Trapeze Asset Management commentary for the second quarter ended June 30, 2016; titled, “Tricky Times Two.”
Trapeze Asset Management - Tricky Times Two
A continuation of our last quarterly letter, "Tricky Times."
And, we emphasize again that this is a period of unusual crosscurrents. At the top of the list is the troubling amount of global debt, with government debt at around $60 trillion and with corporate debt almost equal thereto. Global debt to GDP is almost 300%. And the U.S. problematic too, with government debt equal to its GDP at around $20 trillion and growing faster than its economic growth. How does this debt get repaid in a low inflationary, low growth environment? Not to worry, Donald Trump says he will renegotiate the U.S. federal debt if he is President. A new chapter indeed for the U.S.—Chapter XI.
Many central banks, including Europe and Japan, have gone to very low or even negative interest rates to stimulate growth and inflation and to keep their currencies low to stimulate trade. Over $10 trillion of government debt now has negative yields globally. In Europe, a flight to investment-grade corporate bonds has lowered yields of the same to 1%. And with global interest rates at record lows, global government 10-year bonds yielding less than 1%, riskier assets such as equities and gold are a more attractive alternative.
With U.S. mortgage rates at a 30-year low, the housing market has held up. U.S. consumer confidence is at a one-year high. April retail sales were up 1.3% though, while on-line retailers like Amazon benefited, many individual retailers such as Macy’s, The Gap and Nordstrom suffered. The May jobs report was disappointing even though unemployment in the U.S. remains at a respectable 4.7%. A nervous Fed keeps deferring its next rate hike, now perhaps until after June, concerned about the slowing effect and an even higher dollar than currently.
On the other hand, global economic growth is slowing and the International Monetary Fund recently lowered its global growth forecast, albeit marginally, for '16 and '17.
Specific issues such as low commodity prices, especially oil, are impacting producing countries such as Canada. The refugee crisis is impacting a somewhat improving Eurozone, and slowing Chinese growth is certainly an issue, already suffering from weak inflation and high joblessness, though GDP growth still held up at 6.7% in Q1. Japan has been suffering from the unusually strong yen, with exports down for the sixth consecutive month.
The Bank of Canada believes it could take more than three years to recover from the shock of low oil prices, and having to deal with low interest rates, weak inflation and sub-par growth.
We are concerned that whenever interest rates begin to rise from improving economic conditions or higher inflation, servicing the enormous global debt could become a problem for borrowers and their growth prospects. We continue to believe the bond market is a bubble. The U.S. treasury yield curve is already starting to flatten, with short-term rates rising. On the other hand, we also believe there are opportunities for equity investors in the still depressed commodity sectors which could improve more quickly than anticipated. Indeed, as growth improves from the stimulus, corporate earnings should too, likely recovering more than anticipated. And with interest rates at record lows where else is an investor to go but to other assets such as equities. The earnings yield of the S&P 500 at about 6% is more than 4 times the yield on 10-year U.S. treasuries. And the dividend yield of 2.2% is higher too. Bonds could prove riskier than equities, even in a slow growing economy with equities trading close to fair value.
While negative interest rates show how desperate central banks are to provide stimulus it is likely a boon for the markets. At the same time, a global recession does not appear to be on the horizon though overall growth remains rather slow and corporate America’s earnings keep getting revised lower. China has been slowing yet industrial commodity prices have been rebounding. Global debts are high and stimulus abounds but interest rates stay near record lows. And, now, with Britain having voted to exit the EU, a whole host of uncertainty can be added to the list. Crosscurrents continue to prevail.
Trapeze Asset Management - Upside Appears Capped
Valuations are not extreme but usually trading at fair market value (FMV) is a maximum valuation for the markets. Individual stocks and overall markets tend to fluctuate between a discount to fair value and fair value itself. Over time, as fair values rise so do share prices. Typically, once fair value is reached though, a stock or market will decline because the upside potential is limited and/or valuation risks are elevated. As we witnessed in the bubble of '99/'00, rarely will stock markets trade much above fair value. The S&P 500 has not made a new high in over a year, only the 13th such occasion since the early '30s, ignoring the first year of bull markets. Of those 13 occasions, 8 were bear markets and 5 were corrections. It appears the probabilities are high that a period of market decline may ensue. Though, without a recession market damage tends to be muted.
We still don’t see the typical precursors of a U.S. recession—no oil spike, unemployment is not rising, bank loss ratios are stable, and most important, the yield curve is not inverted. Our own Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is not forecasting a peak in the business cycle. So we do not expect a severe market correction. But, though there is no recession, corporate profits have been rolling over.
Meanwhile, governments in many countries are keeping interest rates below the inflation rate (i.e., negative real rates) to encourage lending. Whether with negative real rates or outright negative nominal rates, central banks are attempting to drive economic activity. This should help keep stocks elevated as the stock market remains the best alternative for reasonable returns.
During a recession it’s not unusual for the market to fall in excess of 40%. Therefore, we are always on the lookout, with our TEC™ tool, for a downturn. Looking back in time, TEC™ tends to flash an alert and then a TRIM™ alert follows a few months to a year or so later.
Here too, we are seeing another unusual crosscurrent. Although TEC™ has not warned yet, our TRIM™ indicator alerted us in 28 of 30 developed markets, including the S&P 500 in late January. And then, after a market rebound from the bottom, our TRIM™ indicator signaled a buy. This flickering is highly unusual. So we look to the weight of the evidence—most key markets remain on TRIM™ sell. As well, our TRAC™ signal has warned too, with the Dow and S&P giving sell signals—with the rebound in the last few months they’ve merely reverted to their ceilings. There have been instances, albeit only 4 in the post WWII era, where a bear market (more than 20% decline) occurred without a recession—1962, 1966, 1987 and 1998. We continue to be concerned about this happening again. The Russell 2000 fell 27% from its 2015 high to its February low, as did the Value Line, falling 28%. Both have rebounded but remain down