Strategist’s Corner
6 April 2017
PAIRING PRICE WITH FUNDAMENTALS
If markets stumble as 2017 progresses, it is unlikely to be because of some
unexpected political event, but rather because of a reversal in the coordinated upturn
in world trade we’ve seen over the past three quarters. The stock market is reacting
more to a synchronized global growth wave than to policy changes in Washington
or elections in Europe. Japan, China, the eurozone and the US have gotten upside
economic surprises in recent months and the market has reacted accordingly.
James Swanson, CFA
MFS Chief Investment
Strategist
But now there are signs that this growth upswing — like three prior waves within
this eight-year-old cycle— could falter. Here are the reasons another slowdown may
lie ahead:
1. C
hina — the main driver of the synchronized improvement in the global economy
beginning in mid-2016 — is beginning to show signs of strain. Year-over-year
growth in both credit and money supply is slowing from the pace we saw in
2016. Furthermore, Chinese authorities have recently tightened credit for car and
home purchases. In the past, credit has been both an economic accelerant and a
braking mechanism within China, especially for commodity prices. Now we may
be entering the braking phase.
2. T he star of world growth surprises in 2017, the eurozone, is also flashing warning
signals. Like in China, credit growth is slowing. Additionally, inflation has lost
its upward momentum. Further, European exporters are heavily exposed to a
slowing China.
3. D
espite solid labor markets and upbeat sentiment indicators, trouble lurks in the
United States, too. While wages have been rising modestly of late, inflation has
been rising faster, squeezing real incomes. Moreover, surging health care outlays
and high housing costs are combining to restrain consumer spending.
4. L ike consumers, US companies are faced with rising costs, which are squeezing
once-lofty profit margins. Rising margins have been perhaps the most important
underpinning of the eight-year bull market. But, the present margin squeeze,
combined with unimpressive pricing power, are elements which threaten the
positive free cash flow story that has propelled this economic cycle. In order for
profits to grow in the later phases of a cycle, margins need to expand on the
back of cost cutting, or on the wings of rising inflation. That way, pricing power
can carry the day, driving year-over-year profit growth. Right now, we see no
convincing evidence of either more cost cutting or better revenue growth.
Despite these headwinds, though, we don’t appear to be at risk of tumbling
into recession.
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Strategist’s Corner / April 2017
Does Washington have our back?
Not a lot of cushion
So, with a recession unlikely, and the markets expecting a
cocktail of tax cuts and regulatory rollbacks from Washington,
shouldn’t investors hold an overweight in US equities? The
answer is no. Against a fundamental backdrop of downward
profit and revenue pressures, we must consider market pricing.
While equities were relatively cheap for much of this market
cycle, that’s no longer the case.
Even with these warning signs, the market continues to
discount a very benign fundamental and macro backdrop.
It discounts that firms will be able to raise prices faster than
costs, boosting profit margins back to robust levels seen earlier
in the cycle. It also discounts relatively stable interest rates,
falling tax rates and that trade barriers will not rise. Add to this
the implicit notion that the duration of this business cycle will
be extended, perhaps for years.
Here are some measures I use to gauge relative valuations.
First, I examine the free cash flow yield of the S&P 500 Index.
It has slowed to a pedestrian 2.6% today versus cash flow
yields of 5% and 6% earlier in the cycle. This tells me that the
market is no longer cheap compared to other cycles and that
pricing dynamics have discounted lots of good news ahead.
Another measure I use to gauge valuations, the cyclically
adjusted price-to-earnings ratio, is flashing warning signs. It
has moved close to 30x, a very high reading, exceeded only
twice in the gauge’s more than 100-year history. The price-tosales ratio of the market is also high, while small companies
have reached some of the highest price-to-forward-earnings
ratios ever seen.
When stocks have relatively low P/E ratios and low priceto-sales ratios, investors can absorb some disappointments,
especially early in the cycle, as these setbacks tend to be
overcome quickly. But eight years into a cycle, the days of
cheap valuations are long since passed. The current high
price of financial assets suggests that each step upward leads
owners to a more precarious perch. To paraphrase Chris
Bonington, famed Mt. Everest climber, each step towards the
summit entails more and more risk. We can’t see the summit
from here, but right now, it seems to be shrouded in clouds.
Past performance is no guarantee of future results.
The views expressed are those of James
Swanson
subject
to change
at any
time.
These
views
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purposes
should
the author(s)
andand
areare
subject
to change
at any
time.
These
views
areare
forfor
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purposes
onlyonly
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relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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