Each time the equity markets wobble and the yield curve inverts, investors start worrying about the next slowdown or recession – and here we are again. Our 27 April letter turned out to have been bang on: we pointed out that Wall Street was 9% overvalued, according to our models, and the S&P 500 was at 2,940 points at the time. It closed at 2,752 points last Friday. It took another twist in America’s trade war with China to focus investors on the reality of the situation, and the war of words between the two has only worsened since. Instead of joining forces with Europe, which has also been sucked into China’s game, Donald Trump is looking to attack it. On equity markets, specialist retailers hit by higher tariffs have been notable casualties, while IT firms are looking at lower exports because of the embargo and weaker demand. Amid fears of slower growth and net sales of equities, long rates have slumped again in America and Europe. German yields are negative out to 15 years! The US 30-year is down to 2.58%, the curve is inverted out to 3 years and the market appears to be ordering the Fed to ease swiftly even though the state of the economy suggests the opposite.
The eurozone economy has never really bounced back from the financial crisis, even though the ECB’s balance sheet has ballooned to €4.7 trillion (61% of eurozone GDP) and its interest rates are negative. The ECB says that it has enough in its toolbox to cope with a significant deceleration or recession: could that be so-called helicopter money, given that it has described the idea as ‘interesting’?
Simply handing out €50 per month to each adult in the eurozone would cost €160 billion per year, compared with the ECB’s sterile €4.7 trillion and could boost growth by over 1%. It would also generate tax revenue. The poorer the country, the more this windfall would be appreciated, and this sort of imaginative intervention could help reconcile EU citizens with an institution that comes in for heavy criticism. Unlike qualitative easing, which parks money among banks before it seeps out to the already rich, direct subsidies to households would boost consumption and inflation expectations. In the USA, QE has raised the prices of financial assets: equities have gained an average 12% per year over the past decade on Wall Street and Mr Trump’s tax reforms have only accelerated the process. America’s inequalities have widened still further. The gap between remuneration on capital and that on actual work is hitting such high levels that the law of the market is bound to correct it.
Macroeconomic indicators are very stable, giving us an unchanged world growth figure for this year of 2.9%. America’s ISM series, which measures expectations for activity in manufacturing and services, is the only indicator showing a marked decline, although nervousness over demand has cut oil prices 19% from their recent highs. France’s ‘yellow jacket’ protesters will be pleased about that. Earnings estimates are also largely unchanged, with S&P 500 profits expected to rise 2.1% this year. The drop in share prices has cut the index’s PERs to 16.6x 2019 and 15.1x 2020.
Lower interest rates have boosted our S&P 500 valuation to 2,993 points for the end of 2019. It would be back down to 2,785 points with a 30-year yield of 3% in a trade war ceasefire scenario. In the event of modest recession with long rates easing to 2.5%, our instantaneous index objective would be 2,666 points, some 100 points below Friday’s close. We suggest re-entering the market at this level, although only partially as it could exaggerate to the downside. We are sticking with our decision to underweight our equities benchmark (an allocation of 35% rather than 40%, in our case). European equities look attractive with such low interest rates but continue to track Wall Street.