Author: Scott Brown, CFA, Founding Partner
As we expected, Quantitative Tightening (QT) is putting some downward pressure on markets. The view that global economic growth is not as robust as had been expected is gaining followers as the data rolls in. Price erosion is quietly taking place in numerous financial assets. We are at one of those points when it’s not hard to find individual stocks down 10-30%, yet the indices seem immune for now as a shrinking group of popular stocks, mostly in tech, holds indices aloft. This is common late in cycles.
Treasuries are widely hated, but in many cases, they have performed much better than quite a few equities over recent months. You are not likely to hear many pundits conveying the fact that longer-dated Treasuries, though down about 5% on the year, are doing much better than a basket of numerous TINA (There Is No Alternative) stocks that have corrected 15-20%. Stocks still look very expensive relative to the growth implied by the extreme flatness of the Treasury curve. A 10-year Treasury now at a multi-year high yield of 3.10% makes a lot of sense versus other options.
Many companies that beat quarterly estimates saw their stocks sold down sharply, so it’s getting quite tough to please shareholders. There is also a sense that future earnings prospects are not as bright as once thought or that companies will have a hard time attracting future investment interest given high valuations and rising interest, wage, and transportation costs. Intense price deflation is hitting a wide array of companies that sell to consumers.
We think the declining market breadth is a result of the fact that central banks are reversing course. Corporate bonds and riskier assets in general are finding it difficult to maintain their euphoric tone. Emerging market currencies, bonds, and stocks are under a good deal of pressure as well. In fact, Argentina had to ask the IMF for help in recent days.
A number of banks are losing deposits to higher yielding alternatives as the Fed raises rates and that will not factor favorably into the lending growth equation. How long can bank earnings remain robust when they are now being forced to pay more than zero for deposits? A flattening yield curve does not help either.
Higher rates are costing businesses and consumers real money, making borrowing less attractive. While a clear benefit to the energy sector, higher oil prices will be a drag on growth as gas prices rise. Those two factors are already impacting consumers as credit card borrowing has moved into reverse in a highly uncommon fashion.
Ford’s recent decision to dramatically reduce its cost base shows that the subprime auto lending binge has clearly run into trouble. It will no longer produce many sedans as it strives to increase profitability by shrinking its offerings dramatically. We think this speaks to the fact that the economy faces many structural issues that were masked by rapid debt creation. Zero rates and cheap leases simply brought forward demand that was not sustainable. The subprime auto delinquency rate now stands at 5.8% according to Fitch. That’s the highest since 1996.
Mortgage rates in the U.S. have risen to 4.50% and that is obviously impacting housing. Mortgage refi activity is cratering. The more interesting story is another burgeoning credit drama in the sector. Ginnie Mae mortgages now contain an inordinate amount of new loans issued outside of the banking system without much oversight. That poses a substantial risk down the road as Ginnie’s loan balances have more than doubled in recent years to a little under $2 trillion.
We have wondered for a long time why internet users would trade their privacy so cheaply to make billionaires of tech titans. We think the Facebook data mining saga makes it quite clear that trillions of dollars of equity values rest on the idea that consumers will continue to give away their personal info for so little benefit and some headaches.
What if consumers themselves got monetary compensation for online activities? Facebook is obviously not alone in benefiting from the surveillance advertising model. It makes little sense that the practice continues without some disruption. New technologies are proving quite capable of blocking unwanted ads and it is becoming increasingly common globally to do so. New privacy legislation looks to be on its way as well.
A company called Unlockd is attempting to shake up the status quo by paying people for their clicks. While it may not ultimately survive a battle with the entrenched tech juggernauts, it seems clear that it or another upstart may force the behemoths to offer some form of compensation to consumers, possibly crushing their ridiculous profit margins. Maybe even smartphones could be given away for free to those willing to trade their data in return.
Importantly, one has to wonder how big the overall online advertising market will ultimately become. Advertising budgets will not grow infinitely and the switch to mobile ads will one day reach a saturation point just like the smartphone market already has. We mention this because so many of the current market favorites are valued as if the good times will never end.
We have seen this before in both 2000 and 2007. Some dot-com era favorites like Microsoft took close to twenty years (and another bubble) to return to its high stock price of that era. Intel and Cisco stockholders are still waiting. Many others are now out of business or are a shadow of their former selves
What is often forgotten in the middle of the euphoria is that even if the current darlings continue to grow revenues and earnings at a rapid pace, the stocks can go nowhere or lower simply because valuations get so far ahead of themselves. It’s important to remember this because once again tech stocks have grown to over 20% of the S&P 500’s overall value. That has proven to be a significant threshold for many favored sectors in the past.
Monetary policy normalization by the Fed and other central banks is an attempt at returning the financial system to reality. We think it cannot work nearly as easily as many technocrat Keynesians and their cheerleaders in markets seem to think. It’s not hard to be skeptical given the asset price erosion already happening in markets. QE did not go as planned either. Normal growth never materialized, particularly when adjusted for population growth and deficit spending by governments.
The foundation for the entire scheme of the last decade was that ultra-low interest rates and QE would solve everything. Businesses borrowed wildly because any project or idea, including stock buybacks, looked like a winner with such low borrowing rates. Investors were told to pile into stocks because they were deemed a “no-brainer” versus low yields on bonds. Rates are no longer very low. Liquidity is being withdrawn. The narrative has changed, but investor positioning does not reflect that new reality.
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.