The approaching half year mark is a good time to gauge the health of world financial markets.
2019 has been better than 2018. World equities fell -7.4% in 2018 in local currency terms and have risen +15.9% YTD in 2019. World Bonds (in aggregate, using the JP Morgan composite) fell 1.0% in 2018 but have returned +4.7% so far this year (data to 18th June). It therefore appears that 2018 was a pause for consolidation, permitting the full-bore late cycle rally that has since transpired.
If we have enjoyed rising bond and equity prices in this most recent period, how rare of an event is this?
Looking back over the last 35 years to 1984, we observe that, in 26 of those heady years bonds and equities have risen in tandem. There have been no years in which they both fell, six years in which equities fell and bonds rose, the rarest instance being the three years in which equities have risen and bonds have fallen, the last one of these being 2013. We can see, at a glance, why balanced investment (a non-determinate mixture of bonds and equities) has been such a hoot.
There is considerable and understandable anxiety about what might loom over the horizon. The phrase “late cycle” is suggestive of cyclical conclusion and it is therefore sensible to imagine what broad factors could trace the cycle’s end. Bull markets in shares are propelled by two things: rising aggregate corporate earnings and/or rising valuations. An intuitive perception of this cycle might be that we have enjoyed both – with valuations more consequential than earnings. But is this true?
Earnings per share in the US have risen by 6.1% per annum compound since 2008; this eclipses earnings growth of 5.6% per annum recorded during the halcyon days of expansion between the end of WWII and the market top in 1962. Whatever you might think of modern US capitalism, it has delivered the manna – in the form of earnings growth – that equity markets need to feed upon.
The current price to earnings (PE) multiple of the S&P500 is 18.1x, exactly the same PE as prevailed in June 2009, suggesting that valuation multiples have not expanded at all in this cycle, somewhat counter to the general thought that the equity market has become more expensive.
17 of the 40 equity markets that MSCI provide index data on world-wide have lower PE ratios than prevailed in 2009 (23 higher, by extension) and the median multiple current stands at 14.1x versus 13.0x in 2009.
As we know from past cycles, the fodder of bear markets is more often a fall in earnings which then exposes the valuation top. Valuations are seldom, if ever, the solitary marker. The TMT bust in 2000 is commonly regarded as a valuation top but broad market (S&P500) index earnings fell by 35% between the 3rd quarter of 2000 and the 4th quarter of 2001(-68% if extraordinary accounting items (losses) are augmented into reported earnings).
The question then becomes, what confluence of factors could generate a fall in earnings? If the epicentre of the last cycle end of 2007-2008 was personal finance vis the US housing market where valuations became high as affordability fell and leverage increased, we suggest that the key area of attention in this cycle is corporate leverage.
A distinguishing feature of this cycle has been rising corporate leverage, especially in the US. It is easy to see why. One of the attendant effects of Quantitative Easing has been to depress bond yields, the cost of debt and thereby reduce the corporate cost of capital. This has incentivised CFOs to take on more debt to boost Return on Equity. As more corporate pay packages become driven by Earnings Per Share (EPS) growth, the easiest way to goose growth in these variables is to take on debt. The Private Equity sector, which has been very high on the hog in recent years, provides further impetus to this by their model activity, typically via streamlining and gearing.
134 of the 398 non-financial companies in the S&P500 have net debt to equity or gearing ratios of in excess of 1:1, a rough measure of overextension. This is one third of the universe of the world’s most successful economy and up 13 percentage points the comparable universe 12 years ago.
The modern argot for estimating the burden of corporate debt on a company-by-company basis has shifted to Debt/EBITDA from pure balance sheet measures – which moves judgements from absolute measure of jeopardy to an affordability-based measure. This is an absolute to relative shift which can often lead to problems down the line.
It is also pertinent to note that private debt in the world runs at 4x public debt. It is convenient to point the finger at governments and central banks for the world’s travails but it is personal and corporate choices that are providing the conditions precedent for the next upset.
If Collaterised Debt Obligations written on willingly mislabelled baskets of mortgages were the truly stinky thing in the last cycle, the Dividend Recap could be this cycle’s nefarious worst practice. Divi Recaps typically taken place when a Private Equity firm takes control of a mature business in a mature sector. The new controllers then look to defray the cash flow cost of the buy-out by leveraging the balance sheet to pay themselves a dividend. This creates a floor for their investment. Even if the business ultimately fails, the new-owners’ downside is capped. Corporate Codes do not often result in owners being retroactively punished for imprudent stewardship. This moral and judicial failing is tacitly justified on account of the need to promote risk taking as the necessary lifeblood of the capitalistic system. Warren Buffet and Charlie Munger rail against this type of activity. Despite their fame, they can only truly influence companies under their control.
With these observations in mind, a rise in the cost of debt would be a very unwelcome shudder on the rudder. This does not seem likely and we have probably reached the cycle top in US interest rates. Whilst the Federal Reserve has yet to become demonstrably dovish in its comments, markets now expect two cuts in base rates this year. If the developed world faces a low growth, low inflation low interest rate future then the world is turning Japanese: a reference to conditions that have prevailed in Japan since its last big cycle top of 1989. This is not all bad but points to fluky markets: bonds flat on their backs and going nowhere and equities operating in big ranges but struggling to hitch onto an upward channel.
Another development to contemplate is the coming “techno-rift” between the US standard and the Chinese standard. Whilst the banning of Huawei is the sharp point of Trump’s government agencies’ attacks and he conflates this as more of a trade war than an intellectual property issue, the anti-Chinese approach is a winner in America and links the aisle in terms of Republican and Democrat. There are two likely consequences of this: firstly that market-by-market, companies and agencies will have to choose whether to take US technology as their standard or Chinese. These decisions will be fraught with geopolitical pressures but may ultimately help secure China’s pre-eminence provided it can achieve sufficient competency in a large enough array of areas. This will be a 20 year war and therefore well beyond the twin terms of President Trump and at the far end of Xi Jingping’s possible influence.
The second set of consequences relate more to manufacturing and here we are seeing more relocation decisions, often that have been delayed, to move contracting out of China. On-shoring is on the up and reallocation within Asia is rising. Other countries could have their moment in the sun: Vietnam is a clear beneficiary and both India and Indonesia have chances to prosper from these shifts.
There is a great deal of concern about what is termed “reverse globalisation” or “deglobalisation”. These concerns may be overblown. In the 21st Century, The President of the United States operates by the grace of US companies, like it or not. The shorthand way of understanding this is to look at the level of the S&P500 index. Decisions that negatively impact corporate America tend not to linger on the vine. Policy reversals are more the norm and this is part of the current construct. Re-allocation of manufacturing and supply chains around the globe are just part of pragmatic decision making and not the end of anything.
The big exception to this line of thought must surely be with respect to the planet and the environment where part of the necessary action must be lessening: less CO2, less plastic, less carbon. Less people, frankly. This is a difficult matter in a world that operates on a growth paradigm and one that is dividing the generations.