The theme remains the same. Risks that had been underpriced because of central bank recklessness are becoming exposed as liquidity is drained from the system. While this view is now mainstream, broad reduction in exposures has yet to hit U.S. indices, likely making them an unsustainable outlier. After all, “passively” taking high levels of risk in index funds, investors in U.S. stocks are paying about three times normal valuations, while foreign equities offer a much better risk-reward ratio after having underperformed dramatically over recent months and the last ten years.
The emerging markets are the canary in the coalmine because many of those nations borrowed heavily in dollars over the last decade as Fed policy became absurdly reckless. As a result, they have two strikes against them as the Fed tightens policy because they must deal with both higher interest rates and a stronger dollar. Add Indonesia, India, Russia, and Brazil to the growing list of global trouble spots that started with Argentina and Turkey.
Emerging market equities are in a bear market and bonds in the sector continue to be under pressure. Growth is slowing. Numerous currencies are hitting multi-year lows still and it’s becoming more difficult for emerging market nations and companies to raise funds in the bond market. One must ask if global weakness will ultimately impact the U.S., which is in the middle of a spurt of growth partly caused by a massive increase in deficit spending and rebuilds from last year’s weather catastrophes. Running an $800 billion deficit outside a recession is highly unusual, but no one seems to care anymore because Corporate America got its tax cuts.
It sure looks like both auto and home sales have peaked in the U.S. Those have been sectors where some of our short positions have worked this year. Payroll growth and activity in energy production look to have peaked as well. Manufacturing production came in at up 0.2% in August, not nearly as robust as the soft surveys. Retail sales slowed down to just a 0.1% pace.
The question remains how long the Fed will continue its Quantitative Tightening program and higher rate path before it becomes concerned enough to halt those twin initiatives. Wage and price inflation here are at cycle highs, giving it little room to maneuver. The Fed will also have to consider tariff and trade issues that don’t mix well with the complacency priced into markets. Prices will be going higher for consumer goods in the U.S. with the tariffs on Chinese goods now in place.
For investors, the question comes down to a choice between owning that which is much less expensive with known risks or seeking comfort in a shrinking list of stocks with ignored risks. U.S. stocks are broadly expensive versus the rest of the world and ignored value stocks here are much less expensive than the growth variety. Most investment flows are knowingly or unknowingly based on momentum to an astounding degree with very little attention being placed on valuations, particularly in a long-term context.
Sentiment changes fast. We have discussed the 80% collapse in the crypto arena with $800 billion in losses and concerns around some tech darlings like Facebook in recent months. Investors are figuring out that sooner or later consumers are going to get tired of giving away their personal info for “free” to large tech companies. Snapchat is now down 60% from its high as the bloom comes off that rose. Other stocks will be repriced. It’s always humorous when one of the hyped names comes down to earth everyone acts like they saw it coming.
The rally in U.S. equity indices continues to lack breadth and is being led by fewer and fewer tech stocks. The Russell 1000 Pure Growth Index has returned 37% versus 4% for the Russell 1000 Pure Value over the last year, so it remains an extremely tough environment for stocks that screen as inexpensive. It’s obviously a big factor making life difficult for long/short hedge funds and value managers in general because the most expensive stocks just got more expensive.
Meanwhile, equities outside the U.S. are much softer this year. Emerging market bonds and stocks are on the cheap side along with value stocks, but few investors are willing to make contrarian calls away from the momentum of U.S. growth stocks. Besides, contrarian managers are not getting new investor flows. Our conclusion is that non-U.S. stocks need to cheapen more and will likely pull stocks here lower. An apples to apples comparison of a popular emerging market ETF in which sector exposures are equalized to the S&P 500 makes the valuation comparison much less favorable for the former.
We sense the same level of wide-eyed confidence that stock indices never go down as we did ten years ago when we were told that home prices never fall. It’s clear that nothing was learned during or after the Great Recession. It was not allowed! The lesson is that that central banks, much of Wall Street, corporate media, and other powers that be are a recklessly self-serving mutual admiration society. Those who did not see problems ten years ago, see no problems now because they are not paid to do so. As a result, they concoct a narrative that the markets and economies of the globe are growing nicely, and investors are behaving rationally. Nothing new there.
It was enormous leverage that caused the collapse in 2008-09 and now nations and companies have piled on incredible amounts of additional debt to create a fiction of organic growth. Warning signs were ignored then, warning signs are being ignored now. Hedge funds which spotted the risks and protected capital as they were designed to do were derided then and are derided now.
We can spot some key differences. Equities are much more expensive now. In addition, the central banks and governments have left themselves with very little room to maneuver in the event of a downturn. You see, things have been so good that policy makers have been employing the sort of measures usually reserved for recessions or worse for much of the last ten years because they fear things aren’t so good. Massive QE and rates held at zero or below were only wild fantasies or desperate measures before 2009, now those policies have been normalized, providing little shock value when needed again.
With QE drawing to a close globally, we reiterate that caution is in order. Better investment opportunities should become available as the world begins to deal with the downside of runaway debt creation without central banks to take down supply. The Fed is now a seller.
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.