BY GUY CARSON
To potentially misquote Robert F. Kennedy, “Like it or not, we live in interesting times.” That certainly has been true in financial markets over the last year. The threat of a trade war combined with a global economic slowdown caused equity and credit markets to panic late last year. The Federal Reserve then stepped in, cancelling their Quantitative Tightening program and putting further rate rises on hold. In a volatile time such as this it is often worth reviewing your investment portfolio and making sure that you are appropriately positioned. This is particularly true given the extraordinary rally we have had in global equity markets over the early part of this year. To understand why it’s important we need to step back and look at the bigger picture to understand the risks and the opportunities currently. If you wish to have a further conversation around this please do not hesitate to get in contact with us.
The impact of the Fed has had this year has been quite extraordinary. After the pivot in policy in December, we have seen the S&P500 rally 17.5% over the first four months of 2019. All sectors are in positive territory year to date with Technology (+22.3%) leading the way. A slowing global growth environment has led to lower interest rate expectations which has boosted asset prices particularly for those high growth stocks with a long duration in earnings.
Higher asset prices means lower future returns and generally a more challenging investment environment. The reality is that whilst lower interest rates are meant to encourage investment to foster economic growth they unfortunately also lead to speculation and mal-investment.
The recent economic history of the world is characterised by slowing growth, low inflation and declining interest rates. When you state that, most people’s minds jump to the last decade since the Global Financial Crisis (“GFC”) or Great Recession but this has actually been a much longer term phenomenon. The charts below show the trend in GDP since the 1960s and the trend in interest rates since the 1980s. Both charts are clearly sloping down.
Source: Federal Reserve Bank of St Louis
The reasons behind these trends are numerous. If we think back to the 1950s and 60s, the world (particularly Europe and Japan) had a post war rebuild occurring which led to a high base in terms of economic growth. We then had the baby boomers pushing up populations and in addition more and more women entered the workforce. We also had a higher education revolution which led to a more productive workforce. More workers and higher productivity led to an economic boom.
By the time we get to the 1980s these factors have more or less played out and hence growth started to slow. In addition a new factor started to weigh on the developed world with the manufacturing base of the globe shifting from East to West. In their fascination with ever increasing GDP growth, central banks took to lowering interest rates. This enabled a consumption boom and the move to a “service driven economy”. However, this model only works with increasing levels of debt fostered by ever lower interest rates. When this model becomes unsustainable (usually when push interest rates to zero) we have problems.
A low growth world with high debt levels is a difficult one to invest in. The “boom/bust” nature of global markets in recent decades is a consequence of this world. The advisers we seek to work with understand these challenges.
These broad themes remain consistent, even 11 years on from the crisis. More specific areas of risk develop as capital flows move way or another. The most concerning to us currently are:
- A slowing China coupled with a significant fall in global trade;
- A rise in the amount of asset bubbles globally;
- The record levels of corporate credit in the US;
- The solvency of the European banking system most notably Italy and Deutsche Bank.
Offsetting these risks is are central banks that have limited ability to tighten policy and governments which are slowly becoming more supportive on the fiscal front. In other words, central authorities are likely to do all they can to support asset prices.
A Slowing China
China has been the growth engine of the world for some time and whilst everyone has been focused on trade and the impacts of Trump’s tariffs, the real story at the moment appears to be an internal slowdown. In the midst of the GFC, China announced an extraordinary fiscal stimulus package and central authorities gave the green light for companies to borrow. The result was a huge infrastructure and property boom as well as an eye watering amount of corporate debt taken on. The large debt levels have since weighed on the growth rate. Fixed Asset Investment growth has slid since 2012 to an all-time low now.
From the above chart we can see the public sector has introduced stimulus measures every time the private sector has stalled (2012, 2016 and 2018). The frequency of the stalling has increased and the effectiveness of the public stimulus appears to be decreasing. Combine this with falling trade and there are some significant challenges for the Chinese economy.
The ideal situation for China would be a rebalancing towards a consumer driven economy though the rise of the middle class. Whilst this is happening the rate of growth in the consumer is unlikely to be sufficient to offset the weakness in private investment. More stimulus appears necessary.
A number of the advisers we work with have positioned themselves to take advantage of the rising middle class in China whilst not exposing themselves to the construction sector.
Since interest rates globally started falling in the 1980s, asset bubbles have become more prevalent. In the late 1990s we had the Dotcom bubble and the lead up to the GFC we had housing bubbles all over the globe. A decade of Zero Interest Rate Policy (“ZIRP”) has led to some further misallocation of capital and a number of mini bubbles globally.
Some of these bubbles such as Australian or Canadian housing are unlikely to have a significant impact on the global economy. One potential bubble that may have an impact is the significant amount of capital flowing into growth companies most notably in the Technology sector. This capital is flowing into the sector via record inflows to Private Equity and Venture Capital as well as into listed companies in the space.
The below chart looks at the differential in performance between value and growth stocks amongst US stocks. The differential is at all-time high, even exceeding the peak of the Nifty-fifty and Dotcom bubbles.
Back in the Nifty-fifty bubble it was believed that investors could not go wrong buying blue chip companies such as Coca-Cola, IBM, Xerox and Polaroid. In the Dotcom bubble it was believed that with the internet changing how business was done that investors could not go wrong investing in internet companies. Currently there is that belief about technology in more general terms.
Our advisers are generally staying out of the hot areas in the market and are focused more on the value segments or finding earnings growth at a reasonable price.
US Credit Markets
Late last year the Federal Reserve suddenly paused their tightening agenda. A big reason behind this was the credit market. Since the GFC household balance sheets in the US have improved, corporate balance sheets have not. Companies have used low interest rates to make acquisitions and / or buyback stock.
In the fourth quarter of 2018, investors began to worry more specifically about BBB credits (the lowest investment grade rating before Junk), which make up approximately half of the $5.3 trillion market for US investment-grade corporate bonds, and the shares of those companies began to suffer. Companies like Anheuser-Busch InBev and Verizon Communications saw pressure in their share price after having used debt to finance acquisitions whilst sacrificing credit ratings in the process.
With a significant amount of outstanding credit bordering on Junk, the Federal Reserve has had to back down but risks remain with a number of companies still needing to reduce their leverage. Lower rated credits tend to be highly correlated with equity markets, and it is important when constructing a diversified portfolio that an appropriate amount of higher rated credit as well as government and semi-government bonds are included. A number of our advisers are focused on this area of the market currently.
The other risk in the credit markets is the number of high profile negative cashflow companies that are currently financed by credit. The likes of Tesla and Netflix are spending money in capturing market share for the future but ultimately will need to become sustainable before credit investors give up on them.
The European Banking System
The Italian banking system has been insolvent for some time. The third largest bank, Monte dei Paschi di Siena, was bailed out back in 2017 and recently the government set up a fund to compensate investors who lost money in a strong of recent small bank liquidations. Ultimately the system is unsustainable. Further bailouts will be needed and the longer it takes to fix, the longer it will weigh on the economy.
Meanwhile in Germany, Deutsche Bank is considering spinning off a “bad bank” in an attempt to be able to move on with life. This follows an unsuccessful attempt to merge with Commerzbank. Overall, the European banking system is better capitalised and less leveraged than pre the GFC but still has problems with non-performing loans. One of the major issues in fixing this is that individual countries have given away their monetary sovereignty to the European Central Bank and have committed to the fiscal policy restrictions of the European Union. There appears to be no easy solution and the extreme tail risk would be a country such as Italy walking away from the Euro.
Whilst there are risks in global markets, there are opportunities. Interest rates will remain low for the foreseeable future and the valuations of quality assets will be supported. However, the investment environment will remain challenging and now appears to be an opportune time to review your portfolios and potentially seek advice. If anyone wishes to have a conversation around how Southpac can help, please reach out to us.