How investors can successfully navigate fear in the market
Fear is a potent force driving investor behaviour but its effects can be successfully navigated, writes Matt Sherwood.
Many old movies can be re-made with modern actors and cutting-edge technology, but few of the new productions end up better than the original.
Nevertheless, one of the two movies that were clearly better than the original was the 1991 remake of 1962 film Cape Fear (the other is Casino Royale).
Cape Fear tells the story of a convicted criminal whose case was deliberately mishandled by a public defender who thought the crime warranted a long sentence.
It featured cameo appearances from Gregory Peck, Robert Mitchum and Martin Balsam, all of whom appeared in the original movie.
The movie,which grossed US$182 million in sales in 1991/92 and scored several Oscar nominations for the leading actors, is a breathtaking thesis on the anatomy of fear, with viewers relieved of the tension only when the credits role.
Fear has dominated sentiment
Although fundamentals dominate asset prices over the medium- to long-term, emotions such as fear and greed clearly influence markets over the short term.
During these times, contradiction between macro data and micro portfolios positioning can exist. This can be seen in the paradox of ‘fully invested bear investors’, ‘long risky assets, but short global growth’ and, more recently, the ‘defensive-led cyclical recovery’, as there is not a perfect pass-through from the macro to the granular levels of portfolio construction.
Over the past year, investor sentiment has experienced profound changes – oscillating between fear of widespread losses in June and November 2012 and fear of missing out on the broad-based gains following even more central bank largesse.
This improvement began with Mario Draghi’s commitment to do ‘whatever it takes’ to keep the Eurozone together in June 2012 and was followed by more quantitative easing by the Bank of England (July 2012), the US Federal Reserve (September 2012), and the Bank of Japan (early 2013).
US Fed stimulus and US shares
Central bank policy in this cycle has had a much larger impact on regional sharemarkets than any macro fundamentals. QE (quantitative easing) announcements galvanised market sentiment and markets rose aggressively.
However, the rise was not underpinned by higher expected earnings and was primarily driven by higher P/E (price-to-earning) ratios.
This trend has culminated in the weekly size of the US Fed’s balance sheet having a 93 per cent correlation with the US sharemarket in 2013, relative to -46 per cent and -48 per cent in 2012 and 2011 respectively, with both factors moving up in unison after the US fiscal cliff was avoided in early 2013 (see Chart 1).
However, the constructive liquidity party cannot go on forever. As the time to unwind the program approaches, it may be the case that good (economic) news, is no longer good (market) news, but bad news is still bad news.
Declining market valuations
Given the subdued outlook for US and global corporate earnings, any hint from the US Federal Reserve of tapering its QE program has sparked market volatility as investors began unwinding their profitable ‘search for yield’ trades.
While the US Fed Chairman is preparing the markets for a reduction in asset purchases, he is not taking away the punchbowl of stimulus that investors have become addicted to over the past year.
Instead, he is likely to begin reducing the monthly level of asset purchases in the September quarter 2013, reducing demand for US Treasury bonds, which will be destructive for government bond markets, with the effect also felt (to a lesser degree) in shares, credit and currency markets.
More than just US dollar strength
Over the past seven weeks at time of writing, the Australian currency has experienced its sharpest deprecation against the US dollar since the GFC.
Given that the decline in the local currency (-9 per cent from its January 2013 peak) has been larger than for any other currency other than the Yen (-15 per cent, relative to -7 per cent for the UK Pound and -5 per cent for the Euro and the Canadian dollar), the decline has reflected the US Fed’s QE program as well as four other factors:
Concerns about the sustainability of China’s growth and its steel intensity, culminating in lower prices for base metals, energy and soft commodities, which dominate Australian trade.
Peaking of the mining investment boom, which has reduced foreign investments in Australia and our growth premium over the US economy.
Foreign investors have eased back their purchases of Australian-denominated bonds as they have most likely reached benchmark weight, with a market share of 70 per cent of the Australian government’s debt on issue unlikely to rise much more from here.
The RBA has lowered official interest rates to record lows and this has seen interest rate differentials decline to the lowest level since the end of 2009.
Depreciation – constructive or not?
The lower Australian currency will continue to ease financial conditions and support domestic growth.
However, it will also remove the dampening effect that import prices have had on domestic inflation over the past year, with price changes in ‘tradable goods’ (where prices are determined on world markets, such as electronic goods and clothing, and which comprises 39 per cent of the consumer price index) likely to return to positive territory for the first time in 15 months.
Consequently, the dampening effect of import prices on Australian inflation has probably run its course, and from here ‘non-tradable goods’ inflation (or domestic determined inflation) is likely to drive the overall CPI result higher, as this inflation has been trending upwards for four years (see Chart 2).
A positive impact for shares?
A lower currency would be expected to have positive flow-on effects for industrial firms with global earnings (such as News Corporation, Boral and Resmed) as these profits would be worth more in Australian dollar terms.
Resource stocks should also benefit, all other things being equal. However, all other things aren’t equal in this sector as headwinds coming from China’s steel intensity and declining commodity prices weigh on earnings prospects of low-cost mega-cap producers (such as BHP Billiton and Santos), best placed as they are likely to benefit from increased ‘volumes’ of commodity consumption.
Earnings growth – where is it?
The combination of a higher Australian sharemarket and easing earnings expectations has culminated in valuations (currently 14.7 times on a forward-looking basis) rising to an 8 per cent premium relative to their long-term leverage-boom average (13.6 times earnings).
Accordingly, earnings growth needs to come through to lift the market higher in FY14.
While the US is improving, the domestic economic slowdown is making domestic earnings delivery more arduous, yet despite this and expectations of a below-trend Australian economy over the next three years, earnings growth is forecast to be above average (see Chart 3).
Indeed, FY14 has forecast EPS (earnings per share) growth of +11.6 per cent, but with the economy growing at just +2.1 per cent in nominal terms, one has to wonder if firms can make up the difference with cost-out drives?
US-exposed stocks will clearly benefit from top-line revenue growth, but for most of the others it will be about the cost-out drive, which has to be significant to justify current valuations.
US-exposed stocks will clearly benefit from top-line revenue growth, but for most of the others
Implications for investors
Sentiment and central bank policy are having a more powerful impact on markets than normal, but US Fed tapering will occur only when US growth risks have diminished and will be more destructive for government bonds than for other asset classes.
Indeed, only the reversal of the US QE program is likely to prove worrisome for shares, but this appears some way off and earnings growth is likely to cushion the adjustment process’ impact on returns.
Meanwhile, softer domestic growth is just one of many reasons the RBA needs to reduce official interest rates in the near term, despite the positive impact of the lower Australian dollar.
In this environment, investors need to assess where opportunities and risks are the most elevated.
Consequently, firms with strong surplus cashflow-generating operating models are well placed to deliver on elevated earnings guidance, even though in some cases valuations may be a bit stretched relative to recent years.
As US Fed tapering approaches, quality assets should allow investors to have a smoother ride relative to other investment alternatives.
Matt Sherwood is head of investment markets research at Perpetual Investments.
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