Equity markets Flashing Amber. October 2018

Transcription

1 0 Equity markets Flashing Amber October 2018

2 1 The great bull run Should you be worried? Equities have delivered exceptional returns with low volatility Equity markets have added considerable value since the global financial crisis in September 2008 (chart below). Equity returns from 30 September June 2018 Total return Sep/08 Global equities 9.4% p.a. Apr/09 Nov/09 Jun/10 Jan/11 US equities 11.0% p.a. Aug/11 Mar/12 Oct/12 FTSE North America (local) MSCI World (local) Thomson Reuters, Bank of England. May/13 Long-term equity return assumption 7.0% p.a. Dec/13 Jul/14 Feb/15 Sep/15 Apr/16 Nov/16 FTSE All Share MSCI EM (local) For the most part, this prolonged equity rally has largely stemmed from unprecedented low interest rates and quantitative easing (QE); as opposed to strong market fundamentals (e.g. corporate earnings). Importantly, equity markets look expensive across a range of metrics. The Shiller Cyclically Adjusted Price to Earnings Ratio (top right chart) is one measure of the value of the US equity market, with higher values of the ratio (relative to history) providing an indication that markets are overvalued. US equities have only been at a higher level than the current position three times in history meaning the probability of a correction is above average at this time and returns could be more muted moving forward. Jun/17 Jan/18 Valuations are high relative to history Price-Earnings Ratio (CAPE, P/E10) Current Value Current Value = Robert J. Shiller. And this is one of the longest bull runs in recent history S&P 500 Bull Cycles Gain % p.a. Total gain % Months Mar 09-Current 19.1% 523% 114 Oct 02-Oct % 221% 60 Oct 90-Mar % 645% 114 Thomson Reuters. Note: Data to 31 August The current equity bull run in the US is developing in to the longest in recent history. Previous prolonged equity market cycles have typically ended with severe market downturns or shocks. Examples include, the 2000 tech crash and the 2008 Global Financial Crisis. Though each of these market crashes were triggered by distinct events, they carried a common theme of a mispricing of assets and risk relative to what fundamentals would suggest KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Recognising the current environment, we summarise the factors which both support and present risks to equity markets in the next section

3 2 What are the supporting factors? 1. Improving fundamentals It is our view that the key driver which should underpin stock market growth is corporate earnings. There has been a sustained rise in earnings over the last two years (following a dip over 2015 and 2016). Rebased to Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Real Price Jul-13 Standard and Poors, Robert J. Shiller. Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Real Earnings Some forward looking measures provide a stronger anchor to current valuations, suggesting that there is scope for the differential between prices and earnings to reduce to a more average range relative to history. Jan-17 Jul-17 Jan Technology Stocks: Innovation driving a more robust boom The technology sector has grown over the past decade and is pivotal to the performance of the broader equity market. However valuations are high on an absolute and relative basis, and raise questions on whether we are in bubble territory similar to the tech crash of We address the risks this poses to investors in the next section, but believe the sector also presents opportunities and has the most potential to continue to drive further growth. Importantly, the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks, which have propelled the stock market, are industry leaders and continue to expand their global footprints, through investing heavily in research and development. Rebased to 100 (log scale) May-12 May-13 May-14 May-15 May-16 May-17 Facebook Apple Amazon Microsoft Nvidia NETFLIX Alphabet Thomson Reuters. Moreover, the largest technology firms possess strong balance sheets and deep cash reserves making the current tech boom dissimilar to the tech bubble in 2000 in our view. Recognising the continued digitisation of the world around us, we expect the tech sector to continue to grow as more innovative firms develop and enter public markets, creating more opportunities for investors. May Monetary Policy: Still lower for longer? Following a decade of ultra-loose monetary policy, central banks have intimated a desire to move towards a rising interest rate environment, citing an improvement in economic indicators and a desire to control inflationary pressures. Though US data has been robust, economic indicators have been softer in the UK and Europe. This suggests both could lag the US in policy execution, creating divergence. If the current status quo remains unchanged, a lower for longer scenario would keep borrowing costs low and aid corporate profitability and equity prices. Having addressed factors which could continue to support equity markets, in the following section we investigate the alternative view on the key risks we believe equity markets are exposed to KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved.

4 3 What are the key risks? 1. Tighter Monetary Policy End of QE Central Bank Assets to GDP Ratio 55% 35% 15% -5% Federal Reserve Economic Data Europe Japan USA With the US beginning to unwind its QE programme and the UK and Europe also signalling intentions to follow suit, we believe there is significant likelihood of elevated volatility over the near future, as market participants come to terms with a new normal. This is unchartered territory for most markets Concentration The technology sector also presents material downside risk Real Estate, 3% Materials, 5% Energy, 6% Consumer Staples, 8% Industrials, 11% Utilities, 3% Consumer Discretionary, 13% Index Rank Telecommunication Services, 3% MSCI World Index 31 August Factsheet. 31 August 2018 Stock Weight Information Technology, 19% Financials, 17% Health Care, 13% P/E (TTM) 1 2 Apple Amazon 2.8% 2.0% Microsoft 2.0% Facebook 1.0% JP Morgan 0.9% Alphabet C 0.9% Alphabet A 0.9% Johnson & Johnson 0.9% Exxon Mobil 0.8% Bank of America 0.7% 15.9 Total 12.9% The composition of the global equity market has changed markedly over the last 10 years. The exposure to the technology sector has notably increased (from approximately 11% to 19%) and technology stocks currently comprise 6 of the 10 largest firms in the global index. In March we witnessed the potential impact of shared risk factors within the technology sector, as various firms fell in value following the Facebook data mining issue contributing to a fall in the MSCI World of approximately 2% in 24 hours. The sector experienced a further sharp sell-off in early October, driven by concerns around the impact of rising interest rates on current valuation levels. On balance, we believe the current concentration risk within passive global equities outweighs potential long-term benefits and investors should consider this. 3. Geopolitical risk: US policies, Trade wars and Brexit We believe a range of geopolitical factors provide headwinds to equity market stability at present: The timing of US fiscal policy could heighten the probability of a US recession. The risk of a widespread trade war could trigger a global slowdown and have grave ramifications for export oriented sectors over the medium to long-term. Investors in UK equity markets must also navigate through Brexit. Currency risk has been driving volatility in UK equities since the Brexit vote in 2016 and we expect further bouts of volatility, given the current political impasse. MSCI; ycharts.com (accessed 25/09/2018) KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. We now look at ways to manage this medium term downside risk

5 4 Managing risk in an uncertain climate The Equity Toolkit 1 Derivative based strategies: Options, volatility controlled funds and synthetic equity 2 Alternative approaches to market capitalisation: Smart beta/ factor investing 3 Active management: Strategies including a defensive focus KPMG Investment Advisory View Equities have delivered considerable value over the past decade. Looking forward, there is significant uncertainty, and overall, we expect heightened volatility in markets over the next 3-5 years. On balance we believe there is more downside risk than potential upside. We acknowledge that many investors focus on the longterm horizon and are comfortable with riding out short term volatility. However, for some investors managing medium term volatility can be critical (for example in the run in to an actuarial valuation or buyout transaction in case of pension funds or a pending transaction/transfer in the case of private wealth). Additionally, some clients require/prefer to maintain a material allocation to equities for return generation (such as LGPS funds) or are constrained in terms of alternative options (small DB schemes). It is our view those investors which meet the criteria of wishing to hold equities but have a strong desire to limit down side risk should consider the options available to manage this position. This can be achieved using the equity toolkit we have summarised opposite KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Summary Summary Factors to Consider Options: While options strategies have traditionally been limited to large investors, pooled products are increasing in availability. Volatility-controlled equity funds use systematic rules to time markets in order to reduce volatility. Synthetic equities: Similar to option strategies, these are now increasingly available in pooled products. Standalone options strategies remain very expensive. This cost can be reduced through structures which sacrifice potential upside. The success of volatilitycontrolled equities has been mixed so far. While synthetic equity reduces risk from a strategic stand point, the passive equity exposure does not reduce the risks we have identified. Smart beta is a rules-based form of equity management, which is designed to provide enhanced risk-adjusted returns compared to an index. Security weights are typically adjusted slightly from the index based on a range of factors including fundamental ratios (such as price/earnings or price/book) and environmental, socials and governance (ESG) factors. Long term prospects for such strategies are unclear. Lack of dynamism with respect to shifting between factors. Active strategies can remedy this but incur higher fees. The current environment presents opportunities for active managers to identify value and manage risk relative to broad equity markets. Certain approaches/styles aim to preserve more capital than the wider market. The average active manager has struggled to outperform over the long term, therefore manager selection is key. Significantly higher fees than passive exposure. We would welcome the opportunity to discuss these options in more detail to identify the most appropriate course of action.

6 5 The contacts in connection with this paper at KPMG are: Farrakh Ashraf CAIA Head of Equity Research Tel: +44 (0) Ajith Nair CFA Head of Asset Class and Manager Research Tel: +44 (0) Andrew Lilley Consultant Tel: +44 (0) Douglas Sayers Consultant Tel: +44 (0) kpmg.com/uk The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. Produced by CREATE CRT103381