Surging animal spirits sent global equity markets off to a flying start in 2018 only to be reined in by a heavy bond sell-off and escalating trade war rhetoric with negative ramifications for global growth. We’ve long highlighted the fact that global growth has been strengthening whilst policy makers focus too heavily on backward looking inflation metrics. Quantitative Easing (QE) kick-started a recovery following the Great Recession, however it also encouraged a dangerous build-up in one-sided risk. The sudden rise of volatility in February and March, one measure of risk we highlighted last year (see our webinar “Volatility – dead or in hibernation?” at https://youtu.be/yTfQKrhqfjg), demonstrated that even with strong growth fundamentals financial markets may be vulnerable.
In our December 2017 quarterly we outlined the potential distortions resulting from this monetary experiment and the risk that, as central banks attempt to normalise policy, carry/low volatility trades could unwind with ferocity. A further potential negative feedback loop exists where leverage is applied to purchase illiquid assets. For example, an Exchange Traded Fund (ETF) that invests in bank loans requires 30-90 days to settle a loan in the secondary market. According to JP Morgan, ETFs own 4% of the entire U.S. high yield bond market, more than the inventory of all broker-dealers combined. With tight bank regulation limiting the ability for trading desks to absorb risk, flash crashes such as experienced in February are a real risk.
Central banks have somewhat cornered themselves. Increasingly, political and economic pressure to normalise interest rates or withdraw stimulus is likely to further trigger volatility and lead to wider credit spreads. The ECB and BOJ still make up of half of QE assets making an exit a potentially bumpy ride. Our analysis suggests that U.S. high yield or junk bond issuers are amongst the most vulnerable to this risk (see our August 2016 research paper titled
“The global corporate debt unwind” at antipodespartners.com/wp-content/uploads/The-corporate-debt-unwind.pdf.
The move in front-end rates attracted plenty of attention over the quarter. The drivers of the rise in Libor-OIS spread appear technical in nature driven by the U.S. Treasury aggressively selling treasury bills to rebuild cash in anticipation of the now predictable “shut-down” circus. Time will tell as to whether this is a short-term liquidity event or the harbinger of tighter financial conditions. Further U.S. corporate tax repatriation reduces availability of U.S. dollar funding abroad. A fifth of the Australian bank system’s entire wholesale funding has a tenor of 3 months or less. A major supplier of funding to this market has been U.S. multinationals holding cash offshore. Whilst we are yet to see the widening of the Libor-OIS spread translate into higher funding costs in money markets outside of the U.S., this remains a risk.
According to UBS, total speculative grade floating rate loans total $2.2 trillion. The primary concern is the riskier half extended to issuers rated below BB. The consensus is while we are in the later stages of the U.S. corporate credit cycle, higher leverage as a result of a significant loosening in credit standards is sustainable as base rates are low and a recession is not imminent. However, in industries such as retail, media and telecommunications, the same forces that are underwriting the success of the mega-cap platform companies such as Amazon and Alphabet are negatively impacting the smaller corporates increasingly caught in the cross-fire. Often these smaller issuers are less likely to have access to fixed rate funding. While funding diversification and interest rate hedges can lessen the impact, there are several characteristics that magnify risk as short-end rates rise. Firstly, there has been a rise in lower rated, longer dated investment grade debt issuance (BBB tranches); secondly, a rapid increase to over 1,400 triple C rated issuers, many of which have floating rate liabilities; and, finally, debt growth for many segments is already outstripping cashflow growth even in a healthy economy.
The Trump administration overturned historical Republican fiscal orthodoxy after signing a 4% fiscal deficit plan for 2018. A stimulus of this size is typically reserved for recessions or war time. The new U.S. Director of the National Economic Council, Larry Kudlow, ventured further into the unknown by suggesting additional tax cuts may be considered. The combination of U.S. twin deficits and trade barrier rhetoric will clearly result in ongoing volatility.
Decades of growing inequality has hollowed out the middle ground, leading to polarised outcomes. Though largely dismissed as pre-November U.S. midterm election posturing, the tax cut-trade barrier discourse seems to resonate with the majority of U.S. voters. The U.S. focus on intellectual property theft seems to have support from the EU, though this also leaves Europe vulnerable to a Chinese response. The impact from proposed tariffs would be immaterial but any further escalation will likely undermine confidence and growth. Given this backdrop, the implications for the U.S. dollar remain uncertain.
Switching focus to China where the banking system is perceived to be opaque and an actor of the State at any cost. In reality, Chinese policy makers’ efforts to clean up the banking system and support the real economy are largely underappreciated. The combination of hardened regulatory restrictions on banks and shadow lending has squeezed the availability of interbank funding for weaker banks and rogue financial institutions such as Anbang Insurance. In response these banks have been forced to raise close to $100 billion in capital via shares, preferred equity and convertible bonds to shore up their balance sheets. Additionally, over the last four years, the large Chinese banks have written off just over $1 trillion in bad loans or close to 10% of GDP. Further, Wealth Management Product (WMP) regulation has been tightened, largely limiting the investable universe to government bonds and resulting in stronger disclosure and slower demand growth. In addition, lending to industries burdened by overcapacity has been restricted, boosting profitability and asset quality.
China’s rapid ascent and integration into the global financial system appears irreversible. In June MSCI will add around 230 of China’s larger listed stocks to its Emerging Market Index, whilst in April 2019, China will likely be added to the Bloomberg Barclays Global Fixed Income Index. This index inclusion, which is still subject to a few operational hurdles, may see China’s weight in the index grow to around 5.5% by end 2020. UBS estimates that the initial one-off flow may amount to 100-120 billion USD via passive tracking funds by April 2019. However, if other indices and active managers follow suit then the initial flow may more than double to $250 billion. Over time, China may attract ~$550 billion of inflows or ~1.5% of GDP/annum of inflows over the next three years. China’s debt market is the third largest in the world and under-owned by foreign investors.
The shift in political power under Xi’s short rule of China is worth addressing. After securing a virtually indefinite term for his presidency, Xi now commands the undemocratic luxury of driving China’s future over a long time horizon. As evidenced by his very successful corruption purge and consolidation of key government portfolios under his individual title, President Xi has the power to dictate short-term sacrifices for longer-term gains.
Already the aggressive response to Trump’s tariff tactics highlight this emboldened posture versus his modern predecessors. Similarly, China’s response to the US-North Korea summit was swift and represents a strong indication of its preference for the status quo or ideally a solution that results in the U.S. military’s withdrawal from the Korean peninsula. China would also take exception to the U.S. policy reversal of limited diplomatic engagement with Taiwan.
China’s current generation of increasingly nationalistic leaders will no longer politely or passively respond to demands from the West. A currency response is unlikely, rather China will push for a diplomatic solution and may perhaps compromise to preserve stability. President Xi potentially holds the trump card in China’s ownership of $1.2 trillion or 7% of U.S. treasuries plus the political longevity to negotiate the best deal. This East-West power transition represents a less predictable global socioeconomic environment especially if the opposing agendas increasingly reflect domestic populist demands.
Finally, the key question for 2018 remains to what extent can the benign environment persist? Putting aside trade wars and policy missteps, the growth environment is unlikely to accelerate much further but thawing financial conditions and pending fiscal stimulus can sustain growth at current levels for longer. Easing financial conditions are a key pillar of growth and current U.S. conditions remain the easiest since the global financial crisis and should support growth above trend for the remainder of the year. However, we believe the unusually favourable goldilocks combination of accelerating growth and tepid inflation experienced in 2017 will not repeat. Instead, normalisation of interest rate policy will likely upset the rhythm with more volatile and less forgiving markets. Last quarter, we warned of excessive investor crowding into structural growth winners and this quarter many technology names underperformed. In a higher interest rate environment, the market will become increasingly less tolerant of such biases.
Regional & Sector Return Expectations
We find it useful to examine long-term empirical data in terms of what starting multiples imply for expected future returns. Given broad differences in the timing of earnings cycles across both regions and sectors, we prefer to measure expectations for future returns based on “Cyclically Adjusted PE” (CAPE) valuations.
When a market commentator makes a pronouncement regarding the valuation of a particular country or region, investors should inquire as to what extent this is driven by a sectoral bias within the market. For an extreme example, the Korean market valuation is heavily tied to the valuation of a single stock, Samsung Electronics (as is Taiwan to Taiwan Semiconductor Manufacturing) and EM valuations are generally sensitive to global hardware, commodity and domestic banking valuations – the three key EM industry “over weights” relative to DM. For this reason, Antipodes Partners’ structures its analytical efforts to get the most out of BOTH global sector (globally oriented businesses) and geographic (domestically oriented businesses) contexts.
However, for the purposes of assessing the valuation of equities more broadly versus other assets, the best data-set is country based, as the pricing of cash and bonds will be heavily driven by domestic considerations. With data back to 1947 and the greatest longevity of record, we can observe a strong relationship between the S&P 500 CAPE, ten year forward S&P 500 returns, and U.S. corporate profit share as a % of GDP (as a proxy for U.S. profit margins, which effectively applies a “structural” adjustment to the CAE). A high CAPE is typically associated with lower forward returns, though this relationship is tempered when profit margins are low and the probability of the market growing into its multiple increases.
Figure 5: Relationship Between The S&P 500 Cape, U.S. Corporate Profit Share And 10 Year Forward Returns
Source: Robert Shiller, Federal Reserve Economic Data, Antipodes Partners
Figure 5 captures this thought process. Given the timeframe of the forecast, it has little relevance to timing shorter-term market moves. However, taking a long-term view, with U.S. corporate profit share at a near peak of ~8.5%, and the CAPE at a 15 year high of ~31x, the historical pattern implies relatively modest ~1% p.a. forward returns, significantly lower than the long-term average.
Table 5: Future Expected Sector and Regional Returns (2018)
See Glossary for CAPE, EMR and Sector definitions. Source: Antipodes Partners
The question then becomes, if U.S. equities empirically appear expensive, what does the global, regional and sector picture look like? Similar to the above approach, this requires the formulation of both a cyclical and structural view of return expectations. Our CAPE based view of returns (Table 4) captures through-cycle earnings expectations (in the context of the long-term CAPE) without an adjustment for the longer-term profit margin potential. For this reason, the expected returns produced by the Sector/Regional CAPE analysis are not directly comparable to the U.S. expected return analysis (Figure 5). Rather, they reflect a relative ranking of opportunities that then need to be adjusted by a longer-term structural assessment of profitability and valuations (Figure 6).
In this sense, with the U.S. as the benchmark for absolute return expectations, broadly both North American and Developed European equities look expensive. Given that these regions represent ~76% of the MSCI ACWI, investing in the global index is unlikely to lead to a great long-term return outcome. Comparatively, both Developed Asia (Japan, Korea and Taiwan) and EM stand out as regions with great return potential.
Figure 6: Region-Sector Valuation Heat-Map – EV/Sales Relative To World – Z-Score (1995-2018)
See figure 9 for a more detailed explanation. Source: Antipodes Partners
We would stress that much of the difference in regional return expectations is driven by compositional differences in industry exposures. From an industry perspective, in spite of growing nationalism/populism, globalisation has resulted in valuation multiples that are relatively similar within industry sectors across regions. In this sense, we broadly observe:
- As the rally in Chinese growth sensitive equities has played out over the past two years, Materials and Industrials outperformed and, though Energy rallied late in the year, it remains very cheap by historical standards.
- Though Financials significantly outperformed in the first half of 2017, the sector remains cheap by historical standards with sentiment and profitability expectations weighed down by macro-concerns, low rates and yield curve compression.
- Domestic Cyclicals are also cheap by historical standards, especially strong incumbent retailers where the market is potentially underappreciating the brand equity and/or a successful adaptation to online reality.
- Interestingly, in a market that until recently has paid up for Yield – most intensely reflected in the North American Infrastructure sector – traditional yield sectors such as Telecommunications have de-rated, coinciding with the apparent value of Good Yield (funded through cash flow, Figure 8).
- Whilst Technology appears expensive on a more structural view of valuations, we guard against comparisons to the 1999/2000 tech bubble – Growth as a style is currently pervasively expensive across the global market, not just in Technology. Whilst real structural change (cloud, social, virtual reality, media streaming, big data, autonomous driving, etc.) has underwritten the outperformance of the sector, due to their sheer size risks are building for the Titans of Tech, including:
- Tax and regulatory risk arising from increased scrutiny from governments around the world due to their influence and role in society, particularly around managing sensitive information.
- Intensifying competition, whether it’s Amazon and Netflix competing on content streaming or Amazon’s Alexa threatening Google’s core search business with its voice search capabilities, the titans are bumping heads. Likewise Google is encroaching on Apple by focusing on its own smartphone and Microsoft is attacking Amazon’s AWS cloud business with its successful Azure platform. Related to this is the growing capital intensity of many of these businesses as they make heavy infrastructure investments in compute capacity required to handle increasing artificial intelligence workloads and video streaming demands.
- Style/Macro risk represented by excessive crowding by investors that have paid up for structural growth. If the current cyclical rebound in global growth continues, long-term global interest rates will be forced higher, triggering a rotation out of expensive longer-duration exposures into out of favour cyclical stocks.
- Consumer Staples were the ‘expensive defensives’, once enamoured for their perceived Profitability and Growth characteristics, that have now underperformed since the beginning of 2016. However, they still remain one of the most expensive DM sectors and in many cases structural pressures, such as substitution by private label, are intensifying.
- Healthcare has underperformed to the point that relative value has appeared. However, healthcare related businesses will continue to be pressured by the public and governments grappling with affordability given decades of high cost inflation.
Most quantitative strategies would measure the attraction of a certain “factor” exposure on the basis of its price momentum. These same systematic strategies see Value as a separate factor, by which they mean low multiple stocks, but will only buy Value if it exhibits momentum. At Antipodes Partners, we worry that factors favoured by systematic strategies will eventually become overvalued (a symptom of momentum based crowding), offering little margin of safety at the stock level and exposure to “regime change” style draw-down risk at the portfolio level. Hence, we value a range of factors (e.g. Profitability, Growth, Resilience, Multiple Dispersion, Good Yield, Volatility and Momentum, etc., Figures 7, 8 and 10) rather than Value in isolation (we prefer to label Value as Multiple Dispersion to make a clear statement that the starting multiple is meaningless without the context of growth).
Keeping with our philosophy of finding investments with multiple ways of winning, another way we can win is by gaining:
- Cheap exposure to an expensive factor, e.g. Cisco Systems, a very cheap “Profitability” exposure at a PE of 15x where an equivalent exposure would cost on average +20x PE.
- An exposure to an out of favour factor based on the premise the market view may change, e.g. “Good Yield”
(cash-flow funded) is offered cheaply by many Utility and Telecommunication stocks, as opposed to the expensive “Bad Yield” (capital market funded) offered by many Infrastructure stocks.
Accordingly, Figures 7, 8 and 10 apply our proprietary quantitative tools to determine how expensive various factors have become relative to the last 30 years (expressed as a Z-Score) by comparing the valuation of the most profitable (highest growth/momentum or lowest multiple) stocks to the least profitable (lowest growth/momentum or highest multiple) stocks.
Figure 7: Z-Score (Median EV/CE of Upper Quintile Relative to Lower Quintile 1987-2018)
See Glossary for factor definitions. Source: Antipodes Partners
Figure 8: Z-Score (Median EV/CE of Upper Quintile Relative to Lower Quintile 1987-2018)
See Glossary for factor definitions. Source: Antipodes Partners
With reference to Figures 7, 8 and 10:
- The market is celebrating stocks that display high Growth, Profitability and Momentum independently of starting multiple. Further, it’s noteworthy that the market’s willingness to pay up for Growth, Profitability and Momentum is approaching the heady days of the late 1990’s tech bubble. More specifically, extreme policy settings in developed markets have led to severe investor herding, evidenced by the extreme overvaluation of Growth and Profitability in these regions. One can also observe the subsequent derating that occurred as high Growth and Profitability attracted competition and these stocks lost their allure, a clear example of how a high starting multiple was predictive of future sub-par returns.
- Extreme thirst for equities with bond like characteristics, i.e. Yield and Low Volatility, without concern as to the inherent risk equities represent. As Minsky alluded to, prolonged periods of stability or low volatility do not necessarily equate with low potential risk. In fact, today many investment strategies are increasingly betting on stability and low volatility to generate returns. Interestingly, whilst equity index and cross asset index volatility remains low globally (Figure 12), at the individual security level, the market’s love affair with Yield and Low Volatility appears to be waning with a notable retreat in the valuation of both these factors from the extremes of early last year.
- Encouragingly, Multiple Dispersion is evident across all regions, however low multiple stocks continue to underperform high multiple stocks.
The general uptrend in the broader equity market seems set to continue given economic data globally remains robust and central banks very accommodating. However, the blind assumption of unending low rates is a dangerous one. As a result, we simplistically see two likely scenarios:
- Growth continues to surprise to the upside driving greater urgency from central banks to normalise policy. To minimise disruption to short-term funding markets, tapering would likely focus on the long-end of the yield curve leading to a potentially self-reinforcing pro-growth steepening, resulting in a significant increase in bond volatility and headwinds for the crowded/expensive low volatility, bond proxy and growth/quality equity exposures.
- Growth disappoints due to policy tightening by China or the U.S. In this scenario, credit volatility would spike triggering a major sell-off in credit sensitive equities regardless of their duration, i.e., a repeat of the 2015/16 commodity high yield melt-down which ended up spilling over into non-commodity exposures. Conversely, the inevitable central bank response would extend the illusion of stability and amplify the imbalances with a continued melt-up in the low volatility, bond proxy and growth/quality equity exposures.
Antipodes Partners’ investment goal is to build portfolios with a capital preservation focus from non-correlated clusters of opportunity. In our long investments we seek both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.
Given the divergent risks that the above two scenarios represent, investors should focus more than ever on uncovering sources of idiosyncratic alpha rather than relying on momentum or passive beta. In this sense, we’re encouraged by the high level of valuation dispersion within and across markets (region/sector/factor) as indicative of broad pragmatic value opportunities, both long and short.
Figure 10: Antipodes Partners Region-Factor Valuation Heat-Map
The Antipodes Region-Factor Valuation Heat-map provides a more granular illustration of valuation clustering across factors and regions, expressed in a sector neutral manner i.e. independent of style biases that may exist within any one sector. Cell colouring indicates how expensive various factors have become relative to the last 30 years (expressed as a Z Score) by comparing the median EV to Capital Employed of upper quintile stocks to lower quintile (indicated on factor labels). The warmer the colour, the greater the relative valuation versus history; vice versa for the cooler blues, with extremes highlighted by the boldest of colours. Good Yield refers to shareholder yield (dividends + buybacks – options issuance) adjusted for funding source (cash, debt or equity). Volatility refers to 180 day variability in price change. Growth, Profitability, Momentum and Multiple Dispersion are composite factors (see Glossary).