David Jallits – CIO – Market Commentary – September 30, 2017

October 5th, 2017

Letter from the CIO

“One great use of words is to hide our thoughts.”

Voltaire (1694-1778)

While I enjoy Voltaire, I do not intend to use this memo to hide my thoughts, but rather to share some of them with you.  There are many issues that exist in today’s world which could negatively impact your portfolio, so please view this note as a simple list of items that could function as potential “market movers”.  While I may take one or two of these items and expand upon them in a later letter, this “laundry list” approach will suffice for now.

It seems that many (myself included) are concerned about how and when this bull market in equities will end.  Let’s be concise and state that bull markets in equities are almost always killed by economic recessions.  While we can certainly experience sell-offs of 10% – 20% in the normal course of market action, a true bear market is usually accompanied by economic contraction (see chart below).  A recession when valuations are high and the Federal Reserve is increasing policy rates can be particularly problematic for risk assets, so today especially, we must be watchful of deterioration in economic growth.

The U.S. equity market has more than tripled since it bottomed in March of 2009 and today’s forward P/E of 18.4 is the highest since the “tech wreck” of 2000.  In fact, by some measures, the U.S. equity market has only been more expensive in 1929 and 2000.  Clearly, a mistake by the Federal Reserve is a growing risk if they continue to increase policy rates despite tepid (but steady) domestic economic growth coincident with weak inflation and wage growth.  The good news, today, is that signs of an economic recession are few and far between.  While housing and auto sales in the U.S. bear watching, global economic growth has not been this strong since 2004.  In addition, the Federal Reserve and the European Central Bank both understand the damage they would cause by moving too quickly to raise rates and “normalize” their balance sheets.  While being aware of the risks they are running will not prevent a misstep, it does lower the odds. Having said that, given central banks footprint in global bond markets – they now own 20% of all sovereign debt globally – and the artificially low volatility they have imposed on the bond markets, (we sit at all-time lows in U.S. Treasury volatility) any central bank misstep will be greatly amplified across all asset classes.

In the positive column, is the fact this has been one of the most hated bull markets in memory.  In fact, in 2017, the amount of money flowing into U.S equity funds has been exactly “0”.  That’s correct, allocations to U.S. stock funds is nil this year despite the strong performance we have seen year to date.  Investor capital has flowed into international equities as the U.S. dollar has declined, but almost $150 billion has flowed into U.S. bond funds.  We can partly attribute that to an aging demographic in our country but it also makes it difficult to paint today’s public as irrationally exuberant toward equities as they were in the early part of this century.  On the professional side, the level of short positions (betting on equity price declines) on the Russell 2000 is at its highest level since 2008, also speaking to a lack of investor enthusiasm.  Please don’t confuse this memo with a call to buy more equities – it is not – I simply do not yet see the pin to prick this market ‘ala 2000 or 2008.

I believe we can all agree equities are richly valued, as are bonds and every other asset class we hold in our portfolio.  This “richness” has been driven largely by global quantitative easing and the persistence of central bank purchases of bonds since the end of 2008.  Here we are, nine years after the crash and central bank balance sheets still sit north of $14 trillion – roughly 4 times larger than a decade ago.  Central bank action has forced many into equities in the past decade as this came to be known as the TINA (there is no alternative) market.  You had to own equities if you wanted a possibility of generating the returns needed to see your wealth grow.  Clearly, exiting this situation will be fraught with risk and mistakes might be made.  Signature, along with others, continues to believe returns will be subdued in the years to come – partly because of central bank normalization – partly because of mean reversion – but barring an economic recession, a rerun of 2008 is not our primary expected outcome.

What else is on our partial list of items that could derail the equity market?

Let’s start with a perennial favorite: China.  With a debt to GDP ratio above 300%, a credit implosion is always in the back of my mind.  China remains almost totally opaque in terms of economic data and they have a lot on their plate politically that, if mishandled, could trigger a global equity sell-off.  The upcoming 19th National Congress of the Communist Party begins in October where president Xi is expected to further tighten his grip on power.  The question is: what actions follow that meeting?  Some have speculated Xi has allowed the country to increase fiscal spending this year to smooth the run-up to the Congress and that he may crack down on state spending following the meeting.  If so, commodities as well as the Chinese currency (RMB) and global equity markets could all be in for an increase in volatility similar to what they experienced in August of 2015 (S&P 500 down 11% in six days) and January of 2016 (another 11% drop) both of which were due to concerns over China’s economy.  If something as large and opaque as the Chinese economy is perceived to be “sliding off the rails” the impact on economies and markets globally will be notable.  Additionally, Chinese politicians now must deal with North Korea, a formerly docile pawn of theirs that is quite openly ignoring the master and causing the Chinese to lose face in political circles.  Will they be able to control both the economy and North Korea?

Geopolitics:  while always a topic of concern, they are usually not enough to derail equity markets without a coincident recession.  North Korea, Iran, ISIS, Russia, Pakistan…the list goes on.  While this area is full of pundits – I am not one of them – and so suffice to say that while I have my opinions, they are just that – opinions – and so probably best to stop here.

Another risk would be an “overheating” of the U.S. economy.  This could lead to much higher inflation, thereby increasing the risk of a Federal Reserve policy mistake where they push bonds into a severe sell-off thereby causing the recession and an equity bear market.  This is possible, but so far even an unemployment rate of 4.3% has not led to sustained higher inflation or wage growth.  This is not just a U.S. phenomenon; inflation globally is low and seems to be under greater downward than upward pressure.  While this topic is beyond the scope of this letter, if a recession does come along with inflation under 2%, central banks will be likely to swing into QE (quantitative easing) mode once again to fight off deflationary forces.  That response function should be the one that scares us all as piling debt upon debt again and again, in a deflationary world, is a scenario that I firmly believe ends in debt deflation, wealth destruction and tears.

Finally, one topic that has been growing in importance to me is the role technology and technology companies play in our society.  I have already written on the impact technology will have on the human workforce in the years to come, but here I am speaking about the sheer economic power “platform” companies such as Alphabet (Google), Amazon and Facebook wield in this country.  Given the monopoly power some of these firms hold (Google and Facebook together control over 85% of the online advertising market while 50% of all online sales go through Amazon and 80% of all online searches go through Google) I believe the risk of antitrust regulators coming after some of these companies is real and growing.  Given their leadership in today’s equity market, that outcome could derail the current rally and set us up for a serious price decline as there appear to be a dearth of firms capable of taking the leadership reins from the tech titans.

While banks were everyone’s industry to hate following 2008 (remember Occupy Wall Street?) they did not collect your personal data and sell it to advertisers and others without your overt permission.  If the conversation in this country again turns back to privacy over safety, technology companies will be in the public crosshairs.  Today’s technology leaders admit having created “backdoors” into their software allowing the Federal Government to see our data and use it to surveil the citizenry.  They have made it more common to utilize other companies Intellectual Property (IP) and then force those who complain into arbitration rather than allowing themselves to be taken to court. They have admitted reading your email in order to sell you more goods. They have been accused of propagating “fake news” and controlling your internet searches to advance their own personal political agendas.

Since antitrust has historically focused on prices charged by companies as being the “trigger” for an investigation these firms may assume they are safe as Google, Facebook, etc. charge their users “nothing” – but they can only do that by selling the information they gather on their “communities” to advertisers and others.  Will the public push back at some point? Will the Government?

One clear fact in the US over the past two decades is that there has been a severe slowdown in new businesses being formed.  The belief in the American Entrepreneur is being hollowed out at the same time as these technology firms grow ever larger, often by buying their competition or adopting their ideas as their own.  New business start-ups in America are running roughly 70% lower since 2008 than what they ran coming out of the previous recessions of 1983, 1992 and 2002.  One could argue these platform technology companies are potentially stifling capitalism, while at the same time they are being accused of contributing to both gender and economic inequality.

Some of you might think it silly to discuss potential antitrust investigations against these firms but the same may have been said regarding previous Government antitrust investigations of IBM, AT&T and Microsoft.  If not for those moves, we might never have seen the rise of the personal computer, the cell phone, digital television, and all things internet (including today’s current monopolies such as Google, Amazon and Facebook…)  There is an argument to be made, in the long run, that breaking up these firms could unleash tremendous innovation and growth in the U.S. economy just as we saw occur following the previously mentioned investigations.  The question, in the short run, is what happens to their equity prices – and that of the broader market – if the Federal Trade Commission does look their way?

To summarize, while there are many risks to global equity markets that could knock prices off their perch, a sustained bear market (a decline of greater than 20%) has historically required an economic contraction.

A recession – today at least – is not on the near horizon.  Clearly, the investing environment could be altered quickly by an economic contraction in China which would have substantial knock-on effects on a global basis.  A policy mistake by the Federal Reserve or the European Central Bank could also create the ingredients for economic contraction and an equity bear market.  And while I realize an antitrust investigation into one or more technology leaders seems unlikely, I think those odds are rising and it could drive equities down in a way that damages consumer wealth sufficiently to slow spending and risk an economic slowdown.

While none of this is fun to discuss – or worry about – it is our responsibility to prepare for any possibilities as we manage your portfolio in the years ahead. It will be interesting to watch how these concerns play out.

As always, we remain grateful for your ongoing support and confidence in us.  We will continue to work to deserve it.  If you have any questions or concerns, please let us know.