- During his presentation at the 2017 MFS Annual Global Analyst and Portfolio Manager Forum, James Swanson, Chief Investment Strategist at MFS Investment Management, discussed where the global markets are and how investors should position themselves
- In the last stage of the cycle in the United States, real cash flow has reverted to its long-term average, suggesting that market valuations are extremely high
- The commitment to reflation may not be sustainable over time. Core inflation in Europe, the United Kingdom or the United States is far from the 2% level that central banks are targeting
The extent of the current geopolitical situation worries investors who focus their discussion between continuing to bet on risky assets or moving toward “haven” assets. Where should investors put their money? During his presentation at the 2017 MFS Annual Global Analyst and Portfolio Manager Forum,James Swanson, Chief Investment Strategist at MFS Investment Management, reviewed what’s happened during the last cycle to determine where the global markets are now, and how investors should position themselves.
The Starting Point
After the market collapse in 2008, when US equity indices fell nearly 50%, the financial press maintained that investment in US stocks was not going to pay off, as GDP growth over the past eight years was well below the 3.5% at which it used to grow. However, Swanson argued that the measure that should really have been taken into account is the generation of free cash flow by companies. In the United States, this metric grew dramatically, reaching levels not previously observed.
Several factors enabled this development, one of the main being globalization. With the onset of the crisis, the American working class was forced to sell its work at a low price, so the companies had an extremely cheap labor force. Likewise, the reduction of interest rates carried out by the Federal Reserve allowed a considerable reduction of the cost of capital. In addition, the use of new technologies allowed the transformation of assets at a lower cost. These elements had repercussions in better ratios, better margins, and finally greater free cash flows.
And where is the cycle now?
Comparing levels of confidence indicators, the so-called "soft data" encompassing various investor sentiment surveys, with data on housing, industry, labor and consumption, known as "hard data", one can observe a great divergence between both. The fundamentals of the economy lie far below the euphoric feeling that investors are showing, something Swanson says had not been seen before in several cycles. The next question to ask is how these two tendencies will converge.
To clarify this point, Swanson showed the evolution of performance in terms of real cash flow in the US equity market, or what is the same, if one invests a dollar in the S&P 500 index, how much cash flow is obtained after discounting inflation. In the long term, the real cash flow is around 2.6%. During the last recession, this measure fell sharply, but in the next two years it experienced a spectacular recovery, and now, while we are in the last stage of the cycle it has reverted to its long-term average. This, suggests that fundamentals are starting to whip in at the same time market valuations are extremely high.
Even though there is a notion of reflation in the environment, Swanson pointed out that core inflation in Europe, the United Kingdom or the United States is far from the 2% level that central banks would like to see. Another disconnect between perception and reality, in the MFS strategist’s opinion, the massive underlying reflation which sentiment is indicating is not happening.
Clouds on the Investor’s Horizon
One of the first concerns that investors should bear in mind is the growth of consumer income in real terms. Swanson has observed that wage in the last cycle has been somewhat subdued in the United States, Europe and the United Kingdom. He pointed out that it would probably be a residual component of the last recession and the demography of these countries. "Globally, we are going through a particular moment in time, in which baby boomers are retiring from the workforce and are being replaced by a generation with lower wage levels. Incomes in real terms are lower and this is going to have a direct effect on spending.”
The second cloud on the horizon is the economic situation in China. Just a year ago, China's credit system was expanding, with lower interest rates and greater liquidity. But now the situation is different, government spending has fallen, consumption taxes have risen, housing purchase credit has been tightened and the Shibor rate, the Shanghai interbank rate, is starting to rise. "Every time they have made this kind of movement within the investment cycle, putting the brake on their economy, the consequences have been suffered globally. China is the largest marginal commodity consumer, and commodities play a key role in global inflation levels. At present, we can appreciate a weakening of the price of commodities. However, China has not entered into recession, nor is in the process of doing so, but will see a slowdown in consumption and spending because the monetary impulse is decreasing. This will have repercussions on exports from the United States and particularly from Germany," Swanson said.
The third cloud that investors should not lose sight of is the production, consumption and the point of the economic cycle in which the United States is currently in. Industrial production, as measured by the ISM Manufacturing PMI index, tends to follow the movement of the money supply. In general terms, a pattern can be observed in which, whenever there is greater liquidity in the system, manufacturing production accelerates and expands. Currently, the real money supply is slowing its growth, showing an anticipated signal that production will also fall. So the bet on reflation may not be sustainable over time. Sales of new residential homes and automobiles are slowing, as are sales of consumer products. Therefore, Swanson invites all those investors who are thinking of increasing their position in risk assets to match the current valuations with the risk of going through a small pullback during the summer or with the risk of entering during the latest phase of the cycle: "We are reaching the eighth-year of the cycle, while the longest cycle ever recorded was 10 years. If you compare the economic situation of the United States with that of a patient who goes to the doctor, we would be talking about a 78 year old person, who could have died a couple of years ago, but is still enjoying relatively good health," he argued.
Some of the signals that indicate an advanced moment in the cycle are already showing: euphoria replacing fundamentals, a squeeze in margins, and a slowdown in consumer spending. However, what is even more worrying for Swanson is that companies are not reinvesting in their own businesses. According to the MFS strategist, the historical evidence is very clear: companies that can reinvest their capital and obtain a return which is higher than that on their capital, over the long term, their stocks have often outpaced the market. However, companies in the United States, which find themselves with massive amounts of cash flow, decide to repurchase their own stocks or increase their dividends.
The Promises of the Trump Administration
Finally, new accusations of obstruction of justice faced by the US president could have serious consequences, increasing uncertainty and instability in the markets. In any case, if the difficulties faced by the new administration can be solved, infrastructure spending would not be sufficient to compensate for the lack of private sector momentum, and the effects would be lengthened over time. Likewise, the contributions of the promised fiscal reform are not expected to be as relevant as those achieved in the Reagan era. This is, because the baby boomer generation is leaving the workforce and there will no longer be the positive impact of the incorporation of women into the working world in the 1980s. In addition, the proposed tax cuts will affect only roughly 20% of the US population, typically wealthiest individuals, who have a much lower propensity to consume than the working class, and which therefore, will not be a significant stimulus. In summary, according to MFS it is difficult for the US expansionary cycle to go on for much longer and current market valuations are very high.