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Let’s Talk Turkey

Benjamin M. Lavine, CFA, CAIA

Source: istockphoto

“We have to be thinking about how much further to raise rates [emphasis added], and the pace at which we will raise rates…[There] are things we are well aware though.  We know that when we’re making policy and we think about those and kind of have a sense of what they might be…”

– Federal Reserve Chairperson Jerome Powell (11/14/2018 Dallas Q&A Session with Powell citing slowing global growth, waning effect of tax cuts and federal spending, and delayed effects of higher interest rates as key economic headwinds.  

“Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral…We may go past neutral, but we’re a long way from neutral at this point [emphasis added], probably.”

– Federal Reserve Chairperson Jerome Powell (10/3/2018 Q&A Session with PBS’ Judy Woodruff)

For the first time under Jerome Powell’s chairmanship (and the first since the Fed started raising rates back in December 2015), the Fed has hinted at a possible scenario where it may ‘pause’ in raising interest rates from the pace they’ve been communicating (three rate hikes in 2019).  In the wake of market volatility and sell-off in risk assets, investors are now questioning the Fed’s resolve in pursuing rate normalization in the face of a slowing global economy.

Fixed income investors interpreted Powell’s latest comments as an acknowledgement of a slowing global economy facing the types of headwinds cited by Powell during the Dallas Q&A.  After peaking close to 3.25% following a strong October U.S. employment release, the 10-Year U.S. Treasury yield has dropped to the low 3% range while implied inflation expectations (longer-term Treasury Inflation-Protected securities versus nominal Treasuries) are approaching 2% after having risen to 2.3% in early October. 

The Powell comments reflect a broader concern that is being felt across worldwide risk assets: the global economy is slowing down and will exasperate financial stresses already stemming from excess corporate debt levels and higher interest rates.

Let’s Talk Turkey

In the spirit of Thanksgiving, we lay out the risks and opportunities (the yield or carry priced into risky assets to compensate investors for the risks they face) that the current investment environment offers to investors in the wake of market volatility that has seen the S&P 500 drop 8% from its year-to-date (YTD) peak (on a total return basis through 11/19/18) and the tech-heavy Nasdaq 100 drop 13% from its YTD peak.  U.S. fixed income credit is also experiencing a risk-off sell-off with BBB-rated and below investment-grade credit spreads widening over U.S. Treasuries (Figure 1).  

Figure 1 – Risky U.S. Credit Feels the Global Equity Market Sell-Off

The Carry (or Market Drumstick)

Based on forward P/Es that range from 10.6-10.7x (Emerging Markets) to 15.4x (S&P 500), equity investors are pricing in a long-term expected real return of 6.5-9.5% (the forward earnings yield is the inverse of forward price/earnings – see Figure 2) depending on the market region.   The long-term forward expected return is one interpretation of Wharton Professor Jeremy Siegel’s contention that the earnings yield provides a long-run approximation of forward expected returns (adjusted for inflation).  If developed market inflation holds at 2% and emerging market inflation at 5% (based on the latest IMF data), then the nominal (inflation-adjusted) expected rate of return for taking on global equity risk ranges from 8.5-10.5% for developed markets and 13.4% for emerging markets. 

Granted, 2018 has witnessed significant multiple compression with forward valuations dropping close to or below the 2015-2016 lows (recall this period saw a mini-meltdown in credit markets as oil prices dropped from $100/barrel to $25/barrel).  However, if one adopts a more optimistic outlook on the global economy with the U.S. (tax cuts and deregulation laying the groundwork for more productive commercial investments) offsetting China weakness, then today’s valuations present a more compelling opportunity versus the beginning of the year. 

Figure 2 – Equity Valuations (Forward Price/Earnings Ratios) Offering Up a Meatier Drumstick to Investors Willing to Take on the Risk of Market Indigestion

Source: Bloomberg (P/E Estimates Through 11/19/2018)

For U.S. corporate credit risk, the nominal expected rate of return ranges from 4.5% (BBB-rated credit risk assuming 3% U.S. Treasury Yield and 1.5% risk spread) to 7% for U.S. high yield (assuming 4% risk spread).  Despite rating agency Moody’s projecting a less benign credit environment for 2019, Moody’s is still expecting the low default rate experience to continue.  Fitch expects U.S. default rates to decline to 1.5% in 2019, from around 2% expected at the end of 2018. 

On a real return basis (assuming 2% inflation), this translates into 2.5% – 5% real risk premium for taking on intermediate-term fixed income risk (one can argue that high yield presents as much equity risk as fixed income risk, especially in a downturn). 

The pullback in equities and credit has afforded investors a meatier opportunity to realize higher returns going forward, but…

…Investors Are Demanding a Meatier Risk Premium at the Risk of Greater Indigestion

What follows are some of the major concerns and risks that have pushed up equity and credit valuations as investors face a new macro risk backdrop consisting of higher volatility and uncertainty than what was enjoyed in 2017:

  1. Prospects of peak earnings
  2. Prospects of the Federal Reserve overshooting on rate hikes, pushing the global economy into a recession
  3. Prospects of a Chinese economic slowdown that could result in a major debt implosion and current devaluation

Of course, there are other ancillary risks such as 1) Hard Brexit (rejection of PM Theresa May’s latest deal); 2) the sudden drop in oil prices from $75/barrel back in October to $56-57 in mid-November; 3) the continuing strength of the U.S. dollar adding to international financial stress; 4) forward guidance disappointments from technology bellwethers Apple and Nvidia.  However, the first three risks listed above are likely the ones causing investors the most indigestion. 

Will Investors Have to Digest ‘Peak Earnings’?

Figure 3 displays the latest earnings projections (white lines) for the major markets.  After steadily rising over the last six months, S&P 500 earnings projections are now flattening out (and declining for the Russell 2000).  Earnings projections are also starting to decline for Japan and continue to decline for emerging markets.  The earnings picture for Europe looks relatively better but the region is also starting to see downward revisions.

Figure 3 – Are We Seeing a Worldwide Peak in Earnings?

Source: Bloomberg (EPS Estimates Through 11/19/2018)

According to the 11/16/2018 Factset Earnings Insight Report, 78% of S&P 500 companies have reported 3Q2018 earnings that have surpassed estimates, well above the 5-year average.  This matters little to investors as investors have more attention focused on forward guidance (any hint of weakness has typically led to a major sell-off).  Analyst estimates for calendar-year (CY) 2019 have been coming down, but analysts are still projecting earnings growth of 9% on top of revenue growth of 4.8% for CY 2019. 

Likewise, Bloomberg economic consensus still expects real U.S. GDP to grow 2.6% in 2019 following real GDP growth of 2.9% in 2018.  One can argue that neither economists nor Wall Street have correctly forecasted an economic / earnings recession, but the base case outlook for 2019 remains for some level of growth even if doesn’t match the levels experienced in 2017 and 2018.

One can also argue that buybacks and corporate tax cuts have goosed per-share earnings growth, but U.S. companies still enjoy competitively high margins and decent revenue growth that should translate into more substantive earnings growth.  Plus, corporate taxes have made U.S. commercial investments more viable relative to other tax regimes (Ireland, Canada to name a couple), so more forward-thinking companies desiring to improve productivity and their competitive edge should consider planning for the longer-term. 

Will the Fed Overshoot on Rate Hikes?

Admittedly, this risk has come down as Fed Chair Powell has acknowledged some of the ‘headwinds’ facing the U.S. economy.  Yet, the Fed continues to maintain its baseline forecast of three rate hikes in 2019, which would take the real Fed Funds rate ~0.25-0.50% above the neutral real rate currently modeled at around 1% (assuming 2% core inflation).  We’ve written about the risks of a Fed overshoot several times over the past year, but you can read our latest thoughts here (“Powell Strangles the Markets”). 

The challenge fixed income investors face in a not-insignificant scenario of a Fed ‘pause’ is how the long-end of the U.S. fixed income curve would react to a pause in short-term rate hikes.  Will the curve steepen (i.e. long rates rise faster than short rates) as investors interpret the ‘pause’ as the Fed falling further behind the inflationary curve (tight labor markets help maintain the risk of higher inflation)?  Or will the curve ‘invert’ (long rates drop below short rates) as investors interpret the ‘pause’ as a sign impending deflationary risks would prompt the Fed to pause in the first place?  Based on the recent drop in the 10-year Treasury yield following Powell’s remarks, fixed income investors appear to be leaning towards the latter.

For now, the Fed will likely raise rates another 0.25% at the December meeting bringing the real Fed Funds rate to ~0.50% (assuming 2% core inflation).  The U.S. economy is experiencing tighter financial conditions (much of which is being felt in housing), but the Fed estimates that the U.S. economy can handle a higher real rate environment without pushing the economy over the edge. 

China, China, China (see Brady Bunch reference)

China remains the major overhang to the markets as the Chinese government aims to micromanage its economy to deleverage without causing a major financial meltdown, a task all the more complicated as the Trump Administration is trying to squeeze China through trade tariffs and restrictions (perhaps in conjunction with a broader strategic imperative to contain China). 

There is no debate that China has enormous financial leverage.  What is debatable is whether this leverage can be managed so as not to cause a systemic global meltdown in the event of a global economic downturn.  Investors are finding it difficult to gauge this ‘black swan’ risk, particularly because of the increased opaqueness on what is actually happening in China from an economic standpoint.  

For a bull/bear case outlook on the implications of China’s economic slowdown, see this Atlantic Council Report (11/16/2018).  Even the bull case scenario doesn’t sound too appetizing as a more benign scenario might see a Chinese debt implosion as mostly ‘contained’ without affecting the rest of the world (a scenario we outlined in our 2Q2017 Market Commentary where China follows the zombie deleveraging experience of Japan post the 1989 peak in the Nikkei). 

Servicing internally-held debt is one thing, but unmanageable external debt burdens are what usually produce meltdowns, and the risk is not immaterial for China.  According to Kevin Lai, an economist for Daiwa Capital Markets, China has $3 trillion in U.S. dollar denominated debt, making it especially vulnerable to a “tightening in US dollar liquidity, a weakening yuan, and the ongoing US-China trade war.” A combination of higher U.S. rates and a weakening yuan could produce a “negative spiral as the US $3 trillion ‘carry trade’ in dollar debt is unwound.”     

A resolution to the U.S./China trade dispute could provide some near-term relief for China, but the large debt overhang will remain a hot-topic issue in the face of a slowing global economy.

‘Price’ Reflects Risk Appetite

Many of these risks have been known for some time, but as is typically the case, it usually takes some catalyst to bring them to the forefront (in this case, the global trade dispute and imposition of tariffs).  Whether the U.S. experiences a post-fiscal sugar high slowdown, the Fed over-tightens, and/or China faces a debt reckoning, global risky assets seem to reflect these heightened risks.  Borrowing a page from Dimensional Funds, asset ‘prices’ represent a real-time gauge for what investors are willing to pay in the face of increased uncertainty.  Individual risk appetites should be shaped by both time horizon and behavioral preferences.  The longer the time horizon, the greater risk appetite for targeting higher expected real rates of returns. 

As we approach this Thanksgiving in the face of heightened market volatility, give thanks that we at least have relatively free-and-open capital markets to help make some sense of the uncertainties facing investors. 

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of November 20, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing or visiting 3D’s website

By: Benjamin Lavine