It was difficult to maintain a positive return in a long-only portfolio last week, and there was no place to hide. Investment grade bonds and Treasuries finally did what they are supposed to do in times of market distress. Yields came down sharply since last week, and that provided a hedge against the falling equities. The question on everyone’s mind is: Is this the big crash?
We believe the answer is no.
Last week it was Moody’s Italy rating, and now S&P’s rating decision is out of the way. Italy retained its investment grade rating from S&P. S&P changed its outlook to negative from stable. That did not stop the Euro and European equities from falling off a cliff in sympathy with the US equity markets.
October’s meltdown in global equities marked a regime change for many quant funds. Trend following strategies no longer work, and mean-reversion is back. Passive strategies, which have been rewarded for being on the right side of the trend, will take a hit in this regime change as prolonged negative returns discredit the notion that you can buy and forget. It is time to dust off the old models and adopt a different strategy.
However, while we did recommend defensive exposure and portfolio insurance strategies in our previous note, we do not see this downturn as the crash that ends the expansion. There is no doubt that the markets will be more treacherous to navigate in the coming months, but selling into a panic is not a wise decision.
The tech sector dominates S&P 500 returns, and Alphabet and Amazon’s earnings reports became the excuse for last week’s sell-off in US equities. However, the facts for aggregate earnings of the S&P 500 tell a different story. Trailing 12-month earnings are beating the forward estimates for the first time in 7 years. The data does not exactly show a bad earnings season for US companies.
Friday’s US GDP data came out stronger than expected at a 3.5% growth rate. Tax cuts, corporate repatriations, low unemployment, and subdued inflation have prolonged the US economic expansion to the disbelief of many economists and financial professionals. We have been hearing the “late cycle” description for more than 2 years now, and most economists see this expansion ending in 2019-2020. We are guilty of using this label as well, but we have been clear that several things need to happen before we call an end to this expansion. Absent any significant exogenous event, the following are markers of the top:
- Volatility remains elevated for several months as bulls and bears fight for the narrative.
- The Fed stops hiking rates after a period of accelerated hikes.
- Signs of stress begin to appear in the riskiest credit markets: junk bonds, CLOs, etc.
- Equity markets will exhibit significantly higher volumes.
A global shock – for example, the oil embargo in the 1970s – can trigger the crash. Significance is a key point here because so far we have seen little impact from the looming Iran sanctions, trade wars, US-China tensions, and the Italian budget crisis. These events have not materialized into a significant economic hit. Even the highly-dramatized 10% tariff on $200 billion translates into a $20 billion hit, and it is not material in the context of the trillions of dollars in global trade.
For all the talk about a tech crash and warnings of a dot-com-like crash scenario, this is a different market than the 1990s. Yes, both rallies have been marked by the dominance of the technology sector, and both have defied naysayers with a decade-long expansion.
Today’s US economy is humming along at all cylinders, with the ISM Manufacturing PMI at 59.8, a level higher than both the June 1994 and December 1999 readings. S&P 500’s trailing P/E ratio is currently 18.7. For most of the 1990s, the P/E traded higher than this level. A growth scare hit the market and brought P/E ratios below that level in July 1994. Within less than 2 years, trailing P/E ratios crossed that level to the upside to reach a high of 29.9 in July of 1999. In fact, it was more than 2 years after the dot-com crash conclusion that P/E levels came down to where they are today.
The Relevant Decade
This is not to say that we cannot have a major market correction at this time, but it will take more negative news and a few months of volatility to confirm this view. The sample scenario we are looking at is the 1937 correction in the US, not the 1990s dot-com era. The 1937-1938 correction was the scary aftershock during the Great Depression that was triggered by the 1929 crash. A few years into the recovery, monetary policy began tightening just as it is today. Some might say we are right on schedule a decade after the 2008 crash, but we would like to point out a few differences:
- Fiscal policy contracted during as the Roosevelt Administration aimed for a balanced budget after the massive stimulus implemented during the New Deal. The opposite is true today with Trump’s tax cuts. Until we see evidence to the contrary, we see fiscal policy being supportive despite the monetary tightening.
- Trump addressed the issue of double-taxation on US-domiciled companies, which is why we found financial conditions looser in the US than they are outside the US. Namely, funding in US dollars was far more constrained internationally than it was in the US. The spread between funding at 3-Month Libor vs 3-Month US OIC reached 60 basis points in March of 2018. The world is far more indebted in USD than it was in the 1930s, which is why we made our call to go long USD in May of 2018.
- Unemployment remained stubbornly high in the 1930s. The unemployment rate fell from 25% to 9% from 1933 to 1937, but it started rising well before the crash, reaching 19% in 1937. A deflationary scare at a time when the unemployment rate is currently sitting at 3.8% is an unlikely scenario. It is not a surprise to us that the Fed is still talking about raising interest rates.
Even with this potential scenario on the horizon, we would like to stress that the US economy is a different beast today than it was in the 1930s, and an aftershock of 2008 is unlikely to happen on the same scale as the 1937-1938 crash. In 1937, the US dollar was not a free-floating currency. Despite abandoning the Gold Standard by suspending convertibility at $20 per troy ounce, the dollar was pegged to gold at $35 per troy ounce. This prevented the flexibility that modern economies have through the FX channel. The US is a far more open economy today, with more capital mobility and a flexible market-determined exchange rate.
The Week Ahead
This week’s GDP data out of the Eurozone might alleviate some concerns of European equity investors. Eurozone CPI data will likely edge higher due to increased energy costs in the previous month. Surveys are showing expectations of October’s Eurozone CPI closer to 1.1% vs 0.9% in the previous month. US unemployment rate for October is expected to stay at current levels of 3.7%. Another metric to watch for signs of a US slowdown is October’s ISM Manufacturing, which will be released on Thursday.
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