Note September 4, 2020: Market Momentum Meets Messaging Mash – Even as capital markets appeared comforted by momentum, there had appeared messaging mash, including in market internals, in central bank assessments and in politics. Over-rationalization of hidden value has a long history, in equity markets especially about groups du jour. In fixed income in June 2017, there was penchant for 100 year maturity bonds including for countries with a checkered financial history like Argentina, only three years later now mired. Globally and as benchmarked by the S&P 500, earnings equity valuation is high. Even if earnings have bottomed amid battered economies, we see earnings recovery as being in a three year and fractured path to prior peaks. Momentum has its risks and even with monetary largesse, rebalance is overdue.
At Jackson Hole, Wyoming in August 2020 and perhaps to finesse into the last pre-election FOMC meeting on September 14/15 2020, much was made about inflation targeting. It moved from a single point of 2% to a range around it with balance for growth. The Federal Reserve risks mixed messaging. It had no inflation target until just a few years ago. In the abrasive runup to U.S. general elections of November 3, opinions may sharpen around Labor Day. Other political tensions stretch from the Baltic to the Mediterranean to the Indo-Pacific to trade.
Markets seem enamored about central banks being both able and willing to cushion risk. Being obfuscated are rebalance of risk premium compression in fixed income and of valuation versus momentum in equities. In the movements of gold, the Swiss Franc, the Renminbi and many G-7 currencies versus the U.S. dollar and notwithstanding relative liquidity, we see a significant ratcheting of tension. We espouse short duration in fixed income and precious metals like gold bullion instruments in asset mix.
In Q3/2020, we see equity opportunities to rebalance. In growth, strong balance sheet Healthcare at overweightandInformation Technology now market weight seem better positioned than Consumer Staples and concept social media that have led momentum. In cyclicals, we favor Industrials over Consumer Discretionary dependent on aspirational spending built on leverage. Strong balance sheet Energy offers opportunity of a severely out-of-favor kind. Financials performance is crucial for market direction and we favor banks where less excess may reside.
Extremes often develop in investment momentum and appear manageable. Inevitably, they have presaged a swinging back again into balance. Capital markets and efficient capital allocation thrive on there being balance between valuation assessments of future prospects and the market momentum that can anticipate change ahead of widespread emergence of the fundamentals. Extremes in either focus lead to risk. Within reach of recent memory have been but some examples such as the extreme weightings of commodities in the late 1970s, the penchant for LBOs in the 1980s, the TMT blowoff of the 1990s and slicing and dicing of credit in the mid-2000s into today. Equally salient events lie in the 1970s period in the response to fears of double digit inflation being chronic,. It lay in the then misjudgments of change from low valuation of equities from the mid-1970s and in then chronic extreme risk premiums in fixed income. Both underestimated restructuring delivering improvement. Even with prolonged massive monetary largesse and exhortations of its prevalence for many more years, at present, market rebalance seems overdue.
In this context today and not so long ago within the fixed income markets, there was penchant for 100 year maturity bonds including even only in June 2017, countries with a checkered financial history like Argentina. In the stretch for yield, corporate junk bonds and the derivatives thereof have also been in favor. However, solvency depends on many factors and not just on low administered rates and direct central bank intervention in suppressing markets. Underscoring changed circumstances have been the summer of 2020, releases of economic contraction worldwide which have included erstwhile global locomotives like the United States and China. As well has been the use of essentially emergency fiscal and monetary rescue packages by the European Union, reflecting hardship cases as large as Italy. Smaller countries and highly leveraged companies are experiencing revenue stressed solvency pressures, irrespective of low administered rates.
Into mid-2020, the Covid-19 pandemic as unforeseen event undoubtedly contributed to the shock of slowdown. It is also factual that prior periods of good growth were not used by companies and countries to strengthen capital structure. Into Q3/2020, as seen from indices from China, the Federal Reserve Beige Book in the United States and from other releases worldwide, some bounce back in global activity may now be taking place. Even ahead of the Covid-19 pandemic and recorded for many years has been reduced efficiency in many countries with different economic circumstances and companies in different industries worldwide. Solvency bifurcation has likely already emerged from these recorded realities. Forecasts from many respected sources appear that it is likely to take many years of mixed growth before the global and individual growth rates of pre-2020 can be re-attained.
As a result, the massive monetary largesse led by the major central banks has likely not spared revenue and solvency challenges for countries and companies alike and which could be long lasting. Over a decade of progressive monetary largesse albeit with successively different monikers appears to us to risk obfuscation and to build in distortions. Lately and perhaps to finesse ahead of the FOMC meeting of September 14/15 2020 with the subsequent one due only on November 4/5 2020, a day after the U.S. general election, at Jackson Hole Wyoming in August 2020, much was made about inflation targeting. It was moved from a single point of 2% to a range around it with balance for growth. However, it seems to us to risk mixed messaging worldwide. Until just a few years ago, the Federal Reserve itself had no inflation target. In global reality in many policy cycles, central banks have tended to be flexible and opportunistic on targeting and aspects to be used thereof. Further, capital markets, efficiency and prosperity do appear to flourish more when risk premiums can be privately allocated – an aspect that was even recognized by state controlled economies back in the 1990s as well as in the privatization of state owned companies in market economies.
A clearly salient political event of note lies in the abrasive runup to the U.S. general election of November 3, 2020. Even if undisclosed as has happened in other elections, intentions may be shrill and sharpen around Labor Day in 2020. Other fractious issues in terms of direct confrontation include political tensions that stretch from the Baltic to the Mediterranean to the Indo-Pacific. On trade and irrespective of the result of the U.S. elections, pressures exist and are likely to expand as growth remains weak and competitive pressures remain strong. It would especially be so in the event that the Covid-19 pandemic lingers.
The rationalization of hidden value as being unrecognized has a long history in equity markets in momentum phases. Examples include in the late 1970s as inflation raged, commodity based equities were hitting the peak of their weightings replete with recognized, probable and then even potential reserves estimates floating. Next it was the turn into 1990 of high weighting and valuations for Japanese equities based on assumed management superiority and then real estate value attributions. Subsequent examples have been similar bouts related to Information Technology in the U.S. markets including lately as momentum has fed into social media amid the Covid-19 pandemic. However as global indicator, the S&P 500 has a long history of around 16x P/E valuation for around 7 % annual earnings growth. Valuations globally seem to us to be extended and which seem to include expectations of a swift earnings recovery. Even if earnings have bottomed in Q2/2020, we believe that the recovery of earnings could take three years to reach their pre-2020 levels. We assess that at around 30x earnings, long term earnings delivery of 15% per year is incorporated. Even on pre-2020 operating earnings of 157 as base, stability would likely need aggregate market earnings delivery of over 10 % per year – both very difficult to achieve. The potential for volatility remains high.
Markets seem over enamored about central banks being both able and willing to cushion risk. In overemphasis on momentum which has characterized markets in recent periods, we believe rebalance of risk premium compression in fixed income and of valuation versus momentum in equities are aspects that are being obfuscated and overdue. Monetary and fiscal stresses seem more extensive than markets seemed to reflect from March to August 2020 in response to Federal Reserve led largesse. In the movements of gold, the Swiss Franc, the Renminbi and many G-7 currencies versus the U.S. dollar and notwithstanding relative liquidity, we see a significant ratcheting of tension. We espouse short duration in fixed income and precious metals like gold bullion instruments in asset mix.
In Q3/2020, we see opportunities to rebalance in equities. In growth, strong balance sheet Healthcare overweight and Information Technology now market weight seem better positioned than Consumer Staples and concept social media that have led momentum. In cyclicals, we favor Industrials over Consumer Discretionary that was so favored for aspirational spending built on leverage. Strong balance sheet Energy offers opportunity of a severely out-of-favor kind. Financials performance is crucial for market direction and we favor banks where less excess may reside. StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.