Don’t bet against the US recovery
There’s nothing quite like local knowledge to give you an insiders view of a foreign country. As the strength of the US economy remains a key focus for investors, Livewire jumped at the opportunity to get a first had account from Lazard’s New York based Ronald Temple.
Temple who is Co Head of Multi Asset for Lazard Asset Management makes his case for investors to hold their nerve despite a rise in volatility. He explains how the large US middle class is slowly but surely experiencing a recovery in their wealth and income in the post GFC period.
Whilst conceding that it he finds it challenging to define many asset classes as cheap, he believes there is a compelling argument for investors, with a timeline measured in years, to maintain an equity exposure.
For those on the look out for some alternative ways to achieve diversity in their asset allocation he offers the solution of ‘liquid real assets’.
Tune in to the exclusive interview below via a video or via the edited transcript.
- The recovery of the middle class in the US.
- Entering the third phase of the post GFC recovery.
- An interesting explanation as to why wage growth has been slow sluggish.
- The trajectory for the US economy.
- Why equities remain attractive despite the fact they aren’t cheap
- US interest rates and will inflation really get out of control?
- Some alternative ways to compliment traditional fixed income assets as part of asset allocation.
How have things evolved for the average American since the GFC in 2008?
Ron Temple: I think conditions on the ground in the US are the best they've been in a decade. If I look at the US recovery, I think we entered the third leg of the growth story in 2015. So maybe as a bit background, from 2009 to 2011, I think of that as being the first phase of the growth cycle. And arguably, it wasn't much of a growth cycle. It was more stabilisation at that point. It was on the back of quantitative easing, fiscal stimulus from the federal government, and forcing the banks to recapitalize. So you could think of it as almost stabilising the economy.
Home prices in the US didn't bottom until 2012. They gradually started to crawl upward in 2013. So the asset recovery for the middle class was late and then the income statement recovery was also late.
From 2012 to 2014, I think was phase number two, which was more quantitative easing driving the story, corporate profit recovery, and then wealth effects from financial assets going up in value. Now, what was missing in that first six years was the middle class. The consumer didn't come back as they typically had come back in prior recoveries. And what we had pinpointed was that this was unlike all the prior economic stories, in that it was a housing driven crisis. If you look at the typical middle class household, about 60% of their assets are their house.
Well home prices in the US didn't bottom until 2012. They gradually started to crawl upward in 2013. So the asset recovery for the middle class was late and then the income statement recovery was also late. You had a really loose labour market with millions of people who had lost their jobs. It took a long time to get back to the point where wage growth started to accelerate higher.
I pinpoint 2015 as the year when that started. And part of the reason I say that, is if you look at real household income for the median household in the US, from 2015 to 2016, in that two year period, we had an 8 1/2% gain in real terms. It's the single biggest two-year gain since the 1960s when the data started. So, when we look at the labour market, we see wage growth expanding, broadening across the economy.
For the average American, home prices are grinding their way back higher. Income statements are improving and things look pretty good.
We've now had home prices go up about 6% per annumfor the last four years. Make no mistake by the way that typical home price is still lower than what it was in 2006 for the average American. Homes in New York City have never been more expensive but that's a very high net worth purchasing audience. But for the average American, basically home prices are grinding their way back higher. Income statements are improving and things look pretty good.
And so, what's interesting about that by the way is that started in 15. Now we've had some tax cuts and other stimulus on the margin that might add a little bit of momentum, but it's a good story overall.
So if that's the base case in 2018, what's the trajectory from here for the US economy?
Ron Temple: It's tough to tell. My base case scenario is that wage growth continues to grind higher. And I do think, there is an argument that labour markets have changed versus where they were in the past. Some people say, well is it because we're going to have autonomous vehicles and people are all going to be replaced by machines? I don't think that's the reason labour markets have changed. I think the big reason labour markets have changed is demographics. If you look at US population growth, the adult population since 2006 has increased by over 20 million people. 97% of that is people over the age of 55.
So when you think about a labour market getting tighter, typically that means to me, if I'm a 35 year old and I've got another job offer, I go to my boss and say, give me a raise or I'm going to go take this other job. If you're 55 or 60 years old, it's a lot less likely you're going to walk into the boss and say, give me the raise or else. Right? You're really not thinking about your next career move. You're thinking about gliding towards retirement. So, I do think it's a grind higher.
There's a risk that I'm wrong and that the labour market actually gets so tight that we see an inflexion higher. So to me the real questions are, is it a gradual increase in wage growth or is it a sharper increase in wage growth? Either way, I think that's positive for consumer spending, positive for consumer confidence, which is then positive for house purchases, which then feeds back to that consumer balance sheet.
The negative side of the story, by the way is, corporate profit margins are at record highs in the US. But what's missing from most people's understanding of that topic, is if you look at the entire US market, the entire increase, the record highs in corporate profit margins, is the 50 biggest companies. The big global tech companies effectively.
So I think you actually could have a little margin pressure but it's less likely to be as negative as people expect. You probably get better revenue growth when consumer has more income and more confidence. So net net , I think it's a positive trajectory that could last three or more years from now.
Are the Fed ahead, on, behind the curve, when it comes to interest rates? What's your take on that particular setting, in terms of inflation?
Ron Temple: That sounds like an easy question, but I do think the fed is on the right track, generally. Admittedly, I wish they were actually being a little less hawkish in their statements. I do think that if anything, it would be a good mistake to make to let inflation run a little hot in the US. If you think about the amount of debt that's accumulated across the western world, in the private sector, in the public sector, a little bit of inflation might not be such a bad thing to devalue some of that debt over the long period of time.
I do think that if anything, it would be a good mistake to make to let inflation run a little hot in the US.
Now, when I say a little inflation, I'm thinking 2 1/2, 3%, not something like 5 or 6. So when I think about Fed policy, I think they're right on track as it relates to a 2% inflation target. I think they might be a little too hawkish on the margin in terms of being worried about inflation. I mean, let's be honest, they have not hit their 2% inflation target in the last, I don't know, 10 years. So, if that's really the target, why are we being so aggressive to try to worry about it?
Having said that, clearly my base case is I think wage growth is grinding higher, so it's a tough balancing act of whether the fed's behind the curve. I don't think they're behind. I think they're probably right about where they should be.
What does that mean for investment markets when you put your investment lens on? How do you view the landscape and what's your view?
Ron Temple: My view is that we actually have three or more years of growth, so that's an important premise on the economic side. As it relates to corporate earnings and translating the macro into the micro, I think this is one of the best points of time in the cycle to own equities in that, that's when you get the earnings growth.
And it's not just US growth. I mean, if you think about S&P 500, about 35% of the revenue is non-US revenue. If I think about Europe, it's growing above trend. If I think about China, two years ago, people were very spooked about the idea of China having a hard landing. The data from China continues to be good and my hope this year, is that the tailwinds from the US and Europe allow China to have more structural reform. So, I look at the US, Europe, China, and even Japan, and I see a good backdrop. That's good for most companies in the US.
My view is that we actually have three or more years of growth, so that's an important premise on the economic side.
If I look at the earnings, the consensus forecast for earnings in 2018, we have about a 17% earnings growth rate projected for the US. And that's a pretty phenomenal increase. About 7 percentage points of that are from the tax cuts, but 10% earnings growth is a good story. And so, when I look at the equity market, I would say I'm optimistic on the economy, I'm cautiously optimistic on the equity market, but the good news is, we finally had a correction. I'm not sure that a full two weeks counts as the whole correction. But we finally had a pull back in markets, in the early part of February. That also gives us a little room to say, okay maybe we've shaken some complacency out of the market and we have a good story for investors with a more than a one-year time horizon.
Do US equities look attractive given this backdrop?
Ron Temple: So it's interesting, if you ask me, what's a cheap financial asset globally? I have a hard time finding an asset category that's cheap. So I want to be very clear, I don't think US equities are cheap, anymore than ... If I look at, the way I tend to look at valuations is I like to compare each market to its own 10-year history. And if I look at the US, the S&P 500, the ASX 200, the MSCI EM, all three of them are about 1 standard deviation expensive to the 10-year level. If I look at Europe and UK, they're less than 1 standard deviation expensive. Japan's a little cheaper relative to its 10-year average.
So I look at the markets. They're not cheap. Some people have questioned, by the way, why don't you look at a 20-year average? And the reason I don't look at 20 years, ironically you get an answer they don't expect is, the markets look even cheaper, because you're including the TMT bubble. And then I was asked recently, why not go back 50 years and I have a hard time believing 1967 is relevant to 2017, in terms of valuation.
So, when I look at the market, it’s not cheap, but if I think about equities relative to my other asset classes, if I think about the most likely risk to equity valuations in the next year is that bonds sell off and interest rates go up. So, when I think about equities versus debt, I think equities are more attractive than say, government rates.
In 2017, we had 8 days where the market closed 1% higher or lower than the day before. The least volatile year in the prior decade had had 42 days where the market moved 1%.
If I look at credit spreads, they're incredibly tight relative to history. So the idea of credit versus equities is a bit of a tough trade-off, and also, they're correlated obviously. So, I do think they're attractive, even though the valuations are a bit above the historical levels. If interest rates stay in the range I expect, I think investors can still do well from equities at these valuations.
When you, across markets, where do you see excessive exuberance and things that make you nervous?
Ron Temple: Well it's funny. I would have said, two weeks or three weeks ago, complacency. As one of my favourite data sets, we look at intra-day range in the S&P 500. And if you looked at it and plotted it over say a 30-year period, last year was just abnormally low. It was the lowest intra-day volatility in the S&P 500 since 1965. And if you take a different cut and you say okay, well how many days out of the year did the S&P move by more than 1%? In 2017, we had 8 days where the market closed 1% higher or lower than the day before. The least volatile year in the prior decade had had 42 days where the market moved 1%.
And the reason I think about that complacency is, I still think there's a bit of risk. I mean, the market moves and the extreme volatility in the last few weeks have probably shaken out most complacency. But there were a number of factors that fed into complacency. One was the consensus view of global synchronised growth. You didn't have these kinds of fear factors that made markets more volatile, say during the Eurozone crisis. Number two is you had these volatility targeting kind of insurance type products where there was a natural seller of volatility in many parts of the cycle. You also had certain structures like Inverse VIX ETFs, which again, were kind of put depressing volatility.
And the last factor, I think that doesn't get much discussion was, you had an absence of buyers of volatility. As the market continued going up and hitting new record high after new record high, hedge funds became more and more net long. They basically said you know what, we're going to just run with the market. We had some multi-year highs in terms of net long positioning of hedge funds. We also saw many investors who historically would have bought downside protection said okay, I'm wasting my money. Let's stop.
So effectively, we had everyone on one side of the trade. And so, it's not clear to me that you can shake all of that out in a few weeks, so I'm still a little worried about complacency.
And the other big risk I am worried about is interest rates. If, again, the one case where I'm most likely to be wrong, I think about the economy and about equity markets, is if the 10-year yield in the US say goes to 3, 3 and a quarter percent, I think we're fine. If we get to 3 1/2 to 4%, then I worry more about how that might disrupt the housing market, how it might disrupt long term financing costs for new investment, what it does to federal deficits in the US.
The average treasury in the US, by the way, has a 2.05% yield. If you move to 4% on the 10-year yield and fed funds go up, that's a big increase in your debt on $20 trillion dollars of debt. So those factors, alongside what that would do to valuation rates, if the risk free rate goes to 4%, PE ratios are hard to sustain at current levels.
If the 10-year goes to 4%, what assets don't you want to be holding?
Ron Temple: Well probably the 10-year. So, at least on the journey to 4%. At 4%, by the way, bonds might be really attractive. I think it's unlikely we get to 4%, just to put that out as a premise.
I think there are a number of factors that would preclude, well maybe not preclude, but reduce the probability of it. For example, a lot of big corporate pension plans are fully funded at this point because equity markets, near all time highs, bond discount rates lows, many of those corporate plans would love the opportunity to take risk off the table from equities and buy bonds. So, to the extent bond yields keep moving higher, you will get a natural buyer of bonds and a natural seller of equity. So that does reduce those probabilities.
That said, if you're up at 4%, I think bonds are one real question mark in terms of historical views of asset allocation. I mean, historically, we think, if our equity portfolio goes down, our bond values will go up because interest rates go down, that natural relationship.
I'm trying to encourage people to think about other opportunities in terms of diversification tools... a globally, diversified liquid real assets portfolio, I think could be one solution.
I think what's interesting about the year ahead is one of the most likely reasons for my equity portfolio to go down in value is the bond portfolio goes down in value and interest rates go up.
I'm trying to encourage people to think about other opportunities in terms of diversification tools. For example, I think, and it's important by the way that if be global, but a globally, diversified liquid real assets portfolio, I think could be one solution.
What are liquid real assets?
Ron Temple: It's funny. In Australia this market's very familiar with real assets. You guys are pioneers in this space, way ahead of the US. So I think Australia and the UK led the way on this. But if you think about it, say 30 years ago, if you were a major institutional investor, you could buy into an actual infrastructure project. Retail couldn't do that. Now you've got choices such as REITs, I mean basically globally. We've got listed infrastructure. We've got still the opportunity to invest in commodities. Obviously, Australians are very familiar with that opportunity. But if we think about the commodity companies, but we also have commodity futures we can use. You've got global inflation linked bonds. And one other asset class or category we've created working with our quant team is companies that have demonstrated an ability to basically pass through their cost increases.
So when we think about globally diversified liquid real assets, we include all of that range. And what we're trying to do here is get some diversification, but also get some inflation protection, get some income generation, and get capital appreciation.
So it's serving multiple functions, which in some ways, overlap with where fixed income has historically fit into asset allocation. Now make no mistake, I don't think people should replace all of their bonds with liquid real assets. But I do think it could be an interesting complement in an asset allocation framework.
How are you thinking about asset allocation at the moment?
Ron Temple: Well I guess I would start with, I think it's tempting, I think in many discussions, you can have people who can bring out valuation data, charts, and say, markets are really expensive. Or in some cases, people might say, markets are cheap. I think the really important thing is to basically step away from some of the charts and think about the fundamentals of what you're investing in.
I think the fundamental backdrop of investing today is again, one of the best in 10 years. This recovery and this crisis before it were unlike any prior experience, so I think we all have to kind of learn from history, but recognise we're not repeating history right now.
I think we've got multiple years ahead of us potentially in terms of growth, globally, with the US partly being at the front of that. So, I would say from an asset allocation perspective, it's critical, don't get shaken out of the market by short term volatility. If you have a time horizon measured in years, not months, then stick with a core equity allocation. I think we've got great earnings growth behind these companies, across a range of markets by the way. It's not just a US phenomenon.
I think, think carefully about your fixed income allocation and think about what role you really want it to serve. I mean, given how low rates are, income generation is quite low, your capital appreciation potential is very limited, diversification is questionable, so think about other alternatives. One option, which I might, we've already discussed, those globally diversified real assets. And basically, try to think differently about exploring the range of options you've got in the investment universe.
Sometimes I think innovation and finance is a bad thing but the good news is we have got a lot more choices than we did in prior years. And so, addressing an environment where for the first time in 30 years, the risk might be higher rates instead of lower rates, is one where we have more tools than we used to have.
And luckily, equities historically have actually done well. If higher rates are driven by higher growth, that's generally a good place to be.
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