Note October 29, 2017: Amid the reporting of corporate results and earnings, from politics to change in the global tilt of quantitative ease, numerous events beckon with impact on risk in hitherto complacent markets. Currencies remain worthy of watch as harbingers of volatility. Despite the repute of a U.S. dollar upswing as being negative for precious metals and gold bullion in particular, in present circumstances, we espouse diversification by including them in investment portfolios. The need to focus on quality of execution and on quality of financial structure seems to us to be crucial across capital market asset classes due to reasons of changing credit conditions, the present position of the corporate earnings cycle and not least, the fragility of global political understandings today.
Fresh political developments tension points range from Asia to Europe and not least to the United States. Beyond ongoing sabre rattling on Korea, in Asia lie new developments after the snap election in Japan and the consolidation of power in post congress China. Now post-election Germany and France in Europe have to deal with Brexit torqued Britain and with Catalonia tensed Spain. In the United States, the discourse appears deteriorating over international trade like NAFTA, over domestic ones such as healthcare reform and taxation with little focus on deficit control. Politically, Latin America appears weakened. Overarching new global flash points include issues of interference in due process in elections, of tensions around the western borders of Russia, of terrorism activity globally and of the ongoing conflagration around the Middle East. The cost of any single political miscalculation could be high.
After a decade, a flurry of central bank meetings has been underway with monetary change in the air. Governments ignoring debt levels amid low borrowing costs never was solely a Greek malady but has in fact been a condition of politics. As a hitherto latent issue, we expect markets to revisit adequate risk premiums across fixed income markets alongside currency volatility as the tide of quantitative ease recedes at differing paces. In addition to growth distribution challenges during this period of better global growth, we believe capital markets also need to focus attention on deficit control.
Notwithstanding equity indices rising to records globally, a broad consideration is that if after a decade of massive quantitative ease that in effect included substantial financial subsidy and close to three years of better global growth, if individual companies are still not able to navigate to safer harbors then in time honored capital fashion, they deserve to fail so that others can replace them. The lesson from Japan today is that despite prolonged quantitative ease, zombie capitalism has not helped quality of delivery. Companies in many industries have had change thrust upon them due to laxity and subsidized leverage is not a panacea.
With its normal initial deluge from companies in the United States, the corporate reporting season has commenced. After its classically intense recovery from bottom in 2009, the corporate earnings cycle now appears to be in a more sedate expansion phase. In the early reporting of results globally, there has been bifurcation not least due to legacy issues in industrials reporting in the United States, in worldwide consumer areas from staples to discretionary due to changed consumer preferences and even in energy despite nascent recovery. Governance and operational scandal could hurt the hard won reputation for quality in Japan that was acquired since the 1960s. The same may be true of diesel gate in the global automobile industry today.
Crucial for the U.S. market but also in China and India due relative weightings, information technology earnings remain a key part of delivery. So far in the United States as seen in their results, a broad spectrum of marque information technology companies appear to be navigating restructuring well. Especially as credit conditions change and unlike recent behavior in sharp upswing, we expect that equity markets will revert to considering price and result performance in the financials to be critical. One overall market valuation issue to contend with is whether present equity valuation can be buttressed by earnings growth for which consensus expectations long term sustained expansion may be as high as for 12%, as compared to actual long term growth closer to 7% annually and consensus upcoming Q3/2017 report expectations of 2% year over year.
From politics to change in the global tilt of quantitative ease numerous events beckon, amid the reporting of corporate results and earnings,. Often glossed over, currency markets are by far the most heavily traded of capital market instruments with a historical ability to distil risk. For instance, the genesis of the October 1987 markets debacle partly lay over the exchange rate value of the Deutsche Mark versus the U.S. dollar in the currency related tiff between the United States and then western Germany. Then as now, even well briefed government officials rode the well-trodden route of railing about unfair trade. Currently overlooked in popular commentary, the U.S. Dollar has been rising against heavily traded advanced country currencies like the Euro, the Yen and Sterling as well, at the margin against the Renminbi. Emerging currencies face risk as the politics of quantitative ease change. Despite the repute of a U.S. dollar upswing as being negative for precious metals and gold bullion in particular, in present circumstances, we espouse diversification by including them in investment portfolios.
Ranging from Asia to Europe and not least to the United States, a number of fresh political developments add to the potential for tensions. Amid sabre rattling that continues between the United States and North Korea in Asia and alludes to nuclear annihilation, there have been major developments in China and Japan. The elevation in China of President Xi and his objectives at its 19th National Congress of the Communist Party is likely to cement a more overt stance from domestic reform to trade and to border disputes including those about the south China seas in Asia. The enhanced Diet win gives Japanese Prime Minister Abe the ability to address domestic reform and also to change its pacifist constitution with impact on the international arena. The snap October 22, 2017 election in Japan yielded a super majority for the incumbent conservative government that distinguishes it from the earlier election results of 2017 in Germany and Britain. Both the latter returned conservative governments but with diminished majorities. They also differ from that of France where the incumbent leftwing party was decimated. France recorded a strong win for reform President Macron carrying the National Assembly on his coattails. Meanwhile even as German Chancellor Merkel cobbles together a new coalition that is likely to be more conservative and as French President Macron unveils his reformist agenda for France and Europe, the immediacy of turmoil in Spain over Catalonian separation and the torque with Britain over Brexit appear heating up.
The U.S Congress could yet intervene as is its right but issues like healthcare reform and the budget also beckon. Even between Republicans in Congress and President Trump, the discourse appears deteriorating. Not unlike prior administrations, the human cost of overseas commitments have also added to stress. Canada and Mexico appear mired in less than fruitful negotiations with the United States administration hard line about revising NAFTA. Politically, Latin America appears weakened. In the Americas, the collapse in Venezuela still yielded a majority for the government in its election and corruption exposes challenge the government in Brazil. Overarching new developments include issues of due process in elections, of tensions around the western borders of Russia, terrorism activity globally and the ongoing conflagration around the Middle East. The cost of any single political miscalculation could be high.
With monetary change in the air after a decade, a flurry of central bank meetings has been underway. Governments seemingly ignoring debt levels amid low borrowing costs never was solely a Greek malady but in fact a condition of politics. We expect markets to revisit the hitherto latent issue of adequate risk premiums across fixed income markets as the tide of quantitative ease recedes. The October 2017 IMF annual meetings included observations that global growth appeared improving to potentially 3.7% in 2018 but also that broadening it remained a challenge. In addition to growth distribution challenges during this period of better global growth, we believe capital markets need to focus attention on deficit control. In terms of actual central bank developments, the Federal Reserve has sent concrete signals of Fed Funds rate increases to occur potentially sooner rather later, accompanied by a path of reduction in its $4.5 trillion balance sheet. Meanwhile, the lack of a rate increase in its October 25,2017 meeting by the Bank of Canada has taken place despite stronger economic growth and it not having a quantitative ease program. Despite Brexit discussions with Europe and in light of domestic economic conditions, the Bank of England has signaled potential reduction in its quantitative ease program. Notably with a Euro 2.3 trillion balance sheet boosted by quantitative ease, the European Central Bank has lately also signaled potential of reduced fixed income purchases for its program from the current Euro 60 billion per month to Euro 30 billion from January 2018 but not signaled interest rate policy. Notwithstanding economic growth above global averages, the proposed recapitalization of state owned banks in India is the latest illustration of issues of impaired credit for central banks in emerging countries. Much dissection of potential succession in Federal Reserve leadership further complicates stability expectations that have been core in complacent markets.
Equity markets globally have been moving higher and often to record index levels. For several reporting seasons now, the expansion of corporate revenues has been reported as being subject to sharp competition. Earnings results have been highly bifurcated, even within the same industry groups. Like that in many asset classes, valuation in equities, has expanded sharply as a result of quantitative ease but also as a result of better business conditions. Notwithstanding equity index behavior, a broader consideration is that if after a decade of massive quantitative ease that in effect unleashed substantial financial subsidy and now after close to three years of better global growth, if individual companies are still not able to navigate to safer harbors then in time honored capital fashion, they deserve to fail so that others can replace them. The lesson fromJapan today is that despite prolonged quantitative ease, zombie capitalism has not helped quality of execution and neither does subsidized leverage. Companies in many industries have had change thrust upon them due to lax.
With a normal early deluge by companies in the United States, the corporate reporting season has commenced. From its bottom in 2009, the corporate earnings cycle then moved into cyclical sharp recovery and now appears in a more sedate expansion phase. A notable exception would be that after the crude oil price debacle only two years ago, energy is in its recovery phase but still bifurcated. Recent consensus expectations for Q3/2017 operating earnings for the S&P 500 have been reported as being for around 2% year over year growth. One overall valuation issue for markets to contend with is whether present equity valuation can be buttressed by earnings growth consensus expectations which may be as high as for 12% for long term sustained expansion for the S&P 500. As benchmark for the S&P 500, earnings growth historically been closer to 7% annually and its valuation closer to 16x P/E on trailing earnings.
In the early reporting of results globally, there has been bifurcation not least due to legacy costs in industrials reporting in the United States. Result weakness due to governance scandal seeping into the quality of products has been denting companies reporting in Japan in a wide range of industries. It has taken place despite prolonged quantitative ease that has been applied as theoretic corporate balm. It could hurt the hard won reputation for quality in Japan that was acquired since the 1960s. The same may be true of diesel gate in the global automobile industry today. In the consumer space, European and U.S. companies have been at the forefront of bearing restructuring pressure in staples. In consumer discretionary, companies appear to show that those earliest into restructuring have benefitted in subsequent reporting in the results so far. The pressures in retail remain intense both from both online shopping and from a change in consumer preferences towards entertainment and electronics over impulse fashion for instance. In energy even among the largest companies, bifurcation in reported results can be currently seen. It has taken place even in cyclical recovery, with crude oil prices that have doubled from their recent lows.
More volatility should be expected and a quality tilt kept intact in equities as it relates both to results and financial structure. Crucial for the U.S. market but also in China and India due to relative weightings, information technology earnings remain a key part of delivery. So far in the United States as seen in their results, a broad spectrum of marque information technology companies appear to be navigating restructuring well. Unlike their recent behavior in sharp upswing, we expect that equity markets will revert to considering price and result performance in the financials to be critical. The need to focus on quality of execution and on quality of financial structure seems to us to be crucial across capital market asset classes due to reasons of changing credit conditions, due to the present position of the corporate earnings cycle and not least, due to the fragility of global political understandings today.