Asset Class: International Equities

The value of valuations

The Treasury Building in Washington D.C

February finally witnessed a break in the seemingly never-ending procession of stock market advances. In fact, at one point a number of markets fell by more than 10% from their January peak. A sizable recovery ensued but almost all markets remained down over the month.

It was a great time for financial journalists and anyone with the vaguest knowledge of the markets to see their name in print or their face on television. As long as they had a forceful point to make they were given air-time. All manner of reasons were advanced for the abrupt change in market sentiment but not many pointed to valuations.

To our simple minds valuation should always be front and center of any discussion. The fact is that dividend yields averaging 2-3% (or less) in a developed market together with real bond yields of zero (or less) are fundamental nonsense. Unless inflation collapses and real economic growth surges to levels not witnessed in the last sixty or so years they will remain fundamental nonsense.

Over the last ten years the major central banks have conjured U.S. $12 trillion from thin air and plowed it into the markets. This is roughly equivalent to the combined annual GDP of Germany, France, the UK, Italy and Canada. Needless to say it’s had a sensational impact upon bond and equity markets. The process is now being slowly reversed and it will expose the market valuations for what they are.

Inflation, or the lack of it, has been one of the main talking points. Wage pressures (cost-push), are obviously central to any assumptions about future inflation trends. We have often remarked about the low “take” of labor from the economy relative to corporates over the last decade. We sense that this is now changing. If, for example, we examine OECD data relating to real household disposable income per capita since the start of the economic crisis we find that in the depressed eurozone most countries saw an uptick in real income commence around the first quarter of 2014 – similarly for the G7 and the aggregate OECD countries.

If we use the start of 2007 as the yardstick and utilize OECD real per capita income data to the latest measuring point (Q3, 2017) we find Canada is up 16.6%, Australia 13.5%, USA 9.6%, UK 2.8%, Sweden 20.4%, Germany 9.7%, France 3.9%, G7 7.6%, OECD 8.7% and the eurozone 1.0%. Within the eurozone, Italy, Spain, Portugal and Greece are well below their respective per capita start-points in 2007 but all except Greece are now comfortably above their lows (which occurred around the end of 2013).

So, yes, there is some traditional cost-push pressure in the system and this is borne out by the inflation numbers now being reported. It should therefore not be a surprise that long-bond yields in many markets have crept up over the last six months. When the U.S. 10-year benchmark yield almost hit 3% during February it created headlines. All of the algorithms driving so much of the day-to-day trading reached a state of apoplexy.

If the markets believe that a U.S. bond yield of 3% is of concern just wait around. It has a lot further to go.

Merkel’s “painful” deal

In Germany, Angela Merkel finally agreed a new “grand coalition” after months of tortuous negotiations – although it still needs the stamp of approval of the rank-and-file of the Social Democrats (SPD). Ms. Merkel heads up the Christian Democrats (CDU).

Ms. Merkel publicly admitted “painful” concessions to get the deal through. There is still a chance that it will be rejected by members of the SPD despite their party being controversially awarded the key finance ministry. This was one of Ms. Merkel’s “painful” concessions. If the SPD members reject the deal at their ballot on March 4 there will probably be another election.

There seems to be no doubt that Ms. Merkel is now entering her final term (her fourth) as leader. She has appointed Annegret Kramp-Karrenbauer as General Secretary of the party – a job formerly held by Ms. Merkel and her springboard to the leadership. The appointment of Ms. Kramp-Karrenbauer, Minister-President (Prime Minister) of Saarland since 2011, was unanimously backed by the CDU board. Our guess is that you will be seeing a lot more of her over the next few years.

The culprit of extremely unaffordable housing

The 14th annual analysis of property prices relative to incomes in a number of countries was recently released by the Demographia group. Once again it highlights the extreme prices in Hong Kong, Sydney, Vancouver, Melbourne, Los Angeles and a number of other major cities. Hong Kong is extraordinary – the median multiple (median house price divided by median household gross income) as at Q3 2017 was a staggering 19.4. To meet Demographia’s definition of “affordable” the multiple should be 3 or less.

Sydney has a multiple of 12.9, Vancouver 12.6, Melbourne 9.9 and Los Angeles 9.4. Australia holds the dubious distinction of having all its major markets being rated as “severely unaffordable” (multiple of 5.1 and over). By contrast only 13 out of 54 are rated as “severely unaffordable” in the U.S. (markets over 1m population).

The IMF has recently wagged its finger at Australia, bemoaning extreme levels of household (mainly mortgage) debt and questioning the long-term viability of the pack of housing cards. Australia’s Reserve Bank has made cautioning noises but publicly believes it can all hang together. It may, but we doubt it.

Probably the key point made by Demographia and its contributors is that extreme market values are wholly contrived – through restrictive planning laws, urban containment policies and the like. To quote Australia’s Senator Bob Day: “…the real culprit…was the refusal of… governments to provide an adequate and affordable supply of land for new housing stock to meet demand… it is a matter of political choice, not geographic reality. It is the product of restrictions imposed through planning regulation and zoning.” Amen to that.

No limits in China?

From China comes the news that the Communist Party intends to abolish the two-term limit for the presidential and vice-presidential roles. This means that 64-year old Xi Jinping, originally slated to vacate office in 2023, can now remain in power indefinitely.

It will take a lot to convince us that this is a sound move.

Global market movements

Let’s have a look at market movements in February. Utilizing MSCI local currency price indices we saw the following country moves over the month: Spain: -6.0%, Germany: -5.4%, Ireland: -5.0%, Switzerland: -4.8%, New Zealand: -4.8%, UK: -4.0%, Italy: -3.9%, USA: -3.9%, Japan: -3.8%, Netherlands: -3.4%, Canada: -3.3%, Hong Kong: -3.2%, Israel: -2.9%, France: -2.8%, Portugal: -2.4%, Singapore: -1.0%, Australia: -0.4% and Sweden: -0.2%. Positive performance was recorded by Norway: +0.5%, and Finland: +4.5%. Before getting too excited about Finland we feel it only fair to point out that the market is still lower than it was ten years ago.

On a broader scale and using MSCI U.S. dollar price indices we saw Europe fall by 6.1%, the eurozone 6.1%, EAFE 4.7%, G7 4.2% and the ‘World’ by 4.3%.

In government bond markets the highlight was obviously the movement in the yield of the U.S. 10-year benchmark bond. It started the month at a yield of 2.7% and finished at 2.9%, having briefly visited 2.95% on February 21. Six months ago the yield was 2.1%. Interestingly most other bond markets experienced quite undramatic movements over the month. In the UK the 10-year yield nudged upward from 1.5% to 1.56% whilst in Germany, Switzerland, Canada and Australia the 10-year yield was flat over the month. All, however, are decisively higher than six months ago.

It now seems clear that the U.S. Federal Reserve under its new Chairmanship will continue with its policy of gradual interest rate hikes whilst simultaneously extinguishing its bond holdings as they mature (shrinking its balance sheet). In other words, double-barrelled tightening. Despite the February gyrations the markets still seem unperturbed by this prospect. We doubt that this remarkable equanimity will last.

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