Global markets kicked off the new year on a somber note. As we assess the damage from December’s market turbulence, we count our blessings and look forward to continued success in 2019.
Where have all the bulls gone?
As shocking as it may seem to the new generation of investors, a little stock market turbulence every now and then is not so bad for a healthy economy. It is the prolonged period of low volatility that creates an environment of complacency. This has been the state of US markets since 2011, the year in which we had last seen a 20% correction. The period of weakness from 2015 to early 2016 was a response to the slow-motion train wreck that crude oil had from the 80+ level to the lower 40s. It was the energy companies that took the brunt of that correction. Shale producers reduced their workforce, and markets were worried about oversupply and demand destruction.
A long period of low volatility rewards leveraged positions, and leverage has been building in the system for quite some time. It was too soon after the 2008-2009 deleveraging process for the 2011 correction to have an impact on the economy. That period was also marked by expanding fiscal spending and expanding Fed balance sheet. The 2015-2016 correction was relatively shallow and happened too slowly to trigger a panic in credit markets. Sector rotation had technology companies carry the torch until the last quarter of 2018.
Fast forward to today, and you will find we are dealing with the same scenario, with crude oil following the same corrective pattern. However, we are mindful that the speed and aggressiveness of this correction have the potential to derail credit markets. So far that has not happened. Credit markets are holding up well during this recent bout of volatility, and US junk bonds have not really reacted in the same way as the equity markets. US economic performance continues to astound. Unemployment figures blew estimates. Services PMI beat expectations. Bank credit continues to expand at a more modest rate than in 2016, and syndicated loan issuance set a record in 2018, exceeding $2.5 trillion in volume.
However, while the credit markets continue to hold, we are now entering the final stage of the expansion. Leveraged loans and Collateralized Loan Obligations (CLOs) have become the new vehicle for “creative finance” to push the credit expansion to the limits. The Fed is right to raise interest rates because this shadow banking system is beyond the reach of regulators, and a little pain in the near-term is better than a relapse of the financial crisis that was triggered by a similar financial product used to package subprime mortgages into investment vehicles, namely Collateralized Debt Obligations (CDOs).
The Track Record
No, we have not exited our long US equities trade. We have been overweight US equities vs. European and Emerging Markets for 2018, and the global equity market meltdown in December was a response to threats we have been warning about in mid-2018, namely rising interest rates and the EU’s struggle for survival in the face of populism.
The market regime is shifting again in favor of active strategies. Passive strategies that benefited from low volatility and a multi-year uptrend are no longer working. Suddenly, some of the younger generations of investors are coming to terms with their flawed logic. This is the time when skill to navigate the uncertainty really matters.
To get a clear picture of how our recommendations panned out, let’s evaluate the total return indices of these markets, which include adjustments for dividend payouts during the period. The S&P 500 Total Return Index was down a measly 4.26% in 2018. Compared to the equivalent US dollar total return, this overweight produces a positive active return of 10.27% vs. European equities and 10.32% vs. Emerging Market equities. The European STOXX Europe 600 benchmark was down a staggering 14.53%. If we exclude the FX movements during this period, the STOXX Europe 600 Total Return index was down 10.28% in 2018. MSCI’s USD-denominated Emerging Market Total Return index was down a similar 14.58% in 2018.
Our overweight recommendation on China was published on our website on the 17th of September 2018. That shift in allocation in September outperformed the S&P 500 by 6.71% on a USD relative return basis. Despite being down over the period, the CSI 300 managed a smaller 6% slide by the end of 2018 vs. the more extreme double-digit losses seen in US and European markets in the 4th quarter of 2018.
Our fixed income allocations were concentrated in short-term USD-denominated investment grade corporates with 10-year exposure limited to US Treasuries. Our hedge worked in December as the investment grade corporates held their ground and the long-duration exposure on US Treasuries benefited from the flattening yield curve. Markets are now pricing in a pause in interest rate hikes.
Yes, our clients are happy with our advice in this treacherous market. Robo-advisors do not replace good quality research, and bitcoin is not a currency.
Walls and Spies
The trade war took an unexpected turn with Trump’s insistence on building a wall between the US and Mexico to slow down migrant labor crossing the US-Mexico border. This is the common theme of right-wing populist movements worldwide, but now Trump is refusing to sign off on a spending bill unless the budget for the wall is included. In the meantime, the US federal government remains in partial shutdown while Trump tries to strongarm Congress into allocating money for the wall.
Trade negotiations resume
Another meeting starts today between US and Chinese negotiators. This time it is in Beijing. The pressure is on, and time is running out. Accurate or not, at least the dominant perception on both sides is that the trade war is causing China’s weak economic performance and, as a consequence, weakness in earnings for China-dependent US corporates like Apple Inc.
These mid-level talks will be followed by more senior-level discussions by end of January. We are expecting some sort of an agreement that ends in China sourcing a larger chunk of its agricultural, oil and natural gas imports from the US as an immediate solution to the bilateral trade imbalance. We also believe that international pressure will force China to implement and enforce stricter intellectual property laws that satisfy the American demands for protection from industrial espionage. Agreement on scrapping automative tariffs should be relatively easy and straightforward to accomplish because they are hurting automakers on both sides.
However, some of the more complicated outstanding issues may need some creative solutions to move forward with an agreement. Foreign banks have been asking for the right to majority ownership in Chinese onshore partnerships for the past two decades. Access to China by US financial firms is viewed as a threat to China’s model of state capitalism. It would mean loosening capital controls and a more significant change for China’s financial system.
The other matter involves China’s dominance of 5G technologies, with Huawei’s ownership of key patents posing a national security threat to the US. The Canadian arrest on behalf of the US of the influential Huawei CFO, Meng Wanzhou, further complicates matters because it escalates the trade war to a new level. The detention of two Canadian citizens by the Chinese authorities on violation of national security laws immediately after the Huawei incident brings back memories of Mad magazine’s “Spy vs. Spy” comic strip parody of the Cold War.
Chinese stimulus accelerates
While we wait for trade negotiations with the US to conclude, the bulk of the Chinese stimulus package kicks off in January. The package, which includes a reduction of tax burdens for low-income households and a reduction in corporate taxes, will make China one of the most lucrative investment opportunities in 2019. We see China’s deleveraging period ending in 2019, and the Chinese government will replace corporates as the engine for credit expansion.
The Week Ahead
It will be a relatively light week on the economic data front. CPI figures out of the US are of note because they will set expectations for the Fed’s next move. CPI figures are also expected out of Russia, Sweden, and Greece. Also worthwhile, watch US Initial Jobless Claims for direction on the tight labor market. The Bank of Canada is expected to keep its rate at 1.75% on the 9th of January.
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