25 January 2018
During the last 10 years, we have seen most yield curves being pulled into negative territory and staying there far longer than even the most dovish central banker anticipated. While this scenario appears to be the biggest aberration since the great depression, many market participants clearly believe it is the new normal and will persist forever. But it will surely unravel sooner rather than later?
‘Misunderstanding is generally simpler than true understanding, and hence has more potential for popularity’
Raheel Farooq, Poet and Philosopher
Between 2000 and 2007 markets transitioned from a major growth bubble to a major value bubble and this time around the shift is likely to be even more pronounced. The market has, since 2009, created some USD 2 trillion worth of new investment vehicles such as ETFs and a wide range of other products which are all chasing the exact same sensitivities – the proxies for low volatility, quality growth and yield. However, the idea that these products can continue to deliver robust returns is predicated on the assumption that economic momentum will wane and the five deflationary factors that have depressed inflation in a major way for almost a decade (fiscal tightening in the eurozone, the China effect, lack of wage growth, suppressed commodity prices and the growing influence of discount retailers) will remain dominant.
Conversely, we would point to the fact that December’s leading indicators are in fact eclipsing the peaks witnessed in 2007 and 2011, consumer confidence across Europe is starting to reach new highs and each of the five deflationary factors have already very visibly turned. Fiscal drag has become fiscal stimulus, China has recently reversed course, labour settlements are rising rapidly, most commodity prices are up 50% from trough levels and the discount retailers are no longer pursuing market share at any price. Yet, European value stocks continue to be priced for a deflationary scenario.
The era of perceived disruptors
It would appear that the reluctance to engage in value stocks is based on the perception that certain ‘disruptors’ will prevent the usual cyclical forces from asserting. Let’s deal with each of these in turn.
Shale eats it all: In June 2016, the price of crude oil slipped back to around USD 46 as US production numbers started coming in ahead of expectations and the spectre of shale disrupting the market reared its head once more. However, the most efficient acreages, employing the most efficient rigs and the most efficient teams have now been harvested, the major shale players will have to accept much lower efficiency and, therefore, higher break-even levels. With OPEC’s decision to extend output cuts, we expect OECD inventories to fall and oil prices to spike, as the oil market is pushed firmly into deficit by the end of the year.
Amazon eats it all: In mid-June 2017 Amazon acquired Whole Food Markets (WFM) and announced price cuts on a select 15 products of 50%. This was taken by the market as a sign that the high street food retailers would be priced out of business by the online giant. However, Amazon specialises in procuring, storing and disseminating hard goods with no expiry date in huge quantities at massive discounts; the fresh foods business is a totally different ball game. The belief in the market is obviously that Amazon can fix it. But after 18 years of trying, they seem to get further and further behind the leading incumbents rather than catching up.
Tesla eats it all: In August 2017, the belief that electric vehicles from Tesla would decimate the traditional auto market led to share-price capitulation among original equipment manufacturers (OEMs). However, the likes of Daimler and VW have made significant progress since the carbon dioxide emissions scandal of 2015, developing very credible EV strategies with detailed product roll-out schedules across the whole product range. These firms are experts in design and are making much bigger commitments to R&D than Tesla, which is massively leveraged and burning cash.
Fintech eats ‘structurally challenged’ banks: It has become such a cliché to refer to banks as structurally challenged, that many investors blindly repeat the phrase. However, the major reason that returns on equity (ROEs) halved over this period is that, by 2017, banks were required by regulators to hold more than twice as much CET1 capital as they had to back in 2007. This is a simple mathematical function of numerator and denominator and has little to do with the banks’ earnings power. We consider continental European banks, which are trading below book value and on single-digit forward earnings – despite offering growing dividend yields of some 4% on modest pay-out ratios of 45-50%, with the added potential for share buy-backs – to be among the most attractive investment opportunities currently available in the value universe.
A return to valuation-based stock pricing?
Even though value once again performed miserably in 2017, we are seeing early indications that some of the low volatility / quality growth / yield momentum trades are gradually grinding to a halt, heralding a return to valuation-based stock pricing, through which fundamental dislocations would have to be corrected. While it is possible to extract alpha from value stocks even in a pro-growth environment, the good news is that the rotation back into value, which should highlight the worth of stock picking, has scarcely begun. Since the low point in February 2016, value has only outperformed the market by a mere 3.7%. Once this development accelerates, true value investors are most likely to be back in the limelight.
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.