Five years and counting

Five years and counting

Posted on 12 March 2014

In the language of game theory, there is a clear dominant strategy.
The Russia/Ukraine crisis could arguably develop into the biggest East-West standoff since the Cuban Missile Crisis, but the S&P500 is at another all-time high as we write. Is this (yet) another instance of financial markets losing their grip on  reality? We think not. We cannot pretend any great insight to the likely evolution of the crisis itself. Beyond the basic points to be made about trade links, gas pipelines, banking exposure and the like, the factors that will shape it are beyond the reach of armchair warriors and instant experts, and unpredictable even to seasoned local observers. The senior protagonists themselves probably don’t know exactly how they will act and respond.

We do judge, however, that the balance of probabilities favours eventual resolution (although nothing can make good the human costs already incurred). Our judgement is based, we hope, on economic realism: self-interest is a powerful motivator, and Russia and the West have far more to lose than gain from any escalation. In the language of game theory, there is a clear dominant strategy. Of course, in this centenary year we have a duty to remember that awful multi-power blunders have been made in the past. But strategic ties may be looser today.

If European gas supplies are not interrupted, and Russian banks and companies are able to continue their day-to-day business, the global economic outlook may not be affected materially (just as it hasn’t been by the even grimmer events continuing to unfold in Syria). And that outlook is not a bad one after all: the last week has seen the US manufacturing ISM survey and payroll report stabilising after a wobbly New Year (as we’d thought they could), while survey data suggest the euro area recovery remains sufficiently on track to deter the ECB from delivering the rate cut we’d expected.

We’ve been happy to give the US economy in particular the benefit of the doubt because the economic pride that usually comes before a cyclical fall has been missing: there are few obvious excesses to correct. The private sector’s financial surplus – its free cashflow – was still at above-average levels in 2013. Regular readers will not have been surprised to see the official data this week confirm that the increase in US consumers’ net worth in 2013 was equivalent in scale to the GDP of China.

Meanwhile, stocks are not particularly expensive if, as we expect, economic growth is going to underpin corporate earnings. Plausible prospective PE ratios for developed stocks are perhaps a standard deviation above their 10-year trend; price/book ratios are in line with theirs. Those 10-year trends are not especially elevated. As we’ve noted here often, more esoteric measures such as Tobin’s Q and long-term cyclically-adjusted PE ratios (CAPEs) don’t tell us much more statistically than stock prices alone. The last five years have seen one of the biggest stock market rallies ever, and it ought not to have been a surprise. The best is behind us, but it may not yet have run its course.

Kevin Gardiner, Chief Investment Officer, Europe

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