Equity markets have pushed higher over the past month as economic indicators continue to paint a rosy global growth picture, and the corporate earnings season was slightly better than expected. There is some disparity with the fixed income markets as bonds have held up resiliently over the past month despite the prospect of faster than expected US interest rate hikes as investors remain tentative pending details on Trump policies. The local reporting season ended with a slightly positive overall outcome, but revenue growth was still weak, with the majority of earnings growth attributed to cost cutting (the resource sector was an exception with commodities pushing higher).
Iron ore broke through 90 US Dollars per tonne and has remained around that level, while the positivity in oil has taken a hit in recent weeks as US stockpiles continue to climb, but prices remain around the 50 US dollar mark. The Australian Dollar remains around the 76 US cents level as the Reserve Bank of Australia (RBA) has held rates and signalled that it continues to expect inflation and the Australian economy to improve over the year.
The rebound in commodities has helped avert a recession in Australia, meaning Australia has now notched up 25 years of uninterrupted growth, just one year away from breaking Netherland’s record of 25 years and three quarters. Meanwhile, other indicators have been mixed. Manufacturing and housing have been strong, but consumer and business spending remain weak. Employment continues to be worrying as the unemployment rate ticked up to 5.9% in February, although the underlying figures was more positive, with full-time employment showing growth again.
The rest of the world continues to show improving growth as manufacturing and services indicators continue to signal more to come. However, Chinese data was mixed as producer inflation was a strong 7.80% but consumer inflation was well below the expected 1.70% at 0.80% but economists speculated that most of this was due to seasonal discrepancies as a result of the Chinese New Year period.
The US posted yet another stronger than expected employment report and unemployment remains at 4.70%, although wage growth remains weak. Core inflation has reached the Federal Reserve’s target, coming in at 2.20%, leading the Federal Reserve to raise US interest rates to 1.00% and continues to expect two rate hikes by the end of 2017.
US interest rates rising
It looks like US interest rates will be rising at a decent pace through to the end of 2018, with the Federal Reserve flagging three rate rises for 2017 and three more in 2018. There is a general perception that rising rates are bad for equities as P/E ratios will have to compress and higher rates slows spending. In reality, this has not been the case.
Historically, periods of rising US interest rates have been positive for US equities (which in turn have been positive for Australian equities due to the close correlation between the markets) as per the chart below.
The reason for this is that interest rate hikes early in the cycle generally signal a sustainable recovery from poor economic performance. Furthermore, when interest rates are as low as they currently are, the monetary environment remains accommodative despite hikes. Interest rate hikes only become restrictive once the interest rate is already above the inflation rate, in other words, when the real interest rate becomes positive. While interest rates are below the inflation rate, people are still encouraged to spend now rather than save as every dollar spent now would buy more than every dollar plus interest that is spent in the future.
The Federal Reserve has indicated that it expects US interest rates to be at 2.25% at the end of 2018. Based on the most recent reading of core inflation of 2.20% (the headline inflation figure is even higher at 2.70%), monetary conditions are likely to remain accommodative for the next two years as real interest rates remain below 0%.
The chart above also shows that both US and Australian equities tend to rise in tandem with interest rates as interest rates remain below 4%. Based on historical data, equity returns should follow interest rates higher at this stage, however, the age old adage that the past is not an adequate prediction of the future must be considered.
Equity valuations stretched
While equities tend to rise in the early stages of a US interest rate hike cycle, current valuations of the US S&P 500 and Australian S&P/ASX 200 seem stretched on many indicators. As the chart below shows, the S&P/ASX 200 is currently trading far above its historical 12-month forward price to earnings ratio (P/E) average.
The S&P 500 is also trading on a forward P/E average of 17.8 times versus the historical average of 15.7 times. The only time that the S&P 500 was more expensive on this indicator was during the dot com bubble. Other indicators such as the Shiller Cyclically Adjusted P/E (where the P/E is adjusted to take into account a full business cycle) and the ratio of US Total Market Capitalisation to GDP also portray a similar picture.
A caveat is that business sentiment and the economic environment is becoming much more positive for earnings. As a result, analysts have been upgrading earnings per share (EPS) estimates. Over the past few years, analysts’ EPS estimates started off at an optimistic level and were downgraded throughout the year, but so far this year, the opposite has happened and EPS estimates continue to tick upwards which could go a long way to justifying the current high valuations.
The primary question here is will business sentiment and the economies continue to improve and lead to an improvement in EPS? This hinges on many factors, but the one that is currently in focus is the political risk surrounding Trump (particularly the details on policies that will be implemented). Otherwise, an equity market correction may be in order.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
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