Rothschild Asset Management: Are the Market’s Fears Justified?

By Didier Bouvignies & Ludivine de Quincerot of Rothschild Asset Management

The first correction was triggered by inflationary risks that emerged from the bull market and a steady upward revision in growth forecasts, suggesting that an acceleration in inflation would lead Central Banks to take more drastic action than expected. The resumption in Donald Trump’s tweets caused a second jolt by triggering a trade war, or, at least, a war of words with Europe and then China, against a backdrop of uncertainties surrounding the business models of the GAFAM (Google, Amazon, Facebook, Apple, and Microsoft).

And, more recently, when oil prices have been pushed up by the risk of an escalation of the Syrian conflict, with threats of Franco-American reprisals after the use of chemical weapons by the Syrian government. As usual, it is worth looking into how much these sources of volatility, beyond making the markets a little jumpier, can actually alter views of the economic cycle.

Economic indicators since January have tended to reassure the markets on inflationary risks. And crises that have occurred since then have actually pushed interest rates downward, thus mitigating the previous fears.

Regarding customs tariffs, Trump’s message is unclear to say the least. Several headline-grabbing threats were made against some countries, but most of them were withdrawn, particularly with regard to Europe, notably Germany, but also Canada, Mexico, and others. The escalation in figures with regard to China seems to be more for show than an actual intention to implement them.

Trump seems to prefer negotiations and, as usual, his negotiating strategy is «shoot first, talk later». Yes, protectionism is bad and can undermine economic growth. But clearly, since it joined the WTO in 2001, China has enjoyed a number of advantages, and now its strength may leads its trading partners to challenge their legitimacy.

«We don’t see any risk of a trade war or a sudden downturn in foreign trade»

There is, of course, its exchange rate, which is undervalued on a purchasing-power-parity basis, the obligation placed on companies to share technologies when investing in China, the obligation to operate under joint-ventures, the high customs tariffs on some product categories, such as cars, and so on. These are all signs that China, aware of the weakness of its arguments in this area and wanting to steer its economy towards services, is trying to take on a tone of openness and appeasement, although it is hard to say how much and how long it will take.

We don’t see any risk of a trade war or a sudden downturn in foreign trade. In any case, this is what the global fixed income markets appear to be pricing in, as seen in the lack of inflation expectation fears following the implementation of customs tariffs.

As for doubts on the business models of the major U.S. tech companies, here again, it is easy to see why recent events have had such an impact, given the margins those companies have achieved, their return on capital employed, and how much and how fast they have built up global quasimonopolies. Even so, given their track-records, this correction is more like a reversal of flows, which had been massive into this sector, than a true questioning of their business models. Given their lack of first-tier tech companies, European markets are unlikely to suffer the same fate.

Of course, the situation in the Middle East and sanctions against Russia continue to push up oil prices, with a knock-on impact on consumer prices. At this point in the cycle, investors would not look kindly on a sharp rise in oil, due to its impact on the fixed income markets, which, in turn would make life difficult for Central Banks in conducting their monetary policy. These geopolitical considerations are obviously recurring themes and few countries are willing to go down this path. So, at this stage, we are ignoring these in constructing our investment strategy.

Alongside these hyped up news stories, some doubts have been raised about the pace of growth in the global economy. True, this pace has slackened, particularly in retail sales with higher inflation, and industrial output has fallen short ofits solid previous figures and early-year expectations (albeit more modestly), but this is also reassuring on the interest-rate front.

Indicators in Europe have disappointed the lofty levels expected of them and now looking more like a return to a satisfactory level of economic activity that is no longer accelerating, which, all things considered, is not bad when you are already hovering around 2 percent.

«In the U.S., the pace of earnings growth has been an enormous surprise»

In the U.S., the pace of earnings growth has been a surprise. Seldom have forecasts been revised so much upward prior to reporting season, and now reach dizzying levels in some cases. In Europe, despite very solid top-line growth, releases did not beat forecast but did confirm earnings growth of about 8 percent. Emerging markets, China and Brazil in particular, were rather reassuring on their growth pace.

In the U.S., these fits and starts and the across-theboard decline in markets in the first quarter even as earnings were improving have resulted in lower valuation multiples, with a P/E of about 17 and growth forecasts holding at about 15 percent. At these levels, and with 10-year yields of about 2.8 percent, the market cannot be considered overpriced.

So the real issue at hand is how long U.S. companies can maintain their stratospheric margins (including a 10-percent-plus net margin) and, even more so, a 15 percent return on equity, which is five times higher than the risk-free rate, keeping in mind that these ratios are inflated by the heavy weighting of tech companies, as well as by the ability of US companies from more traditional sectors to create global leaders.

Europe is currently outperforming the U.S. market slightly on a same-currency basis, and still offers some attractive valuations, at less than about 14 times earnings projected for 2018, with 3 percent yields on upcoming dividend payments and margins higher than their 2012 cycle lows, at about 6 percent, a level, in fact, equivalent to 2005.

So this is obviously the region we find the most attractive, especially as it is relatively immune to the uncertainties hovering above the tech sector and could get a boost not just from downward revisions in macroeconomic forecasts but also from a seemingly schizophrenic market psychology, with big talk in favour of the region but without massive inflows thus far. And we won’t even bring up the uncertain political landscape in Italy, as long as investors seem to be ignoring it!

Italy has been Europe’s top performer on the year to date, even though the situation there is unclear, to say the least. Our view is that, regardless of the coalition that emerges, it will be a shaky one and unable to put through radical decisions.

We continue to weight Japan heavily in our international funds, without hedging for forex risk, for its attractive valuation and the fact that listed companies’ earnings growth momentum has been more robust and even higher than in the U.S. over the past five years. This trend was driven at first by a weaker yen, a fact that has no longer been the case recently. The market itself is being driven by investors’ greater tendency to put massive amounts of money in equity funds.

Emerging markets continued to perform well in local-currency terms, led by Brazil and Asia, the latter also being driven by the tech thematic. However, when converting the performance of South American markets into euros over the past year, we see that they have not truly outperformed Eurozone markets. This shows how shaky these markets have become, such as Russia in recent weeks which has fallen victim to exchange rates, often in synch with the markets, even though money has flowed massively into it in the amount of more than 40 billion euros on the year to date.

«It is through stock-picking that our portfolios have weathered this rough first quarter so well»

Against this backdrop, no overriding theme has outperformed, with the exception of technology, which, after starting out well, has made a complete U-turn. «Growth» has not truly outperformed «value», and, after starting out well, small caps have pulled back somewhat in recent weeks. All in all, it is through stock-picking that our portfolios have weathered this rough first quarter so well.

Our asset allocation funds have neither been particularly hurt, nor helped by their overweighting of equities, European equities in particular, but have been helped by timely management of interest rates. Indeed, bond indices of peripheral countries have outperformed other bond investments by far, particularly in high yield, investment grade, core-country government bonds, and others.

It would appear that, in an environment in which interest rates have held steady, our lack of interest-rate sensitivity has had no impact, but this is reassuring on a fixed income market that is still just as risky, with low yields, particularly compared to the implied real yield of inflation-linked bonds, which are once again at lows of almost -1 percent on 10-year bonds, hence a cumulative and certain loss in purchasing power of 11 percent upon maturity.

It is clear that the markets are more nervous, given the advanced point in the cycle almost worldwide, in which there are still many risks, and after a rather long bull market. This is a normal reaction compared to the abnormal levels of volatility in 2017. Investors could be very tempted to sidestep this volatility by pulling out of the markets. But we feel this would be premature at a time when the cycle, valuation and market psychology appear to be support factors that are easing the discomfort of volatility in equities, in light of their prospects of outperforming other investments, which, at current levels, offer little upside.

Keep in mind that Eurozone markets are just now back up to their levels of April 2015, and even June 2014 for the Euro Stoxx 50, whereas the economy has improved markedly and companies have delivered about 15 percent earnings growth.