2018 Macro Outlook

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“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” ⁱ Do we know ‘for sure’ the past years market returns were because of a robust economic backdrop?Do investors know ‘for sure’ that more good times are ahead? Markets all know this ‘for sure’, right? Or is what the market knows ‘for sure’ just ain’t so? This folksy quote¹ sums up our outlook for 2018. We aren’t running a fool’s errand to specify the ‘next’ black swan event.² This would make for a terrible strategist. Instead, we are focusing on what the market knows for sure, and detailing why it ain’t so.
The S&P 500 returned double digits in 2017 without having a drawdown of more than 3%, a rare combination that has only happened once in 35 years.ⁱⁱ Our Japanese counterparts did better than that, Europe did better than both, and emerging markets performed the best out of them all.³ What was behind this broad price appreciation in 2017, and will it continue into 2018?

Our take: 2017 saw acceleration across nearly all global economies and this trend has been extrapolated forward by the markets. We see most of these trends normalizing or reversing course, neither of which seem to be properly discounted by market prices. In other words, everything went right under 2017 factors – why will everything continue to go just right under different 2018 ones?⁴

The price target chart below contains two ‘firsts’ for Doxa Capital – a base target below the current index price and more than a 20% probability for our bear scenario. We believe asset prices are inflated, central bank risk is being miscalculated, and uncertainty is being replaced with complacency.⁵ We are simply saying ‘the time for caution and discipline is now’. Fighting for the last leg up or the perfect market timing call is not a risk/reward scenario we find advantageous. The biggest risk to our outlook is being early, not wrong.⁶ We have tried to incorporate this into our scenarios, which explains the 1,000 point spread between the bull and bear cases.

Quickly pulling back the cover on our earnings and multiple estimates, the base case assumes a ~5% benefit from corporate tax changes in 2019,⁷ moderating underlying earnings growth from 9% today, 6% for 2018, to 3% in 2019. The multiple will fluctuate based on profitability and the expected return. In other words, if the narrative is good the multiple is high, and vice versa.⁸

On multiples, nearly all market gains since mid-2014 have come by way of multiple expansion. S&P 500 operating earnings and NIPA⁹ profits are both just barely ahead of mid-2014 levels. Yet the S&P 500 index is 20%+ higher. This tells us that continued high growth & profitability are priced in, leaving ample room for disappointment.

Going forward, we believe that 2017 was an earnings rebound year, not the start of a trend – so we have moderated earnings growth, added a 2019 tax tailwind, then applied a multiple at the high end of average.¹⁰

Ultimately, we see good value somewhere in between our bear and base cases and believe consensus is pricing closer to a bull case scenario.

2017 Lookback

Normally our outlooks consist of a quick lookback on the year past, “what we got right/wrong” segment, and then a few themes we see going forward. This year we are going to do it a little differently for two reasons. First, our primary theme for 2018 was laid out in detail in October, here: The 10 Trillion Dollar Question. Secondly, we see many of the 2017 narratives reversing course, so it seems more logical to lay out the 2017 themes and then outline the direction we see those continuing.

So, what was behind the rally in 2017?
As we sit today, every major stock market¹¹ in the world is higher on the year except for two, Israel & Russia, both down 1%. That is near unparalleled synchronization and we challenge anyone who thinks it is a mere coincidence. A common thread that runs through all 43 different markets is accommodative monetary policy and a strong recovery of industrial/energy production. Furthermore, the low inflation narrative continues to run through all developed countries – keeping corporate margins high.

If 2017’s equation amounted to increased monetary stimulus + international recovery + great stock narratives, then think back to 8^th grade algebra and apply the inverse function. Monetary tightening + production normalization + realistic corporate margins = more volatility, bigger drawdowns, and lower multiples.

Monetary Policy
Asset prices are largely a function of liquidity, and not much else. Central banks can increase that liquidity through two channels:

• Lower interest rates. This forces money to move out of less risky assets and into more risky ones in pursuit of yield, i.e. liquidity is shifted.¹²
• Directly inject money into the system through open market operations, i.e. liquidity is added.¹³

Both of these levers have been full throttle in the past years from the Federal Reserve, the ECB, BoJ, BoE, and SNB.¹⁴ In fact, more liquidity was injected into the system in the past two years than during 2008-2010. Since Lehman Brothers collapsed, there have been a collective 705 rate cuts in the world. All of this harmonious liquidity adding and shifting has a profound effect on risk assets. So why are we concerned now? Simple: they have all said they will begin retracting. A $500bn net injection to purchases this year will turn into $1tr draw next. However, our real concern is that market participants don’t seem to believe this. It’s very easy to take for granted the underlying liquidity that has been a backstop for nearly 10 years. This support has been tested through several occasions (’11, ’12, ’15), but each time the paradigm is reinforced as the central banks answered to the despair. It cannot be overlooked that the lack of volatility, muted responsiveness to tail risk, and an unwavering ‘buy the dip’ mentality are fueled by a liquidity backstop the central banks have in place.ⁱⁱⁱ However, now they are saying the backstop is going to slowly be removed. The Federal Reserve has just begun rolling off a small number of assets, which they will be increasing throughout 2018. The ECB will begin tapering in the summer. The BoJ continues to slow their purchases of JGB’s but swaps them for ETF’s.¹⁵

The excess liquidity provided by central banks has undoubtedly been the key driver to markets, because positioning and strategies¹⁶ have been built around the ‘backstop’ status quo existing. With admitted low conviction on ‘when’, we fear the realization of a ‘backstop-less’ market will be an inflection point that is unexpected, sharp, and volatile. This is enough for us to take a cautious stance going forward. Again, we encourage you to go back to our note from October for further insight.

 Global Industrial Production
In one sentence, consensus would tell you that good market performance in 2017 was because of synchronized global growth – all markets performed much better than expected. This is not false of course, as narratives are usually crafted on top of truth, but we see big cracks beneath the surface of this rosy global picture. China makes up roughly 20-30% of direct global GDP growth, so let’s start there.¹⁷

A good leading indicator of global growth is found in the base metals (steel, copper, iron ore, aluminum, etc.), all of which have been on a tear this year. However, the fundamentals look shaky when you peel back the layers.

• China has been supporting the base metals markets. As President Xi Jinping led his communist party into the 19^th National Congress this past October, China’s clear strategy was to build economic momentum as a show of strength and maintain the key 6.5% level of GDP growth.¹⁸
• China accelerated their economy by injecting $4 trillion USD this year, enacting tight capital controls, and implementing supply side reforms (import restrictions, etc.), ex: China steel producers made 1,000RMB more per ton this year versus last.^iv
• But can China influence the whole market? Absolutely. Not only are they the largest consumer of base metals, but these markets are very small. A $150mn swing can influence prices by 10% or more. This can be seen extensively in the nickel and copper markets. Supply plus expected supply is roughly 3% above demand, but prices are at levels showing shortages.^v
• Is it reverting? Yes. China likely overachieved their 2017 targets and have now shifted focus to removing excess leverage and stemming credit growth.¹⁹ New construction in China was said to be higher by 10% from January to June, but slowed dramatically from July to October. Recent PMI data & retail sales also show a drastic slowdown post-plenum.^vi

Another huge factor behind strong global growth? The energy markets.
Oil and natural gas exploration & production alone account for about 5% of global GDP, excluding refining, storage, & transportation.^vii The global supply & demand imbalance in ‘15/’16 accounted for massive write-offs and investment drawdowns, making 2017 “growth” come off the back of big declines the past two years.²⁰ The ripple effects here are wide: transport companies, drill bit producers, maritime, etc. As supply and demand continues to tighten, we expect the energy markets to be less volatile going forward, allowing “growth” to revert back to a normalized level – not continue its same pace from the bottom.²¹

This can be seen on a granular level in US data. At large, production in the United States amounts to three things: energy, cars, and planes. Two primary points to be made here:

• At peak, energy investment (capital expenditures) made up roughly 23% of total private investment.^viii We removed energy investment altogether to see real GDP ex-energy, the result being in the chart to the right. Admittedly this is a messy calculation, but it is clear the rebound in energy investment this year is a primary driver of GDP growth. This underlines our claim that 2017 trends will struggle to continue, but instead revert back to trend.
• Importantly, the USD is used in roughly 52% of all global trade.²² The massive USD rally in 2013-2014 made US goods very expensive and combined with the volatile energy markets – businesses became cautious. However, 2017 brought stable energy markets and a declining USD. This environment was very conducive for businesses to make those purchases they had been delaying for two years. This ‘pent-up demand’ theory is supported by the chart below. We see the strength in ‘new orders (blue dotted line)’ attributed to its weakness in the years’ prior, while inventories, retail sales, and loans outstanding remain muted. 2017 strength, or 2017 catch-up?

Unemployment, Wages, & Inflation
Our biggest call for 2017 in last year’s note was for unemployment to continue lower, wages head higher, and margins (corporate profits) feel the pinch from paying workers more. Unemployment did continue lower, but outside of restaurants and construction, this didn’t really play out. Nevertheless, we are doubling down on this call. We are also prepared to add a new idea to this existing theme: inflation.

Why didn’t it work last year?
We believe two main reasons are behind the low wage growth environment:

• It takes a long time to turn around a big ship full of money. High margins equal high profits. Businesses are going to have to be pressed to sacrifice margins, but we are seeing this happen notably in leisure and hospitality. A shortage of service workers leaves unfilled shifts leaves revenue on the table. We expect it to spread as employment gets tighter.
• The cost of capital²³ is still very cheap. Access to capital is abundant. When a business can easily access capital at a good price (a lender willing to lend at a good rate), this can make labor alternatives cheaper than labor itself. A new machine or new software is much cheaper when a business can borrow money for 10 years at a sub-4% interest rate. In turn, the cost of labor remains low to compete with the cost of capital.

To visualize this, note the chart directly above, titled ‘Personal Income’. When the cost of capital is generally lower than the cost of labor, corporate profits benefit more. When the cost of capital is high, workers benefit more. We think the trend towards corporate profits since 1990 may begin to revert.

On a shorter term scale, the top chart shows labor market slack²⁴ (left axis) compared to y/y wage gains (right axis). Here, labor market slack is defined as U3 (the commonly quoted unemployment rate) minus NAIRU²⁵ (natural rate of unemployment). Put simply – the number of workers displaced in the prior recession that want to go back to work. When this number goes below 0 [note: the axis is inverted], bargaining power shifts from the employer to the employee. This occurs because workers are no longer abundant in the economy, making positions harder to fill. As shown, employment is the tightest it has been since the late 90’s. As employment continues to overshoot, a wage shock could be around any corner.

So why will wage inflation come back this year?
Labor is an input to business and managers will not pay workers more than they have to, i.e. whatever the market price is for an hour of work. Managers can also replace workers with capital (technology). The cheaper the capital (interest rates), the cheaper the worker must work to remain competitive against the capital. Since 2008, very low interest rates have made capital almost free, a prime reason behind tepid wage gains, despite employment getting tighter. However, we believe that jobs that can be replaced by cheap capital have been and jobs that need manual labor are filled – 2017 was the first full year this scenario has existed. A prime example: homebuilders and other construction companies have said they cannot fulfill demand because of the lack of workers. Computers can’t shingle a roof. This means the economy doesn’t need more jobs, it needs businesses to raise prices to fill the jobs it already has. As of November, the economy had about 6 million job openings against about 6 million unemployed people. The economy can’t run much tighter than that.²⁶

We see 2018 as the turning point in this dynamic as ‘must-have’ labor businesses push through the increased costs. The ‘cost-push inflation’ will keep the Federal Reserve and other central banks on the current path of raising the cost of capital, creating a sort of self-fulfilling prophecy as capital gets more expensive against labor. Relating this back to markets, we cannot help but be concerned about record high profit margins going into this environment. Undoubtedly margins will be sustained at higher levels than history indicates because of technological advancements, but at the same time we believe investors have gotten carried away in assuming current margin trends exist in perpetuity. It seems simple to point to labor-intensive industries as the clear losers going forward, but this also seems shortsighted in our view. As inflation drives the cost of capital higher, industries that rely on a large amount of capital will also see margin compression. Only those who have pricing power²⁷ and hold margins will be insulated in the coming years.

We recognize that we wrote about this same relationship one year ago. However, the case will keep getting stronger until something breaks. Additionally, energy & raw material inflation are both much more of a factor this year than last, providing some extra firepower behind the general inflation case. It would not at all surprise us to see a slowdown in inflation readings through the first half of 2018, followed by a strong second half pick up.²⁸

How does it all add up?

 At the beginning of this note, we said the equation for 2018 would be monetary tightening + production normalization + realistic corporate margins = more volatility, bigger drawdowns, and lower multiples. We have detailed the inputs – but how do we reconcile them to get our 2018 targets? We are going to lean on legend George Soros and his “Theory of Reflexivity”: Our collective thinking is what moves markets and produces winners and losers. This means that what we think about reality affects reality itself. And that reality in turn affects our thinking once again.^ix

Let’s use Tesla Motors, Inc. to unpack this statement. Tesla has been a cash drain for all of its existence and makes little profit, yet it is worth more than Ford Motor Co.²⁹ Over years investors have crafted a positive story around Tesla, whether about electric power, batteries, or just momentum – doesn’t matter – because all the narratives collectively continue to push the stock higher. What matters however, is that Tesla’s stock performance alters reality – its high stock price can allow them cheaper financing, can attract top talent by issuing shares, and upends traditional capital allocation decisions since investors aren’t concerned with profit. Imagine if investors wanted to see a profitable electric vehicle company after the first model. Tesla wouldn’t be Tesla and the positive narrative, true or false, has altered reality. But as we know, at some point narratives have to reconcile with reality, for better or worse.

Across broader markets, the persistent narrative since 2010 has been ‘buy the dip’ because central banks will step in every time with an injection of liquidity. Through the US debt downgrade, Euro debt crises, China devaluations, and an energy collapse, global central banks have overcome the challenge and continually reinforce the narrative. The current lack of volatility, unresponsiveness to systematic spillovers, and reluctance to sell, etc. indicate to us that this narrative is now more powerful than ever – right at a time when central banks have deliberately said they are removing the liquidity markets have been obsessed over for 8 years. This shift, along with the other two variables mentioned, define reality catching the narrative. When narratives are forced to reset – more volatility, bigger drawdowns, and lower multiples come with it.

Market Timing
As we said at the beginning of the note, the biggest risk to our outlook is being early, not wrong. So we asked ourselves, why write this now? Market positioning shows a large majority of investors are prepared for another low volatility, high return 2018. We find many of our colleagues assured that trouble will come in 2019, but 2018 will be yet another year unscathed. To us, this says “we see trouble on the horizon but are too worried about missing one good year.” After nine years of exceptional index returns, we should be more concerned about missing out on one more than the trouble in front of us? This is not a gamble we believe investors should make. Market downturns are never a consensus call, why will this time be different?

As market strategists, our job is to not only call out trouble on the horizon, but manage portfolio risk & reward. Simply put, we decided to write this note because the risk now seems to outweigh the reward going forward (over a long-term outlook).³⁰ We are very aware that a hot market can go on for a good while without fundamentals supporting it, and good returns can be had chasing it. No investor should take an ‘all-in’ or ‘all-out’ approach because of this, but instead methodically de-risk along the way and never lose sight of the horizon.

 What you don’t know will get you into less trouble, and what’s not for sure will make for a good opportunity.