Where is the top this time?
We have been concerned around the levels that local and global share markets, and bond markets, have been trading at for some time, however this has not stopped the US share markets continuing to reach and break record levels in share prices.
Below we have included a chart showing the Shiller Cyclically Adjusted Price to Earnings (CAPE) Ratio for the Dow Jones index. This measure which looks at the cyclically adjusted ratio of the price of shares to the earnings of the share, is a reasonably good indicator of when a share market is overpriced or under-priced.
As the chart shows, the only time since the late 1800’s that markets have been more overpriced by a CAPE measure was during the Dot.com bubble in the late-1990’s., This can easily be seen as a signal that US markets are expensive, but this does not seem to stop the markets testing new highs, and to date we have not seen any significant correction. Why?
One bullish argument that some commentators are pointing to is the fact that the CAPE is an average of the last ten years, and is still capturing the period of higher interest rates just prior to the 2007-2008 Global Financial Crisis, and hence is not effectively allowing for the impact the current historically low interest rates is having on share and bond prices. This view is supported by the fact that investors are now much more willing to take on greater risk for lower returns to get higher income payments than could be offered in the safer bonds.
Another view to support these prices at these levels is the acceleration that we have seen in US company’s earnings growth since mid-July this year. Looking under the headline number we see that the majority of this growth has come from the energy sector recovery, which is a fickle sector to be basing a longer-term projection on due to its inherent volatility.
The last argument support for these higher price levels is the current low volatility levels in the global markets. As shown in the chart below the S&P500 volatility is at record low levels, last seen in 1965.
While this bullish view may have been correct to date, we would argue that this is good luck more than good management, as no commentator, or analyst was forecasting interest rates as low as we have seen in this cycle, and hence all investors have been surprised by the recent record low interest rate levels.
We have seen yields being pushed lower on the back of unprecedented support from the global central banks (Quantitative Easing), leading to never seen before negative yields on European bonds. It is anticipated that this will reverse in 2018, with the European Central Bank (ECB) expected to stop their QE early in the new year, supported by rising inflation, and falling unemployment in the Euro region.Lastly, on NZ housing we have heard that banks are tightening their lending practices, as they endeavour to improve the credit quality of their books. This has also been happening in Australia where the Commonwealth Bank of Australia (CBA) has frozen new lending to property investors looking to switch banks and refinance their mortgages.
Source: Daily Shot, Investing.com
As stimulus is gradually removed we remain concerned that this will take the downward pressure off interest rates, leading to rates moving to more normalised levels. Any rise in interest rates from the previous historically low levels will lead to shares, and more importantly bonds, having to reprice for a future with higher interest rate.
At this stage, we are seeing most forecasters anticipating on average a c.2% increase in interest rates over the next 12-18 months, with the common view being that this small increase in interest rates will remove a large percentage of disposable income from the global economy, as borrowers are forced to pay more interest, which will slow down the growth.
Do such small interest rate moves really matter?
As shown in the tables below, given the historically low levels that interest rates have been trading at, small moves in interest rates have a large impact on the value of assets. While the interest rate change may be a small number, the percentage change in interest rates is very large, and, given the bond and share markets are “forward looking”, this must be priced into future earnings, thereby impacting current prices.
New Zealand Market Update
For some time now the majority of local and some global commentators have been debating the arguably overpriced New Zealand property market. We have for some time been expressing concern, and recommending caution in this asset class, as fundamental measures around fair pricing were first exceeded, and then due to QE were blown out of the water.
Initially we have seen limitations (40% deposit on rental properties) being put on bank lending to property investors to try to slow the growth. More recently there has been further pressure slowing the property market down in the form of rising interest rates, and new pressures on banks around their capital adequacy ratios, which has led to bank lending to property investors halving in New Zealand.
Unsurprisingly this in turn has led to a slowdown in property growth with Auckland’s annual percentage change sneaking into negative territory for the first time since 2011. To date this is only a much-needed slowing in house prices which, if sustained, will give first time home buyers a chance to catch up with their first home deposit savings. As long as immigration remains high into New Zealand we can expect this to give some support to house prices, however if interest rates continue to rise, and the local banks start to change their lending from interest only mortgages to principle and interest, we can expect a larger negative impact on house prices.
As discussed in previous monthly commentary we are very concerned about the high valuation of New Zealand stocks, when measured against their long run Price to Earnings (PE) ratios. This bubble has been created by the same low interest rates discussed above. We have seen a strong inflow, from foreign investors hunting higher yields, which has led to the NZX50 now being over 50% owned by foreign investors.
As the charts above show there is a very strong correlation between the inflow of foreign funds, and the Price to Earnings (P.E) ratio, which is now at 22.6X, a level last seen in 2001. We would expect a similar fall in share prices if/when the foreign investors leave our fine shores, in the hunt for safer higher yields.
Some interesting data was discussed in the Salt Long Short monthly commentary this month, highlighting that the NZX index has returned a total return (incl dividends) of 48.9% over the last three years, with annualised volatility of ±8.7%, versus the Australian index which has returned 16.1% with annualised volatility of ±14.5%. This is without a doubt one of the reasons we have seen the strong inflow, as well as the sustained growth we have seen in our economy.
When will the foreign investment depart? This is anyone’s guess, but at present the ASX200 is now trading at a lower P/E ratio (cheaper) and offering a higher yield for investors, than the NZX50, so we may see less support moving forward for NZ shares, should this disparity continue.
Lastly, we have the NZ election end of this year, and on recent polling the minority parties may secure more power that they have previously held. This in turn could lead to offshore investors getting nervous about the sustainably of the growth we have previously seen in this country.
Whatever the trigger is that leads to foreign investors selling, it is very likely there will be insufficient “buyers” to meet the “seller” demand when they do leave, which may lead to a short sharp fall in the NZ share market.
Shares “Fire & Fury” – The Trump Effect
When considering what will knock these share and bond markets off their historical highs, there are always many possible “trigger events”, and it is our view that whatever tips the market will be an “unknown unknown”, and not a “known unknown”, such as President Trump.
We are always hesitant to write about “The Don” in a monthly commentary as the shocking things that he has done at the start of the month will be forgotten by the end of the month, as he is so prolific with his poor behaviour. As an example, can you believe that it has only been 6 months since he came to office? Feels a lot longer than that.
It would be remiss of us not to cover off the recent potential escalation in tensions between North Korea (backed by China and Russia), and the US. North Korea has been test firing intercontinental ballistic missiles that can (supposedly) deliver a nuclear payload to US soil for the first time ever.
Each test has upped the stakes for a confrontation between the US & North Korea, and yet the markets to date have been sanguine regarding pricing in the risk of potential military conflict………that was until President Trump came out and stated that any future threats from North Korea “will be met with fire and fury like the world has never seen”.
Within hours of Trump making this statement, it was rebutted by North Korea, who stated that they were considering firing missiles at Guam, a US territory in the Pacific, and went on to say that they wanted to make the US “first to experience the might of the strategic weapons of the Democratic People’s Republic of Korea”. Subsequently, North Korea has backed down on this threat, for now.
How has this war of words (and let’s hope it stops there) impacted the markets? As previously mentioned the risk of military conflict has not been priced into the markets, with the VIX trading at historically low levels, and share markets climbing to new highs, but this recent flare up has finally caught the markets attention with the VIX index spiking back above 10, and the South Korean Won weakening sharply. We have also seen a sharp selloff in the South Korean and Japanese share markets.
This is something that we will continue to watch closely, as any escalation beyond words is very likely to be the trigger event that ends this latest bull run in the markets.
US versus South Korea impact post “fire and fury” comment from President Trump
Sadly, this sort of big talk from President Trump is expected to improve his overall approval ratings which have been declining since he came to office. Why does this matter? Because “the Don” is all about making big comments, that usually can’t be backed up, and if he thinks more big talk will keep him in office longer you can beat he will not hesitate to make more inflammatory comments.