Date published: 11 January 2020
There has been little shortage of market drama to mark the new year, sparking hefty swings in oil and havens such as gold. For long-term investors, the sudden and — it is to be hoped — shortlived escalation in tensions between Iran and the US provides a lesson in the importance of waiting out passing tempests and focusing on gauging the outlook for the global economy and corporate profits.
The resilience of equity markets this week suggests that investors are well attuned to how messy geopolitical situations can unlock opportunities for allocating new money.
Over the past 18 months, while the US and China have played out a protracted trade war, there have been regular bouts of weakness in equity and credit markets. Buying these dips has been rewarding, but here one must acknowledge the crucial role played by very supportive central banks and a backdrop of low government bond yields. In short, owning stocks and other risky assets is still very appealing, given the limited upside from holding expensive bonds that provide meagre fixed rates of interest. This helps explain much of last year’s rise in equity valuations, despite a lack of much growth in corporate earnings.
Indeed, as oil briefly surged this week, with no shortage of commentary warning of a price shock and a greater escalation in the Middle East, the relatively sanguine response in equities reflected two things. First, that the US Federal Reserve has started to expand its balance sheet once more, weighing on the dollar and boosting prices of risky assets. Second, that traders considered the risk of Iran attacking oil shipments in the Strait of Hormuz to be low, given that China — one of the few friends Tehran has — derives nearly half of its crude imports from the region.
Another consideration for equity investors — and one that ultimately propelled Wall Street back into record territory and sank the haven and oil trades on Wednesday — was the sober message from US president Donald Trump, who appeared to back away from a military confrontation with Iran. This affirmed a view among investors that in an election year, the last thing the US economy needs is a volatile oil price and a consequent hit to both consumer and business confidence.
When gauging the current resilience of equities, you also need to bear in mind that investors’ positioning for much of last year was generally defensive, until a flurry of buying in the final quarter drove the MSCI All-World index into record territory. Money market and bond funds attracted record inflows last year, while sales of global equity funds — which had net outflows of $143bn — were the lowest in three years, according to Jefferies, the US invvestment bank, despite the fourth-quarter surge.
That late-year embrace of equities is a sign of how sentiment has coalesced towards a global economic rebound and one that delivers better earnings growth in 2020. Such faith can put a floor under equities for a while yet.
The key questions for 2020 are whether central banks have laid the ground for an extended economic cycle, and moreover, whether corporate earnings will rebound to ease pressure on margins. Investors may have to wait until April, at the earliest, to judge evidence of a sustained upturn in activity and profits. So while the mood of the market can wax and wane over coming months, any declines will probably attract buyers of the dip.
That is a delicate scenario, though, when plenty of good news is already baked into equity markets. Analysts at Unigestion note that fundamental valuation ratios, such as enterprise value to sales, or price to book value, “highlight how expensive US and European equities have become”.
Prices are similarly high in corporate debt markets, where amid all the noise this week, credit risk premiums barely budged from their current tight levels. That kind of behaviour tends to increase appetites for equities, given that in the past, strains in credit markets have triggered collapses in stock markets.
This week analysts at the New York Fed looked at the spectacular rise in the amount of debt issued by companies with a credit rating just above junk, judging that it “may pose a financial stability concern”. The importance of earnings growth and stronger global activity in 2020 should not be lost on investors, the Fed analysts noted, as companies with these ratings are now carrying more net debt, relative to operating earnings, than the average junk-rated issuer.
The key lesson this week, then: while political developments do matter, the ultimate arbiter of just how equities and credit fare in 2020 comes down to whether lofty valuations are supported by stronger economic data and earnings.
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