Note July 11,2018: A Question of Balance – Equity markets extrude large index level point moves. A question of balance still prevails. It includes that between transactional activity versus a long term strategic focus. This balance has been under pressure. It is so not just in politics for instance in the rise of populism in decrying immigration or in pressuring trade relations between nations. It also lies in the interplay between short term momentum and longer term benchmarks of value for markets. For instance, equity markets need to come to grip on whether longer term, recurring and replicable (for example ex share buyback) corporate earnings growth has sustainably been elevated. In fixed income markets, it is on whether capital has become so sustainably plentiful and risk so low as to maintain yields far below the long term averages incorporating varieties of financial conditions over the decades, or for British data over the centuries.
On geopolitics and stability, ongoing warfare in the Levant, the induced stresses within NATO and G-7 amid a lack of benchmark specificity over Russia and North Korea relations add risks to growth, when combined with the global rise of populism. Positive trade and political initiatives occurred in the late 1940s with greater activity globally and then again in the 1990s. Recent trade tensions are seemingly ignoring that technological change and that moving up a value added chain remain crucial to growth and prosperity.
Prolonged and massive quantitative ease may have distorted the role in indicating direction of pricing in capital markets. Especially as the strong form of efficiency has proven deficient, changes in consensus about risk could be both abrupt and lurching. Helped by quantitative ease earlier in this cycle as earnings bounced off the bottom, markets responded in 2009. They then expanded valuation even as earnings expectations were serially reduced to easily beaten levels. Now, global responses appear volatile despite for the S&P 500, strong operating earnings growth accruals for Q1/2018 and well telegraphed close to 20% year-over-year increases for Q2/2018, stimulated by tax cuts and energy recovery. Volatility lurks below the surface in our favored areas like the financials, energy, and info tech as well as in underweight consumer discretionary and staples. In a decade old business cycle, the present corporate preference for massive share buybacks to restructure balance sheets has yet to be tested, excepting in energy, under more adversity. Emphasis on quality is likely appropriate.
In other than extreme circumstances and as a result of difficulties in ascribing immediate impact on capital markets, politics are often considered to be a qualitative factor. At a NATO summit in Brussels from July 11, 2018 to be followed by a meeting in Helsinki between the leaders of the United States and Russia, the script appears to be similar to that of June at the G-7 in Canada, followed by the U.S./North Korea summit in Singapore. In both sequences, allies have been severely denigrated, then harping on Canada and now harping on Germany. Meanwhile, as a superpower, the United States derives tangible and non-tangible (for example, early warning positioning in the Arctic) benefits from its string of bases and presence around the world. Specifics on achievable benchmarks on Russia/U.S. relations appear absent even while tension points have not curbed fawning over adversaries. Cyber warfare abounds.Tensions at the borders of Europe persist from nerve gas poisoning in the United Kingdom to territorial acquisition in Crimea and ongoing border probing from the Arctic Circle to eastern borders. Adding risks to growth at present from geopolitics and stability are ongoing warfare in the Levant, the induced stresses within NATO and G-7 amid a lack of benchmark specificity over Russia and North Korea relations, when combined with the global rise of populism.
The long term effect of politics can be dramatic for trade relations. It represents uncertainty when restraint is applied whether in the form of protestations of strategic imperative of dubious validity or in foot dragging in the form of non-tariff barriers. Both exist currently. By contrast, positive trade and political initiatives took place in the late 1940s with greater activity globally and then again in the 1990s. Recent trade tensions are seemingly ignoring that technological change and moving up a value added chain remain crucial to growth and prosperity. It is ironic that after decades of espousing freer and less discriminatory trade, the United States currently appears undercutting the World Trade Organization. Meanwhile, late emerging from command economy countries like China, India and Russia appear joining industrial Europe and others in shoring up global trading rules. The very duration of many trade talks have illustrated the difficulties involved in achieving any agreement, whether on the Trans Pacific Partnership among many nations or the Canadian/European Union trade agreement as well as in the ongoing travails of Brexit with its twists and turns between Europe and the United Kingdom. Technology transfer and copying have long been present globally. The United States itself was doing much the same in then crucial textiles in the 19th century as it currently accuses China of doing in high technology. In that regard and even without invoking memories of the 1930s, tariff and counter tariff invocations between Canada and the United States, Europe and the United States as well as between it and China do risk curbing trade as well as growth.
A collateral impact of prolonged and massive quantitative ease may have been to distort the role in indicating direction of pricing in capital markets. An issue in fixed income markets relevant currently is whether capital has become so plentiful and risk so low as to be able to sustain yields that appear so much below long term averages that incorporate wide varieties of financial conditions over the decades globally, or in the case of British data over the centuries. For most of this cycle, there has appeared to be a domination of transactional activity versus a strategic focus on the longer term. It has also appeared in the form of the structure of public budgeting. For instance, absent in the market and political lexicon in the United States as well as Japan and not singularly so have been deficits and the size of debt compared to GDP. Yet the risks to such complacency assumptions have started to appear, for instance for emerging countries like Argentina, Brazil and Turkey.
In the capital markets balance in the interplay between short term momentum and longer term benchmarks of value, equity markets need to come to grips on whether longer term, recurring and replicable (for example ex share buyback) corporate earnings growth has been sustainably elevated. Especially as the strong form of efficiency has proven deficient, changes in consensus about risk could be both abrupt and lurching. Helped by quantitative ease as earnings bounced off the bottom earlier in this cycle, markets responded in 2009. They then expanded valuation even as earnings expectations were serially reduced to easily beaten levels. Now, the market response has appeared globally volatile. It has taken place for the S&P 500 even with sharp already accrued operating earnings growth for Q1/2018 and at the cusp of well telegraphed close to 20% year-over-year increases for Q2/2018, stimulated by tax cuts and energy recovery. Volatility lurks especially below the surface as seen in our favored financials, energy and even in information technology as well as in our underweight consumer discretionary and staples areas. Even ten years after the commencement of quantitative ease, stress tests internationally in the financials have demonstrated weaknesses. In energy, the sudden drop of crude oil prices demonstrated weaknesses in corporate financial structure that euphoria over shale oil had appeared to overlook. In consumer groups and even within information technology, changes in consumer habits have laid bare business risks. Last but not least with a business cycle that is close to a decade old, the present corporate preference for massive share buyback purchases to restructure balance sheets has yet to be broadly tested, excepting in energy, under more adverse conditions. Emphasis on quality is likely appropriate.
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