Note August 14,2018: Data Driven versus Whimsy Oriented – At present, data driven versus whimsy considerations have wide relevance – from the interface between politics and trade to capital markets and valuation to central bank policies. In addition to global conflagration over terrorism that is difficult to incorporate except in extremis, volatility in the terms of conducting trade and currency stress adds to uncertainty about revenue generation. We see reassessment as being overdue of risk, based not on the rear view mirror of a decade of minuscule rates. It needs a more dynamic forward view of debt servicing costs amid rising rates and for spreads implied thereof, including equity valuation. Markets and ventures generally have a mix of being data driven and of being whimsy oriented but imbalance likely elevates risk.
In recent capital markets, much is being made about how using low administered rates makes generally stable valuation. Being data driven within decade old quantitative ease (and in Japan two decades old), artificially suppressed interest rates likely do not eliminate detriment to potential liquidity in markets. In this summer of 2018 and even amid minimal rates in Europe, spreads in 10 year sovereign debt for Italy have risen sharply. Alongside others for myriad reasons, emerging countries Argentina, Brazil, South Africa and Turkey (with collective GDP the size of Germany) show severe stress, along with currency decline in India and noticeable such in China. The historical cost of capital reality is that the impact is not static in being driven by point-in-time interest rates but instead is dynamic in their evolution.
Despite ostensible opportunity costs, such aspects call for diversification including that into cash reserves and precious metals as hedges. Despite present strong year-over-year U.S. corporate earnings gain, from worldwide industrials to financials and beyond, bifurcation in delivery has been present for years now – not least among marque companies. In investment holdings, we favor quality of operations and financial strength, whether in equity holdings of growth or value as well as in fixed income, whether sovereign or corporate based.
We believe that capital markets operate best when politics emphasize a background objective of providing a conducive environment of transparency rather than whimsy whether on business regulations, employment standards and international relations. Much of these issues have at present appeared to be at flux. From the United States itself, have come arguments thought to have been abandoned about national security interests and of punitive tariffs being used for a wide variety of goods from agriculture to manufacturing and against regions and countries from the Americas to Europe to Asia. This stance has apparently been mooted as being also applied about calls for domestic boycotts against American companies daring to optimize global manufacture. It is not just over U.S. policy. Response mechanisms have been equally salutary from Canada to Europe to China in using different American products for tit-for-tat responses, with boycotts also being mooted by some. In other spheres such as over political differences and human rights, fiery language and boycott threats can be seen within Europe as well as from erstwhile low key Saudi Arabia and from economically stressed Turkey. In addition to global conflagration over terrorism that is difficult to incorporate except in extremis, volatility in the terms of conducting trade and currency stress adds to uncertainty about revenue generation.
For equity bull and bear markets alike, cost of capital relationships have been less than static. It has been so whether looking at the expansion of equity valuation from the 1980s ahead of the low ebb of rates to the contraction of the same in Japan, prolonged low rates notwithstanding. For that matter, the same has also held in the aftermath of the technology, media telecommunications blow off into 1999/2000 in the United States. As has become commonplace in recent quarters, the latest series of corporate result releases have come in with managed consensus beating earnings boosted by tax cuts in the United States. There do appear signals still of revenue competition, potentially from currency volatility if the past is guide of stress. As well, business changes appear severe from technology and demographic preference changes not just in information technology but also key areas like the consumer spending and banking businesses. Whether planned or forced by circumstance, the worldwide dynamics are likely upward in interest rate changes. It in turn makes vulnerable a seemingly wide spread assumption that equity valuation risk premiums are presently stable.
With respect to borrowing and the servicing of debt accrued, equally important dynamics are relevant from near and far past cycles. For instance, in the corporate leveraged buyout cycle in the 1980s, there was the hubris that took place in assumptions about being able to service the debt that was accumulated in large individual transactions to buyout and privatize assets. Much later and into the apex of the credit cycle into 2007/8, hubris reappeared this time from financial institutions about the ability of individual country and private borrowers to in effect service housing backed debt. Hubris on taking corporate assets private has currently appeared. As old as the hills has been misjudging dynamic debt servicing costs in terms of coupon rates versus foreign exchange rates. It occurred not so long ago in the 1990s in areas as disparate as Russia and Latin America on sovereign obligations denominated in U.S. dollars and eastern Europe mortgage financing denominated in Swiss Francs. Into the past, such pressures have also extended well into G-7 countries, such as the United Kingdom of the 1960s-1970s and for that matter Canada well into the 1980s. The point of relevance for today is that when the interface between interest rates and exchange rates start to change, its impact can often be misgauged and decried when using static assumptions. In the present cycle, countries and corporations have already started to be weighed by such obligations.
The experience of the 1970s/80s was not just about inflation but also that the ability to be financially stable cannot be taken for granted. Stability became difficult when attention was not being not paid to debt servicing costs (whether from the coupon rate or the size of principal assumed). High debt to equity ratios for companies or debt to GDP ratios for countries have long lead to unpleasant stress. Well before the surfacing of credit crisis into 2007/8 and certainly in the current era of quantitative ease, this rule book has been seemingly discarded as obsolete by many. Still, those afflicted like Greece or individual homeowners in ghost estates have remained burdened by heavy costs as have many financial institutions. Earlier in 2018, both the Bank of International Settlements (BIS) and the International Monetary Fund (IMF) have raised concerns. Seemingly, the mainstream of investment thinking appears to be quantitative ease and central bank pliancy dominated. Changes in terms of rising borrowing costs are hence likely to lead to capital markets becoming much more volatile.
With U.S. inflation even at core being above 2 ½ % as well as annual GDP in the 2 ½-3% range and unemployment under 4%, the U.S. Federal Reserve needs to be on a path of rate increases and may be behind the curve. U.S. Treasury bond yields are well above their lows and closer to 12 month highs as are BBB corporate bond yields but CCC bond yield levels are not. The U.S. fixed income market adjustments are likely still evolving. This summer of 2018, even amid minimal rates in Europe, spreads in 10 year sovereign debt for Italy have risen sharply. Budget laxity has been demonstrably affecting Italy in the G-7 but its benchmark German bund yields remain low, partly due to ECB policy. We see further European fixed income yield increases as likely. Despite the Japanese fixed income market being domestically attuned, Bank of Japan injection into its fixed income and equity markets jars against massive debt to GDP ratios and hence sustainability. In echoes of the past in emerging markets fixed income, politics and central bank policy have been intertwining in some countries but been unable to stem severe turbulence. Alongside others for differing reasons, emerging countries Argentina, Brazil, South Africa and Turkey (collective GDP the size of Germany) already show severe stress, along with currency decline in India and noticeable such in China. On rebalancing whimsy versus being more data driven, we see reassessment as overdue of risk, based not on the rear view mirror of a decade of minuscule rates. It needs a more dynamic forward view of debt servicing costs amid rising rates and spreads implied thereof, including of equity valuation.
Despite ostensible opportunity costs, such aspects call for diversification including that into cash reserves and precious metals as hedges. Despite present strong year-over-year U.S. corporate earnings gain, from worldwide industrials to financials and beyond, bifurcation in delivery has now been present for years – not least among marque companies. Numerous industrial companies from Japan to Europe to the United States have had to divest, restructure financial structure and still have been business challenged. Despite the duration of quantitative ease, the debt portfolios of many banks especially in Europe remain a source of duress. Despite past anticipation of growth helping to service debt, especially on foreign U.S. dollar denominated borrowings, emerging market stress has emerged with fresh challenges for domestic and foreign lenders alike. In key consumer areas, the technology and consumer preference changes from demographics are still evolving. In investment holdings, we suggest focus on quality of operations and financial strength, whether in equity holdings of growth or value as well as in fixed income, whether sovereign or corporate based.
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.