Note February 8,2019: Markets On Worn Path- Subsequent to the start of 2019, we have been watching capital markets for points of reactive sensitivity. It seems to us that the markets remain on their worn path of this cycle, namely being overriding in dependence on central bank intonations, especially from the Federal Reserve; being willing from Treasuries to Bunds to JGB to accept little income amid high duration and in equities, being willing in aggregate to overlook large drops in consensus earnings as long as the latest consensus were exceeded in actual reporting. A momentum and short term tilt in capital markets has appeared to remain strongly enough in place but risks suddenly becoming worn out. Politics in this cycle have been seemingly dismissed as irrelevant. Yet, polarization appears very much in place whether in Global trade strictures; in the post State of the Union U.S.; in Europe grappling with internal dissent and Brexit; in Asia reacting to China flexing; as well as in Levant conflagration and new quasi cold war thrusts. The opportunities of a quality tilt in investments are likely yet to be fully realized.
At policy levels, recently have been unveiled a number of perspectives. From organizations like the ADB, BIS,EU, IMF and OECD as well as individual countries from China to within Europe to the United States and in between, have emerged statistics indicating moderating activity. In the United States in the reality of its size and role as leading edge in financial matters, we have seen the Congressional Budget Office releasing its 2019 report on fiscal matters. It emphasizes the deluge of close to trillion dollar annual U.S. federal deficits and rising debt to GDP levels potentially rising to risk inducing levels. Meanwhile, the latest FOMC statement of January 30, 2019 has been, in our view, tilted again more towards near term aspects to fiscal policy and in obfuscation on U.S. interest rate change policy. The Federal Reserve reiterates reducing its balance size but is being coy on the terminal size therein. In Europe, confusion appears from Brexit to political divides within the continent amongst founders Germany, France and Italy to newer members in southern and eastern areas. European fiscal stretching remains. The same could be said of Japan. Both China and India as faster growing economies do nonetheless also have credit quality issues.
Not just the Federal Reserve but also the other major guardians of capital integrity in the world like the ECB, the Peoples’ Bank of China, the Bank of Japan and the Bank of England appear strikingly obtuse on not just near term policy but also on the longer term monetary imperatives to balance growth and inflation. In fairness, central bankers who have attempted otherwise in this cycle have appeared swiftly batted down. We do believe that the risks of capital market distortion are real. They are likely being underappreciated once more, only a decade after the credit excess debacle from 2008.
We see as interesting that capital markets that are non-traditional in leadership, like those of Asia (ex Japan) and emerging areas generally performed classically, most recently from mid-2018 in fixed income yield spreads rising and equity markets dropping as moderating growth appeared amid credit financing concerns. Meanwhile, the more traditional capital markets leaders like those of the advanced economies generally and in the United States, Europe and Japan particularly performed non-classically. In aggregate, such advanced country capital markets appeared preferring to ignore slowdown risk and instead remain in the main focused upon momentum and especially being overriding in dependence on central bank intonations, especially from the Federal Reserve. Such intonation dependence has appeared in being willing from Treasuries to Bunds to JGB to accept little income amid high duration as well further in these same yields being moved back down in recent weeks, arguably in response to expectations of a so-called central bank, especially Federal Reserve, put. In perspective about long duration low coupon fixed income, it is worth contemplating 100 year maturity bonds versus the fact that many country or company fiscal positions have scarcely been stable going back for long periods, including as it would the debacles like those of the 1930s/40s.
In equities since earnings recovery started in Q1/2009 for the S&P 500, its cycle has been characterized in markets being willing in aggregate to overlook large drops in consensus earnings growth estimates as long as the latest consensus were exceeded in actual reporting. Expectations of easy credit and accommodative central banks, in particular by the Federal Reserve, have appeared globally to buttress equity valuations upwards. In the corporate reporting cycle so far in Q1/2019, we have noted market response characteristics as being back to being similar to those of 2009 through to the first half of 2018. Individual companies below consensus were punished but in aggregate just beating the latest consensus has appeared sufficient for rallies. Still, we also note at the sector and company levels, bifurcation within industries appears in favor of those companies that had restructured earlier. It has appeared from information technology to banking to automobiles. Retail consumer areas from discretionary to staples report stress, and include purveyors of luxury that in the last cycle were regarded as being robust on aspirational activity. Consensus for S&P 500 earnings appears to have dropped precipitously to now for declines or low single digit growth year-over-year, compared to expectations in consensus as recently as in Q3/2018 of double digit growth for Q1/2019. As usual for consensus expectations for onwards from four quarters out, consensus has also appeared to revert once more towards double digit growth expectation aspirations. We believe in benchmarking 7% long term S&P 500 earnings growth and 16x earnings valuation as not offering unusual value and hence conducive for a quality tilt.
Despite in this cycle as seemingly appeared being dismissed as irrelevant, political polarization appears very much in place, whether in Global trade strictures; in the post State of the Union U.S.; in Europe grappling with internal dissent and Brexit; in Asia reacting to China flexing; as well as in Levant conflagration and new quasi cold war thrusts. Amid slowing global growth, previously well established trade mechanisms and strictures appear in flux overtly between China and the United States but also within Europe and more discreetly but existent nonetheless in Asia. In its post 2018 election environment, the U.S. administration as the executive arm and Congress as the legislative arm of government have appeared still to be struggling over preeminence as opposed to focusing on imperatives like infrastructure spending and especially deficit control. In Europe and ahead of its May 2019 European Parliament elections, there has not only been continued stress about deliverable Brexit structures but now as seen between Italy and France, open dissension at the highest levels about policy from foreign affairs to finances to even norms in internal affairs. In Asia, reactions appear far from complete on a new environment of China flexing at the economic and political levels. In the LeVant, conflagration has been chronic with the epicenter shifting rapidly but now apparently with Syria at the cross roads. To these political realities must be added quasi cold war thrusts that started at the eastern European borders with Russia but have now meaningfully expanded into the potential abrogation of older nuclear pacts as well as in rivalries across Asia.
In essence, a momentum and short term tilt in capital markets has appeared strongly enough in place but risks suddenly becoming worn out. The opportunities of a quality tilt are likely yet to be fully realized. 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.