data is improving in many areas, whether it is loans data, manufacturing output, services output or consumer confidence. US economic growth is going to surprise on the upside and we will be discussing 3%-plus growth again. The speed of the improvement in the US federal budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around US$600 billion (A$640 billion) from US$1.5 trillion. It is not implausible that President Barack Obama will finish his term with a fiscal surplus. In which case, we are looking at a US equity market that is similar to the late 1990s (when we had the Clinton fiscal surplus), where equities should be well supported by liquidity. When a government has a surplus, domestic savings flow to the equity market, allowing valuations to rise. As a result of this supportive liquidity, we could see the so-called cult of equity return and, ultimately, certain sectors and stock markets may well become expensive.

Earnings can go higher

In the US market, we have an unusual situation in earnings expectations. Usually, we start the year with high and unrealistic earnings forecasts that have to be revised down. The opposite is the case this year and we are likely to have a strong earnings season versus subdued expectations.

Beyond that, it is prudent to consider the standard counter-argument to the buy case for the US, which has lately become commonplace. This argument points out that the US is on a price-earnings ratio of 16 times yet corporate profitability is at record highs. And if we cyclically adjust for peak profits, then the price-earnings ratio is 22 times. Given that we are approaching an interest-rate tightening cycle, the argument is that this makes the US market a sell.

This is naïve. Profit margins may well be at record highs, but they can move higher. The distribution of profits between capital and labour in the US is going through a fundamental shift. It’s hard to see why margins need to mean revert; for this to happen, labour’s share of profits would have to move higher. Unless we go back to highly unionised workforces, which is unlikely, profits are going to remain at high levels.

There are a number of reasons why profit margins can stay high, such as the globalisation of labour forces, less organisation of labour, technological change and the ability of markets to press companies to focus on profit margins in a way that just didn’t happen 30 years ago. Clearly, if labour’s share of profits were to fall further, we could expect to see some political pressure. Overall, however, the outlook for corporate earnings remains favourable. Combined with healthy liquidity, these two drivers should sustain a multi-year bull market in US equities.

The US equity market is more likely than not to break out strongly on the upside from its current period of consolidation. With compressed yields on US-dollar- and euro-denominated credit, equities will look attractive versus debt as earnings come through. The danger could well be that US equities have a too-strong rather than too-weak a year, given the positive outlook for both liquidity and earnings. It is evident that some investors have been left traumatised by the bear market in equities and are still fearful. However, in my view, we are in the midst of a bull market and in a bull market you buy the dips. In this light, if we get a mid-cycle correction based on the expected onset of the interest-rate tightening cycle in 2015, then this would be a buying opportunity. I believe the S&P 500 could move to 2,000 to 2,300 from its finish of 1,878.5 on May 9.

Volatility is anchored again like it was for much of the 1990s
CBOE Volatility Index (VIX) since 1990

 

Source: DataStream, CBOE Volatility Index. 30 March 2014

Financial information comes from Bloomberg unless stated otherwise.