Tightening liquidity… are we closer than ever to the end of rate hikes?
Finally feeling the tightening liquidity. While the Fed has now been tightening for three years, we are now closer to the end of rate hikes. Moreover, Europe has now stopped bond purchases, leaving Japan as the sole bastion of quantitative easing. Liquidity conditions are now heralding the removal of financial repression and this will put the riskiest assets at risk of a dramatic repricing as safer assets now pay a yield.
Political gridlock means no fiscal boost. Though liquidity conditions have been tightening for two years now, much of the effects of that tightening were masked by pro-cyclical fiscal stimulus. While that certainly boosted the markets during the upturn, the unfortunate double edge to that sword means that global central banks will be at a loss for tools in the coming slowdown. Said another way, the extra liquidity made the party more fun but will also make the hangover more painful.
Valuation is key. The fourth quarter of 2018 began a series of repricing that favors better valuation and recognizes the tighter liquidity conditions as well as the importance of quality. We see value and defensiveness as the leaders of the coming phase in the cycle. That said, U.S. equities have finally repriced to attractive enough levels to support the earnings expectations for the coming year while the cheapest assets, namely emerging markets equities, still need to demonstrate more certainty on the policy front before re-emerging as a market leader.
Figure 1: Market Performance as of December 31, 2018
Market Review: Big Slide, Little Bounce
December started as the worst December since the Great Depression and 2018 finished as the worst year in ten years for stocks. Equities have been on a slide since the end of September as the midterm elections snuffed out any hope for additional stimulus measures. With Congress heading into what can only be expected to be constant political gridlock, equity investors began to discount expectation of slowing earnings as well as continued trade war concerns. The resulting multiple compression shaved 9.03% off the equity market on a total return basis in December. While equities saw temporary relief as they stabilized in the middle of the month following Federal Reserve Chairman Jerome Powell’s delivery of a bullish assessment of the US economy and the job market on the eve of the scheduled release of November employment data, the downward trend continued as trade pessimism resumed and investors proved dissatisfied with the result of the Fed meeting that had a less dovish tone than what was expected and hoped for. Chairman Powell suggested he’ll be more cautious about raising interest rates next year, disappointing investors who wanted even more dovishness. Rates were hiked 25 bps to 2.50% as expected at the meeting as well. Adding fuel to the fire, President Trump continued condemnation of Fed Chairman Jerome Powell and aggravated markets by discussing firing the Fed Chairman. Though valuations enticed some investors to dip their toes back into the market ahead of the Christmas Holiday, the 6.67% rally from December 24 through year-end only improved the final performance from -14.72% through December 24 to -9.11% for the whole month. Though, it did make the difference between -10.37% for the year through December 24 and -4.78% which is how the full year ended.
At the same time, the yield curve has taken a fantastically wild ride with the very short end rising to commensurate with the Fed Funds Rate, but the remainder of the yield curve falling by as much as 40 bps in the 2-year to 10-year segment of the curve. With macro data coming in softer than expected, the markets quickly revised expectations for future fed hikes down to one in the Fed Funds futures markets. The long end of the curve reflects a combination of slowing growth resulting from a normal cyclical slowdown combined with the tightening of financial conditions. The partial government shutdown ahead of the holidays and lasting through year-end added further downward pressure. President Donald Trump’s insistence on a border wall continues to add to flaring tensions in Congress. A shortage of blue-collar workers is presenting itself more prominently in the U.S. labor market helping to boost pay and narrow wage inequality and draw more women into the workforce. The shortfall is being driven by a shrinking supply of manual and low-pay service workers as the U.S. labor force becomes more educated and less willing to take on such jobs and immigration tightens. This inflationary pressure is still not being felt at the top line and therefore not reflected in the bond markets.
Credit risk performed along quality lines in December with high yield falling 2.14% versus investment grade credit up 1.50% for December, reversing a pattern of outperformance for the year, down 2.08% versus 2.11% for investment grade credit. Mortgage-backed bonds came through as the shining star of credit as fundamentals for the mortgage market reflect the very tight lending standards that have been in place for the better part of a decade. December’s credit performance reflects the risk that the lowest quality credits are the most vulnerable to lax lending standards and poor earnings quality.
Developed markets tumbled slightly less than U.S. equity falling 4.85% for the month, driven by continued evidence of global slowing and the continued specter of Brexit haunting Europe and the UK. Italy’s economy unexpectedly shrank in the three months through September and surveys suggest the weakness is persisting. Manufacturing contracted at the fastest pace in four years in November and services companies have seen export demand fall for five straight months.
That said, confidence in the German economy among investors unexpectedly edged higher at the beginning of the month, suggesting they may be starting to see a way through the current gloom of the economy. However, German business sentiment deteriorated toward the end of the month to its lowest level in more than two years as trade tensions and the risk of a no deal Brexit rise. Germany was among the worst performers in the developed international stock markets.
Adding to concerns in Europe, Mario Draghi announced he will be stopping the European Central Bank’s flagship stimulus program even with an economic outlook that is still murky. The ECB president is expected to stick to the plan made six months ago to end bond purchases at $3 trillion, under the premise that the Euro area’s fundamentals are still sound enough to support the buildup of inflation.
Finally, Japan’s factory output dropped again in November, marking the sixth fall in eight months. The data suggests limited strength in a rebound in coming months as businesses persevere through the trade war between the U.S. and China, Brexit, and slowing global growth.
After a brutal year, Emerging Market equity put in a good showing in December performing relatively better than both U.S. and international equity markets losing only 2.66% for the month. The month began with President Donald Trump and Chinese President Xi Jinping agreeing to keep their trade war from escalating with a promise to halt the imposition of new tariffs for 90 days. However, the high spirits were quickly dashed as China’s trade surplus with the US hit a record in November, even as overall export growth slowed amid waning global demand and uncertainty about a constructive resolution to the trade war. Chinese policymakers stated that significant tax and fee cuts will be enacted in 2019, and signaled an easier monetary policy stance, as the government tries to put a floor under the economic slowdown. But, the effects on the outlook were felt across the EM index, driven by steep losses in China, capping an all-around ugly year for EM with a -14.58% loss in total return, US dollar terms. On a more upbeat note, the U.S., Canada, and Mexico officially signed a new trade deal championed by President Donald Trump to replace the old NAFTA pact. This new deal is referred to as the USMCA (U.S. Mexico Canada Agreement) and this largely drove positive performance in the Mexican equity markets in December which were up 3.16% compared with China down 6.74% for the month.
Oil jumped higher at the beginning of the month on the back of efforts across the globe to support prices as Saudi Arabia and Russia extended their pact to manage the market and Canada’s largest producing province ordered unprecedented output limits. Qatar also announced it will leave OPEC next month. However, oil prices dropped steadily in the latter half of the month, supplies continue to increase and demand continues to slow along with the weakening global economy. The final damage for the month came in at a 10.84% loss for the WTI and 9.02% loss for Brent Crude. This capped a brutal year with WTI losing 24.84% and Brent Crude losing 20.42% for the full year.
Going Forward: Roadmap for 2019
As we head into the new year, market dynamics feel dramatically different. If 2018 was marked by Congressional unity and determination to achieve an agenda at any cost, 2019 is likely to be remembered as a year of gridlock. The continued government shutdown is the only first of what will likely be many battles. In 2017, the Fed raised interest rates three times from 0.75% to 1.5% and they raised rates another four times in 2018 to 2.5%. Next year, we are anticipating a slowing in the pace of rate hikes to a pace of two rate hikes with the Fed pledging patience. That said, the world of investing is a dramatically different place with investors now being able to capture a 2.5-3% return with relatively no risk (U.S Treasuries are considered low-risk/high credit quality). Risk appetites will almost certainly shift away from the riskiest investments like high-yield and equities. 2019 will almost certainly mark the peak for growth in the U.S and rotations into value and defensive investments have the potential to lead the way the year. U.S. Equities, which have been rather rocky at year end are now more fairly valued, and though earnings growth rates are slowing, earnings are likely to remain robust. However, they will have to compete with higher yields to attract continued price appreciation. Though there is much value locked up in Emerging Markets equities, the sources of uncertainty remain with trade war still hanging over the markets like a stubborn mist. Europe is now seeing enough inflation to move forward with quantitative tightening, but not enough growth to justify direct monetary tightening. Brexit and the constant threat of populism are only making a bland outlook even less attractive. With global growth peaking out and the onset of quantitative and monetary tightening afoot, perhaps the next shoe to drop will be the global debt which has marched steadily higher in the days of cheap money. Nobody puts it as well as Warren Buffet when he once wrote, “You don’t know who is swimming naked until the tide goes out.” Well, the tide is officially going out and our expectation for 2019 is that quality will be king.
Tightening Liquidity Conditions
The long-anticipated specter of tightening financial liquidity is here and yet the likelihood of poor returns from Treasuries is fairly low. To start with, much of the damage of rising rates has already been had. Short-term rate hikes in the U.S. will likely slow their pace to two and possibly even one depending on how the slowdown progresses. That leaves investors clipping higher coupons already, so some of the anticipated losses in the price can now be absorbed into the coupon before resulting in an overall negative return. In addition, the long end of the curve stubbornly refuses to price in inflation or growth, perhaps because safe-haven buying is now favoring the medium to long term end of the curve as volatility continues to creep up. Finally, high-grade credit has been thrown out, baby with the bathwater. Though we still see significant risk to the lower quality end of the high-grade spectrum and anticipate a shower of fallen angels as credit ratings have likely been generous, particularly at the low end of the spectrum, the impact to credit spreads has been broad, leaving room for well-priced high-grade credit in the portfolio.
Gridlock is Real
If we look at what we got right and what we missed last year, perhaps the biggest miss was the underestimation of the effects that policy can have in the short-term. For example, through a series of executive actions and tweets, the current administration has effectively derailed the trade-driven global expansion that started at the end of 2016. The American First agenda has been broad in its application from the “Buy American Hire American” executive order to the USMCA, otherwise known as NAFTA 2.0, to the trade war with China and other broadly protectionist measures. Though the anticipated inflationary effects have been slow to materialize, the impact to risk sentiment, forward pricing, and real economic growth has been felt. While many a political cynic would argue that political gridlock can keep uninformed politicians from messing things up, the chances that it pushes an already emboldened President Trump to take actions to circumvent the system of checks and balances by pushing the boundaries of executive action could create a whole new level of political uncertainty. While that the probability of that fat tail risk is low, one thing that is a real possibility is that fiscal policy coming to the rescue as financial conditions tighten is low. We are more likely to feel the tightening more than we have felt in the last two years.
Valuation is Key
Our baseline assumption is that when we look back on the coming year, we will have likely peaked. But, we will be entering the next phase of the economic cycle with two major headwinds: tightening financial conditions and an inability to offset those effects through policy. The markets will likely continue to grow more defensive across asset classes. Valuations will play a key role in this year’s market leadership. That said, the upside to political gridlock is that markets have effectively priced for a more realistic outlook, bringing the U.S. equity back into an attractive territory, finally. However, value still looks far more attractive than growth in this coming environment. High-grade credit has also made that segment of the investment universe attractive. This makes the between equities and high credit a toss-up with the safety of cash and treasuries. We would also add that mortgage-backed securities are also quite attractive as a substitute for Treasuries and real estate will likely benefit from some stability in the Treasury market, even in a downturn.
However, there are some segments of the market that are cheap but still not attractive. Emerging Markets equities are certainly cheap and have been attractively priced for some time. However, the two main culprits for poor earnings and depressed multiples don’t look to be abating. Continued oil supply combined with weakening demand calls for a lackluster oil price, though fundamentals support a slightly higher price than today. While we don’t expect oil to fall out of bed this year, we don’t expect a sustained rally either, leaving the outlook for commodities-based earnings not bad but not great. In addition, the trade outlook continues to be cloudy, leaving the markets to price in the worst and leaving trade-based earnings equally in the lurch. That said, if oil is flat to positive and some certainty is introduced into the trade outlook, we could see room for a rally. But, we aren’t quite ready to move this back into an overweight. Once bitten, twice shy.
Finally, some segments of the markets are still just plain unattractive. High-yield, leveraged loans and other forms of high-risk corporate credit are still unattractive, even with the recent widening in spreads. In order to get back to a reasonable fair value, we still have to see significant repricing.
-Your Investment team at Lido Advisors