Where do we go from here?
A new series of interviews from MoneyWeek
In the first of a new series of interviews, Andrew Van Sickle talks to Bill Dinning, chief investment officer of Waverton Investment Management, to assess the outlook for the global economy and markets.
Andrew: Let’s start with the macroeconomic environment. What is your assessment of the banking crisis that kicked off in March and its likely impact?
Bill: We think a systemic banking crisis in America is unlikely. Bank deposits are declining, but as far as we are concerned, instead of a panic this reflects the fact that banks have been very slow to raise the interest rates on savings accounts. Savers are heading to money-market funds or lending to the government for a better rate.
Note that the last time bank deposits (which usually trend upwards with GDP and income, so they tend to rise year on year) fell on an annual basis was 1994, when the Fed was also tightening. What’s more, regulators have erected a strong safety net. Instead of having to sell assets at distressed valuations, the US Federal Reserve will lend money relative to the par value of eligible assets. So there really shouldn’t be a panic here.
Andrew: Can we conclude that tighter credit will bring forward the recession that everyone’s been talking about, but never quite seems to arrive?
Bill: A lot of leading indicators have been pointing to a significant slowdown following all the rate hikes, and if credit is now rationed even more following the banking crisis, that could accelerate or exacerbate the downturn.
For instance, the National Federation of Independent Businesses regularly asks its members, who are small businesses, if it is a good time to expand their operations. In March, 2% thought it was (that was the lowest reading since 1980), and in April the figure was 3%. That question usually produces a score ranging from 1% to 35% and has been conducted since the 1970s.
Similarly, the Index of Leading Indicators and the New York Federal Reserve Recession Probability Indicator (based on the spread between three-month and ten-year Treasury rates), both reliable harbingers of an economic contraction since the 1970s, have been flashing red.
Andrew: What might this mean for US-led global stocks?
Bill: As far as markets are concerned, it’s interesting to note that the US bond market appears to be factoring in a significant slowdown, but equities aren’t. Cheerful equity investors are looking forward to interest-rate cuts (and a lower discount rate, bolstering the value of future earnings and hence valuations).
But they are forgetting that the cuts being factored in from the middle of this year by the Implied US Fed Funds rate curve would constitute the sort of monetary response likely in a recession – with the labour market unravelling and unemployed consumers reining in spending – and the stockmarket does not go up in recessions.
More broadly, Waverton is underweight equities thanks to the threat to earnings in the macro scenario we think is likely to unfold. But we are not massively bearish, as sentiment is fairly pessimistic, and relatively appealing valuations seem to suggest that some scepticism has been baked into earnings estimates: US profits are expected to grow by 1% this year, and global ones 0.9%. That is not a sign of euphoria.
Meanwhile, a widely watched survey, the American Association of Individual Investors’ Investor Sentiment Survey, tells an interesting tale. The percentage of investors who are bullish is a standard deviation below average.
Historically if you buy at these low levels of bullishness you get a double-digit return over the next 12 months. The widely quoted Bank of America Merrill Lynch global fund managers’ survey, incidentally, I pay less attention to as I find it backward-looking. They get more bearish as stocks go down.
Andrew: Shall we take a closer look at valuations?
Bill: Valuations, overall, are reasonable. The MSCI US index is on a forward price/earnings (p/e) ratio of 18.4, compared with a 20-year average of 16.4. But the world ex-US is on a multiple of 13, less than its 20-year average of 14.1. And if you strip out the top ten stocks from the US index, the market is not far off that.
These factors could temper a market downturn, while a broader positive scenario goes as follows. Inflation dissipates as expected, central banks lower interest rates, and later this year investors start to look through the slide and price in a recovery.
So there could be a relatively short shaky period before a market rebound. And in a cyclical economic upturn, Europe, Japan and emerging markets tend to outstrip the US.
Andrew: The outlook for inflation is pivotal. Shall we assess the UK now in the inflation and market context?
Bill: Markets think the Fed is finished hiking, but the Bank of England isn’t. If the market is right about the Fed cutting, the notion that the Bank of England will keep hiking could prove a bit too pessimistic.
There is clearly an inflation problem here, but I doubt whether raising British interest rates further will have much impact. The inflation impulse in the US certainly appears to be slowing, and there is no inflation in China. So if inflationary pressure is abating globally, then at some stage that should help out Britain.
Andrew: So you think inflation is an externally-driven phenomenon.
Bill: Well, I think curbing domestic demand in Britain will have some effect, but it’s hardly on the same scale as curbing the Goliath that is the US consumer. American household spending comprises 70% of the biggest economy in the world. So if the Fed can temper that, there will be a worldwide impact.
The upshot of all this is that we are still overweight UK equities, which remain cheap compared with the rest of the world. The UK MSCI index is on a forward p/e of 10.6, while the MSCI World index costs 15.6 times the next 12 months’ profits. So the British stockmarket is on a 30% discount. What’s more, the defensive nature of the market suggests that it should prove resilient in a downturn, too, as was the case with blue chips last year.
Andrew: Assuming now that inflation doesn’t dissipate as everyone seems to hope, which is MoneyWeek’s key fear, where should investors look?
Bill: If the news on inflation is worse than the market expects, then raw materials are among the few assets where you can find some protection. Gold is still attractive, we feel, even if it is at near-record highs in dollars and sterling.
The overall commodity complex is appealingly valued compared with stocks, and is also a good structural and cyclical growth story. Turning to valuations first, a chart mapping the ratio of the Goldman Sachs Commodity index to the Dow Jones index shows that commodities remain depressed on a historic view.
It is also striking that Apple’s market value will buy you the world’s top 100 miners, three years’ global copper-mine production and last year’s seaborne iron ore – quite a haul. The top-ten miners, moreover, should generate $99bn of free cash flow over the next 12 months, compared with Apple’s $94bn. But the miners are trading at just nine times forward free cash flow, compared with Apple’s 25.
There is plenty of cyclical impetus, too – $2trn is being spent on infrastructure in the US, while governments around the world are upping spending on renewable energy to combat climate change.
Longer-term, new technologies such as electric- vehicles and 3D printing look likely to compound the impact of the climate-change drive and underpin structural growth. Investors can play the theme with the Global X Disruptive Materials UCITS ETF (LSE: DMAT), tracking firms offering metals that are crucial to disruptive technologies, ranging from lithium batteries and solar panels to fuel cells and robotics. On the energy front – we will need fossil fuels to get us to net-zero – Waverton holds Shell (LSE: SHEL) and oilfield services giant Schlumberger (NYSE: SLB).
Andrew: Finally, returning now to the global picture, the past few years have taught us to keep an eye on geopolitics and its ramifications. The one disaster everyone worries about is China invading Taiwan. Is that likely, do you think?
Bill: I don’t think so. The practical difficulties are immense. Only 10% of Taiwan’s coastline is suitable for an amphibious landing. The Germans didn’t have drones and radar that worked in 1944 when the Allies landed on the beaches and didn’t know where we would attack; today Taiwan would be ready and waiting. It would be a bloodbath.
Moreover, the People’s Liberation Army (PLA) is not one of the world’s best armies. It has kept the Communists in power, but their last military campaign outside China was not a success; they merely achieved a stalemate against Vietnam in 1979. The PLA is large and unwieldy. Once you employ well over one million people, it becomes very hard to be efficient.
As for the Ukraine conflict, the only good news is that all the horror scenarios discussed last year, such as running out of gas, have not come to pass. Unless there is a major escalation, it should not move markets.
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