Are we in the ninth inning, or are we heading into extra innings? 2018 was a stellar year for growth as a favorable blend of monetary policy and a record corporate tax bill served as a double shot of espresso boosting an otherwise favorable growth trend.
While the caffeine buzz will wear off, growth will likely continue through 2019 as the economy’s trajectory falls back toward its 2-2.5 per cent trend. While 2 per cent-plus appears tepid by comparison, it is in line with our potential growth rate, which is good news. Economic excesses plant the seeds of a recession, so an economy growing at its speed limit will not accumulate too many excesses. If the expansion were to continue through the Q2/19, as we suspect it will, it would tie the record for the longest-running postwar expansion, set in the 1990s. However, it would also be the shallowest expansion in modern US economic history (Exhibit 1).
Consumer spending, a dominant theme in previous economic expansions, will play a lesser role in 2019 as business investment and government spending will pull more weight. Nonetheless, household checkbooks are flush thanks to low prices at the gas pump and fatter paychecks. Americans can now drive 320 miles on an hour’s worth of work, the highest such reading since 2016 when oil prices plunged. We expect this to translate into robust consumer spending.
Inflation ex-food and energy is running just above 2 per cent, the Fed’s objective, and real GDP readings suggest inflation will be stable around current levels throughout 2019. Our research indicates inflation follows real GDP growth trends with an 18-month lag (Exhibit 2). We expect core CPI to expand between 2-2.5 per cent with a bias to the downside. Historically, the Federal Reserve has had little success returning a below-neutral unemployment rate back to neutral – in other words, engineering a “soft landing” – without overshooting and causing a recession. For now, we see slow and steady stateside growth.
The Euro area witnessed an economic slowdown in 2018 as wage growth increased. We believe cost pressures will prompt the European Central Bank (ECB) to withdraw its stimulus. Although the ECB already announced the cessation of its 2.6€ trillion quantitative easing program last December, it has vowed to reinvest the coupon income and maturities on its massive balance sheet. Eurozone growth slowed in H1/18 due to one-time items that caused the German economy to shrink. Other factors like unfavorable 2017 comparisons and the difficulty of filling job vacancies caused productivity to slip as well. We suspect any slack that was created in the Eurozone economy 1H/18 was eliminated and that growth is likely to resume in Q4/18, with sub-1 per cent growth continuing into 2019.
Europe is not without event risk, however. Italy appears to be reprising its debt crisis and President Macron of France is doing more backpedaling than a Cirque du Soleil unicyclist. Consumer confidence in Italy, Spain and France have rolled over (Exhibit 3). The Eurozone is also heavily dependent on exports and China, the world’s second-biggest economy, is a key customer. China’s Q3 GDP growth was the worst in a decade. Nevertheless, we anticipate slow but steady expansion to prevail over the next four quarters.
China’s economy will face a difficult year in 2019: we expect GDP growth to decelerate from 2018’s projected 6.6 per cent pace to 6.2 per cent because of a significant drag from exports, which are forecast to contract 3.9 per cent following a 13.7 per cent expansion last year. Roughly half of China’s annual exports to the US have been slapped with tariffs, currently totaling $250 billion. Beijing will likely combat the trend by weakening the yuan and offering targeted tax incentives. The yuan, which declined about 6 per cent against the dollar in 2018, will continue to slide and probably breach the widely watched 7 yuan/dollar threshold sometime in H1/19. Credit growth, another key policy lever, is slowing despite the People’s Bank of China’s efforts at cutting the reserve requirement by 2.5 per cent in 2018 (Exhibit 4). Next year the Chinese leadership will likely boost infrastructure spending to address the slowing economy; this is a sector in which the government has a great deal of flexibility. Private investment might pick up as well thanks to easier credit conditions. Beijing is also studying a corporate tax cut, which if passed would represent an alternative growth catalyst.
China’s economic trajectory in 2019 depends to a large degree on the outcome of their standoff with the US on trade. Intransigence represents the biggest risk to near-term growth. Meanwhile, the leadership is slowly prying the country away from low-value-added manufacturing exports and shifting toward highvalue, high-tech exports, but a major transformation will take many years to realize.
Chairman Powell has put investors on notice: the Federal Reserve Bank will no longer be the stock market’s sugar daddy. The “Greenspan put,” the “Bernanke put” and the “Yellen put” served as a veritable safety net for equity investors for decades (Exhibit 5). In January 2001, Greenspan’s Fed slashed the overnight rate from 6.5 per cent to 1 per cent over a period of 29 months to battle the tech bust. The global financial crisis was the central bank’s biggest test yet. Bernanke’s Fed took the unprecedented step of knocking the Fed Funds rate to zero to address investor fears of a systemic breakdown of the US financial system. Yet that wasn’t enough to assuage panicky investors, prompting Bernanke to embark on quantitative easing, an untested strategy of buying bonds with printed money that was continued by his successor Yellen. Between 2008 and 2015, the Fed purchased $3.6 trillion of bonds to push interest rates lower and spur risk taking. The strategy worked. But now, with overnight rates at 2.5 per cent and a $4 trillion balance sheet, Chairman Powell’s Fed has little firepower left for battling the next downturn.
Global investors have become inured to the notion that if equity markets get ugly, the world’s central banks will come to their rescue. Five years ago, ECB President Mario Draghi saved European markets fearful of a euro collapse by asserting that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Draghi’s “whatever it takes” speech was a watershed event for global equity markets. But now global central banks, many of which have not yet raised their benchmark rates, have even less dry powder than their US counterpart. The Bank of England’s overnight rate is 0.25 per cent, the ECB’s rate is zero per cent and the benchmark rate for the Bank of Japan is -0.25%. All told, there remains nearly $7.5 trillion worth of bonds outstanding sporting negative interest rates. The currency-colored cavalry has lost its horsepower.
The world’s central banks have pumped more than $14 trillion into the global financial system since the crisis. Most of that printed money has found its way into the equity markets. In fact, some central banks continue to buy equities directly. According to a recent Reuters story, the Swiss National Bank now has about 20 per cent of its reserves in equities, up from about 7 per cent a decade ago; more than half of it is in US equities. The Bank of Japan currently accounts for nearly three-quarters of the Japanese exchange-traded fund (ETF) market.
Current financial conditions argue for higher rates. The Taylor Rule, a formula designed by Stanford professor and Federal Reserve Chair nominee John Taylor, arrives at a suggested appropriate overnight rate by looking at current economic conditions. It currently calculates that the Fed Funds Rate should be 5 per cent, not 2.5 per cent (Exhibit 6). Additionally, the 10-year Treasury yield, which has historically tracked US nominal GDP growth, is currently about 1.5 per cent below potential nominal GDP.
Over the last 10 years, equity risk takers have gotten comfortable with below-market bond yields, making the price of risk aversion costly. Investors make a trade off every day: to strive for high returns coupled with high risk or to settle for lower-return assets that are more predictable.
For that reason, all investible assets are priced off the “risk-free” rate, which is a rate of return offered to investors seeking daily liquidity in the highest-quality, principal-protected investment (US Treasury bonds, in practice). Investors desiring a return premium to the risk-free rate must compromise on at least one of those attributes. The relationship between risks and expected returns form the capital market line anchored by the expected return from the equity market and the risk-free rate.
When the risk-free rate is zero, the expected returns for risk asset classes can come down, too; that’s what has happened in today’s equity markets. So, while the Federal Reserve attempts to normalize the overnight rate, the equity markets are feeling the impact. The good news: it appears that most of the Fed’s overnight adjustments are behind us.
The second half of 2018 was not pretty for equity investors. The S&P 500, down 6.24 per cent for the year, plunged 19.6 per cent between October 1 and December 24, culminating in the fastest market fade since the Great Depression. The 2018 selloff is already below the median selloff when compared to bear market history (Exhibit 7).
That’s remarkable considering there is no sight of recession on the horizon. Momentum stocks – i.e., large-cap tech names – sold off the most in Q4/18, but maintained their outperformance for the year as well as their dominance over value stocks for the last five years, expanding at an annualized 11.1 per cent vs 6 per cent for value. Most of the differential was likely attributable to a massive shift toward passive exchange-traded funds and away from actively managed mutual funds, which tend to favor “undervalued” stocks. Value stocks will likely continue to trail until we see a reversal of funds flows.
Given that backdrop, how are equities positioned for 2019 and beyond? Cresset evaluates the market from the top down, assessing five factors that have been predictive of future performance historically.
First, valuation: is the market cheap or expensive? It shouldn’t be a surprise that cheap markets tend to outperform expensive markets over time. Currently, our S&P valuation metrics are mixed. The S&P 500’s price-to-sales (P/S) ratio at 1.9x is 18 per cent above its historical median, suggesting the market is relatively expensive. Historically, a P/S ratio of 1.9x translated to a negative 2.7 per cent annualized return over the subsequent three years. It’s interesting to note that the market’s P/S ratio was roughly 1.8x three years ago and the subsequent return was substantially higher than our model predicted (Exhibit 8), thanks to record profit margins. On a forward price-to-earnings basis, all major markets are now trading at discounts to their historical medians, although analysts have yet to adjust their Q3 and Q4 2019 projections. The net effect, in our view, is a fair value reading.
Second, the economic backdrop: it is favorable, but slowing. The one-two boost of monetary accommodation mixed with an enormous corporate tax incentive produced 4.2 per cent and 3.5 per cent growth in Q2/18 and Q3/18 respectively. That rate will most likely slow toward 2 per cent in 2019. Still, despite a yield curve that’s teetering on inversion, we do not see an imminent recession threat. New orders minus inventories, a metric that provides insight into current US manufacturing conditions, is also signaling slowing (Exhibit 9). Tepid inflation readings, however, will likely keep continuing Fed tightening to a minimum.
Third, liquidity: it gauges the availability of money to borrow, spend and invest. Our liquidity metric shifted negative on October 26 (Exhibit 10), as lenders tightened their purse strings.
History has shown that the S&P 500 has an easier time rising when credit conditions are favorable (Exhibit 11). Tighter credit conditions combined with a more aggressive Fed signal headwinds in 2019.
Fourth, psychology: more of a spice than a principal ingredient when it comes to evaluating our equity market risk stance. This contrarian indicator becomes more bullish as investors become more bearish – and as of this writing investors couldn’t be more bearish. A cacophony of news, mostly all bad, is bombarding investors daily. Add trade uncertainties and the government shutdown to the recent equity market downdraft and you have investors battening down their bomb shelters. History suggests when investors get this bearish (in other words, when there’s no one left to sell) markets usually pop (Exhibit 12). The sustainability of an upside pop, however, would likely be short-lived unless the larger fundamental picture improves.
Lastly, momentum: it gauges the market’s direction and persistency. To restate Newton’s First Law, a market in motion tends to stay in motion unless otherwise acted upon. History shows momentum has been a good predictor in risk mitigation and asset allocation (Exhibit 13). Virtually all major equity markets, including the S&P 500, have broken down relative to 3-month Treasury bills. This suggests riskoff until markets stabilize and turn higher.
Emerging markets, which broke down relative to cash in April 2018 and vs the S&P 500 in June, are showing signs of life on a relative basis. Now that the downdraft has enveloped US large caps, emerging markets have been relative outperformers recently and could suggest a trade out of US blue chips and into EM equities in a matter of weeks (Exhibit 14). Developed international equities broke down vs the S&P 500 in early 2015 and, like emerging market equities, are showing relative strength in recent weeks as well.
We are upgrading our 2019 outlook given the recent downdraft. Negative momentum could dominate in H1/19 as political uncertainties cast a shadow over the equity landscape. We believe markets will offer compelling valuations by midyear, although we will stay tuned to ongoing developments on the trade front. While US large caps are slightly overpriced, international large caps are fairly priced relative to their history, and emerging markets are cheap (Exhibit 15). Just as international markets led the market lower last year, they could lead the market
higher in H2/19.
The headline-consuming trade war between China and the US has both tactical and strategic elements. The tactical component challenges China’s unfair trade practices, which include lopsided tariffs and intellectual property theft. The strategic piece targets China’s longer-term economic and technological aspirations. US policymakers are threatened by their up-and-coming trading partner. The economy of world’s most populous country is expanding at more than double the rate of the US.
China displaced the US as the leading contributor to global growth in 2005 and has remained in that position ever since, according to International Monetary Fund (IMF) data. That’s why global investors care more about the vagaries of Chinese manufacturing than they do about US retail sales. China’s economy has expanded dramatically since the early 1990s when its Communist leadership reluctantly entered the global supply chain. In 1990, according to the IMF, China’s economy was ranked 11th in the world behind countries including Iran, Spain and Brazil. By 2010 it ranked 2nd, behind only the US. The Tiananmen Square uprising of 1989 was a wake-up call for the Chinese leadership, who feared that the lack of an adequate social safety net for its huge and aging population would lead escalating unrest.
For decades, Chinese officials have downplayed their country’s power in an effort to reassure other countries, particularly the US, of its beneficial intentions. While China seemingly has no desire to oversee global order, at least militarily – in fact, its defense budget is about one quarter of that of the US – its unambiguous goal is to dominate the Pacific region by becoming an unchallenged political, economic and military force. That means pushing America out. Beijing understands that for its plans to succeed, it must not unduly provoke the US; so China is gradually turning up the heat on the US frog in the pot.
Resisting China’s advances is difficult for many economically strapped countries. It has been expanding its influence in Africa, Central Asia and Southeast Asia, areas that have been low priorities for the US. Beijing has financed major infrastructure in the developing world to establish a strategic foothold. The Belt and Road Initiative, launched in 2013, has helped fuel $400 billion in investments in 86 countries, according to a recent report in Foreign Affairs. US policymakers fear that China could use its influence in Africa, the Middle East and South Asia to pressure host states to restrict US military activity in their respective regions.
President Trump’s trade dispute with China’s President Xi was initially viewed as a tactic to level the playing field. In July 2018, Trump imposed a 25 per cent tariff on $34 billion worth of Chinese goods and threatened to broaden the tariffs to $200 billion more. Market participants initially shrugged off President Trump’s tariff threats as arm flapping, but by the beginning of Q4/18 the trade skirmish had sparked a tariff brush fire, prompting investors to worry about its impact on 2019 global growth. Equity markets worldwide slid in unison. As we mentioned earlier, the toughening US trade policy toward China has both tactical (trade) and strategic elements; the latter aims at addressing the threat “Made in China 2025” poses to our nation’s global economic dominance.
“Made in China 2025” is a government-sponsored 10-year plan launched in 2015 to reinvent the manufacturing base by rapidly developing 10 high-tech industries, with a focus on electric vehicle production, next-generation information technology and telecommunications, advanced robotics and artificial intelligence. Beijing’s goals are to reduce China’s dependence on foreign technology and to lead the world in high-tech manufacturing.
The Chinese Communist Party has taken steps in recent decades to transition away from low value-added, low-wage manufacturing, notably mining, energy and consumer goods, which together comprise nearly half of the country’s economic growth, toward high-tech, high-productivity industries. China currently accounts for 60 per cent of global demand for semiconductors yet produces less than 15 per cent of global supply. The government plans to increase direct subsidies for “Made in China 2025” through state funding, low-interest loans and tax breaks, which are estimated to total hundreds of billions of dollars. Chinese companies have been encouraged to invest in foreign tech companies to gain access to advanced intellectual property. China’s technology leaders, like Huawei whose CFO was recently detained in Canada at the request of US, are privately run but supported by the government.
The Council on Foreign Relations, a foreign policy thinktank, views “Made in China 2025” as a threat to our nation’s vital interests. US intelligence agencies view Chinese recruitment of foreign scientists, theft of US intellectual property and targeted acquisitions of US firms as an “unprecedented threat” to the US industrial base. Policymakers fret that China aspires to control entire supply chains and industries.
While China’s plans are far-reaching, the threat they pose to US interests might be overstated. A recent Bloomberg report suggests that Beijing is considering delaying its “Made in China 2025” targets. Other reports speculate that China may replace the program altogether and instead offer foreign companies more access to its market. While China has no intention of reining in its desire to be a high-tech powerhouse, it’s a long way from achieving its goals. China’s R&D spending as a share of GDP remains well below levels in the US and Japan. In 2017, high-tech manufacturing amounted to just under 13 per cent of China’s total industrial output, according to Bloomberg, and much of its current technology output doesn’t meet international standards. While China leads the world in electric vehicle output, they have yet to produce anything worth exporting; in fact, in an unprecedented move China has allowed Tesla to open a wholly owned local manufacturing facility for its electric vehicles, without mandating the involvement of a Chinese partner. Despite trade tensions, foreign direct investment continues to flow into China. Multinational companies like BMW and Apple have profited there. Increased openness to foreign companies would serve both domestic and foreign interests while enabling China to raise its technology profile.
Despite the most recent swoon, the S&P 500 has delivered impressive investment returns to investors over the years. Try as they might, active managers have faced an uphill battle to beat the widely used market benchmark, particularly over longer-term time horizons. One area of the market that has performed well against the S&P and has the potential to keep its relative strength alive are private equity secondaries.
Private equity secondaries funds purchase limited partnership (LP) interests in individual funds or portfolios of funds. The private equity secondaries market exists to provide liquidity to an otherwise illiquid market and represents one of the only ways for individual LP investors to exit early from their private equity fund holdings. The global private equity secondaries market has grown over the last 20 years, according to a recent report from alternative investments data provider Prequin (Exhibit 16).
Secondary positions aren’t damaged goods: there are several reasons why LP investors might need to liquidate their positions prior to maturity. The decision is often top-down as the LPs’ priorities and strategies change. In recent years, mergers between large insurers have given rise to private equity portfolio rebalancing. Pension funds and asset managers represent roughly half of the universe of LP sellers, and portfolio reshaping is the number one reason they cite for liquidating their holdings.
Private equity secondaries strategies possess several attributes that help boost their investment return potential over traditional investments. The ability to provide liquidity for an otherwise illiquid asset class commands a premium that would-be sellers in effect pay to buyers by offering their shares at a discount, all other things being equal. Since the private equity secondaries market is often characterized by significant price and information inefficiencies, this offers secondaries buyers another lever in generating superior risk-adjusted returns. Private equity secondaries funds have historically delivered competitive and often superior returns relative to equity market investments (Exhibit 17).
Besides their outsized return potential, private equity secondaries offer investors several risk moderating benefits over investing in private equity funds. “Blind pool” risk associated with primary private equity fund commitments, in which investors commit capital without knowing what the specific investments will be, is substantially smaller because investors typically invest in mature, invested portfolios whose holdings are already known. As a result, the “J-Curve Effect” – a period of negative returns while capital commitments are drawn down as investments are acquired – is eliminated.
Secondary funds also offer substantial diversification by investment strategy, geography, and industry sector, and “vintage year”. Investment in private equity secondaries is a great way for investors who don’t have much private equity experience to get involved in the private company markets. The potential for outsized returns is a bonus.