Despite the optimism, we enter the 2017 year with a number of uncertainties. Global equity markets have moved quickly to anticipate the return of global growth and an end to the deflationary ‘lower for longer’ central bank interest rate cycle of the past 7 years. US equity markets (Dow Jones, S&P 500, NASDAQ and Russell 3000) all registered new all-time highs through December, as investors embraced the prospect of ‘Trumpenomics’ and the potential end of a 35-year bull market in bonds. Equity markets have embraced the prospect of reflation with gusto, with the return of ‘animal spirits’ and an almost unbridled optimism for the calendar year ahead. The optimism is not misguided. Assuming Trump and team can successfully implement their advertised policies, there is obvious economic upside from the proposed mass fiscal stimulus measures, regulatory changes and corporate tax cuts.
The most recent global economic data has continued to firm - not least the recent set of global PMI releases (below) - which tend to suggest early tangible evidence that the reflation trade is indeed taking hold.
Indeed, the resilience of the China growth story has served to broaden the optimism for a global recovery, with the latest Producer Price Index readings (a forward indicator for consumer inflation) back to levels not seen since October 2011. Overlay that with the continued strength in global commodity prices - despite a resurgent USD - and the early indicators continue to suggest we may be at a global growth inflexion point.
As such, we continue to monitor the global economic data closely. At times, ‘bottom-up’ style investment managers such as ourselves are asked whether there is any upside in monitoring the macro, given our process is to focus on identifying companies that we feel are growing well and are undervalued versus that expected growth.
In our view, macroeconomic analysis is a risk mitigation exercise rather than a source of alpha generation. We are not in the business of making outsized macro calls and constructing portfolios to best leverage off that outcome. Rather, we seek to intimately understand global economic developments in order to scenario-test the portfolio under various economic outcomes.
The impact of the macro has been very apparent in the last six months in Australian markets – the correlation between the ASX 200 and the S&P 500 has grown increasingly close, a factor that has subsequently then impacted the rotation trade away from small caps through Q4. When one considers (according to Macquarie Research) that ~75% of US stock moves in the 2016 calendar year were driven by macroeconomic developments rather than stock-specific events, one can see the need to monitor these events closely.
We are broadly positive on the re-emergence of global growth in 2017, however, are cautious that equity markets can get over-exuberant in the short term. Casting our mind back a year, consensus expectations for EPS growth across the S&P 500 was +10%, whereas earnings now look likely to come in flat - the equivalent of a 10% downgrade to consensus.
Through the same period, however, the forward PE ratio has expanded from 16x to 17x (versus a 10-year average of 14.4). It is worth noting a large part of that expansion has occurred through Q4 (following the US election), despite 69% of the 111 S&P500 companies that provided guidance through that quarter issuing negative revisions.
Interestingly enough, the release of the December Fed minutes highlighted a similar level of uncertainty – the FOMC Board highlighting a “considerable uncertainty” around the timing and size of any future fiscal stimulus. With a US GDP forecast of +2.1% (vs. 2016 forecast +1.9%), it is worth noting this is also the first year in some time the Fed hasn’t begun the year with a forecast for a meaningful uplift in GDP growth. An irony perhaps, given they have already flagged the need for three additional rate hikes through 2017.
Ultimately, US investors will need to see growth and corporate earnings materialise reasonably efficiently from here in order to justify the re-rating and we are mindful that there are multiple short-term impediments that could stall those expectations – a higher USD, an over-exuberant Fed, the upcoming European elections or the prospect of delayed policy implementation. Then there is Mr Trump’s Twitter account, 140 characters that could end up being the single most potent driver of market direction at any given point.
This is an excerpt from Ophir Asset Management's December 2016 Letter to Investors.