Note January 24,2019: Our take from the parable of Humpty Dumpty is that breaking something is a lot easier than was putting it together, let alone patching it up after breakage. Students of the political economy need to recognize the United States and British leadership from Bretton Woods in 1944 and many subsequent agreements versus the current fissures in both lands. In contrast are the German/French agreement just now in historically fraught Aachen and the many Asian led initiatives, including the TPP.
Further, students of the capital markets need to move beyond rationalizing every momentum move. Recalling our past experiences like the growth valuation collapse of the nifty-fifty in the 1970s, the valuation compressions of the 1980s to build risk premiums, the TMT collapse into 2000, the credit debacle into 2008 and not least the hubris excess into 1987 and many before our time, we look in askance at some considerations placing Q4/2018 as being the equivalent of a bear market cycle. Instead, investors should contemplate as institutions like the IMF and the BIS have suggested, the risks of excess leverage. Also relevant and which many institutions shy away from, whether excessive quantitative ease has so distorted capital market valuation as to impair its role of efficiently allocating capital.
Late January has become a time in which many developments occur. It includes global new year meetings like those at Davos and corporate releases. In 2019, to be added for the capital markets are the political issues of fissure such as in the United States and Britain, of trade tensions and tariffs. As well as within the markets are issues of valuation and risk thereof assumed. Ingesting the lessons of Humpty Dumpty means to us that investors need to move beyond assuming at infinitum that massive quantitative ease equates with expansionary markets. There remains an inherent contradiction between assuming economic growth would be weak enough to result in continued massive quantitative ease and yet have companies also possessing the wherewithal to deliver long term double digit annual earnings growth.
We believe that 16x P/E on long term 7% annual earnings growth remains an important benchmark hurdle for the S&P 500. We suspect that the predisposition since 2009 will not last, of overwhelmingly focus on the beating of most recent consensus. The latest twist in financial engineering and investment thereof of funding leveraged loans accompanied by reduced covenants appears to be dependent on more of the same of the current cycle’s obsession with central bank accommodation. The impact of leveraged ETFs is also yet to be tested over a full cycle. Instead, we expect focus to expand on the quality of delivery being incorporated in reported results for countries and companies alike.
Allowing stressed entities to weaken and leadership to surge elsewhere for rejuvenation of activity remains one of the basic tenets of market based economies. Indeed it was espoused in the 1990s even by managed economies like China and semi-managed ones like India. The 1990s also marked the sale of many state owned enterprises in OECD economies. As one of the first countries to espouse minimalist interest administered rates and for decades now, Japan has nonetheless remained unable to deliver growth by eschewing this tenet. There have undoubtedly been dislocations that have led to populism in many lands. It is likely epitomized in the administration of both countries by the present U.S. government shutdown and the Brexit fissures in the United Kingdom. Unlike its behavior into late 2018, markets need to be cognizant now that such political economy breaks have real costs. These in the 1930s, for instance, were only partially alleviated by infrastructure spending. Then change came only in vision from 1944 onwards, by the series of agreements from Bretton Woods to the General Agreement on Tariffs and Trade as well as myriad other cooperative initiatives to expand growth. These initiatives incidentally also brought in the poor of war ravaged Europe and then those of the Third World. Such faith in the future seems currently scarce in the politics of populism. Humpty Dumpty warnings remain apt.
Trade talks seem fractious even between neighbors like Europe and Britain facing larger competitors or for that matter between economic giants like the United States and China. Not to be overlooked and despite still being in notable quantitative ease, recent economic data shows slowing. China indicates growth below the 7% annual GDP increase needed for stability. Recession fears have gained for Europe and Japan as well as lately, the United States in prolonged government shutdown. Recent releases by the IMF of potential global growth in GDP being lowered to 3 ½% for 2019 should be considered alongside its cut from its 3.7% expectations of just three months ago and closer to 4% expectations of a year ago. For reasons of mix, we believe global GDP annual growth in the 3-3 ½% range would at minimum indicate business risk and possibly, recession. Engendering significant business risk exists in allowing declining standards in global cooperation which then take time to restore, if at all. It is an issue of political economy risk that is additive to the myriad other conflagrations currently present.
Composite equity market behavior seems to us to be as important as that in the much larger fixed income and the massive currency markets. It is so despite its smaller size and is due to equities reflecting the health of companies and hence of businesses. Afterall, business activity is crucial for prosperity. In this cycle and in response to quantitative ease, we have noted two streams of equity behavior. Globally, equity markets have appeared to follow Federal Reserve trends exceptionally closely. Within equities themselves, higher earnings expectations have appeared to be made with abandon. Then notably and even when earnings expectations were cut for individual companies, the related equity price seemed to rise on the actual reported results exceeding even the last minute consensus expectations. In our view, such behavior does show a chronic momentum aspect to be present in current markets. For the longer term for capital markets, such behavior and reduced standards have engendered a financial engineering aspect to managing earnings, including incorporating higher leverage that is likely to entail higher risk. Some of these aspects have already had adverse impact on emerging market equities and fixed income in 2018. It could presage broader impact in global markets.
So far in the corporate releases in early 2019, companies in the retail sphere have been pointing to issues of revenue stress ranged from Christmas sales in the important winter season as well as to signs of fatigue in luxury purchases in the growth important Chinese consumer segment. In growth oriented Information Technology, stress started early and arguably in the Asian component manufacturer business and then to be admitted to in some key global marque finished product manufacturers, notably in the smart phone segment. Interestingly, companies that singly were pressed to restructure early have now appeared to deliver more, ranged individually from within Information Technology to within Consumer Staples. In the Industrials and especially in conglomerates, pressures remain in delivery. In Financials, stress in trading has been evident, legacy investment financing scandal debacles linger and net interest margin management challenges remain as do credit quality challenges. A characteristic of this cycle has been momentum driving equities even if consensus were cut as long as actual reports exceeded them. Also, equity markets overall have tended to peak after rather than before earnings. It occurred also for instance for the S&P 500 in its behavior with respect to the 2000 and 2006 segments of its earnings cycle. Reversion to tightening investment standards and forward looking adjustment is overdue. One sign of change towards tighter standards may have come from Asia where in late 2018, equities did start to weaken ahead of corporate weakness releases.
Investors should contemplate as institutions like the IMF and the BIS have suggested, the risks of excess leverage. Also relevant and which many institutions shy away from, whether excessive quantitative ease has so distorted capital market valuation as to impair its role of efficiently allocating capital. The impact of leveraged ETFs is also yet to be tested over a full cycle. We believe that 16x P/E earnings valuation on long term 7% annual earnings growth remains an important benchmark hurdle for the S&P 500. We suspect that the predisposition since 2009 will not last of overwhelming focus on the beating of most recent consensus. The latest twist in financial engineering and investment thereof of funding leveraged loans accompanied by reduced covenants appears to be dependent on more of the same of the current cycle’s obsession with central bank accommodation. We expect focus to instead expand on the quality of delivery incorporated in the reported results.
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.