Credit gluttons will be the financial roadkill of 2019

Introduction

I reiterate my recommendation in Forecast 2019 that cash should be a real asset class in 2019, not a balancing item in a portfolio. I will be comfortable with a higher cash holding, rather than be tempted to allocate it to a risky or overvalued investment. Patience, prudence and preservation of capital should have high priority.

A flattening yield curve is a reasonable forward indicator of market volatility. As it flattens the more anxious investors become about the outlook for economic growth. So, batten down for more volatility in 2019, perhaps beyond. The US 2-year (2.65%) and 5-year (2.62%) yields are marginally inverted at present and the one-year and 5-year yield are the same at 2.62%. Volatility is the new normal. Credit-reliant companies that have had a free ride on the coat tails of massive central bank easing over the past eight or nine years are likely to be the road kill of financial markets in 2019.

It has been well documented we are in the late stages of the current economic cycle, which was extended due to the prolonged rescue operations of the central banks in the aftermath of the GFC. The magnitude of the stimulus programs was unparalleled in both quantum and duration. Already in 2018 US corporates outlaid a record US$1 trillion in buybacks, easily exceeding the previous record of US$781bn in 2015. These purchases have supported US markets in 2018 helping them to record levels and this could be viewed as a misallocation of capital, at least in the short-term.

Exhibit 1. S&P 500 Dividends and Buybacks

Source: Yardeni Research

In the US, the aggressive monetary policy easing has been supercharged by ill-timed fiscal stimulus, also of very meaningful proportions. However, despite this, the economic recovery has been relatively weak and drawn out. A recent GMO white paper reveals "the current (US) expansion is the slowest and weakest economic recovery witnessed in the entire post war period."

Corporates have gorged on cheap and abundant liquidity. While economies gradually recovered and labour markets tightened, it becomes increasingly difficult to lift productivity meaningfully. In the immediate aftermath of the GFC, between 2009-2011, when the unemployment rate was near 10%, the US nonfarm labour productivity index jumped from just over 92 to almost 100 – near 4% per annum. The mindset was, find a job and keep it by working harder - being more productive. In the seven years between 2012 and 2018 the index has edged higher from just under 100 to a record 105, the rate of improvement slowing markedly to just 0.7% per annum, consistent with a fall in the unemployment rate, which currently sits at 3.7% and a near 50-year low.

Simplistically, the change or movement in GDP is the combination of the change in the workforce, or the number of hours worked and the change in productivity. This combination provides the change in the final output of goods and services in the economy, which is the gross domestic product. It is imperative productivity plays an increasing part in lifting and sustaining GDP growth. An increase in productivity can come in two ways – via the inputs, labour and capital. The former is much harder to consistently achieve than the latter, although capital misallocation is always a risk. The lack of productivity is increasingly evident in highly leveraged companies.

Investors have, until recently enjoyed the benefits of improving earnings growth, boosted in 2018 by a large tax cut. Dividends increased, and buybacks shot to historically high levels, helping to push US markets to peaks in 2018. These collective payouts are at unsustainable levels, especially as corporate earnings growth in 2019 is likely to fall from the 20% plus of 2018 to single digits due to slowing economic growth and the non-repeat of tax cuts.

Exhibit 2. S&P 500 Buybacks and Dividends and Operating Earnings

Source: Yardeni Research

Investors should beware of the possibility of a Wile E. Coyote moment in 2019, where in chasing the roadrunner he is oblivious to the potential risk and is over the cliff edge and in mid-air before he knows it, looks down to see no support. Valuations will be tested.

United States: the Fed moves and markets react

As widely anticipated, the Federal Open Market Committee (FOMC) unanimously raised the federal funds (fed funds) rate at the 19 December meeting for the fourth time in 2018 and the ninth time since the current round of monetary policy tightening started in December 2015. The rate was increased by 25 basis points to 2.5% - the range now 2.25%-2.50%. The announcement triggered violent swings in US markets in the last two hours of trading, with the Dow whip-sawing over 750 points. The fed funds rate is up 67% in 2018 from 1.5% to 2.5%. Blasphemies echoed throughout the White House, across the White House lawns to Wall St and beyond.

The much-watched dot-plot now indicates two further rate increases in 2019, down from three in September, which would take the rate to 3.0%, double the level at the start of 2018. Leveraged corporates will increasingly feel the pinch in 2019. The committee members are clearly concerned about the global economy, after previously citing strong economic conditions in earlier commentary, the tone has softened as tariff and trade implications complicate the landscape. Domestically, the labour market and household spending remain strong while business fixed investment has slowed from rapid growth earlier in 2018. Inflation remains near 2%.

Exhibit 3 – Federal Open Market Committe Dot Plot

Source: US Federal Reserve; Morningstar

Given the dual mandate seeking to foster maximum employment and price stability, further gradual increases in the federal funds rate is appropriate and consistent with the mandate. The committee continues to "monitor global economic and financial developments and assess their implications for the economic outlook."

Signs of weakness in the housing industry persist. The National Association of Home Builders sentiment index fell from 60 in November to 56 in December, the lowest level since December 2015 and well below forecasts. This follows an eight-point fall in November, racking up the biggest two-month fall since October 2001. Demand is being affected by elevated prices and rising mortgage rates.

November housing starts rose 3.2% to a seasonally adjusted 1.256 million units driven by a surge in multi-family projects while single family homes fell for the third consecutive month to an 18-month low. On revision, October’s rise was reversed. The slide in single-family starts indicates a weakening trend, which if not checked could spill over into the wider economy. Existing home sales rose 1.9% to 5.32 million in November, but the 7% annual decline was the steepest since May 2011.

The housing industry is a good bellwether of underlying economic activity. Is this the "canary" in the macroeconomic coal mine for what is to follow for the US economy in 2019? Mortgage rates are up about 60 basis points to 4.63% over the year and have affected activity. However, the recent decline in the 30-year bond yield, the benchmark for mortgage rates, should have a positive effect in 2019.

Former chairman of the Federal Reserve Alan Greenspan suggests the rise in real interest rates is causing the equity market to readjust and that we are not through the cycle yet. The market volatility is associated with the human instincts we speak, think and feel and reflected in herding behaviour. He believes we are entering a period of stagflation, where inflation rises, and economic growth weakens – a toxic mix. It would be very surprising to see markets stabilise and then take off again, but it has happened before and if it does again at the end of the rise "run for cover". He sees overall leverage about average, but it is the level of leverage in toxic assets that is the concern. The outlook is "not terribly enterprising".

Recall US margin debt is at record levels. The slide in US markets in December is shaping up to be the largest since the Great Depression of 1931. The effect of margin call-related selling in addition to redemptions from passive exchange traded funds is having a meaningful influence on daily trading with computer-generated selling accounting for the majority of turnover. The ranks of the "buy the dip" followers have thinned, and temporary bounces suggest short covering.

At close of business on 19 December in New York, all five closely monitored US market indices were either in correction mode (greater than 10% lower than recent 2018 peaks) Dow Jones Industrial Average -13.1%; S&P 500 -14.3%, Nasdaq Composite -17.5% and DJ Transport -19.7%. The Russell 2000 small cap index is in a bear market (greater than 20% lower) down 22.2%. All FAANGs (Facebook, Apple, Amazon, Netflix and Google) are in bear markets.

Australia – Potential risk of over-regulation

The final report from the Hayne royal commission is due in February. The market will eagerly and perhaps apprehensively await its delivery. I think it may not be too bruising as much of the pain and embarrassment is already reflected in the prices of those institutions at fault. This may lead to a relief rally in the sector, which could be short-lived. If the current "credit squeeze" tightens further, it will have a far more wide-reaching impact on the banks, housing prices and the economy as a negative wealth effect filters through to consumer spending.

I believe the chastened will change their behaviour and hopefully for the better. But my concern is the reaction of the regulators. They also let the Australian people down by allowing banks and other financial institutions to conduct operations in a reprehensible manner and failed to prosecute those involved. The final report of the royal commission is likely to outline how banks and financial institutions must conduct themselves in future. This could embolden the already tarnished regulators, including the Australian Securities and Investments Commission (ASIC), the Australian Prudential Regulation Authority (APRA) and the Australian Competition and Consumer Commission. The downside could be that Australian business becomes over-regulated. Australia is already the world’s most prolific manufacturer of red tape and government bureaucrats do not need any incentive to create more, in fact their ranks should be halved.

While the Mid-Year Economic and Fiscal Outlook (MYEFO) revealed an improving budget position and forecasts Australia’s first surplus in a decade in 2019, there were some disappointing aspects. The prediction that wages growth will slow to 2.5% in 2019 from the 2.75% forecast in the May budget is not good news. The knock-on effect is reflected in a downgrade in consumption growth from 2.75% to 2.5% which will hamper GDP growth. In the absence of stronger wages growth, the only way to underpin stronger consumption is to stimulate disposable income with a meaningful cut in personal taxes immediately.

Global growth is slowing so external factors could quickly change to headwinds. Chinese authorities cannot continue to stimulate the slowing economy, buffeted by waning domestic demand and trade issues, by continuing to ramp-up resources-sensitive construction and infrastructure investment indefinitely. Australia must endeavour to generate more growth from domestic sources and reduce our export dependence on China. Canada recently rued their over-dependence on the US.

The minutes of the December Monetary Policy Meeting of the Reserve Bank revealed trade between the US and China had contracted following the imposition of tariffs and indicators of external demand, including new export orders, had "softened" in the euro area, Japan and other parts of Asia. This contagion was evident in the recent downgrades of GDP growth for the eurozone and the 0.6% contraction in the Japanese economy in the September quarter. GDP growth outcomes diverged further in the September quarter, the first quarter since the tariffs were implemented in July.

The board misread the September quarter GDP growth number, predicting growth would be over 3% for the year ended September. The national accounts were released the day after the meeting and showed growth slowing to 2.8%. The forecast growth of 3.5% for 2018 will need to be revised downward with a possible flow-on to a similar forecast for 2019.
The combination of low growth in household income, high debt levels and falling housing prices continued to raise uncertainty over the outlook for household consumption. This combination of factors "posed downside risks". 

November’s labour force data was mixed with 37,000 jobs created, well above forecasts of 20,000, but the unemployment rate edged higher from 5.0% to 5.1% as the participation rate increased from 65.5% to 65.7% as more people looked for work. Part-time jobs increased by 43,400 while 6,400 full-time jobs were lost. Total hours worked declined marginally despite the increase in the number of people employed.

The underemployment rate increased from 8.3% to 8.5% taking the total underutilisation ratio (unemployment and underemployment) to 13.6%, from 13.3% in October. This ratio measures the spare capacity in the labour market and is a good indicator of wages growth. A rising ratio is not a great Christmas for households or the Reserve Bank, both needing increased disposable income to drive the most important contributor to GDP growth – household consumption. Frustratingly, the return to trend, let alone above-trend wages growth is not around the corner, particularly if the unemployment rate backs up in 2019.

Eurozone – Outlook dims as the curtain falls on quantitative easing

The European Central Bank (ECB) has cut its growth forecasts for 2019, while ending its four-year quantitative easing stimulus program. At the last meeting of the central bank for 2018, President of the ECB Mario Draghi painted a sombre outlook with trade tensions, protectionism, geopolitical issues, vulnerable emerging markets and financial market volatility combining to create a “climate of great uncertainty”.

The ECB outlaid €2.3 trillion (US$3 trillion) during the bond-buying program, leaving it with a bloated balance sheet. The Federal Reserve’s bond-buying program was even greater at around US$3.6 trillion, and it has been gradually selling bonds to normalise the balance sheet, while also tightening and normalising monetary policy. It will be some time before the ECB starts selling bonds or raising interest rates. It will continue to reinvest the full principal payments received from maturing securities purchased during the stimulus program and will do so for “as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.” Interest rates will remain unchanged for the foreseeable future.

The eurozone’s GDP growth slowed sharply in the September quarter (3Q18) to just 0.2 % and year-on-year (y/y) from 2Q18’s 2.2% to 1.7%. This was the weakest growth since 2Q14. Germany’s economy contracted for the first time in three-and-a-half years. France’s year-on-year (y/y) GDP growth slowed from a downwardly revised 1.6% in 2Q18 to 1.4%. Italy continues to wrestle with political and budget deficit issues with the economy also contracting in 3Q. Consensus estimates forecast growth for the eurozone of 1.8% in 2019 slowing to 1.6% in 2020. The ECB trimmed its forecast for GDP growth in 2018 from 2.0% to 1.9%, from 1.8% to 1.7% in 2019 and unchanged at 1.7% for 2020 and 1.5% in 2021. There is no economic party forecast for the eurozone for several years.

The three largest economies within the eurozone account for 11.5% of global debt – Germany 3.8%, France 3.8% and Italy 3.9%. The United Kingdom accounts for 3.7%, but is not included in the eurozone, but is a member (at this stage) of the European Union (EU). The zone contributes 16% to global GDP based on purchasing-power-parity. The UK, along with eight other countries of the EU, does not use the euro as its currency.
China – Growth slowing as tariffs distort trade

GDP growth continues to slow and trade tensions with the US further complicate matters. Key benchmarks weakened again in November: retail sales growth slowing to 8.1% y/y from 8.6% on October and against expectations of 8.8% growth; and industrial output grew at 5.4% y/y, the lowest in almost three years, against expectations of 5.9%. Fixed-asset investment (FAI) picked up growing at 5.9% for the 11 months January-November, from 5.7% January-October. Growth in FAI has increased in the past three months, reflecting stimulatory measures to soften slowing GDP growth.

Australian iron ore and coal exporters have been the beneficiary of this stimulatory action, although Chinese policy makers cannot continue to support a slowing economy indefinitely.

Updated snapshot of 2018 at 19 December