After the flood – Beyond fiscal and monetary intervention

After the flood – Beyond fiscal and monetary intervention

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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

A Brave New World for Value Investing

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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.

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

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

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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?

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

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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.

The Self-righting Ship – Debt, Inflation and the Credit Cycle

The Self-righting Ship – Debt, Inflation and the Credit Cycle

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Macro Letter – No 105 – 23-11-18

The Self-righting Ship – Debt, Inflation and the Credit Cycle

recovery_saltaire

Source: Stromness Lifeboat

  • Rising bond yields may already have tempered economic growth
  • Global stocks are in a corrective phase but not a bear-market
  • With oil prices under pressure inflation expectations have moderated

The first self-righting vessel was a life-boat, designed in 1789. It needed to be able to weather the most extreme conditions and its eventual introduction (in the 1840’s) transformed the business of recuse at sea forever. The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.

Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying this time it’s different, the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.

When in doubt, look to Japan

For central bankers, Japan is the petri dish in which all unconventional monetary policies are tested. Even today, QQE – Quantitative and Qualitative Easing – is only seriously being undertaken in Japan. The Qualitative element, involving the provision of permanent capital by the Bank of Japan (BoJ) through their purchases of common stocks (at present, still, indirectly via ETFs), remains avant garde even by the unorthodox standards of our times.

Recently the BoJ has hinted that it may abandon another of its unconventional monetary policies – yield curve control. This is the operation whereby the bank maintains rates for 10yr maturity JGBs in a range of between zero and 10 basis point – the range is implied rather than disclosed – by the purchase of a large percentage of all new Japanese Treasury issuance, they also intervene in the secondary market. During the past two decades, any attempt, on the part of the BoJ, to reverse monetary easing has prompted a rise in the value of the Yen and a downturn in economic growth, this time, however, might be different – did I use that most dangerous of terms again? It is a long time since Japanese banks were able to function in a normal manner, by which I mean borrowing short and lending long. The yield curve is almost flat and any JGBs with maturities shorter than 10 years tend to trade with negative yields in the secondary market.

Japanese banks were not heavily involved in the boom of the mid-2000’s and therefore weathered the 2008 crisis relatively well. Investing abroad has been challenging due to the continuous rise in the value of the Yen, but during the last few years the Japanese currency has begun to trade in a broad range rather than appreciating inexorably.

In the non-financial sector a number of heavily indebted companies continue to limp on, living beyond their useful life on a debt-fuelled last hurrah. Elsewhere, however, Japan has a number of world class companies trading at reasonable multiples to earnings. If the BoJ allows rates to rise the zombie corporations will finally exit the gene pool and new entrepreneurs will be able to fill the gap created in the marketplace more cheaply and to the benefit of the beleaguered Japanese consumer. My optimism about a sea-change at the BoJ may well prove misplaced. Forsaking an inflation target and offering Japanese savers positive real-interest rates is an heretically old-fashioned idea.

Whilst for Japan, total debt consists mainly of government obligations, for the rest of the developed world, the distribution is broader. Corporate and consumer borrowing forms a much larger share of the total sum. Giving the historically low level of interest rates in most developed economies today, even a moderate rise in interest rates has an immediate impact. Whereas, in the 1990’s, an increase from 5% to 10% mortgage rates represented a doubling payments by the mortgagee, today a move from 2% to 4% has the same impact.

The US stock market as bellwether for global growth

Last month US stocks suffered a sharp correction. The rise had been driven by technology and it was fears of a slowdown in the technology sector that precipitated the rout. Part of the concern also related to US T-Bonds as they breached 3% yields – a level German Bund investors can only dream of. Elsewhere stock markets have been in corrective (0 – 20%) or bear-market (20% or more) territory for some time. I wrote about this decoupling in Macro Letter – No 101 – 31-08-2018 – Divergent – the breakdown of stock market correlations, temp or perm? Now the divergence might be about to reverse. US stocks have yet to correct, whilst China and its vassals have already reacted to the change in global growth expectations. Globally, stocks have performed well for almost a decade: –

MSCI World

Source: MSCI and Yardeni

The next decade may see a prolonged period of range trading. After 10 years, during which momentum investing has paid handsomely, value investing may be the way to navigate the next.

Along with stocks, oil prices have fallen, despite geopolitical tensions. The Baker Hughes rig count reached 888 this week, the highest since early 2015. With WTI still above $60/bbl, the number of active rigs is likely to continue growing.

US 10yr bond yields have already moderated (down to 3.06% versus their high of 3.26%) and stocks have regained some composure after the sudden repricing of last month. The ship has self-righted for the present but the forecast remains turbulent.     

Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

  • The US stock market is close to being in a corrective phase -10% off its highs
  • Global debt has passed $63trln – well above the levels on 2007
  • Interest rates are still historically low, especially given the point in the economic cycle
  • Predictions of a bear-market may be premature, but the headwinds are building

The recent decline in the US stock market, after the longest bull-market in history, has prompted many commentators to focus on the negative factors which could sow the seeds of the next recession. Among the main concerns is the inexorable rise in debt since the great financial recession (GFR) of 2008. According to May 2018 data from the IMF, global debt now stands at $63trln, with emerging economy debt expansion, over the last decade, more than offsetting the marking time among developed nations. The IMF – Global Debt Database: Methodology and Sources WP/18/111 – looks at the topic in more detail.

The title of this week’s Macro letter comes from the poet Stevie Smith: –

I was much further out than you thought

And not waving but drowning.

It seems an appropriate metaphor for valuation and leverage in asset markets. In 2013 Thomas Pickety published ‘Capital in the 21st Century’ in which he observed that income inequality was rising due to the higher return on unearned income relative to labour. He and his co-authors gathering together one of the longest historical data-set on interest rates and wages – an incredible achievement. Their conclusion was that the average return on capital had been roughly 5% over the very long run.

This is not the place to argue about the pros and cons of Pickety’s conclusions, suffice to say that, during the last 50 years, inflation indices have tended to understate what most of us regard as our own personal inflation rate, whilst the yield offered by government bonds has been insufficient to match the increase in our cost of living. The real rate of return on capital has diminished in the inflationary, modern era. Looked at from another perspective, our current fiat money and taxation system encourages borrowing rather than lending, both by households, corporates, for whom repayment is still an objective: and governments, for whom it is not.

Financial innovation and deregulation has helped to oil the wheels of industry, making it easier to service or reschedule debt today than in the past. The depth of secondary capital markets has made it easier to raise debt (and indeed equity) capital than at any time in history. These financial markets are underpinned by central banks which control interest rates. Since the GFR interest rates have been held at exceptionally low levels, helping to stimulate credit growth, however, that which is not seen, as Bastiat might have put it, is the effect that this credit expansion has had on the global economy. It has led to a vast misallocation of capital. Companies which would, in an unencumbered interest rate environment, have been forced into liquidation, are still able to borrow and continue operating; their inferior products flood the market place crowding out the market for new innovative products. New companies are confronted by unfair competition from incumbent firms. Where there should be a gap in the market, it simply does not exist. At a national and international level, productivity slows and the trend rate of GDP growth declines.

We are too far out at sea and have been for decades. Markets are never permitted to clear, during economic downturns, because the short-term pain of recessions is alleviated by the rapid lowering of official interest rates, prolonging the misallocation of capital and encouraging new borrowing via debt – often simply to retire equity capital and increase leverage. The price of money should be a determinant of the value of an investment, but when interest rates are held at an artificially low rate for a protracted period, the outcome is massively sub-optimal. Equity is replaced by debt, leverage increases, zombie companies limp on and, notwithstanding the number of technology start-ups seen during the past decade, innovation is crushed before it has even begun.

In an unencumbered market with near price stability, as was the case prior to the recent inflationary, fiat currency era, I suspect, the rate of return on capital would be approximately 5%. On that point, Pickety and I are in general agreement. Today, markets are as far from unencumbered as they have been at any time since the breakdown of the Bretton Woods agreement in 1971.

Wither the stock market?

With US 10yr bond yields now above 3%, stocks are becoming less attractive, but until real-yields on bonds reach at least 3% they still offer little value – US CPI was at 2.9% as recently as August. Meanwhile higher oil prices, import tariffs and wage inflation all bode ill for US inflation. Nonetheless, demand for US Treasuries remains robust while real-yields, even using the 2.3% CPI data for September, are still exceptionally low by historic standards. See the chart below which traces the US CPI (LHS) and US 10yr yields (RHS) since 1971. Equities remain a better bet from a total return perspective: –

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

What could change sentiment, among other factors, is a dramatic rise in the US$, an escalation in the trade-war with China, or a further increase in the price of oil. From a technical perspective the recent weakness in stocks looks likely to continue. A test of the February lows may be seen before the year has run its course. Already around ¾ of the stocks in the S&P 500 have suffered a 10% plus correction – this decline is broad-based.

Many international markets have already moved into bear territory (declining more than 20% from their highs) but the expression, ‘when the US sneezes the world catches a cold,’ implies that these markets may fall less steeply, in a US stock downturn, but they will be hard-pressed to ignore the direction of the US equity market.

Conclusions and investment opportunities

Rumours abound of another US tax cut. Federal Reserve Chairman, Powell, has been openly criticised by President Trump; whilst this may not cause the FOMC to reverse their tightening, they will want to avoid going down in history as the committee that precipitated an end to Federal Reserve independence.

There is a greater than 50% chance that the S&P 500 will decline further. Wednesday’s low was 2652. The largest one month correction this year is still that which occurred in February (303 points). We are not far away, however, a move below 2637 will fuel fears. I believe it is a breakdown through the February low, of 2533, which will prompt a more aggressive global move out of risk assets. The narrower Dow Jones Industrials has actually broken to new lows for the year and the NASDAQ suffered its largest one day decline in seven years this week.

A close below 2352 for the S&P 500 would constitute a 20% correction – a technical bear-market. If the market retraces to the 2016 low (1810) the correction will be 38% – did someone say, ‘Fibonacci’ – if we reach that point the US Treasury yield curve will probably be close to an inversion: and from a very low level of absolute rates. Last week the FRBSF – The Slope of the Yield Curve and the Near-Term Outlook – analysed the recession predicting power of the shape of the yield curve, they appear unconcerned at present, but then the current slope is more than 80bp positive.

If the stock correction reaches the 2016 lows, a rapid reversal of Federal Reserve policy will be required to avoid accusations that the Fed deliberately engineered the disaster. I envisage the Fed calling upon other central banks to render assistance via another concert party of quantitative, perhaps backed up by qualitative, easing.

At this point, I believe the US stock market is consolidating, an immanent crash is not on the horizon. The GFR is still too fresh in our collective minds for history to repeat. Longer term, however, the situation looks dire – history may not repeat but it tends to rhyme. Among the principal problems back in 2008 was an excess of debt, today the level of indebtedness is even greater…

We are much further out than we thought,

And not waving but drowning.

Canary in the coal-mine – Emerging market contagion

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Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

  • Emerging market currencies, bonds and stocks have weakened
  • Fears about the impact of US tariffs have been felt here most clearly
  • The risk to Europe and Japan is significant
  • Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.