Article by Robert Ducker
This year has so far been a positive one for the equity market with the majority of benchmark indices delivering substantial returns. Indeed the MSCI World index is up 11.3% on a year to date basis, already ahead of its full year performance in 2016 and heading towards its best performance since 2013. Every year the equity markets see a struggle between the bulls and the bears and 2017 has been no different. The encouraging theme that has developed this year is the long-awaited macro-economic recovery in Europe as well as lower political risk.
The big surprise has been the resilience of the U.S. stock market with the S&P 500 up 9.9% year to date and the Nasdaq 100 up 17.9% in spite of several headwinds, including an uncertain political backdrop.
The equity market was quite concerned about the possibility of a Trump win, but this shifted completely after the election as evidenced by the rally in the latter parts of 2016 that continued in 2017. The feel good factor was mainly built around the pledge of substantial investment in U.S. infrastructure. In my opinion, the market has failed to appreciate how difficult it will be for the Trump administration to get the infrastructure bill approved by both houses of Congress. The Republican Party controls both houses and has generally opposed measures that increase the deficit. In addition, the Trump administration is suffering from low support ratings, not helped by the Comey testimony and other news flow which added complexity to the situation. Nonetheless, U.S. stocks have so far shrugged off such concerns (S&P 500 up circa 16% since the election).
Moving on from the political arena, U.S. economic data this year has been positive, but has failed to inspire confidence. For several months, unemployment has been low but the labour participation rate is well below pre-crisis levels and wage inflation remains muted. The Citi Economic Surprise Index, a measure of economic data that was weaker or stronger than forecast, has been negative since May. Meanwhile core inflation at 1.7% (June) is well below the 2% target imposed by the Federal Reserve System (“FED”). There is a sharp contrast with what is happening across the pond in Europe, where economic data has generally exceeded expectations, albeit from a lower base.
In my opinion the FED will likely push ahead with the normalisation of monetary policy despite Chair Yellen talking down inflation in her testimony to Congress and the sluggish economic data. There are no practical examples to guide the FED in winding down QE and there is a real possibility that they are too early or too late in tightening monetary policy. Both would hurt the economy, but the decision to hike interest rates when inflation was well below target suggests the FED is more worried about being too late. This would likely lead to an overheating of the economy and asset bubbles (Chair Yellen acknowledged asset bubbles already exist) requiring a much faster tightening process that would have severe implications for the U.S. economy.
The market performance so far this year suggests that investors are bullish about the prospects of U.S. equities. Alternatively, it could mean that investors are complacent. Deutsche Bank tried to quantify market complacency by plotting the Economic Policy Uncertainty Index (“EPU”) against the VIX. The EPU index (Baker, Bloom and Davis) is completely independent of the market as it is constructed by counting the frequency of certain key terms in ten leading US newspapers.
Exhibit 1 – Economic Policy Uncertainty Index vs VIX
The two measures seem to track each other well until 2012, in terms of both levels and spikes. This implies that the market is acknowledging the higher levels of risk as an increase in uncertainty (measured by the EPU) is matched by an increase in volatility (as measured by VIX). This has not been the case post 2012, where the VIX index is constantly below the EPU implying that risk is being underpriced, and points towards complacency.
On balance it is unlikely that the U.S. equity market will plunge in the second half of 2017, unless new factors emerge. However the upside is limited bearing in mind the headwinds. Validating this point is the current valuation of the S&P 500, trading on a Cyclically Adjusted Price Earnings (“CAPE”) ratio of 30.1x, which is above the long-term average of about 15x and a level that has been exceeded only twice: 1929 and 2000. The rising P/E ratio means that equity prices are rising at a faster rate than earnings with valuations looking stretched. Unless we get meaningful earnings growth, investors will start looking at other regions like Europe that are less expensive and have better economic prospects.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business