Economic expansions do not die of old age. They usually die when interest rates are raised enough that economic activity slows down as a result of the increased cost to expand. This is because large projects are typically funded with debt and as the cost of debt increases (via higher interest rates) the expected returns of the projects decline or become unprofitable. As central banks raise short term rates eventually these become higher than longer rates (the yield curve inverts) which is also not good for economic growth. Inverted yield curves hurt bank profitability so they tend to be less inclined to lend for future expansion which eventually leads to potentially negative growth (a recession).
This is pretty much the situation we were in at the end of last year and why we advocated for strong cash positions at the end of last summer. The increasing interest rates were compounded in the U.S. by the Fed’s efforts to shrink their balance sheet. Worldwide they were made worse by increased geopolitical tensions, trade wars and anti growth populist movements in major markets such as the UK (as they attempt to exit the European Union) and France (yellow vest revolts that have affected commerce). China which is now a key cog in the global economy and has over the last decade been responsible for a large part of global growth was also affected by too much domestic debt and the cost of increased tariffs. All of the above was responsible for pretty much bringing the whole world to the beginning of a slowdown during December and into January.
Capital markets are first and foremost largely driven by interest rates, which affect global growth and hence reported earnings by corporations. Concerns that this new interest rate/populist/trade war dynamic would impact earnings in a negative way, collapsed stock markets which eliminated many of the gains of the previous nine months over the course of the last quarter of the year.
Nevertheless, the U.S. Central bank was quick to react to the warning signs and reversed course early January. Rate hikes are now no longer in the works and the balance sheet is likely to remain bloated for the time being. Yield curves slowly are starting to turn positive again. On a global scale, Europe is stimulating and even China decided to add $800bln in stimulus to their economy to offset the impact of trade wars. Britain appears to be moving towards a “softer” or no Brexit which the European continent now appears to be happier to accommodate in order to stimulate much needed growth.
The fact that President Trump wants the economy in the U.S. to keep booming ahead of the election in 2020 will most likely keep pressure on rates to stay low until then. So much negative news has surrounded this President and his policies that the only way for him to be re-elected is by keeping the economy strong. Problems ahead will therefore be pushed down the road once again.
The price of a stock is primarily a function of the earnings growth of the underlying company. Therefore, the biggest concern in the last stage of an expansion phase is anything that could drive profit margins lower such as a tight labour market or higher oil prices and ultimately the higher cost of money for expansion or to pay off past expansions (via higher interest rates). The first two are clearly evident but as long as rates stay low, there is some runway left.
What is different this time is the potential credit crisis that we have written about in the past. The world is awash with debt that has no way of being paid off. Whether it is trillions in student loans, or corporations that have only existed because of low rates, or governments with entitlement promises that exceed their revenues, the world has accumulated massive debt payments it will one day not be able to make. Ultimately it will require writing off a lot of this debt. The only way creditors can hope to get anything back is if that loan is restructured to something much lower. The only problem is this means huge massive losses for creditors holding those debts. Sadly, for the most part, these loans of corporations, governments and individuals (via mortgages and car loans) are largely being held in the average person’s retirement accounts via bond funds. In the end, everyone pays.
Nevertheless, investors continue by and large to manage money as if everything was part of a normal cycle. As the late cycle expansion continues, investors are reaching for returns by going down the quality curve with increased speculation, as secular growth stories and defensive names are no longer cheap. The halt in interest rate increases in developed economies and a revival of credit growth being encouraged in China is fueling expectations for higher global growth once again. As such, financial asset volatility has collapsed. With lower government bond yields, as the central banks stop hiking rates, risk appetite is back and stocks are soaring.
Going forward the focus as always should be on two things: inflation and interest rates. If inflation remains low, rates will stay low, ensuring corporate solvency is not threatened and a recession is therefore more unlikely in the immediate future. Inflation is always and everywhere a monetary phenomenon (central banks control inflation by raising interest rates) so underlying inflationary pressures may be stronger than widely perceived and could get worse if demand for the dollar abates, but for now the game is back on.
With interest rates on hold companies no longer need to focus on fixing their balance sheets to restore debt levels to a more prudent level and can use the funds to buy back their shares (to help their own executive bonuses) instead. The first quarter saw over $200bln employed in this manner. China’s tremendous amount of stimulus (nearly $800bln) is now starting to feed through. With global economic news not getting worse it is possible that the worst of earnings downgrades is over for now. The markets are first and foremost priced based on the outlook for growth and earnings.
So what could go wrong? During the three months to the end of January, global trade declined for the first time in nine years. Trump tariffs continue to have an impact and it is unclear whether they will get worse before they get better. The price of oil continues to rise with the Saudis and the Russians methodically cutting back on production and could escalate even further as tensions grow with Iran. Increases in gas prices are like a tax on consumers and feed into other costs throughout an economy. There is not a lot of slack in the labour market with unemployment at record lows as is normal during the last stage of an expansion cycle. However operating rates at 80% or less would indicate there is still a lot of spare capacity in the system and no real need to expand plant or equipment any further. Technology continues to evolve and the tight labour market for now makes it less painful as robots start to replace humans in a more aggressive manner.
It is not clear whether the world can escape a global recession over the next 12 to 18 months because there are so many conflicting influences that could drive this either way. However we are of the view that the expansion will likely continue, albeit at a slower pace, until the U.S. election, as every effort will be made to keep the party going for as long as possible.
Regardless of this, as we are at the end of a very long runway, we do know that there are now many factors that have the potential to lead to diminishing returns for companies, and ultimately stock markets, regardless of whether there is a recession or not. Valuations are not cheap and interest rates cannot even appear to edge higher as we are now pushing on a string.
The key then is to focus on those areas of growth that are in the markets rather than to invest in any overall market. It will be important to remain very selective. Ultimately it is imperative to own only those companies that are so competitive and have such strong balance sheets that the economy going south is likely to be more a long term advantage (as their competition gets crushed) than a short term crisis. During downturns it is glaringly apparent who the survivors are.
The bottom line is these are not normal times. Being selective on investments will make all the difference between making money and losing money. This time really is different, but not necessarily in a good way. Structural changes due to demographics, geopolitical issues and most importantly advances in technology, means there are likely to be more losers than winners in the future. True growth will be scarce and when it is available, it will cost more. But as with anything else, you get what you pay for.
The Summerhill Team