07 January 2019
Welcome to our first investment review. We would like to wish all our readers a very happy New Year and a prosperous 2019.
After all the volatility into the end of 2018 the big question is, are we at a repeat of the 2007 market crash or what is going on?
In order to answer this question, we need to examine the investment markets from a number of positions.
- Current Situation – starting with the US
The first big question for 2019 in markets, is how much further international trade tension will accelerate and the impact it will have on trade, economic growth, corporate profits and inflation. It is no secret the global economy is beginning to slow, in our view the trade war has certainly aggravated the global slowdown, but it did not cause it.
Since the “Great Financial Crisis (GFC)“ in 2008-2009 Central banks around the world have injected billions of dollars into their economies and the FED in the US was one of the biggest injectors of funds into the US economy. This was achieved by purchasing c.US$10 trillion of financial assets, mostly government obligations. This process called Quantative easing (QE) or accommodation as it’s called, has now started to reverse, and is expected to meaningfully increase in 2019. In reality, this means that the cheap cash pumped in to markets over the last 8 years by Central banks will reverse as Central banks start removing cash from markets. The Fed is doing this as they believe that the US economy is booming, and inflation has starting to kick in.
At the same time, during the last two quarters for 2018, to keep the markets positive the Trump administration undertook a massive programme of stimulation to growth by way of a substantial tax break for corporations. This is now finishing up, with some residual benefits, but a lot of that tax benefit did not result in increased productivity. The money wasn’t reinvested in companies, it was either paid out in the form of dividends or it was used to buy back stock of companies, which doesn’t do anything for the productivity of the economy.
Such outflows (or lack of new inflows) by the ending and reversal of QE coupled with tax cut benefits dissipating, has the potential to lead to asset declines and liquidity disruptions.
As a result of the quantitative tightening, we are now experiencing a dollar liquidity squeeze. We will briefly explain what this means as it is one of the keys to the outlook for 2019.
Since World War II, the US dollar has been the primary global reserve currency. Basically, this means the dollar is central to most real transactions, even when a transaction is priced in another currency and involves two countries other than the US.
Why is this? Because countries’ respective banks main reserves are held in US dollars rather than for example yen, euro or sterling. The result is that when Japanese goods are exported to the UK and the payment is made in yen, the UK firm will effectively intermediate via Eurodollar contracts, which put simply is US dollars available outside the US.
The fed, whether it acknowledges it or not, is the world’s de facto central bank. Therefore, when participating in quantitative easing, the fed effectively provided domestic banks with reserves and increased the domestic monetary base. This increased US demand relative to the rest of the world, which caused the US current account to swell (i.e. positive current account indicates the US is a net lender to the rest of the world) and basically flooded the rest of the world with US dollars too.
The result was that the Fed didn’t only increase the monetary base domestically, but it also increased the monetary base abroad and generally the global monetary base increased.
In 2018, the Fed’s engaged in quantitative tightening. Which meant that global dollar liquidity stopped accelerating earlier in 2018 and began to shrink during the summer of 2018. So almost mathematically global growth followed through.
It is not just the quantity of dollars that are influencing global growth, the price of dollars is also relevant. In 2018, the US dollar strengthened. This was due to macro and monetary policy divergence. A strengthening dollar amplifies the dollar liquidity squeeze. The strengthening dollar automatically deflates the level of existing global liquidity and causes FX reserves to shrink globally. This undermines global economic prosperity.
However, the reverse can also be true: The existing global monetary base would revalue on a weaker dollar. As a result, the movement in the dollar holds the key to the global outlook in 2019.
The Fed funds rate was increased on 19th December 2018 to 2.5%. This was the ninth increase since 2015. The message delivered to investors from the FOMC statement was vitally important. In this statement they lowered forecasts for further interest rate hikes in 2019 amid recent volatility in financial markets and slowing global growth. Markets are now beginning to price in a dovish pivot from the fed as economic data sets begin to be revised downwards e.g. GDP & PMI’s.
Taking all of this into account we recommend for 2019 in the USA, to buy things that look like low beta or bonds or bond proxies. Ie companies with very stable earnings and strong yield. So this would include buying shares of cloud services companies, healthcare, REITs and also consumer staples. We would not recommend our clients to be out of the market but to be out of the things that most of the market is long.
- Emerging Markets (EM)
In 2018 we have seen a significant underperformance from Emerging Markets (EM), the consensus view has generally attributed this weakness to the strong dollar as stated above. That’s the natural reaction: Strong dollar equals weak EM due to their high level of U.S. denominated debt.
However, we believe this EM weakness is not solely attributed to a stronger dollar. The EM weakness has in fact been a case of dollar strength as well as Chinese renminbi (RMB) weakness and slowdown in Chinese economic growth.
If we look at the past 10-12 years. Emerging markets have only had short periods of outperformance. They had massive outperformance in 2009–2010 and big outperformance in 2016–2017. And both periods of outperformance followed massive easing of monetary and fiscal policy by China.
Today, emerging markets are really a levered play not just on the dollar but a levered play on what China is doing. The reality today is that China is slowing. And the other reality is that the Chinese government is not doing a whole lot to re-stimulate the economy. President Xi Jinping is focused on deleveraging and structural reform in China, but with the increased impact of the US-Sino trade war he also needs to implement policy stimulus to counteract the impact of U.S. tariffs. Some stimulus has already been realised, most notably the 10% depreciation in the renminbi since April last year.
The Chinese authorities are set on rebalancing the economy away from investment towards consumption. More stimulus is coming in a mix of fiscal spending and credit easing, but it is not having the same effect as it did previously in 2009 or 2014–15 as it will now be aimed at boosting consumption to benefit the domestic economy. This would be positive for the Chinese economy, but it doesn’t contribute to reflating the rest of the world.
- Back to the USA
Against this background of poor economic data, RMB devaluation, China’s slowdown, emerging market slowdown, treasury yields in the USA actually began moving lower in November 2018 on the back of this deflationary environment.
As inflation data points come out lower, our view is the Fed will continue its change from hawkish to dovish. We now know that after the December hike the number of hikes in 2019 will be very limited if any. In fact, fed officials announced in October that the neutral rates estimates are unclear and that participants will be revising their estimates based on incoming data at each FOMC meeting.
What this means is the Fed has moved from being on a passive autopilot to be more readily responsive in terms of rate decisions. In our view, If the Fed was to continue to hike rates through 2019, potentially 2-3 more times, the stock market is going to fall faster and eventually the fed will end up having to reverse course and cut rates faster. So that is why we believe they have stated that they have lowered their forecast for rate increases in 2019.
- So, is there a recession coming?
Now why should there be a recession in the US? Well, the simplest answer to this is that you must look at the things that are already starting to roll over and break, simply because of the rise in oil prices in the first half of 2018 and the rise in interest rates.
We know, historically, higher oil prices & higher interest rates, are typically what breaks the back of any economic expansion. Although today in the US oil prices continue to decline and are now officially in a bear market, having declined 20 per cent from their (October) peak as fears of oversupply and lack of demand weakened the outlook for oil. We do have higher interest rates as the fed has continued its hiking cycle. As a result, we are starting to see US housing roll over as buyers are getting squeezed by rising mortgage rates and by prices climbing about twice as fast as incomes. Not to mention, the US auto sector which is beginning to roll over also. So, basically, the most interest–rate–sensitive parts of the US economy are starting to feel the pain.
In summary, we believe the ability for US earnings to surprise to the upside in the medium term is now limited. The impact of corporate tax cuts on earnings will soon begin to dissipate, and both borrowing costs and wages have now started to increase higher. A slowdown in the growth of corporate earnings will remove one of the main supports for U.S. outperformance relative to other markets which has already become apparent since October.
So, it is now more likely the US will experience a recession not in 2019 but in 2020 if the FED continues to hike.
- What about the Europe
The picture for Europe in 2019 is dreary but we still see opportunities from a long-term perspective.
The ECB ended its 2.6 trillion-euro Quantitively Easing (QE) programme in December.
What is most concerning after this period of monetary stimulus is the poor performance in Eurozone PMI’s data. The Purchasing Managers’ Index (PMI) is an indicator of economic health for manufacturing and service sectors. The purpose of the PMI is to provide information about current business conditions to company decision makers, analysts and purchasing managers.
To put this in context, the eurozone PMI index fell from 52.7 in November to 51.3 in December (A PMI reading under 50 represents a contraction), well below the consensus forecast of 52.8. More importantly, France’s PMI plummeted from 54.2 in November to a 34-month low of 49.3.
Unemployment in the eurozone, at 8%, is double that of the US and comparable economies. Youth unemployment rate remains at 15%. Economic surprise has plummeted as the ECB balance sheet reached 43 percent of Eurozone GDP (versus 20 percent of the Fed). More than 900 billion euros of non-performing loans remain in the banking system, which keeps a trillion-euro time bomb in its balance sheets. This represents 5.1% of total loans compared to 1.5% in the US or Japan.
Deficit spending is rising. Government debt to GDP has risen to 86.8%. The number of zombie companies, those that cannot pay interest expenses with operating profits, has soared to more than 9% of all large quoted firms, according to the BIS report. Against this backdrop it is no surprise therefore that Europe has performed poorly in 2018. Finally, corporate profit expectations for 2019 have been revised lower.
European sentiment has been dampened due to several factors including the French yellow vest protests which has led to Macron blowing out the French budget with his €10bn plan to spend his way out of the gilets jaunes protests against inequality. In addition, issues surrounding the new Italian government and issues revolving around Italian spending/budget/deficit plans, Spanish bank exposure to Turkey, trade-war fears and finally uncertainty surrounding Brexit negotiations.
The end of the ECB QE leaves the euro-zone in a weaker position than it was in 2011. The fiscal space has been exhausted and the ECB, with its balance sheet at 41 % of the euro-zone GDP and ultra-low interest rates, has also exhausted its monetary tools. The end of QE not only demonstrates the failure of the ECB’s policy. It highlights the failure of governments’ economic policies. It is now imperative that European Governments should implement growth-oriented reforms that lower taxes and attract capital.
- And then there’s Britain……
Negotiations on the UK’s withdrawal from the EU are entering the final phases but a cloud of uncertainty still looms. A positive “soft Brexit” outcome seems less likely by the day and so there is potential for volatility along the way. Talks on softening the backstop or redefining it are ongoing in Europe but so far, the European parliament is standing firmly behind Ireland on the backstop agreement signed with the UK government for the Irish border. Increasingly all parties are starting to focus on what a “Hard Brexit” might look like and the economic and financial implications if this occurs.
But there is no deal until the deal is done and time rushes on……In a no divorce agreement Brexit, according to the British governments’ own guidance papers, all trade and activity that requires external involvement may cease overnight. This is a nightmare scenario that nobody wants but is a real possibility. Even if a divorce deal is done this just kicks the issue of negotiating trade deals down the road. Unfortunately, the UK is going to be shrouded in Brexit discussions for a very long-time to come. Some of the biggest issues from a business point of view is that 85% of their trade is in services yet this is excluded from negotiations, any business owner with no certainty on future trade rules is unlikely to invest in his/her existing business for expansion nor is any new business likely to set up in the UK as the future rules etc are unknown. This is already evidenced by the fall of 95% in FDI into the UK since the Brexit vote. That capital has gone elsewhere.
To all but the UK Brexiteer Tories it appears that it will result in a serious reduction in the relevant economies with the UK being hit the hardest and Ireland also suffering a 3-4% fall in economic growth.
Against this background sterling has weakened considerably and swings daily on rumours of deals or no deals. What is definite, a hard Brexit i.e. no trade deal exit we believe will see sterling move to parity with the Euro.
In summary with total uncertainty in Q1 2019 over BREXIT we believe this is not the time for a Euro investor to buy Sterling assets. Existing investors will need to assess the impact of a hard Brexit on their holdings. The one thing that is certain the market is not currently pricing in a very soft Brexit, so any positive outcome could see a bounce in UK assets.
- Looking at Bonds & Treasuries:
The spread between 2 & 10-year US treasuries now stands at just 17 basis points down from 70 basis points in February 2018 and the lowest level since just before the financial crisis in 2008. The 2 & 10-year US treasuries are currently yielding 2.48% & 2.652%, respectively. A narrowing of the yield spread between the 2-Year and 10-Year bonds suggests increasing concerns by bond investors about the prospects for longer-term US economic growth. Historically this tightening has always been a signal that recession is coming.
We see potential to take a pure duration play in the near to medium term by allocating to short-term & long-term US treasuries (Eurozone investors should be wary of FX risks). We believe the fed may reverse course if the economy begins to slow in 2019, leading to further yield compression (Bond prices have an inverse relationship with yields). Powell recently announced the fed will be patient with rate hikes and said is “no pre-set path for policy”.
In Europe, the German 10-Year Bund now yields 0.207% well below the 2018 high of 0.65%. These are still historically extremely low levels and mean that Eurozone interest rates are not expected to rise in the near to medium term.
The Italian government bond market has been in focus for some time now. The 10-year yields recently exceeded 3.7% for the first time since the beginning of 2014, although the recent agreement between Italy and the EU over its draft budget should help lift some of the uncertainty that has weighed on the economy through the second half of last year. The 10-year Italian BTP is currently trading at 2.911%. An important point to note, the same 10-year Italian BTP was trading below 2% before the populist coalition took power in late May of this year.
While the ECB recently concluded its asset purchase programme, it also stated that interest rates would remain at their current 0% level until at least the middle of 2019. This has resulted in the continued compression in core euro-zone bond yields except for Italy’s BTP.
So overall, we would not be overweight Eurozone bond markets except in specialist situations.
- Summarising the outlook for Global Debt
In our view the most consequential impact of the next downturn is the potential for defaults in the credit cycle. The interesting thing as we ended 2018 was that, the global debt situation is so much larger than ever before. So, any major downturn and the consequences could be catastrophic.
The chart below shows the global debt situation across the four main sectors of any economy: non-financial corporates, government, the financial sector, and household. These four together amount to an economy’s total debt. Add up all the economies of the world you get global debt.
See chart below outlining the Global Sectoral Indebtedness:
Source * Dr. Edward Altman NYU Stern School of Business
The chart shows we are about 100 percentile higher in debt to GDP than we were 20 years ago, and 50 percentage points higher than 10 years ago.
If / when we have a downturn, it can be expected there will be a significant increase in defaults, in all the sectors. Interestingly, a large part of the growth in GDP in the last 10 years has been on the back of low-cost debt. Both countries and companies have benefited from ultra-low interest rates on debt to finance their growth. Coming into 2019, the growth in debt is likely to slow, because of the general fear of debt build up being excessive in countries like China and the US. A company or country does not have to grow much in terms of cash flows or GDP in an ultra-low interest rate environment to pay the financing costs used for growth.
As we alluded to earlier in the note, we have seen a significant slowdown in PMI’s, GDP & forecasted corporate earnings growth. This is a concern going forward and one we will be watching very closely.
So overall what’s our position?
Firstly, we must remember that stock markets anticipate economic outcomes and the rapid falls in the last quarter of 2018 reflect markets anticipating the slowdown in 2019. Secondly, when investing overseas one must have a view on currencies and the implications of your base currency trading against the currency of the market you are investing in. As we mentioned earlier in our note, the movement in the dollar holds the key to the global outlook in 2019, although we expect the dollar to weaken as the fed reverses course and as CPI data weakens. In addition, a hard Brexit scenario would result in a weaker Sterling we would be cautious on entering those markets at the moment.
US Stocks on average had been trading on 16.8x forecast earnings, a multiple that was 14% higher than its 10-year average. Despite this, US retail investors up until very recently have been piling further cash into the market while professional investors have been warning about valuations and market tops.
The recent strong pull back in equities has brought the markets back towards the 200-day moving average which is a long run technical indicator that often suggests markets maybe approaching a bottom. The highest valuations are seen in Technology stocks and many of these have seen large fast falls.
A possible move to more realistic valuations based on less optimistic future growth expectations could see further falls in some of these stocks.
Against this background we would be slow to move into US equities now, rather we will watch for a bottom to form in the markets i.e. a period when prices stabilise and just move sideways. Then we will look to buy into certain names that have low P/E or EV/EBITDA, with strong cash flows, strong balance sheet with stable debt levels (Debt/EBITDA).
Similarly, we would be reluctant to invest in UK stocks at the moment until we have a clear picture on BREXIT. The 29th March is only three months away and a lot can change between now and then. Even if a soft Brexit divorce is agreed there will still be two years of trade deal negotiations and many ups and downs on this road.
We are most likely to recommend Eurozone based investors when looking at equity markets that they should focus on Eurozone stocks and in the regard our preferred equity sectors going into 2019 are the cloud services companies, healthcare, consumer staples and REITS. We are also looking to invest in blue chip high dividend yielding stocks with low beta. We are underweight financials for 2019, why own a group that requires rates to to go up to own it?
We are continuing to recommend being overweight fixed income mainly long duration bonds & treasuries, with an underweight view on high yield corporate credit.
For long term investors we are also recommending real assets i.e. property, alternative energy assets and infrastructural assets. With the current outlook for interest rates now looking like they have either peaked or are at least stable many of these assets offer attractive yield over the medium to long term.
Top forecasts for 2019:
- Treasury bonds are best performing asset class for a good part of the year. Corporate debt remains under heavy stress. Potential strategy to play; Long treasuries vs short corporate bonds. We believe corporate bonds will struggle as global economy slows & business cycle plays out.
- Gold bull market starts in full force in middle of 2019, triggered by central bank policy shift to monetary easing. We believe if the dollar begins to weaken and reveres courses, gold will have its day in the sun.
- FOMC & global central banks are far too slow to diagnose the slowdown & monetary easing does not kick in during H1 2019. They are likely going to let things slow down further before they start to provide liquidity & begin to accommodate again.
- The US dollar index (DXY) resumes its rise but there will be major top in 2019. As we alluded to earlier in the note, that with the U.S dollar funding shortage it possible to see the DXY run to 102.50 – 107.50 (currently 96.20). As a stronger dollar weakens the US economy, we will see a push by the fed to lower rates or stop hiking and begin to provide liquidity…. the question is really when will the U.S peak.
- Europe begins to slow further, and some countries fall into a recession. Forecast Euro Area GDP annual growth rate will gravitate towards 0 or below to some form of negative print. Unemployment rate trending towards 8% (7% in 2008).
- Emerging market have one more round of heavy pain, predominately driven by a rising U.S dollar. Yes, valuations are attractive, but it is too early to deploy capital into EM assets. At some point they will be a great buying opportunity. When U.S Central Bank begin injecting liquidity again, this presents a buy on dip opportunity.
- Stock markets have next uber market wave lower, with at least one more drop of the magnitude of 2018. Next likely significant pullback will be in Q2 2019 event. We believe this will present several buying opportunities post sell off as equity valuations look attractive.
- Commodities (Oil, copper, iron ore etc.) will remain very weak into the global economic slowdown. Although, there is scope for a big buying opportunity in H2 2019, but this could be delayed until the beginning of 2020. As a result of the Chinese, Emerging Market and global economy slowdown, commodity prices will be under pressure. Opportunity to buy them at beaten down prices in H2 2019. We believe commodities will bottom in line with the top in U.S dollar.
- Tesla suffers devastating price drop as the tight corporate credit creates funding issues. Tesla & musk need access to credit markets to access funding, during a bear market or economic slowdown they will struggle to find credit and the company will have to take big steps to tighten the business model. This has the potential to lead to fall in the stock price, similar to how GE dropped throughout 2018 (-55.59%)
Finally, our overall investment method advice to investors
Investment should be for the long term. Diversification is strongly recommended and regular investing rather than picking tops or bottoms is a proven method of achieving long term investment growth.
If you are inclined to buy dips, we would advise splitting your investment amount and set specific price targets and then acquire holdings in stages. The world’s best investors never look to catch a top or bottom in a market rather they phase their investment and look to build positions in strong companies with low gearing and ideally unique or leading market positions over time.
So, going into 2019 we would advise our clients to combine a tactical approach with a strategic longer-term allocation approach to preserve capital in volatile markets. In our view, compounding wealth depends not on chasing returns but avoiding permanent losses.
For our core portfolio choices please contact us at 01 70 70 000 to arrange a meeting to discuss what would best suit your investment criteria
We wish you all a very prosperous New Year.
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