Author (s): Gordon Ong, Lee Xiang Zheng
| Market Insights | 28 January 2018
Is Blue-chip a Safe Harbour?
As the 2009-2018 economic boom reaches its latter stages, do large companies really outperform small companies?
Feel like you’re missing the boat? You’re not alone. The jaw-dropping meteoric rise in cryptocurrencies – Bitcoin has increased more than 10-fold in value in 2017 alone – has left many investors speechless and sceptical, and still others completely elated. Billionaires are made overnight like the Winklevoss Brothers, famously known for suing Zuckerberg over the idea of Facebook. Every investor wants to hold the correct assets at the right moment, and many analysts make a living recommending different industries to rotate into at the right time.
Generally speaking, although a rising tide lifts all boats, each stage of the business cycle affects different sectors and companies differently. As a result, active fund managers often employ sector rotation strategies as the economic expansion progresses. Right now, it is widely recognised that we are in the late stage of an economic expansion that has lasted for around 9 consecutive years, historically one of the longest-lasting upswings. Similarly to how the “Trump trade” has extended the business cycle, expansionary fiscal policies during the Reagan era did not stop the 1987 “Black Monday” correction caused by equities that were trading at similarly high valuations. The price-to-earnings ratio of S&P 500, a means of ascertaining whether stocks are priced expensively, is currently 26.46, when the historical 100-year mean is around 15 (Fig 1). This is an indicator that the market expects future earnings to grow significantly – so significantly that the US can overcome its natural growth constraints as a mature economy. Is this a sign of investor confidence, or overconfidence?
Fig 1: Multiplr.com Data
In this late stage, big firms historically outperform small firms. In normal economic times, you can expect higher returns by investing in a smaller firm, to compensate for the increased risk that you are assuming. However, in the late stage, things are different. A study done by FTSE Russell of 5 recent expansionary periods (Fig 2) show that this “small cap premium” teethers off and enters negative territory a few months before the peak. Firstly, small companies are more vulnerable to wage pressures and high borrowing costs, which are present typically at the late stage. There are evidence of both currently happening, especially with regards to US and European interest rates. Secondly, large companies are better poised to take advantage of growth opportunities worldwide at this point in time – different markets are at different stages of the cycle, and emerging markets still have much room for growth. A case in point closer to home, Singapore-based companies and banks are seizing opportunities to set up branches in Myanmar to take advantage of its nascent markets.
Fig 2: FTSE Russell Research
The data suggests that large companies perform better during late-stage cycle. But how long should we hold on to them? After all, as can be seen from the Fig 2. chart, the small cap premium can re-establish itself quickly once a recession occurs. Moreover, nobody wants to be stuck holding equities that are trading at high valuations at the start of a recession. While nobody can predict the exact timing of recession, economists have a series of common indicators to indicate when the overall economy is close to its peak. You too could watch out for these.
A key indicator to watch in this current climate is inflation. High inflation would signal that the economy is overheated and has reached a peak. In this scenario, prices rise faster than real wages, causing a slowdown in consumer spending and production costs. In order to counterbalance this price increase, the country’s central bank has to hasten interest rate hikes, thereby increasing the cost of borrowing and slowing the economy. Moreover, the central bank is pressurised to raise interest rates preemptively due to the time lag when implementing monetary policy (ex-Fed Chair Yellen, 2016). This pressure could cause an overreaction, where the central bank hurriedly raises interest rates to starve off any possible inflation that it causes a prolonged recession e.g. During the Japan 1989 economic downturn, Bank of Japan continued to raise interest rates due to concern over housing asset prices, deepening the recession and contributing to a decade-long economic stagnation. Another example from history, the two oil crises in 1973 and 1979, highlight the dangers of high inflation and high interest rates at the same time.
US inflation rates are currently 2% year-on-year, which remains lower than the 10-year mean of 3.22%. China’s inflation rates also tend around 2%. Despite quantitative easing and low interest rates across the world inflating the money supply, global inflation seems to still be kept in check. This is because money from quantitative easing is predominantly flowing into financial assets rather than tangible assets. 2011-2017 saw a massive growth in the market price of financial assets, causing a massive disconnect between Wall Street and Main Street. While the U.S. economy has increased by $1.3 trillion since the March 2009 lows, stock market wealth has exploded by $12 trillion. Since inflation is calculated by the Consumer Price Index, the inflation number naturally remains low despite financial markets being at an all-time high. In fact, because of unprecedented quantitative easing, inflation may not be as good a barometer of an impending market correction as in the past.
Another warning sign is excessive financial leverage, especially in a rising interest rate environment and the ending of quantitative easing policies by major central banks (i.e. treasury bonds bought by the central bank are expiring and no new treasury bonds are being bought). Increasing debt while interest rates are rising creates a double whammy effect on the company’s debt servicing costs. One country to watch out for is China, where the growth of behemoth state-owned enterprises post-2008 were fuelled by cheap debt, and finally their decision to leverage is catching up with them. China’s debt-to-GDP ratio already surpasses that of the United States. Worse, unlike the United States, most of this debt is owed by companies and households, which will more directly affect domestic demand. Another indicator to look out for is the average debt servicing costs, as cheap debt will not affect companies until the debt servicing cost creeps up. China’s debt service ratio for firms is at the highest in 20 years (Fig 3).
Fig 3: CEIC Data
In conclusion, in this late-stage economic cycle, large companies are historically shown to outperform small companies. However, before you allocate all your money into blue-chip stocks, you should think about the upside left in the economic expansion, as well as the downside risks. Research has shown that most of the returns in an economic expansion is contained within the first and final stages – and the market has been performing exceedingly well in 2017 and early 2018.