All About The Fed’s Pace To Normalisation

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In this week's Weekly Insights:

– All About The Fed's Pace To Normalisation
– Reporting Season: The Big Brokers Clean Out
– Bull Market? You Aint Seen Nothing Yet!
– Commodities: It's A Different Bull
– Buy Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour

All About The Fed's Pace To Normalisation

By Rudi Filapek-Vandyck, Editor FNArena

We can talk about improving economic data and further growth in corporate profits until the cows come home, fact remains global equity markets, and bond markets, today are where they are thanks in large part to the implicit support provided by central bank policies.

To gauge how much longer the current bull market for global equities can possibly stretch, maybe we should thus concentrate on when central bankers might stop providing support?

Easier said than done.

Both Europe and Japan seem arguably nowhere near the end of their quantitative stimulus programs and it looks increasingly like the Chinese will have to do more, not less, to keep their domestic engines humming as well. The central bank that matters most, the US Federal Reserve, will likely to be the first to stop providing cheap money to heal all economic and financial ailments, but is it really going to happen? If so, when?

Sometime mid next year seems to be what most market participants are expecting, including Janet Yellen and the majority of FOMC members. But markets are no longer afraid of that very first hike in the Fed Funds rate; that was so for the first half of 2014. Instead, large and influential investors have drawn confidence from Yellen's public declarations and testimonies that the path towards higher interest rates in the US will be gradual, if not glacial, and thus they should provide no shock to the current uptrend.

The problem with expectations of a smooth transition during the transformation in US Fed policies is, of course, that nobody knows what exactly comes next, including those at the helm of the world's most influential central bank. What we do know is that the focus remains firmly on the US labour market and that Yellen, herself an expert in US labour market dynamics, remains convinced today's benign dynamics are to a large extent cyclical, not structural. The market has thus drawn the conclusion the Fed shall move cautiously and apprehensively when turning back the monetary stimulus.

Problem number one: current market pricing is not only benign, it is more benign than what most economists are expecting. On current market pricing indicators, the Fed Funds rate will still only be at 0.75% by year-end 2015 and at 1.7% by year-end 2016. These seem hardly the type of numbers that are going to push global equities into a downward spiral.

At the same time, these numbers look so benign it's probably a fair bet they will have changed by the time the US Fed is ready to announce the first rate hike. Investors should prepare for increased volatility. Every change to these benign prospects for higher interest rates is going to affect market positioning and institutional projections. Enter increased volatility. Possibly sooner than we are expecting today.

Global equity markets are going through a period of low volatility and they have been in this state of benign volatility since 2012. Correction? What correction? Not even a suddenly more fragile looking geopolitical context has been able to erode investors' confidence that the invisible hand offered by central banks trumps just about everything else. But the Federal Reserve is about to cease its US bond buying program, likely in November, and history shows the end of QE1 and of QE2 inserted a lot more volatility in markets, until investors started focusing on the next stimulus program.

This time, however, there won't be another stimulus. At least not if Janet Yellen's most preferred scenario plays out and the Fed increasingly starts preparing to become less accommodative.

Increased volatility does not mean we are 100% guaranteed finally going to witness that share market correction everybody has kept on talking about since 2012.

A recent report by analysts at Credit Suisse suggests most global equity markets are supported by an acceleration in earnings growth forecasts. In particular US companies just finished a Q2 reporting season which proved much better than expected and full of promise for the quarters ahead. In Australia, too, expectations are for high single digit growth and this would be a first post 2007 given FY14 saw the return of profit growth for the local market.

It's going to be a little scary though. One thesis that hasn't been tested is how much the Fed's easy money policies have been responsible for the relatively high valuations in US technology and biotech stocks.

The second problem with projections for a smooth transition comes with the market's resilience to date, which has some experts talking about "markets priced as if there is no risk whatsoever". Are we going to be equally as confident from the moment the Fed transitions to becoming less accommodative?

Probably not.

Though current expectations look benign, this does not automatically imply the risk is solely skewed towards more rate hikes sooner and subsequently inevitable corrections for both bonds and equities when large portfolios re-adjust. The latest update by Westpac, for example, suggests those benign market expectations might still prove too bullish.

After observing annual US economic growth has only averaged 2% post-2007, Westpac expects US GDP growth to accelerate to 2.5% in 2015. It's not quite on equal footing with 3% or even 4% forecasts elsewhere, but it'll prove enough for the Fed to start hiking rates, albeit at a slower pace than is currently being priced in by investors.

If Westpac's prognostication proves correct, then US equities should enjoy stronger gains than are currently expected by most. It also implies no imminent revival for the US dollar. Westpac's current projections assume AUD/USD remains around 92-94c for at least the next two years, while assuming sideways trajectories for most commodity prices (on top of iron ore price estimates that seem poised to be downgraded). Given the RBA is expected to start hiking rates by late next year, the bank is forecasting a stronger Aussie in twelve months' time.

Under the Westpac scenario, there will be no dramatic changes to the world in 2015, other than less accommodation from the US Fed. The US economy will lift, without getting spectacularly hot. Europe should improve, slightly. China shall muddle through. Other developing economies should see higher growth, but it'll all remain relatively modest, certainly non-spectacular.

Reading between the lines, the Westpac scenario most likely implies we are staring at a continuation of current market circumstances, possibly with more volatility but with ongoing scepticism about where economies are in the cycle and with central bankers reluctant to pull the rug from under their respective equity markets. The ideal scenario for a continuation of the five year bull market (at least for the US).

No surprise, the Westpac scenario is finding more and more friends amongst analysts and strategists across the globe – in mild variations. Strategists at Morgan Stanley last week issued a report which suggests this bull market might well have another five years in it, precisely because the global economy is so uneven and because the US economy is only starting to find its footing without central bank support (see also below). As such, Morgan Stanley strategists are toying with the idea of a genuinely recovering US economy in the years ahead, supported by demographics, new technologies, cheap energy and reluctant central bankers which can potentially extend the current bull market for the remainder of this decade.

The S&P500 at 3000 in five years' time? (This is 1000 points higher than where the index is today). Morgan Stanley thinks it might just happen.

Gluskin Sheff's chief economist and global strategist, Dave Rosenberg, previously considered a market perma-bear by many, also keeps telling clients and investors there is no reason to suggest this bull market for equities is about to end anytime soon. Unless the US economy is about to fall into a recession in the near term, which he regards as unlikely, Rosenberg makes the prediction that ultra-low interest rates will lead to higher valuations and to higher share prices.

If it were up to him, Rosenberg would like to see the Fed start hiking rates tomorrow. Because he doesn't think it's in the Fed's mandate to worry about whether wages growth is high enough. Besides, he is of the view most of the changes impacting on the US labour market are structural, not cyclical, thus there's very little the Fed can actually influence. But as this is not the view of Yellen, interest rates are likely to stay too low for too long.

"I know full well this will not end well at all when it does end", he concedes, adding it's too early to worry about that right now. Easy monetary policy supports higher equity prices. That's all there is to know for investors right now.

The chart below, taken from the Westpac report mentioned earlier, illustrates the present conundrum facing members of the FOMC: US equity indices are at all-time highs, but the US employment to population ratio has not been this low since the 1980s. More worryingly, in the 1970s and the 1980s the ratio sank lower but it also bounced pretty quickly. This time around, it has been around current low level since 2009, and counting.

The conundrum investors are facing today is that if US interest rates have to rise much quicker than what is currently assumed by global investors, this will negatively affect both government bonds as well as US equities, with ripple effects for peer markets across the world. Because both markets are today where they are because of central bank's policy and because of investors' benign expectations for changes in the years ahead.

Those banking on failure shouldn't feel too comfortable hiding in gold either as history suggests gold thrives during times of negative real interest rates. However, a sudden change in interest rate projections has proven to be gold's kryptonite on multiple occasions. Post 2007 gold has corrected twice on sharp movements in inflation protected bonds in the US (TIPs). Next time is not necessarily going to be different.

Gold bugs ought to be careful what they wish for. Australian investors should not take a weaker Aussie as a given.

Reporting Season: The Big Brokers Clean Out

We all watch daily price movements and hits and misses and if you are a little bit like me, you pay even more attention to what happens to analysts' views and forecasts the following day. There is, however, one factor of the local reporting season that seldom receives any attention. It is the fact that stockbrokers use the occasion to -quietly or with a lot of fanfare- drop stocks from active coverage. Often that last dreadful set of financial results that sees the public light in August represents the final straw. That's it! Let's not bother about this one anymore. Better to focus on more valid opportunities.

I do not have any statistics to back up my personal observation, but while analysing the latest changes and adjustments during August, I caught a sense that stockbrokers got rid of a lot more stocks this year than they've done in years past. Given the overwhelming majority of stocks that were dropped from coverage operate in the mining and/or the mining services sectors, this makes a lot of sense. Also because the flood in IPOs and spin-offs has been pretty hefty too this year and many of the newcomers have proved to be reliable on promises and big on share price performance.

As some funds managers have put it: the market has become more varied because of the many IPOs and as such it's a much more attractive proposition to guide one's clients towards Cover-More ((CVO)) in the insurance space, or Veda Group ((VED)) as a reliable defensive stock (I call it "All-Weather Performer"), or Healthscope ((HSO)) as a cheaper alternative to healthcare's primus inter pares, Ramsay Healthcare ((RHC)), than it is trying to pick the bottom for companies like Boom Logistics ((BOL)) or St Barbara ((SBM)). Both have thus fallen off stockbroker's radar in recent weeks, together with Fleetwood ((FDW)) and Boart Longyear ((BLY)) and a number of others.

Interestingly, none of the stocks mentioned has gone completely off radar (always someone to cling on for longer) but there's definitely a trend towards welcoming more of the new kids on the block. Expect Medibank Private to rapidly become a new addition as well, when it lists later this year.

Bull Market? You Aint Seen Nothing Yet!

One of the research reports that caught just about everyone's attention last week was released by US strategists of Morgan Stanley. In it, the strategists suggest the S&P500 could well be near 3000 in five years' time, which seems a lot of upside potential given the index is presently hovering around the 2000 mark, and finding it difficult to convincingly surge higher. Another 1000 points? Surely this must be the top then, some sceptics responded swiftly.

Morgan Stanley's premise is built upon the fact the US economy hasn't genuinely shown a lot of strength to date and both central bankers and investors remain wary, cautious and divided about what lays ahead. In other words: the perfect cocktail for equities to continue climbing the wall of worry (and to extend this bull market beyond everybody's wildest expectations). The second important factor is that Morgan Stanley believes the real US recovery is starting to happen, right now. Historically, equity markets don't collapse when the US economy embarks on a growth path. This is the second prime assumption underpinning the forecast.

All in all, Morgan Stanley states US corporations only need to grow earnings per share by 6%, on average per annum, over the next five years, while maintaining their current PE. The third premise is that uneven global economic health is keeping central bank policies accommodative.

If Morgan Stanley's scenario plays out, we could be in the midst of the longest uninterrupted bull market for US equities, ever. That's exactly what it says in the report: "this could prove to be the longest economic expansion – ever" (with the implicit assumption that what happens in the US economy will positively translate into US equities markets).

Commodities: It's A Different Bull

A lot has happened since general commodity indices broke out of their longer term trading channels (heading south) and put in a rally upwards. The Chinese property downturn has worsened, for starters. And that long anticipated supply response in markets such as iron ore and crude oil finally solidified. As a result, many investors (including a non-negligible number of fund managers) who positioned themselves for a rally in mining stocks are today licking their wounds. Even those who stuck with the bigger companies -BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue ((FMG))- are today staring at lower share prices.

On the other hand, many share prices for companies leveraged to aluminium, nickel, uranium or graphite, to name but a few, have fared considerably better. Time to dust off a few home-truths. Commodities are no longer in a synchronised unicycle, and they haven't been for years now, so no use in pretending they will all benefit from stronger global growth in 2015-beyond. Supply catch-up is very real in copper, iron ore and in crude oil while gold's conflicting drivers seem to push the former market darling sideways at best.

My view has been, and still remains today, this new bull market will prove to be as uneven and as polarised as has been the upswing for Australian equities since late 2012. Ask any investor today whether he/she is happy with the portfolio performance since 2012 and there's a direct relationship between their responses and the weighting of their portfolios towards banks, discretionary retailers, telcos, All-Weather stocks and… mining and mining services stocks. The more exposure to the latter, the larger the underperformance vis-a-vis the ASX200 and All-Ordinaries.

Copy and Paste the same underlying theme for commodity stocks in the years ahead. Sure, there will be day-to-day volatility, there may even be upswings that last a whole month or longer, but "sustainable" it is not unless supply-demand dynamics remain supportive and that is more likely going to be the case for those commodities that have had a genuine tough time yesteryear. Keep in mind that today's super-hero in the sector, nickel, only last year forced more than 60% of global production into red figures.

Below are Credit Suisse's price predictions for the year ahead, as published here before, clearly making a distinction between the haves and the have-nots. Though investors should keep in mind the table is two months old and crude oil, for example, has lost about US10/bbl over that period. Always good to keep such things in mind.

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past. International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
CSL ((CSL))
Donaco International ((DNA))
Helloworld ((HLO))
Karoon Gas ((KAR))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
GWA Group ((GWA))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Monday – Sky Business – circa 11.20am (Broker Calls)

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 01 September 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of August available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms