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A time for caution in global markets?

We are entering a period of capital preservation and lower returns. Be cautious, be safe

Akash Prakash | New Delhi August 06, 2018 Last Updated at 23:03 IST

Most of the more seasoned investors I speak with globally are

very cautious on markets today. They feel there are more risks
than opportunities, and most, especially those running
proprietary capital are sitting on large cash balances. This puts
them at odds with the current mood in global capital markets.
Most indices globally are near their highs, investor sentiment
seems to be optimistic and earnings are booming. Analysts
remain very bullish on the growth outlook for their companies.
Consensus still sees no recession in the US before late 2020 at
the earliest. If true, there can still be significant upside to global markets, and one cannot rule out a
final blow-off-type of market surge, a move no conventional investor can afford to miss.

At this time of complacency, it is worth listening to the cautious mindset and examining their
thesis.

The main point of difference between the bulls and bears is their outlook on the US economy. The
more cautious feel that as we are in the 10th year of an economic expansion, a slowdown is
imminent. The slowdown will morph into a recession as we have rising rates and tightening
monetary policy by the Federal Reserve. This recession will hit before the consensus view of late
2020, and in a recession, markets fall at least 20 per cent. Markets will begin to decline at least six
months before the recession itself actually hits.

The bear thesis rests on rising rates, driven by rising inflation, caused by full employment. They
make the point that the US has already hit full employment. There are more job vacancies than
unemployed people in the US today. The number of people outside the labour force looking for
employment is near all-time lows, and every business survey highlights the difficulty in hiring
qualified employees. Numerous studies have shown the asymmetric nature of the relationship
between unemployment and wage pressures. Wages surge once we cross full employment. That is
where we are in the US today. Wages are poised to accelerate. Already in Q2 2018, the
employment cost index rose by 2.8 per cent, its highest point in a decade.

Already even before wages have begun to accelerate, the core personal consumption expenditure
deflator (Federal Reserve’s preferred inflation measure) is already at 2 per cent for the last few
quarters, exactly at the Fed’s target. As wages accelerate, inflationary pressures will build, forcing
the Federal Reserve to be aggressive in hiking rates. Markets and the current consensus of only
125 basis points of hikes in rates through the end of 2019 may be caught napping.

We may also have an environment in the US where rates are higher and growth slower (due to
these same-capacity and labour constraints) than current expectations, a horrible set-up for
equities.

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The bulls are obviously far more sanguine. They do not feel that inflation spirals out of control
and question the relationship between unemployment and wage pressures. Bears have been calling
for surging wages for years now. Inflation has continued to be benign. They also feel the Federal
Reserve will take a more symmetrical view of inflation, and let the economy run a little hotter for
longer. They do not see recession risk in the US in 2019 or even 2020 for that matter. They feel it
is too risky to leave one last burst of market performance on the table. It can be career finishing.

Another point of difference between the bull and bear camps is on the trade wars and tariffs. The
bulls feel it is just posturing and noise. Better sense will prevail and some type of face-saving
deals will be eventually struck.

Illustration by Ajaya Mohanty

The bears point to the damage already visible and the entrenched position both China and the US
have already dug themselves into. It is already starting to impact global supply chains and
corporate investment. No MNC likes uncertainty of this type. There will be unintended
consequences across countries and sectors. There exists a genuine but unpredictable risk that
things spiral out of control, which would be corrosive to all risk assets.

The third point of differentiation is on the outlook for corporate earnings, especially in the US.
The bulls point to the fact that earnings have grown by 20 per cent in the last two years (up to Q2
2018) in the US. The current earnings season is also on track for 25 per cent growth and
companies are beating expectations on both revenues and profits. Long-term earnings growth
expectations are over 15 per cent, the highest since 2000. Earnings have consistently over
delivered in this bull cycle. Combined with record share buybacks, these two props to the bull
market show no signs of reversal.

The bears point to the fact that labour’s share of income in the US bottomed in 2014. This also
marked the peak in margins as based on the National Income accounts for pre-tax profits. Since
then the National income (NIPA) series has actually shown a fall in margins. A significant gap has

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opened up in corporate profitability as reported in the National Income accounts in the US and by
the companies themselves (S&P series). The National Income accounts are generally more stable
and less affected by accounting changes and differences in tax rates. This series was definitely
more reliable as an indicator of corporate profitability in the 2000 tech boom and the current gap
between S&P earnings and NIPA numbers has rarely been larger. Years from now will we look
back and with the benefit of hindsight wonder whether the boom in corporate profits was as robust
as it appears today? That is what happened in the tech bubble when there was a sharp pullback in
corporate earnings in the ensuing bust post 2000, and the two earnings series converged again.

There are other friction points beyond the three mentioned above. We have the ever-present
concerns on China and its attempt to deleverage and have a simultaneous soft landing. The
dangers of a strong dollar and obvious geopolitical concerns around Iran and North Korea.

Be that as it may, I have rarely seen the smart and experienced money getting so cautious and
building cash. They may be early and are less concerned with maximising any remaining upmove
left in global equities. As one friend told me just the other day, “We are entering a period of
capital preservation and lower returns. Be cautious, be safe. This will end badly. It always does.”

The writer is with Amansa Capital

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