Note October 29,2018: Alternate Universe – Recurring vs. Amplitude of Delivery. Over the decade of massive quantitative ease, the generally accepted universe has been one of ample liquidity and of low interest rate policies including the suppression of fixed income yields. Progress has been uneven and the efficacy of prolonging quantitative ease has become questionable. In policy and market response, issues set aside have included the levels of deficits and debt incurred by governments and quasi government organizations. Not to be outdone, private companies engineered massive equity buybacks. Complacency about this universe persists, illustrated by discussions about a flattening yield curve. There is an alternate universe to consider.
The political environment seems one of populism from Germany to Brazil. Violence is acute in the Levant but is not limited to it as seen in pre-election United States. Politically palatable appears to be spending increases. In an oblique stance designed to raise the costs of fiscal profligacy with global growth slower but still positive at a 3 ½% annual GDP rate, the central banks in effect could be accepting of the entire yield curve in major economies rising. After many months of 10 year U.S. T-Note, BBB corporate and emerging market yields closer to twelve month highs, signs of change now include rising yields in CCC corporate fixed income and suggest an alternate universe to that of 2008-18.
Equity risk premiums and valuations do change with fixed income yields. We expect Fed Funds to be close to 3.50% and 10 Year Treasury Note yields to be closer to 4.50% as ongoing growth moderates and deficits interplay with markets. Also, focus on recurring earnings is perforce necessary for sustaining equity valuation. The focus of momentum can often be and until recently has been on the amplitude of near term earnings change. In 2018 so far and despite U.S. tax cuts, equity indices have globally turned lower. Individual equity prices seemingly appear less receptive to earnings amplitude alone. Stronger than global economic growth has been no panacea even in larger emerging economies whether more domestically oriented like India or China with its export strategy facing a tariff war with the United States. Amid recent reporting worldwide, focus on revenue shortfalls appears more intense. Bifurcation abounds across sectors. In equities also, expanding appears an alternate universe focused more on recurring strength and less on the momentum of amplitude. It would favor quality even as global growth continues.
Over the decade since the initiation and expansion of massive quantitative ease, the generally accepted universe has been one of unprecedented and sustained ample liquidity and of low interest rate policies including the overt or covert suppression of fixed income yields. That universe has also included in the case of Japan, sustained purchases of equities, a policy previously used for a limited time during extreme crisis such as in Hong Kong subsequent to its October 1987 market closure debacle. In the cycle from 2008 to 2018 in policy and market responses, issues that have been set aside have included the levels of deficits and debt incurred by governments and quasi government organizations. Not to be outdone, private companies have also engaged in financial engineering such as massive equity buybacks. Attracted by managed interest rates, private and public emerging market entities have assumed large amounts of foreign currency, often U.S. dollar denominated, debt that in turn have been favored by money managers in their search for yield. Notwithstanding the turmoil in capital markets of recent weeks, complacency persists about the continuity of this universe and is illustrated by discussions about whether, amid quantitative ease, a flattening yield curve would constitute a recession. There is an alternate universe to consider.
There have been fresh policy assessments from the Federal Reserve, including its Beige Book of October 24,2018, from the Peoples’ Bank of China and the European Central Bank. From the Bank of England about handling post Brexit risks and the Bank of Japan still fearing deflation, further assessments are imminent. In an oblique stance designed to raise the costs of fiscal profligacy and even as global growth continues at a slower but still positive 3 ½% annual GDP rate, the central banks, in effect, could be accepting of the entire yield curve in major economies rising. It would be a universe at sharp contrast with oft made discussions about the potential for flattening yield curves.
Progress has been uneven and the efficacy of prolonging quantitative ease has become questionable. For monetary policy, quantitative ease was necessary back in 2008 in order to break a major dislocation and freeze up of credit around the world. We believe that in providing reprieve, central banks expected the subsequent period to be used by governments to restructure fiscal posture and by companies to invest in efficiency and employment enhancing goods and services. Companies appear to have preferred to engage in financial engineering to respond to capital markets. The political environment has turned out to be one of populism. It appears from Brazil and Mexico in Latin America to the United States at the cusp of its November 6, 2018 mid-term elections to Europe not just in its south but also in numerous elections in Germany. It is less evident in east Asia but can be seen in the Philippines and elections are upcoming in 2019 in India. As seen in the United States several times in the last year, violence may be acute in the Levant but is not limited to it.
The politically palatable decision appears to have become one of spending increases. Currently, such fiscal spending calculations have as illustrations the large tax cuts in the United States that builds in the likelihood of ongoing trillion dollar deficits as well as the budget in Italy that boosts spending while eschewing European Union strictures and potentially, profligacy in several Latin American countries. In many other advanced and emerging countries, the choices may differ but the similarities appear to be in political rationality being seen as spending driven. It is a sharp contrast to the political rationality of the 1990s that had to do with restructuring. An alternate universe may already lie alongside the continuation of quantitative ease being tempered by the Federal Reserve and in comments from the ECB of a reiterated target of new purchases being terminated (but with reinvestment continued) from December 2018. After many months of 10 year U.S. Treasury Note, BBB corporate and emerging market yields closer to twelve month highs, continued signs of change now include rising yields in CCC corporate fixed income and which corroborate the beginnings of an alternate universe to that of 2008-18.
As a result of changes in fixed income yields, aspects of risk premiums and valuations do come into play for equities. We believe there is potential for Fed Funds to be close to 3.50% and 10 Year Treasury Note yields to be closer to 4.50% as growth moderates but continues and as deficits interplay with markets. We believe another aspect to be that a focus on recurring earnings is perforce necessary for sustaining equity valuation. The focus of momentum can often be and has until recently been on the amplitude of near term earnings change. In quarter after quarter in this earnings recovery cycle, even as expectations were being reduced, the beating of consensus was often regarded as being reason to boost equity prices in markets.
In the year of 2018 so far and despite tax cuts boosting S&P 500 year over year earnings gains into a 20-25% range, equity indices have globally turned lower. Individual equity prices seemingly appear less receptive to earnings amplitude alone. Stronger than global economic growth have been no panacea even in larger emerging economies whether more domestically oriented like India or China with its export strategy facing a tariff war with the United States. Initially in luxury purveyors in Consumer Discretionary, in the erstwhile Communications favorites of concept media and even internet merchandising, as well as in sectors like the Industrials and the Financials, the focus worldwide on revenue shortfalls appears to have become more intense. Bifurcation abounds not just in Information Technology with its Darwinian history. Bifurcation exists also collectively and individually in supposedly defensive Consumer Staples and Healthcare. We believe these aspects in equities corroborate that an alternate universe is starting to expand and focused more on recurring strength and less on the momentum of amplitude. It would favor quality even as global growth continues.
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.