If there is one useful conclusion for investors from the crazy year that has just ended, maybe it is this: as they say in Hollywood, “Nobody knows anything.” After all, if the richest and best-informed studio moguls spend tens of millions of US dollars on audience research and then have no idea whether their latest creative brainwave will be a hit or a flop, should we be surprised if the world’s richest and best-informed company admits (as Apple did on Wednesday) that it has no idea how many iPhones it sells in China?
Or if the world’s richest and best-informed oil traders believe a global supply squeeze will send prices rocketing over US$100/bbl, just when a global supply glut is about to crush them below US$50? Or if the equity market predicts a boom while the bond market predicts recession and then the two markets reverse, so as to contradict each other the opposite way? Or if the US president can’t decide if he hates or loves trade?
The consolation for investors is—or at least should be—Benjamin Graham’s famous precept: “The market is a voting machine in the short term but a weighing machine in the long term.” So, while totally unpredictable voting behavior can make or break Hollywood studios and politicians, asset values eventually revert towards economic fundamentals. And while these economic forces are also impossible to predict with any precision, they are not quite as capricious as popular whims.
Specifically, it can be helpful to think about the macro in influences on asset prices in three categories: (i) macroeconomic and monetary conditions; (ii) policy changes with important business impact, and (iii) market valuations.
Towards the end of 2017, when investors around the world were almost uniformly bullish, I suggested ten specific risks, divided into these three broad categories, that could cause a serious market setback in 2018, even though I personally thought (wrongly) that such a setback was unlikely (see Goldilocks And The Ten Grizzly Bears).
Many of my market predictions proved wrong last year. Specifically, I argued that the stock market corrections in February and October offered “buy on dips” opportunities; that the US dollar would weaken; that the US yield curve would steepen; and that emerging markets would outperform the US. Nevertheless, I still believe that the ten risks below, which I recalibrated several times last year (see This Really May Be The Start Of A Year-End Rally and Reasons To Buy The Dip), provided a useful framework for understanding what went wrong last year and, more importantly, what might change in 2019:
•Three macroeconomics risks: (i) Fears of a US recession, which I dismissed as vanishingly unlikely; (ii) Unexpectedly hawkish policies from the US Federal Reserve, which I thought improbable; (iii) Rising bond yields caused by fears of over-heating, which I considered the biggest economic risk.
•Five political risks: (i) US fiscal profligacy, which I saw as a problem for 2019 or 2020, not 2018; (ii) Middle East oil shocks, which seemed quite likely; (iii) US-China or US-Europe trade conflicts, which also seemed possible; (iv) Convergence of right-wing and left-wing populism which seemed to be stirring in Europe; (v) Regulatory challenges to tech monopolies.
•Two valuation risks: (i) Boom-bust in overvalued tech stocks, which was clearly prefigured by the cryptocurrency craze; (ii) Boom-bust in US equities generally, which only seemed probable if interest rates rose sharply.
Why do I claim that this approach was useful, when it produced so many wrong conclusions? Because I believe my framework correctly identified the main fundamental drivers of last year’s market shocks. Where I went completely wrong was in the size and timing of investor reactions, in other words the market’s “voting-machine” function. For example, January’s stock market correction and volatility surge was clearly caused by fears of US overheating and rising bond yields. Once the overheating concerns subsided, bond repricing turned out to be very limited, equities everywhere rebounded, and the US dollar stayed very weak.
This period of US dollar weakness and global equity strength reversed in May, when the markets were hit by a perfect storm of the three political shocks I had considered most likely: soaring oil prices anticipating Iran sanctions; the US-China tariff war; and the left-right populist coalition in Italy.
In October, political conditions changed, suggesting an easing of oil shortages, as well as a ceasefire in the US-China trade war. With these political risks receding, emerging markets started to outperform, stock markets stabilized elsewhere, even in Europe, the oil price returned to what appeared like a stable pre-sanctions range of US$60 to US$65 and the strengthening of the US dollar ended. In short, markets seemed to move broadly in line with the changing political and macroeconomic fundamentals—until everything suddenly went haywire in early December. In the three weeks from December 3 to 24, the S&P 500 collapsed by -16% for no apparent reason, Brent oil plunged from US$61 to US$50, the US dollar again strengthened, and US 10- year bond yields plunged from 3% to 2.75%.
Why did these reversals suddenly happen in December? This is the key question we need to answer in planning an investment strategy for 2019. The market as voting-machine provides an easy answer: if equity prices and bond yields are simultaneously collapsing, this obviously means that the world economy is heading for a recession or at least a period of much weaker growth—and the only real issue is whether the US, Europe or China will sink deepest. But what would be the causes of a recession or severe global slowdown and where, apart from the market’s own behavior, can we see evidence that such a slowdown is likely?
There is nothing in economic theory or historical experience to suggest that expansions die of old age or that recessions happen spontaneously. Recessions or severe slowdowns are usually caused by some combination of high real interest rates, fiscal tightening, rising energy prices, severe in inflation, trade wars, or property collapses leading to banking crises. Several of these problems occurred in 2018: rising interest rates in the US, fiscal tightening in Italy and much of Europe, trade wars in the US and China; and rising energy prices around the world. It is not surprising, therefore, the world economy slowed in 2018, instead of accelerating as most economists (including me) expected.
But many of the forces that caused last year’s slowdown are now reversing— oil prices have fallen, US bond yields are back almost where they started in 2018, trade conflicts appear to be subsiding and China is easing macro policy at least to some extent, and will probably move to outright stimulus if its economy weakens much further. All this suggests that economic growth in 2019 should be stronger than in 2018, at least in the second half.
Why then did equity prices and bond yields suddenly collapse last month? One possibility is that markets “know something” sinister about the future that is not apparent from the straightforward reading of policy changes that I have suggested. Another possibility is that investors have been so confused and wrong-footed by political and financial unpredictability, that they have given up trying to anticipate what may happen next.
If so, then the markets, instead of predicting and discounting the future, are simply reacting to and extrapolating the recent past. In a world where “nobody knows anything”, this is what happens to the voting-machine role of financial markets. But I still believe in the markets as a weighing-machine, which is why I now double down on my call to “buy the dip”, especially in China and Asian emerging markets.
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