The past several weeks of market volatility have revealed one truth: the U.S. economy can no longer claim immunity from the weakening growth that has spread throughout the rest of the world. For instance, the widely-watched ISM PMI registered its largest drop since the GFC, falling 5.2 percentage points between November and December. And, the forward-looking new orders component of the ISM Index fell by 11 percentage points. Five Fed regional manufacturing indices fell in unison for the first time since May 2016. New single-unit housing starts were down 13% year-over-year in November 2018, while existing single-family home sales were down 7% year-over-year. Auto sales grew less than 1% for all of last year. Underscoring the abruptness of the fundamental reversal, FedEx stock fell 30% in the month of December after reducing its outlook, only a few months after raising it.
Not surprisingly, the markets are beginning to price-in a rate cut. Last Wednesday, the U.S. Treasury near-term forward spread fell into negative territory for the first time since March 2008, according to Bloomberg. Yesterday’s Fed meeting minutes illustrated growing uncertainty about the direction of the economy and inflation, raising the likelihood that rate hikes may come to a halt. But, this will not be enough as long as QT continues: as we explained in WILTW December 20, 2018, each $200 billion of Fed balance-sheet reduction is theoretically equivalent to a quarter-point rate hike. Therefore, even if the Fed stops increasing the Fed Funds rate, the reduction of the balance sheet will exert enough of a liquidity drag that it will cause the economy to decelerate further.
Thus far, the exodus of capital from U.S. markets has been gradual, but this can change in a hurry. This is likely to be a recurring theme throughout the course of 2019: the following chart shows that the relative strength of the iShares ACWI ex-US ETF (ACWX, $43.58), bottomed-out during the autumn and appears to have begun moving higher.
Mounting evidence suggests that last year’s U.S. corporate tax cut will not have the intended effect of promoting sustainable growth through long-lived investment, and this could play a large role in triggering further capital outflows. Private nonresidential fixed investment-to-GDP rose from 13.3% in the fourth quarter of 2017 to a high of 13.7% in the second quarter of 2018—only matching the 13.7% recovery high registered in the second half of 2014. This measure subsequently fell to 13.6% in Q3 and, given that it follows the direction of shale-oil drilling, the decline in oil prices is likely to push this figure down in the short term.
U.S. companies repatriated well over $500 billion in overseas cash during the first three quarters of 2018, but how much of this actually made it into workers’ pockets remains an open question. Operating profit margins are at record highs and the S&P 500 companies raised their share buyback allocations by almost 50% year-over-year, to nearly $580 billion during the first three quarters of 2018. But, those buybacks ramped-up just as the S&P went into tailspin to end the year. The investment doesn’t look good with the benefit of hindsight and one wonders when corporate boardrooms will grow more cautious.
The annualized rate of private non-residential fixed investment in the national accounts increased only $177 billion between 4Q-2017 and 3Q-2018—less than a third of the money spent on share buybacks by the S&P 500 companies alone. Moreover, capex as a percentage of free cash flow among the S&P 500 companies stood near a four-year low according to Bloomberg data, as shown in the chart below.
This analysis implies that the additional deficit spending incurred to finance the GOP tax cut—roughly 1.2% to 1.5% of GDP—is not likely to have a sustainable impact on real GDP growth, which averaged 2.8% year-over-year during the first three quarters of 2018, but is likely to shrink to 2.5% or less in 2019. And, since tax revenues are a function of GDP growth, the implication is higher-than-expected deficits, which have already occurred.
By 2020, the U.S. federal budget net interest bill will be more than $150 billion higher than 2018, but the economic growth that is necessary to service the debt is likely to be lower than expectations. On the other hand, emerging markets are likely to grow 4.7% in 2019, almost double the U.S. figure, with lower levels of gross public indebtedness relative to GDP, a higher proportion of fixed-investment driving GDP growth and consumption, a rapidly-expanding middle class that could grow by 1 billion people in the next seven years, and cheaper equity valuations, as explained in greater detail in WILTW December 6, 2018.
Investors are increasingly likely to recognize that EM fundamentals deserve higher valuations in the year ahead, and this may even spread to developed markets that depend on EMs, such as Europe and Australia. Morgan Stanley Investment Management chief global strategist, Ruchir Sharma, made an excellent case in an Op/Ed for The New York Times dated December 29th and headlined “When the Bubble Bursts, Consider the Anti-Bubble,” which resonated strongly with our contrarian philosophy. Bubbles are over-hyped and over-valued, but anti-bubbles are “the mirror image, taking shape in overlooked corners of the world and defined by light trading, with prices stagnating at low levels despite solid growth in the economy or company.”
Until the tech reversal began in October, stock markets from Southeast Asia to Eastern Europe and Latin America were trading at multi-decade lows relative to the United States. For the price of Apple you could have bought all the companies in three of the largest markets of Southeast Asia: Indonesia, Malaysia and the Philippines. Or all the public companies in the three largest markets of Eastern Europe — Poland, the Czech Republic and Hungary — nearly three times over.
This isn’t normal. Typically, prices reflect the market’s best collective bet on the future, and it is a clear sign of mania when the market thinks one company has a brighter future than a large country. But that is the market-defying nature of bubbles and anti-bubbles today…
Historically, the biggest stock market returns came in the fastest-growing economies. But that pattern changed in recent years, as investors chased technology at the expense of everything else. The highest returns came in slow-growth countries such as Taiwan. The lowest came in fast-growing economies like the Philippines. The reason: Taiwan is a tech-driven economy, the Philippines is not.
But as big tech begins to crack, that behavior is beginning to change. Stock markets from the Philippines to Indonesia have started to emerge from anti-bubbles. And in the United States, sound industries that had been left in the dust by the tech giants are starting to make a comeback among investors, too, including telecommunications, real estate and consumer staples. It is not clear where they go from here, but it is not unusual for stocks caught in an anti-bubble one decade to perform well the next.
It is noteworthy that the U.S. dollar’s share of global foreign exchange reserves fell again in the third quarter of 2018, from 62.4% to 61.9%, which was the lowest level since the fourth quarter of 2013, according to IMF data cited by Bloomberg. Even more interesting is that this occurred as the U.S. stock market was approaching its peak, growth was strong, optimism was abundant and interest rates were moving higher. As the risks to U.S. economic growth and the federal budget deficit continue building, will capital flows accelerate their exit from U.S. markets? Moreover, will this cause a more rapid shift away from the dollar as a reserve currency, as we have argued for some time?