My former boss, US asset manager John Angelo, used to say that the best explanation for short-term movements in the stockmarket was that there were “more buyers than sellers”, or the reverse. Media analyses were nearly always nonsense: “fake views” as opposed to fake news.
The popular narrative for the past 15 months has been to attribute market and currency turbulence to a rotating litany of Trump, tariff wars, Brexit and China, as if markets were slaves to geopolitical events. James Ferguson of MacroStrategy offers a more profound analysis.
The liquidity squeeze
In a note written in January 2018, “Winter is coming”, he warned that the reversal in the US of “quantitative easing”, or money printing, combined with the upwards path of interest rates over the next two years as projected by the Federal Reserve, would hamper growth.
Yields on US government bonds, then rising steadily, would drop as the economy slowed, while equity markets would switch from “risk-on” to “risk-off” – investors would become risk-averse and markets struggle. In the US, economic activity would be bolstered by growth in bank credit, but the eurozone, where banks have not recovered from the financial crisis, would be in trouble.
A year on, those predictions have been vindicated. The US economy is slowing, the eurozone is heading for recession, bond yields have retreated and equity markets have struggled.
David Bowers of Absolute Strategy Research, whose views have also been prescient, warns that trouble may not be over yet. Growth in the global money supply has slipped to levels last seen in 2008. “The monetary squeeze is not yet reflected in the global economy or markets,” he says. The Federal Reserve is changing course on monetary policy: no further increases in interest rates are expected.
The European Central Bank will no doubt inject liquidity, but Bowers fears it is too slow. “The longer it takes for the plunge in monetary growth to change, the greater the risk it spills over into corporate credit. The window for action by policymakers is narrowing.”
A crisis without a name
A broader issue is that “this crisis hasn’t got a name yet”, says Bowers. A crisis ends with a financial blow-up that gives it an identity, and there hasn’t been a major casualty yet.
Charles Gave of Gavekal, who warned last July that “a worldwide recession is becoming more and more probable”, is very cautious about equities. While he sees “almost no risk of the US cratering into recession” and points to an upward turn in Asian data, he is very concerned about the eurozone, where leading indicators of economic activity indicate recession.
“This will cause the budget deficits and debt-to-GDP ratios of France and Italy to shoot up,” while “what the European Central Bank would do under that scenario is anyone’s guess”.
Bowers also forecasts trouble in the eurozone, noting that the near-halving in the share prices of European banks is not going to encourage them to lend, while Gave continues to advocate avoiding financial stocks “everywhere”.
Bowers also warns against being complacent about the US market. “The probability of a recession in the next two years is rising” and earnings forecasts are being cut, though not as aggressively as in Europe.
China will bounce back
US investment strategist Ed Yardeni turned cautious on US profits last November. He pointed out that after the tax-cut-fuelled growth of 23% in the operating earnings of the S&P 500 in 2018, analysts became too optimistic. “I can’t see margins going any higher,” he says.
He forecasts earnings growth of 4.9% in 2019, compared with a consensus estimate of 8.6%, followed by 5.3% in 2020 against 10.4%. This means that the US market is on less than 16 times forward earnings: reasonable value given that the yield on ten-year government bonds has dropped to well below 3% as inflation pressures have eased. Other markets are much cheaper, which should limit the downside, but tight money, slowing growth, and falling earnings estimates are not a recipe for a bull market.
While the official data showed that Chinese growth had slowed to 6.6% last year, most independent economists think the true number is less than half that figure. Bowers sees Chinese monetary growth picking up, leading to better growth in the second half, while Gavekal thinks it is in both Trump and Xi Jinping’s interests to seek a resolution to their trade dispute. This would enable Trump to turn his attention to the EU, in particular the food and automotive sectors. Gavekal thinks the imposition of a 25% tariff on US imports of cars from the EU is likely.
The good news is that an upturn in global real monetary growth in the second half of 2019 should be positive for equity markets and boost the world economy. The bad news is that it may take a financial shock to force the hand of central bankers, whether it is, as Bowers suggests, a significant deterioration in corporate credit, or, as Gavekal thinks, another eurozone crisis.
There is a good chance of some sort of crisis, just not the Trump/China/Brexit one that many are expecting. If it comes, investors should bear in mind Nathan Rothschild’s dictum: “buy on the sound of cannons”. Don’t let a good crisis go to waste.