Equities could deliver “jaw-dropping returns” over the coming years, according to CrossBorder Capital, which said that the recent fall in valuations is completely out of proportion to the impact of the coronavirus pandemic on future earnings.
The fund manager said equity market movements are driven partly by emotion and partly by value, based on discounted future cash flows. Yet it pointed out that the first two years of future cash flows only account for 11 per cent of the value of a business, while for a growth stock, this figure is less than 4 per cent.
“In short, most of the ‘value’ lies in more distant future prospects,” it said.
“Clearly, if a business fails it has no future, but for the vast bulk of firms, this will not be true.”
Emotion also plays a huge role in asset valuations, which is typically expressed through risk premia – the amount by which a risky asset is expected to outperform the known return on a risk-free asset.
CrossBorder said the best measure of raw emotion it has found is investors’ risk appetite, which it defines as the degree of skew found in asset-allocation decisions between risk assets (such as equities) and safe assets (such as cash and government bonds).
The group pointed to a graph of asset allocation versus world economic growth, which shows investors tend to become too aggressive in risk-on periods and too cautious in risk-off periods – and said that arbitraging these swings of emotion can be extremely profitable.
Source: CrossBorder Capital
“From past experience, whenever the Risk Appetite Index is below the -40 index threshold, subsequent two-year ahead returns average +33 per cent,” it explained. “Latest readings show a swing into extreme pessimism with an index reading of -79.9. Such a reading has never occurred in the long data period since 1978.”
CrossBorder said it has other “dangerous” views that run contrary to the current consensus. Another one of these that makes it more optimistic relates to the $6trn worth of global stimulus, totalling around 6.5 per cent of world GDP. This is equivalent to around a one-third increase in the $20trn pool of central bank money.
“Many of the currently depressed pundits should start counting,” it added. “Assuming a standard liquidity multiplier of around 7x – it could be even more because regulators have further freed up capital constraints to the tune of around $500bn – then this implies a $45trn boost to global liquidity.
“This could ultimately push global liquidity higher by as much as 40 per cent, taking it to a record-setting 205 per cent of world GDP.”
Another consensus view is that the dollar will continue to strengthen, which is bad for world growth and tends to hit emerging markets particularly hard as many of these economies borrow in the US currency. The dollar is up about 7 per cent against the pound this year, yet rather than move higher from this point, CrossBorder believes it may have already peaked.
Performance of currencies in 2020
Source: FE Analytics
“Clearly the swap markets are technically ‘short’ dollars, given the huge prospective debt roll-overs required and the likely reduced willingness of US dollar holders to remain on the offer,” it said.
“However, we believe much of this is in the price and so we are still less convinced that the US unit will rise from here.
“In fact, economically, the US real exchange rate needs to fall from current levels to help to rebalance the US economy. What’s more, the US dollar fell after the 2008 financial crisis and did so largely because corporate cash flows skidded lower and Fed supply blasted higher. Same could happen again?
“The subsequent strength of the US dollar since then owes something to progressively tighter Fed policies, but much more to the strong pick-up in US dollar demand as the world and US economies then rebounded.”
The group pointed to a chart breaking down capital flows into those created by the Federal Reserve through money-printing and those taken up by the private sector. When the private sector demand exceeds the Fed’s supply, the dollar typically rises in value over the following 12 months, as demonstrated by the Forex Risk Index. When this measure is falling, it indicates that the momentum of the trade-weighted US dollar is rolling over because the Fed’s supply is rising more rapidly than private sector needs.
Source: CrossBorder Capital
“We conclude from this that the US dollar looks close to a peak,” it finished.