Major crises often legitimise and cement radical policy changes. The 2008 Financial Crisis allowed quantitative easing to become accepted and in time to become mainstream. The current crisis has legitimised government deficit spending – financed by central banks. This policy shift may be a reflection of a change in societies’ priorities. The implications for nominal GDP, equities and bonds could be profound.
This recent policy change is the final step in a two part process. Quantitative easing had to be established first in order to facilitate this level of deficit spending. But this second step is more significant for markets than the onset of quantitative easing. Big government deficit spending likely underscores a broader shift in societies priorities, between price stability on the one side and full employment on the other.
These seismic policy shifts occur rarely, with the last taking place in the late 1970’s. The Humphrey Hawkins Act of 1978 gave the Fed a dual mandate of both full employment and price stability. This legislation proved to be a radical step – because in practice – full employment became subservient to price stability. Managing inflation was primary, full unemployment was secondary. A very strong economy was now perceived as a danger, since low levels of unemployment could create wage inflation and drive prices above the Fed’s target. In order to manage this risk, the Fed would deliberately create unemployment by lifting interest rates. With the management of inflation confirmed as the primary driver of policy in the early 1980’s, bonds began the greatest bull market in history.
For the last 40 years there have been very few voices questioning the logic – or the ethics – of the primacy of price stability over full employment. The excessive inflation of the 1970’s ran deep in the public consciousness and it was accepted that defeating inflation was more important than maintaining full employment. Today, priorities are changing. Inflation is no longer seen as a threat, whilst the human cost of high unemployment is obvious for all to see. Today’s paradigm shift appears to be that full employment is gaining primacy over price stability. Higher inflation may be acceptable to our society if it serves the goal of increasing employment.
This turning point in our priorities and policy occurs when markets have reached two polarised extremes. On the one side are those companies benefitting from low nominal growth. These companies are perceived to operate in disruptive technology and have non-cyclical characteristics. Many of these companies faced minimal disruption during the pandemic. The weaker the growth outlook – the more scarce it became – the more attractive these growth companies appeared. The combination of this scarcity premium and rock bottom interest rates has allowed for all-time record valuations for this part of the market. These record valuations should not be surprising. The tailwind for secure growth equities started 40 years ago and has run fairly constantly, until now.
On the other side of the equity market are those companies exposed to the economic cycle. These businesses have faced disruption not only due to the current crisis, but also due to the low levels of nominal growth in recent years. As pessimism about nominal growth has deepened, the discount for these companies has widened. Given a lower visibility of earnings’ growth, these companies tend to have a shorter duration and have not seen their valuations rise with the decline in interest rates. Given the policy headwind for these companies also began 40 years ago, it is not surprising that there are deep value opportunities to be found in this area of the market.
In our analysis, the opportunity of the coming decade is to exploit this polarisation in valuation and enjoy the tailwind of this policy shift. Higher government spending means higher nominal GDP. Higher nominal GDP means higher cyclical earnings growth. If nominal earnings growth is easy to find across equities, the case for the scarcity premium for secure growth companies disappears.
The case for the LF Lightman European Fund and for value in general is simply that there is no need to pay such record valuations for earnings growth today. Earnings growth is available across the market at much cheaper prices than is available in secure growth stocks.
Whilst this is the big picture, there are of course numerous individual supportive drivers for many value stocks in Europe. The clean energy transition is a secular driver for many “old economy” companies in materials, autos, industrials and power generation. European banking consolidation and the stabilisation of interest rates and regulatory capital are also powerful drivers.
There are tentative signs of value recovering in Europe in recent months. This makes sense. Policy is shifting from headwind to tailwind. It has been many years since investors have faced valuation risk, where high price contributes to increase risk and low price helps to reduce risk. We believe the conditions are aligning to bring the return of valuation as a key driver of markets over the coming decade.
Sources: Lightman, Bloomberg, Howard Mason (Renmac), Don Rissmiller (Strategas) – January 2021
Risk: Past performance is not an indicator of future performance. The value of investment might fall as well as rise.
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