Don't worry, there are no Game of Thrones spoilers here, so you can read on safely. Actually, I haven't even been watching the latest series myself yet, but just thought this was an apt title to use for today's investing climate and couldn't resist jumping on the GOT bandwagon here!
To start with my conclusions, I do not believe winter has arrived, however it is most certainly coming. I wrote in Q4 last year how we were late cycle and posed some ideas and themes to consider when investing. Many of those still apply of course, however I am feeling that we are getting closer to a major and aggressive correction which could be triggered by any number of events. To be clear, the music hasn't stopped yet, but there are only a few chairs left in the room.
I wanted to put all this in writing when the S&P500 hit 3,000 but given new market highs recently, I'm cautious of (too) many red flags popping up everywhere, and a number of hazards that could trigger a significant market drop. Trade wars, Brexit, yield-curve inversion, recession. These are not new topics, but they are gradually coming about. Any of these ending worse or sooner than expected could be the catalyst, however it is the last one, recession, that concerns me most today as this would lead to more than just a correction.
I want to have a look at the 2 key economies in the world, China and America, and see where we are today, and where they could be heading to tomorrow. However, first let's look at the recent history of these two major world economies. Many investors and 'experts' seem to think that 2019 is feeling similar to 2016. I'd say that is very much not the case. There are so many different things to consider, but one key stand out difference is inflation. Back in 2016 inflation around the world was non-existent whereas today it sits at around 2%. Also, it is more often than not, not the case that everything goes up and down at the same time. Yes there are periods where this happens of course, but actually going back through history, 63% of the time the US actually de-couples from the rest of the world. Let's now go back to the 2016 vs 2019 scenario. In the US, GDP was seen growing for 10 straight quarters (is it now slowing again?). Conversely, China has slowed for 8 straight quarters in a row. These are two very different stories, so let's have a look at each of them now...
The United States:
Ok so it's not slowing down, the US economy is back on track! Or is it? Markets celebrated the recent data out of America, and many experts rejoiced that the US economy was as strong as ever. The most recent reports suggest growth is back and certainly not slowing, this can be seen in the above chart courtesy of Hedgeye Risk Management. The Fed had previously changed policy to acknowledge the slow down, and have been dovish for the last 3 months now, and perhaps this has worked. The latest data does indeed suggest that growth is back. However there are a couple of worrying points to consider carefully here. Whilst Q1 2019 US economic data was strong and we saw year-over-year growth accelerate too, the reality is a little underwhelming in my opinion when you dig below the surface. Inventories and Net Exports accounted for 53% of the total headline win. These are very volatile inputs and this represented the largest share of the numbers since 2014. Also Real Final Sales, which is probably the best and most realistic indicator of underlying demand, decelerated by 0.63% to 1.44% versus the previous quarter and this is the slowest pace since the end of 2015. Furthermore, the US Government uses the GDP Deflator to take into account inflationary pressures.
According to Trading Economics this was 0.64%. The US CPI (Consumer Price Index) has inflation sitting currently at 1.90% which is a very different number. Using this against nominal GDP would have seen the real GDP growth rate cut in half. This paints a totally different picture to the headline reported numbers, so buyer beware. Even the CPI rate is somewhat undercooking things - oil and commodities are up +30% and +8% so far this year, and wages are at a 9 year high. Perhaps inflation is higher than it actually seems. The record 10 quarters of GDP growth is the best ever, with no period in history ever showing such a continuous run of improving economic conditions in the US. But as we progress through 2019, there are cracks appearing and in the second half of the year I think we'll start seeing that in the numbers.
2018 saw China's economy at the slowest growth rates for 30 years. That's a big deal for sure. Wage growth has cooled, unemployment in the manufacturing sector is increasing, imports are falling and this is all against the back drop of a drastically changing demographic. China has an ageing population and birth rates are falling. China cannot risk a recession or even growth slowing much more, that may cause more problems in the future of course, but for now it cannot be allowed to happen. Massive stimulus is in full flow still, and there is so much leverage in the system, but a concern for me is not just the size of this but also how much actually filters down to SMEs. Most of the boost is still seen in infrastructure and state owned organisations. How much longer can this continue? On the positive side of things, their GDP growth is still there. It is growing. The base is so huge, any growth % figures achieved is still absolutely massive. Whilst they face the problems of an ageing population, there is also an incredibly large number of Chinese millennials. In fact there are more millennials in China than there are people in all of America and Canada combined! This is a important demographic which will continue to help push along Chinese growth for a number of years. Also, back to the investing side of things and away from the economics of it all, the Chinese are very risk tolerant and aggressive in investing. There is a huge FOMO (Fear of Missing Out) mentality there, as there is in many investors worldwide. This should help fuel further market gains for now. Most importantly though is the ever increasing % weighting China is now getting in the MSCI. In an ETF world, one cannot underestimate the positive boost this will provide Chinese stocks. It will be a roller coaster but there will be many opportunities for good returns, and for the very long term is a must for everyone's portfolios.
So, that's the landscape right now and whilst there are some positives, there are definitely reasons to worry that the wheels might fall off sooner than many think. I mentioned a number of hazards that still haven't gone away (Trade wars, Brexit, yield-curve inversion etc). These are more likely to trigger corrections rather than anything larger, but their effects can all lead to a negative impact on the economy, and when people feel a recession is round the corner, that's when a big draw down in markets could begin. Europe is facing so many problems too, having, in reality, never properly recovered since the GFC in 2008. Italy is in recession and German economic data is more suspect than the recent US numbers. Oh yes, and how we have all just forgotten about the US debt ceiling and the humongous debt levels they operate on. Remember sub-prime debt? The US sub-prime mortgage market was one of the key contributors to the GFC. Well did you know that the global corporate leveraged loan market is today larger than the US sub-prime mortgage market was at the end of 2006? It's also growing at the same pace as at the peak. How has this "growth" escaped the media?! Of course, these loans are also packaged together and sold as CLOs (Collateralised Loan Obligations). Sound familiar? If not, watch the Big Short movie (or better yet read the book by Michael Lewis) and for now, here's Margot Robbie in a bubble bath to explain...
So what to invest in now?
Hopefully my gloomy picture hasn't put you all off and I didn't lose you to YouTube and Margot Robbie! Well, much of what I suggested in my late cycle investing article (which you can read again here) still applies. Consumer Staples continue to very much appeal to me, though I would be cautious of Healthcare for now. It's always a hot topic in US election years and there could be a lot of volatility to come here. But I would also look to add in long plays for energy and gold too. Not only are we late in the business cycle, but based on the economics looked at above, the US is most certainly heading into a 'slowing growth, rising inflation' phase. Energy and Gold should do well in these scenarios and certainly worth adding to portfolios. Major energy players offer safe and high dividend yields (Shell 5.89%, Exxon Mobil 4.32% and BP 5.57%) and Gold is a natural 'safe haven' asset class with good anti-inflation qualities, plus at $1,280 is looking very good value. Some also believe that real estate and utilities would do well in such an environment. One should be cautious of property, as many countries have high and/or complicated tax regimes, plus if rates continue back up it will strain mortgage payers. However while rates are low, and certain markets do indeed very much stand out, there will be some great opportunities. I see Australia as being very attractive at some point in the next 12-18 months, with rates low (probably to drop again?), the Aussie Dollar low (almost certainly to continue to weaken further) and the property market taking an unusual breather (and likely to fall more). The UK right now also represents an extraordinary opportunity. Low interest rates, very weak currency and after Brexit, housing is the number one area of focus for the country.
Back to global stock markets. The party hasn't stopped and there is certainly still lots of momentum. Earnings season in the US was expected to be disastrous by many, myself included, but has so far pleasantly surprised. Those that follow me on Twitter (@ianjamespryor) or my website (www.pryor-ifa.net) will be familiar with my recent post:
I said that I was expecting a bad earnings season, though of course with Quality company stocks I follow and invest in, I had complete faith! Here you can see that Facebook, Microsoft, Visa, and Paypal, all beat expectations and had very good results. There are a number of others too of course, but this was a personally very pleasing screenshot to see! Anyway, across the broader market, it's so far actually been a good set of corporate earnings. So this, together with "reported" strong GDP figures out of the US keeps the lights on and the music playing.
Those of you that know me know that I'm the perennial optimist, and I do still believe there is upside still to come in the markets, but I think that a nasty turn around is much closer than most seem to think, and that the economic data coming out of the US is not as rosy as everyone considers it to be. Therefore I would recommend people, depending on their risk profile and time horizons of course, start re-positioning away from being very overweight in equities, to underweight equities and start utilising more fixed income and safe haven investments. Some money market funds have returned over 2% per annum in the past 5 years, which is pretty good for daily liquidity and given the low interest rate environment we've been in. A nice parking spot for sure. But this doesn't mean sell out of the stock market completely, it's more about locking in recent profits and giving some protection against a turn of events, and ultimately having the liquidity ready to redeploy into the stock market once prices have come off. It also doesn't mean not investing at all. Any cash held over emergency funds and monthly liquidity is pointless.
So reduce your equity exposure but still have some. Invest in Quality companies over Growth or even Value. Look at sectors that can do well in the current 'slowing growth, rising inflation' environment - namely consumer staples, energy and gold. Physical gold is not easy for some people to buy (large bid-offer spreads, storage costs, insurance etc), but a Gold ETF can be used. Make sure they hold the physical bullion though. Dollar cost averaging is also a great way to mitigate the downside risk, so those that don't already do this, start it! It's a particulary good strategy over the long term and particularly for volatile assets like equities and emerging markets. Asia and emerging markets remain my top long term pick, even in today's market, but the volatility is high so a long term regular monthly investing strategy works best here for those that don't have the time to follow and make phased investments. Lastly, for those that do agree with my outlook here, or even perhaps take an even more pessimistic view, remember to still be invested, just in the right things! A global ETF simply won't cut it at this stage of the cycle. It will follow the general market up and down. Instead use the sectors I mention above, and invest in Quality companies not growth. Get back to investing basics. I first heard the now well used adage at an investment talk by Blackrock when I first moved to Singapore 13 years ago - "It's not timing the market, but time in the market" that matters. This still very much applies. Stay invested, and if you are not yet, get invested, just bear in mind the lower allocation to equities, and the specific areas to focus on.
You can see in the above (courtesy of Fundsmith LLP), that staying invested rather than trying to time the market has it's merits. Even just missing the 10 best days in the last 15 years would have resulted in half the return. That's really quite powerful. So again, I'm not saying to not invest or to move everything to cash, that's the worst move anyone can make. Legendary investor Peter Lynch says it best...
In summary, winter is not here, but winter is coming! I do not necessarily see all this happening tomorrow, or even next week, but I do think we'll see all this happen in the summer / Q3 2019. A US recession is closer than many believe. Hopefully I've presented some good reasoning for this view. I do not say this every year (Ray Dalio!) and don't conveniently run a market neutral hedge fund. Enjoy the returns still available and position yourselves to firstly protect yourself, and then to take advantage when things do indeed turn for the worse.
I'll reiterate once more. Consumer staples, energy, gold, Quality companies and for now go overweight on short term safety holdings in fixed interest, money markets and guaranteed products. Money in the bank does not guarantee capital, it guarantees losses. We are not in 2016 and inflation is here!
Please note these are my own thoughts, and not necessarily the house view of IPP Financial Advisers Pte Ltd, a Licensed Financial Adviser, for whom I am an Appointed Representative of in Singapore. I publicly disclose my own personal investments, and these can be viewed here at any time...
Any questions and feedback welcome, though no GOT spoilers please! For enquiries or advice please contact me via Linkedin or at firstname.lastname@example.org
Author: Ian Pryor, Managing Partner