The markets appear to have stabilised after an extremely volatile end to 2018. In line with a strong rally that has lifted the MSCI World 11.7% this year, the VIX index of volatility has fallen back to almost normal levels. The threat of recession has eased, at least for the time being, thanks to the Federal Reserve’s return to an accommodating monetary policy and hopes of a settlement in the US-China trade war. The S&P 500’s 20% correction in the final three months of 2018 was a severe setback that we see on average only once every six years: corrections of this magnitude have signalled recession slightly more than half the time. The market effectively forced the Fed to adjust its policy and the US yield curve now looks a little odd. It is slightly inverted out to the 5-year maturity and positively sloped beyond that point. That implies unchanged Fed rates for some years, but that could all change in the event of rising inflation. US economic growth was a robust 2.9% last year, including a 6% jump in investment. The trade deficit reduced growth, but the current balance is now only marginally negative at 4 billion, even with apparently elusive profits at GAFA and certain other firms.
Forecasts for world GDP growth this year appear to be stabilising at a very respectable 3.1%, after 3.3% in 2018. Persistently sluggish activity in the euro zone is more than offset by the resilience of the USA and several emerging economies. Germany is struggling, while France is posting slightly better growth following the budgetary sop thrown at the so-called yellow jacket movement. The American economy is the engine of international activity and is reporting a whole array of positive indicators, from rebounding consumer confidence to the services PMI and a rising participation rate. Credit markets have recovered a measure of calm and spreads on the riskiest borrowers have contracted. The prospects of a no-deal Brexit have faded and the UK could yet be tied to the EU for some years because of the Northern Irish issue.
This backdrop has helped analysts to stabilise their earnings estimates, and the up/down revisions ratio has started to pick up again. The consensus forecast for American EPS growth in 2019 is 3.3%, and 4.3% excluding energy. Our own top-down hypothesis is an unchanged 2.1%. The consensus figure for 2020 is 11.6%; we are retaining 9%. The 12-month forward PER is 16.5, and comparisons with the 2000s show that the gains in the PER can be attributed entirely to a fall in the 30-year rate from 5% to 3%. Our S&P 500 valuation gives us a year-end objective of 2,699 points with a 30-year rate at 3.09% and a CAGR of 3.4%. The market’s current level implies an 8-year CAGR of 4.5%, which could be justified by an inflation rate of 2.2% and 2.3% GDP growth.
The catch is that US profit margins are at their highs and massive asset depreciation slashed GAAP earnings dramatically in Q4. Non-GAAP earnings suffered far less. Given that there is every likelihood of a slowdown in the coming eight years that could dent profits, our more conservative CAGR is more comfortable. Being right two years down the line is not so comfortable, however! This is why asset allocation is not a matter of black or white but of playing at the margins. We happen to be moderately underinvested, but cash-rich investors would be advised to go with sound equity management. In Europe, our Digital funds have made good earlier losses. If another correction materialises, investors should look at the situation at the time and take decisions with our valuations in mind.
