Note February 14,2018: Mortals Don’t Walk On Water: Amid capital markets flaring into higher volatility, it is worth recalling that it is normal. Central banks previously have acted as restraining forces on massive deficit financing, currently need to do so but appear too genteel. Extrapolating quantitative ease already engineered does not mean that crowding out in financial markets cannot occur. Many countries, consumers and companies are already structured on elevated debt. In the already rising cost of borrowing, yet to kick in are uncertainty premiums of the 1990s variety. With trade and politics tense, currency volatility beckons. The market abnormality has been in the accruing of major gains in myriad asset classes, including that until recently in short volatility instruments. Technical market aspects (like the recent short volatility collapse) can be more than a shot in the dark. They could presage fundamental change versus ample liquidity assumptions. This S&P 500 earnings gain phase already stretches to eight years. Instead of market share, companies cannot be oblivious to margins. Recent results show worldwide revenue competition to be severe in production, services and resources alike. At low unemployment levels in the OECD countries, labor costs could increase pressures. At current valuations, equity price volatility is likely to be far from subdued. Unlike during momentum, more risk premium gatekeeping is likely. It includes quality and diversifying such as into precious metals.
In recent weeks in fixed income, initially the yield of U.S. Treasury 10 year Notes reached 12 month high levels to be followed by the same for emerging market bonds, BBB and aggregate high yield corporate bonds but not yet for CCC bonds. Rather than marching into proactive credit risk readjustment, reappraisal has instead appeared to follow that in segments like U.S. Treasuries in which liquidity is unquestionably better. The same can be seen worldwide in the universe of sovereign fixed income markets. Covenants have appeared to be lightening in high yield fixed income worldwide. These aspects are of more than passing interest in indicating that investors have been reactive in allowing excess to develop. At one point, academic theory may have argued that markets are wholly efficient but the reality is different on the ground. For instance , credit pressures were evident in 2006/7 but it took until 2008 for the full force of illiquidity to be felt. From 1996 in the TMT (technology, media, telecom) phase, the counting of eyeballs as rationale instead of tangible financial performance drove fervor with the resultant catharsis only emerging over 1999/2000 in equities and fixed income alike. Even more to the point, equity P/E ratios had started to drop back from 1973 on inflation and balance sheet structure pressures. Nonetheless, it took a further half decade of following upward inflation for fixed income yields to peak out. It then arguably took another decade for them to fully and proactively incorporate uncertainty risk premiums to force change. Subsequent exhortations (like 50% debt to GDP targets) by institutions like the IMF, the OECD and most central banks domestically were therefrom an integral part of restructuring downwards fiscal largesse and deficits. Central banks previously have acted as restraining forces on massive deficit financing, currently need to do so but appear too genteel. Simply with quantitative ease already engineered and gradualism espoused does not mean that crowding out in financial markets cannot occur. It is likely to increase stresses as interest rates rise from minimalist levels and liquidity becomes more constrained.
Across the world and historically unlike the 1990s in particular, politics of all stripes have become ones of largesse in spending whether of the defense or civil spending variety. With many countries, consumers and companies already are structured on elevated debt. Public Budget commitments, share buybacks by companies and consumer borrowing, including mortgages, have all had roles. The cost of borrowing is already rising substantially, with the uncertainty premiums of the 1990s variety yet to kick in. Political and trade tensions remain elevated even if below the surface. As has been the case in prior confrontation cycles, tariff regime retaliation is being mooted from industrial goods to materials and agricultural goods. Multilateral trade agreements NAFTA and the TPP have been under stress, especially vociferously by the United States. However into 1987, United States trade tensions were versus Germany and Japan but the latter two were also dependent on it for cold war defense. Yet, tensions even among allies could not be avoided. Currently, Europe is much stronger than three decades ago. More crucially the risks are different in potential and current trade tensions between the United States and China, both are militarily and economically strong. In move and countermove, U.S. tariffs on solar panels was followed by that on sorghum by China to be followed by steel by the United States. Renminbi exchange rates having risen have apparently on band loosening, been pulling back. With trade and politics seeming fractious, currency volatility beckons once more.
Operating earnings levels for the S&P 500 bottomed in 2009. Since then, there has been an almost classical doubling and then even more. The bounce back from a bottom low in earnings to expanding beyond the prior peak appears to have been classical in taking two years. Still, the total length of the continuing earnings gain phase has already stretched to eight years. Alongside low interest rates and massive share buybacks which have increased corporate leverage, the length in earnings expansion in the current cycle has also accentuated reflective quarterly reaction onto the beating of the latest expectation for individual companies. It has also fostered a global expansion in equity valuation, with other aspects receiving shorter shrift. When global economic growth was lower, for instance into 2016, brutal competition for revenue was being experienced across equity sectors. This brutal competition for revenues appeared in growth areas like smart phones, in recovery areas dependent on the consumer as well as in sectors like energy experiencing commodity price collapse. It occurred as much in emerging areas with strong growth geographically as in the advanced countries endeavoring to go above the 2 ½% GDP growth level. Individual company releases have indicated a far from comfortable existence, sharply contrasting with low volatility and sharp gains in capital markets and real estate.
As annual global GNP growth expands potentially towards a 4% level mooted by institutions like the IMF and the OECD, we believe that it also needs to be recognized that so far in early 2018, corporate releases continue to disclose strong competitive pressures. It appears where economic growth has accelerated for example in Europe, or Japan or the United States based industrial and consumer conglomerates facing restructuring pressures as well as in countries like China and India amid retail overbuilding and credit issues for instance during strong growth. Much has been made about tax overhaul in the United States. Still, according to some reports (Wall Street Journal, February 12, 2018), the actual scheduling could be prolonged in the recognition of taxes due on offshore earnings by companies. It would add to cash flow complexities in capital budgeting. In an expansion phase of the corporate business cycle, companies often have focused on gaining market share. The present composition of the corporate revenue cycle and the fast pace of change in production, services and resources alike have amply demonstrated that even during expansion, companies cannot be oblivious to margins. At low unemployment levels in the OECD countries, labor costs could further increase pressures. Currency gyrations also have a tendency to come at inconvenient times. Market participants need to reflect that technical market aspects (like the recent short volatility collapse) can be more than a shot in the dark. They could presage fundamental change versus widespread ample liquidity assumptions. These aspects mean that, especially at current valuations, equity price volatility is likely to be far from subdued. Unlike in recent momentum markets, investors need to act as risk premium gatekeepers and be less reliant on official sources. It includes quality and diversifying such as into precious metals.
Kind Regards,
Subodh
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