The rally in risk assets has been fast and furious in the last five weeks. Back on 14th February, we said “we certainly see the potential for a bit of a bounce if the “animal spirits” can summon up enough strength.” Not exactly a high conviction statement, we know, but we did recognise that markets were oversold and due a rally. Then on 27th Feb we highlighted a potentially bullish pattern that would be confirmed with a move above 1963 on the S&P 500. Last week, the S&P500 closed at 2050 points.
So, although we did call for a rally in risk assets, we did not expect the rally to be so spirited. The main question has to be whether the rally is sustainable or just another flashy rally in what may prove to be a long term topping process in many risk assets. This week’s note is a little longer than usual, but we think we are at an interesting juncture which needs a bit of explaining so we will cover oil, inflation, corporate profits, earnings growth and equity market potential moves amongst other issues. We hope that you can spare the time to read this – and enjoy it!
The first chart below shows the movements year to date in US equities and the price of oil. As can be seen, they are moving in almost perfect harmony. There has been an intense focus on the performance of oil so it is possible to claim that the recovery in oil prices has in fact been a driver of US equities in recent days and weeks. With oil now up year to date, not only is the pressure off for producers to collaborate to freeze production, it is possible that marginal production (especially from the flexible shale regions) that was shuttered in with oil below $30, will in fact come on stream above $40 and nearer to $50.
Basically, it has been our opinion for a few months that oil will stabilise after a decline of more than 70% from the peak. We still think that a period of trading between $30 and $45/50 is likely in the months ahead. If that view is near correct, then the positive influence on equities from a rising oil price should begin to dissipate.
Chart 1 – The S&P 500 and the price of oil since end of December
Of course, we can’t simply rely on short term correlations between assets to form fundamentally robust macro views. What we have been trying to grapple with in the last week or two is whether anything has changed fundamentally and what impact recent central bank policies may have on the real economy and financial markets. Firstly, we must note the growing debate over the recent increase in inflation. The chart below shows various measures of US inflation, all of which have been rising of late.
Chart 2 – Various measures of US inflation
To be clear, the Fed’s favoured inflation measure is the Core PCE (see the green line in the chart above), which is currently running at 1.7%. This is a bit below their 2% target but not a million miles away. It is fair to say that the majority of economists expect inflation to be higher in the second half of this year, a view that we won’t argue with. Ahead of the Fed meeting this week, with their unemployment and inflation goals all but met, and financial markets rallying hard, many expected the Fed to be relatively hawkish in their outlook. However, the Fed yet again displayed their institutionally dovish bias, seemingly ignoring the recent increase in inflation.
There is an increasing chorus that the Fed is falling behind the curve, thereby risking having to increase rates much faster in the future to ward off the building inflationary threat. Higher interes rates will likely hurt all asset prices, a potential threat highlighted very well in an article penned by Ambrose Evans-Pritchard (see link here http://www.telegraph.co.uk/business/2016/03/15/aep-us-inflation-rears-its-ugly-head-as-global-cycle-nears-dange/).
From our perspective, we can imagine the panic reaction from the Fed to higher inflation as a potential policy error. We have said this before and will say it again. The time for raising interestrates was over a year ago, not now. In our opinion, the economy has been slowing down and may well slowdown further later this year. Furthermore, with non-financial companies moreleveraged than ever before, rising interest rates will crimp corporate profits at best and at worst, help usher in a recession and a rising default cycle.
Another factor that may well encourage the Fed to raise interest rates is if the US economy performs a bit better in Q1, which seems very likely. With the final revision for Q4 GDP due next week, the consensus expects real GDP to remain at 1% QoQ annualised. It would appear that Q1 will accelerate to nearer 2%. Although this may seem a decent enough increase in growth,we have our doubts on the quality. There are 2 reasons for the anticipated GDP growth. First, the statisticians have been struggling for a few years to understand why the US economy seemed to be much weaker in the first quarter of the year compared to the rest of the year. Late last Summer, they decided that they should change their seasonal adjustments to “improve” their accuracy. It is highly likely that the improved seasonal adjustments will in fact lead to a higher GDP estimate. Second, the weather in the US has been much milder this year, and has already made some data look a little whacky (e.g. the recent downward revision to retail sales versus a huge increase in retail sector employment). We can easily imagine a weather influenced GDP report that paints the US in a better than expected condition. If this encourages the Fed to raise rates, this increases the likelihood of a policy error.
We are not sure we have seen any significant improvement in the real economy in the last few weeks. Aside from a statistical improvement in Q1, we expect US growth to remain near what many would consider stall speed, with recession risks rising sharply in the event of a new equity bear market.
We have previously shown how the swing factor for changes in GDP is in fact driven by the corporate sector, not the consumer as is often claimed. Historically, as companies have seen profits rise, they have added jobs and invested for the future, driving growth in the real economy. When profits fell, the reverse occurred. In the last 20 or so years, a new dynamic has reinforced this relationship. This new force is the increasing use of share options as part of executive remuneration.
With the vast majority of compensation now in the form of share options, executives are incentivised to do whatever it takes to boost the share price. We see the following problems with this;
1. This has led to increased leveraged as companies borrow to buy back shares.
2. It has led to increasing short termism resulting in an intense focus on costs.
3. It has led to a substitution of capital with cheap labour as capex is avoided in favour of short term hiring to meet increases in marginal demand (n.b. this may be flattering the employment numbers).
4. It has led to more oligopoly like structures in some sectors as big companies keep prices high to protect short term profit margins.
5. It has also resulted in companies being the only marginal buyer of stocks which is unhealthy as this buyer is incentivised to pay ever higher prices to boost the value of their share options even if it hurts long term shareholders.
In chart 3 below, we have shown the relationship between non-financial corporate profits (in red) and the S&P 500 (in white). In the last two cycles, profits peaked about a year or so ahead of the equity market. The measure we have used for profits, derived from the national accounts, peaked in September 2014, over a year ago now. We have also showed the total number of employed persons (in green) and lagged this by 12 months. As can be seen, the relationship with corporate profits is pretty decent when using this lag and indicates that employment should soon be peaking unless corporate profits can regain some momentum.
Chart 3 – US corporate profits, the S&P 500 and total US employment
We don’t believe corporate profits can regain momentum in the quarters ahead. For a start, Q1 looks to be a bit of a disaster. On December 31st , consensus had earnings growing at 0.3% yearon year. Today, that number is minus -8.3%, the worst downgrade period to earnings expectations since 2009. If Q1 represents a kitchen sink job collectively by corporate America, then perhaps the worst is over and equities can move higher but we simply do not buy this. The recent downgrades in earnings expectations have been across the board, not just the energy sector. The recent troubles for a high profile Pharmaceutical company may be an extreme example of what is wrong with corporate America, but surely not an isolated case. Companies have benefitted from lower interest rates, lower energy prices (ex. The energy sector of course) and oligopolistic pricing structures, and this is beginning to unwind. Energy prices have probably bottomed and politicians seem set to rail against sharp corporate practices.
Of most interest is the balance sheet side of corporate America. In chart 4 below (courtesy of Soc Gen), we illustrate how the net increase in corporate debt has been used entirely for buying back shares. What is interesting is that in recent quarters, the amount of buybacks has stalled at a very high level, whilst net new debt continues to march higher. This illustrates how desperate companies are to keep their share prices higher, and as organic cash flow is drying up, they are resorting to increased debt issuance. This is neither healthy nor sustainable.
Chart 4 – Net buybacks and change in debt by US companies
the income side of corporate performance, we think it is notable that despite interest rates being cut to zero and trillions of QE to boost asset prices (lower the cost of corporate funding), corporate interest expense has risen by about 40% since 2007 (see chart below courtesy of Goldman Sachs). Even as the average interest rate has fallen from about 6% to 4%, interest expense has risen as debt has doubled.
This fragile corporate structure has occurred during the most experimental monetary policy ever seen. If the Fed were to normalise policy by raising interest rates to say 3% over the next coupleof years, this would have a material effect on the profitability of corporate America, which would very much risk a new US recession. However, the fragility may become apparent quicker than that.
As shown above, companies have been increasing debt at a record pace in recent years, with each new Dollar of debt being used to fund buybacks to reward management through their share options. As profits have been falling for over a year now, and corporate funding costs have been rising over the same period, can we really expect investors to fund ever rising leverage by buying corporate bonds?
The party certainly seems to be carrying on longer than we had expected, most likely because investors continue to hunt for yield in a world where central banks are forcing them to take ever increasing risks. This is now bad for the economy as it will lead to a misallocation of resources. Too much debt actually becomes a deflationary force at some point, and a misallocation of resources will end in either significantly higher losses as the default cycle picks up or zombie companies left alive as seen in China recently and Japan over the last 20+ years.
To try and wrap up here, we do not see and improving fundamental back drop. Although the reflation trade can of course extend higher, we do not believe it is based on sound fundamentals. In fact, the equity markets appear to be levitating as the fragility of corporate balance sheets worsen, which could easily spill over into the real economy if share prices were to suffer ameaningful decline.
The risk versus reward looks absolutely terrible today in our opinion. Chart 6 below shows the S&P 500 back to 2011 and in the lower panel, we have plotted the 25 day rate of change. There have been three occasions in the last 5 years when this rate of change was anywhere near today’s +12% in 25 days. Not a huge sample size admittedly, but markets just don’t go up in a straight line forever. Looking at the three previous times the market was this overbought, price either consolidated sideways as in early 2015, declined a bit as in 2011 or declined sharply as seen early this year. At the most optimistic, we think equities will track sideways for a period from here.
We have also shown a bearish curve on the chart that has capped prices for 18 months now. We wouldn’t claim this to be a classical technical indicator, more of a reflection that the market appears to be in a long term topping process. If this view is valid, then this may be the last opportunity to reduce equity exposure before a significant bear market takes hold. In this scenario, a break of 1800 needs to occur, which would then open the door to 1600 later this year. If we are wrong, we still think the upside is limited.
Chart 6 – The S&P 500 with 25 day rate of change
So to conclude, we do not think the recent reflation trade is anything more than a very flashyrally that is now pretty much over. We remain of the view that the US and World economies are stuck just above stall speed at best, and are vulnerable to a new recession that would be triggered by falling asset prices. The bear market is likely to happen alongside a decline in corporate buybacks as profits continue to decline and the market pushes back on funding bond issuance purely to buy back shares resulting in higher and higher leverage.
We have become much more cautious in our multi asset portfolio with some bearish trades implemented in the last week or so. We expect this environment to usher in a more bearish period in FX as well, with commodity and EMFX vulnerable to new declines. Bonds may be a bit trickier as the inflation increases and the economy appears to improve in Q1 due to statistical changes and warm weather. We would, however, be buyers of bonds if yields were to move much above 2% on the 10 year bond.
Stewart Richardson, Chief Investment Officer
