From Russell Napier of ERIC [9] [9]
No man is an island even when she's a woman
Can the US economy ignore or even benefit from the winds of deflation blowing from offshore? With a current CAPE (Cyclically Adjusted PE) in excess of 27X, the US market is clearly answering this question in the affirmative.
It is worth pausing to ponder just how much this optimism for a US de-coupling has already been reflected in prices. The Solid Ground was very bullish on global equities from 1Q 2009 to 1Q 2011, but then turned bearish, believing that QE was insufficient to prevent deflation. The failure of QE to generate ever higher inflation is now a matter of record, but very clearly US equities cheered this failure and the need for continual QE from 2011 to 2014.
U.S. AND THEM
However, this cheer in the face of lower inflation has been very much a US phenomenon. The table below shows the performance of various global equity classes, in US$ terms, from their peak levels in 1Q 2011
Performance of Global Equities From 1Q 2011 Peaks (US$)
- FTSE All World Index (Capital) +17%
- FTSE All World Index (Total Return) +29%
- FTSE All World Index ex US (Capital) -7%
- FTSE All World Index ex US (Total Return) +4%
- FTSE North America Index (Capital) +47%
- FTSE North America Index (Total Return) +60%
SOME EQUITIES ARE MORE UNEQUAL THAN OTHERS
In the past four years there has been no bull market in non-US equities. This is even more striking when we consider the massive expansion in the Bank of Japan’s balance sheet since 2011. This has lifted the Nikkei just 10% above its 2011 highs in US$ terms. Commodity prices peaked just a few months after equity prices in 2011. From the peak in April 2011 the CRB index has now fallen 38%. The gold price has fallen 37% from its peak in September 2011.
An investor buying a basket of US Treasuries (7-10 year maturities) when equity markets peaked in February 2011 has seen a total return in USD of 26%. The decline in inflation and the growing threat of deflation has been good for bonds compared to equities and commodities, as one might expect. There is, however, one major exception --- US equities.
THE GREATEST CAPE
So for those investors who believe that US equities can buck the deflationary trend, let’s make it clear that they already have. Of course, they can head higher still. The CAPE had reached its current level of 27X in 1996. This was a level of valuation only previously recorded in 1929. From 1996 to its peak in 2000 the S&P then doubled! The S&P sailed higher through the Asian economic crisis which began with the devaluation of the Thai Baht on July 1st 1997. Only in July 1998 did events outside the US create any major setback for US equities, as the bankruptcy of Russia and LTCM threatened the stability of the US banking system. The S&P500 fell 20% in the summer of 1998 but was soon heading to new highs as a rescue ensured creditors to LTCM were made whole and the Fed funds rate was cut from 5.5% to 4.75%.
CAPE FEAR?
For many the Asian crisis of 1997 and the deflationary crisis outside the US signals provides a playbook for today’s market. But it already had produced a major outperformance and, crucially, real interest rates are much more likely to spike today than they were in the late nineties. From its peak level of inflation, of 3.3% in December 1996, it then declined to a low of 1.4% in March 1998. In that period the Fed Funds rate started at 5.5% in early 1997 and was cut to 4.75% in the following year. Real rates of interest rose but, of course, the market was very aware that the Fed Funds rate was at 4.75% in 1998 and there was a long way to go to zero.
Things are very different today. The Fed Funds rate is at 0.25% and inflation is at 1.3% and likely to head lower as the full impact of the recent oil price decline works through the economic system. So real rates will rise but, even more importantly, the market will realise that the Fed’s ability to manage real rates is much weaker than it was in 1998.
CAPE ABILITY BLOWN?
With nominal rates basically at the zero bound, the Fed’s ability to control real rates is based on its ability to generate inflation. Inflation’s decline from 3.9% in September 2011 to just 1.3% today means that there must already be questions as to how effective QE can be at delivering on this part of the bargain.
Will the US economy and the US equity market behave in 2015 as it did during the deflationary scare generated by the Asian economic crisis and its fall out in Russia and elsewhere? Well, think of 2013 and 2014 as similar to that period from July 1997 to July 1998 when the US equity market ignored the deflationary threat being priced into other markets. Now ask what monetary policy options there are if we have a similar scare to that which brought the S&P500 lower in the summer of 1998.
CAPE CALM AND CARRY ON?
If you are happy that a return to QE will reassure the markets that the Fed is in control of real rates, then you should probably buy US equities. However, this analyst is much more concerned that the Fed’s failure to boost inflation and control real rates of interest after almost five years of QE will show up the inadequacy of monetary policy to reflate the world and inflate away debts.
In particular, if the key deflationary forces are seen to be generated far from US shores, investors may well ask how the Fed’s purchase of US assets can produce a major shift in the global supply and demand imbalance for goods. When investors last asked this question the CAPE was at 13X!
