Note May 15,2018: Real & Trade, Proxy and Proximity Wars – Arguably after many decades, political economy brinkmanship seems alive. Contrary to strategic doctrine to not initiate two front confrontations, the U.S. appears willing to engage simultaneously on trade and geopolitics with friends and rivals alike. Real and trade policy trade tensions have been building up. Real Estate may be replete with brinkmanship but it is also replete with bankruptcy from New York and Canary Wharf in the last century to Argentina and the Suez Canal further back with countless others in history. The beneficiaries come later from picking up the restructuring pieces. Capital markets need to consider tensions in real and trade, proxy and proximity wars that appear all too real, quantitative ease notwithstanding. It means that risk premiums are all the more necessary. In fact, in fixed income and despite stronger growth than global GDP averages, emerging market debt especially in dollar denominated areas show wear and tear. After large interest increases not calming its currency, Argentina has had to approach the IMF. The reaction gap remains glaring between low grade CCC corporate bond yields being sticky versus other portions of fixed income including 10 year U.S. Treasury Note yields as benchmark. In FICCs, energy prices appear slightly above our benchmark range.
We believe that equity market assessments have been shifting from earnings momentum and towards balance sheet strength and revenue competition. Quantitative ease from central banks is likely to be diminishing in providing sustenance for momentum equity markets. Despite market chatter about death crosses averted for the S&P 500 between 50 and 200 day moving averages, we see no reason to lower our guard about enhanced volatility nor about the need for higher risk premiums than equity valuations or credit spreads indicate. Rather than geographic rotation, we expect industry sector rotation to likely dominate, with the unparalleled sector diversity of the U.S. market being critical for leadership. In our favor for quality of delivery and financial strength as likely to be crucial than momentum for more selective markets, we do not see a contradiction between being overweight in both Information Technology and Energy.
Arguably more so than has been the case for many decades, political economy brinkmanship seems very much alive. Domestic issues about alleged Russian collusion in elections and large budget deficits do loom. It means that risk premiums are all the more necessary in capital markets. Contrary to strategic doctrine not to initiate confrontations on two fronts, the U.S. appears willing to engage simultaneously on trade and geopolitics with friends and rivals alike. Internationally, real and trade policy trade tensions have been building up. Proxy and proximity wars are very real. Not to be forgotten are the conflicts in the eastern Ukraine. The constant probing of Russia continues, from the Black Sea to the Baltics and into the Arctic regions. Most overtly in terms of live fire wars, proxy and proximity battles include Yemen and Syria as well as Iraq and Afghanistan in the Levant. After the withdrawal of the United States from the Iran nuclear agreement, it needs calibrating that Iran is much more diverse in influence and impact than North Korea which is in effect a one issue point of stress. Considerations about Iran include its religious leadership for globally a significant portion of Islam and consequentially long lasting rivalry with Saudi Arabia. Vicious real proxy wars exist between the two in close proximity Yemen and Syria. The Israel/Palestinian stresses remain very real in impact on the populace throughout the Levant.
The fight against radical terror Islam is also far from over. Events demonstrated as much as recently as last week in Paris, France and Jakarta, Indonesia as well as all over Iraq during its elections and already destabilizing Afghanistan. On economic impact from its significant position in energy to its industrial capabilities and well beyond religious considerations, Iran represents much more than does North Korea which is very dependent on China and global largesse even for basic sustenance. A potential meeting between North Korean and U.S. leaders is making headlines as did the meeting of leaders of both Koreas a few weeks ago. Not to be overlooked is that the North Korean leadership met twice in a month in China for talks with its leader. Furthermore stressing its pivotal role, China met with Japan and South Korea leadership just last week. China continues to cement its presence in the south China seas, astride across many key shipping lanes. Regional jockeying for power has not diminished in Asia or globally.
As if these real proxy and proximity wars were not consuming enough, those over trade also loom. In trade, a form of brinkmanship seems to be concurrently at work. Subsequent to the 1930s and then world war, opening freer trade has underwritten prosperity but now in sharp contrast, bilateral trade balances then tariffs and now quotas are apparently being re-mooted as viable policy options primarily by the United States. The NAFTA talks appear dragging out between the United States, Canada and Mexico and apparently include not just North American content in the key automobile manufacturing sector but reportedly have now included minimum wage level demands for the industry. For most countries, wages would be a domestic sovereignty issue and so are likely to be contentious in any international discussions. In addition to using U.S. national security as reason for imposing tariffs in steel and aluminum that in effect impacts others including European strategic allies, the United States has apparently also mooted imposing quotas on automobiles.
After tit for tat proposed tariff flaring that included a sharp response on agricultural items, recent events in informational technology demonstrate that trade initiatives appear to have very much of an individual rather than overall policy tilt not least between the United States and China, which has both a trade large surplus and robust political leadership. World trade has amply demonstrated that prosperity was enhanced in recognizing the importance of efficiency in moving progressively from individual autarky to bilateral trade in the 19th century to multilateral trade in the second half of the 20th century. Real Estate may be replete with brinkmanship to test opponents but it is also replete with bankruptcy. New York and Canary Wharf should be salient examples that are within recent memory, Argentina and the Suez Canal further back with countless others in history. The beneficiaries usually come later in picking up the pieces from restructuring, not least with direct or implicit government assistance.
Capital markets need to consider the tensions in real and trade, proxy and proximity wars that appear all too real, quantitative ease by central banks notwithstanding. In fact, in fixed income and despite stronger growth than those of the global average of close to 4% annually for GDP, emerging market debt especially in dollar denominated areas have started to show sustained wear and tear. In Latin America once more and despite many hopes, after large interest increases not calming its currency, the populous country of Argentina has had apparently to approach the IMF for relief, with the only aspect apparently to be decided being the type to be publicly defined. As well, the reaction gap remains glaring between low grade CCC corporate bond yields being sticky versus other portions of fixed income, including 10 year U.S. Treasury Note yields as a benchmark for valuation. Along with these aspects in brief as sources of volatility, in the Fixed Income, Commodities and Currencies (FICCs) space, energy prices appear slightly above our benchmark range.
Earnings reporting season has been transitioning from being U.S. centric to corporate reports also emerging from other areas like Europe and Asia, including Japan. We believe that equity market assessments have been shifting from being dominated by earnings momentum and towards balance sheet strength and revenue competition. Similarly in aggregate, quantitative ease from central banks is likely to be diminishing in providing sustenance for momentum equity markets. Continuation of the prior equity characteristics of this cycle by its logic should for example have led to outperformance from the lower valuation in Japan. Instead and amid Yen currency uncertainties, Japanese equities have lagged once more. We believe global intermarket equity developments currently presage significant change. Despite equity market chatter about death crosses for the S&P 500 being averted between 50 and 200 day moving averages, we see no reason to lower our guard about enhanced volatility nor about the need for higher risk premiums than equity valuations or credit spreads indicate.
Rather than geographic rotation in current equity market conditions, industry sector rotation will likely be dominant with the unparalleled sector diversity of the U.S. market being critical for leadership. With our expectation for quality of delivery and financial strength as likely to be crucial rather than momentum, for more selective markets, we do not see a contradiction between being overweight in both Information Technology and Energy. Both Information Technology and Energy are likely to benefit from a quality of delivery, restructuring and strong financial statement tilt. While markets have focused on the concept of social media which has runup against privacy and regulatory issues, for the underlying exposure to the reality of a communications revolution, the software and hardware portions of Information Technology offer advantages both from restructuring accomplished and from financial statement strength. Energy has had its catharsis of restructuring amid $ 25 Bbl. WTI almost two years ago. Amid commodity price recovery now, Energy offers advantages for its stronger companies to deliver while also acquiring assets from its weaker competitors.
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.