Are global capitalism and free trade in decline? This is the first question that comes to mind when I consider where we are today in terms of the global economy. Since the Trump election, “America first” and similar nationalist paradigms have generated significant impact in economic considerations throughout the world. What does this mean, and how will this affect the future of economic growth and trade? For Trump, tariffs have been a favorite tool. He has accelerated the increases in tariffs and continues to threaten more unless he gets his way. To some extent I agree that certain countries have benefited at the expense of the U.S. for too long. Principle among the issues where this disparity can be identified is in the case of intellectual property rights. With that said, several questions remain: Are tariffs the best course of action? Does trying to renegotiate every trade agreement at once make sense? Thus far this course of action has been extremely disruptive with few, if any, tangible successes. History clearly shows us that tariffs are a lose-lose mechanism.
Nobody wins with tariffs.
Trump tries to portray the imposition of tariffs on foreign products as a huge windfall for the U.S. with billions in additional revenue for the U.S. treasury, but is this really true? Who pays for these tariffs? The reality is that everyone pays. Let’s begin with U.S. farmers; thus far they have been the biggest losers in the tariff strategy. Tariffs were placed on U.S. agricultural exports in the first wave of retaliatory tariffs imposed by nearly every foreign country where the Trump administration employed a tariff strategy for trade negotiations. China and other countries can very easily find other suppliers for the agricultural goods they need. South America for example is thus far a winner with these retaliatory agricultural tariffs. They are able to fill the demand created when these retaliatory tariffs made the import of U.S. agricultural goods prohibitively expensive. Interestingly, the EU and Mercosur have finally agreed on a new trade deal. It has been 20 years in the making, was its successful conclusion a result of the Trump antagonistic trade views? This we will never know, clearly the EU is sending the message trade free trade is good. The question yet to be answered is who will become permanent winners as foreign countries find more stable trade partners to fulfil their demands. U.S. corporations lose as they cannot pass on the full price impact of these tariffs on goods sold, and the consumer will pay higher prices for goods as the corporations endeavor to offset as much of these import taxes as they can. For example: the price of a washing machine is estimated to be $100 higher for a U.S. consumer due to recent tariffs. This is true whether the machine is manufactured overseas and the tariff is exercised on the import of the finished good or the machine is manufactured domestically but the tariffs are imposed on the raw materials imported to manufacture the machine. The negative knock on affects are significant. Over time they will lead to slower economic growth and higher inflation.
Peeling back another layer:
It has been a very interesting past six months. We have gone from fears of acute weakness in Q4 2018, when we saw a significant correction in the public equity markets, to just recently seeing new highs in the SP500. Why such a dramatic change in this short period of time? What has changed?
Let me begin with China, it is not the small emerging market of 15 years ago. It has become the second largest economy in the world, so what happens in China matters to everyone. The U.S. is the largest exporter to China, followed by Germany. We saw a real impact in economic terms in Q4 2018 due to the slowing Chinese economy. Despite this, the U.S. FED raised rates to 2.5% in December 2018, and were forecasting continued rate increases in 2019. German exports to China fell off a cliff, and this has led to particular weakness in Germany. U.S. exports to China have also been hit; we have seen significant declines in exports to China recorded by large industrial companies like Caterpillar, John Deere, and others. Corporate financial reports for Q4 2018 brought about the realization that earnings estimates for 2019 were way too high. These estimates quickly came down in Q1 2019 to a low of -3% projected earnings growth for 2019. In economic terms we saw a real slowdown in Q4 2018, and this continued into Q1 2019 but appears to have stabilized.
I have always been a firm believer that interest rates lead the way in terms of what the economy is doing. Let’s look at interest rate changes over the past six months: In Q4 of 2018 the U.S. 10 year treasury bond was yielding around 3%. Since then the yield has fallen to just over 2%. We have seen the same collapse in yields globally. We are back to having +13 Trillion in negative yielding debt globally. This is something we have not seen since the financial crisis of 2007-2008. This must be recognized as a clear warning sign. At the recent FED meeting they kept rates unchanged but are now leaning towards rate cuts, something Trump has been very vocal about in recent months. So much for an independent FED…and the equity markets have taken this as great news moving to new highs. I am somewhat troubled as it appears the FED is losing its independence with Trump’s meddling in what FED policy should be. Equally troubling is the fact that equity markets are taking everything as good news. When this happens we usually see some type of correction (back to reality) trade.
What should we expect as investors in the coming 12-18 months? There are several key points I score to get a measure as to how investor friendly the climate is going to be. They are:
- Monetary Policy: This has taken a huge swing from being a headwind (negative) to a tailwind, (positive) in the past six months.
- Earnings: We are still yet to see the full impact of tariffs, and they could get worse from the sounds of Trump’s rhetoric, therefore headwind.
- Earnings visibility: as above we have low confidence in earnings visibility, so a headwind.
- Corporate balance sheet: Corporate balance sheets are stretched. With interest rates having been so favorable for financial engineering, borrowing to conduct share buybacks has been a popular theme. So long as rates stay low and earnings are stable and most corporations should be able to operate as normal. BUT, they do not have the investment power they had three years ago, and we are seeing cracks in the BBB or lower debt. Therefore, I would give this a headwind, a flashing yellow signal.
- The Global economy: Thus far seems just ok. Yes, we are seeing a slowdown, but we are not falling off a cliff. The sharp drop of Q4 2018 appears to have stabilized. We have seen real resilience in Europe, particularly from the consumer. In the U.S. we are seeing some mixed signals, Slowing manufacturing and services, PMI, new home sales and consumer confidence. Some signs of consumer debt issues in particular related to auto loans. Some 8 million auto loans are now in arrears more than 3 months, meaning default status. The data thus far is not pointing to a recession, but we need to see future data stabilize and stay alert. Overall though I would give the global economy a mildly positive rating, therefore it’s a slow tailwind, supportive for investment, but subject to change quickly as we are seeing weakness.
- Geo-political backdrop: While there is little we can do about what happens in the geo-political scene we must be aware of what the risks are. There has been a huge swing from globalization to a more protective regional bias. This has been driven by Trump’s tariff strategy. Faith and confidence in the U.S. as an ally and trading partner has taken a significant hit. This will, without a doubt, be a damper on global growth. There are a number of what I would call “hot spots” that could create instability. Iran is where we are focused at the moment, but there are other areas in the Middle East, as well as N. Korea and Russia. I have to conclude that the Geo-political landscape is a headwind.
Final score: Headwinds 4 and tailwinds 2. Now this does not mean one should avoid investing or become extremely defensive. Rarely have I seen all six of these measures at once signal tailwinds. But it helps us be aware of where the macro risks are and what to watch out for when making an individual investment. For example, if we are considering an investment which is highly reliant on China for products/parts, they are presently facing a more uncertain environment. While we may still want to make an investment, the price we are willing to pay will certainly be affected. Interest rates are a critical factor in determining valuations. With the U.S. 10 year around 2% and others around the world in negative territory equities/PE/ Real Estate appear the only sensible place to invest. But we do see early warnings as noted by recent economic data and bond market movements, therefore caution is urged.
Taking a look at where public company valuations are, I begin with the SP500. Looking at current performance, Q1, Q2, and Q3 are looking at negative year over year comparisons in 2019. However, Q4 of this year earnings are expected to rebound to +6.7% YOY (keep in mind that this is compared to a down Q4 2018), and Q1 2020 to +10.3% (again, as compared to a down Q1 2019) (Factset Data). Earnings numbers have been steadily coming down since the beginning of the year. Factset sees a 12 month forward price to earnings ratio of 16.8 which is above the 5 year and 10 year averages (16.5 & 14.8 respectively). One can conclude that the SP500 is trading a little rich, but not something to be overly concerned about, particularly with interest rates where they are. One sector that stands out today is IT. It now represents 25% of the SP500, vs 15.8% of the S&P500 in 2007, but not as high as the bubble period of 1999 when it was 29.18% of the S&P500. My only reason for pointing this out is that once a sector represents +25% of the SP500 it normally means a correction is ahead for the sector in question. This long bull market we have witnessed has been driven by technology. How many of you are aware that technology companies are more exposed to factors outside the U.S. than any other sector in the market? If tariff wars continue IT will be one of the sectors hardest hit. Therefore, I would be more cautious with technology allocations and valuations.
What does this mean for us as private equity investors?
For us it means that we must be more selective and discipled in our new investments. We may be right on the thesis behind an investment, but if our entry price is wrong, we can still easily lose money on the investment. We are clearly very late in the bull cycle, so discipline must prevail. Sometimes doing nothing, waiting, is the most difficult thing to do as an investor. In today’s environment I believe patience will be rewarded when approaching any investment.
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