The year 2019 was never going to be an easy one for markets. Between the record amount of corporate debt, trade conflicts between the US and China, and the fact that we are almost 10 years into a recovery cycle – the time when economic slowdowns typically occur many of us have been expecting the volatility of the past year to continue, if not worsen.
We have already begun 2019 at a point when Benjamin Graham’s description of the investor’s customary lot – switching between panic, euphoria and apathy – truly resonates. Investors are locked into a tug of war. Are equity prices cheap enough to warrant buying the dip? Or is the gloomy government bond market on the money, with its message of a slowing economy and less robust corporate earnings growth in 2019? Sentiment at the end of last week received a nice one-two uplift via a robust US jobs report and some soothing words from Jay Powell, Federal Reserve chair. That good mood flowed into Asia as US and Chinese officials met in Beijing for a new round of trade talks.
Yet Donald Trump’s administration has thrown kerosene on the fire with a number of unforced errors – most notably the US president’s politicization of the Federal Reserve. Fantasizing about firing its chairman, Jay Powell, is a great way to tank stocks and further reduce already weak public approval ratings.
Live by the market; die by the market.
Mr. Trump’s tantrums aside, there is a legitimate, data-driven debate to be had about where monetary policy should go in the short term. But, even as the president and investors cling to the old narrative of low rates and easy money, hoping against hope that such tactics can last just a few more quarters, the Fed is increasingly turning its own focus towards the real economy.
Several regional Fed governors – including those in Boston, Dallas and Kansas City – are prioritizing another, less well known, function of the central bank: community development. Just as central bankers stepped in 10 years ago to stabilize the economy via low rates and massive asset purchases, when politicians struggled to create more fiscal stimulus, so now they are stepping in to address issues not in the markets, but on Main Street.
While the Fed has a mandate to keep unemployment low and inflation stable, it is also empowered to bolster growth in local communities. This includes everything from industrial policy initiatives in the rust belt, to helping immigrants in depressed areas start businesses, pushing educational reform and encouraging efforts to bring broadband to rural areas. With the potential of monetary policy largely exhausted, and political leadership still lacking, community development is the one under – used weapon still left in the Fed’s arsenal. And it will be an increasingly important one in our opinion in the years ahead, as it becomes clear that the gains of this recovery has not been evenly spread.
Thanks to a US Treasury 10-year yield back down near 2.7% and a big drop in the forward price / earnings ratio for the S&P 500 since September, the valuation case looks in principal pretty good. If you think early 2019 chimes with 2016 – a popular refrain in some parts – then it is time to get back into the water. More broadly, risk asserts reveal that equity valuations are back in line with past-crisis averages, as gauged by earning yields. The trouble in our opinion is, that markets face formidable challenges. The Sino-US trade sparring continues and China’s economy including the European as well as Germany’s is clearly slowing – which has knocked Japan, Europe and the emerging market sector – while threats over Brexit and Italy loom large for the eurozone.
Fears of a prolonged slowdown in the eurozone grew after a sharp fall in German industrial production in November raised the risk of the region’s manufacturing powerhouse entering recession. Industrial activity in Germany fell by 1.9% between October and November – the third straight month of decline – as sectors from consumer goods to energy weakened. The figures from Germany’s Federal Statistics Office were far worse than the 0.3% gain forecast by economists in a Reuters poll and showed how the eurozone’s largest economy remains exposed to trade wars and a global slowdown. They follow confidence surveys and data that suggested weakness seen in the third quarter will linger longer in our opinion than first thought.
Germany’s gross domestic product fell in the third quarter and a further fall in the fourth quarter would place the country in a technical recession, defined as two consecutive quarters of negative growth.
The impact of a weak German economy in our opinion could be strong on the euro area’s momentum, further leading to a downward revision of the regional growth forecast. Germany generates about a third of all economic output in the eurozone and the fall in industrial production in an economy that relies heavily on manufacturing bodes ill for the region.
The next hurdle is an earning season already marked by Apple and Delta Air Lines guiding lower. The December US jobs report saw average hourly earnings growing at 3.2% annually, the fastest in a decade, suggesting margin compression looms. Analysts expect 7.3% revenue growth in the first quarter but 2.9% earnings growth, according to Data Trek. For the second quarter, the call is 6% for revenue, 3.7% for earnings. For us re-entering the market, companies first must convince us that 2019 will show earnings growth even as profit margins actually decline. For us, typical top-of-cycle stuff, in other words… and that’s never easy.
Global Debt has reached the highest level in history which is one of our biggest concerns. The burning question that naturally comes to mind is, “Should we be worried?”
As per the recently released report by the International Monetary Fund (IMF) the world’s total government and private debt climbed to 184 trillion US-Dollar at the end of 2017, about 2 trillion US-Dollar higher than previous estimates, thanks to the inclusion of new data from economies not counted in earlier calculations. The 184 trillion US-Dollar debt is 225% of global GDP in 2017, and is more than 86,000 US-Dollar per person in the world population.
The Us, China, and Japan together account for more than half of the global debt, and China’s liabilities are growing the fastest among major economies. In 2000, China accounted for less than 3% of global debt; at the end of last year, that share had ballooned to more than 15%. The combined debt of these three economies alone already exceeds global economic output.
The IMF report makes no definite judgments about the significance of such high global debt levels, but the majority of analysts’ views are that the apparent “debt bubble” has some dark implications for the world economy. Debt in principle by itself is neither good nor bad; it is simply a financial management tool. Almost every economy and many businesses routinely operate with some level of debt, even if they are generating healthy cash flows and profits. Therefore debt is not a bad thing but default is, and since the risk of default automatically increases as the amount of debt increases, it is only natural to be concerned about the current historically high levels of global debt.
In our opinion, the dark clouds have gathered overhead and, clearly, there is visible anxiety in the current drop in asset prices and of economic activity including global debt. Focus seems to have reverted to the level of leverage and the possible “toxicity” of real estate assets, even though it is difficult to see the said contagion effect in the balance sheets of these entities. Clearly, investors, having been fed on the trope of “investing in assets for the long run” have been left to lick their wounds as most asset classes have shown increasing volatility.
But, mind you, nowhere close to the commensurate amount of returns that would have been predicted for stomacking such volatility. In most developed markets – as well as some emerging markets – holding on to assets over the last two decades would have gotten you a rate of return inferior to that of bonds. Even though history attests that investing in assets over the long term is the best way of creating wealth. Economics is supposed to have been a predictive science. If so, then it clearly gets a failing grade, for not only did it not manage to predict the current recession, it has had very little to say about what exactly needs to be done. Policy prescriptions have been very different.
One focuses on the level of leverage and the consequent effects of financial fragility – what happens to economies when asset prices decrease – and therefore argues for austerity. The other ignores it and relies on government spending and quantitative easing to keep the economy perpetually stimulated.
Is history to be ignored? Is it to be repeated? Do we need to keep having these crises before we decide what a sustainable mode of creating wealth is? At what point does disillusionment kick in?
There are no easy answers, especially when we note that since 1980, there have been a total of 124 economic “crises”, as defined by asset falls of 20% or more. Clearly, with increased globalization has come increased turbulence. Even as America and Mr. Trump try to turn back time, it is clear to us that this is a genie that cannot be put back into the bottle.
