Will they or won’t they……cut?
Over the last quarter global markets have shown a high level of uncertainty around what the US Federal Reserve will do with interest rates. The markets had priced in a 90% chance that the Fed would reduce the cash rate by 0.50%, and a 51% chance of 0.75% rate cut by the end of 2019. This is a significant change from September last year when the markets were pricing in a high chance of two rate increases.
US jobs data came out stronger than expected and the hopes of further stimulus via a rate cut declined. This “good news” sent US share markets lower, and bond yields higher (bond prices declined). In a world addicted to stimuli any positive growth data is currently being seen as a negative as the chance of continued stimulus via lower rates and Quantitative Easing declines.
ISM Manufacturing Purchasers Manager Index
US Non-farm Payrolls
A slowing global economy
The global economy has continued to slow in 2019, and the fear of an escalation in the trade war between China and the US has certainly been a further drag on growth for both economies. The chart below shows the current PMI measure for the globe now firmly below 50, meaning that global economies are contracting. The grey shaded part of the chart shows the consecutive months of decline which have now been in decline for a longer period than we saw during the 2008/2009 global financial crisis.
The US China Trade War
President Trump and President Xi met at the G20 summit in Japan in early July. Out of this meeting came increased hope that the two nations might come to an agreement to avert further tariffs being imposed on their traded goods. These trade talks are scheduled to recommence mid-July after a two-month hiatus. Currently no progress has been made as the same roadblocks are still in place on both sides. We will have to wait and see if an agreement can be reached, but we believe this is only the opening discussions in what will be a longer struggle for economic and military dominance between these two super powers.
US Gross Domestic Product (GDP) is 2.2% y.o.y but the impact of the trade war has been felt in the US as growth slows. The US Federal Reserve is now suggesting that there is a 33% chance the US will slide into a recession (two quarters of negative growth) within the next 12-months. We are also seeing several other economies such as Canada, Germany, and even Australia slowing and heading for potential recessions in 2020.
Atlanta Fed GDPNow estimate Q2 2019
NY Fed Prob US recession next 12-mth
The slowdown in growth has translated through to a lowering of earning per share (EPS) in the US share market in 2019. Interestingly, the markets have not yet priced in a sustained lower EPS in 2020. If the US economy continues to slow and moves closer to a recessionary environment we can expect to see the earnings per share forecast for 2020 also decline, which in turn will likely lead to a revaluation of US shares lower.
US Earning Per Share slowing
US P/E vs Rest of World
The US Price to Earnings Ratio is currently just under 18 times, versus the rest of the world at 14 times earnings. This is mainly due to the high valuations of the US tech stocks pushing the S&P5000 P/E ratio higher. The US share markets remain slightly expensive at this level and we continue to invest with caution. When compared to the NZX50 which is trading at a P/E ratio of 26 times earnings the US shares looks positively cheap.
Who is buying all the US shares?
The S&P500 sold off at the end of 2018 as retail and wholesale investors alike reduced their exposure on the back of the dip. The 20% decline in the S&P500 lasted from September to December 2018 and then we witnessed a very speedy recovery back to the pervious heady heights in January 19. So, who was buying all the shares? It wasn’t the usual investors as shown in the chart below.
Global equity flows since January 2017
The US share market growth has been heavily supported by the record high level of share buy-backs by US companies as they utilise their profits to underwrite their share price and increase their companies’ earnings per share returns to investors. Since the GFC in 2008 US$15 trillion worth of funds invested into the market have come from the “non-financial corporate sector” with a high percentage of this being in the form of share buy backs. Non-financial corporates mean corporations that primarily produces goods or non-financial services (i.e. not an investment bank). Apple was the biggest spender last year and has now used over US$250 billion to purchase back its own shares over the past decade ($74.2 billion in 2018 alone).
In 2018 the total for share buy-backs hit a new record in the US of US$806 billion. It was expected that 2019 would see this slowing but the first quarter of 2019 has already produced US$205 billion of share buy backs. Is this support sustainable in a market where earnings are forecast to decline?
Quarterly share buy-backs – US S&P500
Our portfolio share exposures are positioned conservatively so our investors can benefit from any further upside in the market but are proceeding with a healthy dose of caution. This is not done to try and pick the top or bottom of the markets, it is simply that the current market rally is one of the longest in history and they don’t usually end with a sigh, but more likely with a bang!
Bond investing gone mad
Over the past 30-years global bond rates have been declining around the world. This has been a great time to be a bond investor as lower interest rates means bond values increase. We got back to the historically average interest rate for global interest costs of around 4% in 2008, but then Quantitative Easing (QE) started in the US, and interest rates moved lower. Then the Bank of Japan, ECB and the Bank of England joined the money printing experiment and interest rates got to 0% in the US and Europe.
Average yields of six nations government debt
Then we moved into a near era for humanity as yields on government and corporate bonds went negative in Europe. This had never happened before in history and the economic books around the world have had to be re-written because the lowest interest rates can go is no longer 0%. As of the time of writing this there is currently US$13 trillion worth of government and corporate debt in the world that is trading at a negative yield.
European Debt selling at a negative yield
Has the world gone mad? Of course, not nobody wants to hold those 10-year, negative yielding bonds to maturity. The holders of this debt are betting that interest rates move even lower pushing their bond prices higher. They will then be the smart one in the room that sell out before the peak. We are not currently investing in this market and predict many will be disappointed and left holding a loss to maturity or realising a greater loss as bond prices fall.
We will finish this month’s update with an excellent chart from the Economist. They have been compiling data on house prices since 1990, and the table below shows the return from different property markets around the world assuming $100 start price back in 1990. As you can see Italy’s house prices are still below where they were 30-years ago, and the US, Britain, Ireland, France and Spain’s average house prices are still below their respective peaks in 2008.
House prices a decade after the GFC
It is this sort of long-term capital loss that we remain concerned about for New Zealand investors who are overweight NZ property, which is currently the most over valued property market in the developed world. New Zealand property owners cannot conceive of house prices going back year on year for a decade.
Will we see a similar decline in New Zealand property? Auckland house prices are down 3.4% over the past year ending May, but barring an unexpected bout of inflation that drives interest rates higher, or a reduction in the local banks ability to lend, we see the NZ property market as likely to have a more sedate flat to slight decline over the coming decade. But if we have another GFC style event NZ property values will be tested again, as they were in 2008.