Note September 26,2018 – Search Beyond QE For More Solid Ground: After a decade of basking in quantitative ease that in equities included massive mainly U.S. share buy backs, capital markets will likely search for different solid ground. Capital markets will potentially be more volatile. Common for more mature phase capital markets, fraying in 2018 can be seen for example in fixed income, in emerging market equities and in a narrower composition of the stocks driving up U.S. equities. We expect another 25 basis point increase in Fed Funds in December 2018 as well as 3.50% rate by September 2019, just above but earlier than the Fed FOMC forecast of a potential cycle peak. Performance and valuation risk appears in fixed income for a variety of reasons but is more classical than many appear willing to countenance.
Even as some espouse high valuation as appropriate amid quantitative ease, we hold two equity episodes to be historically instructive namely that neither prebubble 1980s Japan suppositions of superior management and low interest rates driving valuation held nor did the prebubble 1990s NASDAQ suppositions of valuations being irrelevant for secular growth. Reformulation of sector composition seems more of an ETF and leadership composition issue. Differentially, potential for U.S. 10 year Treasury yields to rise to 4.50% into late 2019 would likely constrain both valuation and share buybacks. The next phase of earnings and corporate performance will start soon. Our favor is for quality.
The fall September/October period of any year tends to contain deliberations ranging from the IMF to the BIS to the OECD and several central banks, especially from the Federal Reserve as leader. This time in 2018 is no exception. The BIS has a justified reputation for being most direct. The BIS in its latest September 2018 quarterly indicates that markets have been diverging amid Bank of Japan and European Central Bank policies being accommodative and the Federal Reserve tightening monetary policy. Indeed after its September 25-26 2018 FOMC meetings, the Fed statements did show both a rate increase of 25 basis points to 2.25%, removal of its accommodative sentence and continued to espouse reductions in its balance sheet. We expect another 25 basis point increase in Fed Funds in December 2018 as well as a 3.50% rate by September 2019, slightly above but earlier than the Fed FOMC forecast for a potential cycle peak. Emphasis on data and domestic economic developments inside the United States mean that on tightening policy, the Federal Reserve may already be behind the curve. Of course, politics also loom as considerations as do issues of stress in international capital market, including in politically sensitive currency exchange rates. In our opinion, organizations like the IMF and the OECD indicate global growth with risk of being in a plateau of around 3 ¾% annually in GDP. Already, currency pressures appear, especially in emerging markets. Trade tensions of various strains do appear whether in U.S relations with its partners including China or whether in Europe with respect to European Union relations with Britain in a post Brexit environment. It seems that the potential for volatility to rise is high in capital markets.
Currently in the fixed income, currency and commodities markets and for differing reasons, pressures have been salient within several emerging economies ranged from Argentina, Brazil, Mexico and Venezuela as well as South Africa and Turkey. The emerging market commonality has been one of higher interest rates failing to stabilize currency levels. Even the stronger than global growth large giants of India and China have not been immune. Foreign currency movements, appear to be also exposing vulnerabilities in emerging countries especially via U.S. dollar denominated debt. Such stress has been common in many prior cycles at points of maturity. In the advanced countries, Japan continues to suppress rates by direct purchases. Still, Japanese JGB fixed income yields have moved up, albeit at miniscule levels. In Europe, German Bund benchmark yields may be low but bank credit remains an issue as do concerns about coherent fiscal policies. It is demonstrated in not just peripheral and small EU members but also in the sharply higher Italian 10 year government bond yields. In the United States, the Treasury yield curve may be flattening for reasons related to quantitative ease exit. Still, the more salient development recently has been the rise in 10 Year Treasury Note yields now to close to 3.04% and potentially to 4.50% over the next 12 -18 months. There remains the anomaly of BBB corporate bond yields as having increased close to 12 month highs while CCC yields have been attached to closer to 12 month lows. It indicates complacency about credit quality and cash flow risk in the lower reaches of fixed income markets. After a decade of quantitative ease and for a variety of reasons, performance and valuation risk in fixed income is much more classical than many appear willing to countenance.
Hitherto in 2018 as appears common in more mature phases in capital markets, more fraying can be seen not only in fixed income but also for example in emerging market equities and in the narrower composition of the stocks that have been driving up U.S. equities. Even as some espouse high valuation as being appropriate amid quantitative ease, we perceive two historical episodes as being historically relevant, namely that neither the late 1980s prebubble Japan peak suppositions of superior management and low interest rates driving valuation held nor did the late 1990s prebubble NASDAQ peak suppositions of valuations as being irrelevant for secular growth. Globally and despite many years of stronger than global economic growth, some similar fraying of pre peak assumptions this time on sustainability can currently be seen in emerging equity markets. In the advanced markets and indeed for world markets at large, we see the reformulation of sector composition as more of an ETF, stock leadership composition and sector rotation issue. For the equity markets at large, the potential for U.S. 10 year Treasury Note yields to rise to 4.50% by late 2019 from an increased 3.04% level already would likely constrain both the valuation and share buybacks that have been components in per share earnings growth especially in the United States that still acts as equities locomotive. The next phase of earnings and corporate performance will start soon. Our investment favor is for quality.
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.