Global Outlook 2018: where policy and markets will jostle for supremacy?
By Robert Swift
The Dow Jones Industrial Average closed above 26,000 for the first time recently, sprinting to a fresh 1000-point milestone only eight trading days after toppling the previous one, its fastest run ever. Since the bottom in 2009, the global equity market has almost doubled in price. It is also above its pre GFC peak by about 30%. Since the last meaningful sell-off in 2016, the taper tantrum when bond yields were first mooted to be on the rise, it is up 40%+. This equity run is not at an early stage, nor is it modest!
This phenomenon looks like Fear of Missing Out, (FOMO) or a “melt up”, where investors stampede in without worrying much about valuation or fundamentals. FOMO, can be a real problem for investors since it is human nature to enjoy being with crowds and amongst popular fashions, but this desire is a problem when it comes to investing where popularity typically means over valuation.
So let’s assess the market prospects after such a run. As is often quoted, “Be greedy when others are fearful, and fearful when others are greedy”. Is it time to be fearful? Should investors stay long; get long, or be looking for the exit and the carriage home before the magic wears off at midnight?
Valuation matters and both the entry point (yield and P/E) and the prospects for growth in profits, are both important to consider. There is no point in investing even with reasonable valuations, if prospects just around the corner look dire?
Let’s look first at the outlook for corporate profits with a focus on recent USA tax changes.
The USA (corporate) tax changes are actually quite complex and there are some increases as well as the well-publicised decreases. The reduction in corporate tax from 35% to 21% will help boost EPS. (Note that this bottom line boost will be offset by some personal tax increases, reducing spending power and the top line growth rate.) The 100% expensing of new capital investment will help a lot in prompting new projects and job creation in the USA – other countries which are running below trend should copy! (UK, even Germany, Australia come to mind. Japan needs to do the opposite.) Some balance sheets will change for the better or worse as deferred tax assets get reduced or deferred liabilities reduced.
The expected cash ‘repatriation’ of foreign held profits may not happen since the tax is mandatory on historic profits regardless of whether the cash is repatriated or not. Assuming an average 10% tax rate on $2.8 tln of cash offshore, leaves about $2.5 tln in the corporations’ books, which will either end up as buy backs, dividends, or invested somewhere sometime. Much of this offshore cash is held by 5 companies Apple. Microsoft, Pfizer, Cisco and Oracle. Many companies will have (over) reserved or not reserved for a tax hit on these accumulated offshore earnings so there is little point in trying to get too precise, but we think the USA market in the front part of the year is going to be excited by the possibilities even if reality is less substantial. Already Apple has announced a large investment in the USA and to hire more USA workers. Note that further USA company profits generated offshore are not liable to this tax.
Don’t forget that foreign companies operating in the USA are also entitled to this tax break. So if USA operations have been running at a profit, then they get a boost. Daimler Benz may be one such beneficiary?
In conclusion there looks to be little to prevent continued solid profits announcements in the USA in the near term.
Elsewhere global growth is synchronous for the first time in quite a while, and valuation looks less stretched outside the USA with Japan becoming more popular after years of neglect and Europe enjoying a recovery of sorts.
While GDP matters little for equity market returns, the political consequences of wealth inequality are easier to manage if growth is reasonable or better? Increased confidence in Central Banks’ skill/luck in engineering this GDP recovery also means there is more confidence that any future adversities can be successfully negotiated?*
Relative to equities, bonds’ valuations look more stretched. Especially if we have seen an end to the ZIRP experiment which we were again reminded recently, has effectively been monetary policy for rich people. (In fact the USA central bank, the Federal Reserve, has begun tightening policy without raising interest rates but this is arcane stuff and not relevant here.)
We do understand that a bond market sell-off creates cost of capital headwinds for equities, but equities possess a claim on real assets and an inbuilt inflation hedge which bonds do not. If in doubt most politicians typically choose to inflate away the value of the debts they have incurred on your behalf to buy their votes. Equities represent better protection against this form of larceny of your money. It’s still our view that ZIRP went on too long; was a ridiculous ‘one size fits all’ mistake; has caused as many problems as it has solved; and that central bankers would love now to declare victory and get the hell out, leaving the hoi polloi to deal with the consequences. Regardless of our views on the morality of ZIRP, and its political consequences, it is likely we will have to deal with more central bank tightening in 2018**.
In summary, valuation for equities is ok in the USA; and attractive in Europe Asia, and Japan.
There are some early warning signals that are widely used to indicate equity market peaks and provide evidence to be careful. We use the ones below – we acknowledge that lots of other investors use them too but that’s beneficial.
Junk bond spreads over government bonds are currently narrow or tight. This is typically a sign that risk appetite is too high. Investors are taking on too much risk and driving the price of risky assets too high.
The popularity of investing fads is illustrative of a dangerous universal euphoria. Low doc loans and P.I.K. bonds are making a comeback and more worryingly, the crypto currency mania shows risk appetite is hitting the roof. Kodak (yes that ex bankrupt business) announced plans for a new crypto currency and its stock went up over 300% in half a day’s trading. It’s not blockchain we think crazy, it’s the belief that a crypto currency can continue to be increasingly traded without politicians getting involved that’s crazy. Government has been getting bigger and more intrusive for the last 25 years and there is no end in sight – sadly. To invest in crypto currency in the belief that it won’t be regulated as a commodity or security and that one should be holding large claims on a newly regulated, non-yielding, speculative asset is optimistic to say the least. Physical gold has an industrial value at least and we aren’t fans of that either.)
There is very low price volatility in equities which again implies complacency and thus vulnerability
USA interest rate increases are being priced into the yield curve but not yet discussed in equities. A lot of people have had 10-year investment careers without ever seeing rising interest rates and so the impact of higher interest costs, refinancing of maturing debt at higher rates than anticipated, and falls in asset values used for collateral, will be new to many fund managers. We are surprised at the lack of discussion and consider this a sign of complacency.
However, and it is a BIG however, the yield curve is NOT inverted and that is the MOST useful early warning sign of all. Until it does invert, we think the froth is confined to particular stocks and segments of the market, not the market as a whole.
There is one other ‘hidden’ risk of which to be aware. The above warning signs are useful, but such metrics are almost always post hoc rationalisations. In so far as we look back at the indicators we now know to have been sending warning signals before the LAST sell off, we have a so-called look ahead bias. It is always possible that the reaction to the risk asset sell-off has created new problems which did not exist before, and is therefore not on the radar screen, or seen as Someone Else’s Problem (SEP). Ignoring the possibility of new problems because the existing economic model “explains everything” is rear view mirror driving.
Our favourite candidates for SEP or unseen problems, are:
- the now very large Chinese State and shadow banking debt obligations;
- the increasingly enormous underfunded USA public pension obligations;
- the dominance of capital markets by money flows to increasingly fewer money managers, exacerbated by the reduction in market-making liquidity provision by banks due to capital adequacy changes, regulation and lunatic regulation such as Mifid 2 in Europe which will result in less bio diversity in the fund management eco-system.***
These three were much smaller in size or scope or did not even exist 10 years ago. The policy response to the 2008 crisis has effectively created them such that they are now new factors and sources of instability. Equity volatility would rise pretty quickly from very low levels if a USA public pension fund had to receive Federal backing or if the scheme had to reduce benefits meaningfully in a swing State? President Trump walked away from underwriting Puerto Rico’s $80bn debt but there are lots of States and municipalities like Puerto Rico within the USA from which he cannot walk. Pension Tsunami provides sobering reality on some tough choices to be made and the political ramifications will be challenging to market equanimity.
So with all this being juggled, how are we positioned for the start of 2018?
We use a sophisticated **** model to help identify attractive stocks, sectors and regions. This is heavily weighted towards ‘Valuation’ but also uses Momentum to get a sense of (un)popularity, and Quality to get a measure of resilience to adversity. Given the chance, we would like to buy cheap assets with high resilience and which are becoming popular. Would that it were so easy because these signals tend to work in opposite directions, which means that cheap stocks tend to be unpopular, and have quality ‘issues’. Likewise popular stocks with lots of momentum tend not to be cheap. Suffice to say that the models need human interpretation and interaction but it generally provides good signals.
What is it showing us?
The above bar chart indicates which sectors look attractive and which don’t. The classification is based on industry rather than the more familiar economic breakdown, however this analysis provides greater granularity and more information. Lines to the right are attractive and vice versa. The distance is proportional to their attractiveness.
Banks and insurance companies especially those with hidden assets such as global fund management companies (eg Orix) remain attractive. Banks will benefit from a steeper yield curve and insurance companies from higher interest rates. We have been invested here for a couple of years or more.
Cheap Technology looks attractive and hardware companies like Intel and Cisco have made significant inroads into new applications and have shaken off complacency surrounding previous product dominance. Japanese technology is very under-appreciated.
It is interesting to see how the price moves in some technology stocks have now taken them into unattractive territory, at least as we model them.
Telecom stocks especially in the USA (eg Verizon) have woken up to the possibilities afforded by an enormous, well monitored and loyal, customer base to extend their technology into media and content as offerings to their customers.
Automobiles and components is another area where we like car makers and parts suppliers. The car industry is seeing change (to hybrid and more electronic content); decent growth from emerging markets, and a replacement cycle is long overdue in the USA where the average age of cars is rising fast.
Value stocks generally are attractive and there are many lowly rated cyclicals with a more sophisticated product line-up than realised (Evonik, Lear Corp). They trade on a low P/E multiple as if they had low quality profits, but their margins and product profile are more resilient.
We have recently invested more in stock laggards believing that other market participant will rotate into cheaper stocks to maintain equity market exposure but at a lower price. Utilities have underperformed significantly as investors have anticipated rate rises and they have become so cheap that it may all be in the price?
We invested in a beaten-up USA utility recently.
Importantly, we don’t chase dividend yield where it is not supported by cash flows or balance sheet strength or has been created by endless M&A transactions.
Wall Street knows investors are desperate for yield and will cook up any story to meet that demand regardless of underlying fundamentals. GE anyone?
* We shall not here return to our favourite topic about the inadequacies of using GDP as a measure of economic advancement without regard to population dynamics. If you do wish to engage with us then please do!
** Frankly, if populism is defined as politicians pandering to special interest groups; government always doing the things which please the noisy (minority) activists; and administrations continually refusing to make sensible balanced economic decisions for the benefit of the general population, then we have had a form of populism for about 25 years and it is to THIS form of populism that the ‘deplorables’ are now objecting. Since the 1990s, the fostering of “identity politics” with large handouts to select groups, spending promises that are impossible to honour, political correctness, and the continued free put option granted to special interest groups aka banks and ‘minorities’, have all been ‘populist’ policies in so far as only certain groups have benefitted. Brexit and Trump are the exasperated ‘deplorables’, voting for any kind of change from this version of populism for ‘liberals’, whom they perceive as having had their snouts in the tough for quite long enough. They, the ‘deplorables’, may be ‘turkeys voting for Christmas’ but perhaps they now feel that at least they did vote against the ‘liberal’ status quo! The world, and words, have been turned upside down for quite a while.
Those of you with more than 5 minutes experience may recall that the Asian crisis in 1997 had the IMF prescribing austerity, insisting that Asian countries take hard medicine and endure fiscal austerity with serious debt write downs and bank restructuring. This was a nasty experience. Roll the clock forward to the West’s self-prescribed medicine to their version in 2007 and it wasn’t quite as tough on the ‘bonus classes’ and banks? Lots of free taxpayer money for banks to play with; a nicely steep yield curve engineered by ZIRP, and financial repression in the form of zero interest rates for those who wished to save and take only a little risk. For those citizens unfortunate enough to live in countries with a banking system with obligations to German and French banks, (aka Irish and Greeks), they now live in debtors’ prison. It wasn’t actually an Irish bank rescue in 2009 but a German bank rescue where the average Irish citizen was forced into indentured servitude so that German banks didn’t lose money on bad loans to Irish banks. Underwriting the private sector bank debt on behalf of the general population was a government mistake. A crash is the recognition that capital has been allocated badly in the past and is now being marked to market. The write downs and responsibility for bad allocation decisions need to be taken by the investors and lenders not by citizens who have no responsibility for the decision! To make the citizens of the borrowers solely responsible is the stuff of WW1 reparations and ensuing political resentment. To blame the ‘deplorables’ for objecting to this stuff, and then decrying how they vote, is naïve at best.
*** Guess what happens if there are only 10 equity managers who control 90% of trading volume, and they all try to sell the same stocks when there are fewer market makers and less liquidity? We have yet to establish equity trading with Martian fund managers, and so prices will fall precipitously if the ever larger managers on Earth all need to make the same trades to exit a stock to meet redemptions. Another example of bureaucrats providing a ‘solution’ to a non-existent problem.
**** We think so anyway…