The world might seem like a very tranquil place right now. Looking at the stock market fly higher in the face of geopolitical and economic concern gives credence to the increasingly heard notion “this time it’s different.” It’s not different, says Altalis Capital Management in a third-quarter letter to investors. It might be better obfuscated through rose-colored glasses, but signs of forthcoming trouble are all around with debt levels across the world being among the largest concerns. The issue for investors is seeing the coming storm behind the cloud line.
Corporations are earning record high profits and this won't last
This stock market expansion is built on a reach for yield. Stocks are a yield-producing financial commodity driven by hopes for future earnings, and this moves in cycles, Taconic alums Adam Fox And Samuel Elder recognize in a tone which makes Paul Singer look bullish in comparission.
Looking at corporate profit margins, profits are busting records and with tax benefits on the horizon, the earnings cup is overflowing.
“While expanding corporate margins have been a tailwind allowing earnings to grow in excess of weak underlying economic growth, corporate margins are now at extreme levels approximately 50% above long-term averages,” the statistical fund managers noted. They recognize that corporate margins are subject to mean reversion, looking at more than a century of data. Given that the end of a reversion cycle is statistically at hand, earnings growth is “far more likely to instead be a headwind” in the future.
The current corporate expansion is a “dynamic… enabled by rising debt levels, allowing household consumption to outpace income growth and thus corporate revenues to grow faster than labor costs, heavily flattering corporate margins.”
The volatility explosions that markets have exhibited are not “one-off” events that markets quickly recover from, but they send a larger message. “Markets appear to be extrapolating the mirage of an earnings acceleration in the first half many years into the future, ignoring that much of this growth rebound has been driven not by sustainable organic trends,” the letter stated.
But it is more than just earnings that are going to be challenged in a mean reverting market.
Central bank stimulus has put the finger on the hand of the markets and won't be easily extracted
The excessive market “accommodation,” commonly known as central bank stimulus, has created a “blind faith that policymakers have the inclination and ability to swiftly rescue them from any downdraft, artificially boosting valuations and suppressing volatility,” the letter noted. “However, we think that this faith in central banker omnipotence has been misplaced.”
Noting the combination of “asset prices, economic distortions, and worldwide debt levels are already at historical extremes,” much of this due to placing the finger on the market scales.
This is a historical oddity. Never before have bond yields been so influenced by central bank policy for so long. With an attempt at market normalization and “quantitative tightening,” the Fed is pulling back its finger on the scale ever so slightly and Altalis is concerned about the repercussions.
With worldwide leverage at record highs, growth generally weak, and asset prices unusually elevated, any attempts at policy normalization will carry a dramatically amplified negative impact, even as they lead to a more sustainable long-term growth path.
We believe the overly narrow focus on inflation targeting employed by policymakers over the past several decades has led to interest rates being consistently set well below sustainable “equilibrium” levels. These artificially suppressed rates have consequently fueled recurrent asset bubbles of increasingly greater magnitude, an investment boom that has left the world awash in excess capacity, and a cumulative rise in global debt to dangerous record levels.
While the Fed was focused on inflation targets, it failed to consider “the dangerous and destabilizing side effects this approach has simultaneously produced: asset bubbles, excess capacity, and ballooning worldwide debt.”
Over time markets will revert back to equilibrium, and that is when the roaring party turns into an uncontrollable hangover. This leads “to worse long-term outcomes (and certainly not sustainable “equilibrium” growth). This path ultimately culminates at a point where the magnitude of capital misallocation reveals the limits of policy intervention.”
Debt levels in uncharted areas
The following themese are highlighted in the letter:
Heightened risks and costs of deferring the removal of excessive accommodation
Central banks’ current inflation targeting framework doesn’t produce “equilibrium” rates consistent with sustainable growth
The hedge fund managers warn that we are in "in unprecedented territory" with massive debt levels, relative to GDP and central banks having excerbatted the problem. They state:
While the last financial crisis initially appeared to be that point, policymakers drew few lessons from that episode and instead doubled down on their credit-driven growth model in its aftermath. With most of the world, including those areas more insulated from the last crisis, now saturated at record debt levels relative to history, it is doubtful that this approach will be successful the next time it’s attempted.
In short, we have a history lesson in the limits of central bank omnipotence. Just try and keep your head above water during the market adjustment when it finally arrives.