The Winter Of Our Discontent?...You may remember that this was indeed the title of the last novel published by John Steinbeck. Maybe a bit apropos to our current circumstances as the big themes in the book revolve around the ubiquitous human condition issues of honesty, integrity, morality, societal corruption, and greed. But maybe most striking is the theme of awareness. Specifically the growing awareness of the perhaps Faustian bargain embedded in the whole perception of the proverbial "American Dream". Can we extend this a bit to include in our current circumstances the previously leverage driven Euro and Japanese "Dreams", also? The financial markets are speaking loudly and clearly. In order to navigate the current environment successfully, we need to listen.
Although these are strictly personal comments, we suggest to you that perhaps the largest of near term issues of the moment for both the financial markets and the real global economy is both political action and inaction. To set the stage a bit, as you know from our previous writings, we're convinced THE key macro of the moment is the collision of generational credit cycle reconciliation (largely in the developed economies, but certainly with ramifications for emerging economies) with short term business cycles. This is a collision, if you will, that has not been seen in the US since the 1930's. So the seeming chaos and confusion in political action and inaction of the moment is in part understandable from the perspective that not one politician in the US or Europe today has any real world decision making experience whatsoever in this type of environment. But, of course, this is also the key danger point. Without question the politically motivated melodrama of debt ceiling antics during the summer in the US put a huge dent in in the very precious commodity that is confidence. An incredibly necessary ingredient for decision making both among businesses, the investment community and consumers. Whether we're looking at consumer or business confidence surveys, straight down post July pretty much characterizes it. Plus you need only look at the financial markets for a read on the emotional stability, or otherwise, of the investment community.
Likewise in Euroland, patch work bailouts, on again and off again subsidization schemes, and hastily devised cross geography currency swap programs speak to the fact that one very important thing is missing from the larger equation and discussion - a coordinated overall plan. Although this quite clearly is not time for political grandstanding and tactical maneuvering, both are what we have been treated to in spades both in Europe and the US as of late while financial markets and credit structures appear to be melting. If there is one bright spot in all of this it's the issue of growing awareness on the part of the electorate on both sides of the pond. For years politicians have been incented to either ignore or hide the inconvenient truths of sovereign balance sheet integrity, while imbalances have festered and grown to the point where they can simply no loner be ignored. The good news is that's changing. It's an initial step toward recovery, awareness, but there's a long way to go. As summer fades and roses die, will this become the winter of our discontent? Without fail, summer will come again, but for now it's our same old friends the wind and rain very much being driven by the more than obvious lack of coordinated and strategic political decision making as well as childish and destructive partisan behavior.
As a final comment, just what would change our outlook for a winter of discontent ahead? We'd change our minds in a second if we could expect politicians on both sides of the pond to develop, communicate, commit to, and execute a longer term strategic plan that dealt openly and honestly with the issues of deficit reduction, longer term debt reconciliation, entitlement reform, and true TBTF financial sector restructuring. For now, that seems miles away. If indeed we do not move toward an outcome like this over the near term, the winter of our discontent will surely become the year of living dangerously. Winston Churchill once remarked, "Americans can always be counted on to do the right thing...after they've exhausted all other possibilities." Winston, that implication behind that comment can now be extended to all of the major developed economies on planet Earth, very importantly including your Euro brethren very near term.
Enough personal philosophical pontificating? You bet. Let's get to the matter at hand that is trying to anticipate financial market outcomes ahead. As we see it, THE three key issues moving into the fourth quarter are the trajectory of the US, Euro and Chinese economies, the outlook for corporate earnings, and the ever evolving Euro response/plan to what will be the inevitability of at least a Greek default. As you know, we tend to be fundamentalists at heart, but ignoring the messages of the market in this environment borders on insanity. It's the technical side of the equation we want to focus on a bit in this discussion as we so often cover the fundamentals.
THE ECONOMY
Macro economic slowing of the moment is self evident. The issue is extent of slowing to come and how that translates into the reality of forward corporate earnings. The fact that at least the US economy is slowing should not be surprising at all. The historical lessons of deleveraging environments are clear. In the 1930's in the US it was on and off again recoveries very much in line with Fed actions. Stimulus provided a reprieve and monetary tightening virtually immediately choked off growth. In our current circumstances, the US economy experienced perceptual headline GDP expansion under QE1. Post QE1 growth stalled virtually immediately as leading economic indicators turned south almost on a dime, only to reaccelerate again at the very inception of QE2. QE2 ending in June of this year again witnessed macro economic slowing within a month of stimulus cessation. The rhythm of stimulus is key to the rhythm of real economy and financial markets both inhaling and exhaling across deleveraging event cycles. We do not expect this to change any time soon. In terms of the Euro area, once past the immediacy of financial sector crisis, we expect the same.
Moreover, Japan has taught us that in deleveraging environments, economic expansions are short and shallow as are economic contractions (usually because contraction is the birthplace of stimulus episodes).
Finally, although we're suggesting this in near bullet point fashion, the emerging markets will not be immune from this rhythm given the character of their primarily export driven economies and dependence on Western consumer markets. Near term, the markets have been increasingly concerned with China primarily, being a key driver for the industrial, materials and general commodity sectors. The sell offs in these areas as of late have been swift and decisive. We simply need to remember that on the one hand, China is a controlled economy. Will bad debt be a problem? Without question, but the more important question is when will this be allowed to be "seen" within the confines of a controlled environment? Our outlook is that there is still time until this becomes an issue that will completely derail the trajectory of positive Chinese economic movement. Unfortunately, lack of true transparency makes this statement a guess. From a true long term standpoint, if changing perceptions engender meaningful declines specifically in the price of oil and the broader energy sector equities, we suggest investors with any type of horizon take advantage of these gifts. But that means being in possession of a cast iron emotional constitution.
CORPORATE EARNINGS
Right to the point, management guidance in 3Q numbers will be key, not the results of the prior quarter. We all know that corporate profit margins in aggregate are at or very near all time highs. It's margins that are our personal focal point highlight of earnings season to come. Corporations did an absolutely fabulous job of reconciling operations and achieving margin acceleration in the current expansion cycle. As such the bulk of cost efficiencies achieved are simply not repeatable in magnitude as we look forward and assume at least some type of top line pressure. Near term, it's management guidance and the ability to maintain margins that will be key to equity prices over the remainder of the year from a fundamental perspective. We personally believe margins are at risk, but it's also clear that the financial markets are discounting this possibility as we speak.
Longer term, and this we believe will not come into play until perhaps the bottom of the current corrective cycle for equities, we need to remember that large blue chip balance sheets are very solid. Valuations have been contracting for over a decade for many while revenues and earnings have continued to expand in uninterrupted fashion. These companies are largely irreplaceable global franchises that produce significant organic cash flow allowing ongoing flexibility in shareholder value creation (buyback and dividends). Although we're not there yet, the theme of global capital at the margin gravitating from public sector assets (sovereign and muni debt) to the private sector investment largely driven by changing perceptions of capital safety lies in our future. It's will be a big positive for private sector financial assets, but it's "tomorrow's" positive, not today's.
So, just how do we "listen to the message of the market" as it applies to equities, equity sector performance, the broader economy and corporate earnings? Again, fundamentals lead the way in terms of the earnings reality to come, but relative equity sector performance can be quite helpful in combination with fundamental analysis from an anticipatory standpoint. What we hope is that listening to these "messages" will allow us to correctly assess the probability of an outright recessionary outcome as well as a commensurate decline in macro S&P earnings. Let's look at a few historical relationships of importance.
In anticipation of an outright economic contraction and earnings downturn, we have historically watched investors increasingly gravitate to defensive equity sectors - specifically utilities, health care stocks and consumer staples. There's more than a fair amount of institutional money that is captive in the equity markets of the moment - it simply cannot leave. Important in the very near term in that these are exactly the equity sectors that have held up on a relative and in many cases absolute basis (a number of utilities have gone to new highs as of late in absolute terms) over the last two to three months. So here's the key point, as you'll see in the very simplistic charts below, the staples, health care and utility stocks began to outperform the broad equity market prior to the last two recessions. We're seeing exactly this same pattern right now. Additionally, this pattern of outperformance continued as these recessions developed. But maybe most important to our decision making immediately ahead is that relative performance of all three peaked prior to or with the final bottom in equities during each cycle. Important issue being broad equity market health will return as the relative price performance of these sectors peaks.
Below is a look at the consumer staples sector relative to the broad market using the S&P as a proxy.
A very quick note of explanation that applies to all of these relationships. You'll see that the relative price performance peak for staples and healthcare early last decade came in late 2002, well after the official end of the 2001 recession. As you'll remember, first on an historical revisionary basis, the 2001 recession was the recession that really never was. A recessionette. Secondly, the headline US economic recovery into early 2003 was incredibly shallow. The US kept losing jobs all the way into mid 2003. The equity markets had this one correct in that the sell off continued until March of 2003 that was about three months in advance of new job creation and reacceleration in growth for that cycle. The relative performance peak of the staples sector occurred about six months prior to the final bottom in equities in early 2003.
Of course what we're really after here is not only trying to assess the forward reality of the economy, but quite importantly turns in financial market price cycles. The initial out performance of these sectors foreshadowed real world economic contraction. In like manner, the peak in relative out performance foreshadowed important equity market lows. The relationship between the healthcare sector and the S&P lies below. Concepts discussed above play out in more than similar fashion below.
Finally a look at the utilities. The patterns once again repeat.
One last issue germane to the current cycle that we'll discuss in expanded fashion in the last portion of this letter. As we stated above, stimulus can and will move both the real economy and financial markets in a post generational credit cycle deleveraging environment. Does that stimulus have the ability to mask or somehow shift individual equity sector relationships relative to the broad market itself? We do not know, but it's something we need to at least be aware of within the context of our current circumstances. For now the charts above seems pretty clear in their collective message about the market's interpretation about the near term direction of the economy and implications for the rhythm of earnings ahead. We simply need to keep our eyes open. One last relative price performance relationship we've followed for years is that of the consumer versus cyclical equity sectors. This leaves the S&P, per se, out of the equation. We can get a taste for this by looking at the relationship between the Morgan Stanley Consumer and Cyclical indices that you see below.
Although consumers (and consumer stocks) are certainly not immune from recessionary outcomes in absolute terms, it's simply the lesson of history that cyclical stocks far underperform their consumer brethren in recessionary periods. And as with the relative performance comparatives above, the relative performance of consumer issues set against cyclical sectors peak prior to not only official recession conclusions, but important equity market cycle lows. The chart above is in complete harmony with the message of the staples, utilities and health care stocks of the moment.
Although this is fodder for an entire discussion, historical fundamental markers are telling us the probability of a recession to come is very high. Yet having said that we need to again think back on the rhythm of the Japanese experience - shallow recoveries and shallow contractions. With just about zero prior cycle recovery in housing, autos, employment and small business conditions, are we looking at a gaping recessionary hole ahead? We doubt it. Shallow recoveries and shallow contractions. So, watching for peaks in these collective relative price performance relationships reviewed above will hopefully be helpful in gauging the depth and timing of a potential contraction to come. We simply need to listen.
THE EURO (AND GLOBAL) CENTRAL BANKER RESPONSE
A few last comments combining the political, the fundamental and market driven "messages" embedded in financial asset prices. As mentioned, a very important anecdote is that the political body of the moment especially in the US and Euro area have no historical context of decision making within the bigger picture macro of a generational deleveraging environment. As such, confusion and indecision are to be expected as opposed to superficially vilified. As to the very near term, we expect a meaningfully large response out of the European Central Bank/Euro area powers at some point very soon. The Euro politicians have dithered, but Mr. Market has little patience with mortal indecisiveness and has extracted its toll in price, ultimately have bearing on real world economic outcomes that lie ahead in the absence of a political/central bank response. As such, the response will come.
So one outcome we at least need to assign some type of probability to right now is a Euro centric reflationary (money printing) program. You'll remember that in early 2009 we saw exactly this outcome, but on a widespread basis encompassing Europe, the US and Asia. The reflationary attempt to come directly ahead will remain largely specific to Europe, most likely with some Fed related aid (although this will not be "televised", so to speak). Will this type of event move financial markets? Indeed it will, at least for a time. Again, this is all about the very short term as longer term it's the structural issues we discussed above (entitlements, financial sector reform, debt reconciliation) that remain the key issues for just how global economies work through the macro deleveraging environment of the moment.
In the endgame, it's really all about cycles. We can't lose sight of this fact or eventually opportunities present will be unseen amidst the wind and rain. Broken ground of the moment ultimately beckons to tomorrow's nourishing spring showers. Black dirt will live again. It's all in the rhythm of cycles that define economies, financial markets, and human decision making.
