Dec. 24, 2018
On Bay Street and Wall Street, the prevailing mood is more downbeat than a goth band’s lyrics. Ajay Singh Kapur of Bank of America Merrill Lynch warns of “a pervasive and persistent global downturn.” David Kostin of Goldman Sachs says returns on cash in 2019 could rival those on stocks. For his part, John Higgins of Capital Economics cautions of more losses ahead for U.S. stocks.
Even Jay Powell, the unflappable chairman of the U.S. Federal Reserve, felt compelled to note the “mood of angst about growth going forward” when he hiked interest rates this week.
Point taken. When so many of the smart kids are nervous, it makes sense to be cautious. Especially after the past few days of brutal declines, including a 2.1-per-cent drop in the S&P 500 benchmark on Friday, the case for pessimism can seem overwhelming. U.S. stocks endured their worst week since 2011, and sank to 17-month lows. Canadian stocks declined to mid-2016 levels.
But it is also worth asking if the outlook is quite as hopeless as the gloomsters suggest.
Look away from the dire headlines about plunging stock prices, and several indicators suggest the year ahead may not be quite as bad as many people fear. After a miserable quarter for equities worldwide, many stocks look reasonably priced.
There is, to be sure, the spectre of rising interest rates. They tend to hurt stock prices because they raise the cost of borrowing and diminish the present value of future pay outs. But this trend also has an upbeat aspect. Central bank policy-makers are hiking rates precisely because they feel confident in the strength of their underlying economies. This is not entirely a bad-news message.
If the world can tiptoe past its political crevasses, 2019 could turn out be a decent year for investors, especially those willing to venture beyond North America. Of course, this relatively benign outlook could disintegrate if Brexit, U.S. President Donald Trump or U.S.-China trade tensions disrupt global markets. But similar risks are always present.
“Some analysts are darkly warning of a recession some time in the next two years,” writes Jim Hamilton, an economist at the University of California, San Diego. However, "if in any random month since 1947 you’d declared that the economy would be in recession some time in the next two years, 43 per cent of the time you’d have been right.” Now is actually rather typical.
In both Canada and the United States, economic growth is slowing, but not disappearing. The Bank of Canada expects the Canadian economy to expand 2 per cent in 2019. Meanwhile, the Federal Reserve is counting on a 2.3-per-cent expansion in the United States.
Many of the standard warning signs have yet to flash red. The yield curve, a measure of how shorter-term interest rates compare to longer-term rates, typically inverts before a U.S. recession – that is, short-term rates move higher than long-term rates. That has yet to happen except in the relatively minor space between two- and five-year Treasuries. Most of the curve is still positive.
The excess bond premium, a wonkish indicator based on the extra pay out that bond investors are demanding to offset the risk of default, is also relatively optimistic. Based on November’s data, it indicates only a 20-per-cent chance of a U.S. recession during the next 12 months. Similarly, the most recent reading from the Federal Reserve Bank of New York’s Recession Probability Index puts the chance of a U.S. downturn in the next 12 months at less than 16 per cent.
Another much-watched indicator is retail sales growth. It usually declines sharply before the broad economy. So far, no such slackening is visible. Meanwhile, gold, the traditional haven in times of economic stress, has yet to show signs of panic by shooting upward. The yellow metal has traded in a narrow range all year and is still slightly below where it stood in January.
For all the gnashing of teeth over rising interest rates in Canada and the United States, monetary policy remains supportive. The world’s most closely watched benchmark, the federal funds rate set by the Federal Reserve, is still low by historical standards and hovers just barely above the rate of inflation, even after recent increases. No U.S. recession in the past half century has started with interest rates as low as they now are.
So why are market mavens so nervous? Some worry that a decade of easy money is ending, with potentially dangerous consequences for the mountain of debt accumulated in recent years. Others are concerned about China’s slowing economy and the possibility of a China-U.S. trade war. Still others fret that U.S. growth will fade rapidly in the second half of 2019 as the stimulating effect of the Trump tax cuts wanes. All reasonable grounds for anxiety.
But it is worth pointing out that today’s markets appear more fairly valued than those before the two most recent major market downturns. By 2000 or 2007, prices for major categories of assets had soared to unprecedented levels. Enthusiasm for dot-com stocks in the late 1990s, or for U.S. housing in the early years of this century, propelled valuations in key sectors to unsustainable levels and made markets vulnerable to a crash.
It is difficult to spot similar manias now. Sure, home prices in Canada and some other countries look frothy. On a global scale, though, these potential bubbles are not of the same magnitude as the real estate excesses in the United States or Europe on the eve of the financial crisis.
For the most part, world stock markets also appear reasonably valued after their recent mauling. Canadian stocks are trading for just less than 14 times their forecast earnings next year, while European stocks and emerging markets are typically going for around 12 times. By historical standards, these all represent fair value.
U.S. stocks offer a more mixed case. On the basis of forecast earnings, they appear attractively priced after the recent sell-offs, with the S&P 500 benchmark trading for less than 15 times next year’s forecast earnings. However, they are pricey if you assume today’s corporate profit margins are doomed to fall to more historically typical levels.
The cyclically adjusted price-to-earnings ratio, which compares current share prices to average real corporate earnings over the past decade, indicates U.S. stocks are at their most expensive since the dot-com bubble. This has been true for several years, but rising interest rates and slowing growth could be the catalyst that finally brings U.S. equities back to earth. They have vastly outperformed their international counterparts since the financial crisis, and it would not be a big surprise if they were to fall back against their global rivals.
Canadians who want to play it safe have plenty of options. Consider bonds and other fixed-income investments, for instance. Thanks to rising rates, for the first time in several years, Mr. and Ms. Average Canadian can grow their savings with a simple GIC, even after accounting for the corrosive effect of inflation.
The payoffs still are not lush. But after years in which savers had no alternative to stocks that was not guaranteed to shrink their purchasing power, the chance to derive even a little bit of real return from a safe investment is welcome.
Those who want more can consider dividend plays. A wide swath of Canadian utilities, banks and telecom providers now offer yields in excess of 4 per cent. Even if growth disappoints, the rewards from holding such stocks seem reasonable.
People who are willing to embrace more risk can also look outside North America for bargains. European and Asian stocks could be buffeted as the global economy slows in coming months, but at current valuations, they appear likely to deliver decent long-term results.
Maybe, just maybe, there is a case for optimism. Aswath Damodaran, a professor of finance at New York University, notes in a recent blog post that the fall in long-term bond yields in recent weeks offers a sobering warning that investors are scaling back growth expectations for both the U.S. and global economies.
However, he adds, “the flattening of the yield curve in the last two years has been more good news than bad, an indication that we are coming out of the low-growth mindset of the post-2008 crisis years.”
Robert Buckland, global equity strategist at Citigroup Global Markets, is willing to go a step further. He expects global stocks to rise 20 per cent by the end of 2019. His bear market checklist, composed of 18 indicators that can signal cause for concern, is still largely upbeat, he noted in a recent report. At the end of November, only three of its factors were flashing “sell” compared with 17.5 in 2000 and 13 in 2007.
“The checklist is telling us to buy this dip,” he wrote. “Sure, returns will be lower and volatility higher, but this bull market is not finished yet.”
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