Monday’s remarks by Jerome Powell, Chairman of the US Federal Reserve, raised some eyebrows in financial circles. He stated “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect” and “Another sharp increase… could increase vulnerabilities appreciably”. These comments prompted some investors to draw comparisons to the mortgage crisis. The chart below shows US corporate debt to GDP levels, currently at a 30-year high of 50.1% (vertical axis), and it is alarming. Not only does the current reading exceed the Financial Crisis but the measure also exceeds readings reached during the debt-fueled technology bubble era. One major difference today is that during both previous crises, interest rates (yield-to-worst according to the Bloomberg Barclays US Corporate Debt Index) were near or above 8% whereas now rates stand at 3.6%. Powell did qualify his comments by adding that debt servicing costs remain low and debt growth is in line with GDP growth. Cold comfort unless rates remain structurally lower for longer.
US stock markets have continued to be roiled by ongoing US-China trade negotiations. Departing Washington DC last Friday, Beijing issued a strong statement challenging US demands for fairer trade. The core issue for the Chinese is that the US is forcing the Chinese to change their laws regarding intellectual property protection, dispute resolution enforcement, and mandatory joint ventures, among other issues. That is seen as an affront to Chinese sovereignty. Beijing needs to “save face”, avoiding being seen as a weakened nation from a domestic perspective and just as importantly throughout the region. To form a trade agreement with the US, China’s lead negotiator Liu He will have to concede on these points which will then form the template for other major trading partners such as Europe to follow. Beijing probably realizes that, by giving ground to the US now, it is only a matter of time before their decades-long trading advantages evaporate. While this major global event plays out, we expect more volatility and would not be surprised to see US stocks test or even trade through their long-term trends as depicted by this week’s S&P 500 Total Return chart.
Interest rate spreads in
the US High Yield bond market have risen recently after narrowing some 130
basis points since the beginning of the year.
While that is a concern, we point out that current readings are still below
trend. Comments from Pres. Trump over
the weekend regarding tariff increases in trade negotiations with China have
rattled stock and credit markets around the world and undoubtedly contributed
to the near-term widening of US High Yield spreads. How these negotiations play out towards the
end of the week are critical for the capital markets. Key components of the
earlier discussions – intellectual property protection, dispute resolution enforcement
and freer market access – may be in jeopardy or be diluted. That could lead to
economic disruption and derail the recovery in risk asset classes we have
experienced so far this year.
Bloomberg maintains a series of global and regional financial conditions indices that combine several key fixed income and equity market metrics such as interest rate spreads and volatility. Taken together, this data gives an indication of how benign or strained conditions are in the capital markets. Currently, the reading in the US is positive, indicating a benign environment for risk asset classes. It is important to recognize this indicator can maintain long periods of positive or negative readings but when it begins to move in a downward direction capital markets become stressed. US financial conditions could continue to remain in a positive state due to favorable economic trends — low inflation, accommodative monetary policy, strong productivity gains, high labor participation and robust GDP growth.
A little off-schedule so
we’ll call it the Chart of the Moment. Based on Standard & Poor’s indices,
the rebound in US technology stocks since the beginning of the year is an
impressive 27.8% while the overall equity market has advanced 17.5% through
April 24th. US technology
companies play a critical role in the American economy and the sector is the
largest in the US equity market based on capitalization. Further gains of US
equities overall largely depend on tech sector performance and valuation
readings are approaching historically high levels. We show the technology
sector along with its price-to-cash flow (P/CF) valuation metric. The current P/CF is 16.2 which is below last
March’s five-year high of 17.6 but still in an area where the sector has
struggled. We are currently in the midst
of the US earnings season, and if technology companies can continue to deliver
strong earnings and cash flow, share prices should advance further. (all data
citations as of April 24, 2019)
The Eurozone has faced several roadblocks to growth since the Financial Crisis ranging from the debt crises in Italy and Greece, to the uncertainty related to Brexit to stubbornly sluggish economic growth. We have been concerned that economic conditions on the Continent would strain corporate performance and therefore we have not been fully committed to Eurozone equities for quite some time even though the region has favorable valuations compared to global peers. Now there may be positive trends developing. This week’s chart shows Citigroup’s Earnings Revision Indices for Continental Europe and the Globe. The latest reading for Europe was flat while the World registered -0.12. Both indices appear to be trending towards positive revisions which could provide a key underpinning for further gains in global equity markets. If positive developments continue in the European corporate sector, investors may rotate funds into the region.
We’ve been proponents of Environmental, Social and Governance (ESG) investment disciplines going back long prior to founding WCM and it is one of our key investment offerings. A common misperception is that ESG-related investing is prone to significant underperformance due to limitations in order to achieve ESG compliance. This week’s chart shows the total return of the MSCI World ESG Leaders Index and the MSCI World Index over the past five years. Generally, the two indexes move in a similar direction and over the five year period ending last quarter the annualized performance differential is about 0.2% in favor of the broader index, but the performance differential is not persistent. This is the most naive way to look at ESG investing, but it decisively busts the myth that there is an automatic ESG penalty.
Purchasing Managers Indexes (PMIs) are now signaling expansion in two of the world’s largest economies as China’s reading joins the US measure in positive territory. China’s rebound from negative territory may be an early indicator that expansionary monetary and fiscal policies are beginning to take effect. That’s welcome news. However, the Eurozone PMI is continuing to deteriorate with disappointing results in the German and French manufacturing sectors. The lack of pro-growth fiscal policy in the EU is still a major drag on economic vibrancy. That said, European bourses have posted robust returns so far this year although not as strong as US counterparts.
After the conclusion of US Federal Reserve’s scheduled meeting, Chairman Jerome Powell said that the Fed has reduced their planned Fed Funds rate increases to zero for the year by a unanimous 10-0 vote. Additionally, he announced that they would begin slowing the pace of balance sheet contraction beginning in June from $30 billion to $15 billion per month and end the planned shrinkage by September. These developments were received favorably by stock and bond markets because it signals that accommodative monetary policy will be supportive of asset prices. Investors have been concerned over the past several months that the Fed had adopted an overly restrictive monetary stance while economic conditions in the US were exhibiting signs of softening which could lead to recession. This week’s chart comes to us from the Bloomberg Economics team and shows the relationship between real US GDP growth and the real Fed Funds rate along with recessions going back nearly 50 years. The point the team makes is that, historically, the economy has yet to head into a recession with the real Fed Funds rate at current levels, and it is not until this key rate exceeds real GDP growth that a recession follows. Those occurrences are highlighted in the circles on the chart and do appear to be an early warning of recessions. We may have a fair amount of time before seeing those conditions develop.
Since the S&P 500 bottomed on March 9, 2009 in the aftermath of the Financial Crisis, the index price has risen over three-fold and the MSCI World Index has doubled. Disappointingly, European shares have risen only one-third of the S&P’s price gain in the same amount of time and lagged global equities considerably. The question in our minds is whether this is a permanent condition or will European shares become competitive with other global equity markets. European equities do offer compelling valuation measures, particularly versus the US, but the macro pressures facing the Euro region, the uncertain outcome of Brexit and the absence of fiscal policy support may limit the price appreciation of shares in the region.