Levatus Investments | Trepidations of Transition

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Staying Focused on the Data

Based on a composite index, financial conditions in the United States continued to loosen through the end of 2017. This meant that despite the Federal Reserve raising short term rates, money remained readily available via bank loans or securities issuance. In both the United States and the euro area, high-yield and investment-grade credit spreads narrowed (meaning cheaper borrowing for companies). This was accompanied by rising equity prices and low market volatilities.

In the context of continued liquidity growth, global real GDP accelerated from 3.2 percent in 2016 to 3.8 percent in 2017, close to its long-run average. The growth pickup was more synchronized and evenly balanced than in past years. Also during 2017, growth in emerging markets returned to near its historical average, recovering almost completely from the lows in 2014-2015. Overall manufacturing output and global trade expanded strongly. As economic activity gathered pace, unemployment rates fell to post-crisis lows in many places with Europe being the glaring exception.

Signs of Transition

As 2018 has progressed liquidity conditions have tightened. This means U.S. companies are paying more to borrow, costs are rising and the “safety net” of liquidity is shrinking. The composite index of financial conditions that had continued to loosen during 2017 shifted lower in the first part of 2018. The relatively smooth upward trend of this measure during the past decade has become more volatile. With this, headline inflation in 2018 is expected to rise in most countries, reflecting both the reduction in labor market slack and recent increases in the price of oil and other commodities.

U.S. Corporate Buybacks as % of Operating Earnings

In addition, the imposition of tariffs and other trade restrictions on an escalating scale because of actions initiated by the Trump administration could boost import prices and thus headline inflation. Shortages and bottlenecks could further exacerbate an already unfavorable global trade situation. Even before trade tensions arose, global trade had slowed sharply. The year-on-year rate of export growth slowed from a healthy pace of 5.8 percent in January to just 1.1 percent in March.

To guard against having to play catchup with inflation and to maintain a course of monetary policy normalization, the Federal Open Market Committee (FOMC) of the Federal Reserve has raised policy interest rates twice so far in 2018. Market participants for the most part have taken this in stride, although there does seem to be growing concerns that Chairman Powell might become overzealous in an effort to prevent the recurrence of overly inflated asset prices. In his press conference following the June FOMC meeting the Federal Reserve chairman stated, “It’s worth noting that the last two business cycles didn’t end with high inflation. They ended with financial instability, so that’s something we need to also keep our eye on.” He went on to add, “I’m really committed to staying in our lane on things. We have very important jobs assigned to us by Congress and that’s maximum employment, stable prices, financial stability.”

A combination of concerns regarding a less favorable monetary environment along with pressure on liquidity, rising inflation and trade tensions has taken its toll on bond performance in the first half of 2018. The ten-year U.S. Treasury bond yield pierced 3.0 percent earlier in the year on worries about inflation and the projected growth of the federal deficit without the Federal Reserve as a ready buyer of government securities. With the rise in interest rates U.S. and other equity markets have seen a good deal of volatility this year and corporate borrowing costs have risen. Even with this, however, earnings have held up, supporting a continuation of corporate stock buybacks.

Buybacks & Dividends

Looking Ahead

In addition to the transition away from the extraordinary conditions that defined the post financial crisis decade, consensus is increasingly pointing to the arrival of the late stage of the economic cycle. With so many moving parts, it seems an appropriate time to weigh the rising risks of inflation, tighter monetary policy and greater financial market volatility alongside the continued rewards of economic and earnings growth as well as high consumer and business confidence, particularly in the United States. Although the immediate prospects for the U.S. economy are generally favorable, tightening in the labor market and the impact on inflation expectations could put further upward pressure on interest rates. Over time this will impact economic activity, especially capital investment. Both top-down and bottom-up analysis suggests continued strong earnings growth. The Thomson Reuters forecast for second quarter S&P 500 earnings growth is 21 percent, following 27 percent in the first quarter. The forecast for the third and fourth quarters of 2018 is 23 percent and 20 percent, respectively. A crucial question is whether expectations are getting set too high and when will investors anticipate the inevitable inflection point in earnings momentum. The answer now is complicated by the impact of tax reform on earnings and the future effect of trade/tariff issues, rising labor and input costs, the strong dollar and rising interest rates.

While there are many variables that complicate the earnings picture, there is one that is not complicated at all, corporate buybacks. Corporate stock buybacks have reached unprecedented levels with an estimated 80% of total U.S. stock market buying coming from corporate buybacks or mergers and acquisitions. Buybacks were first supported by low interest rates, then bolstered by the uncertainty around capital investment and now supported by cash repatriation via the tax reform package. When corporate buybacks begin to slow one of the most significant pillars of US equity market outperformance will come into question. Until that time, it remains a significant and important source of U.S. equity market resilience.

Keeping an Eye Out for Strong Fundamentals and Absolute Value

There is no more valuable time for a disciplined investment approach than during periods of transition. As we maintain our investment discipline, we believe that the growth outlook for investment favors regions with the potential for low inflationary above-trend economic growth, continued accommodative policy settings and corporate margin expansion. This puts emerging markets and Japan, in our view, ahead of the United States and Europe in the cycle pecking order. In the past few months, emerging market assets have been maligned by some analysts for fear that a strong dollar and rising U.S. interest rates will see capital flows exit the asset class. Some commentators, content to dig up their stories from past bouts of emerging markets weakness, are using the asset class as a punching bag and headline attention grabber without distinguishing between countries and regions.

From our analysis of the data, not all emerging market borrowers are as vulnerable to a rising dollar as they once were. Many countries have reduced their current account deficits and are less dependent on fickle portfolio flows. More reliance is being placed on foreign direct investment (FDI), which historically has been amore stable source of funding. In general, emerging market basic balances—current account position and FDI flows—have improved in every region.

As for emerging market companies, they are less exposed to an appreciation of the U.S. dollar than investors might realize. For many companies their export revenue is denominated in dollars which acts as a natural hedge against their dollar liabilities. Moreover, a rising dollar can boost companies’ margins which translates to higher cash flow and creditworthiness. Some companies keep their liabilities manageable by hedging them back to their home currency. It is also important to note that emerging market high-grade corporates in recent years have been less volatile than their U.S. counterparts. This reflects the fact that these assets tend to attract larger institutional investors with longer investment horizons.

Conclusion

The uncertainties facing the global economy and implementation of macro-policies are likely to translate into higher volatility in financial markets. Therefore, it is increasingly important to manage overall portfolio risk and pinpoint solid investment opportunities. This means taking advantage of the more attractive interest rates available in high quality, short term bonds and using broad downturns to pick up assets with solid long-term growth prospects at attractive prices. The luxury of having a long-term investment horizon affords an opportunity to add value in fundamentally strong asset classes where future returns are enhanced by a disciplined portfolio strategy.

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