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Does Valuation Matter?

Pascal Blackburne & Luc Synaeghel 2019-03-01

Helping financial markets extend their rally late February was an unexpectedly solid 4th quarter 2018 US GDP report. With the Fed now on pause, a trade deal with China seemingly at hand and Trump-promised infrastructure investments to possibly finally materialise, the largest world economy looks set to continue growing this year, breaking its post-war cycle length record.

In fact, as long as money remains nearly free, the only limit to the US expansion will be the budget deficit and public debt levels, which, judging by the Japanese example, still have ways to go. True, most of Japanese government bonds are held domestically, which limits the country’s dependence on external financing – and hence the need to pay higher rates as the debt burden swells. But the US have a different advantage, in the form of the world reserve currency.

Ultimately, in our view, inflation is the only factor that could force US rates higher again and eventually derail the economic cycle. The Fed has suggested that it will tolerate some overshooting of its 2% inflation target, following the lengthy period of undershooting. But if large infrastructure programs do achieve consensus in Congress, the pressure put on an already very tight US labour market will be substantial. Also, it should be noted that there is a considerable gap between the relatively contained message given by official prices indices and the pinch actually felt by main street in terms of purchasing power. Which makes social unrest a potential issue to monitor.

For now, though, the fact that the US economy continues strong supports our thesis that the world economy is in no immediate danger. In fact, given the sizable stimulus measures taken by the Chinese authorities, we could be in for a positive growth surprise during the second half of the year – boding well for equity markets at large.

That said, as we write, the S&P 500 index has almost recouped all of its late 2018 losses and is standing close to all-time highs. Valuation is thus again becoming an issue – but does it even matter? Sentiment is clearly what drives equity markets, with a very short-term horizon. How else to explain the abrupt shift, over just a few months, from panic (about higher Fed rates causing a recession and China collapsing under the pressure of US sanctions and its own debt pile) to buoyancy (that a trade war will be avoided and money remain free forever).

Most non-US stock indices have also undergone strong bounces year-to-date but remain well short of their historical highs. And for good reason, at least in the case of Europe. Brexit is the most imminent issue of course, but the May elections compound the European risk premium. On Brexit, both parties obviously have an interest in avoiding a hard outcome. Still, the longer uncertainty prevails, the more companies are forced to prepare for such an outcome. As regards the parliamentary elections, although populist parties stand to make gains, they will nonetheless end up with far less representation than in the EU Commission – simply because the weight of France, Germany and Spain is large in Parliament, whereas each EU member gets to appoint its own Commissioner. How the EU will function in this strange configuration is an open question…

The US Economy Defies Expectations


Source : Bloomberg

According to the “initial” estimate released on February 28 by the Bureau of Economic Analysis, the US economy grew 2.6% (on an annualised basis) in the last quarter of 2018. As an aside, this report was termed “initial” because it replaced both the “advance” and “second” estimates that should have been released at the end of January and February, respectively, had the US government not been forced to shut down.

While this 2.6% figure is not definitive, with shutdown-related measurement issues compounding the usual revision process, and does mark a slowdown versus the 4.2% growth recorded in the 2nd quarter and the 3.4% pace of the 3rd quarter, it well exceeded consensus expectations and clearly put to rest fears of an imminent recession in the US.

Looking at the 4th quarter GDP report in more detail, growth was mainly driven by a 2.8% increase in consumer spending. This contradicts the very weak December retail sales report – that so rattled stock markets – and confirms that it was likely distorted by the government closure, which forced some of the underlying surveys to be postponed into January, a seasonally weak month for retail. Business investment and federal government spending also added to GDP growth, with the weaker domestic link being the residential segment (down 3.5%). As for trade, exports increased 1.6% but imports rose a larger 2.7%, making for a somewhat negative net contribution.

For the full year 2018, US GDP expanded by 2.9%, faster than the 2.2% pace of 2017. We expect this solid trend to continue this year, thanks to the fundamentally good shape of US consumers (lower indebtedness, higher savings rate, tight labour market) but also to gains in trade on the back of a hoped-for deal with China. Indeed, if US and Chinese negotiators do find common ground, this will likely involve China buying oil, gas and soya beans from the US in substantial quantity. Which, incidentally, would be positive for the transportation sectors, with tankers and bulkers particularly put to contribution.

On the government front, one big electoral promise on which President Trump has yet to (try to) deliver is infrastructure spending. Fortunately, this is an issue on which Republicans and Democrats tend to agree: US bridges, airports and highways, just to mention those, date back several decades and are in major need of repair or upgrade. Despite the divided Congress, legislation supporting infrastructure spending thus stands a reasonable chance of being passed, which would also support US economic growth going forward.

Such spending can of course only serve to worsen the public deficit but, with the Fed having reversed stance and basically agreed to keep money cheap, this is not a concern for the time being. What will need to be watched, though, is inflation – notably upward pressures on wages that could well intensify if major infrastructure programs are rolled out, calling on (currently scarce) labour.

“In the long run we are all dead”

The strong market swings of the past few months have not only been rough on investors’ nerves, they have also made it very clear that sentiment – rather than valuation –sits in the driving seat. More broadly, we worry that the quality of financial analysis in general is declining. Most analysts seem systematically behind the curve, reacting to old news and simply adjusting their price targets to recent stock behaviour, irrespective of (unchanged) fundamental assumptions.

The dwindling quality of analysis is perhaps attributable to less money being spent on research, in this world of lower brokerage fees and MIFID 2 regulations. Or else to diminished hedge fund means, following a couple of mixed or bad performance years that have weighed on the fees that they earn. Or simply to reduced interest for fundamental research given the rise of passive investing.

Whatever the reason, we find ourselves in a situation where the importance of valuation as a factor in the buy/sell decision has diminished. As such, and although we remain convinced that buying cheap will work out in the long run, we are forced to recognise that the current investment context requires short-term results, with limited investor patience.

There have been times in the past when value investing was also out of favour, notably during the dotcom bubble of the late 1990s. But in that instance at least, when the market finally turned, patience was rewarded, and the cheapest stocks prevailed. Last October and December, this was not the case: all stocks took a beating, with the less liquid and cheaper stocks sometimes even hit harder.

hit harder. This indiscriminate selling and buying will remain with us as long as money flows in and out of the market through ETF’s, indexed funds and benchmarked portfolio strategies. The ability to correctly time these flows has become a more important factor to generate portfolio returns (for the time being) than investing in “undervalued” companies and being patient for the market to recognize that and correct the stock price to a more “normal” level based on the underlying value of the company’s assets and discounted estimated future cash flows. Patience is and will remain a virtue!

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