Note June 4,2018: Rising Interface of Policy and Market Volatility
After initial sell offs ostensibly on the Italian political impasse, worldwide equity markets moved up sharply and fixed income yields stabilized. We do not see wild swings as signals of rude health. In reality, capital markets are less efficient than many model. Real life participants tend to ignore signals. Two recent examples suffice. In the late 1990s, the existence was not sudden of high equity multiples overall and nor was the paucity of revenues across technology/media/telecom. Until dispensed with, it became the source of risk and debacle. Similarly in the mid-2000s, there was sustained exuberance about ability in the credit market to repackage risk. It was threw up risk and illiquidity, even now a decade of quantitative ease later. Recent political, central bank and capital market developments likely indicate that the backdrop for the next crisis of risk assessment may be over sovereign debt paved, even if inadvertently, by excess quantitative ease. Concurrently, aggressive politics, international trade and internal fiscal-monetary interactions appear for advanced and emerging areas alike, not least in the United States with odd felicitations. In business risk evaluation (much like vehicles in real life) too much friction results in gridlock and too little results in chaos, including for markets. We have cash above benchmark, with precious metals as overweight hedge.
Even though interest rates are low, we underscore favor for strong and conservative balance sheets as well as quality of product/service delivery, whether in fixed income or in equities. Despite their better growth, emerging markets have dropped on signs of global moderation. Lower equity valuation has once more, not helped Europe or Japan. Despite 25-30% year-over year gain in Q1/2018 for S&P 500 earnings, we see its long term annual growth as 7%, not the consensus 12%. As is also classical, banking is likely to set direction. Those having earlier and more thoroughly continuing restructuring are likely to press advantages while others, having lost opportunity, now struggle with restructuring just to keep up.
Central banks and especially politicians have appeared to be content with espousing a reactive response subsequent to crisis. In contrast to the prior two decades into the early 2000s of restructuring, currently and worldwide, many national, regional and municipal governments appear to have chosen to use the ample liquidity of more than a decade as not to be a reason to readjust fiscal posture but instead to be a reason to continue dancing while the music plays. It should not be considered surprising that politicians generally prefer to operate on promises but sovereign financing issues could be the backdrop for the present cycle of risk reassessment. In this regard, the sovereign financing and political crises of Latin America and southern Europe have attracted attention. However and despite its external assets, the debt-to-GDP ratios of Japan cannot be indefinitely brushed aside. Nor can the potential $ 1 trillion plus annual deficits projected for example by the Congressional Budget Office and others as the likely result of present U.S. federal budget policy. Nor for that matter can be overlooked the credit excesses of emerging countries including China and India, despite their stronger than global average GDP growth.
Into 2019, a number of elections and political developments have taken place or are likely to be doing so, amid an unmistakable rise of populist chauvinism. Increased confrontations are a likely and present risk. In Asia, they include developments in its east, around the south China seas and the Korean peninsula as well as elections in India by mid 2019. European politics appear in flux now, not just about relations with the United Kingdom but also within the continent. Ahead of its November mid-term elections in 2018, the United States appears to also be willing to engage its allies and China alike in trade/ tariff wars while being felicitous to North Korea and Russia. The ongoing trade talks about NAFTA revisions appear fraught, just ahead of a Mexican presidential election in July that has a strong populist tinge. Further, vast parts of Latin America from Argentina to Brazil to Venezuela appear politically stressed. The Levant remains violent. Turkey is coming up to a presidential election in late June/early July 2018. Revocation of U.S. acceptance of the Iran nuclear agreement appears leading to fresh turmoil.
More than has been the experience of recent years, friction between fiscal policy and monetary strictures have been more of a norm within which capital markets operate. It makes risk premium vigilance necessary. Given the size and duration of quantitative ease that appears to have given rise to complacency, reversion to more normal conditions would likely come as being uncomfortable for many strategies of politics and investment. They appear based on little or no change from current conditions. Amid the machinations about Brexit with Europe, now also apparent seem disagreements between the U.K. Treasury and the Bank of England on future policy links with Europe. The changes in government in both Spain and Italy raise new challenges for the European Central Bank, itself undergoing a phase of leadership change. Unusually responding to the large deficit in the proposals of the new Italian left-right coalition government, the Bank of Italy through its governor felt compelled to issue constitutional warnings. In the Americas, the Bank of Canada has signaled future rate hikes, after a considerable hiatus during which U.S rates rose several times. In the midst of FOMC composition changes in play, the Federal Reserve has nonetheless signaled more rate increases and less quantitative ease to come. In emerging economies, Chinese monetary policy appears geared to greater liberalization but also stricter provincial funding. In India, changed bankruptcy laws, bank scandals, higher oil prices and an impending election by mid-2019 all add up to challenges for monetary policy. Among several others, central banks from Brazil to Turkey to Argentina to Venezuela are having to deal with currency weaknesses despite interest rate increases. For monetary authorities, the signs of more stress have already emerged.
Rather than a battle of dispassionate statistical dissection, we expect a rising interface of policy and market volatility to prevail well into 2019. It is likely means an interplay in political economy that was more prevalent decades ago. By contrast, the immediate decade of 2008-18 has been anomalous in terms of a business cycle. As is well documented for the decade of 2008-18 but seems less scrutinized so far for ancillary distortions, both massive quantitative ease and massive fiscal ease have prevailed to an extraordinary degree with little pushback. Valuations in equities soared and fixed income yields generally declined, until recently. However and not unlike a two decade long experience with quantitative ease in Japan, efficiency has suffered in worldwide and individual country estimations. Not uncoincidentally amid signs of moderating global growth below the 4% annual GDP level, more friction has emerged.
We have cash above benchmark, with precious metals as overweight hedge. Despite their better growth, emerging markets have dropped and become volatile on signs of global moderation. Lower equity valuation has once more, not helped Europe or Japan so far in 2018. Despite a likely 25-30% year-over-year gain in Q1/2018 earnings for the S&P 500 with tax changes partly driving momentum, we see its long term earnings growth as being 7%, not the consensus for sustained annual growth of 12% for the longer term. As is also classical worldwide, banking is likely to set direction. Those having earlier and more thoroughly continuing restructuring are likely to press advantages while others, having lost opportunity, now struggle with restructuring just to keep up. Even though interest rates are low, we underscore favor for strong and conservative balance sheets as well as quality of product/service delivery, whether in fixed income or in equities.
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.