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But are global stocks in a ‘bubble’ like technology stocks were in the late 1990s and commodities were in 2008? We believe they are and, as outlined earlier, is a result of a misallocation of capital to stocks, which has occurred due to the excessive application of zero-interest-rate policies across the globe since 2009. This has induced behavior among investors that forced them into riskier investments than they would normally tolerate in order to achieve adequate rates of return. While there are numerous excess valuation measures, economic risks, profit margin deterioration and technical indicators that make us believe we are in the process of a ‘market top’ process, there are also some ‘capital flows’ impacts that we think add further risks. Like the commodity bubble, at the top of the market in 2007 we saw the industry players such as Rio Tinto, BHP and Glencore making large takeovers of major metals companies (mostly Canadian) such as Alcan, Inco and Falconbridge. The so-called industry experts were caught up in the euphoria as much as anyone else. We see the same behavior today in the corporate buybacks and merger/acquisition activity that have been the biggest sources of stock market demand over the past two years. Many companies have used low borrowing rates to fund their stock buybacks, which also increases earnings per share and supports higher stock prices. But there is no value creation and, if markets ultimately fall, companies will find they have just wasted billions of dollars of shareholders capital.
Another new buyer of stocks over the past 8 years had been the world’s sovereign-wealth funds, which together have assets of $7.2 trillion. That is twice their size in 2007, and more than is managed by all the world’s hedge funds and private-equity funds combined. Nearly 60% of sovereign-wealth-fund assets are in funds dependent on energy exports. The collapse in oil prices is forcing them to sell investments, potentially pressuring global markets just as other investors are pulling back from risk. Saudi Arabia’s central bank, which functions in some ways like a sovereign-wealth fund as it holds significant reserves that are invested widely, has sold billions in assets this year. Norway says it plans to tap its fund, the world’s largest, for the first time in 2016. Selling is picking up. Sovereign-wealth funds pulled roughly $100 billion from asset managers in the six months to Sept. 30th. The countries that have accumulated these vast reserves over the last 20 years will be dipping into those reserves. The Saudi Arabian Monetary Agency sold close to $2 billion of European shares this year through November. The International Monetary Fund, examining the fallout of low oil prices, said in October that a large-scale liquidation of government funds’ extensive bond holdings could drive up interest rates. “A substantial change in the path of asset accumulation by sovereign wealth funds,” it said, “will likely have a direct effect on financial markets.” We believe that this ‘over allocation of capital’ to stocks will have to be unwound by many of the weaker players. That will put continuing downward pressure on stock prices.
We also are concerned about earnings growth going forward, particularly since the biggest source of profit growth in recent years was the net investment in emerging market export capacity. But that growth has come to an end as excess capacity now exists in that region. It is evident not only from the data on exports from major capital goods exporters, but also from companies. One after another, when they talk about their outlook and performance, companies refer to weakness in the emerging markets. Parts of the global economy have already turned down, including Russia, which has some special problems related to energy and economic sanctions, and Brazil. Most of South America looks pretty close to recession, and we’ve seen slowdowns in other parts of the world. The one area that has picked up somewhat is Europe. But it is entirely accounted for by the improvement in Europe’s trade. Obviously, the cheaper Euro helped their exports. They also get an extra bonus from falling petroleum prices, but Europe’s momentum is showing signs of starting to fade. The bottom line is that profit growth looks set to head lower. The chart below shows the Earnings Revisions Ratio as calculated by BAML. It is a simple measure of the ratio of earnings upgrades to downgrades over various shorter term periods. The data has clearly turned lower again over the past three months.
What about China? Can they once again bring the economy back on track or are they a lead indicator for more problems ahead? We believe that the problems in China are deeper than most investors realize. They cannot make a significant adjustment to economic growth, because they already have enormous excess capacity. Almost 50% of their GDP comes from investment. That is way above even the worst of the Japanese bubble. Moreover, most of this growth has been financed via a ‘shadow banking system’ where lenders have yet to accept the write-downs of their loans. At its peak, government and private investment in Japan totalled 33% of GDP in 1990. China will need to take their currency lower to help export growth and this will put more pressure on their emerging market neighbours. Bit by bit, we now expect the global economy to slip into recession, with the U.S. bringing up the rear. The Fed announced in December that it was raising interest rates for the first time in over ten years. Meanwhile, the global economy continues to deteriorate, and the U.S. expansion is showing broad signs of deceleration. We expect that the Fed will be forced to reverse course later in 2016. In all probability, the slowly spreading global recession will intensify and ultimately engulf the entire global economy. Unfortunately, with interest rates already near zero, central banks will have few, if any, policy tools to extricate themselves from that downturn. In that environment we have a hard time believing that we should be investing in stocks. We continue to implement a strategy of maximum defensive exposure in all of our managed accounts.