Stubbornly optimistic equity markets

Luc Synaeghel, CIO 2016-12-09

Having begun 2016 in an extremely pessimistic mood, equity markets are ending the year on a high note. Brexit vote, Trump election, OPEC agreement to cut production (pushing the oil price upward), political disruption in Italy: no event has been “bad” enough to derail the upward march of most equity indexes for more than a few hours or days.

The extent to which western growth profited from two years of low oil prices is open to debate. Some would argue that the benefits never materialized. But perhaps the underlying situation was worse than anyone realized, and low oil prices helped avert a recession? In any event, rising oil prices will be a headwind going forward. A consumer who pays less for energy can choose to spend the windfall on other items or to save it. But when energy prices rise, that same consumer has no choice but to fork out more dollars. As such, higher oil prices stand to hamper economic growth, as well as corporate profits – outside of the energy sector.
The future trajectory of the US economy and earnings is, however, difficult to predict. Beyond rising oil prices and rising wages, other adverse winds include possible protectionist measures (depending on the congressional support that President Trump can summon) and higher interest rates (depending on how far the Federal Reserve is prepared to let inflation run up). Blowing in a positive direction will be the tax cuts promised by the President-elect, as well as the expected launch of an infrastructure spending program in the latter part of the year.
At this point, analysts expect S&P 500 earnings to grow some 10% in 2017 which, all other things being equal and assuming actual valuation is “correct” (at a price-to-earnings ratio of 21x !), would justify 10% price appreciation at the index level. As we write, half of that potential has already been discounted by the US market – and we were never granted the lower entry point that we hoped for in the aftermath of the election.
Turning to Europe, higher oil prices will obviously also be a headwind. But, with deflationary scares only just dissipating, a looser labour market and a still very interventionist central bank, should the upward pressure on interest rates and the negative effect to corporate profits not be lesser that in the US? Sadly, we find it illusory to hope that European yields will not follow suit as their US peers climb. Not only is the European Central Bank reaching limits in terms of what paper it can find to purchase (and therefore had to change some of its buying restrictions this week) but natural arbitrage forces will lead European bond holders to switch into higher yielding US bonds – pushing European bond prices down (yields up) and keeping the euro weak in the process. As for the looser labour market argument, remember that wages are less market-determined on this side of the Atlantic. They are more the result of negotiations, often confrontations, with workers. In the present political climate, we would wager that many European governments will not be opposed to letting wages move up – further compromising the outlook for European profits and equity performance.

OPEC MEMBERS AGREE ON PRODUCTION CUTS

OPEC members proved true to their September word. At the close of their November 30 meeting, a production cut of 1.2 million barrels per day (mmb/d) was announced, to be complemented by reductions of 300’000-600’000 barrels per day by non-OPEC countries (notably Russia, said to have been a key facilitator of the agreement).
OPEC or not OPEC, excess oil inventories have been on a downtrend since April already. Put differently, oil consumption already exceeds production. The OPEC measures will only serve to accelerate the disposal of excess inventories – meaning that the oil market should reach equilibrium sooner than projected. Provided OPEC members honour their commitments, we now put that point somewhere in the middle of 2017 (rather than at year-end or in the early months of 2018).
While the oil price benefitted from the OPEC deal, it did not appreciate as much as might have been expected for a commodity that risks being short of supply within a year. This tempered reaction is attributable to hedging by large shale oil producers. Financially crushed by the oil price weakness of the past two years, US tight oil producers with costs under USD 50 per barrel took advantage of the news to lock in selling prices for their 2017 production.
Hedging next year production at ca. USD 53 certainly makes business sense for US shale companies. With a USD 60 barrier that will be a challenge to break, the 2017 average oil price will probably not be significantly higher than their locked-in price. They are thus giving up limited upside, in exchange for downside protection should OPEC producers not deliver on promises.
Assuming half of the shale producers are actually in a position to hedge (i.e. their production cost lies below market price), the selling of some millions of barrels of future production needs to be absorbed by the market before the oil price can resume its upward climb – probably a matter of weeks only.
Sometime next year, when the oil price approaches USD 60, and more shale producers reach their breakeven level, another bout of such hedging is likely. Reinforcing the near-term cap on the price at that point should be a resumption of production, as tight oil companies begin to tap into their large pool of Drilled but Un-Completed (DUC) wells.
All told, the upward march of the oil price should take the form of a staircase, with the larger upside really beginning in 2018. Similarly, energy stock prices are bound to move up in steps. At this point, given their strong recent performance and the large weight that they have come to represent in portfolios, we are looking to take some profits on our holdings.

EUROPE IN POLITICAL TURMOIL

Ongoing European politics remind us of the “Lech Walesa” period in Poland, with shipyard strikes having been replaced by populist/anti-elite votes. Rather than protesting on the streets, citizens are using their first democratic opportunity to cast discontented ballots – with unusually high participation rates (Italian leader Renzi was ousted not only by a large majority, but by a large majority of a large majority).
In the Soviet era, the reaction to the people’s dissatisfaction were glasnost and perestroika policies. Russian authorities understood that something had to give but moved too slowly. In no time, they were overtaken by the people and the communist regime was gone.
Today’s European leaders find themselves in a similar situation, talking but not acting fast enough or in a meaningful way. And it is not just a matter of institutional bureaucracy. Even within a large union of 28 countries, two or three strong leaders with clear goals could manage to achieve a form of unity. The candidates for such leadership are unfortunately all embroiled in domestic political tensions – save perhaps for Germany. But, for all her qualities, Angela Merkel has shown herself over the years to be a follower rather than a true leader: she tends to repair, rather than build.
Fears that the European construct could collapse, just as the USSR did a quarter of a century ago, thus appear legitimate. Indeed, 2017 could well be a crucial year for the existence of the European Union in its current form. The difficulty though, as the USSR downfall teaches us, lies not in recognizing that a system is flawed but in taking the appropriate measures.
For the time being, (too) much responsibility is left to the European Central Bank, in whose almightiness financial markets still appear keen believers. How else to explain the relentless upward progression of equity indices?
Investors appear blind to the political turmoil, ignoring “impossible” electoral outcomes until they actually do occur and then simply brushing aside their negative consequences. While this attitude could well go on for some more months, we caution that reality checks likely lie ahead.
We will try to surf this wave of inexplicable optimism in the short term (in balanced portfolios only) but have recently also upped our exposure to volatility-protecting instruments. With difficult Dutch, French and German elections lying ahead, it would be very surprising for financial markets to remain “dead calm”.