Rudi's View | Mar 21 2018
In this week's Weekly Insights (published in one single edition this week):
-What Chance Of A Big Correction?
-No Weekly Insights Next Two Weeks
-An Evening With Rudi – Sold Out
-Finance Ruled By Self-Interest & Bias
What Chances Of A Big Correction?
By Rudi Filapek-Vandyck, Editor FNArena
Two things happened last week. I had quite an elaborate telephone conversation with a worried investor, let's call her K, after she'd read about a prediction that global equities might be poised for a -43% sell-down, and she since felt very uncomfortable with having her money in the share market.
Then another subscriber, Martin, who's a professional working in the local finance industry, sent me a message in which he confided to be "very confused".
The world economy is growing, Martin observed, with the USA a standout. More people are working, less tax is being paid by corporations in the USA, and some of the tax savings will flow into workers pay. The majority of companies in the USA and locally have been reporting improving returns. Interest rates are rising, but only gently, Central Banks are easing QE while inflation seems under control. Et cetera
Yet market commentators continue to predict a major correction to equities in 2018.
Martin asks: Why does improving economic conditions equal a correction? Is this more about the length of time that the bull run has been going that makes all these voices say it can't go on forever? Your truly a confused Martin.
Both events combined have inspired me to write the response below.
The share market is, above anything else, a mix of conflicting emotions, in particular when assessed on a short term scale. Sometimes even a hint of potential risk on the horizon can set off a stampede of money fleeing onto the sidelines, as has happened on many an occasion, but that's simply the emotional side that makes anything involving human sentiment transitory and unstable by definition.
For temporary share market weakness to morph into something much more sinister we need a lot more ammunition than simply human emotion. There needs to be a genuine prospect of economies facing a recession, or for corporate profits to wither, or for a military conflict to break out, or something of equally severe negative impact.
The global economy is experiencing a rare synchronised move upwards with all major economic regions improving, for the first time since pre-GFC, supporting global GDP at a level not seen for a long while. This is reflected in corporate profits and margins which, around the world, are in the healthiest shape for a long while. But asset prices are far from cheap, while the era of exceptional, abundant liquidity is coming to a close.
Already, the Federal Reserve is reducing its balance sheet and lifting the official cash rate with other central banks expected to follow.
Arguably, risks have been rising all throughout 2017, but sometimes investors simply don't want to pay attention. I think it was the prospect of the corporate tax cut in the USA that outweighed just about everything else. Now that those tax cuts are in place, and we all come to the conclusion that any infrastructure program will be long-winded and medium-term at best, while geopolitical tensions are rising, as well as political risk inside and outside the White House, we are left with many reasons to feel less confident about the outlook, and maybe pay more attention to potential booby traps.
Many a share market commentator tends to refer to healthy economies when asked about the direction of share markets, but history shows there is not a strong relationship between the two. One reason as to why is because financial markets try to look forward, into the future. So it matters a lot less about what is now, or even tomorrow, and a lot more about what we, collectively, think/hope/fear might be on the horizon.
Back in early 2008 global markets were selling off and Goldman Sachs came out with the bold prediction the US economy was descending into recession. At that time, global growth seemed solid, corporate margins and profits were on a high, but three quarters down the track Lehman Bros folded and the US and the global economy were staring into the abyss.
This time around the Federal Reserve is intent on removing the excess policy stimulus that has supported financial markets post-GFC, and a lot has changed since the last tightening cycle. From demographics to technology, from ultra-low interest rates for an extended period of time to populist, strong-man politics overpowering democracy, and so many new elements in between. Typically, equity investors are not used to having to spend a lot of time wondering what global bond yields might do, and what the potential implications might be, and they feel uncomfortable about it.
Look no further than the many predictions that inflation is about to break-out; that bond yields are on their way to 4% (from below 2.9% now); that elevated asset prices will de-rate (if not deflate); that gold is back as a safe haven, together with cash; that government bonds are now in a bear market and the only way forward is down in price, and up in yield; that the technical picture is deteriorating for equity markets; that the sell-off in crypto currencies is a harbinger of what is about to happen to other risk assets; we have yet to see the global debt bubble burst, et cetera, et cetera.
Two certainties we have, apart from the usual ones about death and taxes: most of these predictions will be proven wrong. This, however, won't prevent investors to bebeing less sanguine about the outlook this year because even the most ardent bull will have to acknowledge that, overall, risk is on the rise.
Asset prices are not cheap. But we need a major change in the landscape to pull equity markets down by -20% or more. What can it be?
The biggest fear among investors is that inflation is making a come-back and thus more central bank tightening will be necessary; this pushes up bond yields, creating ever stronger headwinds for equity valuations. It also brings forward the idea that at some point the Fed Funds rate will reach its neutral level, meaning the next hike will be the one step too far.
History shows us central bankers always move one step too far. Firstly because monetary policy works at great delay, it's not an exact day-to-day framework with immediate impact. Secondly, economies are fluid. All we know today is the neutral rate setting is a lot below what it used to be. But we don't know exactly what it means, neither where exactly the new neutral is located.
It cannot be denied inflation in the USA is rising and bond yields have risen in response. But equally important: this does not imply the next step is a break-out with the Federal Reserve scrambling to stay in control. The best description I have come across, and I believe it's from economists at Citi, is that financial markets have been pricing out the death of inflation.
Previously, financial markets were focused on deflation, with central bankers putting in their might to retain some sort of price inflation into the global system. Financial markets have now accepted that inflation is not completely dead and buried. This is all that has changed over the past six months or so.
It doesn't mean one-way traffic for bonds. It doesn't mean inflation is about to explode. It doesn't mean, by default, equity markets are poised for a big correction. There is a lot more impacting on and inside today's economies to make the present sufficiently different from the past. But fear is an important driver, it can be all-consuming under the wrong circumstances and with so many market participants unsure about what exactly is the trajectory of inflation in the US, nobody should be surprised market volatility has made a come-back with a vengeance.
My view is too many commentators and experts too eagerly predict inflation will only move higher from here. Note global bond markets are not reflecting any such scenarios. This even to the dismay of central bankers like RBA Deputy Governor Guy Debelle who likes to think the battle against deflation has been won, and bond markets should be more reflective of potential upside risk.
Bond markets can be wrong, just like equities. A popular saying is that bonds have successfully predicted the last few recessions more than 15 times. They might be proven wrong tomorrow. After all, it wasn't that long ago economists in Australia were tripping over each other to predict the next RBA rate hike and local bonds were reflecting just that.
Those same economists have gone eerily quiet. Forecasts about Melbourne Cup day 2017 rate hikes, or February-May 2018, have proved to be unquestionably wrong. Most forecasts are shifting into 2019, sometimes into late 2019. In financial markets, just like in daily life, the speed and timing of events is of crucial importance. Australian bonds today are suggesting the RBA is in no hurry, with plenty of time on its hands, and no disaster scenarios, like a return to the high yielding eighties, should be on the agenda.
Equally important, the opposite scenario remains just as valid. There is an argument to be made global economic momentum peaked late in 2017, and there's now an underlying shift towards a decelerating pace. Look no further than, for instance, to the recent changes in predictions for Q1 GDP growth in the USA by the Atlanta Fed.
Between last week and February 1st, that forecast for Q1 USA GDP has declined to 1.9% from 5.4%. This is a widely followed economic indicator by many a professional investor.
Under a not so favourable scenario, global growth is now decelerating, also because China is putting more focus on quality. Were this slowing to extend, and to become front of mind for investors, while the Federal Reserve staunchly sticks to its tightening agenda, one can see how this combination can easily unsettle investors nerves.
Maybe today's bond market is balancing out the probabilities between these two opposing outlooks?
Finally, the world is swimming in debt and we now have a President in the White House who is likely to increase government debt and future liabilities even further. Plenty of worrisome analyses around also about what potentially can go wrong with highly indebted consumers in countries like Australia and Canada. Analysts at Deutsche Bank recently published a study into zombie companies. These are companies which cannot service its debt and only continue to operate with government support, and for as long as interest rates stay low.
After so many years of ultra-low interest rates, cheap money if you like, there is bound to be some unknown, hidden vulnerability inside the global financial system. Very few were aware in early 2008 there was excess in subprime loans and related derivatives originating from a fraudulent Wall Street, yet once the system tightened, weaknesses simply opened up more weaknesses.
It would be quite naive to think this time the transition will be nothing short of smooth. In this context, anti-volatility investment products blowing up in late January might as well serve as a canary in the coal mine. As the economic cycle matures and global liquidity tightens, there will be more of such sudden hiccups. That's almost a guarantee.
Yet, none of all this means equities cannot possibly climb the wall of worry for another year, though I am quietly confident 2018 won't be a repeat of 2016, nor of 2017. The best we can do is accept that risk is on the rise, and so will be market volatility and uncertainty.
It remains far too early to predict which of the scenarios will gain the upper hand in the months ahead. It may yet turn out the answer is: none of the above. That wouldn't be the first time either.
No Weekly Insights Next Two Weeks
Due to travel arrangements, there won't be a Weekly Insights next week. The following week turns Monday into a public holiday due to Easter, hence Weekly Insights shall resume in three weeks, on Monday April 9th.
It is my intention to write a Rudi's View in early April to break this rather long interruption.
Citi's US equities strategist Tobias Levkovich has put forward the idea that while the S&P500 might not necessarily have peaked for this cycle already, it's going to be tougher nevertheless for equity investors to avoid "performance frustration".
The strategist's suggestion is that sector rotation and shorter term trading strategies will be the panacea that heals all ills at a time when US equities can potentially throw up a lot more volatility for the remainder of 2018, though not necessarily also with a lot of gains to compensate for it.
In Australia, Morgans continues to provide its army of stockbrokers with plenty of ideas to keep the clientele happy. Morgans has selected three standouts which it believes offer exceptional value with share prices thought to be too cheap in the order of -20-25%. These three are (don't laugh) Telstra ((TLS)), Macquarie Atlas Roads ((MQA)) and Australian Finance Group ((AFG)).
Actually, Morgans refers to AFG Group but there is no such company listed on the ASX, and yes, we did check with both the ASX website as well as afgonline.com.au
The three standouts are part of the stockbroker selecting Key Buys post the February reporting season, further including: Sydney Airport ((SYD)), BHP ((BHP)), Kina Securities ((KSL)), Orora ((ORA)), CML Group ((CGR)), Wagners Holdings ((WGN)), Motorcycle Holdings ((MTO)), Noni B ((NBL)), PWR Holdings ((PWR)), Aventus Retail Property ((AVN)), Webjet ((WEB)), Lindsay Australia ((LAU)) and Emeco Holdings ((EHL)).
Morgans also selected Key Sells, motivated as companies having reported underwhelming results and where the stockbroker sees better opportunities elsewhere: Woolworths ((WOW)), QBE Insurance ((QBE)), Brambles ((BXB)), Santos ((STO)), Blackmores ((BKL)), Accent Group ((AX1)), Monash IVF ((MVF)), Virtus Health ((VRT)), National Storage REIT ((NSR)), Bega Cheese ((BGA)), Infigen Energy ((IFN)), and Range International ((RAN)).
An Evening With Rudi – Sold Out
No use in sending in any more inquiries, next month's An Evening With Rudi in Paddington has sold out. This has become quite the popular event. FNArena didn't have to address the full database to get all bums on seats.
We might inquire with a number of investors in the FNArena database to see whether there is sufficient interest elsewhere to possibly take this initiative beyond the boundaries of Sydney's eastern suburbs, but amidst tight schedules and plenty of things on my personal To Do list, this is one promise I simply cannot make.
But I'll try.
Finance Ruled By Self-Interest & Bias
Even the Romans knew it: if you lay down with dogs, you are likely to get up with fleas.
In the Australian financial sector this means it is extremely difficult to find intelligent, reasoned opinion that is not tied by vested interests. Cue the ALP's proposal to scrap the cash back component of the dividend imputation policy introduced by the Howard government in 2000, which has since become an integral part of the survival tactics employed by many a struggling retiree.
What is not on the agenda is that the Australian tax system should be updated, renewed and structurally reformed as many of current benefits and payouts, including the ATO's cash payback, are unlikely to remain sustainable longer term.
What is never touched upon, amid the loud and biased pamphlets and protests, is that generous and skewed tax benefits have lured retiree investors into sub-optimal investment strategies, effectively tying them up with ball and chain into capital loss generators such as Telstra in the share market, just like they once upon a time got caught up in dud investments in the agricultural sector, which were also supported and motivated by tax benefits.
The tax man should never engage in financial advice, but that's essentially what such unsustainable benefits amount to.
Anyone looking for a dividend oriented strategy today should take on board the knowledge that yield plus growth is, has been, and shall remain the superior investment strategy in the share market, but not one without the other. This has been a constant returning statement in my own analysis and observations stretching over many years, and there is plenty of third party research supporting the same conclusion.
I hereby submit evidence exhibit A from the recent investor presentations given by Janus Henderson. All one needs to know is both performance lines on the chart below show global equities and higher dividend global equities backed by growth.The latter (in red) wins the race hands down, even after falling substantially more during the GFC.
The same observation also stretches to a general consensus throughout the Australian financial sector, including journalists, throughout 2017 that a Royal Commission into the banking sector was an utter waste of taxpayer's money. What more could it possibly dig up than what was already public knowledge?
Well, this year, the Royal Commission has only just started and already it is clear the sector smells on many accounts. Once this Royal Commission releases its final findings it is but likely the sector will be covered in shame and the government and regulators forced to put in practice a much more stringent regime for the sector.
Consumers will be better off, one presumes, but for shareholders low expectations and being prepared for a lot more disappointment seems but the logical thing to do at this stage.
Last week's audio interview on changed dynamics for the Australian share market:
Rudi On TV
This week my appearances on the Sky Business channel are scheduled as follows:
-Tuesday, 11.15am Skype-link to discuss broker calls
-Friday, 11am Skype-link to discuss broker calls
Rudi On Tour
-An Evening With Rudi, Paddington, 11 April (sold out)
-Presentations to ASA members and guests Gold Coast and Brisbane (2x), on 12 & 13 June
-ATAA members presentation Newcastle, 14 July
-AIA National Conference, Gold Coast QLD, late June-August 1
-Presentation to ASA members and guests Wollongong, in September
(This story was written on Monday 19th March and it was published on the day in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website).
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