As we head into the final quarter of the year, September has once again lived up to its track record of being the worst month of the year in terms of equity price performance. September 2021 dropped -4.8% and broke a seven-month win streak in the S&P 500. Equity prices are now back to where they stood in June. Unfortunately, the Stock Market Almanac reports that October is also traditionally a rough month in the market. The good news is November and December tend to be positive. In this market commentary, we do not plan on talking about short term market fluctuations, but rather longer term headwinds we see facing the market. Currently, the biggest headwinds we see are the rising debt loads in the United States, high valuations in the equity market, and China pivoting away from Western style capitalism. On the opposite side of these headwinds, we see corporate stock buybacks and high money market cash levels as market supports, ready to move in during market corrections, thus creating a choppy market going forward.
The rising U.S. debt load remains our biggest concern. As of October, the U.S. public debt stands at $28.8 trillion, or $228,999 per tax paying family (source: U.S. Treasury). We view this debt load as unsustainable. The country has added $8 trillion in debt in just the last eight years alone. In fact, over the last fifty years, only one administration (Clinton) has run a balanced budget.
At current levels, U.S. public debt is over 100% debt to GDP (Gross Domestic Product). According to Reinhart and Rogoff analysis, which has been extensively cited by policy makers in both the United States and Europe, suggest that public debt in excess of 90% of GDP is unsafe and harmful to growth in advanced economies. Furthermore, according to the non-partisan Congressional Budget Office (CBO), rising U.S. debt levels could reduce projected annual income between $2,000 and $6,000 per person by 2040. For a family of four, that could equal $8,000 to $24,000 dollars, a significant sum for most families. In the United States, consumer spending accounts for over two thirds of GDP (Gross Domestic Product), so reduced incomes would slow growth, making high debt loads harder to pay back. Europe and Japan, some of our largest trading partners, have even higher debt levels.
Making matters worse, the CBO projects the U.S. debt will continue to grow, with annual U.S. budget deficits remaining elevated through the end of the decade. The CBO projection of an over 8% budget deficit in 2030 is not much better than the budget deficit during the financial crises of 2008-2009. In short, policy makers are using debt to stimulate the current economy.
We believe that ultra-low interest rates have driven up equity and real estate valuations because bank and bond returns yield so little, so investors have few other options to invest their assets. The question going forward is that with the ten-year U.S. bond currently yielding 1.4%, there is very little room for rates to fall further. If interest rates rise, this will put pressure on equity prices. If interest rates remain at their current low levels, further equity gains will have to increasingly come from real earnings growth, not valuation and multiple expansion. An interesting research piece put out by Liz Ann Sonders of Schwab, shows that when the equity markets are trading at high valuations, there is a weak correlation of returns one year out, but a strong correlation of weaker returns over a ten-year period.
Notice how on the top chart representing returns 1 year out, that when PE Ratios (Price/Earnings) are high (above 25), as indicated on the horizontal axis, that the corresponding returns are almost equally divided between positive and negative returns as indicated by the vertical axis. However, on the 10-year chart below, high PE’s usually represent lower returns in the future.
We interpret this data to mean that even though valuations are high, and there is a lot of political and geopolitical problems, in the near term returns can still be positive as investors put excess cash to work. However, once that occurs, the returns of the market begin to get affected by the high valuation rates and future returns could be lower than average.
China is another headwind facing the market. Xi Jinping is the top leader in the Chinese Communist Party and his sweeping crackdown on business has drawn comparison with Mao Zedong’s Cultural revolutions. President Xi has called for a “national rejuvenation” with tighter Communist Party control of business, education, culture and religion. China has taken tighter control of companies, and Goldman Sachs reports that over the last several month’s actions by the Communist Party have wiped over $3 trillion off the market value of China’s largest companies as well as scared many business leaders into hiding. As of early October, the Ishares China Large Cap Index (FXI) was down over -18% year to date and is back to price levels not seen since 2007. Furthermore, CNBC highlighted that China’s increasing efforts to regulate society have even lead to a crackdown on celebrities and their fan groups, video games, and banning of gay relationships and effeminate men from being on television.
When China first entered the WTO (World Trade Organization) in December of 2001, there was tremendous excitement that the world’s most populated country could become a great new market for Western business. Foreign Direct Investment poured into China. In a very short period of time, low cost, hardworking labor have turned China into the manufacturing capital of the world and the second largest economy on earth. However, as China has gotten bigger, they have become less open. President Xi has accelerated this. The New York Times reported in November 2019 how China has become a minefield for Western companies. Today, the deteriorating relationship between the U.S. and China on everything from intellectual property (IP) theft, human rights violations, the eroding of Hong Kong’s autonomy, and Taiwan have caused many globally-renowned companies to leave China. In fact, research firm Gartner revealed last year that a third of supply chain leaders had plans to move at least some of their manufacturing out of China by 2023.
In addition to reduced economic opportunity, China represents a geopolitical headwind. The United States budget deficit is already a big problem and defense is the biggest component of discretionary spending. With the winding down of wars in Iraq and Afghanistan, there was some hope for a peace dividend. With the Chinese militarizing the South China Sea and declaring all the area around the South China Sea as Chinese territory, that looks increasingly less likely. The South China Sea is a prominent shipping passage lane with $5.3 trillion worth of trading cruising through its waters (EIA, US Energy Information Administration, Aug 24, 2021). More than half of the world’s LNG (liquefied natural gas) pass through the South China Sea. Half of this amount goes to Japan, South Korea and Taiwan, important U.S. allies. Almost six percent of U.S. goods and just over 19% of Japanese goods pass through these waters.
We see China’s ambition for Taiwan as another headwind for the market. China considers Taiwan as part of China, and has vowed to take it back, by force if necessary. China’s growing military capabilities make this a possibility. Over the last several years China has routinely sent aircraft into Taiwanese airspace in a sophisticated effort to see which radars detect the planes, which planes or coastal missile defense systems are activated, which crews respond, and even monitoring email communications among Taiwanese defense forces to probe for weaknesses. In fact, the U.S. Navy’s Asia Pacific commander Philip Davidson told a U.S. Senate armed services committee hearings that “China could invade Taiwan within the next six years as Beijing moves to supplant American military power in Asia”. In response, the U.S. State Department issued a statement on Sunday, October 3rd, “urging Beijing to cease military, diplomatic, and economic pressure and coercion against Taiwan”. On Monday, the 4th, China responded by sending 52 military planes into Taiwan’s defense zone, the most ever in a single day.
In a normal market, these headwinds would have most likely already created a market correction. What is different this time is that ultra-low interest rates and high money market cash balances have left investors few other options on where to put their money. Every time the market pulls back, cash comes back to the market. Corporate stock buybacks are also the highest on record and are usually executed when the market pulls back.
Likewise, the financial markets usually hit bottom after investors have sold, creating large money market balances.This happened in both the 2000 technology bubble and 2008-2009 financial crises.Today we have high money market balances, implying there is a lot of fear in the market.Eventually this money gets reinvested as things settle out and the large cash balances act as support for the market going forward (see chart below).
Thus, every time the market begins to sell off, there is cash on the sidelines looking for a better return. This short term support for the market could go on for some time, but the long term trends still persist.
In conclusion, the last couple of years in the financial markets have been strong. However, we are concerned that rising debt loads, high valuations, and increased geopolitical uncertainty could create headwinds for the market that could lead to more sluggish returns in the future. Counteracting these headwinds, we see high levels of stock buy-backs and large amounts of cash on the sidelines ready to move in on market dips. As a result, we believe that brand name, large capitalization companies, who are returning cash back to investors through dividends and stock buybacks and providing goods and services needed by consumers on a daily basis represent the best risk adjusted returns in a market facing increasing levels of risk.
We thank you for your continued support. Sincerely,
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