As always, we’d like to take a moment to share our assessment of the current investment landscape (please find the 2017 edition here).
While we cannot predict what may come to pass regarding the global economy or financial markets, 2018 very much felt to us like a transitional year. As it unfolded, investors were compelled to reckon with two seemingly contradictory sets of considerations. On the one hand, many fundamental macroeconomic indicators continued to post strong readings, especially in the U.S., lending itself to the rosy narrative that the global economy is in a balanced, sustainable uptrend, with plenty of room to grow further. On the other hand, many of the issues we referred to in our last annual report came to the fore of investors’ minds, including:
- An era of unprecedented monetary easing that is gradually coming to an end (for now).
- Debt levels that are unsustainably high and rising fast.
- Growth in global GDP and corporate earnings that look likely to have peaked.
Overall, these interrelated considerations proved decisive in turning investor sentiment from positive to negative, leading to a clear spike in volatility and the worst yearly decline in the price of risk assets such as equities since 2008.
Fundamental macroeconomic indicators
On the positive side, most – if not all – fundamental macroeconomic indicators point to a strong underlying U.S. economy. According to OECD estimates, real U.S. GDP growth accelerated to 2.9%, versus 2.2% in 2017. A large contributor to this economic expansion was consumer spending, with retail sales growing at a rapid pace of approx. 4-5%, supported by rising real median incomes, which recently surpassed their prior 1999 and 2007 peaks.
Manufacturing activity also expanded, although the rate of growth did slow down in the second half of the year, with industrial production, durable goods orders (ex. transportation), and capacity utilization all trending upward versus 2017.
The unemployment rate fell to 3.7%, as low as it’s been in a generation, which traditionally tends to indicate that there isn’t a lot of slack in the economy. Having said that, the labour participation rate remains more or less flat at approx. 63%, reflecting a number of structural trends such as the overall aging of the population.
All of these positives were reflected in corporate earnings, which reached an all-time high in 2018, with S&P 500 earnings expected to amount to USD 163 per share. This represents a yoy growth of approx. 23%, versus 12% in 2017.
However, what would normally be cheered as a robust economic backdrop was overshadowed by a number of gradually sinking realities facing investors today, as discussed below.
The end of the era of monetary easing (for now)
While the process of seeking to ‘normalize’ the unconventional monetary policies of the past decade has been in progress for some time in certain geographies, only now is it reaching an inflection point at the global level.
In the U.S., the Federal Reserve (Fed) has been steadily raising the federal fund rate since late 2015, increasing it to 2.5% last December. This marked the fourth rate hike of 2018, and the ninth increase since the Fed began raising rates from near-zero three years ago, which highlights the quickening pace of monetary tightening. The other main facet of monetary normalization is the shrinking of its balance sheet. This effort started in October 2017, at a rate of USD 10 billion a month, gradually increasing to USD 50 billion a month in the last quarter of 2018.
Looking at other major central banks, the European Central Bank’s (ECB) main interest rate remains unchanged at -0.4%, although it is guided to start increasing slowly from mid-2019 onwards. The ECB also moved to reduce the size of its asset purchase program, cutting it by half in both January and October 2018 (down to EUR 15 billion a month), and finally ending net purchases in December.
Even the Bank of Japan (BoJ), one of the most eager proponents of quantitative easing (QE), has started to taper its level of monetary easing over recent months. While it has been less open with its communication relative to its counterparts, the minutes to its July meeting indicate that the BoJ has given itself more ‘flexibility’ in its purchases of Japanese government bonds. So, while the official target for the BoJ’s balance sheet holdings to grow by approx. JPY 80 trillion a year (approx. USD 60 billion per month) remains unchanged, the BoJ has slowed down its asset purchases significantly. For instance, between November 2017 and November 2018, the BoJ’s total assets only increased by approx. USD 300 billion, less than half of the ‘guided’ level of QE. Its level of short-term interest rate remains negative at -0.1%.
The People’s Bank of China (PBOC) has also been engaged in some level of monetary tightening, with a marked slowdown in open-market operations, as evidenced by a 5% yoy decline in the PBOC’s total assets to approx. USD 5.2 trillion by November 2018. However, China did also take some counterbalancing measures to stimulate its economy throughout the year, as discussed later. Its benchmark interest rate remains at 4.35%, unchanged since late 2015.
Overall, looking at the pace of quantitative easing from the combined perspective of major central banks that provide some form of forward guidance (i.e. FED, ECB, and BoJ), one can observe that QE seems to have peaked in the third quarter of 2017, and has been declining ever since. Starting in January 2019, it has likely turned negative (i.e. quantitative tightening) to the tune of USD 20 billion a month.
The tightening of monetary conditions, via both interest rate hikes and the unwinding of central banks’ balance sheets, is a challenging undertaking for various reasons. First, it acts as a withdrawal of liquidity which limits the availability of credit, thus constraining debt-fuelled economic growth. Second, it increases the cost of servicing outstanding debts, which negatively impacts profitability levels and leverage ratios. Third, as short-term interest rates increase at a faster pace than longer-term rates, the shape of the yield curve flattens, or even runs the risk of inverting, as is the case in the U.S. This impacts the level of profitability banks earn on maturity transformation (i.e. taking in short-term deposits and giving out longer-term loans), which in turn typically leads banks to tighten lending standards and thus the availability and cost of credit. Last, just as quantitative easing impacted asset prices positively, quantitative tightening will likely depress asset prices, with potentially negative consequences on confidence, consumer spending, and investments.
Debt levels are unsustainably high and rising fast
Excessive debt accumulation facilitated by irresponsible monetary and fiscal policies is of course at the heart of the predicament we currently find ourselves in. As we’ve pointed out in the past, credit creation does have a role to play in stimulating economic growth, but only up to a certain point. Just like everything else, credit has a diminishing marginal productivity, which implies that past a certain threshold, it becomes counterproductive and actually hinders economic growth. What distinguishes productive from unproductive debt? Mainly the manner in which it is utilized. If reasonable financial leverage is built into an asset that generates a sufficiently large income stream to repay the principal and interests, as well as earn an excess return on capital costs, then it makes sense to borrow. But when debt is used by a government to cover chronic budget deficits, or by a loss-making corporation to stay in business indefinitely, or by a household to finance current consumption above their means, then such an accumulation of unproductive debt leads to an increasingly precarious position, which eventually comes to a crashing halt. It is difficult not to be concerned with the manner in which sovereign governments, corporations, and households across geographies have used up much of their borrowing capacity on unproductive uses, and continue to do so at an accelerating rate, just as much of the cyclical recovery appears behind us and central banks attempt to normalize monetary policy.
According to estimates by the Institute of International Finance, total global debt increased to USD 244 trillion by the end of the third quarter of 2018, which is more than three times the size of the global economy (318% of global GDP). Non-financial corporate debt continued to be the fastest-growing category in 2018, growing to nearly USD 73 trillion, or approx. 92% of global GDP, an unprecedented level.
Source: Institute of International Finance Bloomberg
Taking a closer look at the U.S. in particular, total non-financial debt has increased to USD 51.3 trillion by the end of the third quarter of 2018, or approx. 254% of GDP. According to the latest monthly statement released by the U.S. Treasury, total public debt outstanding, including intra-governmental debt, was just shy of USD 22 trillion by the end of the year, or close to 110% of GDP. Note that this figure does not account for future unfunded liabilities that are essentially kept off the books, which some economists estimate to be a multiple of the stated public debt.
According to the Congressional Budget Office’s latest estimates, the U.S. budget deficit is expected to increase to close to USD 1.0 trillion in 2019, and over USD 1.5 trillion by 2028. We would argue that these are rather optimistic projections, that don’t account for the real possibility of a recession in the coming years. Should similar budget dynamics apply as in the previous two recessions (i.e. approx. 20% decline in receipts, 25% increase in outlays), the deficit could conceivably increase to a staggering USD 2.8 trillion, or approx. 15% of GDP.
Turning to U.S. non-financial corporate debt, one disquieting development that must be highlighted has been the deterioration of corporate credit quality over the past decade. For instance, the percentage of BBB-rated corporate bonds has increased from 34% in 2008 to nearly 50% in 2018. Another indicator is the increasing willingness of lenders to issue loans under looser terms, known as ‘covenant-lite’ loans. While such loans represented a fraction of the global corporate bond market a decade ago, they now account over USD 1.0 trillion, and an estimated 80% of 2018 issuances. While the ballooning of sovereign debt over the past 10 years has been the most apparent, perhaps the growth and worsening credit quality of corporate debt is one of the things we should be most worried about at present.
Last, while the situation regarding household debt is better relative to government and corporate debt, student and auto loans remain a cause for concern, and the evolution of credit card debt is also something to keep an eye on. One indicator that we’ve referred to in the past is the personal savings rate, which measures the average level of disposable income (ex. capital gains on financial assets and real estate) that is saved. However, following a ‘comprehensive revision’ to the U.S. national accounts, the Bureau of Economic Analysis revised the U.S. personal savings rate from about 3% to over 7% this summer. The main reason for the increase was that proprietors’ income was higher than previously thought. This could be seen as good news, but it should be pointed that a higher level of unreported proprietors’ income perhaps says more about the extent of tax evasion than the strength of the financial position of the average U.S. household.
Peaking growth in global GDP and corporate earnings?
Looking forward, it is difficult to see growth in global GDP and corporate earning accelerate further, for a number of reasons described below.
First and foremost, global efforts to normalize monetary policies are impacting economic activity, by reducing the availability of credit and increasing the cost of debt, as previously described.
It is also crucially important to note that in certain geographies, economic growth and corporate earnings were massively boosted by a number of one-off events, the effect of which will gradually wear off. For instance, throughout 2018, the U.S. economy benefited from a massive fiscal stimulus, consisting of corporate and personal income tax cuts worth USD 1.5 trillion, as well as a USD 300 billion increase in federal spending.
As is to be expected when providing a large fiscal stimulus in a late-cycle economy, labour shortages are rising which is leading to wage inflation, especially in the U.S. According to OECD estimates, U.S. wages are expected to grow by approx. 3.5% in nominal terms throughout 2018-2020, versus only about 2% over the past 10 years. This will likely have an impact on corporate profitability levels, especially for labour intensive companies with limited pricing power. Also, higher wages lead to accelerating inflation, which would typically result in higher interest rates.
Another important additional constraint on growth has been the deterioration of trade relations and the rise of protectionism. In March 2018, President Trump moved ahead with a number of import tariffs on steel and aluminium products, and China predictably responded with some tariffs of their own, creating some uncertainty about a potentially escalating trade war. The global trade situation indeed worsened in May, as the U.S. announced additional tariffs aimed at China, Canada, and the European Union. As a result, all of these trading partners challenged this move in the World Trade Organization (WTO), and announced retaliatory tariffs against the U.S. So far, few of the trade negotiations have made tangible progress, with the United States–Mexico–Canada Agreement (USMCA) being the only deal that has been struck (although not yet ratified). Both a potential U.S.-EU and U.S.-China trade deal are still under discussions. In a fully globalized world, the impact of trade wars is not to be underestimated. For instance, according to the OECD’s worst-case scenario, world trade and global GDP could be impacted by as much as 2.0% and 0.8% respectively by 2021.
Moreover, economic growth in certain key geographies hasn’t trended as strongly as in the U.S. For instance, GDP growth in the Eurozone has been slowing from 2.5% in 2017 to 1.9% in 2018. The all-important German economy showed a marked slowdown (GDP growth of 1.6% versus 2.5% in 2017), with an actual contraction in manufacturing new export orders late in the year. This should perhaps come as no surprise, given that China has become Germany’s biggest trading partner since 2016.
The Chinese economy has indeed entered a more complicated phase over the past couple of years, as it has tried to reduce the country’s burden of debt by reining in on bank lending and curbing its large shadow-banking system. As a result, monetary growth, as measured by M2, has slowed significantly from 12% in 2016, to less than 10 % in 2017, and approx. 8% in 2018. However, these efforts were halted fairly rapidly, as the Chinese economy started to show increasing signs of vulnerability. As the year progressed, a weakening of domestic demand as a result of this monetary tightening became evident, especially in the industrial sector. Unsurprisingly, much of this weakness has been associated with the sharp decline in infrastructure investment, as authorities tightened spending to rein in local government debt, and financial regulators shut down shadow-banking credit for project financing. Additionally, it is worth noting that automotive production has been exceptionally weak in the second half of 2018, as the expiration of certain subsidies has taken a toll on the sector. Last, China’s trading position has also been an additional source of stress, with the country’s trade surplus shrinking for some time and turning into an actual trade deficit for the first half of 2018.
In response to these developments, China reversed course on its efforts to restrict credit growth and contain the accumulation of debt. On multiple occasions throughout the year, the PBOC aimed to stimulate the domestic economy by reducing the reserve requirement ratios of commercial banks, thus encouraging lending. The government also announced fiscal measures ranging from tax cuts (focused on value-added tax) to infrastructure spending. Last, the PBOC has also stepped up its efforts to ensure that there is sufficient liquidity in the financial system, by resuming open-market operations in its medium-term lending facility with commercial banks. All signs point to further stimulus throughout 2019, should there be a need to do so to prevent economic activity to slow down further.
The last point we’d like to emphasize centers on growth in corporate profits specifically. Over recent years, a meaningful driver of earnings per share (EPS) growth has been the proliferation of large stock buyback programs, themselves enabled by rising corporate debt levels. In 2018, both of these indicators reached all-time highs once again. According to Goldman Sachs estimates, stock buybacks at the perimeter of the S&P 500 increased a massive 48% yoy to USD 770 billion, up from approx. USD 520 billion in 2017. S&P 500 buybacks are expected to climb by another 22% in 2019, to USD 940 billion, versus ‘only’ USD 715 billion expected to be spent on capital expenditures. Given the elevated level of corporate debt and the wearing off of transitory events like the cut in the U.S. corporate tax rate, it seems reasonable to assume the rate of growth in buybacks, which directly impacts earnings per share, will slow in the years to come.
All things considered, there are many interconnected considerations that point to a peak in growth in GDP and corporate earnings in fiscal 2018, which has weighed on investors’ minds and asset prices.
Valuation levels remain elevated
Despite a meaningful drop in asset prices in 2018, valuation levels remain elevated in view of the current investment landscape and risks.
The yields on 10-year government bonds across key geographies remain extraordinarily low (and even negative or close to 0% in the case of Switzerland and Japan). Across geographies, short-term interest rates remain below inflation, in other words, negative real interest rates. Looking ahead, the future trajectory of inflation remains highly uncertain, but it seems reasonable to assume that central banks will aim to keep real short-term interest rates suppressed for the foreseeable future, in view of elevated debt levels.
Looking at corporate credit, while U.S. and EU high-yield spreads have risen quite rapidly in late 2018, and currently stand at 4.4% and 4.7% respectively, the level of insurance against default that investors' demand for such bonds remains quite low. In view of underlying credit quality, we remain largely uninterested in the real return proposition of most credit investments, and are wary of using such instruments for the purpose of real capital appreciation.
Moving on to equities. Whether one looks at trailing or 12-months forward P/E multiples for major indices, one can see that the valuation levels of equities have come down quite substantially. As a result, some opportunities are starting to appear, especially in European and emerging markets, but also in the U.S. It is of course wise to remember the various reasons why current P/E ratios arguably understate the extent to which equities are expensive, including high profitability levels and likely peaking corporate earnings growth. Two long-term valuation metrics that address this issue are the Shiller P/E, which takes a 10-year average of earnings in order to smooth out cyclicality, and the ratio of total market capitalization to GDP. The Shiller P/E for the S&P 500 currently stands at 29.4x, down from 32.5x a year ago. It remains in the 90th+ percentile, or nearly the most expensive it has been for over a century. Likewise, the ratio of total US market capitalization to GDP is approx. 131%, which remains close to the all-time high of 1999.
Despite a fall in asset prices in 2018, current valuation levels don’t strike us as particularly attractive. Specific opportunities are starting to emerge in various markets, but overall, we’ve reached neither the kind of fundamental backdrop or valuation levels that would merit a significantly more aggressive asset allocation, as described later.
Conclusion & positioning
Students of the Austrian school of economics are likely tempted to see 2018 as a typical ‘Minsky moment’, when a sudden and sizable drop in asset prices sets off a credit and/or business down-cycle. We won’t be making any predictions about the future, but would agree that 2018 has felt like a transitional year.
Overall, what seems clear is that investment risks are probably higher now than they have been at any point in recent years. But it is key to acknowledge that there are risks both to the downside and the upside. On the negative side, the tightening of global liquidity could easily lead to a recession in Europe, sparking another sovereign debt crisis. Likewise, U.S. GDP growth is slowing and a recession in the next couple of years cannot be ruled out. Rising U.S. interest rates could spell trouble for most emerging markets that hold sizable amounts of USD-denominated debts, and trade protectionism could escalate further. Last, further geopolitical tensions could flare up in multiple places in an instant. Things that could potentially help the global economy in 2019 include further Chinese stimulus, a resolution to the Brexit stalemate, a normalization of trading relations, and lower oil prices boosting growth and slowing the pace of interest rate increases.
All things considered, as we enter 2019, the current investment landscape remains one that warrants prudence. What does this mean in terms of overall positioning for a Swiss-based family office such as Oyat? First and foremost, it means staying true to our investment philosophy and principles, as detailed in one of our recent articles. As we argue, in a world of monetary abundance, one should focus on owning truly scarce assets. Following a value-based approach, we also try to deploy capital in a counter-cyclical manner, accumulating reserves when prices are unattractive in order to capitalize on its option value when the inevitable cyclical busts occur.
As of the end of 2018, we hold a sizable portion of assets in cash, predominantly in Swiss Franc (our base currency). To quantify it somewhat, we hold enough cash to more than double our public equity exposure, should valuation levels become more attractive. Serving as additional long-term ‘reserves’ and a hedge against potential negative developments, we own gold related investments representing approx. 5% of total assets. Most of our exposure is actual physical gold, supplemented by gold mining and royalty/streaming companies. One of our largest positions is Franco-Nevada (FNV), on which we recently wrote an article. Our other gold & silver company holdings include Goldcorp (GG), Fresnillo (OTCPK:FNLPF), Newcrest Mining (OTCPK:NCMGF), and Barrick Gold (GOLD), among others.
We do not own any fixed-income securities, with the exception of private loans. While we still have significant exposure to public equities, we are below what we would consider an average weight in more ‘normal’ market conditions. The public equities that we do hold are focused on high-quality companies with strong balance sheets that can weather a downturn, or even thrive in tough times. Many of our top holdings are defensive holdings with safe and growing dividends. Some of our top holdings include Berkshire Hathaway (BRK.B), Roche (OTCQX:RHHBY), Enbridge (ENB), Nestlé (OTCPK:NSRGF), and Novo Nordisk (NVO), among others. We also hold a number of ‘hedges’ to limit the downside to our risk assets. This includes a futures contracts on the NASDAQ 100 and S&P 500, resulting in a 60% long / 40% short overall equity exposure. Finally, our asset allocation is balanced with private equity and direct real estate investments, as well as real estate exposure through REITs such as Ventas (VTR), Klépierre (OTCPK:KLPEF), and Realty Income (O).
Overall, our asset allocation reflects a highly prudent positioning that should perform satisfactorily in a market environment characterized by the status quo, while also setting us up to capitalize on the increasingly likely chance that negative developments unfold over the coming years.
Disclosure: I am/we are long BRK.B, RHHBY, ENB, NSRGF, NVO, FNV, GG, FNLPF, NCMGF, GOLD, VTR, O, NUMEROUS OTHER INDIVIDUAL STOCKS, PHYSICAL GOLD, AND HOLD SHORT POSITIONS ON THE NASDAQ AND S&P. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.