When markets drive the economy, cash flow is king
There was a time, not that long ago, when it was the economy that drove asset prices such as equity and real estate valuations. Today, the causation is viewed, even in policy circles, as running in the opposite direction. It is asset prices that now drive the economy.
There was a time, again not that long ago, when the Federal Reserve cut the overnight rate when it wanted to stimulate the economy and stir investor animal spirits. But policy rates have been zero for nearly four years. The Fed has resorted to unconventional measures for more than three years and the latest move towardsopen-ended quantitative easing is the boldest step yet.
The Fed also believes this will work from a growth-revival standpoint. But the facts speak for themselves: the US equity market has rallied 116 per cent from its trough, the Case-Shiller 20-city index suggests that home prices have rebounded 4 per cent from the bottom. And even with that, the pace of economic activity has remained weak ... and is getting weaker.The Fed has completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates. Therein lies the rub. The economy and earnings are weak, and getting weaker, but the interest rate used to discount the future profits stream keeps getting more and more negative and that, in turn, raises earning expectations. The fact that the S&P dividend yield is triple the yield in the belly of the Treasury curve has also added to the allure of equities, or at least those that have compelling dividend yield, growth and coverage characteristics.
Until 2009, there was absolutely no correlation between the Fed’s balance sheet and the equity market. Now the correlation is at least as deep as it is with corporate earnings and the stock market. I am not convinced all this “wealth effect” is going to be the answer for an economy beset by myriad factors, from labour market stress to re-regulation, from the European recession to a muddled fiscal policy outlook. But there is no question that the Fed can influence asset prices, at least for a while, and that it intends to continue with this policy of perpetual intervention until the unemployment rate gets much lower.
One last point. Ben Bernanke, the Fed chairman, has also said he wants corporate bond yields to come down. While they are at modern-era lows, their “spread” off Treasuries for triple B paper remains attractive.
For the risks involved, especially given corporate balance sheet strength and default rates that have stayed minimal despite the stalled pace of economic activity, this is a part of the capital structure that still looks good.
And remember – this is another part of the market that Mr Bernanke wants to see rally in his quest to promote risk-taking and sanction a further reduction in the overall cost of capital. Again, I’m not sure how far this goes to underpin economic growth but it should help underpin investment returns in this sector.
Perhaps Mr Bernanke et al are deliberately pushing investors into risky assets but the overriding issue is the acceptable level of risk to take on, given the likeliest outcome for the total return potential for any given asset class or security. Being in credit strategies has been a better alternative than cash this year.
As conservative as I have been over the equity market, I have never advocated cash as an asset class. Cash may be the ultimate in capital preservation but it earns you nothing. In a zero return environment – notwithstanding all the financial, economic and geopolitical uncertainties – cash is not king. What is king, however, is cash flow.
Within the equity sector, this means a focus on dividend growth, dividend yield and dividend coverage. This includes Canadian banks and some pipeline exposure. It also includes large-cap US technology, where growth in dividends is second to none.
Another area of the market I like for similar reasons is the precious metals complex, as the supply of paper currency continues to outpace the production of gold, silver and the like and central banks pledge to maintain negative real interest rates. Broadly speaking, gold bullion has significantly outperformed gold mining shares over the past decade.
Recently, though, gold mining equities have finally begun to outperform gold bullion given their attractive valuations, widening profit margins and the fact that management teams are running their gold mining businesses with a much greater focus on cash flow generation. In addition, they are now offering something that is the most compelling feature of the stock market at the current time: a dividend.
David Rosenberg is chief economist and strategist at Gluskin Sheff