Ignoring the gathering storm in US sub-prime mortgages and tangible signs of a slowing European economy, the then ECB President Jean-Claude Trichet infamously presided over an ECB rate hike in July 2008, subsequently seen as hastening the onset of the global financial crisis. Then inflation in the Eurozone was running at 4% and the ECB’s backward looking models suggested that a 25bps hike to 4.25% was appropriate. This hike was the proverbial straw that broke the camel’s back. Just three months later the ECB would, in a coordinated move with other global central banks, be cutting rates by 50bps. After a further 50bps cut in November and an unprecedented 75bps easing in December, the ECB deposit rate would end 2008 at just 2.5%. Having peaked at $146/barrel in July, crude oil would touch $37/barrel before the year was out. It was a classic example of a central bank setting monetary policy using the rear view mirror.
Overlooking the precipitous slowing of the Chinese economy, the risk of a deflationary spiral as evidenced by plummeting commodity prices, and dismissing tangible signs of recession in the European industrial complex as temporary, a decade later the world’s central banks are potentially risking making the same mistake as Trichet’s ECB. Just before Christmas the ECB ended their asset purchasing programme, Sweden’s Riksbank raised their benchmark interest rate for the first time since 2011 citing full employment and labour cost pressures, and the Federal Reserve took the Fed Funds rate up to 2.5% whilst still signalling further hikes ahead (albeit at a marginally slower pace). With Chinese and Brexit trade angst unresolved, their actions can at best be seen as naïve and backward looking and at worst hastening a downward spiral in the global economy and in financial assets in general.
Markets often run out of steam before tangible signs of slowdown manifest and there can often be a lack of catalysts for a mature economic cycle to develop into a downturn. European stock markets peaked in January, well before October when the cyclical slowdown began in earnest. Whilst we did not foresee the exact timing of the slowdown, over the past couple of months we have repositioned the portfolios from late cycle to end of cycle: cutting cyclical and commodity longs, adding to shorts and raising liquidity in long only mandates. There probably was a point over the last few months where policy response could have prolonged the expansionary economic cycle and the current slowdown may just have been a meaningful industrial inventory destocking cycle. But a negative feedback loop has now developed, which will likely eventually require even more vigorous monetary and fiscal response to regain positive momentum. Unfortunately, there are few signs of central banks grasping the magnitude of the situation or governments compromising on trade diplomacy.
In the Q3 2018 corporate reporting season, good earnings were often not rewarded by the market for fear that they were backward looking and at the peak of the cycle. It is now difficult to believe that the likely poor aggregate Q4 earnings reports will conversely be discounted as the cyclical low point. Monetary policy has subsequently been tightened and trade issues, whether they be over Brexit or China, show few signs of being resolved. Indeed, both the UK and Chinese governments would seem to be in the process of concluding that giving in to diplomatic bullying from the EU and President Trump respectively involves too big a loss of face to be politically palatable, whatever the near-term consequences for their economies. The UK is preparing for a “managed no deal”. The Chinese government has decided it no longer wishes to report key economic statistics and has so far failed to come up with any anticipated meaningful economic stimulus. These are strong signs that both governments would rather play a more dangerous longer game than suffer humiliating diplomatic capitulation.
Stock markets during 2018 have been going through a period of rolling capitulation which is now hitting previously unscathed sectors that led index gains, most notably technology. Bulls of the sector believe it is no more than a hiccup in the technology bull market: after all, they argue, we will be using more, not less technology in the future. But this has always been the case and past technology bear markets have nearly always had their genesis in too much capital investment chasing the same pool of profits. We have already seen this in the global semiconductor industry where unprecedented investment in new manufacturing capacity over the past couple of years has resulted in a glut of commodity DRAM and NAND chips. Semiconductor companies that saw their business boom in the upturn now face a prolonged downturn and collapse in revenues. The willingness of the market to look through poor results is highly dependent on confidence in policy makers to be able to change the near term course of the global economy: without this the glass will always be half-empty rather than half-full. This is the mentality of a bear market: rapidly deteriorating economic demand, elevated competition for corporate profits and loss of confidence in policy makers.
There are signs that this is spreading to other previously glamourous technology sub-sectors where, in the short term, too much capital has been chasing the same growth. The recent profit warning at ASOS, Europe’s leading online fashion retailer, was widely reported as relating simply to the downturn in consumer confidence in the UK. A closer reading would suggest instead that ASOS has also been the victim not just of ailing consumer confidence but also of a prolonged capital upswing where competitors have received capital all too easily and this has eroded the sustainability of profit margins as the industry has lost pricing power (in a way which has mimicked bricks-and-mortar peers). In other words, this is not a sign that online retailing is not the future but rather that this particular capital cycle is too long in the tooth and that a cleansing capital destruction end of cycle is needed. This example could now be replicated across a range of fast growing innovative industries where companies have been delivering rapid revenue growth without necessarily any sustainable competitive advantage.
It is an old adage of bear markets that they end when policy makers panic. More often than not the end of a bear market heralds the ‘fattest part’ of the stock market cycle for positive returns. At some point in 2019 it is probable that there will be a fantastic buying opportunity, but it currently seems too early to expect this in weeks rather than months. It is more likely that this moment will come post-Brexit (whatever the outcome) and after recognition from the Federal Reserve that the slowdown witnessed elsewhere in the world is hitting the US economy and easing its monetary policy accordingly. Experience of previous bear markets has taught us to be patient and wait for negative momentum in economic lead indicators and credit markets to be sustainably reversed. It would therefore seem prudent to hold meaningful liquidity until this point and focus on stocks that can thrive in a tougher macro environment through idiosyncratic catalysts, whilst increasing allocations to short positions in the expectation that these will pay-off handsomely in the weeks ahead. Our funds are therefore positioned for Q1 to be a particularly tough start for markets in general but with an open mind about how the year overall will develop.
It is a necessary aspect of fund management to change your mind when the facts change, as they invariably do all too frequently. But central bankers are much more reluctant to recognise a change in the economic environment or that backward looking data is no longer a good predictor of future trends, for fear of criticism of inconsistency. It would therefore seem unlikely that they will perform the needed about turn on policy until the downturn is more firmly established and the pain is deeper. It is therefore likely that a decade on from Trichet’s policy mistake in 2008 that we are witnessing another major policy error from global central banks.
Barry Norris
Argonaut Capital
December 2018