Note February 7,2018: Rotation of Rotation: Unlike the fear and restructuring of 2007 to early 2009, more recent markets until February 2018 have been about complacency with liberal quantitative ease. Amid volatile trade, internal and global politics worldwide, miscalculations could take place. Even if for currently obscure reasons, likely to be next is rising vigilance in the capital markets. These changed dynamics for markets and central banks would be a rotation of rotation. Within the current business cycle in the sequencing of consumer spending versus production versus capital investment versus resource demand, the first phase has been elongated and potentially in excess. The elongation drivers likely lie in all of massive quantitative ease, major technological changes in retailing and the rise of emerging country consumers. Subsequent business phases are likely but be more volatile. Long term corporate project capital budgeting is unlikely to be on hurdle rates based only on presently minimal administered rates. As global growth continues, the future amplitude of interest rates is unknown. Rates are likely to rise with public deficits concerning. In the capital markets response to volatility, the availability of funds (leveraged or direct) is likely to be scarcer. Whether on fundamental or technical aspects, risk premiums are likely to rotate up. No change strategies have already been found vulnerable, whether on liquidity in volatility ETFs or on rotation to Europe and Japan based on lower P/E ratios versus the U.S.. There is all the more reason currently to have a quality, diversification and business sector tilt over one on low quality that has long benefitted from massive ease. It overrides even geographical rotation.
The directions in which the political environment is currently moving in is potentially adding to volatility, whether in major countries or in individual regions as well as globally. Several political and trade issues exist around which miscalculations could take place. Politics worldwide require a rotation of considerations towards risk premiums.
In the United States, the long concerning issues of political fracture fester about its major internal choices like the sanctity of elections, immigration policy and healthcare. Budget deficits appear to have low political priority but have heavy funding requirements. On its international trade choices, tariffs and bilateral balance appear gaining currency. Getting shorter shrift appear the benefits from global trade expansion of lowered costs for consumers. The State of the Union speech of 2018 and the machinations over the Russia investigation intelligence memorandums underscore such stresses. The NAFTA discussions between the U.S., Mexico and Canada seem fractious. Very quietly but shortly after U.S tariffs on its solar panels, whether or not on cause and effect, China has proposed tariffs on sorghum, or agricultural exports long a strength of the United States.
In Europe, there have been a series of individual country resistance points still to be fathomed. France has been an exception. After an earlier aborted attempted right leaning government to now a repeat of a grand coalition, the German federal elections of 2017 have yet to result in cohesive government, let alone policy.. For Italy with upcoming elections, right wing nationalism appears to have new vigor. In Spain, a referendum and then regional election for Catalan in 2017 have not resolved the politics of separation. On negotiations on Brexit separation from Europe, considerable fracture has been evident among the constituent assemblies of Britain and now increasingly publically so within its Westminster government. Amid discussions on inviting new Balkan members, the existent eastern European members have underscored a lack of desire to adhere to community wide decisions, for instance on refugee burden sharing and the separation between judicial versus political portions of domestic governance. Further prominence appears on fringe nationalism in European politics.
Asia has among the highest of current individual and collective economic growth rates in the world. An increasingly outward economic outlook was underscored by China in 2017 and India in 2018 at the World Economic Forum. The Trans Pacific Partnership has moved forward, ex the United States. China continues to expand its Belt and Road initiative with itself at core in developing new infrastructure trade routes through to Europe. However, political issues loom in Asia on balance between large and small countries. The geopolitical stresses also remain around the south China seas, around the Korean peninsula, throughout the Middle East/ Levant into south Asia and at the Russian interface with Europe.
In the current business cycle sequencing of consumer spending versus production versus capital investment versus resource demand, the first phase has been elongated and potentially in excess. The underlying reasons likely include all of massive quantitative ease, major technological changes in retailing and the rise of emerging country consumers. As has been lately corroborated in economic statistics, massive quantitative ease from the major central banks has been accompanied in many countries by low savings rates and sharply higher consumer leverage. Real estate prices have risen sharply since 2009 on low rates and ample financing but more lately have appeared to stagnate amid overbuilding and affordability concerns worldwide. The emerging market consumer also transitioning from higher brand led spending as is classical during initial changes (such as Japan in the mid-1970s) to now appearing more selective. Finally and not least, the emergence of internet based consumer retailing technologies has lately been throwing up victims of change after contributing to elongate this traditional consumer spending phase of the business cycle. Even amid global growth, the business cycle is likely ripe to be moving into a more mature phase. The subsequent business phases are likely to be more volatile. Despite low administered rates that at minimum have stopped declining and appear now increasing, risk assessments should emerge.
On risk premiums appropriate for investments, we have grave doubts that in capital budgeting decisions for individual long term projects in companies, the efficacy would exist for a return on investment hurdle rate of under 10%. When individual uncertainty or aggregate risk like inflation are considered for frontier investments whether on geographical location or in resources in production or services, the risk hurdle rate would be much higher. In aggregation to reduce risk, conglomerates have demonstrated at best a mixed history in assessing risk. As a result, making long term assessments using a risk free rate of 1½% or less appear fraught. Yet, minimal rates have been used in capital markets recently with which to justify elevated equity valuation or low yields in junk bonds. It has given rise in our view to a prolonged momentum market and arguably so since 2013. After all, forcibly reduced interest rates have neither a reputation of efficiency in capital allocation and nor of stable longevity, current quantitative ease notwithstanding. In fixed income, yield spreads have come into focus amid more volatility in rising U.S. Treasury benchmark yields. In equities, the momentum rotation sequence of adding to Japanese and European equities based on lower aggregate P/E ratios appears not currently paying off. Even before the current equity market selloff, both have underperformed the U.S. and emerging market aggregates on parsing FTSE worldwide data into 2018. Further and during changing conditions, especially fraught is the use of current multiples on forward earnings versus historical multiples that are calculated on historical earnings. The momentum rotation sequence based on lagging P/E ratios appears to us to be at least implicitly dependent on unchanged capital market and business conditions. After an elongated consumer phase, a business cycle rotation now would likely have differing dimensions.
A momentum market that has been conducted amid massive quantitative ease and suppressed rates does represent liquidity risk as recent events in short volatility ETFs have demonstrated. More broadly, such a momentum market represents a milieu in which the developing dark corner risks are unknown. At the same time alongside elevated P/E ratios in equities and concept investing, leveraged investment and ultra-long duration fixed income have proliferated. Even if interest rates were to remain below historical averages and global growth to continue, the availability of funds (leveraged or direct) could become scarcer. Furthermore, in public finance, deficits have received less attention and rising rates represent additional pressures worldwide. On vigilance, central banks are not always able to determine direction. As risk premiums reassert, there is all the more reason currently to have a quality, diversification and business sector bent instead of one on low quality that has long benefitted from massive ease. At this stage of the business cycle and in current market conditions, a quality, diversification and business sector focus is likely to override geographical rotation based on valuation.
Kind Regards,
Subodh
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