Next year will be different

MFS strategist Robert Almeida summarised it best in his latest reflections: "Investing is simple, but hard".

Those who had been expecting logical, straightforward outcomes for financial assets in calendar year 2019 have been hit with multiple surprises as the year went by.

One of the biggest surprises, no doubt, is that the year that saw corporate earnings growth grind to a halt in the USA, with Australian dividends going backwards on top of falling profits, while there has been no tangible progress in the conflict between Washington and Beijing, yet also witnessed share market indices surging to new all-time highs, with short term momentum pointing further upwards.

This ain't normal, is it?

Well, according to Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, global equities don't seem overvalued, but rather fairly valued and there are no signs bond yields should be surging higher any time soon.

Siegel's view, which usually swings between mildly optimistic and outlandishly bullish, is based upon the observation that financial markets function differently in a world of persistently low interest rates. In simple terms: equities have become the main attraction for income-hungry investors whereas government bonds are now being used to hedge against negative risks.

Irrespective of whether one agrees or disagrees with Siegel's optimistic outlook for equities in 2020, maybe the more important question is whether things are genuinely different this time, and if so, whether investors can expect things to revert back to the old normal?

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Share market experts and commentators like to talk about the longest bull market in history, but nowhere has the equities bull market been as consistent and as profitable as in the USA. At face value, this is easily explained by what investors casually refer to as "market fundamentals".

In practice this means: American companies have shown better growth than their foreign counterparts. It seems but fair their share prices have outperformed the rest of the world. Add bond yields persistently near historically low levels and it should be no surprise equity valuations have moved beyond historical averages too.

The fact US utilities and infrastructure stocks have become a popular go-to destination for investors worldwide seems to combine all the important themes that have dominated this bull market since 2012: income plus growth.

Behind the scenes of it all, there is one ingredient to the secret sauce that receives far less attention: the fact that American companies have used this new environment of exceptionally low interest rates and bond yields to buy back their own shares and leverage up their balance sheets.

It has been dubbed "financial alchemy" by some of the more critical bystanders. One of the direct consequences is that American share markets have shrunk in recent years (less shares available to invest in), which could explain why markets kept rising while investors have been withdrawing more funds than directing them towards US equities.

Note: post 2012, every single year has seen the US share-count shrink compared with the year prior, including 2019.

Buying back shares also improves the apparent growth in earnings and in dividends. American companies have been far more proficient in using these financial tools to accommodate shareholders (and C-suite bonuses). At the very least, this additional piece of insight suggests American companies are a lot less superior than their peers in Australia and elsewhere.

This also opens up an interesting dilemma. At what point does this financial alchemy become exhausted? American companies have continued to apply their financial tools throughout 2019 yet there has been no earnings growth for US corporates in aggregate. A recovery in global growth, from depressed level this year, might provide some stimulus next year, but how much longer before there is no more magic sauce to be added?

In addition, this raises a lot more questions about the risks for corporate balance sheets in the US if/when the environment changes and higher interest rates alongside bond yields rising become the new normal again.

In a recent update on this matter, analysts at Citi highlighted some 25 companies in the US are responsible for nearly 50% of all buybacks. They anticipate US Financials are next to join in.

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The US experience thus far once again highlights one fact that usually escapes investor attention: the superior investment strategy when bond yields are low and corporate profitability is challenged is achieved through combining yield/income with growth. It's not either, it's both.

Recent analysis by analysts at Citi shows a global dividend momentum strategy (picking dividend paying stocks that enjoy positive growth momentum) would have outperformed the MSCI All-Country World Index -an oft used proxy for global equities- by no less than 13% since 2010.

This strategy does not solely involve high yielding stocks. In Australia, it would include Goodman Group as well as Aristocrat Leisure and CSL as opposed to regional lenders and the Big Four banks, AMP and Challenger Financial who have all at best kept their dividends stable and saw their share price underperform noticeably.

Remarkably, on Citi's assessment, taking guidance from dividend momentum now would continue to favour US equities over the rest of the world (Australia is one of few countries where dividends are retreating). Amongst global sectors, Energy and IT look better placed than Materials, while Healthcare still looks attractive too.

On this specific measure, US equities have outperformed since 2010 because they offered 11% per annum dividend growth over the period. High-yielding Australia, on the other hand, has only managed 4% growth per annum over the period. Since the August reporting season Australia is facing contraction in dividends, as witnessed from banks reporting recently.

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Equally different has been the enormous incremental support provided by central banks from all the major economies around the world, including China. Originally employed to prevent the world from going under post the demise of Lehman Brothers in late 2008, central bankers have increasingly morphed into the world's fire brigade, opening up the liquidity tap whenever economies or financial markets needed additional support.

Everybody is now convinced this never-before-witnessed tsunami in global liquidity has propped up asset prices, from bonds to equities to real estate, while also sharpening social inequality which has led to the surge in anti-democratic populism and political extremism. But what if the global financial system is now addicted to the drug and can no longer function without it?

This time last year the Federal Reserve thought it was mildly tightening and reducing its balance sheet but global equities quickly fell into a bear market spiral. A reversal into renewed stimulus, followed by other central banks around the world, has allowed equities to recover and subsequently gain in excess of 25% (with no profit growth in Australia and the USA).

Does this imply we can never go back to what it was pre-2008?

Equally important: can we count on financial banks and their liquidity taps indefinitely to keep solving all problems, including preventing equity bear markets and economic recessions forever? Is this now an integral part of the New Normal?

Within this framework, it remains remarkable the Federal Reserve is having difficulties to sooth the repo market where US companies turn to for short-term lending. When the first signals of problems occurred back in September, the official mantra was this was nothing unusual and would simply be taken care of via the injection of extra funds by the Fed.

Almost three months later, the Fed has injected US$300bn and counting, but the repo market won't settle down. Is this the first sign that showering the world with sheer endless liquidity is creating unforeseen problems?

Nobody knows, but the world is watching.

Of course, the other Big Elephant in the room is that global debt, in aggregate, continues to rise, year after year after year. By the end of 2019 global debt is projected to accumulate to more than US$255trn, with no end in sight to it further accumulating next year. Forget about paying back this debt, what are the real consequences and can the world simply keep on functioning as if it wasn't there?

Macquarie analysts recently spelled out the bad news: any time the world attempts to constrain debt, GDP growth rates rapidly fall-off. Something else fundamentally has changed too. Whereas in the 1970s and 1980s one extra dollar in debt translated into an extra unit of global GDP, nowadays the global economy requires four to five units of debt to generate one incremental unit of global GDP.

One key source for the rapid expansion in debt has been China. The country's debt has grown from US$3.5trn in Q1 2015 to US$42trn by Q2 2019. This is more than three times the size of the Chinese economy and represents by far the fastest debt accumulation ever. So don't count on China to keep bailing out the rest of the world.

One oft mentioned prospect is that when central bankers' policies stop having an impact, governments can step in through fiscal stimulus and infrastructure spending. The key danger here is that those governments won't jump in unless there is a crisis first.

(See Canberra and farmers and fires).

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One of the straightforward consequences of seeing equities rise by 25% without any growth in aggregate earnings per share is that the share market has simply become more expensive, in generalised terms. Price earnings (PE) multiples have risen in the absence of higher profits and dividends and this even applies to the banks whose share prices are higher compared to this time last year.

This might imply that higher profits and/or dividends next year might not be sufficient to push share prices higher. If global growth does recover, as many anticipate, and there are no major calamities, geopolitically or otherwise, bond yields might settle around current level, or even rise a little. This means there won't be an extra kick for equity valuations from lower trending bond yields.

It is for this reason that (some) strategists are advocating investors should redirect their funds into cheaper priced cyclicals and other "Value" stocks. The relative gap between the winners and losers in the share market -between "Growth" & "Quality" and "Value" including energy stocks, miners and banks- has never been wider in modern times.

However, the experience in Australia since September, when this switch started taking place, has been mixed at best. It seems every time investors decide now is the moment to make that switch, something happens to interrupt or even push back the newfound momentum for yesterday's share market laggards.

Strategists at JP Morgan -a fierce proponent for making the switch- recently observed "Value" stocks on the ASX had two of their weakest monthly performances from the past twelve months in October and November. The local banks are greatly responsible for this.

Globally, the strategists highlight, "Value" has had a great time for three months in a row, with global financials (up 12% since September) making a significant contribution. There are differences in dynamics locally and globally for banks, of course. The RBA is still expected to further cut the cash rate and potentially even apply QE in 2020.

With monthly PMI surveys across the globe expected to bottom out, many a professional funds manager has added positions in Energy and Mining. Equally noteworthy is that many year-end 2020 targets for the ASX200 don't reach much further than where the index is already trading at this year.

Strategists at Credit Suisse, for example, on Monday published a target of 7000 for the ASX200 by year-end next year. Earnings growth next year -finally!- will be withered away, they forecast, by a general compression in multiples. Credit Suisse thus advocates investors should have a firm eye on "income" for their investment return next year. Income combined with growth might just remain the best performing strategy, irrespective of valuations possibly deflating in general terms. See Citi research mentioned earlier.

One other potential source of outperformance might well come from stocks that already had their correction from elevated highs. On the premise, of course, that no bad news -like a profit warning or dividend cut- is forthcoming.

Starting with the February reporting season, and irrespective of macro-themes and trends, Australian companies will be tried and tested on their resilience and ability to overcome threats and challenges.

If recent history can be relied upon, High Quality will be ready to shine, though investors would want companies like ResMed, Cochlear, REA Group and Seek to do better than in February this year when strong results were not enough to hold off a period of underperformance. It didn't last long, though.

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Possibly the key factor that has been responsible for keeping positive momentum alive for global equities throughout 2019 has been the promise of a substantial trade agreement and truce between the two economic super powers of the modern era. I am with the sceptics on this one.

If there is any kind of deal between Trump and Xi Jinping, it will involve a minimum of substance. We have recent history to back up such expectation (Canada-Mexico and North Korea). More importantly, I think the schism is too wide, and the issues too numerous and too heavy-weight to expect any deal of substance in the short to medium term.

But markets have held on to an optimistic mindset.

Within this context, the worst possible outcome might still be no deal in the short term. But how much better is a deal that's essentially empty on substance, making markets realise the art of deal making a la Trump is a lot like parading in front of cameras like an Emperor with no clothes.

Summarising all of the above, it would seem the best advice for investors ahead of 2020 is to enjoy the good, but to prepare for the bad and the ugly because it looks very unlikely that next year will be an extension of this year.

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