Pop goes the weasel?
While results in the September quarter of 2018 were mixed globally (and nothing out of the ordinary, if you were simply going by headline performance numbers), the post September run on equities, would have no doubt, put the jitters in bulls. The ongoing downdraft however (at the time of writing) will surely be concerning to the wider herd. Is this quite possibly the sound of the, long cautioned about, balloon prick? Or simply a much expected (some would say much needed!) market re-pricing in the face of revising cost of capital, and as a consequence, a trimming of fat and bloat?
Before we go any further, let’s mention that while no one can be completely prepared for any bout of sudden and outsized volatility, 2018 was definitely throwing up some cautionary signs. If one had scratched a little further into the detail, one would have discovered that apart from U.S. markets, plenty of other global indices were turning up flat and even sliding back into the red, over the last few months and before this sell off.
And interestingly enough, most of the recent gains (up till September’s end) in the American markets were generated by the tech sector, as other stalwart sections of the economy started to dip.
While we have been privy to other selloffs over the last few years, here’s a lot of what we do know about the current investment environment.
Tightening monetary policy
A recent Bloomberg opinion piece said it best – “The shift to tighter monetary policies in the West is putting pressure on global equity and real-estate values. Even more critically, it’s weakening credit markets. Over-indebted emerging markets face headwinds from rising borrowing costs and dollar shortages.”
The cheap money that flooded the financial world is now being withdrawn, without question. With the Federal Reserve shrinking its balance sheet and simultaneously raising rates (although thankfully for markets and indeed investors that seems to be on the go slow for time being) and the European Central Bank and the Bank of Japan contemplating wind backs, yields have risen to the detriment of share prices, as is their typical inverse relationship. The much watched but dreaded U.S “yield curve inversion” has now reared its ugly head as well i.e. when short dated bonds yield more than long dated ones. A long-held marker of a possible impending recession. However, early 2019 has shown some reversal of this, which may suggest that all of the puff, may not yet be gone.
Another consequence of this flood mop-up operation? The well-known investor strategy of “buying the market dips” is losing its firepower. Central banks that inundated the world with liquidity are now hoovering it back. More expensive and less abundant money means less resources for buybacks and discretionary buying.
This activity in markets has long been known and talked about, it was just a question of time, and indeed again, timing is of the essence.
Trade wars starting to wound
Tariffs and the ensuing trade conflicts might be starting to take the shine off company values as cost of raw materials increase and supply chains get disrupted, impacting US corporate profits. This is evidenced in recent tech giant warnings of slowing earnings growth.
It has already helped steer Chinese stock markets back into bear market territory! While recent headlines may indicate that some sort of truce may be on the horizon between the US and China, the reality remains still foggy as these economic powers dig in their heels to play politics (and chicken) with each other.
Plenty of American businesses, identifying with President Trump’s core voter base (the people he claimed he was helping with these tariffs), are now going bust as well. But it seems there’s plenty more nationalistic pride at stake for either to blink too early. Expect a tempering of egos over the coming weeks for the good of both sides, however when it comes to Trump, we also know to expect the unexpected!
Geopolitics on steroids
The world is currently suffering from no lack of geopolitical drama or other instabilities.
A lack of clear US leadership in world affairs (and domestic to some extent), it’s administration’s ever growing and distracting legal difficulties, the UK’s messy Brexit saga, political instabilities in France, Germany, Italy (and who knows where the other Eurozone bodies are buried!), the Saudi Arabia debacle, Russia and Iran sanctions, another round of the bottom falling out from crude oil’s price etc. You get the idea! All this growing uncertainty might clearly be starting to impact the real economy, primarily through the wealth effect of falling asset values and supply of credit.
The Walking Dead
While it probably has not gotten the coverage it deserves, we need to mention the twin ticking time bombs of “zombie firms” and “leveraged loans”. Yet more evidence of where cheap money unfortunately finds its way into, and what monsters it can create! “Zombies” are firms that can barely pay the interest on their debts (never mind the actual principal). According to the Bank of International Settlements, more than 16% of US companies are zombies. And those are the ones that they know about! Leveraged loans - typically issued by nonbank lenders to companies that are risky borrowers or are already highly indebted – are now estimated to pose a USD 1.6 trillion risk to the financial system. Not yet zombie territory but definitely on its way! The Bank of England recently sounded this warning - “The global leveraged loan market was larger than — and was growing as quickly as — the US subprime mortgage market had been in 2006."
In short, there is now plenty of low quality/junk debt out there that will be potentially downgraded triggering a possible mass sell-off (or possibly already playing a part in the current one), when interest rates rise.
Meanwhile on the home front….
While most headline local economic measures remain in the positive, there is now concern growing as to how falling house prices and weak wage growth will start to eat into household consumption – itself the largest part of the Australian economy. Recent statistics pointing to softer retail spending and falling new car sales are some evidence of this. The RBA, in its recent minutes, also said that average earnings were barely keeping up with inflation growing at "roughly the same rate as consumer prices" over the past five years.
We have consistently stated that as the housing market starts to the turn, the spectre of human sentiment will be underestimated. Whilst those who remain positive on the property market’s prospects, will point to supply and demand fundamentals, there is something to be said for Family A who decides to hold off on buying that next home (or investment property) vs Family B, who elects to sell based on short term uncertainty. Tightening bank conditions, threats to negative gearing and
capital gains concessions all remain key concerns for the investment market, which has underpinned Australian growth and financial institutions over the past 10 years. Watch this space.
So, what now?
Here’s the deal. Any astute investor worth his alpha knows and understands that markets (and economies) work in cycles. Why? Aside from 5000 years of anecdotal evidence in nearly every market with a willing buyer and seller and a product that inadvertently froths for some reason? The human emotions of greed and fear (high five John Maynard Keynes!) and cycles, while bringing with it challenges, always delivers opportunities as well! Yes, you read that right! Most sell-downs aren’t meltdowns!
If markets didn’t work in cycles, what credibility would “buy low and sell-high” hold? If not for cycles and patterns, plenty of value investing firms would have been laughed out of the door, a long time ago. Ever since its inception, Private Wealth has constantly and overtly stressed on value and diversification in order to capture quality gains for our clients but minimise risks as best as we foreseeably could. We’ve also kept our very close touch on the pulse of markets and have always opted for prudence, every step of the way. Timing, however, plays a major part in any investment strategy – to stay, switch course or take gains off the table
While the risks to the downside are now far greater than they ever have been in the last decade, we shouldn’t be getting too much into a tizzy. Markets are correcting and global growth is forecasted to slow, but plenty of domestic and regional real economic indicators are still reasonably positive, albeit slowing. A recession (that dreaded dirty word), while possibly looming in the distance, is simply not yet on our doorsteps. One can’t sprint forever without needing to slow down and rest. Of course, you’ll say “Dear cool investment blog writer, market movements are predictors of what’s to come for the real economy”. But let’s not get too ahead of ourselves like markets can and have at times in the past, done. Thanks to cheap money, valuations, have for some time, been at above-normal to beyond ridiculous levels. The rising cost of capital simply (and necessarily) drains the water level to reveal who’s been swimming in Speedos! And those who haven’t :o
A challenging environment simply requires a different set of weapons. Value can and will still be found via smart cyclical rotation i.e. finding companies/investments that tend to do better in tougher times. Beer lovers (like this writer) rejoice – did you know your stocks tend to not only withstand a slowdown but actually go up during such times? Drink up!
A great company is still a great company because it makes great products or provides amazing services and more often than not withstands market challenges. In times of a market revaluation, yes even their stock prices will take a hit. But that simply now means and opportunity to get in on great company at even better value! Alternative strategy funds, most of which are far nimbler than your bread and butter managers, and to which a lot of our clients have some level of exposure too (as part of our focus on prudent diversification), also tend to shine during periods of volatility. In fact, many count on it! Switching to cash or cash like investments is a very healthy defensive strategy that surely wouldn’t be scoffed at during such periods. In fact, with rates now rising in various parts of the globe, why wouldn’t you? Who says you can’t sit on your bum and be profitable. Fear not. Tightening investment conditions simply requires a different investment game.