Note September 4,2018: Forewarned Is To Be Forearmed – In the markets as elsewhere, to be forewarned is to be forearmed. Especially U.S. led, equities have been in a seemingly relentless upswing with little correction, valuation notwithstanding. Fixed income yields have remained low, with only the curious mix of U.S. Treasury, BBB Corporates and Emerging Market yields even close to twelve month high levels. Commodity prices appear beholden more to U.S. dollar exchange rates than other aspects like individual industry features.
Global annual GDP growth may be closer to 4% but imbalances loom ahead of the October 12, 2018 IMF/World Bank meetings. When considering the centuries before the 1930s, it is easy to see why far sighted politicians developed trade agreements, including friends and foes alike. The tangible benefits to prosperity now appear taken for granted or denied. Trade tensions seem taking on a political dimension in the United States and Europe while highlighting emerging country contradictions.
The central bank context of massive quantitative ease seems now of side effects, especially on exit. So far, fixed income yields have mainly been low enough for the dominant factor to be momentum, to-and-fro within and even without for example in commodity pricing. In the context of U.S. growth and its inflation, we believe the Fed to be behind the curve. For capital market valuations, change is likely to be a key factor.
The current mantra is at best a truism that valuation of equites is not excessive if growth remained strong and rates remained low. Market volatility is all about change. The contortions to justify valuations during bubble Japan in the late 1980s offered subsequently, sobering consideration. While consensus for the S&P 500 appears of 11% earnings increases into 2019, its long term sustainability seems still to be determined as is maintaining a trailing earnings P/E of 20x. In the current market cycle, geographical rotation strategies favoring Japan and Europe ostensibly based on lower valuation have failed to deliver amid slower restructuring in heavy weight Financials and large weights in Consumer Staples. Currencies have returned to flail emerging markets.
We expect higher volatility and more focus on value than momentum than seems in consensus. Investments should have a quality tilt with greater emphasis on sector and stock selection.
Global economic growth may be closer to 4% in annual GDP but imbalances loom. The IMF/World Bank October 12,2018 annual meetings in Bali Indonesia should offer interesting perspective. When considering the decades and even centuries for trade before the 1930s, it is easy to see why far sighted politicians cooperated with administrators to develop trade agreements, not least of the multilateral type including friends and foes alike. The benefits to prosperity have been tangible for both consumers and companies. With the passage of time, these benefits appear now being taken for granted or even denied. Meanwhile, trade tensions have increasingly taken on a political dimension replete with unilateral tariffs and threats to abrogate participation. Due to the stance of its administration, these developments appear at high pitch ahead of mid-term elections in the United States. There has appeared little pushback yet from Congress that does have at minimum an equal and constitutionally, a dominant role in trade relations. In Europe beset with internal contradictions on the continent, posturing in negotiating Brexit still appears in Britain as time runs out. Meanwhile in emerging countries, several governments appear losing the economic imperative that for several years, currency stability had buttressed.
For a decade, the central bank context has been one of massive quantitative ease but seems now to be about collateral side effects, especially on exit therefrom led by the United States. Easy money has been primary driver in this credit rescue cycle underway in capital markets since 2008. From the just concluded Jackson Hole, Wyoming congregation of central bankers in August 2018, we believe salient points have emerged. Federal Reserve Chairman Powell clearly enunciated that better balance was needed between managing by model and assessing the on-the-ground landscape. Further, the Federal Reserve appears to be firmly on constricting its extremely large balance sheet and engaging in moderate increases in its Fed Funds rate. As the premier central bank, the Federal Reserve has perforce to be watchful of global impact. Still, our experience has been that domestic focus is paramount for the Fed, arguably more than many (including financial participants) outside the United States may anticipate. Our experience over the cycles has also been that interest rate changes tend to exert with a lag. Whether intended to ease or tighten conditions, interest rates need greater change to be effective than may be initially anticipated. Our expectation is that Fed Funds rates could reach 3.50% into mid- 2019, above consensus. The impact of cumulative change on global capital markets has the potential to ratchet up tightening further than that already seen, initially in emerging market and BBB corporate bond yields. Elsewhere, even as it tones down its quantitative ease, the European Central Bank is perforce going to be in leadership change leading to policy anticipation into October 19, 2019. The Bank of England has to be cognizant that conditions could be volatile into the Brexit target of March 29, 2019. In emerging countries, central banks are likely to continue to have to deal with domestic issues like inflation but also of credit excess, including that which is denominated in foreign currencies.
For capital market valuations, a key factor is now likely to be whether the Federal Reserve is behind the curve on the U.S. economy. So far and now with some exceptions, fixed income yields have been low enough for the dominant market factor to be momentum to-and-fro within, and even without for example in commodity pricing. Momentum fraying appears for instance in weakness in emerging market currencies, even for stronger large economies like China and India as well as acutely in the inability of sharp fixed income yield increases to stem crisis for instance for Argentina, Brazil, Turkey, hyperinflation riven Venezuela and now South Africa. Yields may have increased in advanced country crisis areas like Italy but are still low in the context of its budget pressures and the impaired credits already existent on bank balance sheets. Yields elsewhere in Europe are minuscule, especially in benchmark German bunds. In the United States, Treasury fixed income yields may have increased sharply from bottom but lately have appeared to-and-fro momentum driven. In the corporate segment, there is the contradiction of higher BBB yields but much lesser movement in the CCC rated corporate arena. Momentum may appear still dominant but change looms in the context of U.S. growth and its inflation. We believe the Fed to be behind the curve and that Fed Funds moving to 3.50% into mid 2019 and 10 year Treasury Note yields of 4.50% then would be appropriate.
Market volatility movements are all about change. The current mantra is at best a truism that valuation of equites is not excessive if growth remained strong and rates remained low. For consistency, it is the reason in part for our preferring to use using trailing earnings for P/E comparisons over time. In equities and about valuation risk, the contortions to justify valuations during bubble Japan in the late 1980s offered subsequently, sobering consideration. In present day markets, using as benchmark a P/E valuation of 16x on long term delivery of 7% annual earnings growth would imply for us that a P/E of 20x would need sustained long term earnings growth of 12% annually or an increase of 70% over historical delivery. While consensus for the S&P 500 would appear to countenance 11% earnings increases into 2019, we see its long term sustainability as still to be determined as is the case for maintaining over the long term, a trailing earnings P/E of 20x. In this market cycle as well as not just in 2018 to date but also before, geographical rotation strategies favoring Japan and Europe ostensibly based on lower valuation have failed to deliver due in part to slower restructuring in heavy weight Financials as well as due to large weights in Consumer Staples. Currencies have returned to flail emerging markets.
We expect higher volatility and more focus on value than momentum than seems in consensus. We believe investments should have a quality tilt with greater emphasis on sector and stock selection.
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.