Investors love a good narrative, a story spinning together economic and financial market trends into a cohesive whole.
Turmoil, such as that we experienced in the first quarter of 2016, is common when the narrative suddenly changes, as we suggested it would last quarter. We see a new spin for a new cycle emerging for the balance of 2016 and beyond.
Reversals of some recent themes
For the past four years, the dominant narratives were captured in phrases such as lower for longer (interest rates, growth rates, capital market returns, inflation). The consequences of a low growth environment rewarded finding growth stocks in growth markets, particularly in strong currency countries, such as the United States. We felt last quarter, as now, that most market participants expect the U.S. dollar to strengthen while commodity prices and emerging equities fall further. It turns out our out-of-consensus stance has fared well so far.
Starting in February, a U.S. dollar reversal—from strong to weak—started stabilizing commodity prices and firming emerging-market equity and bond prices. Even gold, which presumes to preserve value against a declining U.S. dollar, staged a remarkable comeback. To be clear, we're still not calling for a major secular trend reversal, but we do see a cyclical stabilization that runs counter to the long-term secular decline in commodity prices and emerging-market commodity exporters.
This trend change is not quite a story of enduring love for the out-of-favor cyclical stocks, but it is more than a fleeting tryst. Investors are looking at beaten down value stocks in old cyclical sectors-mining, base metals, oil, and industrials. After more than eight years of growth beating value, the narrative is changing.
Equity multiples: higher for longer?
Amid the gloom of low growth and low expected capital market returns, there is one other contrarian idea that may have to make its way into our narrative: the potential to enter a regime of permanently higher equity multiples. To explain, sovereign bonds, particularly those with negative yields, are grossly overvalued. Valuations of equities and their close cousins, high-yield bonds, are fair, and in the case of some value sectors, they're on the cheap side of fair. Bond and equity values typically converge, or in industry parlance, mean revert toward each other. In a low inflation world, the tale or spin for the new cycle may be a return to animal spirits, a major rotation out of the over 30-year bull market in bonds and to a regime of permanently higher equity multiples. If so, the new spin cycle will focus on higher long-term equity returns.
The precursors of stronger economic activity and the potential for an expanding global recovery are showing up in the United States, Europe, and Japan; moreover, China is stabilizing. Global surveys of service sectors remain in strong expansionary territory. We believe that persistent deflationary pressure results in underreported economic strength. Global economies are churning through higher volumes of output than are reflected in the standard index measures. As a result, we're starting to focus on some of the more downtrodden areas of the capital markets.