January 2020 Macro Commentary

A Decline in the Equity Risk Premium Has Driven Markets Higher

Fundamentals Still Matter: Prepare for the Risk that the Global Economic Rebound Stalls

By Sanjay Khindri, CFA

For some, the resilience in equity market returns may seem irrational, particularly given that S&P 500 earnings are expected to decline in 2019 (according to Factset).  The resulting expansion in equity valuation multiples (price-to-earning ratios) will be explained by others as a consequence of low global bond yields. We offer another explanation:  the risk premium that investors require for holding stocks over bonds has fallen. Bulls should more heavily rely on this explanation because the drop in bond yields has exactly mirrored the drop in global GDP, and thus yields should rise as the global economy “reflates” in 2020 (see our December 2019 commentary on the outlook for U.S. bond yields).  Before diving further, let’s take stock of the last two years.

Following strong economic activity in 2017 and early 2018, the U.S. Federal Reserve appropriately responded, according to their mandates, by gradually raising short-term interest rates.  The Fed went a step further however, by taking account of global developments (i.e. trade) in their reaction function. The result was an avoidance (as of now) of a recession and a fairly mild deterioration in overall earnings.  This outcome has been atypical in a historical context, as generally, sustained tightening in monetary policy leads to an economic recession and more dramatic earnings declines. The main takeaway:  the realized economic and earnings volatility was much less than what should have been expected.  Because of this outcome, equity investors must ask themselves if they should lower the extra return they require (over bonds) to accept economic and earnings risk (i.e. the equity risk premium).  We believe this is what’s partly driving equity markets higher.

A third factor that has played a role in recent equity market returns, one which is not picked-up as much by the general investor, is a change in the Fed’s interpretation of their inflation mandate.  What this means is that the Fed has decided that in order to maintain its credibility, it must allow inflation to be “symmetric”; in other words, it should allow inflation to run above its target for a period of time if inflation has run below target in the past.  The reason this is bullish for equities is that any near-term rise in long-term interest rates should be primarily due to shifts in the expected rate of inflation (as opposed to shifts in real yields). Inflation that is not counteracted by tighter monetary policy (i.e. rising short-term rates) is positive for corporate earnings (all else equal).

The above assessment provides a guideline for how to explain the strong recent equity returns.  The problem is we can’t measure this theoretical reduction in the equity risk premium. Therefore, we can’t evaluate with confidence whether equities are overvalued or undervalued according to this new dynamic of lower volatility and persistently dovish Fed policy.  What we can say, however, is that the market is attuned to these developments (as it is “past” information) and has ”priced-them-in” in some fashion. The graph below supports this claim as equities have meaningfully outpaced fundamentals, (indicated by business surveys, i.e. PMI’s).  But the graph also highlights that even if we assume the market is simply leading fundamentals, there is a lot of catching up to do as it relates to economic growth.

Source: Gallatin Capital Management, LLC

So how do we invest in a market that has outpaced fundamentals, but where that outpacing may at least partly reflect a new risk paradigm?  We believe that investors must re-focus on bottoms-up, company-by-company fundamental analysis in order to drive sustained returns in 2020. 

The biggest risk we see in 2020 is a stalling of global economic growth.  This would be very consequential to overall equity returns because we think it would lower confidence in global central bank policy success and reverse the bullish backdrop described above.  While flows into Active Management products continue to come under pressure due to historical underperformance, Active Management should now be viewed as a way to discern, capture and validate any rebound in economic and earnings growth in 2020.  Active Management can also guard against underperforming global growth by sourcing idiosyncratic investment ideas less exposed to macro developments, and less reliant on the assumed equity risk premium within valuation models. 

It’s important to point out that we are not advocating that investors shift out of their equity allocations, but rather re-assess how they source returns within those allocations.   Most of the recent valuation multiple expansion has been centered at the less cyclical, large-cap, U.S. stocks. This means that investors putting money to work in passive products continue to overweight these same companies.  A shift in allocations to Active Management secures the gains from a contracting equity risk premium and re-weights exposures to underlying fundamentals.

 Gallatin Capital Management, LLC

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