Fourth Quarter 2017

 In Market Commentary

2017 was profitable for all global assets despite the drama from geopolitics, severe weather, and the solar eclipse.  First, North Korea did not launch a nuclear weapon on the United States.  Trump’s Twitter account personally helped revive the ailing social media company, and kept the writers at Saturday Night Live fat on material.  Plus, Republicans managed to pass a massive tax cut for corporate America and some folks with qualifying pass through incomes.  In the United States, and most of the rest of the world, economies performed better than they did in 2016.  Globally, unemployment rates fell, inflation stayed subdued, and growth was stronger than expected.  Bond markets rallied, equity markets did even better, and commodities managed to put in a positive performance, especially oil, which recovered from a major slump in 2015 and 2016.  Apple launched a new iPhone that reads our face rather than our finger, and Amazon’s Alexa put a human voice on artificial intelligence that the world mass adopted.  In fact, I asked Alexa to write my annual investor letter, but she responded, “Sorry, I don’t understand your request.” Well, maybe next year, as the world is changing fast.

We think that the current global expansion will continue and financial markets will lead the economic expansion in the short term. As all crowded financial trades are becoming extreme and market moves are synchronized across all asset classes, any changes in expectations (about inflation/growth) could lead to a trimming in extreme positions later in the year. At that time, investors will watch the directionality of the US dollar, as well as the outlooks for US inflation and China to determine whether to continue “buying the dip” or to begin “selling the rallies.”

Chart 1: Purchasing Managers’ Index in the Eurozone, the United States and China

As the chart shows, Europe and US growth expectations have moved strongly forward, while China has been less than stellar.  A PMI reading above 50 signals expansion while below 50 signals contraction. China never really had its cathartic event to clean up its banks’ balance sheets, like the US did in 2008 and Europe did in 2011/2012.  Instead, they chose to sweep problems under the rug, and occasionally look under that rug at night when no one is looking to haul away the trash.  The slow deleveraging at Chinese banks puts a damper on growth and inflation expectations and could confine them to years of meager future growth, similar to Japan in the 1990s.  Emerging Market equities and bonds rallied aggressively this year as it became clear China probably averted a crisis, but are still going to be constrained by lower commodity demand from China going forward.  There is hope that India can pick up some of the demand slack coming from China. The Indian government managed to pass one of the largest tax overhauls in Indian history last year, while bumbling an attempt to bring more of the financial sector out of the black market.  India, however, still faces fiscal problems, such as trade deficits (-2.2%) and fiscal deficits (-3.7%)[1], and large regulatory and infrastructure hurdles that make it difficult for them to turn into an export driven economy like China.

Nearly every equity and credit market in the world rallied in 2017.  Increasingly, we believe market positioning on the long side is vulnerable to changes in the fundamental story.  In the near term, fiscal stimulus in the form of tax cuts in the US will likely support growth.  Lower corporate tax rates will most likely fuel increased stock buybacks by US corporations. Further, they will use the cash they have parked offshore to unwind tax arbitrage structures, where they issued low cost debt onshore to allow them to avoid paying taxes on their offshore earnings.  It’s pretty amazing when you think of it; the S&P 500 alone has returned $900 billion a year in cash to investors since 2014 (see table 1).  I’m sure much of this has been recycled into buying more equities, creating a virtuous cycle for investors.

Table 1: S&P 500 Dividends and Buybacks ($ in Billions)

However, as we reach full employment, the surprise for 2018 could be the rebirth of inflation.  In fact, 10-year breakeven inflation measures have recently picked up despite the yield curve flattening.  Yield curve flattening typically portends a slowdown in growth, as investors seek safety in longer term bonds. However, inflation protection bonds are saying something different. Breakeven inflation often rises as the economy overheats.

If the Fed were to be forced to get more aggressive in hiking rates, this could be a serious damper on financial assets. Further, as we discussed in the Q3 letter commentary, 2018 will be the first year when central bank balance sheets stop growing.  We don’t know how important this will be for asset prices, but we suspect the bull market may become much more data dependent by summer.

The fact is, monetary policy across the globe may be too loose. At some point these gaps between nominal growth and the cost of capital will need to close, otherwise inflation will occur and asset bubbles will grow. When the real cost of capital is negative, investing in anything looks good, including cryptocurrencies, covenant light high yield bonds, or any stock with a story. If that gap gets closed, and the real cost of capital is positive, then we might expect investors to become more rational in their asset allocation process. At a time when inflation and growth are normalized, policy rates appear way too low. Unemployment in the world’s major economies is already near their best levels in 20 years. We see a major risk in 2018 that central banks have to play catchup, hiking rates more aggressively than they planned, in response to both higher global inflation and potential asset bubbles.

Table 2: Cost of Capital Below Nominal GDP Growth Globally

The bubble in cryptocurrency prices in 2017 was striking and is probably the greatest evidence that the cost of capital as set by central banks is too low. The rapid moves higher in the second half of the year dominated headlines. According to Google Trends, the most searched news in 2017 was Hurricane Irma, followed by Bitcoin, the Las Vegas Shooting, North Korea, and the Solar Eclipse. People cared more about Bitcoin than a potential nuclear disaster. The “fear of missing out” is strong amongst investors.  I’ve read a great article recently about why cryptocurrencies will never see mainstream adoption.[2] That being said, Peter Theil has been adding Bitcoin to his venture-capital fund, Founders Fund.  My feelings are nuanced. I think that Blockchain, i.e., distributed ledgers, definitely will find acceptance throughout the financial and technology sectors. I also think these currencies could have some value to people in countries with oppressive governments, hyperinflation, and currency controls in place. This is supported by the fact that Bitcoin trades at a premium in places where such conditions exist, like Zimbabwe (hyperinflation) and South Korea (tough capital controls).  But, I’m hard pressed to say their current prices reflect any reality about their actual value. If you want to invest in a bubble, hoping to be smart enough to get out early, well, that’s gambling. Unfortunately, most people join at the end of a bubble, and that’s when the pain begins. Cryptomania feels strikingly like the boom to me.  I remember in the late 1990’s, there were these day trading shops in my local mall, the Coolsprings Galleria near Franklin, Tennessee, where you could rent a workstation and trade stocks all day. I always wanted to have a seat at that table, as the flashy lights, big screens, and making quick money was very tempting to a teenager.  It was like walking into a casino. Now, with mobile phones and Coinbase (the Charles Schwab of Bitcoin), the barriers to entry for retail investors are tiny. No need to rent a workstation, no need to fly to Vegas or drive to Atlantic City. Just download an app, link your bank account, and you’re off.  Coinbase is the casino taking a cut via high commissions and bid/offer spreads.  The house always wins, but it’s unlikely most gamblers will.

[1] Data Source: Bloomberg. Numbers expressed as a percentage of nominal GDP.


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