The New World Order - Merlin Commentary March 2018
War & Peace
The first quarter of 2018 was excellent from the perspective of global economic expansion, revenues and earnings growth for the vast majority of companies. As we expected, the biggest risk to the equity markets were misguided policies of the US administration. All of the potential Washington related risks remained in play. As a result, volatility came back to the markets during the rest of the first quarter. The recently revived animal spirits driven by lower corporate taxes and loosening of the regulatory environment were challenged by the increasing unpredictability of the US administration’s interactions with the rest of the world.
Although the threat of withdrawal from the WTO remains remote (at least for the time being), NAFTA renegotiations were increasingly pressured by the hawkish President, the trade war with China seemed to be only in its early stages and tariffs targeting even the closest US allies were starting to have an effect on businesses and future expectations. The TPP (Trans-Pacific Partnership), abandoned by the US, surprisingly came back to life as the CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership) and became the third largest trade bloc in the world, representing nearly 500 million people and 13 percent of global trade. Many believed that the CPTPP revival was helped by the US’ protectionist policies as it gave Canada and Mexico more global free trade opportunities.
Evidence of any successful trade wars does not exist. In fact, trade wars were usually implicated as significant contributing factors in many recessions and in the 1930s depression. In addition to the brewing trade wars, US policies or threats of policies have negatively affected US ratings in many nations. Unfortunately, such effects undermine American influence and lower the interest of any governments willing to cooperate with Washington to advance shared goals. It is unfortunate that trade wars are brewing during this unprecedented period of relative peace around the world.
Are quarterly earnings relevant?
With the start of a new quarter, we have already started to pay more attention to earnings. Many argue that quarterly earnings distract public companies from focusing on long term goals, but there is nothing in the cards that would suggest a change to longer term reporting. Regardless of the analysts’ focus on short term data, it is always more interesting for investors to pay attention to those companies that still focus on long term goals, largely ignoring sell-side analysts’ quarter to quarter obsession. Typically, those companies focused on long term goals are leaders in their field and follow visions which are only to be realized years from now.
One example of such a company is Nvidia Inc.* Nvidia’s founders believed that an accelerated computing model could solve problems that general purpose computing could not and that the next wave of computing would be graphics based. Nvidia introduced the first consumer level Graphics Processing Unit (“GPU”) in 1999 (GeForce 256) and in 2006 created CUDA - a platform enabling use of GPU for general purpose computing. With rapid evolution of GPU hardware, CUDA became the ecosystem of choice for high performance computing.
Over time it turned out that the unique power capabilities of GPU computing were perfectly suited for applications that did not exist when Nvidia initially developed the graphics processors. Whether it is deep learning in modern AI, processing of multiple simultaneous data streams for autonomous cars or mining bitcoins or another cryptocurrency, Nvidia’s programming ecosystem with many years of experience of applying it to a variety of computational problems moved Nvidia ahead of its competitors.
In fact, the recent spike in demand for cryptocurrency mining was so great that Nvidia asked distributors to restrict sales of high end video cards to gamers only and changed the End User Licensing Agreement (“EULA”) to restrict the commercial use of those video cards to non-cryptocurrency mining applications. While such acute shortage situations are quite rare and will be resolved in time, the situation was created by an ecosystem that was developed way ahead of its current uses, showing the vision and bravery of Nvidia executives, willing to invest in the future rather than pandering to analysts criticizing the company’s capital expenditures. As a result, twenty five years after its founding, Nvidia’s platform dominates gaming, high performance computing, virtual reality and artificial intelligence markets.
Notwithstanding the short term nature of quarterly earnings, the record number of S&P 500 companies issuing positive guidance (especially in Technology sector) and unusually low number of negative guidance announcements supports the continuing momentum in economic activity. For many companies, earnings growth will result in multiple contraction with earnings growing faster than the recent modest price increases. The recent 2018 Q1 Thomson Reuters earnings estimates for the S&P 500 have been consistently increasing and currently imply 20% growth, a long way from the negative earnings growth just a few short years ago.
It is clear that despite the trade war concerns, the economic data so far suggests robust activity in both manufacturing and in services. Continuing gains in employment and compensation are likely to support robust consumer spending. Of course, high and increasing expectations are also likely to result in disappointments (and related short-term volatility) with many analysts and investors displaying an amazing ability to become overly optimistic in a very short period of time.
Michael Obuchowski, Ph.D.
Founder & Chief Investment Officer
Merlin Asset Management
*Nvidia Inc. (NVDA) had been included in at least one of Merlin Asset Management’s investment strategies since 12/23/2013.
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