Come what may, just be prepared

  • Evidence of slower economic growth is accumulating across the globe.
  • Looking at the reasons behind the Federal Reserve dovish pivot makes us feel less sanguine.
  • Despite the short term optimism that the Fed will, yet again, save the day, one has to be always prepared for the worst possible outcome, just in case.

As equities continue to shatter resistance levels, bad news trickle through. Recall that one of the reasons for the recent market debacle was late cycle concerns and fears of slower earnings growth. Unfortunately, on that front, it's been a succession of bad news.

Evidence of economic slow down in both China and Europe is accumulating. In China, manufacturing activity in December contracted for the first time in 19 months and industrial profits contracted for the first time since 2015. Exports and imports have been growing less than expected and car sales in November contracted by 14% versus the previous year. And the foregoing is just a sample of the negative indicators that keep trickling through. China accounts for a significant chunk of global economic growth, so all such negativity does not bode well for the global growth outlook. In Europe, similar examples abound, starting with the European Commission's projection that economic growth will slow down to 1.3% in 2019 (from 1.9% in the previous year). This is partly due to global trade tensions and lower economic activity, mainly in the manufacturing sector, in major contributing countries (e.g. France, Germany and Italy).

In the US, which continues to hold the fort, we already know that economic growth is projected to slowdown from 2.9% to 2.5%. While this is still decent, chances are that, starting in the second quarter, we will begin to see evidence of an earnings slowdown. Robust earnings growth of 2018, on the back of a massive tax stimulus, will fade away. So as they start comparing 2019 earnings to those of the previous year, investors will be disappointed. Moreover, the capacity of corporations to leverage their balance sheets and keep buying back shares is not unlimited.

On the global trade front, the fact that the US is willing to extend the March 1 deadline is only an attempt to kick the can. Major issues remain unresolved and the conflict with China is way too deep to get settled that fast. As we repeatedly said, an agreement will eventually be reached but not so soon. The road will be long, tortuous and full of bumps.

Technically speaking, the S&P 500 is starting to look overbought, and is gradually losing momentum. This signals the possibility of a pull back although if it happens, we think such pull back would be temporary. Investors are still relishing the positive impact of the Federal Reserve's (Fed) so-called "dovish pivot", which in itself has propelled the market by a robust 18% since December. However, this gives reason for a pause. If we look at the main reason behind the pivot, we suddenly start feeling less sanguine.

If the Fed is signalling its willingness to ease on monetary tightening, that's because the economy is weakening. What's so bullish about that? Two things, albeit both (unfortunately) are short-term in nature:

First, other things being equal, lower interest rates make dividend and earnings yields of equities more attractive relative to other asset classes such as cash and bonds. Moreover, easier monetary policy increases liquidity in investors hands, which also props up demand for all investments, including equities.

Second, the hope is that the Fed, by easing monetary policy, will help prevent a recession and orchestrate a soft landing.

Both explanations are plausible. Problem is, economic and earnings cycles are inevitable, and this time it's no different. If we can avert a severe recession, that's only good for the near term but this boom cycle cannot go on forever. Sooner or later, something will bring it to a grinding halt. At this point, it is very difficult to tell what the next negative trigger will be, but as always, there are dark clouds on the horizon. Could it be China, with its massive structural issues and mounting debt? Or could it be Europe, with Brexit being just the tip of the iceberg? Or could it be the ballooning US deficit? Eventually, tax incentives will fade away, earnings momentum will slow down, and corporations ability to leverage and finance share buybacks will reach an end.

These are all serious concerns that one needs to worry about, although not necessarily now. In the short term, the Fed will, yet again, save the day. It still has a couple of rabbits to pull. At first, it will stop selling bonds. Then, it could launch another round of quantitative easing. The question is: will it be able to continue printing money indefinitely? Can it keep doing so without triggering inflation? The right answer to these questions holds the key to the future of equity and debt markets and the whole global financial system. Unfortunately, nobody has the answer to such question given we are in major uncharted territory here.

You could say that such major existential issues are for the future and that, in the short-term, one must (and can) only enjoy the ride. That makes sense as long as we do not lose sight of the bigger, longer term picture. With every short term market rally, the case for better preparation for the next setback becomes more compelling. Investing is not about guessing what the market will do next. It's about being prepared for various possible outcomes. Lately, we have seen major market setbsacks of 20%, 30% or even 50% every ten years or so. Are you sure you are prepared for that? Are you sure it will not financially destroy you if it happens, even if you think it is unlikely? After all, if the probability of an accident happening is only 10%, and the outcome of such accident would be disastrous, it is still something to worry about.

How to be prepared for the worst case is a subject we will take up in future updates, although this is something you should be discussing with your advisor at every meeting. The only thing we can do here is suggest key points for your discussions.

February 20, 2019

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