“Someone is sitting in the shade today because someone planted a tree a long time ago” is a famous Warren Buffett saying which reflects the sage of Omaha’s attitude towards building wealth, namely having a methodical value investing approach that is focused on long term objectives, and nurtured through patience and a refusal to be distracted by short term developments and noise!

Last quarter review

The Federal Reserve (Fed) at its September Federal Open Market Committee (FOMC) meeting, cut US interest rates again as anticipated by 0.25%, and left the door open to further cuts as and when necessary. The FOMC press release of the 18th September advised that, “In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 1-3/4 to 2 percent. This action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain.”

Two senior members of the FOMC, namely Fed Chair Jerome Powell and New York Fed President John Williams have both subsequently mooted the possibility that a reintroduction of quantitative easing (QE) could prove necessary in the coming months to help ease liquidity issues that appeared in the Fed’s repo markets (short term overnight funding for banks) in late September. While equity and bond markets were temporarily spooked by the event, the Fed was quick to explain that the spike in repo rates “reflects one-time items such as the mid-September tax remittance, the rapid buildup of cash in the Treasury’s general account and a flurry of Treasury settlements.”

During the quarter stocks on Wall Street drifted sideways and ended the three month period more or less unchanged, albeit with occasional wild volatile price swings, depending upon the latest news on the Chinese US trade talks (which remain unresolved), or threats to the oil supply such as the Yemeni Houthi (allegedly backed by Iran) drone attack on a key Saudi installation. US Treasury yields after having fallen all year towards record low levels backed up markedly towards the end of the quarter with the yield on the benchmark US 10 year which dropped to just 1.47% at the beginning of September rising to 1.68% by month end.

In the UK, the Bank of England’s Monetary Policy Committee (MPC) as expected, left interest rates unchanged at 0.75%, as well as maintaining the stock of UK gilts, financed by the issuance of central bank reserves, at £435 billion. The press release following the MPC’s meeting on the 18th September offered an excellent synopsis of the economic situation in the UK as well as globally when stating that, “since the MPC’s previous meeting, the trade war between the United States and China has intensified, and the outlook for global growth has weakened.  Monetary policy has been loosened in many major economies. Shifting expectations about the potential timing and nature of Brexit have continued to generate heightened volatility in UK asset prices, in particular the sterling exchange rate has risen by over 3½%.”

The worst news on the UK economy was announced on the 30th September, namely that GDP fell 0.2% in the second quarter (down from +0.6% in Q1), as gross capital formation contracted sharply, while private consumption, government spending and net trade contributed positively to GDP growth. On the production side, industrial output fell the most since the fourth quarter of 2012.

The UK Stock market took the economic news in its stride, falling only marginally on the last day of the month, and like Wall Street’s main indices, ended little changed over the quarter after rising strongly before falling back over the period for similar reasons to those in America, but with the added complexity of the seemingly never to be resolved Brexit negotiations thrown into the mix. The UK bond market has seen yields see-saw back and forth, as the interest rate on the 10 year benchmark gilt consistently fell during the first half of the quarter, before then rising sharply in the first fortnight of September and then falling again to 0.48%.

In the European Union, the European Central Bank (ECB) left its main refinancing operations rate unchanged and lowered the deposit interest rate by 0.1% to -0.5% percent during its September meeting. Policymakers also approved a new round of bond purchases at a monthly pace of €20 billion as from November 1st, in an attempt to boost growth and inflation amid global trade tensions and Brexit uncertainty.

The ECB has lowered its economic (GDP) forecasts to 1.1%  in 2019 and 1.2% in 2020, while inflation expectations were also slashed to 1.2% in 2019, 1% in 2020 and 1.5% in 2021. Meanwhile, European stock markets have been volatile and largely flat reflecting growth concerns and trade tensions globally.

The Chinese economy grew by a seasonally adjusted 1.6% in the second quarter, up from 1.4% in Q1. Interest rates remained largely unchanged, while the yuan continued to fall against the US dollar from 6.80 to 7.14, making Chinese exports cheaper and partially countering the trade tariff imposed by President Trump.

Japan’s central bank, the Bank of Japan left its key short-term interest rate unchanged at -0.1% at its September meeting. Japan’s economy has again slowed with the Q2 GDP just 0.3% (Q1 0.5%), which prompted policymakers to say they would review economic and price developments more thoroughly at the next policy meeting, heightening the chance of expanding stimulus as early as October.

GDP Data shown are to the 30th June 2019; Interest Rate, Equity & Bond Index Data are to the 30th September 2019; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

Current Considerations

For the past eighteen months, the global economy has been slowing, with the annualised Gross Domestic Product (GDP) declining over this period by around a third from more than 4.5% to just over 3%. With the exception of China (6.2%) whose data are seldom independently verifiable, and the US (2.3%), most other major economies annualised GDP numbers have slowed dramatically.

The UK’s latest GDP fell by 0.2% during  the second quarter, the first time in almost seven years that the UK’s economy has contracted. Germany which during the last decade often single-handedly provided industrial growth to help ensure the European Union economic block avoided recession, may now itself have finally succumbed as its GDP contracted 0.1% in the second quarter, and worryingly its latest annual GDP growth was just 0.4%, compared to almost 3.5% just eighteen months ago.

While the unresolved trade disputes between the US and some of its trading partners, and most especially China are partly responsible for the slowing global economy, there can be no denying the phenomenal headwind of the unprecedented government and corporate debt that now exists in developed economies. The total outstanding has grown enormously since the 2008 credit crisis, and in January this year according to the Institute of International Finance was believed to be $244 trillion, which is more than three times the size of the global economy, and perhaps most worryingly China, (which a decade ago arguably helped bail out the global economy with its continued expansion) now has debt levels comparable to those of major developed economies.

The great American strategist and statistician Irving Fisher is regarded as the pioneering economist on debt deflation and much of his original observations and analysis have been adapted to modern markets by Dr Lacy Hunt, a renowned strategist and institutional fixed income manager with Hoisington Investment Management in Texas. Dr Hunt has made some fascinating observations concerning debt and GDP trends based on Irving Fisher’s original findings that “GDP equals M2 (the money supply that includes cash, checking deposits, and easily convertible near money such as short term T Bills etc.) times V (velocity of money, i.e. how many times in a given year the average dollar gets exchanged or changes hands)”

Dr. Hunt suggests that, “the dominant secular determinant of velocity appears to be the GDP-generating capacity of debt, which is declining in all major economies worldwide. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then velocity will rise since GDP will eventually increase beyond the initial borrowing.”

Dr Hunt continues, “If advancing debt produces increasingly smaller gains in GDP, then V falls. Financing consumption may temporarily boost GDP and velocity over short timespans, but it does not generate new funds to meet longer term debt servicing obligations. Consistent with this interpretation, velocity has dramatically fallen since 1998 for all four economies: the US, Europe, Japan and China”

Dr. Hunt’s analysis identifies the seemingly catch-22 trap that Japan entered at least two decades ago and which the rest of the world would appear to be inevitably headed, namely “the diminishing returns of excess debt”. As Dr Hunt explains, “diminishing returns rests upon the production function that states physical output is determined by the inputs or factors of production. When a factor of production, such as capital, initially increases, output rises at an increasing rate. As excess use of that factor continues to advance, the rate of gains in output slow, flatten, and eventually turn down, a condition referred to as negative returns. Thus, the relationship between the excess use of a factor of production and the output is nonlinear.”

Dr Hunt continues, “Using this theory – that the excess application of an input will lead to diminishing returns – it is possible to see why academic work has concluded that excess application of debt within an economy leads to slower economic growth in a nonlinear fashion. If debt is adjusted for price level changes, then debt is in real or physical terms and thus consistent with the law of diminishing returns. The pattern of unexpected economic weakness in heavily indebted economies has been repeated frequently in Japan, Europe, China and the emerging markets. Japan, the most indebted nation, experienced three additional recessions after the 2008-09 recession.”

Perhaps unsurprisingly, Dr Hunt reveals that, “among the world’s major economic areas, the U.S. economy presently stands out. The disparity in this performance is an unseen consequence from the excess use of debt. After decades of overuse, debt is increasingly less productive in all of these areas. Ten years ago, the debt overhang was centered in the U.S., the euro area and Japan.”

As Dr. Hunt reveals, “currently, all major economic regions fit this description as China and the emerging markets now separately carry record levels of debt relative to GDP. The Bank for International Settlements (BIS) shows that in 2017, one dollar of non-financial debt generated $0.40, $0.38, $0.39, $0.35 and $0.27 of GDP, respectively, in the U.S., the euro area, China, the U.K. and Japan.”

The really frightening fact is that as Dr Hunt explains, “all of these data points have significantly worsened over the last decade, the greatest deterioration being that of China which has declined by 43% since 2008. Among all regions, Japan’s debt exhibited the weakest level of debt productivity at $0.27. While one dollar of emerging market debt produced a seemingly enviable $0.52 of GDP in 2017, this ratio was down 38% from 2007.”

Historical data analysis such as that provided by Dr Hunt, illustrate the phenomenal debt headwinds now facing the global economy, as each new dollar (or yen, euro, pound or yuan) created as debt generates a smaller and smaller economic return, as it adds to the unprecedented burden of repayment for future generations. In reality it is an impossible circle to square and begs the question as to whether some form of debt jubilee and currency reset will have to occur to finally resolve the problem.

Meanwhile, markets worry about how protracted and deep the current global economic slowdown will be. Historically the US bond market has been the canary in the mine shaft as far as alerting investors to potential economic recessions on the horizon.

Accordingly the Treasury yield curve inversion that began in March this year, when the yield on the benchmark 10 year T-bond fell below that of the 3 month T-bill, is a concern. This indicator (as opposed to others such as the inversion of the 10 year and 2 year T-bonds that the mainstream media often mention) has been the preferred indicator of the Fed since research it carried out at the turn of the millennium proved how uncannily accurate it had been in forewarning of impending US recessions since 1953.

The “10 year minus 3 month” rate has inverted on ten occasions since 1953 and an economic recession has followed within a couple of years on every occasion since, except in 1966 when it is believed the Fed’s prompt action in aggressively cutting interest rates averted one. Currently there are plenty of respected market analysts and economists whom are convinced a recession will not occur following this year’s inversion, either because they believe the Fed has, as it did in 1966, managed to get ahead of the business curve, and or because the monetary policies of the last decade namely zero interest rates (ZIRP) and quantitative easing (QE) means the economy will react differently this time to previous occasions.

Forward Outlook

Of course we have to be wary of the presumption that this time will be different, since as renowned economists Kenneth Rogoff and Carmen Reinhart proved in their best-selling book (This Time is Different), these are “the four most dangerous words in finance.” What we can confidently say is that we are almost certainly in the last quarter of this business cycle that began in early 2009, and is already the longest on record.

As we observe wage rises accelerating, while business costs largely remain elevated, profits are inevitably being squeezed. Accordingly we are likely to experience an earnings recession as the economy slows down, with the share prices of more highly rated growth stocks impacted while cheaper value and income stocks should continue to do relatively well.

It therefore makes sense to begin positioning portfolios more defensively by focusing upon value instead of growth or momentum. We believe Savita Subramanian, head of US equity and quantitative strategy at Bank of America Merrill Lynch is correct to suggest in a recent report that “value stocks are acting like a tightly wound spring that has started to uncoil”

September saw value stocks in the US outperform momentum by more than 9%, the biggest margin in the sector’s favour since 2010. This pattern has often been witnessed towards the end of business cycles as investors begin to shun highly-rated or overpriced growth stocks in favour of value, which usually come with attractive dividend yields to add to their total return potential.

Similarly here in the UK and in Europe, there are some very attractively priced value stocks paying reasonable yields that appear to offer good potential compared to more expensively priced growth stocks which have been the winners in the business cycle up until this point. Accordingly, we shall be progressively recommending client portfolios take advantage of these opportunities in the UK and globally.

On balance, we believe the equity asset class continues to offer investment portfolios the best relative risk reward potential, and in particular value and income stocks. At the same time, we recommend maintaining some exposure to other defensive asset classes including fixed income, property and lower risk alternative investment options.

As always, investment risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our client’s needs.

Copyright © Ash-Ridge Asset Management 1st October 2019.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

The Market View reflects our in house assessment and views and is posted for client interest only. Please refer to our Terms of Use at the bottom of this page.