Happy New Year and welcome to 2018.
What a start to the new year it has been!
This is our investment markets update, provided with the purpose of letting you know what we are currently thinking about when constructing, reviewing and discussing portfolios with clients.
Our key message is: Whilst 2018 is considered to be the year of the Dog it’s also likely to be the year of the traditional battle between ‘bulls vs bears’. This year should shape as one which sees increased ups and downs (i.e. the return of volatility). With this backdrop opportunities will arise and we remain very positive on the continuing prospects for both economic growth and share market returns if we can look through the volatility and newspaper headlines it will inevitably bring (out to the longer-term where investors should be focusing).
This update does get a bit heavy on the technical, so for those interested – please read on.
Following very strong returns in share markets during January the major indexes have taken a hit in the last week with markets such as the US swinging between gains of 2% to losses of 2% intraday.
Overall markets have now moved down around 10% in a week – this is classed as a technical ‘correction’. Taking shares indexes back to valuations they were sitting at in late November 2017 – so we have lost around 3 months worth of gains.
This is a natural part of investing and as we all know the best action is to ride these situations out. Timing (trading in and out of) a market is virtually impossible and history tells us often very unwise.
Share market indexes taking a breather..
In our view this current pullback in markets is likely to be something to get used to over the next say 1-3 months. So buckle up and hold on this may not be very pleasant.
However long term we remain very positive – we’ve looked to articulate the reasoning for our “longer term” optimisim later in this update.
This following has a strong focus on the United States economy and markets – so we apologise in advance for those looking for an Australian focused Market Update. However, as usual the US markets will generally lead and influence our market here.
Why the big ups and downs?
Global Share Markets, and especially the US market, have had very strong returns for the past number of years. The US market was turbo charged in the second half of 2017 with the passing of meaningful tax cut legislation during December. This boosted the Dow Jones further as you can see in the above chart.
Thus, this week’s fall was simply giving back some these recent gains.
While the US tax cuts look very positive (for US companies) – the real effects in company returns won’t be seen for months, and the flow through effects can even take years. This means the US market is in little bit of “no man’s land” for a while – that is – we are between the anticipation of higher earnings and when companies actually begin to report those earnings.
This creates uncertainty and for those ‘trading’ the market, or those new or uninitiated to markets – uncertainty is seen as the enemy.
When such uncertainties flow into market corrections, they can nowadays be magnified due to the nature of share market trading in this technology driven world. Now the majority of ‘trading’ is done be computers using various algorithms to buy and sell in fractions of seconds – in huge volumes. These trading systems make the possibility of sharp movements up and down significantly more likely. The flip (or positive) side to such market participants is that in normal market conditions they provide important liquidity for all of us when we want to buy or sell.
When Bad News is Good and Good News is Bad
For the last 8+ years markets have risen on both good and bad news.
For instance as the economy looked weak – Governments and Central Banks would cut interest rates and print cash – thus providing fuel for markets to rise.
Therefore bad news for the economy = good news for shares.
Last week employment figures in the US were very strong – with unemployment at 4.1% (near full employment) and wage growth up around 2.6% for only 3 months. Thus, more people had jobs and those jobs were paying more.
This means markets expect to see interest rates rise and a scale back of central banks printing of money (quantitative easing).
So good news for the economy has been interpreted (for now) as bad news for shares.
This is quite a weird situation and soon more than likely Good News will mean (and be interpreted as) Good News again. If employment is high and wages a growing, this leads to more spending power in the economy, better prices for goods and services, and stroonger profits for business….which means share markets can justify (ans should reflect) higher prices.
But we consider this silliness will prevail for a little longer, until the numbers start to show up with businesses reporting better earnings.
What are the positives?
Over the past year or two, the overwhelming view of investment managers have been negative on share markets – especially in relation to the US and President Trump. This has proven to be very wrong as markets – especially the key US indexes of the DOW and S & P 500 have grown strongly. But will it continue?
The benchmark US index currently trades on a Price Earnings Multiple of around 18x earnings, this is a little above the long term average around 16x.
So the market is slightly ‘expensive’ – though it has been a lot more expensive (trading at much higher price to earnings valuations) in the past; none-the-less it is slightly above its long run average.
Essentially this means companies need to generate higher earnings in order to justify these higher valuations.
So where do we think earnings are headed?
Based on calculations provided by global asset manager Epoch, the recently announced US tax cuts provide an average earnings benefit for US companies of 11%. That is based only on the tax cuts.
Capex Spending is a good indicator of Earnings Growth
One of the best leading indicators of higher earnings is Capital Investment – If a business invests in new capital – i.e. equipment, technology, factories etc, a year or two later that investment should lead to higher earnings as the benefits of that investment begin to flow through. Post the US elections Capex has lifted strongly.
Bonus: The Flow of Money and 100% Capital Deductions
Two of the other recent changes announced in the US were the repatriation offer (reduced tax for repatriating offshore cash) and the 100% deduction for Capital Investment. (PS this area was discussed in our July Market Update and is now coming into effect).
The table below shows the level of CASH held offshore by only 10 companies in the US. In the past if these funds were repatriated to the US they would have incurred 35% tax – they now only pay around 15.5% and can pay the tax over the next 8 years.
Apple has already announced they are returning this cash back into the US. Assuming other companies follow, this is likely to result in around $2-3 TRILLION of funds returning to the US. This is 15% of the size of the entire US economy coming back as cash!
That cash will need to go somewhere
If business then decides to spend some of these funds on capital investment – they will receive a 100% tax deduction – thus more capital investment – which as we discussed above this is likely to flow into higher earnings/profits.
In the last day or so we have received a lot of enquires from clients about looking to add funds into the market to take advantage of the recent sharp sell off in markets. It tells us that our clients are well educated about risk, focusing on their long-term goals and have the right mindset when it comes to investing. But, while we make a point of not ‘timing markets’ we do want to make it clear that we expect that this is not the end of the volatility.
The next few months should provide more opportunities to invest as traders await companies to report earnings in coming months.
In the short term emotion drives markets – and we expect emotions to run high in coming weeks and months – but we look to the long term and remain positive.
We hope you have found this update informative.
Sam Adams Glen Orbell
All charts and figures sourced from Armstrong Economics, Epoch & Grant Samuel Fund Management, and J P Morgan Asset Management Guide to markets 1Q 2018
Disclosure Statement: Samuel Adams, Glen Orbell and GPL (Melbourne) Pty Ltd are Authorised Representatives of Godfrey Pembroke Limited ABN 23 002 336 254 an Australian Financial Services Licensee Registered address 105-153 Miller Street North Sydney NSW 2060 and a member of the National Australia Group of companies. General Advice Warning: Any advice in this publication is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information. Past performance is not a reliable guide to future returns. Opinions constitute our judgement at the time of issue and are subject to change. Neither, the Licensee or any of the National Australia group of companies, nor their employees or directors give any warranty of accuracy, nor accept any responsibility for errors or omissions in this document.