Note March 7,2018 – Market Correction Distilled: Frequently, market correction and much rarer extreme bear phases seem ostensibly to appear at inconvenient times, notwithstanding history. Much has been expended about the capital market correction of recent weeks. Explanations as to the catalyst range from volatility ETFs to fear of deficits and tariffs to change potential in central bank policy. It seems much like the fable about men in blindfolds when tasked to describe an elephant and who instead relate various individual attributes. The behavioral reality is that assuming perfect knowledge is risky. Particular assumptions have raged in past cycles but perforce unraveled. It occurred whether about commodities and inflation into the late 1970s or eyeballs rather than revenue growth driving information technology into the late 1990s or in the 2000s on slicing and dicing credit averting systemic risk. Currently, the elephant in the room encompasses much. It can be distilled into unusual investor complacency over widely ascribing low risk premiums onto low interest rates. Complacency seems being expunged. At opposite ends have been political developments in the U.S. and China. Europe is amid fractious politics like the Italian election. Seemingly small tariffs draw response and protectionism acceptable. Stress testing ability to pay is crucial for fixed income and not just a central bank function. Lately and despite widespread expectations based on lagging valuation in Europe and Japan, peloton like equity rotation in leadership has faltered. Despite global growth appearing better than that of 2009-2017, higher risk premiums and sharply divergent delivery of investor return loom geographically and among industries.
Administered suppression of interest rates have been closer to the epicenter of this cycle than was the case in many other cycles, excluding war or depression. Yet there is currently in capital markets a behavioral dimension that defies neat formulation. Assuming perfect execution by the central banks has not been a perforce assumption of the markets. Between markets and central banks, the instances are myriad of testing and often testy relationships ranged in example from the run up to the inflationary 1970s to the substantive risk premiums of the early to mid-1990s versus the Federal Reserve as well as versus policy in many other individual countries like Malaysia of the mid-1990s to Britain of the late-1960s. Authors Z. An, J. T. Jalles and P. Loungani of the IMF in their Working Paper No. 18/39 dated March 5,2018 (http://www.imf.org/en/Publications/WP/Issues/2018/03/05/How-Well-Do-Economists-Forecast-Recessions-45672?cid=em-COM-123-36702) and titled “How Well Do Economists Forecast Recessions?” assess forecasts for 63 countries and conclude in part “ … that forecasts of the private sector and the official sector are virtually identical; thus, both are equally good at missing recessions. Strong booms are also missed, providing suggestive evidence for Nordhaus’ (1987) view that behavioral factors—the reluctance to absorb either good or bad news—play a role in the evolution of forecasts…”. The behavioral reality is that assuming perfect knowledge is risky, not least in the positioning of investments.
In any event, further change in the posturing of central banks has appeared in the February 2018 semi-annual testimony of the new Federal Reserve Chairman to Congress. It seems so amid political change with Brexit positioning for the Bank of England and for the ECB amid better growth. Interestingly, it seems so even in that of reappointed Bank of Japan Chairman Kuroda, a hitherto unflagging supporter of massive quantitative ease for Japan. Central banks in emerging countries, not least in India and China have had to again tighten supervision in response to credit scandal. One after another, central banks in the overseeing of banks have adopted systems of stress testing. Much seems in flux.
By contrast, discussion about fixed income yields has tended to be about moderate change in yield basis points. Certainly, the present almost 150 basis point increase from the mid 2016 low to 2.88% as of March 6, 2018 may seem low compared to the almost 1200 basis point increase in 10 year U.S. Treasury Note yields during over two decades to their late 1981 peak (15.68% by November 16, 1981) as central banks appeared to struggle to recover their grip. At present, in dollar value terms and due in no small part to low coupons, the loss in value from June 2016 lows still adds up to a not insignificant 11%. In addition, the impact of interest rate or fixed income yield changes tends to have a ratcheting effect. In contrast to momentum fever in fixed income, overdue from investors are similar assessments linked to stress testing in adversity. For example, covenants in high yield debt have reportedly once more being deteriorating and suggest complacency. According to the OECD, sovereign debt currently is close to $45 trillion compared to $25 trillion in 2008. U.S. Government debt currently stands at close to $20 trillion or twice that of 2008 with average rates half the levels then of close to 4%. An increase to those levels would mean interest costs above $1 trillion and likely more than twice those at present as further debt is accumulated. The same would hold in other OECD countries. Emerging country debt has reportedly increased by $ 40 trillion since crisis. Interest cost and foreign exchange cost continue to have potential for arbitrage upset that seem under recognized. Deficit stress and crowding out in capital markets remain a risk.
Overall in the rise of populism politics, both strong man behavior and a willingness to blame externalities have appeared to coexist with weakness. It is historically not unprecedented and is worth considering as a risk in the present environment. In Europe, a series of elections ranged from the Brexit linked one in Britain in 2016 to that in Germany in 2017 to that in Italy now in March 2018 have had reversion into governments with more tentative mandates of types not experienced for decades. In other democracies, the same can be said about politics from Japan to Australia to India to Brazil to Mexico. In addition to ongoing conflagration in the Middle East, there appear extensive political and economic under currents from Iran, Saudi Arabia and up into Egypt. At opposite ends in terms of geography and outlook, there have been political developments in the U.S. and China. Into early March 2018, China has held its National Peoples’ Congress in which cementing leadership and boosting higher technology manufacturing have had major emphasis. Without leadership change, both Russia ahead of its election and China underscore more assertive policies. Economic policy and internal dissension appear dominating developments in the United States. The level of deficits likely expanded now in United States tax policy, a preponderance of heated dialog on trade and upcoming elections in November make its politics fluid. Seemingly small tariffs that are robustly announced as proposed by the United States for steel and aluminum on ostensibly national security grounds are perforce likely to draw response in myriad products or services whether from China, Europe, Mexico or Canada and many others. It makes protectionism seem acceptable and directly contrary to trade objectives that have been decades in the making.
In being based on central bank ease, the close packing of returns in equities has been a feature of this cycle. Lately, the investment schematic has faltered of peloton like rotation in leaders boosting all. Despite widespread such expectations based on lagging valuation, it is most clearly seen in robust global equity leadership failing to be assumed by those of Europe and Japan. The underlying rationale for continuity of the momentum since 2009 has likely been based on expectations of support of low interest rates and ample liquidity for low costs of funding even for fragile companies and for rotation in the expansion of equity valuation. However for global and local reasons, we see such complacency as being expunged. There appear signals of slackening of support from quantitative ease at work. The business cycle appears at an advanced stage, both globally and individually in many countries. The business cycle appears most advanced in the United States and hence there appears a more aggressive Federal Reserve disposition towards higher rates. In Europe, business issues appear in its key global Consumer Staples and Healthcare companies in the requirement of change. As well, European Financials have lagged in restructuring. In Japan, decades long low rates have not alleviated evidence of the loss of leadership and quality in many industries that is still being addressed. In emerging markets, fast growing India has nonetheless structural issues related to indebtedness in real estate, many basic industries and consequent scandals within nonperforming loans on the balance sheets of banks. For China, also lie issues of corruption in Financials and real estate even as the long term government objectives are for greater emphasis on manufacturing.
In this cycle, politics appear to have played a minor role in capital market assessments but low fixed income yields generally (and miniscule ones in Europe and Japan) have left little allowance for fractious behavior. The same can be said about the risk premiums at present in emerging market debt. Lately and despite widespread expectations based on lagging valuation in Europe and Japan, peloton like equity rotation in leadership has faltered. Despite global growth appearing better than that of 2009-2017, higher risk premiums and sharply divergent delivery of investor return loom geographically and among industries.
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. For disclosures, see www.subodhkumar.com .