Developed Equities update
Posted on 20 July 2015
In spite of the announcement of a historic deal to bring Iran back into the international fold and widening cracks in the current Greek administration, the most recognisable fingerprints on capital markets this week were those of central bankers. Both the Bank of England and the Federal Reserve are now more firmly hinting that higher interest rates are on the way – borrowing costs across the curve rose in both regions over the week while both sterling and the dollar surged against the euro. For the moment, equity markets seem to be too busy basking in the admittedly pretty toxic afterglow of the Greek government’s chaotic capitulation. However, we’ve warned for some time that the more durable source of volatility for capital markets is likely to come not from Greece, but from the market’s changing estimations of the path of interest rates in the US economy in particular and this remains the case. That we are still suggesting that clients, of appropriate behavioural personality and risk appetite, continue to lean portfolios towards developed equities speaks to our continuing belief that rising corporate profits are still likely to be the dominating influence on returns over the next 6 – 12 months.
Developed Equities – conflicting forces
We expect to see a pick-up in global activity in the second half of the year, driven by a US economy characterised by normality in all but the current level of interest rates. Taken in isolation, this should be good for corporate profits growth and therefore equity markets performance. However, this increasing economic pep will likely continue to be accompanied by a little less pessimism on the prospects of inflation and therefore higher borrowing costs across the curve. It is worth remembering that while central bankers on both sides of the pond are currently promising a very shallow path of interest rate rises, this may not be a promise that they are allowed to keep if inflationary pressures pick-up a little as we suspect. In any case, most of the time, big turning points in interest rates are usually driven by economic developments and their accumulating impact on money and bond markets, not by central banks. As businesses and consumers spend a higher proportion of their income, lower savings ratios can begin to squeeze money market rates and bond yields higher. Central banks preside over this, and effectively rubber-stamp the process with their own policy rates, but they are not usually the prime movers of it.
Anyway, many worry that higher interest rates will see equity markets suffer as the estimated current value of future corporate cash flows is crimped by a rising discount rate. For our part, we see the threat to valuations as a little less immediate, as explored below in more detail – we still see rising corporate profits as likely the more dominant factor.
Discounted cash flow
Theory suggests that a company’s share price (and therefore that of the equity markets) should encompass all of the future cash flows that this company will generate discounted back to a present value. Within this equation, there are three important moving parts: the expected growth this company or index will generate over its life, the level of profitability the company can sustain, and how to adjust those future cash flows to factor in the risk inherent in having to wait for them.
First of all, what sort of growth rate should we assume? Looking at earnings from the US stock market, the average over the last 50 years is close to 7% (geometric). However, for our purposes it is probably worth erring on the conservative side – 4% is the geometric average of the last five years.
In terms of profitability, the US 10-year rolling average return on equity is around 14%, but to give ourselves some wriggle room, we move to a standard deviation below the rolling average trend which currently sits at roughly 13%.
Adjusting these forecast future cash flows in order to bring them back to the present day, we need to filter them through a discount factor that adequately compensates us for the uncertainty of the time spent waiting for them.
This is a two-stage process because, first, we could spend this time invested in less risky assets and enjoying the returns that they would generate for us. For this, the US 10 year treasury is still the best proxy, but we shall again be cautious by assuming that we are looking not at the still depressed yields of today, but a normalised yield of 4%. Remember that the higher the discount factor, the lower the present value of those cash flows.
On top of the risk-free rate, we need to add an equity-risk premium, (a figure that describes the extra return that investors demand for taking on equity risk). A plausible measure might be 4%.
William Hobbs, Head of Equity Strategy, Europe