By Justin Pawl, CFA, CAIA
In this week’s edition:
- Last Week Today. A quick rundown of market-moving news.
- Looking Back, Moving Forward. Using history to inform forward market expectations.
- Earnings (mis)Management. Unique regulations governing Chinese corporations.
Last Week Today. President Trump announced he will sign the Phase I trade deal with China on January 15th – China confirmed the signing today. | China’s central bank (PBOC) cut the banking reserve ratio by 0.5%, releasing about $114.9 Billion in liquidity to buoy its slowing economy. This was the PBOC’s 8th reduction in the Reserve Requirement Ratio since early 2018. | Minutes from the December meeting indicate the Fed is comfortable with a prolonged pause on raising interest rates, citing elevated risks of weaker-than-expected growth. | Supporting the Fed’s concerns, the December ISM Manufacturing PMI fell to 47.2, its lowest level since the Great Recession in June 2009, and its fifth consecutive month in contraction (i.e., below 50). | The U.S. killed Iran’s military commander Soleimani, generally considered the second most powerful man in Iran and also recognized as the chief architect of Iran’s terrorist activities in the Middle East. The geopolitical and financial market ramifications are unlikely to be resolved anytime soon.
Much like the choppiness most of us felt with the Christmas and New Year’s holidays falling midweek, the first two trading days of this decade were uneven. On January 2nd, the first day of trading, it seemed like we might be entering a similar type of market environment that we saw 100 years ago. Call it the Roaring 20s v2.0. Equities higher, bonds higher, commodities higher. Then came Day 2 of the new decade. Geopolitical strife and weak economic data reminded investors that the world is indeed risky, and asset prices do not move in a straight line for very long.
For detailed weekly, MTD, and YTD financial market performance, please click on the table below.
Looking Back, Moving Forward. Closing the books on what was a fantastic year for financial assets, some historical perspective can help inform expectations for the future. First, the impressive returns of 2019 were born out of a poor 2018, characterized by the unique circumstance where cash was the best performing asset class. Investors that remained disciplined in their strategy at the end of 2018 reaped the benefits of 2019’s financial market largesse, and over this 18-month period earned equity returns in line with the long-term average.
Investors should not expect that 2020 will be a repeat of 2019. Equity performance in 2019 was primarily driven by a rising Price to Earnings (P/E) ratio. Whereas earnings growth accounted for 67% of the S&P 500 return over the previous ten years, only 8% of the S&P 500’s gains in 2019 were due to earnings growth (Goldman Sachs). Said differently, the forward P/E ratio grew from 14x at the start of 2019 to 19x by the end of the year, as the prices of equities increased at a much higher rate than corporate earnings. Similar P/E growth in 2020 is not in the cards, and with expected S&P 500 earnings growth of around 5% in 2020, the equity market will likely follow earnings.
Lower potential appreciation is not a reason to give up on equities, however. As demonstrated in the first two days of this year, equities are volatile. But, in the long run, publicly trade stocks provide the greatest liquid opportunity for capital appreciation. The chart below highlights the S&P 500’s performance by decade.
Source: LPL Financial
Of the seven post-World War decades, the 2010-decade ranks fourth overall in total return. In only one decade did equities produce a negative total return, as the 2000s were bookended by the Dot-com crash and the Great Financial Crisis. Like other decades, the 2010s had its fair share of volatility with six corrections – unlike the other decades, 2010 was the only decade in which the U.S. economy did not experience a recession.
Looking forward, it’s unlikely that the U.S. economy will avoid a recession in the coming decade. Moreover, with an economy expanding at only 2% – 3% and elevated asset valuations as a starting point, a period of below historical average returns is likely over the next five years. In this type of environment, avoiding large losses becomes increasingly important, especially for those investors funding lifestyles with their investment portfolios.
Looking back at the last decade disciplined investors were rewarded for staying the course. I suspect the next decade will be the same, but the path will be much different from the last decade and every decade before it. The key to staying the course is constructing a portfolio you can live with during the inevitable periods of market stress (i.e., managing volatility) so you can avoid selling assets at the wrong time.
The best approach to managing portfolio volatility comes from diversifying a portfolio among several types of assets and strategies with different return and risk drivers (e.g., a portfolio of 100 stocks is not diversified because in periods of stress stocks generally move down together). Diversification also enables one to maximize returns for a given level of risk by consistently rebalancing the portfolio to sell high priced assets and buy other assets at a better value. Portfolio diversification is tried and true both in academic research and in practical application. It may not be the coolest thing to talk about at cocktail parties, but portfolio diversification will help you achieve your financial goals, and that’s the ultimate objective.
Earnings (mis)Management. Official Chinese economic data has always been viewed suspiciously by economists and financial analysts. Increasingly so as the economy has become one of the largest in the world. While well below China’s peak growth rate of 15.4% in 1993, many believe the “official” growth rate of around 6% over the last few years is inflated by the communist government to project power externally and national pride internally. Poor data quality notwithstanding, the Chinese economy is undoubtedly expanding faster than that of the U.S., and it is highly likely that China will become the largest global economy in the next few years.
Capital generally flows to high growth opportunities, and China is no exception. Aggressive investors have long viewed China as an opportune locale to place capital, but the Chinese government severely restricted access to their capital markets. As a result, foreign capital participation in Chinese capital markets is low compared to China’s relative size as the second-largest equity market and the third-largest bond market in the world (International Publishers Limited). Recognizing the benefits of foreign investment, and with ambitions to compete with the U.S. as a global superpower, the Chinese government has opened several channels to overseas investors to facilitate access to its financial markets.
Better access to the second-largest economy is generally good for investors. Yet the data quality issue remains a bugaboo not only with regards to the Chinese economy but also with publicly traded Chinese companies, which is of particular import to would-be investors. Though not perfect, the U.S. financial markets achieved global prominence because of comprehensive financial disclosure rules requiring transparency that are enforced by strict regulation. China has financial regulation as well, but the enforcement and the motivations behind it are far less investor-friendly than those of the U.S. Indeed, Chinese regulations incentivize companies to manage earnings carefully.
For example, the China Securities Regulation Committee (the CSRC, which regulates China’s stock market) has a rule in place that Chinese publicly traded companies reporting two years of consecutive annual losses are ineligible to issue additional equity. If a company posts three successive years of losses, it is delisted by mandate. Moreover, the CSRC requires that publicly traded companies seeking to raise additional equity must meet a minimum Return on Equity threshold of 6% (Seeking Alpha). So, guess what? The percentage of publicly listed Chinese companies earning 6% is unnaturally positively skewed compared to U.S. markets.
Source: Wind Information
Suspicious looking distribution in the chart on the left? Yes. Essentially, Chinese regulations incentivize management teams to massage their numbers to avoid delisting and remain eligible for follow-on equity offerings. These perverse incentives erode the quality of corporate financial data, making the art of traditional security analysis and true price discovery for Chinese stocks more challenging.
However, these challenges also present an investment opportunity. Despite the questionable veracity of economic and corporate financial data, China is home to a growing number of innovative, rapidly expanding companies that either serve the large domestic population or that compete on the world stage. Accessing these companies can help diversify and boost investors’ portfolio returns.
The bottom line is that investors should not dismiss China entirely – the country is a growing global influence and too large to ignore. Instead, investors must take special care in researching investment opportunities, or they need to entrust their capital with experts well-versed in the unique characteristics of the Chinese market.