Note May 23,2018: Risk Premiums, Inconsistencies and Weak Links – In any market, risk premiums need monitoring, not just in overall terms but also at weak links for creaks and inconsistencies. Many rationalizations are tardy, after the fact of breaks. Currently all more so than in the past, global links do matter. Politicians prefer to run on promises rather than on having to justify actual delivery – which means that issues could linger, ranged from trade to nuclear regulations. In the swirl of volatility amid higher levels of algorithmic activity than in previous market cycles, changes in risk premiums are evident in some but not in other market segments. On the rationalization of chasing yield, the risks of weak link dislocation are already emerging in emerging market debt denominated in foreign currencies, severely so for Argentina, Turkey and Venezuela but also among G-7 members Britain and Italy. Even as U.S. Treasury yields rise markedly, they have not yet done so for sovereign equivalents German Bunds and Japanese JGB, nor oddly in CCC corporate bond markets. We believe risk premium assessments could irregularly ratchet up worldwide, especially if 10 year U.S. Treasury note yields were to be 4.50% and Fed Funds at 3.50% in a year, as is our expectation. Equity valuations appear elevated and many market levels subject to large point moves – which indicates more fragility in confidence than earlier in this cycle on quantitative ease as support. The just released FOMC minutes for May1-2,2018 corroborate evolution. These aspects are contributory to our Energy and Materials equity overweight and at the asset mix level, to precious metals as alternate asset overweight. Furthermore, in our otherwise Fixed Income underweight, we favor shorter duration as well as for diversification, smaller sovereign nations that are fiscally conservative and flexible. Similarly in equities across sectors and geographies, strength of balance sheets and quality of operational delivery may be especially attractive in the mid capitalization investment space, such as $1.5-5 billion in a U.S. context.
Most clearly on the agenda of the Federal Reserve remaining prominent appears to be reduction of quantitative ease. The just released FOMC minutes for May1-2,2018 corroborate policy evolution. Significantly so has been the increase already in yields at the long end of the U.S. Treasury yield curve to 3.17% for 30 year maturities and 3.00% for 10 year maturities, close to 12 month highs and close to double their levels at the bottom of this cycle. These fixed income developments in the United States in turn increase the competition for current income in fixed income worldwide, as well as for yield oriented equities and are likely to boost the base for risk premium assessments. In turn, BBB corporate bond yields have also moved towards 12 month highs in the United States as have emerging market bond yields. As is classical as cycles mature, some Fixed Income, Currency and Commodities (FICCs) dynamics appear in flux but other aspects do to be appear currently inconsistent.
As expansion beckons in global growth, emerging countries have long been sources of opportunity but they also can become sources of unpleasant turmoil as conditions turn out to be less favorable. The current environment is no exception. Creaks of weak links have apparently been building in the foreign, especially U.S. dollar denominated, currency issues of emerging countries from a variety of industries and countries that had been in favor for a pickup in yield amid assumptions of monetary stability. Compared to earlier in the quantitative ease process after the credit crisis flared from 2007, currently with dislocations amid currency weaknesses can be seen, despite sharply higher fixed income yields for commodities oriented Argentina and Venezuela in Latin America as well as industrial oriented Turkey, at the interface of the Middle East, Asia and Europe.
Fixed income yields and premiums for Britain and Italy have increased, in post haste especially for the latter. Among the G-7 countries and for half a century since the 1960s, uncertainty has periodically flared about Britain wanting to belong to Europe and about Italy wanting to be as fiscally responsible as other founding members of the European Community. Currently, Britain appears in more political angst about its response as it grapples with Brexit negotiations and the concreteness of European Union conditions for future relationships. After inconclusive elections, Italy appears to have a coalition government that is weak as in the past and more importantly that seems willing to engage in financial brinkmanship. After having brusquely ditched its Commonwealth and other trade links when it first joined the European community, Britain is now likely to find negotiations much more arduous on its Brexit path. With a coalition of convenience filled with inconsistent promises of fiscal largesse, Italy is likely to run into domestic and European Union roadblocks. Currently, these uncertainties about Britain and Italy that have resurfaced also potentially impact advanced country fixed income markets.
In contrast to developments in U.S. fixed income markets however, German bund yields have declined and remained low at 0.51% as the preferred European benchmark. So have fixed income yields in Switzerland as it attempts to control its exchange rate. Further afield but certainly part of global finance, fixed income yields in Japan appear lower still at a minute 0.06% and a stable currency exchange rate. Ostensibly there is a shortage of German bunds due to the fiscal restraint of Germany within Europe but the largesse of Japan has been accompanied by a sharp rise in debt to GDP ratios. These differing inconsistencies have been present long enough for complacency to creep in. It could be that there lingers deep seated belief that even as global conditions change, central banks would still provide unlimited support but they may not be reliable.
Within the U.S. fixed income market, CCC corporate bond yields remain far lower and closer to 12 month lows. Similarly, the Russell 2000 has been holding up more so than the S&P500 or the DJIA in U.S. equity markets. It suggests that corporate risk is widely regarded as being low in that which historically has been a more vulnerable segment. It is worth reiterating that corporate cash flow duress tends to accentuate for smaller companies as conditions become less favorable. As was seen from 2007 in overall credit markets and just two years ago for energy companies, liquidity can quickly seize up. We believe risk premium assessments worldwide could irregularly ratchet up, especially if 10 year U.S. Treasury note yields were to be 4.50% in a year and Fed Funds at 3.50%, as is our expectation.
Compared to earlier periods in this equity cycle when earnings momentum dominated, more recently, equity markets have appeared worldwide to revolve between sharp upswings and downturns, practically on a daily basis. Valuation gains in this cycle have been salutary. Factually for the S&P 500, earnings since 2016 have moved well beyond their cyclical recovery phase. Even taking tax changes in the U.S. into account, the upcoming potential for earnings expansion seems perforce slower. These aspects have appeared obscured by massive share buybacks but revenue reporting and rising interest rates seem indicative of change currently, as evidenced in recent corporate reporting including that in Europe. We believe equity market assumptions of tranquility could be tested in more ways than one and without warning.
In Europe, expanding is the circling around on the issues of Brexit for politically weak Britain and now for Italy, post its inconclusive election. Tension is building between the United States and Iran affecting not just the Middle East but also Europe over trade restrictions. Repartee between the United States and North Korea seems to have an air of protagonists testing weaknesses rather than negotiators at the cusp of conclusions. On political undertones about trade, we believe that it is entirely possible that in the time honored sequence of politicians preferring to run on promises than on having to justify actual delivery, the United States could prefer to have the crucial NAFTA, China and European/Iran sanctions talks remaining in limbo until after its November 2018 midterm Congressional elections. Political uncertainty is both hard to model and is an inconvenient truth that tends to stymie corporate decision making. It especially clouds longer term planning that is now crucial for markets at their present position in the capital market cycle underway since early 2009 and could lead to higher capital investment hurdle rates.
We see the elevated volatility potential as symptomatic of a lack of conviction about future capital market drivers in light of the gains that have already accrued. After all, there is history for the markets. While markets had assumed extraordinary growth in the 1960s, individual companies were not able to justify the equity multiples ascribed. In the 1970s overall, changed central bank policy and an agricultural revolution curbed the basic assumptions behind the already elevated commodity prices. Reliance on liquidity proved ephemeral both in the 1987 equity debacle and in the credit debacle into 2007. These aspects are contributory to our Energy and Materials equity overweight and at the asset mix level, for precious metals as alternate asset overweight. Furthermore, in our otherwise Fixed Income underweight, we favor shorter duration as well as for diversification, smaller sovereign nations that are fiscally conservative and flexible. Similarly in equities across sectors and geographies, strength of balance sheets and quality of operational delivery may be especially attractive in the mid capitalization investment space, such as $1.5-5 billion in the U.S. context.
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