The End of The Cycle?
This year was no walk in the park. Investors were faced with a number of dilemmas, uncertainties and temptations. Each year, different from the last, comes with its own unique challenges and circumstances as new unpredictable risks emerge and certain predictable risks become realized. The fundamental backdrop of the markets is in constant flux. This is what makes investing difficult, but then again, it isn’t supposed to be easy. There is no Holy Grail manual providing exact instructions to follow under a fixed set of circumstances. Flowing water cannot be studied by capturing it in a bucket. This is why adaptation is a required discipline in this field, as the environment is in constant motion.
In this article, we revisit a few of the major themes that shaped this year and which altered its expected path.
Investors entered the year with a high level of enthusiasm. Their optimism was grounded in the record earnings that companies were reporting alongside the global synchronized growth of the major economies and the enthusiasm underpinning Trump’s tax cuts. Markets were priced as if nothing could go wrong as stock market valuations achieved cycle highs while volatility was still at unprecedented lows. This narrative quickly changed with the sudden spike in interest rates which led to both the return of anxiety and volatility, while at the same time wiping out those investment products that were built on the false assumption that low volatility was the new norm. As a result, the U.S. stock market had its first correction in a number of years.
As the U.S. stock market rebounded from this correction into the summer, it became apparent that other global markets had failed to follow suit. The recent tax reform in the U.S. had given its economy a significant boost, propelling company earnings higher. This earnings jolt was, at the time, more than enough to offset the lower valuation multiples that come with the expectation for higher interest rates. Other global economies, absent their own tax reform, did not receive a similar economic or earnings boost but instead continued to follow the natural course of a late cycle economy with diminishing growth. As the U.S. stock market appeared to be the only rollercoaster still ascending, capital flowed in for the ride helping to keep asset prices elevated. All the while, cracks were starting to show.
The weakest pillar is always the first to break under stress. In today’s integrated and global financial system the most vulnerable pillar is still in the emerging markets (notably Turkey and Argentina). The tightening of the U.S. monetary policy provided the stress. To attract foreign capital, emerging markets typically have to issue debt denominated in a foreign currency, mainly U.S. dollars. However, since they generate revenue (via tax collection) in their own local currency while their liabilities (the foreign debt) are in foreign currency, this mismatch makes them vulnerable to a strengthening of the U.S. dollar relative to their own. The U.S. dollar strengthened this year which resulted in this U.S. denominated debt being more expensive to service. When there are fears that a country might not be able to pay its debt, capital flees the country. To stem off this capital flight, central banks will increase interest rates to very high levels to attract investors which unfortunately ends up throttling economic growth. A negative self-reinforcing downward spiral takes hold. The Bank of International Settlements estimates that emerging markets have $3.7 trillion in U.S. dollar debt outstanding, a much higher level than was seen during the last currency crisis in Asia in 1998. All this debt eventually needs to be repaid.
During 2018 China experienced an economic slowdown. Economic growth was hindered by a combination of the People’s Bank of China trying to orchestrate a slowing of its economy to deal with its non-performing loans as well as the trade war with the U.S. As a result the yuan weakened substantially. The Chinese government stepped in and cut taxes and enacted measures to increase liquidity in an effort to revive the economy. As the second largest economy in the world, its slowing growth sent ripples across the globe.
The price of oil took a nose dive during the second half of the year with benchmark prices falling as much as 50%. Too much supply and limited pipeline capacity have been cited as the culprits. It is worth highlighting that for the first time, the U.S. has become a net exporter of oil. The ability for the U.S. shale industry to attract the capital that it does continues to amaze us. A typical oil well gets 50% depleted in its first year, meaning drillers continually have to drill new wells in order to show growth. Finding and drilling new wells is not cheap. Cheap cost of capital has been this industry’s saving grace allowing it to become one of the largest industrial sectors in the U.S.
At times this year it seemed like the U.S. was an island immune to outside issues, but this is unfortunately not the case. 40% of S&P 500 earnings are derived abroad. The boost from the tax reform did provide an expensive face lift providing only a short-lived impression of a younger self. However, as sales of large ticket items (that typically require financing) such as homes and automobiles, started to decline, the effects of the tax break and the ability for the U.S. to continue to grow above its potential was called into question. The worry as to whether consumers and businesses would be able to absorb higher interest rates and wages, quickly led to the fear that things were as good as they would get and that perhaps U.S. companies have reached their peak earnings potential this cycle. The slight inversion of the U.S. yield curve added to this negative sentiment. The stock market experienced another correction.
As 2018 comes to an end, the markets are struggling to find their footing. Investors have taken a “show me” stance knowing very well that any of the outstanding issues could progress or deteriorate based on the latest tweet. Valuations levels have come down materially as the price to earnings multiple adjusts to higher rates, albeit off a very low interest rate base. Those companies with sustainable earnings power have fared better than those without. These are the only companies that should be owned. However most investors are now in passive funds where they hold both good companies and bad ones. As the bad ones continue to perform badly, they create panic sellers for those funds which means the good companies are sold off too.
We enter 2019 with a continued obsession around protecting for any downside. Many stocks are already down anywhere between 10% and 20% in the last quarter alone. At some point, these declines will present an opportunity when they also extend to the higher quality names that Summerhill tends to favour. Until then, patience is a virtue.
The Summerhill Team