Deflation Rears Its Ugly Head
Equity Investment Outlook
Several years ago we developed a view that the U.S. economy and its equity market were misunderstood, out of favor and undervalued. The world was infatuated at the time with the mesmerizing growth rates of many emerging market economies while the U.S. was viewed as having been bumped from center stage by the ascendant BRIC (Brazil, Russia, India and China) economies. Over the five years, 2009-2014, investors moved a stunning $1.6 trillion into emerging market funds. We saw things differently and took the view that it was premature to count out the U.S. Much progress has been made in the U.S. over the past four years since we espoused this contrarian view. The U.S. economy turned out to be well on its way to recovery and has now expanded for seven years in a row since the Great Recession ended in early 2009. Unemployment in the U.S. has dropped sharply. The consumer has delevered. The banking system has been recapitalized. Corporate profits are healthy. Housing is on a grinding recovery and auto sales are running at near record highs. Government spending (state, local and federal) is finally growing again. To top it off, the Federal Reserve (Fed) finally blessed the recovery by embarking on its first interest rate increase in 10 years. So with all this good news, what’s the problem?
In a nutshell, the problem is no longer the U.S. but diminished economic prospects in the once adored emerging markets – most notably China. We highlighted the importance of Chinese trade to many emerging market economies in our last quarterly letter. The economic boom in China over the past decade lifted many other economies with it and together accounted for a very large percentage of global growth. With economic growth prospects continuing to cool in China and in many of the countries that rode China’s coattails, investors are selling risk assets in general because of uncertainty over two very important questions. First, where will global growth come from going forward and second, will sagging China/emerging market growth result in global deflation? The major central banks around the world (the European Central Bank, Japanese Central Bank, Chinese Central Bank and even the Fed) are all squarely focused on combating this deflationary trend. The result is that the Fed may not be able to raise rates as quickly or as much as it would like in coming months and quarters. If the Fed turns out to be the lone central bank tightening, the risk is that the U.S. dollar will continue to strengthen, capital may continue to flow out of the struggling emerging market economies and deflationary forces may worsen as a result.
During the economic boom of the past 20 years, China developed excess and uneconomic capacity in just about everything: manufacturing, real estate and infrastructure. Much of this excess capacity was developed with borrowed money that will never be repaid, leaving China today with a looming bad debt overhang of unknown dimensions. The economic boom also drove up wages in China to such an extent that Chinese exports are no longer as competitive as they once were. The Chinese authorities understand the problem and are now appropriately guiding to slower growth going forward. They also appear to be managing their currency lower as a way to stimulate exports.
Recognition that the China boom is over has sent shock waves through its own stock market, the economies of its major trading partners and through global financial markets. While equity and fixed income returns in the U.S. were disappointing in 2015, returns were far worse for investors in emerging market debt and equities, commodities, emerging market currencies and more recently high yield bonds. The collapse in commodity prices has pushed many commodity exporting countries into recession. Capital flows out of China and the emerging markets into the U.S. have driven up the value of the U.S. dollar. In many ways, this has left U.S. financial markets and asset values (equities, fixed income, real estate and the dollar) as the “last men standing” in a global rout. This begs the question of how much longer the U.S. can remain a holdout.
A key variable in answering this question will be the future path of the U.S. dollar. As noted above, deteriorating economic and financial conditions in the rest of the world, combined with firming U.S. conditions, have driven up the value of the U.S. dollar by 33% against a basket of currencies of key trading partners since 2011 and by 25% in just the past 18 months. This has curtailed our exports, pushed U.S. manufacturing into recession and undermined the profitability of U.S. multinational corporations. In effect, the positive reversal of fortune of the U.S. versus the rest of the world that we predicted several years ago may be proving to be too much of a good thing, thanks in part to the surge in the U.S. dollar.
The result today is that there are more than just a few whiffs of deflation wafting over investors’ heads. This is an historic anomaly that none of us has ever seen. Normally, seven years into an economic recovery, inflation and interest rates would be moving higher and the Fed would be actively trying to slow down the economy. Today, however, there appears to be plenty of slack capacity in the U.S. economy to accommodate continued non-inflationary growth. Nearly all commodity prices have collapsed. The largest drivers of global growth over the past decade are either in recession (e.g., Brazil, Russia) or are experiencing sharply lower growth rates (e.g., China, Taiwan, Korea, Australia). Last but not least, many major economies are actively attempting to lower the value of their currencies in order to boost exports (e.g., China, Japan, Brazil, Europe). All of these factors are serving to keep inflation and interest rates unusually low this late in the economic cycle as well as raise fears of deflation.
The logical course of action for investors monitoring this deflationary landscape is to increase cash levels, avoid highly indebted companies, steer clear of emerging markets and commodities, and minimize currency risk by investing in U.S.-centric companies that can sustain revenue, earnings and cash flow growth even in a slowing economic environment. This sounds almost exactly like the winning approach in 2015, which makes us wonder if this will turn out to be the right recipe for a second year in a row this year. While we would like to take a contrarian view on growth and deflation, the case is strong that the factors that have led to slower growth in China will likely stay in place.
We still believe that the U.S. economy is likely to avoid recession in the next 12-18 months on the strength of the U.S. consumer, but risks have clearly escalated in recent months owing to economic weakness globally and the ongoing strength in the U.S. dollar. Credit markets in the U.S. are still functioning, broadly speaking, but high yield markets are flashing cautionary signals. In a slow growth, deflationary environment, debt can be like an albatross around the neck of consumers and corporations. This is why consumers appear to be saving more than expected and spending more cautiously, corporations are investing less and investors are steering clear of highly levered companies. In general, U.S. corporate sales and profits (outside of companies and sectors directly hit by the collapse in commodity prices and exports) remain firm at high levels but do not appear to be growing much. The combined forces of a strong dollar, weak emerging market economies and falling commodity prices are hurting the profits of manufacturing as well as oil and gas companies. On the other hand these factors are helping the U.S. consumer through lower inflation and of course lower gas and oil prices, which should help sustain the U.S. economy in 2016.
Taking a step back from fundamentals, it is important to note that over the past 12-24 months, investors (directly or through passive vehicles) have migrated to an ever shrinking number of companies that are still seeing robust growth. This has led to a very narrow stock market in which the vast majority of the performance of the broader indices is being driven by a small handful of richly valued “growth champions.” In 2015, we estimate that the top ten S&P 500 contributors gained an average of 36%. The average return for the other stocks in the index was a negative 2%. More than half of the stocks in the S&P 500 are now down more than 20% from their 52-week highs as of the time of this writing. A narrow market like this usually results in an eventual correction in the performance leaders. This can have a surprisingly large impact on investors who think they are diversified via passive vehicles. Also, as value sensitive investors, we are well aware of the wide and still growing divergence in valuations between growth and value stocks. This divergence has not been as wide since 2000. In 2015, we estimate that the top 10 contributors to the Russell 3000 Index were trading at 31x trailing twelve month earnings versus 18x for the average of the entire index. While it is frustrating to not own the current darlings, we think that over the long term focusing on out-of-favor companies with good businesses, rather than just following the herd, should better serve our investors.
In conclusion, while we are mindful of the potential risks of deflation, we think the U.S. expansion has further room to run for a number of reasons. Corporate profits are unlikely to fall off a cliff, but their composition may shift (e.g., away from energy, materials and industrials and towards U.S. consumer-oriented companies). Stock valuations are not excessive broadly speaking, but valuations are getting stretched for the premier consumer growth companies. Our guess is that the Fed’s interest rate normalization will be slow and deliberate. We don’t think that rising rates will pose a real risk to the stock market for some time. That said, risk is always of chief concern. We continue to invest selectively in a group of companies that we believe should be able to grow despite a sluggish global economic environment and a strong U.S. dollar. In particular, we think that companies serving the U.S. consumer should do well in the coming year.
We thank you for your loyalty and patience this past year. We look forward to helping make 2016 a happy and prosperous New Year.
Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The Russell 3000 Index is a market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire U.S. stock market.
Basket of currencies is a selected group of currencies in which the weighted average is used as a measure of the value or the amount of an obligation. A currency basket functions as a benchmark for regional currency movements - its composition and weighting depends on its purpose.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
One cannot invest directly in an index. 
© Osterweis Capital Management
© Osterweis Capital Management