A contrarian opportunity in small caps

A contrarian opportunity in small caps

by | Jun 7, 2023 | Investments, Markets and Economy, Small Caps

Contrarian investing is always difficult because, by definition, it requires swimming against the tide, which can be uncomfortable and tiring. While it’s certainly not for everyone, it is often where the best value and opportunity is to be found. Small cap companies in Australia and the United States may well be offering that opportunity right now.

Since the Australian share market peaked back in August 2021, the Small Ordinaries Index (XSO) has copped a way harder beating than its large cap peers falling by more than 20 per cent over the course of the market correction, while the ASX100, made up of the 100 largest companies on the Australian stock exchange, has dropped by only 5 per cent.

For a bit of longer-term perspective, the returns from XSO relative to the top 100 stocks is more than 20 per cent below its 20-year average, or more than 1.5 standard deviations. That is only 5 per cent away from its lowest level in at least the last 30 years – see chart 1.

 

The relative performance of the Small Ords<br /> vs the ASX100 is at a multi-year low

Similarly, the Russell 2000 (R2K) index of US small cap stocks has taken a similar beating during this market correction and is still down 22 per cent from the market’s high at the end of 2021. After tracking the large cap S&P500 for most of that time, over the past two months the performance gap is now the widest it’s been over that 17-month period.

Again, however, for some longer-term perspective, after the recent AI-driven rally in the mega cap tech stocks, the R2K’s returns relative to the S&P500 is about 27 per cent, or almost two standard deviations, below its 20-year average.

What is of far greater significance, though, is the valuation gap that’s opened up between US small cap companies and their large cap peers. When you compare their PE ratios, small caps are the cheapest they’ve been versus large cap stocks for well over 20 years and are now 2.5 standard deviations below the 20-year average – see chart 2, putting it in the 99th percentile.

US small caps are as cheap as they’ve<br /> been vs large caps for at least 20 years<br />

Luke McMillan, Head of Research for one of Australia’s best performing small cap fund managers, Ophir, points out that, unlike the GFC where markets fell because earnings collapsed, the current market correction is largely due to investor sentiment turning sharply negative, which gets reflected in a drop in the PE (price to earnings) ratio.

Not unusually, when the market experiences a sentiment driven correction, referred to as ‘PE compression’, small caps companies get hit harder than large caps as investors opt for the perceived safety of bigger companies.

And that can be the rub with investing in small cap companies. While it’s easy to get excited by the runaway small cap success stories that made early investors rich, like Afterpay or REA Group, there are far more stories of investors that have either lost everything or have watched their investments go nowhere year after year. The annualised volatility of the Small Ordinaries index is 25 per cent higher than the ASX100, in other words, investors need to be prepared to buckle up for a bumpy ride.

Many small cap companies have either no analysts covering them or very few, so getting your hands on reliable information can be difficult, especially if the company’s based overseas. That can make for great opportunities for those investors capable of picking apart a cash flow statement and balance sheet, and who are prepared to put in the time and effort to get to know a company in detail and spot the gems before the crowd. But, as McMillan says, a great small cap company needs a lot more than a good story; smart management and strong financials are critical.

While fund managers can find it a real challenge to beat large cap indices, making passive investing via an ETF an attractive option, because of the huge dispersion between profitable and loss-making small caps, it’s usually much easier for a good manager to beat the small cap index. The trick is finding those good managers.

The final thing any smart investor needs to remember when investing in a riskier asset like small caps, is to size the investment appropriately for both their portfolio and, importantly, their risk appetite.

Where you can find higher returns with less risk

Where you can find higher returns with less risk

by | May 9, 2023 | Investments, Markets and Economy, Wealth Management

Every smart investor dreams of higher returns with less risk. While scepticism is definitely in order for most investments claiming to offer it, there is growing evidence to suggest private assets do indeed hold out that tantalizing prospect.

First, what are “private assets”? They are any kind of asset that can bought or sold outside of a public exchange and can include everything from companies to loans, to property or even stamp collections.

Unlisted property syndicates are a form of private market investing that have been popular among individual investors for years. But the biggest growth among institutional investors, and lately individuals as well, has been private equity, so investing in companies from startups through to well-established or even multibillion-dollar ventures, and private credit, where you invest in a loan.

It’s easy to think public markets must be bigger than private markets, but it’s in fact the opposite, and in a big way. Worldwide, at the end of 2022, there were more than 140,000 private companies with annual revenues of more than US$100 million, compared to approximately 19,000 public companies. And globally, it’s estimated the private credit market is worth more than US$1 trillion per year.

According to Hamilton Lane, the world’s largest private equity consultant, private equity and credit have outperformed their public market equivalents in 20 of the last 21 years, and with significantly less volatility, which is often used as a proxy measure of risk. In fact, they estimate cumulative private equity returns since 2000 were about four times higher than global shares.

Similarly, KKR, one of the largest private equity companies in the world, reports that between 1981-2021 the Burgiss US Buyout Universe index returned 16.7 per cent per year compared to the S&P 500’s 10.0 per cent. Investing $1000 into the private equity index in 1981 would have been worth $482,000 by 2021, compared to $45,000 in US shares.

One of the principal reasons private equity outperforms public share markets is because there are no insider trading laws in private markets. If a transaction is not open to all and sundry, then there is no requirement for everyone to have access to the same information.

That means there are almost no obstacles to the super detailed due diligence private equity managers can undertake in analysing a potential acquisition, including access to things like board papers, financial projections or interviewing employees, the stuff a public equities fund manager would go to jail for!

Then once a manager acquires a company, not only will they have full visibility of its financial progress, it will also typically have a board seat and discretion to hire and fire executives of its choice. That’s a level of transparency and control that public fund managers can only fantasize about.

Private equity still has a bad reputation among some investors as predominantly an exercise in stripping assets from an acquired company, loading it with debt and then dumping it on unsuspecting investors through a share market listing. Whilst there may be a handful of private equity managers who still operate that way, these days the best managers carefully plan a multi-year strategy to transform acquired businesses.

Critics of private assets argue the lack of volatility is because the investments are not revalued on a minute-by-minute basis like shares or bonds are. That is indeed true, but that lack of liquidity in the underlying investments is not necessarily always a bad thing. One of the main reasons share markets are volatile is because they are subject to the vagaries of human sentiment, especially fear and greed, which invariably causes markets to overreact on both the upside and the downside, reflected in gyrating price to earnings ratios.

By contrast, typical private equity deals are run on a multi-year timeframe by cold-blooded managers who are neither driven by sentiment nor required to disclose earnings results on a regular basis. Whilst that can mean private assets don’t benefit as much from sharply higher PE ratios, nor do they suffer from sharply lower ones either.

The main risk of investing in private assets has always been liquidity risk. Private equity funds will normally lock investors’ money up for 7-10 years, which is why they have largely been open to only institutional or ultra-high net worth investors. And they’ve loved it, with global participation in private markets estimated to have grown from US$600 million in 2000 to US$9.7 trillion in 2022.

But over recent years, the so-called democratisation of private markets has seen novel funds that offer monthly or quarterly liquidity, making this exceptional asset class available to individual investors who are happy to take a long-term approach to investing.

It is possible to calculate a portfolio’s liquidity requirements, to meet things like pension payments or regular expenses, and keep sufficient public market investments to cover them, then invest the balance in a diversified mix of private market assets. 

 

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Central banks and interest rates: myths vs reality

Central banks and interest rates: myths vs reality

by | Apr 11, 2023 | Investments, Markets and Economy, Wealth Management

In June of last year, Jerome Powell, the Federal Reserve Chair, admitted, “We now understand better how little we understand about inflation.”

That alarming, but at least honest observation from the world’s most powerful central banker, comes despite the Fed employing more than 400 Ph.D. economists who enjoy access to the world’s most up to date data.

What is truly disconcerting though, is that governments around the world have happily passed on responsibility for managing inflation, and usually unemployment as well, to central banks via the control of monetary policy. But they essentially have only one tool to do that: interest rates.

Passing on that responsibility to central banks rests on some long-standing beliefs around monetary policy that sound fine in theory but lack real world evidence to back them up.

For example, the presumption that raising or lowering interest rates can control inflation. During the 2010’s, central banks around the world were concerned about deflation, that is, inflation being too low, so the biggest central banks in the world cut interest rates to never before seen levels.

The United States had effectively zero interest rates between 2010 and 2016, yet inflation averaged only 1.6 per cent per year over that period. Over those same seven years interest rates in the Euro Area averaged about half a per cent but inflation was -0.1 per cent, and in Japan rates were stuck at zero yet inflation averaged only 0.2 per cent.

Likewise, if high interest rates are supposed to cure inflation, how is it that Argentina can have an interest rate of 78 per cent yet inflation is 102 per cent? Defenders of orthodox monetary policy would say Argentina’s long been a basket case, but that’s the point, its interest rate has been above 40 per cent for the past five years but it has failed to control inflation.

Another shibboleth of monetary policy is the so-called Phillips Curve, which asserts that inflation and unemployment are inversely related. That’s why the Reserve Bank and the Fed regularly talk about the 50-year low unemployment levels and the inflationary risk from the price-wage spiral. The theory is that low unemployment causes such high demand for workers that they will flex their bargaining power and drive up wages, so raising inflation.

That may have been an issue 50-plus years ago when more than 60 per cent of the workforce belonged to a union, but with now only 9 per cent of Australia’s private sector in a union, things have changed. Wage increases have been below the CPI for the past nine consecutive quarters in Australia, see chart 1, and real average hourly earnings in the US declined by 1.3 per cent over the year to February, meaning it has been a deflationary influence in both countries.

 

Chart 1: Australian wages growth has lagged the CPI for the past 9 consecutive quarters

Chart 1: Australian wages growth has lagged the CPI for the past 9 consecutive quarters

 

In fact, Quay Global Investors analysed the US inflation and unemployment data between 1985-2020 and found there was no meaningful relationship – see chart 2. 

 

Chart 2: there has been no meaningful relationship between inflation and unemployment in the US over the past 40 years

Chart 2: there has been no meaningful relationship between inflation and unemployment in the US over the past 40 years

 

However, there have now been five different analyses covering the US, UK and Australia, that have each found corporate profiteering accounts for the majority of inflationary pressures in each country. That is reflected in US corporate profit margins hitting a 70-year high last year. One of those studies dubbed the phenomena “excuseflation”, because companies were using the first bout of inflation in years as cover to raise prices as much as they felt the market would bear.

Yet central banks continue to focus on consumers and households, with no mention of the role played by companies. By contrast, at the start of the pandemic the Japanese government made it clear to companies they would be watching for opportunistic price gouging, resulting in an inflation rate that peaked at about half the rest of the developed world, despite importing almost all their food and energy.

Also, monetary policy is frequently, and correctly, referred to as a blunt instrument because it can only work indirectly, by encouraging or discouraging people and businesses to borrow money and it can take ages to have any effect. The usual expression is that it operates “with long and variable lags.” However, all the central banks continue to say they will be “guided by the data”, but that data, be it the CPI, unemployment or industrial data, is all backward looking. There is an obvious logical mismatch.

Another logical mismatch is expecting that raising interest rates, which can only influence demand driven inflation, will do any good against supply driven inflation. For example, the floods last year contributed to double digit food inflation. Obviously, families have to eat, so raising interest rates is entirely non-sensical as a way to counter those inflationary effects.

The very clear problem is that by sticking dogmatically to those underlying economic theories, without accounting for the lack of real world evidence to back them up, central banks risk pushing economies into recession. Central bankers are muscling up trying to show they can be as tough as Paul Volcker, who was credited with stopping the inflationary episode of the 1970s-80s, but there are compelling arguments to suggest he gets way too much credit. They insist the pain of inflation, which by their own admission they don’t fully understand, is worse than the pain of people losing their jobs or their houses.

Interest rates can definitely play a role, after all, if central banks push interest rates high enough they will inevitably force a recession, which will certainly have deflationary consequences, but it’s ridiculous to argue that’s the only way to address the problem.

There are no easy solutions to controlling something as mysterious as inflation in a modern, complex economy, however, acknowledging the critical role fiscal policy plays would be a start. Professor Isabella Weber of the University of Massachusetts, who specialises in inflation, argues governments should explore strategic price controls, which have been extremely effective in the past, such as during war times.

However, until the dogmas of orthodox economic policy are left behind, smart investors need to remember to base their investment decisions on what they think will happen, not what should happen.

Are Australian banks safe?

Are Australian banks safe?

by | Mar 16, 2023 | Investments, Markets and Economy, Wealth Management

Spoiler alert: Australian banks are safe and what’s happened in the US and with Credit Suisse over the past week does not represent a threat to your bank deposits nor to the Australian economy in general.

The US

Silicon Valley Bank (SVB) was the sixteenth largest bank in the US, with $209 billion in assets, and collapsed last week largely due to poor management.

With the explosion in venture capital investing over the pre-COVD period, SVB had experienced incredible growth by banking standards: deposits had quadrupled in five years. However, it had a massive concentration of depositors, 93% were corporate compared to a median of only 34% in the US’s 10 largest banks, and most were venture capital-backed businesses with relatively large deposits. This left the bank vulnerable to an old-fashioned run on its deposits.

In an effort to make a bit of extra money, SVB had invested a lot of those deposits into US government bonds, which are super safe, but some were long dated, out to a few years. If they had have invested in 3-month bonds, there wouldn’t have been a problem, but the bank chased the higher yield of 3 and 5-year bonds. This left the bank vulnerable to a rise in interest rates, which reduces the value of bonds. Given SVB’s CEO sat on the board of the San Francisco Fed, which had been warning of ongoing rate hikes, you can see how poor management was.

With venture capital investors slowing their rate of handing out money since last year, some of those depositors were forced to draw on their deposits to run their companies and fund basic working capital.

SVB was forced to sell some of its government bonds and take a loss on them, which was reported to the market and they unsuccessfully tried to tap shareholders for $2.25 billion in new equity. This caused some of the venture capitalists to worry that if more and more depositors started wanting their money back, SVB wouldn’t be able to meet the demand, so they jumped on Twitter or sent text messages telling their investee companies (the depositors) to get their money out ASAP. This caused that old fashioned bank run to snowball, and at one point SVB had copped $42 billion worth of withdrawals in six hours.

By Thursday of last week, it was lights out for SVB. The Federal Deposit Insurance Corporate (FDIC) moved in that day, stayed all night assessing the state of withdrawal requests, and announced it had taken control of the bank by Friday. That’s the day all hell broke loose for US banking shares, with the regional bank index falling some 16%. By Sunday night the Federal Reserve announced all depositors would be made good, but equity investors will lose their money, which is exactly the way it’s supposed to work: depositors have faith a bank will look after their money, while investors take on the risk of a company screwing up.

In summary, the SVB situation was idiosyncratic, i.e. a situation peculiar to that bank. There have since been two other smaller US banks closed down by the FDIC, mainly because they had excessive amounts of deposits tied up in crypto assets. Certainly, it wouldn’t have happened if the Fed had not been raising rates, but there’s a popular expression on Wall Street that the Fed keeps raising until something breaks.

It’s worth bearing in mind, the US banking industry is structured very differently to ours. There are literally hundreds of small banks, a legacy of the Great Depression era. Since 2001, there have been 563 banks go belly up in the US, with about 500 of those as a result of the GFC. If Australia’s banking system was able to withstand that, it will be fine with what’s happening now.

Credit Suisse

Credit Suisse has been a mess for years, with a string of scandals and poor investments going back over decades, which culminated in a growing number of clients taking their money and business elsewhere by the end of last year. The bank’s CEO tried to woo back customers, but last week the Securities and Exchange Commission (SEC) in the US (equivalent to ASIC here), queried the bank’s annual report. Combined with the SVB situation, panic started to set in.

Then on Wednesday, CS’s biggest shareholder, the Saudi National Bank, said it wasn’t going to be able to invest any more into the bank because it was hitting regulatory limits. That caused CS’s share price to plunge, and they asked the Swiss central bank to issue a statement of support, which it did.

However, other banks around the world started worrying about counterparty risk, in other words, looking at contracts where CS was on the other side, and trying to buy protection. Pretty soon, the cost of that protection skyrocketed, implying a high likelihood of default.

A you can imagine, a lot of investors started having flashbacks to the death of Lehman Brothers in 2009, and worrying what threats CS poses to the global banking system. However, CS has substantial liquid assets it can call on as well as access to central bank lending facilities. The CEO has said it has sufficient cash-like liquid assets to pay back half its deposit liabilities and loans from other banks.

Subsequently, the Swiss National Bank has said CS “meets the higher capital and liquidity requirements applicable to systemically important banks” and it stands ready to provide CS with liquidity. CS has announced it will borrow SFR50 billion to meet any liquidity demands from depositors and buy back a bunch of debt that was trading way below its issue price.

Is this the start of another GFC?

No, it’s a very different situation. However, stress levels in financial markets have certainly risen which is being reflected in bond market dislocation, which will result in higher funding costs for banks. It depends on how markets and central banks respond to a crisis, and so far, the US Fed and the Swiss National Bank have done very well.

How will it affect Australian banks?

In 2016, the Australian bank regulator, APRA, announced it wanted Australian banks to have “the strongest balance sheets in the world”. At the time the banks pushed back, but lost, and now their balance sheets are indeed very strong.

Their funding costs may rise a bit, and access to capital markets may be restricted while markets are unsettled, but there is no risk of any bank failures in this country.

As for depositors, the federal government already guarantees deposits up to $250,000 and we’ve seen the US regulator increase that to pretty much no limit for the SVB depositors.

A silver lining?

It is entirely possible this will cause central banks around the world to pause their interest rate rises while markets are in turmoil.

Is the era of US share market dominance coming to an end?

Is the era of US share market dominance coming to an end?

by | Feb 14, 2023 | Investments, Markets and Economy

Between the end of the GFC in early 2009 to the end of the 2021 share market melt up, US shares returned an astonishing 486 per cent, a compounded annual return of 14.5 per cent. It was enough to make other share markets look positively pedestrian: Europe was up 228 per cent, the emerging markets 251 per cent, Japan 266 per cent and the laggard was Australia, at 198 per cent.

If you didn’t have some exposure to US shares you missed out on one of the greatest bull market runs in history. And much of that stellar performance was due to the tech sector: over the same period the Russell 1000 Technology Index rose by a whopping 1477 per cent.

Table showing the 2022 share market returns in local currencies

Regime change

Having gone through the pain of a bear market, it’s tempting to presume the markets and sectors that did best in the last rally will lead the way again, but in fact, often that is not the case.

Instead, the end of a bull market often sees a regime change and when that happens the former market leaders can underperform for years. For example, Japan has never regained its 1990 high, the NASDAQ took 14 years to recover its dotcom boom levels and some finance stocks that were in the S&P 500 top 10 in 2007 have yet to recover as well.

In other words, when a market or sector booms, the bust on the other side can take years to play out, especially when the leading sector ends a bull market on high valuations.

Are US shares expensive?

In short, compared to other markets, yes, and on various measures. The ‘CAPE’ ratio (Cyclically Adjusted Price to Earnings ratio) measures the last 10 years’ inflation adjusted earnings, and while it’s a terrible indicator for timing markets, it’s a good indicator of long-term valuations. At 28, the US is not only miles above its long-term median of 16 but is more expensive than any other market: with Europe on 16, Australia 17 and China 8.

Similarly, Morgan Stanley calculated that on a price to book value measure, at the end of 2022 the rest of the world was trading at a 60% discount to the US, the lowest in almost 25 years.

Bar graph showing the main negative influence of share prices was sentiment based on source of return 2022 AUD

And JP Morgan estimates that at the same time, the US was trading on a price to earnings ratio of 16.7 times, bang in line with its 20-year average, compared to Australia on 14.2, Japan on 12.2 and Europe on a bargain basement 11.7.

A potential change in the top sector

When the US market undergoes a regime change, it is not unusual for the leading sector in the index to change as well. In the 1990s consumer staples became the largest sector, then it was financials, and in the post-GFC period the tech sector became the dominant engine of growth.

Line graph showing the probability of recession over the coming 12 months in the Fed's Survey of Professional Forecasters

Likewise, the top companies change around as well, sometimes dramatically. In 2000 the four largest stocks in the S&P 500 were Microsoft, Intel, Cisco Systems and General Electric, boasting a combined weighting of 16 per cent of the total index. By the end of 2022, the same four had a combined weighting of 6 per cent, with Microsoft accounting for 5 of that.

At the height of the market in 2021, the top four companies accounted for 22 per cent of the S&P 500’s total market capitalisation. That has already dropped to 17 per cent, and if history’s any guide, it could have a lot further to fall.

Line graph showing the Morgan Stanley Leading Earnings Indicator against the Actual S&P 500 LTM EPS Growth Y/Y

Letting go can be hard

Financial markets are far more dynamic than many investors’ mindsets. Humans are usually reluctant to let go of a paradigm, presuming that what worked best in the last investment cycle will win out again.

That partly explains why the best performing stocks in the Russell 2000 index over January were unprofitable tech stocks, and those which had fallen the most: the presumption being that if the market’s rallying, just buy what’s been hit the hardest.

A regime shift doesn’t happen quickly, and it doesn’t mean you should sell all your US and tech holdings immediately. A smart investor understands these things are not binary, but more a question of relativities. Changing by increments can produce a better result.

What just happened and what lies ahead

What just happened and what lies ahead

by | Jan 17, 2023 | Investments, Markets and Economy, Wealth Management

2022 – the scorecard

By some measures, 2022 was one of the worst years for financial markets in the last century and it was all due to central banks aggressively tackling a sharp rise in inflation.

Global bond markets suffered their worst year ever, with the Bloomberg Bond Index falling 13%, compared to the previous worst fall of only 3%.

Share markets were very mixed, with previous laggards like Australia and the UK doing relatively well (though still falling), while the US, which had left the rest of the world in its dust over the past 13 years, recording its seventh worst year in the past 100 – see chart 1.

Table showing the 2022 share market returns in local currencies

The big falls on global share markets was by and large because of ‘PE compression’, meaning the price to earnings ratio at which investors were prepared to buy stocks fell. That reflects a change in sentiment, as opposed to a fall in earnings (the opposite to what happened in the GFC). The grey bars in chart 2 show the extent to which that change in sentiment offset any positive contribution from earnings growth and dividends (the chart is in AUD which is why there’s a currency effect as well).

Bar graph showing the main negative influence of share prices was sentiment based on source of return 2022 AUD

The huge difference in returns was due to the resurgence of ‘value’ stocks, the old fashioned sectors like resources and industrials, smashing the ‘growth’ stocks, like tech.

Lessons from 2022

Financial markets throw up new lessons all the time, here are a few of the takeaways from last year.

Be wary of central banks: as late as November 2021 the Governor of the Reserve Bank of Australia, Philip Lowe, reiterated the board’s often repeated view that inflationary pressures were not a concern to them and interest rates in Australia would not rise before 2024, six months later they began the most aggressive rate rise campaign in decades, with eight consecutive monthly rate increases taking the cash rate from 0.1% to 3.1%, with the likelihood of more to come.

The US Federal Reserve was the same and was more or less bullied by financial markets into launching aggressive interest rate rises, with seven consecutive increases taking their cash rate from 0.25% to 4.5%.

Don’t trust forecasters: out of a survey of 16 US forecasters, the lowest estimate for how the S&P 500 would go over 2022 was a 3.5% fall, the highest was an 11.1% gain, with the average being a 3% increase. The final result was a fall of 19.4%.

This just shows how tough it is to make forecasts. It’s a truism that over the long-term share prices follow earnings growth + dividends, which, according to chart 2, was about +3%. So it’s pretty understandable the average estimate came in at that level, but any strategist will tell you they hate making one year forecasts because sentiment is invariably the swing factor, and that’s simply impossible to guess.

Bonds can lose money too: over the past 40 years, when interest rates were on a long-term downward trend, bonds provided a counter-correlated air bag against falls in share markets, but 2022 was dramatically different. Government bond yields fell to all time lows in 2021, which increased their sensitivity to a rise in inflation. And while corporate bonds offered a better yield, they were also susceptible to repricing on concerns that companies would be more likely to default in a rising rate environment.

Base decisions on what you think will happen, not on what you think should happen: there were plenty of strong arguments that rate increases, which are designed to reduce demand by increasing the price of credit, were not the right weapon to use against inflation that was driven mostly by a combination of supply bottlenecks and companies opportunistically increasing prices.

If interest rates hadn’t risen as much as they did, it’s unlikely share markets would have fallen as much as they did. But the fact is central banks made it clear they were going to hike rates, and that was especially going to affect the growth stocks.

The falling tide can affect almost all boats: when markets go into a broad reversal because of a PE derating, it doesn’t matter if you avoid the clearly overvalued parts of the market, like unprofitable tech stocks, because even ‘fairly’ valued sectors supported by solid earnings can get whacked too, as we saw with highly profitable tech companies like Apple and Microsoft.

The bulls vs the bears

There is, as always, a raging debate between the bulls and the bears as to what 2023 holds in store. While it’s always prudent to bear in mind what Yogi Berra apparently said that it’s always risky to make predictions, especially about the future, here are some observations.

What the bears argue: the consensus view among investment banks and fund managers, especially in the US, is that the US economy will go into recession some time in 2023 – see chart 3, but that is not yet reflected in earnings forecasts.

Line graph showing the probability of recession over the coming 12 months in the Fed's Survey of Professional Forecasters

After recent downgrades, the consensus forecast for US earnings in 2023 is roughly flat, whereas in past recessions earnings have typically fallen 15-20% – see chart 4. As we pointed out above, markets normally follow earnings, so the consensus forecast for the S&P 500 this year is a 20-25% drop to new lows (between 3000-3300), before a recovery toward the latter part of the year (consensus is 4038 by year end).

Line graph showing the Morgan Stanley Leading Earnings Indicator against the Actual S&P 500 LTM EPS Growth Y/Y

The expectation of a recession is based largely on the fact that there has never been an inflationary episode like we’re in now that hasn’t required the Fed raising rates so much that it drives the economy into recession. That view is reinforced by the US reporting its lowest unemployment rate in 50 years, which is generally seen as a harbinger of wage-driven inflation: orthodox economic theory argues there’s an inverse relationship between unemployment and inflation, and the Fed governors have repeatedly made it clear they are prepared to sacrifice jobs to reduce inflation, i.e. they will keep raising interest rates to choke the economy.

Line graph showing the US Bureau of Labour Statistics unemployment levels

Finally, the bears point to the ‘inverted US yield curve’, meaning the yield on 2-year government bonds is higher than the yield on 10-year bonds – see chart 6. Every US recession for the past 50 years has been preceded by an inverted yield curve.

Line graph shows 10-year treasure yields minus 2-year yields (1980 - Present)

What the bulls argue: it looks for all the world like US inflation peaked in June last year, and it’s now declined for six consecutive months – see chart 7.

Bar chart showing US inflation stats throughout 2022

A range of things that caused prices to spike last year have fallen dramatically: freight costs are back to pre-COVID levels, oil and gas prices are back to pre-Ukraine war levels, as is wheat, semiconductor supplies have all but normalised, lumber is below where it was in 2020, etc. – see chart 8.

Line graphs showing the price ranges throughout 2022/23 for oli,gas,shipping and wheat

A quirk of how the US reports its inflation rate is that it compares the most recent month to what happened 12 months before. However, former Fed vice-chair Alan Blinder commented last week that if you instead annualise December’s monthly CPI number, which was -0.1%, the US is now experiencing disinflation!

Also, the December US jobs report was full of good news: although the US economy added 223,000 jobs over the month, average hourly earnings growth was only 3.4% for the year, so lower than the inflation rate and slowing – see chart 9. There is absolutely no evidence of the wage-price spiral the Fed is so concerned about. These are all arguments militating against the Fed continuing to raise interest rates.

Line graph showing US wage prices

What about the risk of recession? US research group, Renaissance Macro, commented that “recessions don’t happen when real incomes net of government transfers (pension payments and the like) are on the rise and this is up 3.2% annualised since June.” In other words, households are doing OK, which should underwrite consumer spending.

Also, last year the US economy added 4.3 million jobs and Carson Investment Group pointed out that of the 17 previous years where the US added more than 3 million jobs, only once did the following year go into a recession, 1972.

What about the scary inverted yield curve? Last week, Professor Campbell Harvey, the economist who came up with the indicator, said he believes this time it’s a false signal.

What about the record that inflation has never fallen without the Fed pushing the economy into a recession? Two things: first, this inflationary cycle is different to previous ones insofar as it’s easier to identify the causes, like people being locked in quarantine only able to spend on goods and consequent supply chain bottlenecks, all of which are turning, or have turned, around, and second, there has never been a time when a rising interest rate cycle was preceded by a government injecting 25% of GDP directly into households. Even the lowest quartile of households are still sitting on net savings.

What about the prospects of earnings downgrades? Again, the ginormous amount of money from those fiscal injections is still bouncing around economies, which will help underwrite corporate earnings for a while yet. Also, historically the S&P 500 has bottomed out on average 6-9 months before corporate earnings – see chart 10. Another way of looking at that is the share market is a forward looking indicator and has a knack for factoring in all the news that’s out there well ahead of economists and analysts. The S&P 500 fell 27.5% at its worst, and it’s now down 17%, meaning it may well have already factored in all the nasty prospects of earnings downgrades.

Line graph showing Price vs EPS

Other economies and markets: I’ve focused on the US because that’s where all the best information and data is available. However, for Australia, the monthly inflation rate is still above 7% and hasn’t shown signs of slowing anywhere near as clearly as the US, partly because of the effects of floods on food prices, the reintroduction of the petrol excise and the high cost of housing. It’s considered a certainty the RBA will raise interest rates for the ninth time in a row when they next meet in early February, but Governor Lowe has indicated the board is prepared to be less aggressive and wait to see if their handiwork has had an effect. It’s difficult to find an Australian economist forecasting a recession.

Europe was considered a basket case, but even there, a surprisingly mild winter has meant the nightmare scenario of energy shortages appears very unlikely and inflation also looks like it peaked in October and has fallen since. The natural gas price has fallen more than 60% from its peak in August and is now trading below where it was before Russia’s invasion of Ukraine. Unemployment in the Euro area is at its lowest since its inception and, although 6.5% is still significantly higher than the US or Australia, it is trending downwards – see chart 11. There are some brave souls arguing even Europe won’t go into recession.

Line graphis showing unemployment figures for the Euro area
China, which was one of the worst performing markets in 2022 because of the government’s strict COVID-zero policy and problems with the property sector, is bouncing back quickly. In late 2022 the government lifted almost all COVID restrictions following widespread protests, which was terrific from a libertarian and economic perspective, but clearly they had failed to put a comprehensive plan in place over the lockdown period and now infections are running wild. The government has already talked about stimulating the economy through fiscal and monetary measures, which will no doubt spur a recovery and contribute to global growth as well.

Thoughts on where to invest

A benefit of the global selloff is that valuations have come back to relatively attractive levels. They might not be as bargain basementish as after the GFC, but they’re a lot better than late 2021 – see chart 12, especially for Japan, Europe and the emerging markets.

Bar graph showing current and 20-year historical valuations

Not surprisingly given the Australian share market didn’t fall as much as others, it’s only just below the long-term average PE ratio and the US is a smidge above.

Record high margins: one issue is the record high level of margins in both the US and Australia – see chart 13. For the US that has largely come from the tech sector, not so sure about Australia, although it’s noteworthy that Australian margins have been higher the whole time. In 2021, of the 70% earnings growth reported by US companies, 50% came from margin expansion. It would not be surprising to see margins come under pressure.

Line graph showing profit margins of 12-month training earnings to revenues

Outperformance of the US: since the GFC, US shares returned 14.1% p.a., which was 38% higher than Australian shares and 33% more than international. Chart 14 shows the extent to which the US has become expensive compared to the rest of the world, based on a combination of PE, price to book value and price to cash flow (the chart is only to March 2022 but it’s unlikely to have changed significantly since then). The point here is this chart has historically reverted to the mean, will it do so again?

Line graph showing relative valuation MSCI ACWI ex-US Index vs. MSI US Index

As always there are great arguments on both sides as to why the US should or shouldn’t continue to do well versus the rest of the world. It remains a source of corporate and financial innovation with the lion’s share of globally recognised brands. However, it is expensive compared to the rest of the world, and the Republican dominated congress looks like it will be held to ransom by a handful of extreme views that could well wreak havoc with the government’s finances.

Will the emerging markets return to favour? Chart 15 shows the emerging markets smashed the developed markets over the 10 years up to the GFC (the rising blue line) and has underperformed since. At the end of 2022, the PE ratio for the emerging markets was 34% lower than the developed markets.

Line chart showing the correlation between emerging markets rel MSCI-World & USD

The emerging markets tend to do poorly when the USD strengthens, and it has just come off one of its strongest years ever, rising 22% at one point. Chart 16 shows the USD has rolled over dramatically, which should support EM.

Line graph showing the DXY Dollar Index / 40 week moving average

Looking ahead

As always, there are compelling sounding arguments on both sides. On balance, it would be surprising to see economies fall into a deep recession when unemployment levels are at 50-year lows and household incomes are healthy. Inflation appears to be falling at a rate that would justify central banks pausing, or at least slowing, to see what effects the interest rate rises they’ve already pushed through will have.

Having endured some significant losses in 2022, global markets have started 2023 strongly. Indeed, the ASX has had its best start to the year since 1988, three quarters of stocks in the S&P 500 are more than 20% off their lows, Europe has bounced 20% off its lows and the UK is only 2% off its all-time highs.

We know when markets turn positive it can be difficult to put your finger on why it’s happening at the time, but then they tend to run hard as investors play catch up. There is no assurance we won’t revisit the lows, but it’s looking less likely and after a tough year last year, you can see light in the proverbial tunnel.

The views shared in this article are the author’s views and don’t necessarily reflect those of the whole firm.