January 31, 2019

Stormy weather arises as fronts of different temperature and pressure meet each other. Recent months
have brought market volatility back as a weakening earnings outlook is being confronted by a significant
change in stance by central banks globally.

A few things are clear to us in this environment. First, there is no doubt that the keepers of monetary policy are going to take any chances letting inflation slide too low or financial system stress induce
economic weakness. This is most apparent in China and the US.

China has been cutting interest rates and reserve requirements for its banking system. They have also
intervened by effectively recapitalizing some of the banks through long term loans. To stimulate economic activity, they pumped liquidity into their system at record levels in January. These actions tell you that stress has been accumulating in the economy with more leverage than the world has ever seen.

In the US, the Federal Reserve in a matter of only a few weeks went from raising interest rates to
signaling a complete stop to rate hikes. They also pivoted from a stern statement of continued reduction in bonds they own to signaling a stop in that reduction as soon as later this year.

The same sentiment was reflected in both Europe and Japan by central banks, where short and
intermediate interest rates continue to be at or near zero. The Bank of Japan reiterated that they have no intention of stopping their purchases in the stock market (yes, they print money to buy stocks…a lot of stocks). The European Central Bank is already talking about new programs to finance debt despite having bought large swaths of both government and corporate bonds.

It no longer seems like a surprise to hear policymakers act in this fashion, but it is staggering to realize these actions are still needed ten years into an economic expansion. There are a number of questions raised by these policies, the most important being – will more now bring better results?

The second clear and present force is the deterioration of global economic activity and with it the
outlook for corporate earnings. It is important to note that even though we see slowing activity globally, it is not yet clear whether the slowdown is shallow and short lived or leading to a deeper downturn. It is also important that the slowdown thus far is affecting different regions less, especially the US.

Asia and Europe seem to be leading the decline in activity, primarily in manufacturing. While it is
possible that some of this is an effect of US-China trade disputes, the root seems like Chinese domestic deleveraging. Years of massive lending ultimately have times where the amounts come due. China is starting to face this headwind. Corporate defaults have been popping up, something that was virtually unheard of in the managed Chinese economy of the past. There also seems to be a tightening in the property market in China where many individuals would borrow money and then invest in speculative construction as an almost “sure thing” safe investment. As property prices have slowed or declined, suddenly people start running to get money out. This has caused some hiccups in the banking system.

Japan is also showing economic weakness. Keep in mind they just celebrated twenty years of zero or
near-zero interest rate policy. No breakout velocity has been achieved. Additionally, slow or declining activity is continuing across the region, from India to Malaysia to the Philippines. All of this tends to depict a picture much greater than just a spat with the US over tariffs that are relatively small in the scheme of things.

Europe has a consistent story, most countries have low growth and have sectors with recent declines in activity, primarily in manufacturing. Italy, France and Germany all are struggling economically. Germany is the biggest economy in the Eurozone and is heavily dependent on exports to China. The global linkage is strong.

The US has been less clear as to the direction of economic activity. Some economic indicators remain
strong, while other are slowing but have come from very high levels. The boost from tax cuts in 2018 seems to be fading and it appears that much of the corporate tax cuts did not go to capital expenditures but rather for share buybacks. What is certainly clearer is that corporate earnings are set to cease growing at recent levels. In the fourth quarter of 2018, companies beat expectations, but the bar had already been lowered. Early 2019 will likely see a decline in earnings – not slower growth, an actual decline. This is still assuming a decent economy but with various headwinds that are growing such as a strong dollar, slower overseas opportunities and inflationary pressures in the labor market.

The rally in riskier assets to start 2019 has meant the markets seem to be siding with the central bank forces, at least for now. However, the next moves are critical to detect whether markets have become fatigued from the monetary ‘kitchen sink’ approach. For now the fundamentals remain crucial and we stay on alert for developments on all fronts.