And it’s not the only factor that could end the bullmarket party – which means advisors need to make some tough decisions, writes Thierry Tremblay
Aside from short-term pullbacks, the equity market has been going almost straight up, so it’s easy to fall back into complacency. Most asset classes were up significantly in 2019, pulling forward future returns. The market is confident that consumers will do the heavy lifting; their spending represents two-thirds of the US economy. Additionally, Merrill Lynch’s most recent survey of global fund managers shows that the cash level among portfolio managers is the lowest since 2013.
What could go wrong?
Two things are mispriced. First, inflation: We think inflation, in the medium term, is going to surprise to the upside. Globalization trends will continue to reverse, supply chains across the world will be increasingly disrupted, and numerous countries will be looking to produce more goods locally. Furthermore, given that unemployment is trending downwards globally, according to the latest figures from the International Labour Organization, we can see that wage growth is accelerating and putting pressure on corporate margins, as it tends to do in late-cycle environments.
Also, a lot of new business models have been supported by venture capital firms, where growth was the main objective. Now, as we’ve seen from numerous failed IPOs, investors are looking for sustainable business models with shorter horizons to profitability. A lot of those disruptors could be forced to raise their prices in order to achieve this goal.
In addition, on a global level, the latest Chinese CPI has accelerated the most since 2008, which could limit the Chinese government’s ability to supply more accommodation.
During 2016–2017, China’s stimulus was the engine behind global reflation. Not this time. Any inflation surprise could put a dent in the expected earnings acceleration story in 2020.
Second, earnings: Price-to-earnings multiples have moved from a low of 13.5 earlier this year to over 19 today in an earnings slowdown. There seems to be a disconnect between earnings per share of publicly traded companies and profits of the National Income and Product Account (NIPA) – since early 2016, the former has grown by 30%, while the latter has decreased by 4% since 2013. NIPA numbers are very important, as they reflect the broader economy, not just public companies, which tend to be much larger. One explanation of this divergence could be the dominance of certain market leaders and higher debt levels.
In an environment where capital expenditures are negative, CEO confidence is cratering, and the OECD leading indicator is down for 20 consecutive months, eventually something must give. Either the NIPA profits will catch up, or the S&P earnings decrease. How, then, do we as advisors position portfolios for potential stagflation?
We recommend investors diversify their portfolios and hold some inflation-protected investments. It’s the best way to hedge risks in a future that’s still uncertain. Bloomberg recently reported that the world’s central banks have been buying close to 20% of the planet’s gold supply. To us, this is further confirmation that something is afoot, that inflation is lurking around the corner.
We also think the time is ripe to have a discussion with your clients about balancing growth and about the wisdom of defensive positioning. Now is the time to diversify into low-correlated or negative-correlated assets and positions that will protect against rising inflation and higher volatility. One such asset, of course, is gold. Commodities like oil, coffee and wheat are another area that can be used as an inflation hedge. Additionally, real estate and infrastructure-related companies tend to do better in slower growth periods and in times of high uncertainty. Alternative investments like market-neutral funds or private equity are another possibility to consider. Whichever option you choose – and why not hold a mix? – it’s time to rebalance your clients’ portfolios.
Trying to beat the market during every phase of the business cycle is a losing proposition. Improving your clients’ outcomes by sometimes making the hard decisions is what clients are hiring us to do, and I believe that’s a winning ticket.
Thierry Tremblay has been in the investment industry for almost 20 years. He is lead portfolio manager for the multi-factor portfolios and the macro strategist for the Shinder-Tremblay Group, part of Echelon Private Wealth.
