Byron Wien: Us versus Them
Economic progress continues in the United States, making the current expansion likely to be the longest since World War II. While investors might be expecting signs that the economy’s momentum is losing its mojo because of its duration, the data coming in is some of the strongest we have seen in this cycle. Recent reports on employment show a continuing expansion of the workforce, a strong increase in average hourly earnings and real Gross National Product well in excess of 3%. In spite of this evidence of economic growth, interest rates and inflation, while increasing, remain relatively low. As a result of reduced taxes and increased spending on defense and infrastructure, the Federal deficit is rising. So far, however, the impact on interest rates has been small. Critics worry that the increase in Federal debt will eventually cause interest rates to rise sharply and stifle housing and capital spending, but that has not happened yet.
Meanwhile, the economic news across the rest of the world is not so favorable. In Europe, where the economy was growing at close to 2% last year, business activity has tapered off. The United Kingdom faces growth of 1%, compared to a level of twice that before the Brexit referendum. In the final Brexit outcome, I expect that the European Union will avoid placing punitive trade measures on the U.K. because both sides would be hurt and they are already vulnerable. Nonetheless, whatever deal is finally negotiated will restrict travel and have a negative effect on the U.K. economy on a continuing basis. Higher tariffs imposed by the United States, plus a natural softening of demand both internally and from China, have caused Europe to slow. In addition, financial problems in Italy have weakened the banks in France and Spain. While the European financial system and the European Union are likely to survive this over the intermediate term, the problem is more serious than the Greek crisis of several years ago. At the beginning of the year, Chinese leaders wanted to slow their economy down somewhat to deal with the non-performing loans on the books of their banks and shadow banks, but demand slackened more than they expected. The renminbi weakened and capital outflows increased. The government has cut taxes and increased monetary expansion to shore up the economy. In Japan, monetary policy continues to be accommodative to maintain growth at 1%.
In addition to all of these economic challenges, the geopolitical environment remains problematic. Extreme political parties are gaining influence in Europe and leaders like Angela Merkel in Germany do not have the power they once enjoyed. The refugee crisis has been a huge source of humiliation for countries in North Africa and the Middle East. War continues and casualties mount in Syria, and an escalation of hostilities against a rebel enclave is being threatened. The Taliban is gaining strength in Iraq and Afghanistan and our relations with Iran and Russia are increasingly strained. The increase in tariffs imposed by the United States on our trading partners has made diplomatic relations across the globe more tenuous. The major question confronting investors is whether the U.S. equity market can continue to move higher when the rest of the world is experiencing an economic slowdown, political turmoil and trade disputes.
To put all of this into context, let’s start with valuation. Currently the Standard & Poor’s 500 is selling at 17 times earnings, substantially below the peak multiples reached at the end of the last century or in 2007. Using my dividend discount model (which is based on the concept that stocks compete with bonds and that as the yield on fixed income rises equities become less attractive), the index is now slightly above equilibrium, or fair value. In terms of sentiment, investors are optimistic, but not as euphoric as they were in January. These factors would argue that the market could move somewhat higher, but that a major surge is unlikely.
As for whether the U.S. market can make further progress when the rest of the world is slowing, looking at some earlier periods might be useful. During the mid-1990s, according to Strategas Research, the emerging markets declined 33% and European stocks were down 20% but the U.S. market stayed reasonably flat. The S&P 500 dipped more in 1997–98 when the emerging markets collapsed as a result of the Asian currency crisis. So, weak markets elsewhere in the world don’t necessarily have a negative impact on the United States. If the economies of Europe and particularly China weaken seriously, that could have an impact because S&P 500 companies generate more than 40% of their earnings from abroad. That is especially true for the large capitalization stocks that make up the index. Small cap stocks tend to get the largest share of their earnings from domestic sources.
One of the most important tenets of my current view is that the next recession will probably not occur until after the election in 2020. This conclusion, which has nothing to do with whether or not Donald Trump will be re-elected, is based on our analysis of fundamental economic and market factors and the warning signals they have given in the past. For example, the U.S. has never experienced a recession when corporate profits have been increasing, and this is the current trend that is expected to continue in 2019. S&P 500 earnings are projected to be up 20% in 2018 and 7% in 2019. Also, there has never been a recession in the U.S. when the leading indicators have been rising, as they are now. Even when they turn down, there is usually a lead-time of a year or more before the economic decline starts. The stock market may anticipate the downturn and begin to weaken well before the recession starts. Average hourly earnings have moved up to a 2.9% increase year-over-year, but that is still a long way from the 4% annual increase that has proven to be a warning signal for more inflation and more Fed tightening in past cycles. Strategas maintains a bull market checklist of factors that usually appear before a decline in stocks commences. It includes a surge in volume as the market makes a new high, heavy inflows into equity mutual funds, a big pick-up in merger and acquisition activity, a heavy calendar of initial public offerings, rising interest rates, weakening earnings revisions, a declining number of new highs in the market, a move towards defensive leadership and widening credit spreads. All of these were evident in 2000 and 2007. Only heavy merger and acquisition activity is evident now.
A variety of indicators suggest the economy is actually gaining momentum. Consumer confidence is high, boosted by rising employment and higher wages, and as a result, retail sales are strong once again. Job openings at small businesses (which account for 70% of total employment) have reached an all-time high and higher wages are expected there as well. The Manufacturing Purchasing Managers’ Index is still strong, and while some observers fear it is topping, there is no clear evidence of that occurring. It has had readings this high in the past without a recession being imminent. Unemployment claims are the lowest since 1969. Inflation as measured by the personal consumption price deflator is still below 2%. The most recently reported median household income has risen to $61,000.
On the negative side, light vehicle sales are weak and housing starts have been erratic, partly because of affordability. The Federal Reserve is continuing to raise interest rates, but the yield curve is not likely to invert over the next year. The big question is, what will the Fed do next year when earnings growth slows while inflation is rising?
At the beginning of the year, I expected the dollar to be strong. My thinking was that United States interest rates are higher than those in Europe or Japan, our growth is stronger and we have always paid our sovereign debt. After a slow start, the dollar has strengthened. This has created problems in the emerging markets, many of which have obligations in dollars and also buy goods from the United States. This has also caused economic problems in China, which as the second largest economy in the world is probably no longer an emerging market. In China, industrial production is flat and retail sales are down. Hopefully the upcoming talks on tariffs and trade will ease tensions there. China has been an important factor in world growth and, while it is still showing GDP increases at 6%, any loss of momentum is significant.
Investors are always looking for assets that have lagged the overall market and have reached a point where the fundamentals indicate a reversal is near. The strong dollar and weakness in the major industrial countries has hurt the emerging markets, but Joe Zidle has taken a hard look at whether a buying opportunity is at hand.
After peaking in January, emerging market equities officially entered bear market territory in early September. Declines of this magnitude in EM aren’t unusual: since 2008 there have been seven periods when the broad emerging markets index declined by 20% or more. Over the same period EM equity has underperformed nearly all other major country and regional equity indices with the exception of Japan. EM debt has fared better this year, experiencing a peak to trough decline of a little over 4% and has produced less volatile results. The Bloomberg Barclays Emerging Market USD total return bond index has been down only one year since 2009.
But the recent volatility in emerging markets coupled with the underperformance has investors wondering if they should allocate there at all. Asset allocators would argue that the combination of EM debt and equity exposure provides an opportunity to diversify a portfolio and thereby potentially reduce risk. Perhaps a more compelling answer is that long-term growth prospects in EM are too great to ignore. Economically speaking, there are several ways for any country to compete globally: (1) attractive demographics, (2) productivity growth, (3) low cost of production, or (4) rich natural resources. Many emerging markets have three or even all four, but virtually no developed market has more than one.
Oftentimes a bullish secular story becomes overshadowed by shorter term forces and the resulting market decline carries with it its own set of fears. This pullback in emerging markets is no different as investors worry over trade tariffs, U.S. Fed policy and the strong dollar. Some countries are more exposed than others – particularly those with the most USD debt outstanding – but all countries were punished in the sell-off that occurred this year. According to the Bank of International Settlements, EMs have approximately $3.7 trillion in USD debt, with Turkey, Mexico, Argentina, Indonesia and Saudi Arabia the most prolific issuers from the perspective of USD debt as a % of their GDP. The dollar may end up remaining strong to the detriment of those that gorged most on USD debt in the era of quantitative easing. Valuations would, however, argue that the market has discounted a significant portion of the risk to the entire group: the forward price to earnings ratio of EM is around 10.6 today (using fiscal year 2019 earnings estimates) compared to an average p/e of 13.2 since 2000. This time last year the p/e was over 500 basis points higher. Historically, a valuation at these levels or lower tends to be fairly good for EM returns, averaging about 21.2% twelve months later vs approximately 14.1% for all rolling 12-month periods inclusive of dividends.
We would advise investors who are interested in emerging markets to be ready to enter the markets either via the public models or private alternative investments. While the direction of the next 5% move might be difficult to predict, most of the damage appears to be done.
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The views expressed in this commentary are the personal views of Byron Wien and do not necessarily reflect the views of The Blackstone Group L.P. (together with its affiliates, “Blackstone”). The views expressed reflect the current views of Byron Wien as of the date hereof,and neither Byron Wien nor Blackstone undertake any responsibility to advise you of any changes in the views expressed herein.
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