Note March 27,2019: More of the Same and yet Different- At a mature phase of capital markets, more of the same appears and yet seems different at the same time. Compared to prior cycles of hubris, companies do appear more cognizant of the importance of revenues, margins and the like. Still needing care are share buybacks and IPO volume increases in sectors in vogue. It is classical as markets mature. Fresh company reports are imminent. Noteworthy as a risk is that with the S&P 500 as an indicator in 2000 and 2008 cycles, equity indices tended to peak after rather than ahead of earnings. Unlike the 1980s, central banks appear more cohesive but also reactive. Latent distortion risk seems little understood even amid a decade of massive quantitative ease. As well, central bankers appear currently increasingly reticent to challenge political assumptions.
Risk could arise from political misunderstandings. Wars, populisms, deficits and trade tensions are all flared up. Absent crisis management, addressing deficits currently fight for profile. Moving beyond one-off announcements, trade talks appear fragile worldwide. In recent cycles, markets have appeared reactive rather than being proactive. On policy pronouncements, seemingly so are the central banks. Even as markets appear returned to momentum in investments, quality appears called for.
From within the financial world, in recent weeks, much has been taking place for the markets. Now for a decade worldwide and over two in Japan, capital markets have been mesmerized by central banks and by massive quantitative ease as espoused therein as an emergency maneuver. Recently led by the Federal Reserve that in effect now seems espousing a policy freeze rather than its prior measured change stance, many advanced and emerging country central banks appear to be following this lead. This comfort in numbers may reduce the risks of policy discord. Such discord risk took place in the late 1980s, most famously between the Fed and the Bundesbank with spillover elsewhere. The justification for policy freeze may be that currently measured inflation seems low but it can lag change. To us, it does seem to be odd to be considering a decade as being near term and hence having little distortive effect to worry about. For decades before, central banks had been warning about debt, deficits and the importance of the long term for public policy and company management alike. Central banks appear nowadays to be taking for granted a lack of latent risks. As well and compared to three decades ago in particular, central bankers appear increasingly reticent currently to challenge political assumptions. We believe these aspects of current central banking positioning add to a reactive tinge in capital markets.
Within capital markets themselves, there has been tumult in individual emerging country currencies especially when interest rates in the United States seemed to be rising. Over time, the sheer volume of trade in currency markets has long been considered to be a harbinger of crisis for capital markets as a whole. This positioning has been as a result of the heft of participation from individuals to companies to countries alike, replete with technical and fundamentally based analysis. Yet recently among the major currencies, activity has appeared remarkably stable when compared to times of turmoil in the past. Once more in recent weeks, market participants have been willing to push both German bunds and Japanese Government Bonds further into negative yield territory. Such positioning may have to do with internal dynamics in those markets but does seem a conundrum.
Despite much higher U.S. Treasury yields, the reactive impact appears to have been minimal on broad currency movements versus the U.S. dollar. In Europe, sovereign bond yields have generally followed Bund yields lower and thus suggest little change in risk differentiation. In North America, the Canadian dollar did weaken earlier but more recently appears flat, notwithstanding lower yields in Canada versus those in the United States. Within the U.S. fixed income market, not just Treasury yields but also lower grade corporate bond yields appear once more to have declined, even as data indicates slower growth (as the Federal Reserve FOMC also highlighted) and concerns build about corporate margins. There appears a return in the markets towards momentum and more acute focus on quantitative ease central bank policy rather than on broader balance. This lack of concern about risk appears to us markedly different from prior cycles and thus remains potentially distortive to capital markets. We believe this aspect in the Fixed Income, Commodities and Currency (FICCs) markets also adds to a reactive tinge to capital markets.
Currently, fresh company reports are imminent. As has appeared de rigeur in this cycle, consensus earnings estimates appear once more being reduced but in the case of the S&P 500 to close to or below the zero earnings gain line. Previously considered defensive areas like Consumer Staples have been issuing warnings of unfavorable change. They have not been the exception. In the equity markets in recent cycles and not least in the performance of U.S. indices like the S&P 500 into 2000 and into 2008, markets have tended to follow and not lead earnings peaks. By contrast, more classical behavior in equity markets has been for prices to lead earnings and not vice versa.
Even if led by promise of massive quantitative ease, the commencement of this cycle was classical in that equity price recovery came ahead of S&P 500 earnings bottoming in 2009 and was followed up globally. With massive quantitative ease forcibly driving down interest rates, market valuations did expand therefrom and companies cut costs to improve margins. Still, in this cycle, equity markets have tended to be momentum driven as long as the most recent consensus estimate was exceeded and have tended to overlook the gap between initial expectations of earnings and actual delivery. It suggests a primary focus as being on the near term. Financial engineering has seen expansion in this cycle as debt was assumed amid low rates. Consistently, share buybacks have been expanding.
Noteworthy is that just ahead of the S&P 500 peak, share buybacks in the United States did peak at $589 billion reportedly in 2007. In the present cycle, share buybacks in 2018 have reportedly set a new record at $806 billion. Further, initial public offerings (IPO) in sectors in vogue have a history of being in crest as markets mature and their volumes are currently expected to be strong. The S&P 500 group of companies can be expected to face cost headwinds even as global growth slows and U.S. tax cuts run their course. It likely is indicative of earnings pressures as developing, almost a decade since the S&P 500 earnings cyclical bottom of 2009. We believe these aspects of valuation gains already attained and of earnings cycles in equities markets also accentuate a reactive tinge to capital markets.
Risk could arise from political imperatives adding up to misunderstandings. Among just some issues of import, wars, populisms, deficits and trade tensions all appear flared up. In the United States, the 2018 Congressional elections seemed to return checks and balances as a result of a House Democratic majority but the just released Special Counsel report on Russian activity in elections appears to have rejuvenated aggressiveness from the administration ahead of 2020 elections. The March 2019 National People’s Congress in China appeared very much based on long term visions of domestic balance and increased global interaction from China. In Europe with elections due in May 2019, populism and delivery appear uppermost, with Brexit still very much in flux in timing and content. In India rapidly becoming the fourth largest economy after the United States, China and the European Union, a snap election into May 2019 looks increasingly to be no holds barred. The Levant remains engulfed in violent confrontation from North Africa to Afghanistan. It includes competition for dominance between Saudi Arabia and Iran, political change within Algeria now and snap elections in Israel.
As seen as far away from Middle East sources as Venezuela, oil politics remain important despite the rise of U.S. shale oil deliveries. The bilateral trade discussions between the United States and China seem to have all the trappings of similar talks between Japan and the United States in a different era that proved fraught and prolonged. The political response to the Belt and Road initiative of China also appears to have all the trappings of political and economic content in a global context. In Europe, governments have turned to both criticizing trade practices and engaging in pomp while signing trade deals with China. Moving beyond one-off announcements, trade talks appear fragile worldwide. Just two decades ago and amid broad global growth as well as in Europe a decade ago in crisis, deficit reduction and restructuring thereof appeared well accepted. Despite well known risks from chronic deficits and absent crisis management, addressing deficits currently fight for profile. Politics do matter.
In recent cycles, markets have appeared reactive rather than being proactive. Seemingly on policy pronouncements, so are the central banks. Even as markets appear returned to momentum in investments, quality appears called for. 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.