The answer lies in the interest market - alpha beta asset management's strategy commentary
The first quarter of 2018 is behind us. The volatility on the markets is back, with weaker prices on most stock markets.
A few "highlights":
In March, the DAX delivered the fourth negative month within the last five months and closed the quarter with a loss of 6.4%. The US technology index NASDAQ again showed a change of at least 2% on four consecutive days in March, but closed the quarter with a gain (!) of 2.6%. The US S&P 500 Index showed a sequence of 8 days with at least 1% price movement, but lost significantly less compared to the European markets, only around 0.8% in the quarter.
The traditional explanation for the relative underperformance of the DAX is well known: High beta, bank share, high liquidity, etc. But what happens next? Current "sources of fire" are above all:
- US policy (punitive tariffs or the risk of a trade war, "chaos" in the White House, geopolitical concerns due to the conflict in Syria)
- Valuation of US technology stocks
- Possible economic slowdown in the USA and the euro zone
While the first aspect is subject to the random principle and can therefore hardly be planned (except as a reason for a general risk premium), the valuation of the so-called FAANG shares (Facebook, Apple, Amazon, Netflix, Google) and the medium to long-term economic development give cause for concern.
FAANG shares have dramatically outperformed other asset classes in 2017 and also at the beginning of 2018. Not only did they rise to dramatically high, in some cases three-digit, price-earnings ratios, they also drove "market-wide" indices such as the S&P 500 index to historically high valuation levels due to their high market capitalization. Analyses show that the valuations of the US stock market only in about 10% of all cases were higher than currently. This applies both to classic price-earnings ratios and to a comparison of index performance relative to gross domestic product.
Is it justified that one unit of growth today leads to double the performance of the stock market compared to previous cycles?
Four out of five FAANG shares are among the global top ten in terms of market capitalization. It therefore seems difficult to imagine a continuation of the stock market boom without the technology sector. In this context, a look at Asia is a good idea: The world's largest money market fund comes from China and is managed by Ant Financial, a spin-off of Jack Ma's Alibaba. Although this company "only" manages USD 230 billion in assets, its main business model is the processing of digital payment transactions (e.g. via bar codes, face recognition, etc.), especially for Amazon competitor Alibaba. This non-listed company is currently raising fresh capital from international investors, e.g. the Singaporean sovereign wealth fund, in the amount of around USD 9 billion, thus achieving a valuation that is around 50% higher than Goldman Sachs' market value. So much for growth markets. The music plays in Asia!
The key lies in the interest market.
The Federal Reserve's Open Market Committee expects growth of around 3% this year, which should then fall to a level of around 2% in the medium to long term. The trend in labour cost development means that the committee currently tends to become "hawkisher". The question now is whether this is merely driven by the desire to have more room for manoeuvre in monetary policy for the next recession or whether a stricter monetary policy is or will actually be needed to combat inflation. In our opinion, this represents the "breaking point" of the stock market. Should the market get the impression that the Federal Reserve is "overrun" or surprised by inflation developments, this could have fatal consequences for the stock market.
The economic situation in the USA can provide information on future market developments: The ratio of household assets (high dependence on the stock market) to disposable household income is at a cyclical high and indicates a bear market in the medium to long term. With a more short-term perspective, the purchasing managers' indices in the USA are already signaling a slowdown in growth. The reporting season for the first quarter of 2018 has started in the last few days, initially with outstanding banking results. In the first quarter of 2018, for example, JPMorgan generated the highest quarterly profit ever achieved by a US bank, with revenues of USD 8.7 billion. However, higher stock market volatility and Trump's tax reform helped here. If, on the other hand, a declining moment of profit in the real economy
We are also seeing weaker purchasing managers' indices in the euro zone. The Citibank surprise index shows significantly negative changes in the economic data published by the euro zone compared to analysts' expectations. We have also seen three consecutive declines in monthly industrial production data in the common currency area. Japan will also hardly help in the long term with positive news: Tens of thousands of Japanese demonstrated this weekend against Prime Minister Shinzō Abe and his involvement in a corruption scandal. At the same time, consumer spending there is falling and the hoped-for wage growth remains absent. This is not the way to achieve the 2% inflation target...
As already mentioned, the answer lies in the interest rate and bond markets. However, we are facing a difficult macroeconomic problem: so far, wages and inflation have not reacted as expected in the textbook, so the question arises as to whether there will (still) be a "normalisation" of the developed economies at all, towards the levels we observed before the 2008/2009 financial market crisis. Will it even be possible to close the production gap in the classic, large economies? According to an analysis by Deutsche Bank, it has never happened historically that inflation in a country first rises to the inflation target and then remains constant there for 12 months. Will this continue in the future? Accordingly, the risk of overshooting in the US, with corresponding implications for the Federal Reserve's monetary policy, would be more than real. But: We are in a new world, the neutral interest rate of monetary policy will be reached earlier than in the past.
What is the market currently pricing for US monetary policy?
Currently, the futures market expects at least two further rate hikes from the Federal Reserve this year, with a third rate hike (in December) already coming with a certain probability. Against the background of the economic risk described above, can we even allow monetary policy to normalise beyond the expected level? Here, too, a look at the interest rate market helps: the interest rate differential between 2 and 10-year US government bonds is currently at its lowest level in 11 years at 47 basis points. Flat or inverse yield curves are generally regarded as indicators of emerging recessions. However, it has to be considered here that the movement comes mainly from the short end of the curve. The interest rate differential for German government bonds is therefore currently stable, as the two-year period cannot (yet) move due to the ECB policy.
The S&P 500 has already fought with its 200-day line at the beginning of April. The good news is that this has not immediately led to follow-up sales. The bad thing is that with a buffer of only about 2% this can also happen practically overnight. Likewise, the DAX is already running below its 200-day line against technical chart resistance. In this environment, the German government is undecided as to whether it makes sense to support the ideas of French President Emmanuel Macron on the reform of the EU/Eurozone. Germany is wasting valuable time and possibly also its last chance to get France back on course economically and thus stabilise it as a European heartland. Meanwhile we observe the calm before the storm in Italy...
Considering this constellation, we currently see the risks as outweighing the opportunities and recommend strict risk management. 2018 will hardly be remembered as a year of above-average stock returns, which is why stock market opportunities should actually arise at a tactical level or in low correlated individual markets such as in Brazil or China in the first quarter.