“I Don’t Know Why I Go To Extremes”
– Billy Joel, 1989
The market has been on a wild ride. December 2018 was the worst December for the S&P 500 since 1931. Then, the first quarter of 2019 was the best first quarter in over 20 years. From sentiment to markets to economic data, there are a plethora of opposing extremes.
Strong U.S. equity market returns (S&P 500 returned 13.65% for the first quarter) have been fueled by a rebound in multiples, as earnings estimates have been declining. On a U.S. dollar basis, several foreign markets have risen even more than the U.S., notably China, Italy and Canada. Most major markets are up between 5% and 15% and no major market was in the red for the first quarter.
Global Macroeconomic Backdrop
Global growth slowed in 2018 with several factors contributing. Chinese credit growth fell steadily over the course of the year. China is now the most important driver of global credit flows. Also, the global economy was rocked by rising oil prices. Brent rose from $45/bbl on June 21, 2017 to $86/bbl on October 3, 2018. Finally, government bond yields increased. For example, the 10-year U.S. Treasury bond yield increased from 2.04% on September 7, 2017 to 3.24% on October 8, 2018. The subsequent end-of-year decline in yields was accompanied by steep stock market corrections and widening credit spreads. This led to tighter financial conditions, further hurting growth. At this point and for the most part, these negative forces appear to be behind us.
More recently, financial conditions have eased; oil prices have rebounded from a steep year-end decline, but are still well below the 2018 highs, and slowing China growth will likely bottom around mid-year. As a result, global growth should improve. In contrast to 2018, we believe growth outside the U.S. could exceed expectations, while domestic economic data may disappoint.
China is now the largest driver of global economic growth and 2018 was an incontrovertibly weak year for the second largest economy in the world. While trade issues may have had some impact, most of the weakness in the Chinese economy can be traced to a deleveraging campaign which started in 2017, long before recent trade sanctions and trade war angst. The good news is Chinese credit growth has typically reaccelerated whenever it has dipped toward trend nominal GDP growth, which is probably where we are today. It is increasingly likely that credit growth deceleration has bottomed. The six-month credit impulse has already surged and the 12-month impulse should begin moving up if current month-over-month credit growth maintains its trend line.
We think Europe may be the standout performer of the year relative to expectations, not necessarily a common view. Most investor surveys rank Europe last or next to last with regard to 2019 performance expectations. While the deterioration in European stock markets captured attention last year, slowing economic data had already foreshadowed the declines. Slower global growth, higher oil prices, and a spike in Italian bond yields all contributed to poor performance in European economies last year. Economic activity was further hampered by a decline in German automobile production following the introduction of more stringent emission standards. These headwinds are set to reverse. Italian bond yields are well off their highs, as are oil prices. German automobile production is recovering. In addition, the European Commission expects the euro area fiscal thrust to reach 0.40% of GDP this year, up from 0.05% of GDP last year. This should add about half a percent to growth. Finally, if our expectation that Chinese growth will improve proves correct, European exports should benefit.
Now onto the U.S. The U.S. added only 20,000 jobs in February, against a consensus expectation of 180,000. Economists had been expecting a slowdown, but the deceleration has been more than anticipated. As a result, the Citigroup U.S. Economic Surprise Index, which measures economic data relative to consensus estimates, has fallen to an 18-month low.
Weaker U.S. economic news may actually be better news for stocks. If U.S. growth underperforms expectations relative to other regions, the U.S. dollar will weaken. A weaker dollar will likely lead to easier financial conditions, and easing financial conditions have a high correlation to positive stock returns. In fact, post the Global Financial Crisis, the correlation between S&P 500 returns and financial conditions is roughly 85%, as shown here.
We do not expect a U.S. recession in the near term despite irrefutable signs of a slowing domestic economy. Jobless claims are about flat compared to a year ago which is generally associated with trend growth and a neutral Fed. Moreover, the 12-month change in the unemployment rate, a telling business cycle indicator, is also flat for the last ten months, a further indicator of trend growth.
Credit quality typically deteriorates late cycle, as rising costs, both labor and interest, impair companies’ ability to service debt. In 2018, despite accelerating wages and rising interest rates, coverage ratios actually improved with 49% of companies paying down debt, the highest ratio since 2010. Generally, corporate savings rates decline leading into a recession.
Finally, high profit margins prevalent today are also inconsistent with the onset of a recession. A recession will come, but likely not in 2019. Some economists have already pushed their recession forecasts past 2020. We’re not ready to go that far.
One of our thematic strategies is to exploit the undervaluation of intangible assets. The asset base of U.S. companies has shifted from a largely physical world into a virtual realm. In the 1990s, publicly-listed companies spent less than 40 cents on research and development (R&D) for every dollar invested in capital spending. Today, it’s 63 cents. Many of the tools and heuristics that investors (still) rely on were developed when physical assets represented most of the return-generating capacity of the economy. Those tools are less reliable today.
While there is increasing recognition of the importance of network effects, access to big data, intellectual property and other intangibles, recent research indicates that the recognition is still not being fully reflected in valuations.
Fundamental analysis typically involves constructing financial models to forecast near-term revenue and earnings for companies. Analysts then apply a multiple to earnings to derive price targets. In our view and based on research, this type of analysis systematically undervalues companies with higher concentrations of intangible assets. Intangible assets usually result from spending that is expensed as it occurs. This weighs on near-term earnings during the creation of a long-life intangible asset. In contrast, spending on traditional fixed assets such as buildings and machinery is depreciated over the life of the asset. As a result, near-term earnings are a particularly poor measure to explain market valuations of firms with high intangible-intensity, because these earnings do not necessarily reflect the value-creating potential of intangible assets.
The above chart highlights that over the last 50 plus years, earnings have become less relevant as an indicator of value, and this is particularly true for companies with higher intangible-intensity. At the same time, not all R&D spending is equal. The first chart below shows that over the past 40 years, incremental R&D spending has produced less and less return on investment. While the second chart shows that when the R&D spending results in patents, firm market value has increased markedly.
Less value is being placed on overall R&D spending while more value is being attributed to the tangible by-products of R&D. The analysis uses patents as a manifestation of intangible assets. The investment conundrum is the disconnect in time between R&D spending with less than favorable accounting treatment and resulting patents with long-lived but downstream earnings. This is the investment opportunity we are focused on. It is particularly important in the U.S. where innovation and invention are preeminent while manufacturing and physical industries have moved abroad.
We expect U.S. economic growth to fall short of expectations and most major foreign economies to exceed expectations. In the U.S., the profit share of national income appears unsustainably high, equity valuations are demanding, and monetary and fiscal policies make further multiple expansion unlikely. None of this is true in non-U.S. equity markets. In fact, many international markets are no higher today in U.S. Dollar terms than they were 20 years ago. We believe this contrasting pattern between U.S. and global markets, shown in the chart below, will begin to reverse. As a result, we have reduced our U.S. overweight and increased exposure to other developed markets.
In the U.S., we expect growth to outperform value. Growth stocks tend to outperform when economic growth is scarce because growth companies are less reliant on the economy to generate revenue growth. As long as economic growth remains sluggish, the growth premium should remain intact. Cyclical sectors like Financials, Materials, and Industrials, which dominate value indexes, are among the most sensitive because their earnings tend to be tied to the economy. Sluggish growth also implies that yields will remain low and the yield curve relatively flat. The sector most negatively impacted by a flat yield curve is Financials, because tight spreads between short-term borrowing costs and long-term lending rates crimp profits.
Growth has been in a long-term secular uptrend relative to value since 2006. That is the longest run on record, leading to the obvious question of when will it end. The problem for value is that the conditions that have favored growth – sluggish economic growth, an accommodative Fed, and a secular bull market – remain in place.
This is the first year in recent memory without widespread predictions of higher bond yields in the U.S. For at least the last four years, fixed income strategists have called for the U.S. 10-year Treasury bond yield to rise to 3.5% or higher. We have consistently expected U.S. bond yields to fall short of consensus expectations and despite the recent decline in expectations, we still do. Due to aging demographics and continued risk aversion demonstrated by consistent fund flows out of equities and into fixed income, we don’t see a near-term scenario that supports significantly higher U.S. bond yields.
Since the start of the equity bull market, investors have withdrawn $329 billion from domestic equity funds and invested $1,941 billion in bond funds. The flight to safety is not just a U.S. phenomenon. Globally, there is somewhere between $9-$11 billion of negative yielding debt today, or about 22.6% of total global debt. This means investors are literally paying banks to hold their money.
The U.S. 10-year Treasury yield ended the first quarter at 2.41%, 28 basis points lower than the start of the year. Portions of the yield curve have slightly inverted with the 3-year Treasury yielding 2.2%, while the 3-month T-bill and 10-year Treasury are both at approximately 2.4%. An inverted yield curve is one indicator of recession, but the average duration between yield curve inversion and recession is about 12 months. So far, the inversion is relatively mild and is only occurring along parts of the curve. If it were to steepen, we would be defensive.
Recently, we have found interesting opportunities in both the municipal and investment grade corporate markets. We believe both munis and corporates offer better after-tax returns than Treasuries.