It is an old investment adage that “markets climb a wall of worry”. Markets certainly did successfully climb this wall following the Global Financial Crisis (GFC), but had a helping hand. The big global central banks, led by the Fed, through extraordinary loose monetary policy (exemplified by Quantitative Easing), provided a ladder and helpfully propped it against the wall.
Now, however, the ladder is slowly being pulled away as rates are hiked, and QE turns to QT (Quantitative Tightening). We fear that 2019 may leave markets perched, like Humpty Dumpty, atop the wall. While we hope 2019 doesn’t bring a “great fall”; hope is not a strategy. We made the call early in 2018 that we were in the late stages of the long bull market that started in March 2009. While we didn’t (and aren’t) calling an economic recession, we said then that we believed it was prudent to resist the urge to ride the bull right to the inevitable end and to begin moving portfolios to a more defensive posture.
Since then we’ve seen volatility pick up and, unlike in January 2018, the FAANGs have not reasserted leadership and led a bounce back. We think this provides affirmation of our view that we are seeing a market regime change which is likely to continue to play out in 2019.
The counter-argument to this view (and one we debate internally) is the strength of the US economy. Main Street seems in fine fettle, even if Wall Street seems somewhat out of sorts. None of the key recession indicators we monitor are flashing red (i.e., inverted yield curve, year on year fall in the Conference Board’s Leading Economic Indicator, unemployment ticking up, fed funds rate greater than equilibrium).
What we point to in response is the vulnerability of the US share market to a correction. Valuations, on any sort of long-term valuation metric such as Cyclically Adjusted PE (CAPE), Tobin’s Q, total market cap/GDP, etc; look toppy. As the chart below shows, the only other points in history where the S&P 500’s CAPE P/E was higher was on the eve of the 1929 crash that ushered in the Great Depression; and at the height of the dot-com bubble in 1999/2000:
Cyclically Adjusted Price/Earnings Ratio (CAPE)
It appears Humpty Dumpty is currently sitting atop quite a high wall indeed!
In addition to the withdrawal of central bank largesse — which arguably has suppressed volatility for the last decade — a number of other factors could tip Humpty over. Front and centre here is the Sino/US trade war. China is a centrally planned economy. We are sceptical that China will give into US demands to reduce government intervention into the economy. The US position seems just as entrenched. Consider that:
U.S. Trade Representative Robert Lighthizer has represented the nationalist view on trade within the GOP for three decades, since he led trade negotiations with Japan under Reagan — which resulted in the Japanese voluntarily acquiescing to Washington’s demands.
Donald Trump took out full page newspaper ads in 1987 calling for “taxes” on countries that, he believed, were taking advantage of the US. This is one of the few issues he has been consistent on ever since. A “get tough on China” message resonates with the swing voters of the Midwest and rust-belt states that carried him to victory in 2016 but abandoned the GOP in the recent mid-terms. These are the voters that have arguably been the losers from Globalisation as manufacturing jobs were offshored to China.
Consequently, we expect Trump to continue with his hawkish trade stance in order to appeal to this voter bloc. The failure of the Democrat establishment to grasp the importance of this issue with key constituencies was one of the reasons behind them losing the White House. As a result, there is bi-partisan support for containment of China in the mid to long term.
In summary, we don’t see the trade war as ending any time soon. There may be “deals”, announced with great fanfare, on a cease fire from time to time. But an agreement addressing the substantive issues anytime soon seems unlikely to us. The trade war is impacting on global economic growth. At some point this will begin to impact S&P 500 earnings. Indeed, more recent reporting commentary has seen a sharp pickup in warnings regarding trade and the outlook for corporate profits. At the same time monetary conditions are tightening. We believe the sugar rush from the Trump tax cuts and fiscal stimulus will start to wear off in 2019.
All in all, it would seem to us this is a recipe for continued volatility in the year to come. But the fact remains that the US economy does have a decent head of steam. There is also a reasonable chance that Trump and the Democrats agree on an infrastructure centred fiscal stimulus.
It would be premature to reduce equity exposure too drastically at this point. Instead, we think increased defensive equity exposure is in order, and infrastructure stocks are one of the key ways investors can achieve this.
2019 Investment Outlooks
The Limits of U.S. Growth
An Extended Business Cycle
Liquidity is the Question
A Plethora of Risks
Current Volatility, Long-Term Opportunity
Choppy Markets Ahead
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Focus on Growth
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The cyclically adjusted price-to-earnings ratio (CAPE) is defined as price divided by the average of ten years of earnings, adjusted for inflation.
The Conference Board’s Leading Economic Index is an American economic leading indicator intended to forecast future economic activity from the values of ten key variables.
The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
Market capitalization (market cap) is the total dollar market value of all of a company's (indexes) outstanding shares; it is calculated by multiplying a company's (indexes) shares outstanding by the current market price of one share.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
Tobin's Q (Q ratio) is the ratio of the market value of a company's assets (as measured by the market value of its outstanding stock and debt) divided by the replacement cost of the company's assets (book value).
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities. Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
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