Ron Temple, head of US equities and co-head of multi-asset investing at Lazard Asset Management, predicts the strong bull run will continue but sees protectionism, and escalating tariffs from a trade war between the US and China, as a lurking danger.
At the AIST Superannuation Investment Conference to be held in held in Hobart on September 3-5, the US fund manager will explain why he is more positive on the health of the world’s biggest economy and financial markets than many of his peers.
“Between monetary and fiscal policy, I think there is good news ahead,” Temple says in an interview held in advance of the SIA conference.
“The Fed U-turn has been anything but graceful, but they’ve finally got it right,” Temple states, referring to the US Fed cutting the federal funds rate by 25 basis points at the end of July.
“I can’t see why the stock market can’t give us mid to high single digits for the next few years with real GDP growth of around 2 per cent.”
Effectively, he adds, monetary policy is squeezing people up the risk curve.
“I think it is one of those rising tides that lifts all boats.”
Temple is not saying this story will necessarily end well in the long term, but he does believe prices for equities, bonds and unlisted assets will rise higher in the next one to two years.
The fund manager prefers equities as an asset class, over debt. He does not believe investors are adequately compensated for rate risk in developed market sovereign debt markets or for credit risk in developed corporate markets.
“I recognize that there could be further short-term gains as investors reach for yield and spread, but taking a 12 plus month view, I would prefer to be exposed to equities in companies with high sustainable returns on capital, strong balance sheets, robust cash flow and attractive valuations.”
Deterioration in corporate debt
One of his biggest concerns is that in the desperation for yield, the market is seeing a serious deterioration in underwriting, especially in the corporate space.
The US high yield bond market has approximately US$1.1 trillion of outstanding debt. There is approximately US$2.7 trillion of triple B-rated corporate bonds.
It is easy to imagine a scenario, Temple goes on to say, in which over US$500 billion of investment grade bonds could be downgraded to “junk” status, causing a significant dislocation in the high yield bond market (ie spreads would likely gap wider to accommodate the downgraded bonds).
“If you do get a downturn and you do start getting these fallen angels it’s like throwing a bolder into a birdbath since you have so much scale that could be downgraded that you could potential see a pretty serious gap risk in terms of credit spreads gapping.
“This is where markets actually create a recession because it doesn’t take much of that spread widening for people to de-risk their portfolios which, in turn, feeds on itself with more widespread widening.”
But he stresses that investors are unlikely to face this prospect in the near term. For Temple, it is something to keep an eye on.
Much of his optimism is due in the strength of the US labour market and the continued improvement in household finances.
“With unemployment at 50-year lows and under employment at multi-decade lows that should at some point lead to further acceleration in wage growth,” he notes.
Temple argues that economic expansion typically ends with some kind of inflation ramp either because central banks feel the need to hit the brakes, or because they can see an asset price bubble.
“But there are no signs of either,” he says.
“It looks like a really abnormal expansion in that we don’t have the inflation you would expect.
“The economy is running hot and pulling people back into the labour market.”
Clear and present danger
Protectionism, though, is a clear danger. According to Temple, populism in the US was born out of economic stagnation, frustration and disfranchisement. “It took 30 years to create and it isn’t going away any time soon.
Temple says investors outside the US fail to realise that China is now viewed by both sides of politics in the US as a national security threat even though the China issues first started out being about market access, intellectual property and trade deficits.
Consequently, he says, investors should be taking protectionism much more seriously and start fully appreciating that trade wars poses a material threat to corporate earnings growth.
“Tariffs slapped on China thus far are on capital and intermediate goods. Consumer goods have remained largely untouched. But, if additional tariffs come into play on consumer goods on September, they will become far more visible.”