Equity Cyclical Outlook: Between Fed Lift-Off And Living In The New Neutral by Virginie Maisonneuve, Mark Richards, PIMCO
- While all rate hiking cycles have their own idiosyncrasies, there is a consistent pattern of equity market behavior around the time of the first rate hike. Typically, in the first few months after the first rate hike in a tightening cycle, the S&P 500 falls modestly, but has frequently returned to higher levels after six months.
- How the FOMC manage expectations about the future path of short rates, estimates of trend GDP growth and the long-end of the yield curve will determine the performance of equity markets.
- Share buybacks, which have been more prevalent in the US, could become a growing trend in other regions too. In Europe, for instance, the ratio of free cash flow to dividends plus buybacks is 2X the US level, while the ECB’s QE program could eventually encourage debt-funded buybacks as has occurred in the US. In Japan, increasing corporate governance and companies targeting higher returns on equity (ROE) could lead to companies distributing their record cash holdings to shareholders.
Virginie Maisonneuve, PIMCO’s CIO Global Equities, and equity macroeconomic analyst Mark Richards provide an update on PIMCO’s views on equity markets.
Q: With the Fed poised to start the slow process of rate normalization, what do you expect from the equity markets?
A: As we discussed in January, we believe that global equity markets will be volatile in 2015. While our New Neutral outlook is supportive of equities, the US monetary normalization process is likely to have some short-term impact on equity markets.
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The Federal Reserve removed the word “patient” from its March monetary policy statement, shifting from forward guidance to an explicitly data dependent mode. This move signals that the Fed may well tighten rates soon, which PIMCO expects to happen at the June, September or December Federal Open Market Committee meeting, depending on the strength of incoming economic data.
While all rate hiking cycles have their own idiosyncrasies, there is a consistent pattern of equity market behavior around the time of the first rate hike. Typically, in the first few months after the first rate hike in a tightening cycle, the S&P 500 has fallen by about 7%, but has frequently returned to higher levels after six months.
When assessing the current health of the equity market one has to consider additional factors including starting equity market valuations, corporate profit margins, corporate leverage and prevailing risk appetite. In addition, long-term interest rates are a fundamental component of equity valuations.
PIMCO’s outlook, The New Neutral, calls for slower growth and lower rates than in recent tightening cycles and with a lower equilibrium neutral real policy rate. This is borne out in the FOMC lowering their estimates of the long-term fed funds rate in recent months. Lower rates over the longer-term should be supportive for equities, and, traditionally, rate hikes are actually a confirmation of the health of the economy which is also a positive for risk assets. Striking a balance between the end of the zero interest rate policy (ZIRP) and the realization of the New Neutral will be a key determinant for the path of global equities in 2015.
Additionally, the continuing wave of easing by non-US central banks – with many emerging markets in particular making surprise cuts in recent months – should keep a lid on the long end of the US yield curve which is a key input in terms of discounting company cash flows.
Q: How have equity markets reacted as the world has come to embrace PIMCO’s thesis of The New Neutral?
A: The broad global decline in long-term rates has led to some anomalies in the equity markets over the past few years, some of which we believe are reflective of this new world order. For instance, cyclical stocks, which usually outperform in a rising equity market, have actually underperformed defensive industries, which typically perform better in a down market, even as the market in the U.S. has rallied. Weak demand in China has been a headwind for cyclicals, including basic resources that have underperformed given the end of the commodity super-cycle. In contrast, low interest rates have also helped sectors that have above average leverage ratios, such as real estate, as well as utilities, which, again, are typically seen as a defensive play. Additionally, quality stocks have outperformed so-called value stocks, which is also unusual in a rising market. Typically, rising equity markets lead to higher risk appetite, encouraging investors to seek out value opportunities. This time, the market has viewed those cheap stocks more as “value traps” instead, preferring to focus on companies with reliable cash flows and relative certainty – properties more characteristic of fixed income securities.
Another decoupling example is the performance of Euro area bank stocks. Unusually, they lagged the broader European market, underperforming in late 2014 and January of 2015. But now that decoupling is starting to close. Banks had suffered under concerns of falling inflation expectations, which are a negative for banks because it reduces the ability of borrowers to service their debts, weak growth and restrictive lending as banks rebuilt balance sheets. All three trends are now beginning to reverse and become supportive for the sector: inflation expectations have edged higher, growth indicators are improving and credit growth is positive. An additional support comes from a marked improvement in capital ratios – higher than those of US banks – that could facilitate a rise in payout ratios in coming years.
Q: What are the dominant themes you see in the next 6–12 months?
A: The search for bond substitutes in equities has been a theme for many years, but is likely to continue. Flows into dividend funds have outstripped those into equities for most of the last five years. However, it is likely to enjoy another burst as the ECB embarks on its aggressive QE program and central bank after central bank around the world cut rates, likely keeping bond yields depressed on a global basis. Investors continue to look for options that can replicate the quality, stability and income associated with bonds.
While there are a variety of approaches to equity income strategies simply buying the highest yielding stocks may seem like an obvious choice, but it is frequently a red herring. At PIMCO, in our dividend-focused equity strategies, we look to buy stocks that have stable distributions to shareholders and the conditions in place for the company to grow the dividend over time and/or companies that are likely to increase or have a history of share buybacks. These approaches tend to do better than simple high dividend yield strategies.
In some of PIMCO’s other equity strategies, there is an emphasis on quality and sustainable earnings growth. Companies with high barriers to entry and a clear growth profile should do well in The New Neutral, an environment that is new to many companies created in the modern era. Sustainable growth gives companies the option to increase payout ratios and deliver sustained dividends as well as possibly buy backs, when appropriate.
Share buybacks, which have been more prevalent in the US, could become a growing trend in other regions too. In Europe, for instance, the ratio of free cash flow to dividends plus buybacks is 2X, which is twice as high as the ratio for US companies. The ECB’s QE program is likely to keep high quality European corporate bond yields low and could encourage debt-funded buybacks as has occurred in the US. In Japan, increasing corporate governance and companies targeting higher returns on equity (ROE) could lead to companies distributing their record cash holdings to shareholders.
Q: How do you see foreign exchange rate volatility effecting equities, in particular the impact of a stronger dollar in the emerging markets?
A: Currency volatility, like equity volatility, presents challenges and opportunities. Overall, increased FX volatility is a marginal negative in aggregate for companies as the cost of hedging currency exposures increases and, faced with increased uncertainty, companies are likely to hedge a greater proportion of their operations than would typically be the case. We expect the first quarter earnings season to be dominated by FX beats and misses. For investors, FX has been a dominant theme in recent months. When such themes dominate other fundamentals, this can create opportunities to own promising companies at better prices.
For EM countries, much has been made of their potential vulnerabilities to higher US rates and a stronger US dollar. We have said this before, but it remains true, we no longer think of the emerging market as a single undifferentiated market, but a market made up of diverse countries with diverse conditions that need to always be taken into account. For example, there are stark contrasts between the commodity exposures of various emerging markets: the energy divide is highlighted by Russia’s commodity exports at 18% of GDP compared to China importing the commodity equivalent of 6% of GDP. There are also big differences in the US dollar sensitivity, with many Asian economies having current account surpluses of more than 5% of GDP, while some EMEA and Latam economies have equally large deficits. Of course, much of this is no longer news to the market, with the 2013 taper tantrum providing a template for the winners and losers from higher interest rates. This diminishes the surprise aspect and, combined with more supportive emerging market central banks and a slow pace of monetary tightening in the US, could limit the impact from Fed lift-off. However, for those EM economies that did not use the warning of the taper tantrum to engage in reform, their financial markets remain at risk.
So while markets ready themselves for an end of “ZIRP” in the US, the tide of other central bank policy easing, lower long-term rates and the potential for higher shareholder distributions could help to buffer the impact on equity markets. At PIMCO, our goal is to be both rigorous and nimble, and build equity portfolios that can withstand times of stress, while maintaining our long-term outlook: always seeking to buy good companies with positive long-term earnings growth prospects. We want to offer our clients a diversity of investment styles and strategies geared to provide diversity and stability through different market environments. And that is what we will continue to focus on in 2015.