Republished courtesy of the National Post
by Tom Bradley
The longer market cycles go on, the more investors turn uncertainties into assumptions.
We’ve been on a one-way street since 2009. There’s been the odd bump in the road, but generally we’ve had an expanding economy and rising stock markets. At this point, it’s worth exploring three important drivers of this period to determine if we’re indeed treating uncertain variables as foundational assumptions.
1. Interest Rates
Assumption: Interest rates will remain low because governments and individuals can’t afford higher rates.
When it comes to rates, the affordability argument is regularly put forward, but it’s losing its punch for two reasons.
First, bond buyers are not in the business of giving governments and households what they need. Rather, they’re seeking a return that will leave them better off for taking the risk. If they can’t get a reasonable, real (after inflation) return, they’ll demand a higher yield and/or look for substitutes.
And second, it’s getting harder to claim poverty when we’re seeing strong sales (and in some cases, record sales) in autos, houses, iPhones, travel and many other areas of the economy. On the employment front, job vacancies are increasing and wage growth is picking up.
We’ve seen zero or negative real yields before, but it occurred because rates couldn’t keep up with skyrocketing inflation. This is the first time central banks have used negative rate strategies when inflation is low.
Probability of change: High.
Timing: Slow moving train wreck.
Assumption: With low interest rates and credit readily available, leverage is a good thing.
The amount of debt in the world should naturally rise as economies grow, but the pace has been faster. Since the debt-induced crisis of 2008/09, overall debt levels have increased more rapidly than GDP.
Central banks have been expanding their balance sheets and governments are running deficits despite healthy economies and daunting future obligations (healthcare and infrastructure).
Corporations have lenders throwing money at them and their climbing debt obligations have been outpacing cash flow growth. Bond issuance has allowed U.S. corporations to disburse cash to shareholders (dividends and share buybacks) in excess of their profits.
And household debt is expanding faster than disposable income, particularly in Canada. Canadians are highly levered with mortgages, home-equity loans, lines of credit, car loans and leases, investment loans and credit cards.
You may be familiar with the expression, pay it forward, which gained prominence with the Helen Hunt movie of the same name. It means the beneficiary of a good deed repays it to other people instead of his/her benefactor.
From a financial point-of-view, we’ve ignored this wonderful philosophy and have been spending forward. The beneficiaries of the goods and services are relying on others to pay in the future. The baby boomers’ lifestyle will ultimately be their children’s burden.
Probability of change: Inevitable.
Timing: Unknown, although the ring leaders of the debt parade, the central banks, are about to start shrinking their balance sheets.
3. Growth vs. Value
Assumption: Growth stocks will outperform value stocks.
Growth companies are increasing their sales and profits faster than the average. In many cases, their stock prices are influenced more by the pace of growth than the price-to-earnings multiple.
Value stocks aren’t growing as fast, may be more cyclical in nature and are likely going through a difficult period, but their valuations reflect this. They trade at considerably cheaper multiples.
If we divide the MSCI World Index into two, the growth side has been winning the race for eight years. Technology stocks led the charge, joined by steady companies that regularly raise their dividend (referred to as bond proxies because they’re a popular alternative to low-yielding bonds).
The result of this divergence is the biggest valuation gap between growth and value since 1999. As a reminder, following the tech boom, value stocks smoked their growthier cousins for the next seven years.
Probability of change: Certain
Timing: No signs yet.
This bull market has been partially fuelled by debt, interest rates and growth-oriented stocks. These drivers may have more left in the tank, but when we’re looking back in five years, I suspect returns will have come from a very different mix of factors. Easy credit, near-zero rates and large premiums for growth will be back in the uncertain pile.
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