Note June 27,2018: Neither Spiraling Nor Soaring Markets – As the first half of 2018 draws to a close, prevailing events mean neither spiraling nor soaring markets are likely. A readjustment of risk premiums is needed in the current cycle, divergent from the complacency prior to 2018. Daily and intraday swings of 2% in equity markets are indicative of an efficiency deficit compared to theory, not just in tiny markets but also in the heavily weighted United States, Japan and Europe. In the cycles that we have followed, bouts of illiquidity coexist with liquidity whether individually like in silver or aluminum in commodities or junk bonds in fixed income or individual and cohorts of equities. Amid evolving quantitative ease, such bout swings are likely in this cycle as well. To name some businesses under pressure worldwide, restructuring continues from banking to industrial products to information technology. On government policy, twilight zone fawning over adversaries and poking at weaknesses in allies appears on military matters and even on trade as backbone of growth. In the capital markets, there appears an imbalance. It lies between quantitative drives via algorithmics in markets and quantitative ease by central banks versus qualitative pressures in political economy that affect business fundamentals. These events cast doubt on the robustness of valuation expansion in equities and for that matter, in fixed income yields. Anticipating higher volatility and lower predictability than appears generally expected, we stress a focus on quality of operations and of financial structure.
Into the end of June 2018, a number of major central banks have held meetings that have been evaluating and explaining their policies. Clearly, a scale of change about quantitative ease has emerged in 2018. It ranges from the Federal Reserve on a path of reduction to others at various less salient points. In its just released Economic Report, on June 24, 2018, the Bank for International Settlements (BIS) does point to a narrow path away from depending on quantitative ease. It discusses lurches in risk appetite reversal and rising fixed income yields as risks for stretched capital markets. It points to protectionism risk as well. However, it includes the now well-worn phraseology about central banks having singularly buttressed economies. More attention is needed about the role in systemic risk of prolonged minuscule rates stoking fiscal complacency. Events have amply demonstrated that flareups can and do occur. It includes in emerging economies earlier in this cycle in Greece as well as now Turkey and Argentina as well for an economy as large as the United Kingdom, several times over the decades. Our experience is that central banks have not perforce had the control over fixed income markets that many participants currently appear to assume in their risk premium assessments.
Even beyond the long drawn fight against terrorism and the violence ensuing, other long established political relationships appear fraying and range from migration to trade policy. In the inevitable weave between politics and security, there has been a twilight zone like fawning over adversaries and poking against long established allies. It has been evidenced against a forward based military strategy that has been long established by the United States, been long utilized by global powers in their heyday as far back as the Roman empire and which continues to be currently utilized for example by China and Russia. On migration policy and absent the howling German shepherds of the 1930s, there have nonetheless been troubling current developments like families and children being separated at southern U.S. borders in the dead of night as well as ships of refugees being denied landing both in the Mediterranean Sea and the Pacific Ocean. Meanwhile even while being maligned, the United Nations High Commission for Refugees and countries like Turkey, Jordan, Lebanon and Bangladesh have been strained in hosting millions. These interfaces of tension add to qualitative risk.
In politics and trade in recent weeks, many developments have also been unfolding with increased velocity. Within Europe, little appears developing into consensus in vision among its leaders. Ahead of its March 19, 2019 deadline, Brexit discussions have become fractious for the United Kingdom both within it and with the European Union. The decision by the United States to engage in trade warfare via tariffs appears now to be in the implementation stage led by those on steel and aluminum. However, assumptions have proven unrealistic of no retaliation by the countries, whole regions and even companies affected. Canada responded forthwith in June 2018 and comprehensively from agriculture to manufactures in response. Via its President at a public meeting in late Jun 2018, China has pronounced a decision to strike back hard in targeted fashion as well as holding out the potential of internal market boycotts developing against goods like automobiles or services such as in finance provided by U.S. based companies. Targeted tariffs starting in July 018 appear from Europe on a wide range of American goods. In a global economy, the ancillary effects of tariff warfare have already been demonstrated by the opening up of soya bean markets for Brazil and the shifting of manufacture to Thailand of American branded high end motorcycles bound for Europe. Political economy issues may appear qualitative to some in the capital markets but it has some tangible consequences in the long term fundamentals that are essential to buttress markets beyond near term money flows.
Even now and close to a decade after the emergence of credit stress, worldwide restructuring continues for businesses. Merely illustrative as to its breadth, severe restructuring is underway in German banking. It is underway in U.S. industrial products companies ranged from spinoffs in major conglomerates to production offshoring by single product companies despite taxation revisions. Restructuring is evolving in information technology manufacturing in China in response to trade restrictions by suppliers. It is also present in social media responding to changes in European governance regulations that are likely to have global impact. Compared to generally complacent behavior in capital markets prior to 2018 that envisaged quantitative ease to be an easily dominant investment factor, a requirement exists now in the current cycle for a readjustment of risk premiums. Daily and intraday swings of 2% in equity markets are indicative of an efficiency deficit compared to theory. It appears not just in peripheral and tiny markets but also in those that are heavily weighted like the United States, Japan and Europe. In the cycles that we have followed, bouts of illiquidity do coexist with liquidity, whether singly for silver or aluminum in commodities or junk bonds in fixed income or in whole cohorts and individual equities.
With evolving quantitative ease, it would be unusual if such liquidity/illiquidity bouts did not occur in this cycle as well. These events cast doubt on the robustness of valuation expansion in equities and for that matter, in fixed income yields. For instance, P/E ratios currently for the S&P 500 seem anticipatory of double digit sustained earnings growth versus actual long term annual averages closer to 7%. Yet for the backbone for many global business, global GDP growth has only recently approached pre-2007 levels which could not be sustained even with ample credit and latent trade tensions. Propositions abound of junk bonds being robust. In this cycle, junk bonds have yet to be tested in adversity, other than in energy where yields and illiquidity soared just a few years ago when crude oil prices dropped. Anticipating higher volatility and lower predictability than appears generally expected, we stress a focus on quality of operations and of financial structure.
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.