China’s Problems are America’s Opportunity
February 4, 2014
Fear not Federal Reserve tapering, lackluster U.S. earnings, oncoming deflation or markets heading into bubble territory, says Francois Trahan. Our economic and market growth will be fueled by structural changes driven by rebalancing in China. Don’t be surprised to see a repeat of 2013’s U.S. equity market performance, according to Trahan, who offered a script for countering clients’ unfounded fears over what might go wrong.
Trahan leads portfolio strategy efforts at Cornerstone Macro, a New York-based economic-consulting firm. He is an economist by training, and he is widely praised for his differentiated insights into the dynamics of the markets and his unique understanding of the business cycle. In 2013, Trahan was voted to Institutional Investor magazine’s All-American Research Team as the #1 portfolio strategist and has been selected as #1 for seven of the past nine years.
At a January 14th meeting of the Boston Security Analysts Society (BSAS) on the challenges and opportunities for investors in 2014, Trahan told advisors how to address client pushback. He provided a compelling explanation for continued price-to-earnings ratio expansion, structural changes and macroeconomic forces that will dampen U.S. inflation and other risks that might quell clients’ optimism.
How inflation rates drives P/Es
Trahan said that the chartered financial analyst curriculum is primarily focused on accounting and earnings and lacks a good explanation for the movement in P/E ratios. Companies focus on earnings and don’t talk about P/Es. As a result, he concludes that investors do not know enough about P/Es.
Trahan notes that last year the S&P 500 began with a forward P/E of 13 and is currently at 15. “As long as inflation is moving lower, we are going to see multiples notch higher,” he said. He expects P/Es to increase to 18 and potentially beyond. In explaining the relationship between expanding P/Es and low inflation rates, he said it is very important to distinguish the differences between the Consumer Price Index (CPI) core versus food and energy rates. “When the Fed talks about inflation, they are really talking about the core inflation,” which includes shelter and other consumption but excludes food and energy, he said. In contrast, he explains that what is generally referred to as the U.S. inflation rate, or headline CPI, combines the CPI core with food and energy. Food and energy are commodities and represent only 24% of headline CPI by weight, but they have a large influence due to their volatility. Therefore the beta of the CPI food and energy component is very high at 5.37. In contrast, the CPI shelter and non-shelter components, representing the remaining 76% of headline CPI, are not very volatile. Each of these components has a beta that is less than 1. Trahan concludes that the US inflation rate is driven by the food and energy component due to its high beta relative to the other components of CPI.