stocks

When does a recession become a depression?
by

When does a recession become a depression?

Macro Letter – No 131 – 21-08-2020

When does a recession become a depression?

  • Defining a depression as opposed to a recession is open to wide interpretation
  • Recessions are a natural part of the credit cycle
  • Depressions are destroyers of a nation’s wealth
  • Fiscal policy can help ease the pain of ‘creative destruction’ but long-term planning is key

There is a tide in the affairs of men

Which, taken at the flood, leads on to fortune.

William Shakespeare (Julius Caesar)

When your neighbour loses their job, it’s a recession.

When you lose your job, that’s a depression!

Harry S. Truman (33rd President of the Unites States)

The common knowledge definition above is grim and highly specific, but its banality serves to highlight the fact that the recession/depression question is not that simple to answer. Back in 2007 The Federal Reserve Bank of San Francisco – What is the difference between a recession and a depression? – attempted to reach a conclusion. They embraced the NBER definition of a recession: –

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

And turned to Gregory Mankiw to distinguish between the two states of economic contraction: –

There are repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe.

Despite the Federal Reserve’s valiant efforts, the simpler and more commonly accepted definition of a recession is a consecutive two quarters of decline in GDP. When it comes to depressions, however, there is little consensus; the two most common descriptions are: –

  • A decline in GDP of more than 20%
  • A period of more than two years of declining GDP

Whilst the two definitions are not mutually exclusive, they are broadly different. I believe the difference between a recession and a depression is more nuanced. A recession is a natural part of the business (or perhaps we should say credit) cycle, a depression, by contrast, involves the physical destruction of the economy – businesses are irreparably broken, employment opportunities terminally destroyed, investment has to be totally written off.

An alternative approach is to examine previous great depressions. Alas, this method proves equally inconsistent, for example the Great Depression of the 1930’s is generally considered to have lasted from 1929 to 1941 and yet, as the chart below reveals, there were only two distinct periods of declining GDP growth between 1930 and 1933 and again between 1937 and 1938: –

Source: Federal Reserve Bank of St Louis

Notwithstanding my more prosaic definition above, I favour the two year plus definition over that of a sharp decline in GDP. A recession hurts some parts of an economy, a depression is more widespread.

Another factor often associated with recessions and depressions is a rise in the rate of unemployment. Historically, rising unemployment has preceded the onset of recessions and only once recessions have become protracted have they been dubbed depressions.

A further differentiator relates to the absolute level of inflation. In general, as inflation rises, central banks respond by raising short-term interest rates. This helps to cool overheating economies, however, if they tighten too aggressively they may prompt a recession as the credit cycle is forced into a sharp contraction. By contrast a depression is often accompanied by an absolute fall in the price level, caused by an excessive overhang of domestic or corporate debt.

As an investor, why does a depression definition matter? Because financial markets are forward looking. If investors believe the recovery from the Covid-19 pandemic will be ‘V’ Shaped, then, even a 20% decline in GDP, together with zero interest rates, price support for government bonds and a fiscal expansion on a scale not witnessed since the ‘New Deal’ of FDR, will rapidly translate inot a sharply rising stock market. If, by contrast, it becomes clear that a tsunami of creative destruction is sweeping away entire industries, then even the most lavish of New New Deals may be insufficient to hold back the tide of stock liquidation as market participates rush to the safety of cash.

So far the official policy response has been sufficient to convince investors that a depression will be avoided. Scratch the surface of the S&P 500, however, and a rather different picture appears. The chart below shows market performance up to the end of May. The same five technology stocks have continued to drive S&P 500 index performance since then: –

Source: FactSet, Goldman Sachs

Technology has been the top performing sector. One argument for such elevated valuations rests on the premise that the pandemic has accelerated a wide range of technology trends bringing with it the potential for much swifter profits. In finance parlance, the net present value of future technology cash-flows has been brought forward by, some analysts suggest, several years. No wonder, they argue, that these stocks have broken to new all-time highs: and will continue, higher.

Since May, the broader stock market has hung of tech coattails (at the time of writing – 19-8-2020 -the MSCI World Index is up 1.73% YTD). For the present, hope triumphs over fear, yet vaccines remain many months from being widely available, meanwhile, for the Northern hemisphere, autumn – and fears of a second wave of infections – draws imminently near.

For emerging markets the situation is worse still. As Carmen and Vincent Reinhart, writing in Foreign Affairs – The Pandemic Depression– put it: –

Although dubbed a “global financial crisis,” the downturn that began in 2008 was largely a banking crisis in 11 advanced economies. Supported by double-digit growth in China, high commodity prices, and lean balance sheets, emerging markets proved quite resilient to the turmoil of the last global crisis. The current economic slowdown is different. The shared nature of this shock—the novel coronavirus does not respect national borders—has put a larger proportion of the global community in recession than at any other time since the Great Depression. As a result, the recovery will not be as robust or rapid as the downturn. And ultimately, the fiscal and monetary policies used to combat the contraction will mitigate, rather than eliminate, the economic losses, leaving an extended stretch of time before the global economy claws back to where it was at the start of 2020.

The World Bank estimates globally more than 60mln people will be pushed into severe poverty. Meanwhile, in developed countries, bankruptcies, which have been postponed by government intervention, may meet their personal epiphanies as fiscal largesse is suddenly withdrawn. Unless the lockdown restrictions are lifted and people feel safe, both medically and financially, to venture out and spend, the destruction of large swathes of developed market economies has simply been deferred.

By next month we will have experienced two quarters of diminished growth – this is a deep recession already. Swathes of the economy have been permanently altered, making a depression highly likely. Millions of workers have been displaced, it will take more than a handful of months for them to be retrained. Without the consumption demand from these erstwhile workers, it will be difficult for new and existing companies to create the growth they need to hire new employees.

Fiscal spending will need to be undertaken on a much larger scale, and for much longer, than has been envisaged so far. In all the major financial crises since 1850, the average time for per capita GDP to recover to the pre-crisis level was eight years. To date it is estimated that the G20 response to the pandemic has amounted to $11trln. Most of these measures have been ‘temporary’ or ‘short-term.’ It is quickly becoming clear, the disruption to employment, business and sectors of the economy will be protracted and, in many cases, permanent, The IMF estimate that for advanced economies the deficit-to-GDP ratio will rise from 3.3% in 2019 to 16.6% this year. For emerging economies, where the capacity for fiscal expansion is more limited, the ratio is expected to swell from 4.9% last year to 10.6% in 2020. Whilst for advanced economies the cost of borrowing has remained low in emerging markets financing costs have risen. The burden of fiscal stimulus will inevitably fall most heavily upon the treasuries of the advanced economies.

Conclusion

As Sir Winston Churchill once said: –

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.

In the aging societies of the West (and elsewhere) the individual need for income remains key. Developed nation governments are fortunate in their ability to borrow more cheaply than at any time in economic history. Whilst it is at odds with my Austrian, free-market instincts, I am forced to admit that fiscal policy is the least panful weapon available to combat the economic catharsis created by the pandemic. Economically, there will be a heavy price to pay, but the alternative is a dangerous cocktail of political fragmentation and polarisation.

For investors the task of securing steady real income remains challenging. Private debt and asset backed lending, which offers high yield, comes with both default and liquidity risk. The chart below looks at some of the public market options, financial repression is rife across the credit spectrum: –

Source: Federal Reserve Bank of St Louis

High income stocks might be an alternative but they offer no guarantee, no matter how ‘blue-chip’ the name. An addition to the acceleration in technology trends, growth stocks in general are benefitting from the exceptionally low interest environment, but there will be a greater number of failures because the cost of speculative finance is also at an historical low. Active management has been unfashionable for at least a decade but looking ahead preservation of capital is going to be more important than capturing out-sized gains.

I wrote about value investing back in June in – A Brave New World for Value Investing – concluding that: –

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

I would add an additional strategy to the investment armoury, a momentum overlay. With fiscal and monetary policy continuing to support economies as they transition to the new world order, capital flows will be a powerful arbiter of investment return. Technology stocks may look expensive by most normal metrics but the trend is patently clear. Do not emulate Cnut The Great, but do as Brutus advises in the opening quote, after all, financial market liquidity flows like tide.

After the flood – Beyond fiscal and monetary intervention
by

After the flood – Beyond fiscal and monetary intervention

in-the-long-run-small-colour-logo

Macro Letter – No 130 – 26-06-2020

After the flood – Beyond fiscal and monetary intervention

  • Monetary and fiscal stimulus to ameliorate the effect of the pandemic has exceeded $9trln
  • Stock markets have recovered, although most are below their February highs
  • The combined supply and demand shock of Covid-19 is structural
  • A value-based investment approach is critical to navigate the transition

In my last Macro Letter – A Brave New World for Value Investing – I anticipated the beginning of a new phase for equity investment. In this Letter I look at the existing business and economic trends which have been accelerated by the pandemic, together with the new trends ignited by this sea-change in human behaviour.

In economic terms, the Covid pandemic began with a supply-shock in China as they were forced to lockdown the Wuhan region. This exacerbated strains which had already become evident in trade negotiations between China and the US, but also revealed weaknesses in the global supply chains. A kind of ‘Mexican Wave’ has followed, with a variant on the initial supply-shock occurring in successive countries as the virus spreads from region to region and governments responded with lockdowns.

The supply-shock has gone hand in hand with a global demand-shock. The key difference between this recession and previous crises is the degree to which it has impacted the service sector. According to 2017 data, the service sector represents 65% of global GDP, whilst Industrial/Manufacturing accounts for 25%, Agriculture represents only 3.43%. Over time, Agriculture and Manufacturing has become more increasingly automated, the principle growth sector for employment is Services. The ILO Monitor: COVID-19 and the world of work. Fourth edition states:  –

As at 17 May 2020, 20 per cent of the world’s workers lived in countries with required workplace closures for all but essential workers. An additional 69 per cent lived in countries with required workplace closures for some sectors or categories of workers, and a further 5 per cent lived in countries with recommended workplace closures.

The latest ILO estimate for Q2, 2020 indicates a 10.7% decline in working hours – equivalent to 305mln lost jobs worldwide. 60% of these job losses have been in four industries, leisure, retail, education and, perhaps counter-intuitively, healthcare. The knock-on effects have been felt almost everywhere.

Governments and central banks have responded. The chart below shows the rapid expansion in central bank balance sheets: –

CB Balance Sheets - Yardeni

Source: Yardeni, Haver Analytics

The Federal Reserve began their latest round of quantitative easing in August 2019, well before the onset of the pandemic. They have added $3.3tlrn in nine months, seeing their balance sheet balloon to $7.1trln.

Around the world, governments have also reacted with vigour; on May 20th the IMF updated their estimate of the global fiscal response to $9trln, of which $8trln has emanated from G20 countries. The geographic breakdown as a percentage of GDP can be seen in the table below: –

REVISED-fiscal-firepower-eng-may-11-image-fm-chap-1-chart-2-2-600x757

Source: IMF

The majority of global stimulus has come from the richer developed nations. Assuming this pattern continues, emerging market equities are likely to lag. The table below ranks a selection of emerging economies by four measures of financial strength, public debt, foreign debt, cost of borrowing and reserve cover: –

20200502_BBC380

Source: The Economist, IMF, JP Morgan, iShares

Overall, whilst the flood may subside, global expenditure should continue to rise as the pandemic sweeps on across the globe. Whilst loan forbearance and forgiveness, together with state guarantees, will help to maintain the solvency of many existing corporations, new spending will be aimed at stimulating employment. Infrastructure projects will be legion.

Impact on Industry Sectors

For investors, the abrupt changes in supply and demand, combined with the impact of the fiscal and monetary response, make navigating today’s stock markets especially challenging. To begin, here is a chart from 2019 showing a breakdown of industry sectors in the US by their contribution to GDP: –

Deloitte Fig 1 (1)

Source: Deloitte, BEA, Haver Analytics

This tells us that finance, insurance and real estate are the largest sector but it fails to tell us which sectors are thriving and which are not: –

Deloitte Fig 2 (1)

Source: Deloitte, BEA, Haver Analytics

Here we see the continued march of digital transformation, but also the ever increasing share of healthcare services in GDP; near to four decades of asset price appreciation has created an asset rich aging cohort in developed economies which, if not healthier then definitely wealthier. Looking ahead, developed nations are better equipped to weather the crisis better than their developing nation peers. Within developed nations, however, smaller businesses, especially those which cannot access capital markets, will fail, whilst larger firms will fare far better. Private Equity funds will also find rich pickings among the plethora of distressed private market opportunities.

Since the outbreak of Covid-19, several trends have accelerated, others have been truncated or reversed. Social behaviour has had a negative impact on travel, leisure and retail. Declining demand for travel has damaged a range of industries including airlines, autos, oil and gas. The leisure sector has been hit even harder with hotels, restaurants and bars closed, in many cases forever. The sports industry has been severely undermined. Meanwhile the decline in retail has accelerated into a downward spiral.

Nonetheless, several industries have benefitted. Within retail, online sales have hit new records, grocery sales have ballooned. Healthcare has gone digital, from consulting to dispensing productivity gains have been evident. The home improvements industry has benefitted even as commercial real estate has suffered. Working from home will be a permanent feature for many office workers. Every existing home owner will need to create a permanent office space, every new home buyer will need more space to incorporate an office. Longer, occasional, commutes will lead people to move further from the city. Some workers will move to more clement climes, requiring less energy. Structural changes in where we live and how we live present threats and opportunities in equal measure. For example, every house will require better communications infrastructure, high speed connectivity and broad, broadband will become the norm.

Changes in the delivery of goods (direct to homes rather than to retail outlets) means more inventory will held in out-of-town locations. Inner city retail and commercial property businesses will consolidate as out-of-town commercial thrives. New out-of-town property demand will also emerge from the manufacturing sector. The on-shoring of production was already in train, with robots replacing cheap labour from developing countries, now, concern about the robustness of supply chains, especially for critical manufactures such as pharmaceuticals, will encourage a wave of old industries in developing countries to be reborn. Whereas in retail, larger inventory may become more prevalent, in manufacturing, ‘just-in-time’ delivery and lower transportation costs will compensate for higher fixed production costs.

The energy sector has suffered a medium-term setback, for example, 28% of all US gasoline is consumed in the daily commute. After the lockdown, some commuters will choose to travel alone rather than by public transport, many more will now work permanently from home. Yet whilst gasoline demand falls, demand for diesel, to fuel the home delivery revolution, will rise. Home heating (and cooling) is also set to rise and, with it, demand for heating oil and natural gas. Overall demand may be lower but there will be many investment opportunities.

In healthcare, aside from tele-medicine, which is forecast to capture between one third and half of consultation demand, there is also increased appetite for bio-sensors to measure multiple aspects of health. Hospital consolidation will continue in an attempt to drive efficiency. On-shoring of drug manufacture may well be mandated, online delivery is likely to become the new normal, especially to the elderly and infirm who are advised to shelter-in-place. On-shoring creates domestic jobs, government favour will focus on these companies.

Airlines will be forced to diversify or merge; I envisage a mixture of both strategies. A diversification into car hire, travel insurance and hotels seems likely. Many airlines are national carriers, they possess an implicit government guarantee, their financing costs will remain lower, their low-budget competitors will diminish, fare discounts will become fewer and, thereby, their fortunes may conceivably rebound.

The automobile industry remains in a state of turmoil, but new technology will continue to determine its fortune. If de-urbanisation continues, whilst commuting will decline, there will be an increased demand for individual car ownership, especially electric vehicles. In the fullness of time, the industry will transform again with the adoption of driverless transportation.

Technology will, of course, be ubiquitous. The fortunes of the cybersecurity sector have been ascendant since the crisis began, but even relatively ‘non-tech’ businesses will benefit. Commercial real estate will gain as tech firms seek out ever larger data centres to support their cloud computing needs. The auto industry will benefit from improvements in battery storage and charging times. This will also change the economics of electricity for homes and factories. Green energy will come of age.

Tourism will recover, the human race has not lost the desire to travel. In Europe tourism is down between 30% and 40% – it accounts for 10% of GDP. The rebound will be gradual but the travellers will return. More consumers will buy on-line.

Banking and finance will evolve to meet the challenges and needs of the industrial and services sector. Certain trends will continue, bricks and mortar will give way to on-line solutions, branch networks will consolidate. With government support, or threat, existing loans will be extended, new loans made. As household savings rise, new credit will be granted to new and existing entities, few questions will be asked.

Insurance companies will consolidate, once claims are paid, premiums will rise and competition lessened. As with banking more consumers will move on-line.

Employment

Looking beyond the business potential of different industry sectors and the technological advances which will support them, we should remember that governments around the globe will direct fiscal policy to alleviate unemployment, the initial flood of fiscal aid may moderate but if the tide goes out the ebb will be gradual, this is one of the benefits of a fiat currency system. According to the ILO, in 2019, employment in services accounted for 50%, Industry 23% and Agriculture 27%. The chart below shows how employment by sector has evolved over the last 28 years: –

Global Employment by Sector – Services – Agriculture - Industry (1)

Source: World Bank, ILO

The services sector has embraced employees leaving agriculture, whilst industry has grown without significant employment growth. The leisure industry, including hotels, restaurants and bars, is one of the largest employers of low-skilled, part-time employment. Consolidation within the hotels sector is inevitable. Larger, better capitalised groups will benefit as smaller enterprises fail. Corporations from beyond the leisure sector will diversify and private equity will fill the gaps which public companies step aside.

Conclusions and Investment Opportunities

In my previous Macro Letter I concluded that value-based analysis would be the best approach to equity investment. On closer examination, one can find risk and opportunity in almost every industry sector. In the last three month, stock markets have risen, but stock return dispersion remains heightened. A prudent, value-oriented, framework should yield the best results in the next few years.

A Brave New World for Value Investing
by

A Brave New World for Value Investing

In the Long Run - small colour logo

Macro Letter – No 129 – 05-06-2020

A Brave New World for Value Investing

  • Stock markets have rebounded from their March lows on fiscal and monetary stimulus
  • Corporate bond spreads have narrowed in their wake
  • The prospect of further fiscal spending and broader quantitative easing remains
  • The global economy has changed forever and value analysis is back in demand

Perhaps the most frequently used adjective during the Covid pandemic is ‘unprecedented.’ On the 14th February, when I published – Macro Letter – No 126 – 14-02-2020 – When the facts change – I wrote: –

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Much has happened since, yet, in my conclusion, I stated: –

…the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy.

… Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

To judge by the current level of the Nasdaq 100 (current level 9,683 as at COB 03-06-2020, just 1.6% below its all-time high) the unprecedented crisis has been met by an equally unprecedented policy response. The S&P 500 has lagged the Nasdaq somewhat and the MSCI World Index still more: –

Nasdaq 100 v SPX v MSCI - Yahoo Finance (1)

Source: Yahoo Finance

Returning to my letter from February, the facts have changed, governments and central bankers have responded to a crisis, a crisis which proved far worse than anticipated. The stock market collapsed, but has now regained composure, nevertheless, the main driver of stock market performance for more than a decade – ability of central banks to lower interest rates – has been exhausted. The central bankers’ armoury is not quiet empty, however, they still have the QE bazooka which can be aimed at corporate bonds and even common stocks, but, not wishing to exceed their mandates they have turned to their respective governments’ for guidance and succour.

Governments’ can and have responded to the pandemic in a manner which is both broader and more direct in its impact on the economy and businesses. Going forward the effect of government largesse will be felt in a less consistent manner than the largesse of central banks. For governments’ employment will take precedence over corporate profits, corporate executives would be wise to recognise the profound change in the terms of engagement. Stock performance can no longer be assured by increasing debt to repurchase stock. Mergers which rely on rationalisation will be thwarted from above. Wages are unlikely to rise given the increase in unemployment, but the cost of making incumbent employees redundant will have adverse consequences both seen and unseen. Firms that hire will find favour, those that trim payrolls will not.

We will witness the return of the Value Investor, an endangered species who underperformed the Index Trackers during the decade since the great financial crisis. The great rotation away from index tracking or hugging is about to begin. Technology will continue to provide new employment opportunities even as more roles in the wider economy become automated. The public sector will create opportunities. Infrastructure spending is set to bring a ‘New, new deal’ to those in need of work. Healthcare will continue to expand as the population of developed countries age and life expectancy increases.

Other changes are also afoot. Working from home is about to become the norm for many people. Video conferencing, now widely adopted, brings into question the need for excessive travel. Demand for office space is already in retreat. Many firms are reporting unexpected productivity gains from the enforced ‘work from home edict,’ and have cancelled leases in favour of smaller, more flexible office space. Meanwhile, those eponymous start-ups, for whom flexible office space was the norm, have made a virtue of necessity, slowing their cash-burn – and mollifying investors in the process – by closing their offices altogether.

As economies recover from the effects of the lockdown, companies will fall into three categories based on their prospects for recovery from the dual supply and demand shock – ‘L,’ ‘U’ and ‘V’. The Tech giants (V) have rebounded and their prospects remain strong, even at these exalted valuations. Investment Grade Corporates (U) will take longer to recover, but even before interest rates were lowered by the Federal Reserve (Fed) these corporations were preparing for an economic slowdown. Q1 corporate debt issuance surged to the highest since records began in 1980: –

1-US-debt-issuance-20-05-2020 refinitiv

Source: Refinitiv

The High-Yield bond market followed in the wake of Investment Grade issuers, although the sudden widening of credit spreads in March dampened their ardour. Issuance returned with renewed urgency as soon the Federal Reserve announced that ‘Junk bonds’ where to be included in its expanded asset purchase program: –

2-US-debt-issuance-20-05-2020

Source: Refinitiv

This chart from the St Louis Fed tracks yield changes year-to-date for the High Yield bond index: –

fredgraph (1) HY YTD

Source: Ice Data Indices, Federal Reserve

High yield bond yields remain elevated despite the interest rate cuts and Fed asset purchase promises. On 3rd June they averaged 5.8% up from 3.56% in mid-February, but far below their 23rd March high of 10.87%.

Many of the firms in the high yield sector (L) are involved in the Oil and Gas industry. As oil and gas prices rebound, they will regain some composure and, being high profile employers, they should receive government support. Other firms may fare less well, these are those destined to follow an ‘L-shaped’ recovery. Their survival will be dependent on their ability to provide employment, some will be saved, others will fail.

Conclusion

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

When the facts change
by

When the facts change

In the Long Run - small colour logo

Macro Letter – No 126 – 14-02-2020

When the facts change

  • The coronavirus is a human tragedy, but the markets remain sanguine
  • A slowing of global growth is already factored into market expectations
  • Further central bank easing is expected to calm any market fears
  • A pick up in import price inflation has been discounted before it arrives

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Is the impact of Covid-19 going to be seen in economic data? Absolutely. Will economic growth slow? Yes, though it will be felt most in Wuhan and the Hubei region, a region estimated to account for 4.5% in Chinese GDP and 7% of autopart manufacture. The impact will be less pronounced in other parts of the world, although Korea’s Hyundai has already ceased vehicle production at its factories due to a lack of Chinese car parts.

Will there be a longer-term impact on the global supply chain and will this affect stock and bond prices? These are more difficult questions to answer. Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs. The longer-term impact remains unclear. Why? Because the performance of the stock market over the last decade has been driven almost entirely by the direction of interest rates, whilst economic growth, since the financial crisis, has been anaemic at best. As rates have fallen and central banks have purchased bonds, so bond yields have declined making stocks look relatively more attractive. Some central banks have even bought stocks to add to their cache of bonds, but I digress.

Returning to my title, from an investment perspective, have the facts changed? Global economic growth will undoubtedly take a hit, estimates of 0.1% to 0.2% fall in 2020 already abound. In order to mitigate this downturn, central banks will cut rates – where they can – and buy progressively longer-dated and less desirable bonds as they work their way along the maturity spectrum and down the credit-structure. Eventually they will emulate the policy of the Japanese and the Swiss, by purchasing common stocks. In China, where the purse strings have been kept tight during the past year, the PBoC has already ridden to the rescue, flooding the domestic banking system with $173bln of additional liquidity; it seems, the process of saving the stock market from the dismal vicissitudes of a global economic slow-down has already begun.

Growth down, profits down, stocks up? It sounds absurd but that is the gerrymandered nature of the current marketplace. It is comforting to know, the central banks will not have to face the music alone, they can rely upon the usual allies, as they endeavour to keep the everything bubble aloft. Which allies? The corporate executives of publically listed companies. Faced with the dilemma of expanding capital expenditure in the teeth of an economic slowdown – which might turn into a recession – the leaders of publically listed corporations can be relied upon to do the honourable thing, pay themselves in stock options and buyback more stock.

At some point this global Ponzi scheme will inflect, exhaust, implode, but until that moment arrives, it would be unwise to step off the gravy-train. The difficulty of staying aboard, of course, is the same one as always, the markets climb a wall of fear. If there is any good news amid the tragic Covid-19 pandemic, it is that the January correction has prompted some of the weaker hands in the stock market to fold. When markets consolidate on a high plateau, should they then turn down, the patient investor may be afforded time to exit. This price action is vastly preferable to the hyperbolic rise, followed by the sharp decline, an altogether more cathartic and less agreeable dénouement.

Other Themes and Menes

As those of you who have been reading my letters for a while will know, I have been bullish on the US equity market for several years. That has worked well. I have also been bullish on emerging markets in general – and Asia in particular – over a similar number of years. A less rewarding investment. With the benefit of hindsight, I should have been more tactical.

Looking ahead, Asian economies will continue to grow, but their stock markets may disappoint due to the uncertainty of the US administrations trade agenda. The US will continue to benefit from low interest rates and technological investment, together with buy-backs, mergers and privatisations. Elsewhere, I see opportunity within Europe, as governments spend on green infrastructure and other climate conscious projects. ESG investing gains more advocates daily. Socially responsible institutions will garner assets from socially responsible investors, while socially responsible governments will award contracts to those companies whose behaviour is ethically sound. It is a virtuous circle of morally commendable, albeit not necessarily economically logical, behaviour.

The UK lags behind Europe on environmental issues, but support for business and three years of deferred capital investment makes it an appealing destination for investment, as I explained last December in The Beginning of the End of Uncertainty for the UK.

Conclusions

Returning once more to my title, the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy. The chart below shows the diminishing power of the credit multiplier effect – Japan began their monetary experiment roughly a decade earlier than the rest of the developed world: –

Credit Multiplier

Source: Allianz/Refinitiv

Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

Value, Momentum and Carry – Is it time for equity investors to switch?
by

Value, Momentum and Carry – Is it time for equity investors to switch?

In the Long Run - small colour logo

Macro Letter – No 121 – 04-10-2019

Value, Momentum and Carry – Is it time for equity investors to switch?

  • Index tracking and growth funds have outperformed value managers for several years
  • Last month value was resurgent, but will it last?
  • In the long run, value has offered a better risk adjusted return
  • The long-term expected return from growth stocks remains hard to assess

Value, momentum and carry are the three principal means of extracting return from any investment. They may be described in other ways but these are really the only games in town. I was reminded of this during the last month as value based equity managers witnessed a resurgence of performance whilst index tracking products generally suffered. Is this a sea-change or merely a case of what goes up must come back down?

My premise over the last few years has been that the influence of central banks, in reducing interest rates to zero or below, has been the overwhelming driver of return for all asset classes. The stellar performance of government bonds has percolated through the credit markets and into stocks. Lower interest rates has also made financing easier, buoying the price of real-estate.

Traditionally, in the equity markets, investment has been allocated to stocks which offer growth or income, yet with interest rates falling everywhere, dividend yields offer as much or more than bonds, making them attractive, however, growth stocks, often entirely bereft of earnings, become more attractive as financing costs approach zero. In this environment, with asset management fees under increasing pressure, it is not surprising to observe fund investors accessing the stock market by the cheapest possible means, namely ETFs and index tracking funds.

During the last month, there was a change in mood within the stock market. Volatility within individual stocks remains relatively high, amid the geo-political and economic uncertainty, but value based active managers saw a relative resurgence, after several years in the wilderness. This may be merely a short-term correction driven more by a rotation out of the top performing stocks, but it could herald a sea-change. The rising tide of ever lower interest rates, which has floated all ships, may not have turned, but it is at the stand, value, rather than momentum, may be the best means of extracting return in the run up to the US presidential elections.

A review of recent market commentary helps to put this idea in perspective. Firstly, there is the case for growth stocks, eloquently argued by Jack Neele at Robeco – Buying cheap is an expensive business: –

One of the most frequent questions I have been asked in recent years concerns valuation. My focus on long-term growth trends in consumer spending and the companies that can benefit from these often leads me to stocks with high absolute and relative valuations. Stocks of companies with sustainability practices that give them a competitive edge, global brand strength and superior growth prospects are rewarded with an above-average price-earnings ratio.

It is only logical that clients ask questions about high valuations. To start with, you have the well-known value effect. This is the principle that, in the long term, value stocks – adjusted for risk – generate better returns that their growth counterparts. Empirical research has been carried out on this, over long periods, and the effect has been observed in both developed and emerging markets. So if investors want to swim against the tide, they need to have good reasons for doing so.

f226feaceadbe054cd0a2a9c19c06082_buying-cheap-fig1_tcm17-20864_639x0

Source: Robeco, MSCI

In addition, there are – understandably – few investors who tell their clients they have the market’s most expensive stocks in their portfolio. Buying cheap stocks is seen as prudent: a sign of due care. However, if we zoom in on the last ten years, there seems to have been a structural change since the financial crisis. Cheap stocks have done much less well and significantly lagged growth stocks.

e918dbcd886cb734f02aff26c491667f_buying-cheap-fig-2_tcm17-20865_639x0

Source: Robeco, MSCI

Nevertheless, holding expensive stocks is often deemed speculative or reckless. This is partly because in the financial industry the words ‘expensive’ and ‘overvalued’ are often confused, despite their significant differences. There are many investors who have simply discarded Amazon shares as ‘much too expensive’ in the last ten years. But in that same period, Amazon is up more than 2000%. While the stock might have been expensive ten years ago, with hindsight it certainly wasn’t overvalued.

The same applies for ‘cheap’ and ‘undervalued’. Stocks with a low price-earnings ratio, price-to-book ratio or high dividend yield are classified as cheap, but that doesn’t mean they are undervalued. Companies in the oil and gas, telecommunications, automotive, banking or commodities sectors have belonged to this category for decades. But often it is the stocks of these companies that structurally lag the broader market. Cheap, yes. Undervalued, no.

The author goes on to admit that he is a trend follower – although he actually says trend investor – aside from momentum, he makes two other arguments for growth stocks, firstly low interest rates and secondly the continued march of technology, suggesting that investors have become much better at evaluating intangible assets. The trend away from older industries has been in train for many decades but Neele points out that since 1990 the total Industry sector weighting in the S&P Index has fallen from 34.9% to 17.3% whilst Technology has risen from 5.9% to 15.6%.

If the developed world is going to continue ageing and interest rates remain low, technology is, more than ever, the answer to greatest challenges facing mankind. Why, therefore, should one contemplate switching from momentum to value?

A more quantitative approach to the current environment looks at the volatility of individual stocks relative to the main indices. I am indebted to my good friend Allan Rogers for his analysis of the S&P 100 constituents over the past year: –

OEF, the ETF tracking the S&P 100, increased very modestly during the period from 9/21/2018 to 9/20/2019.  It rose from 130.47 to 132.60, a gain of 1.63%.  During the 52 weeks, it ranged between 104.23 and 134.33, a range of 28.9% during a period where the VIX rarely exceeded 20%.  Despite the inclusion of an additional 400 companies, SPY, the ETF tracking the S&P 500, experienced a comparable range of 29.5%, calculated by dividing the 52 week high of 302.63 by the 52 week low of 233.76.  SPY rose by 2.2% during that 52 week period.  Why is this significant?  Before reading on, pause and make your own estimate of the average 52 week range for the individual stocks in the S&P 100.  15%?  25%?  The average 52 week price range for the components was 49%.  The smallest range was 18%.  The largest range was 134%.  For a portfolio manager tasked with attempting to generate a return of 7% per annum, the 100 largest company stocks offer potential profit of seven times the target return if one engages in active trading.  Credit risk would appear to be de minimus for this group of companies.  This phenomenon highlights remarkable inefficiency in stock market liquidity.

This analysis is not in the public domain, however, please contact me if you would like to engage with the author.

This quantitative approach when approaching the broader topic of factor investing – for a primer Robeco – The Essentials of Factor Investing – is an excellent guide. Many commentators discuss value in relation to investment factors. Last month an article by Olivier d’Assier of Axioma – Has the Factor World Gone Mad and Are We on the Brink of Another Quant Crisis? caught my eye, he begins thus: –

To say that fundamental style factor returns have been unusual this past week would be the understatement of the year—the decade, in fact. As reported in yesterday’s blog post “Momentum Nosedives”, Momentum had a greater-than two standard deviation month-to-date negative return in seven of the eleven markets we track. Conversely, Value, which has been underperforming year-to-date everywhere except Australia and emerging markets, has seen a stronger-than two standard deviation month-to-date positive return in four of those markets. The growth factor also saw a sharp reversal of fortune last week in the US, while leverage had a stronger-than two standard deviation positive return in that market on the hopes for more monetary easing by the Fed.

The author goes on to draw parallels with July 2007, reminding us that after a few weeks of chaotic reversals, the factor relationships returned to trend. This time there is a difference, equities in 2007 were not a yield substitute for bonds, today, they are. Put into the context of geopolitical and economic growth concerns, the author expects lower rates and sees the recent correction in bond yields as corrective rather than structural. As for the recent price action, d’Assier believes this is due to unwinding of exposures, combined with short-term traders buying this year’s losing factors, Value and Dividend Yield, and selling winners such as Momentum and Growth. Incidentally, despite the headline, Axioma does not envisage a quant crisis.

Returning to the broader topic of momentum versus value, a recent article from MSCI – Growth’s recent outperformance was and wasn’t an anomaly – considers whether the last decade represents a structural shift, here is their summary: –

Growth strategies have performed well over the past few years. For investors, an important question is whether the recent performance is an anomaly.

For a growth strategy that simply picks stocks with high growth characteristics, the recent outperformance is out of line with that type of growth strategy’s historical performance.

For a strategy that targets the growth factor while controlling for other factors, the recent outperformance has been in line with its longer historical performance.

The chart below attempts to show the performance of the pure growth factor adjusted for non-growth factors: –

GrowthFactors_Exhibit_2

Source: MSCI

If anything, this chart shows a slightly reduced return from pure growth over the last three years. The authors conclude: –

…to answer whether growth’s recent performance is an anomaly really depends on what we mean by growth. If we mean a simple strategy that selects high-growth stocks, then the recent performance is not representative of that strategy’s long-term historical performance. In this case, we can attribute the recent outperformance relative to the long term to non-growth factors and particular sectors — exposure to which has not been as detrimental recently as it has been over the long run. But for a factor- and sector-controlled growth strategy, the performance is mainly driven by exposure to the growth factor. In this case, the recent outperformance has been in line with the longer-term outperformance.

As I read this I am reminded of a quant hedge fund manager with whom I used to do business back in the early part of the century. He had taken a tried a tested fundamental short-selling strategy and built a market neutral, industry neutral, sector neutral portfolio around it, unfortunately, by the time he had hedged away all these risks, the strategy no longer made any return. What we can probably agree upon is that growth stocks have outperformed income and value not simply because they are growth stocks.

The Case for Value

They say that history is written by the winners, nowhere is this truer than in investment management. Investors move in herds, they want what is hot and not what is not. In a paper published last month by PGIM – Value vs. Growth: The New Bubble – the authors’ made several points, below are edited highlights (the emphasis is mine): –

  1. We have been through an extraordinary period of value factor underperformance over the last 18 months. The only comparable periods over the last 30 years are the Tech Bubble and the GFC.

  2. Historically, we would expect a very sharp reversal of value performance to follow. This was the case in each of the two previous extreme periods.

  3. We tested the drivers of recent value underperformance to see if we are in a “value trap.” Historically, fundamentals have somewhat deteriorated, but prices expected a bigger deterioration, so the bounce-back more than offset the fundamental deterioration. In a value trap environment, we would expect a greater deterioration in fundamentals. In the last 18 months, we have actually seen an improvement in fundamental earnings for value stocks, but a deterioration in pricing. This combination is unprecedented, and signals the opposite of a value trap environment.

  4. …we examined the behavior of corporate insiders… The relative conviction of insiders regarding cheaper stocks is higher than ever, which reinforces our conviction about the magnitude of the performance opportunity from here.

  5. It is never easy to predict what it will take to pop a bubble, but there are multiple scenarios that we envisage as potential catalysts, including both growth and recessionary conditions.

These views echo an August 2019 article by John Pease at GMO – Risk and Premium – A Tale of Value – the author concludes (once again the emphasis is mine): –

Value has underperformed the market in 10 of the last 12 months, including the last 7. Its most recent drawdown began in 2014 and the factor is quite far from its high watermark. The relative return of traditional value has been flat since late 2004. All in all, it has been a harrowing decade for those who have sought cheap stocks, and we have tried to understand why.

We approached this problem by decomposing the factor’s relative returns. The relative growth profile of value has not changed with time; the cheapest half (ex-financials) in the U.S. has continued to undergrow the market, but by no more than what we have come to expect. These companies have also not compromised their quality to keep growth stable, suggesting that any shifts that have occurred in the market have not disproportionately hurt value’s fundamentals.

The offsets to value’s undergrowth, however, have come under pressure. Value’s yield advantage has fallen as the market has become more expensive. The group’s rebalancing – the tendency of cheap companies to see their multiples expand and rotate out of the group while expensive companies see their multiples contract and come into value – is also slower, with behavioral and structural aspects both at play. Though these drivers of relative outperformance have diminished, they still exceed value’s undergrowth by more than 1%, indicating that going forward, cheap stocks (at least as we define them) are likely to reap a decent, albeit smaller, premium.

This premium has not materialized over the last decade for a simple reason: relative valuations. Value has seen its multiples expand a lot less than the market. This makes sense – because value tends to have significantly lower duration than other equities, a broad risk rally shouldn’t be as favorable to cheap stocks as it should be to their expensive counterparts. And we have had quite a rally.

It isn’t possible to guarantee that the next decade will be kinder to value than the previous one was. The odds would seem to favor it, however. Cheap stocks still provide investors with a premium, allowing them to outperform even if their relative valuations remain low. If relative valuations rise – not an inconceivable event given a long history of mean-reverting discount rates – the ensuing relative returns will be exceptional. And value, after quite the pause, might look valuable again.

A key point in this analysis is that the low interest rate environment has favoured growth over value. Unless the next decade sees a significant normalisation of interest rates, unlikely given the demographic headwinds, growth will continue to benefit, even as momentum strategies falter due to the inability of interest rates to fall significantly below zero (and that is by no means certain either).

These Macro Letters would not be In the Long Run without taking a broader perspective and this July 2019 paper by Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, and Franklin Wan of AQR – Do Factor Premia Vary Over Time? A Century of Evidence – fits the bill. The author examine four factors – value, momentum, carry, and defensive (which is essentially a beta neutral or hedged portfolio). Here are their conclusions (the emphasis is mine): –

A century of data across six diverse asset classes provides a rich laboratory to investigate whether canonical asset pricing factor premia vary over time. We examine this question from three perspectives: statistical identification, economic theory, and conditioning information. We find that return premia for value, momentum, carry, and defensive are robust and significant in every asset class over the last century. We show that these premia vary significantly over time. We consider a number of economic mechanisms that may drive this variation and find that part of the variation is driven by overfitting of the original sample periods, but find no evidence that informed trading has altered these premia. Appealing to a variety of macroeconomic asset pricing theories, and armed with a century of global economic shocks, we test a number of potential sources for this variation and find very little. We fail to find reliable or consistent evidence of macroeconomic, business cycle, tail risks, or sentiment driving variation in factor premia, challenging many proposed dynamic asset pricing theories. Finally, we analyze conditioning information to forecast future returns and construct timing models that show evidence of predictability from valuation spreads and inverse volatility. The predictability is even stronger when we impose theoretical restrictions on the timing model and combine information from multiple predictors. The evidence identifies significant conditional return premia from these asset pricing factors. However, trading profits to an implementable factor timing strategy are disappointing once we account for real-world implementation issues and costs.

Our results have important implications for asset pricing theory, shedding light on the existence of conditional premia associated with prominent asset pricing factors across many asset classes. The same asset pricing factors that capture unconditional expected returns also seem to explain conditional expected returns, suggesting that the unconditional and conditional stochastic discount factors may not be that different. The lack of explanatory power for macroeconomic models of asset pricing challenges their usefulness in describing the key empirical factors that describe asset price dynamics. However, imposing economic restrictions on multiple pieces of conditioning information better extracts conditional premia from the data. These results offer new features for future asset pricing models to accommodate.

This paper suggests that, in the long run, broad asset risk premia drive returns in a consistent manner. Macroeconomic and business cycle models, which attempt to forecast asset values based on expectations for economic growth, have a lower predictive value.

Conclusions and investment opportunities

I have often read market commentators railing against the market, complaining that asset prices ignored the economic fundamentals, the research from AQR offers a new insight into what drives asset returns over an extended time horizon. Whilst this does not make macroeconomic analysis obsolete it helps to highlight the paramount importance of factor premia in forecasting asset returns.

Returning to the main thrust of this latter, is this the time to switch from momentum to value? I think the jury is still out, although, as the chart below illustrates, we are near an all-time high for the ratio between net worth and disposable income per person in the US: –

fredgraph (8)

Source: Federal Reserve

This is a cause for concern, it points to severe imbalances within households: it is also a measure of rising income inequality. That stated, many indicators are at unusual levels due to the historically low interest rate environment. Investment flows have been the principal driver of asset returns since the great recession, however, now that central bank interest rates in the majority of developed economies are near zero, it is difficult for investors to envisage a dramatic move into negative territory. Fear about an economic slowdown will see risk free government bond yields become more negative, but the longer-term driver of equity market return is no longer solely based on interest rate expectations. A more defensive approach to equities is likely to be seen if a global recession is immanent. Whether growth stocks prove resurgent or falter in the near-term, technology stocks will continue to gain relative to old economy companies, human ingenuity will continue to benefit mankind. Creative destruction, where inefficient enterprises are replaced by new efficient ones, is occurring despite attempts by central banks to slow its progress.

For the present I remain long the index, I continue to favour momentum over value, but, as was the case when I published – Macro Letter – No 93 back in March 2018, I am tempted to reduce exposure or switch to a value based approach, even at the risk of losing out, but then I remember the words of Ryan Shea in his article Artificial Stupidity: –

…investment success depends upon behaving like the rest of the crowd almost all of the time. Acting rational when everyone else is irrational is a losing trading strategy because market prices are determined by the collective interaction of all participants.

For the active portfolio manager, value factors may offer a better risk reward profile, but, given the individual stock volatility dispersion, a market neutral defensive factor model, along the lines proposed by AQR, may deliver the best risk adjusted return of all.

A global slowdown in 2019 – is it already in the price?
by

A global slowdown in 2019 – is it already in the price?

In the Long Run - small colour logo

Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

Divergent – the breakdown of stock market correlations, temp or perm?
by

Divergent – the breakdown of stock market correlations, temp or perm?

In the Long Run - small colour logo

Macro Letter – No 101 – 31-08-2018

Divergent – the breakdown of stock market correlations, temp or perm?

  • Emerging market stocks have stabilised, helped by the strength of US equities
  • Rising emerging market bond yields are beginning to attract investor attention
  • US tariffs and domestic tax cuts support US economic growth
  • US$ strength is dampening US inflation, doing the work of the Federal Reserve

To begin delving into the recent out-performance of the US stock market relative to its international peers, we need to reflect on the global fiscal and monetary response to the last crisis. After the great financial recession of 2008/2009, the main driver of stock market performance was the combined reduction of interest rates by the world’s largest central banks. When rate cuts failed to stimulate sufficient economic growth – and conscious of the failure of monetary largesse to stimulate the Japanese economy – the Federal Reserve embarked on successive rounds of ‘experimental’ quantitative easing. The US government also played its part, introducing the Troubled Asset Relief Program – TARP. Despite these substantial interventions, the velocity of circulation of money supply plummeted: and, although it had met elements of its dual-mandate (stable prices and full employment), the Fed remained concerned that whilst unemployment declined, average earnings stubbornly refused to rise.

Eventually the US economy began to grow and, after almost a decade, the Federal Reserve, cautiously attempted to reverse the temporary, emergency measures it had been forced to adopt. It was helped by the election of a new president who, during his election campaign, had pledged to cut taxes and impose tariffs on imported goods which he believed were being dumped on the US market.

Europe and Japan, meanwhile, struggled to gain economic traction, the overhang of debt more than offsetting the even lower level of interest rates in these markets. Emerging markets, which had recovered from the crisis of 1998 but adopted fiscal rectitude in the process, now resorted to debt in order to maintain growth. They had room to manoeuvre, having deleveraged for more than a decade, but the spectre of a trade war with the US has made them vulnerable to any strengthening of the reserve currency. They need to raise interest rates, by more than is required to control domestic inflation, in order to defend against capital flight.

In light of these developments, the recent divergence between developed and emerging markets – and especially the outperformance of US stocks – is understandable. US rates are rising, elsewhere in developed markets they are generally not; added to which, US tariffs are biting, especially in mercantilist economies which have relied, for so many years, on exporting to the ‘buyer of last resort’ – namely the US. Nonetheless, the chart below shows that divergence has occurred quite frequently over the past 15 years, this phenomenon is likely to be temporary: –

MSCI Developed vs MSCI EM 24-8-2018 Yardeni Research

Source: MSCI, Yardeni Research

Another factor is at work, which benefits US stocks, the outperformance of the technology sector. As finance costs have fallen, to levels never witnessed in recorded history, it has become easier for zombie companies to survive, crowding out more favourable investment opportunities, but it has also allowed, technology companies, with no expectation of near-term positive earnings, to continue raising capital and servicing their debts for far longer than during the tech-bubble of the 1990’s; added to which, the most successful technology companies, which evolved in the aftermath of the bursting of the tech bubble, have come to dominate their niches, often, globally. Cheap capital has helped prolong their market dominance.

Finally, capital flows have played a significant part. As emerging market stocks came under pressure, international asset managers were quick to redeem. These assets, repatriated most often to the US, need to be reallocated: US stocks have been an obvious destination, supported by a business-friendly administration, tax cuts and tariff barriers to international competition. These factors may be short-term but so is the stock holding period of the average investment manager.

Among the most important questions to consider looking ahead over the next five years are these: –

  1. Will US tariffs start to have a negative impact on US inflation, economic growth and employment?
  2. Will the US$ continue to rise? And, if so, will commodity prices suffer, forcing the Federal Reserve to reverse its tightening as import price inflation collapses?
  3. Will the collapse in the value of the Turkish Lira and the Argentine Peso prompt further competitive devaluation of other emerging market currencies?

In answer to the first question, I believe it will take a considerable amount of time for employment and economic growth to be affected, provided that consumer and business confidence remains strong. Inflation will rise unless the US$ rises faster.

Which brings us to the second question. With higher interest rates and broad-based economic growth, primed by a tax cut and tariffs barriers, I expect the US$ to be well supported. Unemployment maybe at a record low, but the quality of employment remains poor. The Gig economy offers workers flexibility, but at the cost of earning potential. Inflation in raw materials will continued to be tempered by a lack of purchasing power among the vastly expanded ranks of the temporarily and cheaply employed.

Switching to the question of contagion. I believe the ramifications of the recent collapse in the value of the Turkish Lira will spread, but only to vulnerable countries; trade deficit countries will be the beneficiaries as import prices fall (see the table at the end of this letter for a recent snapshot of the impact since mid-July).

At a recent symposium hosted by Aberdeen Standard Asset Management – Emerging Markets: increasing or decreasing risks? they polled delegates about the prospects for emerging markets, these were their findings: –

83% believe risks in EMs are increasing; 17% believe they are decreasing

46% consider rising U.S. interest rates/rising U.S. dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat

50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latin America to have the greatest potential

64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.

The increase in EM bond yields may be encouraging investors back into fixed income, but as I wrote recently in Macro Letter – No 99 – 22-06-2018 – Where in the world? Hunting for value in the bond market there are a limited number of markets where the 10yr yield offers more than 2% above the base rate and the real-yield is greater than 1.5%. That Turkey has now joined there ranks, with a base rate of 17.75%, inflation at 15.85% and a 10yr government bond yield of 21.03%, should not be regarded as a recommendation to invest. Here is a table looking at the way yields have evolved over the past two months, for a selection of emerging markets, sorted by largest increase in real-yield (for the purposes of this table I’ve ignored the shape of the yield curve): –

EM Real Yield change June to August 2018

Source: Investing.com

Turkish bonds may begin to look good value from a real-yield perspective, but their new government’s approach to the imposition of US tariffs has not been constructive for financial markets: now, sanctions have ensued. With more than half of all Turkish borrowing denominated in foreign currencies, the fortunes of the Lira are unlikely to rebound, bond yields may well rise further too, but Argentina, with inflation at 31% and 10yr (actually it’s a 9yr benchmark bond) yielding 18% there may be cause for hope.

Emerging market currencies have been mixed since July. The Turkish Lira is down another 28%, the Argentinian Peso by 12%, Brazilian Real shed 6.3% and the South African Rand is 5.7% weaker, however the Indonesian Rupiah has declined by just 1.6%. The table below is updated from Macro Letter 100 – 13-07-2018 – Canary in the coal-mine – Emerging market contagion. It shows the performance of currencies and stocks in the period January to mid-July and from mid-July to the 28th August, the countries are arranged by size of economy, largest to smallest: –

EM FX and stocks Jan-Jul and Jul-Aug 2018

Source: Investing.com

It is not unusual to see an emerging stock market rise in response to a collapse in its domestic currency, especially where the country runs a trade surplus with developed countries, but, as the US closes its doors to imports and growth in Europe and Japan stalls, fear could spread. Capital flight may hasten a ‘sudden stop’ sending some of the most vulnerable emerging markets into a sharp and painful recession.

Conclusions and Investment Opportunities

My prediction of six weeks ago was that Turkey would be the market to watch. Contagion has been evident in the wake of the decline of the Lira and the rise in bond yields, but it has not been widespread. Those countries with twin deficits remain vulnerable. In terms of stock markets Indonesia looks remarkably expensive by many measures, India is not far behind. Russia – and to a lesser extent Turkey – continues to appear cheap… ‘The markets can remain irrational longer than I can remain solvent,’ as Keynes once said.

Emerging market bonds may recover if the Federal Reserve tightening cycle is truncated. This will only occur if the pace of US economic growth slows in 2019 and 2020. Another possibility is that the Trump administration manage to achieve their goal, of fairer trading arrangements with China, Europe and beyond, then the impact of tariffs on emerging market economies may be relatively short-lived. The price action in global stock markets have been divergent recently, but the worst of the contagion may be past. Mexico and the US have made progress on replacing NAFTA. Other countries may acquiesce to the new Trumpian compact.

The bull market in US stocks is now the longest ever recorded, it would be incautious to recommend stocks except for the very long-run at this stage in the cycle. In the near-term emerging market volatility should diminish and over-sold markets are likely to rebound. Medium-term, those countries hardest hit by the recent crisis will languish until the inflationary effects of currency depreciations have fed through. In the Long Run, a number of emerging markets, Turkey included, offer value: they have demographics on their side.

by

Stocks for the Long Run but not the short

In the Long Run - small colour logo

Macro Letter – No 93 – 23-03-2018

Stocks for the Long Run but not the short

  • In the long run stocks outperform bonds
  • For a decade stocks, bonds and real estate have risen in tandem
  • The risk of a substantial correction is high
  • Value-based equity investment is unfashionably enticing

The first part of the title of this Macro Letter is borrowed from an excellent book originally written in 1994. Among several observations made by the author, Jeremy Siegel, was the idea that stocks would at least keep pace with GDP growth or even exceed it at the national level. The data, which went back to the 19th Century, showed that stocks also outperformed bonds in the long-run. The price one has to pay for that outperformance is higher volatility than for bonds and occasional, possibly protracted, periods of under-performance or, if your portfolio is concentrated, the risk of default. This is not to say that bonds are exempt from default risk, notwithstanding the term ‘risk free rate’ which we associate with many government obligations. A diversified portfolio of stocks (and bonds) has been seen as the ideal investment approach ever since Markowitz promulgated the concept of modern portfolio theory.

Today, passive index tracking funds have swallowed a massive percentage of all the investment which flows into the stock market. Why? Because robust empirical data shows that it is almost impossible for active portfolio managers to consistently outperform their benchmark index in the long run once their higher fees have been factored in.

An interesting way of showing how indexation has propelled the stock market higher recently, regardless of valuation, is shown in this chart from Ben Hunt at Epsilon Theory – Three Body Problem. He uses it to show how the factor which is QE has trumped everything in its wake. I’ll allow Ben to explain:-

Here’s the impact of all that gravity on the Quality-of-Companies derivative investment strategy.

The green line below is the S&P 500 index. The white line below is a Quality Index sponsored by Deutsche Bank. They look at 1,000 global large cap companies and evaluate them for return on equity, return on invested capital, and accounting accruals … quantifiable proxies for the most common ways that investors think about quality. Because the goal is to isolate the Quality factor, the index is long in equal amounts the top 20% of measured  companies and short the bottom 20% (so market neutral), and has equal amounts invested long and short in the component sectors of the market (so sector neutral). The chart begins on March 9, 2009, when the Fed launched its first QE program.

epsilon-theory-the-three-body-problem-december-21-2017-quality-index-graph

Source: Bloomberg, Deutsche Bank

Over the past eight and a half years, Quality has been absolutely useless as an investment derivative. You’ve made a grand total of not quite 3% on your investment, while the S&P 500 is up almost 300%.

Long term there are two strategies which have been shown to consistently improve risk adjusted return from the stock market, momentum (by which I mean trend following) and value (I refer you to Graham and Dodd). Last month the Managed Futures community, consisting primarily of momentum based strategies, had its worst month for 17 years. Value, as the chart above declares, has been out of favour since the great recession at the very least. Indiscriminate Momentum has been the star performer over the same period. The chart below uses a log scale and is adjusted for inflation:-

S&P 1870 to 2018

Source: Advisor Perspectives

At the current level we are certainly sucking on ether in terms of the variance from trend. If the driver has been QE and QQE then the experiment have been unprecedented; a policy mistake is almost inevitable, as Central Banks endeavour to unwind their egregious largesse.

My good friend, and a former head of bond trading at Bankers Trust, wrote a recent essay on the subject of Federal Reserve policy in the new monetary era. He has kindly consented to allow me to quote some of his poignant observations, he starts by zooming out – the emphasis is mine:-

Recent debates regarding future monetary policy seem to focus on a degree of micro-economic precision no longer reliably available from the monthly data.  Arguments about minor changes in the yield curve or how many tightening moves will occur this year risk ignoring the dramatic adjustments in all major economic policies of the United States, not to mention the plausible array of international responses…

…for the first time since the demise of Bear Stearns, et al; global sovereign bond markets will have to seek out a new assemblage of price-sensitive buyers…

Given that QE was a systematic purchase programme devoid of any judgement about relative or absolute value, the return of the price-sensitive buyer, is an important distinction. The author goes on to question how one can hope to model the current policy mix.

 …There is no confident means of modeling the interaction of residual QE, tax reform, fiscal pump-priming, and now aggressive tariffs. This Mnuchin concoction is designed to generate growth exceeding 3%.  If successful, the Fed’s inflation goal will finally be breached in a meaningful way…

…Classical economists will argue that higher global tariffs are contractionary; threatening the recession that boosts adrenaline levels among the passionate yield curve flattening crowd.  But they are also inflationary as they reduce global productivity and bolster input prices…

Contractionary and inflationary, in other words stagflationary. I wonder whether the current bevvy of dovish central bankers will ever switch their focus to price stability at the risk of destroying growth – and the inevitable collapsed in employment that would signify?

Hot on the heels of Wednesday’s rate hike, the author (who wrote the essay last week) goes on to discuss the market fixation with 25bp rate increases – an adage from my early days in the market was, ‘Rates go up by the lift and down by the stairs,’ there is no reason why the Fed shouldn’t be more pre-emptive, except for the damage it might do to their reputation if catastrophe (read recession) ensues. A glance at the 30yr T-Bond chart shows 3.25% as a level of critical support. Pointing to the dwindling of foreign currency reserves of other central banks as the effect of tariffs reduces their trade surplus with the US, not to mention the deficit funding needs of the current administration, Allan concludes:-

…Powell will hopefully resort to his own roots as a pragmatic investment banker rather than try to retool Yellenism.  He will have to be very creative to avoid abrupt shifts in liquidity preference.  I strongly advise a very open mind on Powell monetary policy.  From current levels, a substantial steepening of the yield curve is far more likely than material flattening, as all fiscal indicators point toward market-led higher bond yields.

What we witnessed in the stock market during February was a wake-up call. QE is being reversed in the US and what went up – stocks, bonds and real estate – is bound to come back down. Over the next decade it is unlikely that stocks can deliver the capital appreciation we have witnessed during the previous 10 years.

Whilst global stock market correlations have declined of late they remain high (see the chart below) the value based approach – which, as the Deutsche Bank index shows, has underwhelmed consistently for the past decade – may now offer a defensive alternative to exiting the stock market completely. This does not have to be Long/Short or Equity Market Neutral. One can still find good stocks even when overall market sentiment is dire.

Stock Mkt correlations July 2017

Source: Charles Schwab, Factset

For momentum investors the first problem with stocks is their relatively high correlation. A momentum based strategy may help if there is a dramatic sell-off, but if the markets move sideways, these strategies are liable to haemorrhage via a steady sequence of false signals, selling at the nadir of the trading range and buying at the zenith, as the overall market moves listlessly sideways. Value strategies generally fare better in this environment by purchasing the undervalued and selling the overvalued.

The table below from Star Capital assesses stock indices using a range of metrics, it is sorted by the 10yr CAPE ratio:-

CAPE etc Star Capital 28-2-2018

Source: Star Capital

Of course there are weaknesses in using these methodologies even at the index level. The valuation methods applied by Obermatt in the table below may be of greater benefit to the value oriented investor. These are there Top 10 stocks from the S&P500 index by value, they also assess each stock on the basis of growth and safety, creating a composite ‘combined’ evaluation:-

TOP 10 VALUE SandP500 - Obermatt

Source: Obermatt

Conclusion

I was asked this week, why I am still not bearish on the stock market? The simple answer is because the market has yet to turn. ‘The market can remain irrational longer than I can remain solvent,’ is one of Keynes more enduring observations. Fundamental valuations suggest that stocks will underperform over the next decade because they are expensive today. This implies that a bear market may be nigh, but it does not guarantee it. Using a very long-term moving average one might not have exited the stock market since the 1980’s, every bear-market since then has been a mere corrective wave.

The amount of political capital tied up in the stock market is unparalleled. In a world or QE, fiat currencies, budget deficits and big government, it seems foolhardy to bite the hand which feeds. Stocks may well suffer from a sharp and substantial correction. Even if they don’t plummet like a stone they are likely to deliver underwhelming returns over the next decade, but I still believe they offer the best value in the long run. A tactical reduction in exposure may be warranted but be prepared to wait for a protracted period gaining little or nothing from your cash. Diversify into other asset classes but remember the degree to which the level of interest rates and liquidity may influence their prices. Unfashionable value investing remains a tempting alternative.