Browsing asset managers' notes for the fourth quarter of 2018, it was unsurprising to find many attempts to reassure investors spooked by the whipsawing markets at the end of the year. More interesting were a couple of very detailed pieces of research discussing reasons to be pessimistic. The overriding issue, discussed at length in the new e-book by Ray Dalio of Bridgewater Associates, Principles for Navigating Big Debt Crises, is the world being in the late stages of a debt super-cycle. Such phenomena have occurred throughout history and Niels Clemen Jensen, author of The Absolute Return Letter, cites allusions to the economic effects in The Old Testament. Ominously, the last debt super-cycle ended with World War II.
Before readers reach for the whisky and valium, a silver lining is found in the work of Elroy Dimson, Paul Marsh and Mike Staunton of London Business School. As first shown in their seminal book, Triumph of the Optimists, the annualised rate of real total return on world equities between 1940 and 1950 was just positive at 0.3 per cent. Neither we nor the reports we have read are predicting a catastrophic war but the fact last time such a devastating event occurred stock markets weren’t destroyed provides valuable perspective. To cheer investors further, it is worth pointing out that by 1960, thanks to the post-war boom, the annualised real rate of return on an investment in world equities in 1940 had risen to 7.9 per cent.
If we assume the Doomsday Clock isn’t about to strike midnight and consequences of the current debt super-cycle unwinding won’t extend as far as thermo-nuclear Armageddon, then it isn’t time for investors to run to the hills. In any case, theories based on huge cycles make for poor market-timing indicators. Still, understanding the headwinds facing the global economy and the bear cases for different asset classes can help investors position themselves for more unsettled times and even to take advantage of tactical opportunities which may arise.
Anatomy of a debt super-cycle
Short-term debt cycles, explain Mr Jensen and Mr Dalio, last roughly seven to eight years and super-cycles occur over a 50-75-year time span; this makes our current super-cycle one of the longest. There are five identifiable phases. In step one, the early stages of debt expansion, the economy benefits as credit availability encourages investment and growth. Step two sees the emergence of bubble conditions as debt grows faster than income. Mr Jensen is critical of central banks in this phase as "where they should seek to constrain the bubble, they often inflate it by being far too lenient [with monetary policy]". The result is equity markets rally and the yield curve flattens, both of which have been in evidence over the past year. He continues:
"As you near the end of the bubble stage, the debt-to-GDP ratio, which was about 1:1 earlier on, changes dramatically. It now takes about $5 of additional debt to generate a dollar of GDP growth. In some of the largest economies in the world, and that would include both China and the US, the ratio is now 0.20-0.25; ie, we are not far from hitting the proverbial wall."
Step three is when borrowings peak, which leads to step four: depression, defined as a period when GDP falls by 3 per cent or more. This is what occurred in the financial crisis and great recession a decade ago. Most short debt cycles then proceed to step five, which is what Mr Dalio describes as "beautiful de-leveraging". This assumes that consumers and businesses unwind their debt and the stimulation provided by monetary policy-makers is powerful enough to offset the deflationary forces, before the next mini debt cycle begins.
While the phenomenal scale of monetary stimulus after the financial crisis averted meltdown, conditions have far from normalised. Quantitative easing (QE) has inflated the value of asset prices, but this has disproportionately benefited the wealthy and there has been stubbornly low growth in many developed economies in the absence of any trickle-down effect. Low interest rates make the cost of borrowing cheaper, but this has been taken advantage of by corporations, especially in the US, to fund share buybacks that flatter earnings per share (EPS) figures. This has seen debt swell in the corporate sector, but without the productivity gains that would have resulted had the money been spent on capital expenditure (capex). This failure to boost productivity is an example of what Mr Jensen describes as monetary policy becoming inefficient. He continues: "This was a condition first recognised by central bankers in the 1930s, and they even coined a phrase to describe it: pushing on a string, they called it. When that happens, you have come to the end of the debt super-cycle."
What this means for asset classes
With central banks at the limit of what they can do with monetary policy and GDP growth stuttering, the prices of assets such as property, bonds and equities cannot continue to defy gravity. This means that there will be some messy unwinding of a lot of investment positions as the world either defaults or inflates its way back to a new debt-to-GDP equilibrium. Research from Colorado-based hedge fund Crescat Capital, published on 31 December 2018, examines the effect on several bubble asset classes.
Crescat’s report, written by chief investment officer Kevin Smith and global macro analyst Tavi Costa, posited that: "September 20, 2018 should mark the closing high of the S&P 500 to end the second-longest bull market in US history". They continued that: "It should also mark the top of the 'everything bubble', a term coined by investment newsletter writer Jesse Felder to describe historic valuations in every major asset class, commodities being the one exception." Their reading of the current macro picture and consequently their investment strategy is based on a conviction that there is a natural economic cycle, including business, market, liquidity and credit cycles, which are all intertwined.
On US equities, Crescat believes that investors should beware a value trap. Following the heavy selling in December, forward price/earnings (PE) multiples were low again for US equities, but Mr Smith and Mr Costa were sceptical. They pointed to unsustainable profit margins and a likely peak in the economic cycle as reasons that earnings were likely to plunge as corporate credit became an issue and as the economy heads into recession. Using a cyclically and margin adjusted PE ratio, Crescat found the US stock market to be at an all-time high valuation – above the levels in 1929 ahead of the Great Crash and in 2000 at the peak of the tech bubble.
Another trend the Crescat team spotted was the global yield curve inversion at the turn of the year. With the Federal funds rate at 2.4 per cent, they noted 13 countries (including Switzerland, Japan, Germany and the UK) with 30-year sovereign bonds that yielded less than US overnight rates. What this meant is that the rate of holding cash in the global reserve currency was competing with all other assets in global credit markets. They point out: "The global yield curve inversion is highlighting a perceived flight to safety in global sovereign bonds despite their record low yields." Such a development signals a recession.
US corporate debt, largely built up to fund share buybacks, is one of the flashing danger signals for the world economy. There should be a risk premium for investing in corporate bonds – a credit spread where higher yields are paid compared with US government debt which has less risk of default. Companies with weaker balance sheets and less robust cash flows have a lower quality credit rating and therefore should offer a wider spread to compensate for the greater risk of lending them money. Crescat’s research noted, however, that non-investment-grade bonds (ie, those without a high credit rating) hit historic low credit spreads at the end of the third quarter, which caused them to pose the question: “With US corporate debt at record levels compared to GDP, while the Fed has been tightening, why were the credit spreads so tight for so-called high-yield or junk bonds?" Their interpretation was that this was yet another sign of a market at its peak. With the US and global economy facing powerful headwinds in 2019, Crescat is shorting US high-yield bonds with put options.
China recently posted its lowest rate of annual GDP growth (6.6 per cent) since 1990, which was in the aftermath of the Tiananmen Square massacre. Crescat is extremely bearish on China, citing signs of severe credit tightness. Shadow bank lending (ie, unregulated lending facilities, which Bloomberg reported in June 2018 has grown into a "$10 trillion ecosystem" in China) has been shrinking, starving inefficient Chinese companies of the capital funding they need to remain as going concerns. Crescat also points to the slowing growth in Chinese money supply as indicative of pressures for Chinese growth.
The Chinese banking system represents a source of systemic risk to the country's real economy which, given half of global GDP growth in the past decade has relied on China, has serious ramifications for the rest of the world. Exporter nations such as Germany, which had trade worth €186.6bn with China in 2017 (source: Reuters), could be especially vulnerable. Monitoring this risk is incredibly difficult and uncertain, however. Most of the world turns a blind eye, comforting itself with the thought that in a planned economy the government is both lender and borrower, which would prevent a default crisis getting out of hand. This is wishful thinking.
With over $40 trillion of assets sitting on balance sheets in the Chinese banking system, Crescat notes that "China is sitting on a massively inflated currency and a credit bubble due to the vastly overstated value of these assets from years of not writing off non-performing loans". The monetary policy levers the country operates are difficult to understand and opaque. On the one hand, the country has been cracking down on shadow bank lending and on the other it has frequently resorted to reducing the reserve requirement rate (RRR) of its banks to boost liquidity. China, like its counterparts in the west, is close to the string-pushing stage in its monetary policy options.
Crescat discusses how the divergence between US monetary policy and the People’s Bank of China (PBOC) puts the yuan under severe pressure to devalue. This comes at an extremely sensitive stage of trade negotiations between the world’s two biggest economies; President Trump has labelled China a currency manipulator (concerns that were probably shared if not expressed by his far less maligned predecessor, Barack Obama). Despite Mr Trump’s accusations, however, with the spread between the Federal funds rate and Shibor (Shanghai interbank offer rate) at its widest level since 2008 and China’s deteriorating current account balance, the Chinese renminbi (note: renminbi is the name of China’s currency but yuan is the unit of account) is now among the most overvalued of world currencies.
Chinese equity markets were in freefall at the time of Crescat's report, having lost close to $3.6 trillion in market value, accounting for close to 25 per cent of China’s GDP. The A-shares market has stabilised in early 2019, but with valuations still suppressed, pressure continues to mount on the PBOC to allow the yuan to devalue against gold and the US dollar. In Crescat's view: "The decoupling of gold versus offshore Chinese yuan (USDCNH) is among the greatest macro trade opportunities in the world today."
Seeking safe havens
Precious metals are an asset class Crescat is bullish towards. It believes there is a deep value set-up with prices "historically cheap relative to the global fiat monetary base which is now close to $19 trillion". Predicting a US stock market meltdown, the team expects the Fed to use up all the monetary policy ammunition it has stored up in its recent tightening cycle and then some, which they see as a great buy signal for gold and silver. As well as the physical metals, relevant mining stocks are identified as an opportunity: "Gold and silver mining companies own valuable gold in the ground and, in many cases, are producing and generating positive free cash flow today, even at depressed gold and silver prices. Many of these stocks are deep-value plays with significant upside potential. The ratio of the S&P 500 to the Philadelphia Stock Exchange Gold and Silver Index of mining stocks recently retested its early 2016 record extreme from which it rallied 200 per cent in just seven months.”
The relationship between gold and oil is another macro indicator that Crescat monitors closely, with the trend in the gold-to-oil price ratio seen as a bellwether for the stock market and the economy. "Previous breakouts in gold versus oil have corresponded with stock market crashes and proved to be great times to play the ongoing widening of this spread. The recent spike above its three-year resistance line supports our views that there is further downside in equity markets globally." Oil prices have come back (Brent crude is back to around $60 per barrel having dropped to $50pb in December; WTI is back at $53pb from a low of $42pb) but the sharp decline in the fourth quarter of 2018 "was the worst during a Fed tightening cycle in the history of WTI futures and occurred despite the telegraphing and announcement of a new OPEC supply cut during the quarter. The oil decline is yet another one of many signs of the end of the business cycle."
One last insight we have taken from the Crescat report is its scepticism on buying utilities companies as a defensive holding in anticipation of market turmoil. Their work is based on US utilities stocks but our chart shows that in the last recession the FTSE All-Share Utilities index plunged by nearly as much as its parent and has significantly underperformed in the recovery. Like in the US, UK utility stocks carry a high degree of leverage and in many cases, have negative free cash flow – indicating these companies "cannot even make money at the likely top of a business cycle".
