Note January 3,2019: Assess Market Continuum Over Distinct Frames – Phrases like risk on/risk off and santa claus rally in markets or for that matter use of breaking news generally may sound pithy but in fact tend to reinforce considering events as distinct frames. However and much as in motion pictures, going frame by frame does risk missing the continuum in markets. In order to assay the market continuum, we have deliberately refrained from commentary during the last several weeks.
In our assessment, central banks overshot in expanding quantitative ease from as long ago as 2013. It resulted in among other things in laxity in fiscal deficits and corporate leverage. Seen in this context, the Federal Reserve increases in Fed Funds rates and reduced quantitative ease seems an overdue check. Further, it is often misunderstood by domestically and populist oriented governments that actions have international consequences. Other politicians in other countries have their own imperatives. Then, the capital markets themselves have long histories of excess on the subject du jour to be followed by reassessment. In this cycle, the subject du jour has been the scale and duration of quantitative ease. Still, in fixed income markets, CCC junk bond yields at 13.6% are up some 400 basis points from their recent lows. Not to be overlooked has been euphoria over social media and among companies, penchant for financial engineering. Related equity valuation still has to fully account for such change.
Fraught with risk at mature phases of a cycle is using forward earnings to calculate equity valuations for indices like the S&P 500, comparing them to recent valuation levels and then proclaiming them to be inexpensive. Equities tend to peak at high levels precisely because turbulence was unanticipated. In the last three decades, over the 1988 onwards cycle and then again in their 2000 onwards cycle, S&P 500 earnings dropped 20-25% and in extremis, in their 2008 cycle dropped over 40%. Global GDP growth appears widely expected to trend around 3.7% annually, or midway to recession and meaningfully below a two decade average of 4% annually. Even if recession is avoided and earnings growth were to be flat at around 0-5% for the S&P 500, equity valuation can scarcely be defined as cheap.
Seen in continuum and despite the modern advent of computational power, reappraisal is evident with major market point swings, otherwise defined as volatility. It seems more realistically as being a result of misjudging the stability of the fundamentals of economies and companies alike. We expect it to continue into mid-year. As is classical, the Financials sector will likely give the early indications of recovery.
In our assessment, central banks overshot in expanding quantitative ease from as long ago as 2013. It resulted in among other things in laxity in fiscal deficits and corporate leverage. Seen in this context, the Federal Reserve increases in Fed Funds rates and reduced quantitative ease seems an overdue check. A full appraisal has yet to occur of the efficacy of money supply growth management by central banks as compared to more traditional methods that included letting credit duress flush out excess. From 2008 to 2013, there can be little argument with quantitative ease as having been helpful in containing the freezing of credit. Since then however, it appears that governments in terms of fiscal policy have followed the traditional political route of offering largesse rather than using low interest rate environments to restructure public finance. Some governments such as in the United States have ignored recommendations like the bipartisan Simpson Bowles Commission. Others such as in Italy have deliberately offered massive spending proposals despite weak finances that already were being rescued by the European Central Bank. Still others such as in India have attempted to browbeat their central bank into in essence rescuing nonbank financials beset with lax lending policies. Rather than assuming an unending crisis largesse mode, for a continuum, market reappraisal of risk appears relevant.
Further, it is often misunderstood by domestically and populist oriented governments that actions have international consequences. Other politicians in other countries have their own imperatives. In this cycle more so than in recent ones, politicians have appeared being hemmed in by their own promises and being unwilling to change. However, international relations can be fragile. After decades, tariffs have been brought back into the trade armories of many countries, not least the United States.
The United States currently has to interact with several economic zones of similar heft, China, the European Union and the Trans Pacific Partnership group of nations. As a singular country with an economy second in size only to the United States, China has a particularly sensitive transition underway from being export driven to building up domestic consumption. Even within the European Union in long existence as customs union, brittleness appears not least about and within Britain about exit. Global GDP contraction of (0.6)% in 2009 was clearly an extraordinary event that required unusual response. However, global GDP growth appears widely expected to trend around 3.7% annually, or midway to recession and meaningfully below a two decade average of 4% annually. The room for misunderstandings appears to us to have increased and arguably more so than the capital markets appeared to assume.
The capital markets themselves have long histories of excess on the subject du jour to be followed by reassessment. In this cycle, the subject du jour has been the scale and duration of quantitative ease. Not to be overlooked has been euphoria over social media and among companies, penchant for financial engineering. On assessments of the potential for greater or lesser quantitative ease, the yields in sovereign fixed income markets have waxed and waned while also affecting currency exchange rates. For instance and as benchmark, the yield of 10 year U.S. Treasury Notes was as low as 1.36% in June 2007 to reach 3.23% in October 2018 and currently stands at 2.67%, or almost double its low point. Still in fixed income markets and after a prolonged hiatus until mid-2018, CCC junk bond yields now at 13.6% are up some 400 basis points from their recent lows. The cost and availability of funding has emerged as a market issue. Related equity valuation still has to fully account for such change. Balance sheet risk appears to be an overlooked continuum in a market that until recently was mesmerized by single frame factors such as share buybacks to boost reported earnings.
For that matter at mature phases of the cycle, fraught with risk is using forward earnings to calculate equity valuations for indices like the S&P 500, comparing them to recent valuation levels and then proclaiming them to be inexpensive. Equities tend to peak at high levels precisely because turbulence was unanticipated. In just the last thirty years, over the 1988 onwards cycle and then again in their 2000 onwards cycle, S&P 500 earnings dropped 20-25% and in extremis, in their 2008 cycle dropped over 40%. Company delivery bifurcation has been a part of this cycle and is likely to increase. Even if recession is avoided and earnings growth were to be flat at around 0-5% for the S&P 500, equity valuation can scarcely be defined as cheap.
Seen in continuum and despite the modern advent of computational power, reappraisal is evident with major market point swings, otherwise defined as volatility. It seems more realistically as being a result of misjudging the stability of the fundamentals of economies and companies alike. We expect it to continue into mid-year. As is classical, the Financials sector will likely give the early indications of recovery.
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.