It’s like Jenga with real money at stake. Slowly, but surely the support for the current market structure is being eroded as “pieces of wood” are pulled away just like in that classic game. You may remember how excited investors were about global equities to start the year because Fed tightening would not impact them since future growth prospects were supposedly assured. Not so fast!
As the global growth begins to look less robust, the synchronized upswing narrative is looking suspect. Pull a few blocks out of the tower with that turn of events. Consensus bullishness is changing with only the most “glamorous” growth stocks in the U.S. remaining the last refuge, but they sit atop a structure growing shakier by the day. Even some of them are losing their mojo. Numerous cyclicals are a bit wobbly as well. Cryptocurrencies and commodities are also being sold down hard with copper off 20%. Most sectors in the S&P 500 have suffered a correction at some point this year. Change is afoot.
The cost of capital is going up and that is one major factor that forces investors to think about valuations and simply riding momentum. Some of those issuers that depend the most on cheap capital are generally being punished the hardest across a wide array of markets as central banks tighten policy. Interest rates and the dollar are rising, causing havoc for those with exposure to either or both. As a result, emerging market currencies, bonds, and stocks continue to be under the most pressure. One emerging market stock index is now down 20%.
Argentina and Turkey are among the first major casualties of central bank tightening. The IMF was forced to bailout the first, but Turkey should become a more meaningful credit event given its debt picture. China’s economy is also showing signs of more than moderate stress and that’s important because it has been the main economic locomotive in recent years as $30 trillion of debt was created out of thin air there.
A lesser worry for now is that European growth seems to be losing steam. We still wonder who is going to buy the bonds of weaker EU members like Italy as the ECB steps away from QE. Credit problems have not gone away there. Portuguese bonds anyone? No, thank you.
With core inflation rising in the U.S. at the fastest pace in years, the Fed will have a tougher time reversing its tightening course. That is providing a bid for the dollar. Meanwhile, new tariffs are pressuring the dollar higher as well. That combination will hurt foreign sales of U.S. companies, potentially reversing any positive impacts of new trade policies. The housing sector already feels a bit soggy as higher rates weigh.
The tombstone for value investing has been pulled out of the closet once again, but we see it as a bit premature given how cycles have traditionally progressed. As we have said before, with so many securities and commodities becoming cheap versus the U.S. indices which are dominated by Facebook, Amazon, Apple, Microsoft, and Google, we have to wonder how much longer it will be before investors gravitate to the value side.
We have been writing about the risks we see in the growth and margins priced into social media and tech equities. Disappointing user numbers out of Facebook, Twitter, and Snap seemed to confirm our suspicions in recent weeks. Maybe those reports along with the Netflix subscriber miss and Apple lagging some estimates on phone sales will prove to be one catalyst for a migration out of growth.
Investors have been chasing the same stocks that still have perceived momentum and staying away from those that are less expensive on a price/earnings, price/book, or price/free cash flow simply because they lack sponsorship. This a common late cycle phenomenon taken to an extreme currently. The correlation among individual stocks is historically quite low in yet another sign that market breadth is not good as the Fed removes liquidity.
Value stocks do win over time and we are in one of the longest stretches of value underperformance that we can find. At the heart of it, we are devout mean reversionists who use math based on historical data, so we expect this to reverse. Perhaps the fact that capital is becoming more expensive will change the focus of investors. Regardless, because investing comes down to discounting future cash flows, buying stocks with higher free cash flow yields works over the long term.
We do find it significant that the Japanese central bank (BOJ) and the political class are losing faith in QE as it becomes clear that it has been a failure relative to the outlandish expectations that ushered in the latest round of monetary largesse there a few years ago. Growth and inflation rates are just not what were promised. At the same time, the commercial banks are finding it difficult to make money given the rate regime currently in place.
The BOJ is trying to change course, but it seems to be struggling mightily to do so. Its confusion over a future course of action is becoming apparent. Of course, the biggest problem is that once QE has been used for so long and in such a massive way, reversing policies becomes virtually impossible as the financial system becomes distorted and addicted to central bank interference. This, of course, has implications for the Fed and ECB.
When the nation that took QE to its furthest extreme and has used it for decades to varying degrees realizes that it does not work to improve the real economy, how long will it take for the rest of world to lose faith in central bankers who have been calling the shots for too long? It already seems that the turmoil in emerging markets may force investors to rethink a complacency predicated on monetary witchcraft that has created a rickety Jenga tower of a market. We will avoid playing.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.