Down Under Daily, 13 December 2014

2015: The Ageing Bull Stumbles

After two years of broad-base gains, the bull market stretch target, for sure, but still-dovish rates market
started to age through 2014. Credit was uneven; could be unsettled by what the Fed actually delivers
equities outside the US fell (in US$ terms); next year (Exhibit 2).
commodities were weak; and in the US leadership
narrowed to large caps. Modestly better economic Exhibit 2

growth in 2015 may lead to moderate returns for Nasty If The Fed Even Half-delivers On The Dots
FED FUNDS TARGET, MARKET AND FOMC FORECASTS
equities outside the US, although there are clear, but 4.0 LONG-RUN FOMC MEDIAN 4.0

unpredictable, risks. US equities face a struggle as 3.5 MEDIAN FOMC

MEMBER
3.5

margins flat-line, the Fed starts tightening, and US$ 3.0

FORECASTS
3.0

strength crimps foreign earnings. Here are a few 2.5

EURO-DOLLAR
2.5

%
FED FUND
thoughts on next year: 2.0 TARGET
CEILING
FUTURES 2.0

1.5 DAILY FED 1.5

3M LIBOR FUND RATE

First, the best reason to be upbeat about risky assets 1.0 1.0

in 2015 is that global growth may improve for a 0.5 FED FUND 0.5
FUTURES

while. Falling oil prices will help Europe, Japan and 0.0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
0.0

much of Asia. More importantly, policy makers
have noticed the most blindingly obvious lesson of
the past five years: fiscal policy works. Japan may
delay another growth killing consumption tax hike,
while Europe should take the foot off the fiscal
brake; perhaps even tap the accelerator (Exhibit 1).
Exhibit 1
Europe May Stop Suffocating Growth
EUROPEAN GROWTH AND FISCAL THRUST
6 6
EUROPEAN RECESSIONS SHADED
EURO-ZONE GDP
4 4
2 2
4 QTR %
Source: Bloomberg, Federal Reserve, NBER; Minack Advisors
Fed tightening tends to cause equity de-rating
(Exhibit 3). That does not end an equity rally when
earnings are strong. But earnings are not likely to
be strong next year. Domestic margins are peaking,
buy-backs are largely offset by dilutive option
exercises, and a rising dollar will damp the 40% of
earnings made outside the US.
Exhibit 3
PE Compression Through Fed Tightening
DECOMPOSING 12 MONTH S&P500 RETURNS
50 50

FED
HIKES
40 40
0 0 SHADED
30 30
-2 -2 20 20
FISCAL 'THRUST'*
10 10
12M%

-4 -4
0 0
* 4 QTR CHANGE IN EURO-ZONE BUDGET
DEFICIT. LEADING BY 2 QTRS -10 -10
-6 -6
2000 2002 2004 2006 2008 2010 2012 2014 2016 -20 -20

Source: Eurostat, CEPR, NBER; Minack Advisors -30 RATING (PE) -30
-40 EARNINGS* -40
INDEX * CHANGE IN 12M TRAILING OPERATING EPS
-50 -50
However, growth looks most assured in the US. 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015

More workers are getting paid (a little) more, and
their pay will go further with falling energy costs.
Corporate sentiment seems upbeat, while low oil
prices, if sustained, wont damp US oil production
until the second half of 2015 and 2016.
Second, equities thrived through the tepid growth of
the prior four years while better growth will bring
two problems for US equities in 2015. First, the
rising wages bill points to flat-lining domestic profit
margins. Second, it seems likely that the Fed will
start tightening in mid-2015. The Feds dots are a
Source: IBES/DataStream, Federal Reserve; Minack Advisors
Third, I do not think that unconventional monetary
policy outside the US will provide a significant offset
to the impact of Fed tightening on markets. Interest
rates matter but I think US QE was over-rated. To
be fair, QE did provide a signal on how long rates
would stay at zero. QE elsewhere will not have
much impact on markets that already expect lower-
for-longer rates outside the US. More to the point,
global equities rallied 65% from the 2011 lows with
no change in earnings (Exhibit 4). Asset price re-

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Saturday, 13 December 2014
rating was the story of the past three years; it is not, European earnings. Finally, investors appear over-
in my view, the story for 2015. weight US equities, so positioning favours Europe.

Exhibit 4 Exhibit 6
A 65% Pure PE Expansion Rally A Wide Margin
MSCI ALL-COUNTRY PRICE INDEX AND EARNINGS EUROPE AND US FORECAST MARGIN
456 WHATEVER IT TAKES
38 11 11
MSCI ALL COUNTRY INDEX
432 36
10 10
408 34
PRICE INDEX (MXWD)

384 32 9 9

EPS INDEX

MARGIN
360 30
8 8
336 28

312 26 7 7

288 12M FORWARD 24

EPS (RHS) 6 EUROPE MSCI 6
264 TRAILING 22
MARKET IS ON A PE OF 12 WHEN THE S&P 500
EPS (RHS) INDEX OVERLAPS WITH THE EPS SERIES US RECESSIONS SHADED
240 20 5 5
2010 2011 2012 2013 2014 2015 2016 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: MSCI, IBES/DataStream; Minack Advisors Source: MSCI, IBES/DataStream, NBER; Minack Advisors

Fourth, equities outside the US will do poorly unless The big problem, however, is that politics is fraught
growth improves. Non-financial sector sales in and could quickly unsettle markets in Europe. My
emerging markets sustained 30% annual growth base case is that Europe has another major crisis
through the last cycle; sales are now flat. Developed within 2-3 years. The crisis will be driven by
market sales outside the US are falling (Exhibit 5). internal competitiveness imbalances. But politics
will dictate when it matters for investors. That is
Exhibit 5 difficult to time. There may be a trade to be
No Sales Growth Outside The US overweight Europe, but it comes with clear risks.
NON-FINANCIAL SECTOR SALES
50 50
SALES IN US$ TERMS. US RECESSIONS SHADED
EM
Fifth, the forces of disinflation remain strong, so any
40 WORLD EX-US 40
rise in long-end yields most likely in the US will be
30 30
temporary. Bond yields rarely fall when the Fed
12M%

12M%

20 20 starts tightening (Exhibit 7). But a major sell-off

10 10 seems unlikely: global growth will likely remain
0 0
weak; zero rates elsewhere and the prospect of US$
strength suggest US Treasuries will be attractive to
-10 -10
2002 2004 2006 2008 2010 2012 2014 2016 foreign buyers; equity returns will be patchy; and
Source: DataStream/Worldscope, NBER; Minack Advisors the world remains short of quality collateral.

The prospect of sales and margin improvement Exhibit 7

seems highest in Europe, but the risks for investors Long-end Yields Dont Fall When Fed Tightens
are also unusually high, although unpredictable. 9
10 YEAR TREASURY YIELD AND FED POLICY CYCLES
9
FED
TIGHTENING
8 8
Several factors should assist European growth: 7 7

falling oil prices; reduced fiscal restraint; and a 6 6

weaker euro. Moreover, while margins in the US

%

5 10 YEAR 5
TREASURY
appear near a peak, margins in Europe have fallen 4 4

through renewed recession (Exhibit 6). Even a 3 3

modest inflection in European growth should help 2 FED 2

EASING
earnings given operational leverage. In addition, 1 1
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
dollar strength is a headwind for reported US Source: Bloomberg; Minack Advisors
earnings, while euro weakness is a tailwind for

Page 2 of 3
Saturday, 13 December 2014
Sixth, its not clear that theres a strong case to be Exhibit 8
overweight equities versus bonds. Returns in both Credit Struggles To Keep Up
are likely to be low next year. Equities may do a 17
S&P500 PROSPECTIVE PE & HIGH YIELD SPREAD
2

little better, but not give the excess return typically 16 S&P 500 PE (LHS) 3

OAS SPREAD % [INVERTED]

15 4
expected by investors as a reward for holding a
14 5
riskier asset class. Tactically never my strong

PE RATIO
13 6

point it may be a year of two halves, with modest 12 HIGH YIELD OAS
SPREAD
7
11 8
equity out-performance first half, but bonds 10
[INVERTED] (RHS)
9
stronger through the second half. 9
AVERAGE SPX PE FROM
1985 EX 1998-2006 10
8 11
WHATEVER IT TAKES
In summary, while the structural forces of 7
2008 2009 2010 2011 2012 2013 2014 2015 2016
12

disinflation remain strong, global growth may
temporarily improve in the next 2-3 quarters. This
will see the end of zero rates in the US, a shift of
global importance. Fed tightening will likely bring
down the curtain on an extended period of risky
asset re-rating. This points to low or no equity
returns in the US. Better growth if it comes will
help equities outside the US. Any set-back in
Treasuries will likely be short-lived.
There are three risks that may worsen this patchy
outlook:
First, credit markets start to rapidly deteriorate.
The positive correlation between credit and equities
is starting to fade (Exhibit 8). Transactional
liquidity appears to have dried up, and credit
markets have seen at least pockets of zero-rate-
inspired investing recklessness.
Source: IBES/DataStream, Bloomberg, Barclays, NBER; Minack Advisors
Second, dollar strength causes significant financing
stress, most likely in some emerging markets. EM
have significantly increased leverage since the Great
Recession, global growth remains weak, and it
seems that much of the debt is dollar financed.
There is a risk of an adverse feed-back loop as a
rising dollar increases stress, forcing dollar
repatriation, which lifts the dollar further.
Third, Europe returns to crisis. Economics will
cause the crisis, but politics will be the catalyst.
Europe faces an election landmine over the next 18
months; almost any could be disruptive for markets.
Finally, on the upside, one risk is that investors
continue to cram into US large-cap equities,
squeezing the S&P500 sharply higher for a while.

Minack Advisors
Level 8, 167 Macquarie Street, Sydney NSW 2000, Australia
gerard@minackadvisors.com www.minackadvisors.com
Authorised Representative No. 443937
Minack Adv isors Pty. Ltd. ABN: 84 163 503 044

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Saturday, 13 December 2014