There’s a general tendency amongst investors – and investment commentators – to be cautious about prospects for the new year. I, like most people, tend to invoke words like late cycle or fully valued which tends to signify a high level of caution. But what happens if we’re all too cautious? Maybe 2020 might be another great year for investors despite 2019 also being a great year?
This duality echoes what one might call the static vs dynamic explanation for markets. The static explanation looks backward, at backward-looking measures such as valuation. In recent years, these measures have tended to always look a bit high. One current example – currently, 61% of S&P 500 stocks are trading above their respective 100-day average. The natural next thought is that what goes up, must eventually come down.
But maybe that will happen in 2021 or 2022? Cue the dynamic view which says that although valuations matter, investors should follow the flow (or flood) of money. More pertinently they should follow the flood of money coming from central banks. This more dynamic way of looking at markets as giant momentum machines tends to support a more bullish view.
So, which approach to follow? Let’s take two contrasting charts and explanations. The first uses the static approach and involves the chart below which is from the latest US equities take by analysts at SocGen. It shows how US corporate profit margins have been declining. It clearly signals a recession risk.
“According to our US economist Steve Gallagher, our recession call is driven by a profit squeeze, not an exogenous shock. Given the limited scope for fiscal support due to this year being an election year, US corporate profit margins are all the more under scrutiny. Focusing on National Income and Product Accounts (NIPA) profit margins, we expect the profit now in its fourth year to continue. With labour productivity continuing to rise at a sub-average rate of around 1.7% and wage growth gradually picking up, unit labour cost growth has jumped to its highest pace in five years.”
The alternative, dynamic approach comes with a second chart from London based research house Cross Border. This approach ‘follows the money’ or more specifically looks at the liquidity provided by central banks. According to Cross Border
“Investors need to recognize the scale of the recent liquidity easing. Conscious action is needed: either go with this flow, or else go against it, but at least acknowledge that we are in very abnormal monetary times. Liquidity-driven markets tend to end suddenly, but they also can go on for longer than many investors believe”.
For me this is the key bit in their latest report out this week – they reckon that the new monetary easing (QE4?) has “ delivered the greatest liquidity boost to the US economy since the immediate aftermath of the 2008 GFC and the 9/11 terrorist attacks in 2001. Measured over a 12-month period and put into standard form, this is arguably the biggest boost ever!”.
Cue the second chart below which shows a dramatic easing in liquidity.
This alternative, more dynamic explanation built on liquidity, momentum flows suggests an alluring prospect. That the US Fed along with other central banks will flood the global economy with more money in 2020. That, in turn, could result in a strengthening in the US economy as it heads into a presidential election. The Chinese might also celebrate Stage 1 of the trade talks with their own boost to the economy.
All of this might feed through into better than expected sales and earnings growth – and above-trend GDP growth. But there’s a sting in the tail according to Cross Border. They think it possible that as the economy picks up speed, “US 10-year Treasury yields could test 3%, which is equivalent to a 10-15% fall from current levels. Bond market selloffs typically precede stock market falls. Consequently, although we remain invested in equities, we shall be closely watching both the liquidity data and the response of the bond markets to time our exit from stocks”.
My finger in the air guestimate is that Cross Border might be on to something and that 2020 could (my guess is a 25 to 50% probability) surprise very substantially on the upside, smoothing Trump back into a second term. At that point expect the Fed to take the gloves off and clamp down on possible inflationary trends, sharply increasing interest rates. Stranger things have been known to happen!