EQUITY VALUATION

The debate on inflation is intensifying. Are we living through another short term inflation burst that will, as in 2011-12 and 2015-17, fade under the weight of a slowing economy, globalisation and technology, or is this the beginning of something more serious fuelled by synchronized global growth and a strongly stimulated U.S. economy already operating with stretched resources?

If the fixed income market is given any attention, something more serious seems to be developing: this time, interest rates, short and long, are rising strongly before inflation actually registers a clear uptrend:

Is this another false alarm and a repeat of 2017 when 10Y yields dropped 23% from 2.6% in March to 2.0% in September as core CPI peaked out and decelerated from 2.3% to 1.7%?

An important clue may be in the behavior of real interest rates: they declined meaningfully when inflation rose during 2011 and 2015 but they are currently rising:

Even at their current 1.1%, real 10Y yields remain abnormally low. In normal times, when central banks are not massively involved in financial markets, real rates are well above 1.0% (90-year average = 1.9%, 50-year: 2.4%, 30-year: 2.6%) which means that 10Y rates should currently be between 3.5% and 4.5%, not 2.9%,

A bet that real yields will return to the normal 2.0-2.5% range should carry good odds at this time.

The inflation scare is one thing but inflation forecasting is iffy; bond supply, however, is another, very significant factor and something that is much more measurable well into the future. From the CBO:

At 77 percent of gross domestic product (GDP), federal debt held by the public is now at its highest level since shortly after World War II. If current laws generally remained unchanged, the Congressional Budget Office projects, growing budget deficits would boost that debt sharply over the next 30 years; it would reach 150 percent of GDP in 2047. (…)

If, instead, policymakers wanted debt in 2047 to equal its current share of GDP (77 percent), the necessary measures would be smaller, totaling 1.9 percent of GDP per year (about $380 billion in 2018). The longer lawmakers waited to act, the larger the necessary policy changes would become.

A $380B shave in the deficit would require a 10% increase in revenues or a 9% cut in spending over and above current projections. Nobody should hold his/her breadth for anything near that to happen. While still breathing, now consider that net federal government borrowings will average $1 trillion per year in 2018 and 2019. Net borrowings totalled $519B in 2017, $680B in 2016 and $535B in 2015 (average: $578B).

In effect, the U.S. Treasury will need to double its supply of bonds over the next 2 years.

Add the supply coming from the Fed’s Quantitative Tightening that just got underway: about $140B in 2018 and $200B in 2019 based on current trends.

Total bond supply from the enlarged U.S. government: $1.1T in 2018 and $1.3T in 2019, more than double the average of the last 3 years. This assumes no recession and no nasty surprises for CBO forecasters.

To drive interest rates to the floor, the Fed boosted its assets by some $460B annually on average since 2009. Not only is that offset gone, the world will have to absorb over $1.1T in new government securities during each of the next 2 years.

There’s more if you don’t mind looking out a few more years, required when buying bonds. Off-balance sheet items (Social Security, Medicare, Medicaid, etc.) are financed through trust funds. The Office of Management and Budget’s numbers reveal that, starting in 2020, the two largest trust funds will begin to bleed under the weight of retiring and aging baby boomers. More external financing needed.

Secondary supply could also increase materially if Treasury holders decide to reconsider their investments. Holding U.S. dollars has not been very satisfying since 2002 and the trend since December 2016 is troubling. The dollar lost 12% against major currencies during a 14-month period when the economy accelerated and interest rates were on the rise.

The reality is that there is no Fed driving the market anymore, the GOP has abandoned itself to the self-proclaimed “King of Debt”, and the Tea Party and just about anybody in D.C. with any sense of fiscal discipline are either retired, retiring or MIA.

It seems almost inevitable that sometimes over the next 12 months, the bond vigilantes will take over the fixed income market. Whatever inflation is then will be secondary to “out-of-control deficits”, “twin deficits” and “crowding out” scares.

Rising interest rates are not good for the economy and financial markets, especially when the economy is so highly levered.

• Household debt service payments are only 10% of disposable income, down from 12.5% in 2009…but debt on income is at an all time high of 26%, up from 24% in 2009. Americans are taking on credit based on their ability to meet current monthly payments. We have seen this movie before. It would not take much to squeeze disposable income, let alone the squeeze that could simultaneously come from rising inflation.

• Corporations are more levered than ever. Rising interest rates will directly eat into return on equity, even more so now that tax rates are much lower. A 5.00% interest expense cost 3.25% after tax at 35% and 3.95% at 21%, nearly 22% more. A 100 bps increase in interest rates is really 122 bps with the new tax rate. From a debt servicing point of view, the tax bill is actually increasing corporate leverage and the potential earnings bite from higher interest rates.

The market is not much pre-occupied by leverage or increased leverage these days:

But it should, more than ever:

The whole rate curve has begun to lift:

On a YoY basis, the hikes are not insignificant. In less than 5 months, three-month LIBOR rates have spiked 41% and 2Y Treasury yields have nearly doubled. By mid-year, the YoY jump in 10Y yields will be nearly 50% at current levels. Fifty basis points is actually a big deal with nominal rates so low and total debt so high. Interest rates have rarely jumped so much in the past and such quick spikes will undoubtedly bite many borrowers.

• Governments are also at risk. The U.S. government paid an average interest rate of 2.3% on its gross debt of $19.9 trillion during fiscal 2017 for gross interest expense of $457 billion. Each 1% increase in the average rate would inflate the interest outlay by some $220B in 2018, more than 1% of GDP. BTW, the U.S. budget deficit was $665B annualized in Q4’17.

A very possible scenario over the next 6-18 months would be rising real rates on top of rising nominal rates along with accelerating inflation and generally widening spreads. For the fixed income market, this is la totale as the French would say.

Higher interest rates would slow the economy down, boosting the budget deficit, requiring more borrowing, right when a flood of refinancing from governments and corporations would further exacerbate supply. Refinancing some $45 trillion of total debt impacts the economy by $225B annualized every time rates rise 50 bps. By comparison, the CBO estimates that the Tax Cuts and Jobs Act will cost the federal government $224B on average between 2018 and 2021…What D.C. giveth, the market taketh away.

Most investors have little real experience on the effects of rising interest rates, the most important price factor in the economy. Broadly rising financing costs cannot be faded with substitution.

• Levered consumers must immediately reduce discretionary spending.
• Corporate P&Ls are also hit immediately and officers must decide whether to cut costs or accept lower margins.
• Government deficits swell and pressures to cut spending grow rapidly.
• The dollar declines, spooking foreigners and fuelling more imports inflation.
• Equities suffer on slowing revenues, declining margins, higher discount rates, reduced buybacks and the disappearance of TINA and FOMO.

Beware of “analysis” claiming that equity markets generally behave well during periods of rising interest rates (e.g. Inflation Is a Bigger Danger to Stocks Than Rising Rates). As Mark Twain said, facts are stubborn, but statistics are more pliable (see RISING LONG-TERM RATES: THE SCARY FACTS! and EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954).

In the 12 periods of rapidly rising long-term rates between 1965 and 1996 (I grouped a few short periods on the chart), not one was accompanied with any meaningful gains in equities while most saw equities perform a really deep dive (average –14.5%).

Since 1996, there were some instances when rising rates coincided with higher equity prices, like in 1998-2000, maybe 2005-06,  and 2010. The first two instances saw equity valuations truly explode as investors bought into “great stories”, only to totally deflate when the dreams turned into terrible nightmares.

We have done a complete 180-degree turn since the equity valuation generational lows of 9 years ago, when most people and most media were too scared and confused to recommend, let alone actually buy stocks. Now that equities have quadrupled, valuations and enthusiasm have reached nearly historical highs right when leverage is dwarfing all previous excesses.

There have been several periods of economic slowdown during the last 9 years but this is the first time that I can build a credible scenario that would end this cycle.

Is there a way out of this spiral?

• Can we get continued low inflation numbers when Congress is stimulating an already pretty strong economy operating with stretched resources? 
• Can we get stable interest rates when borrowing needs are exploding with the Fed also on the Ask side?
• Can we avoid a recession if inflation and interest rates keep rising given current widespread high leverage?

Benjamin Graham warned to always maintain an adequate margin of safety. This is nowhere to be found nowadays. The odds are stacked against investors wherever we look as most asset classes are in “Buy High” territory.

In 2009 and through 2016, probabilities of success for investors were favorable as equity valuations went from extraordinarily low to full value while the Fed and other central banks were taking care of liquidity and the cost of money, ensuring economic growth, however low it could be.

Current valuations offer no margin of safety anymore, quite the opposite, right when the Fed is stepping aside after its low rate policies have boosted personal and corporate indebtedness. With its untimely and irresponsibly expensive fiscal programs, the Trump government has seriously compromised the Fed’s plans to softly normalize its unsustainable monetary policy.

Is it too early to sell, given the “good fundamentals” as the merry talking heads say? Maybe. But not because of “good fundamentals” which are well known and priced in. Corporate America keeps surprising and liquidity remains high. However, the current P/E of 17.5x 2018 forecast EPS of $158 (+18.8%) offers little margin of safety and only bubble-like potential returns.

As legendary mountaineer Ed Viesturs said: “Climbing to the top is optional, getting down is mandatory”.

With the king of debt piling onto the current mountain of debt, it is time to gradually make cash our new, safer king.