Merlin Asset Management Commentary – January 2018
More (ir)rational exuberance?
The excitement of synchronized acceleration of global economy combined with scant evidence of rising inflation pushed the equity markets sharply higher in January with increasingly optimistic market expectations forcing pessimists into hiding. As we have seen with the very one side expectations of the outcome of Super Bowl LII, such situations can change very quickly. Eventually the markets ran out of breath at the new dizzying heights just before the month’s end and crashed, starting the usual round of panicked selling around the world. Regardless of this painful short-term volatility, January gave many investors a solid start to the year and a more positive outlook for the future. This was true especially for those who questioned the strength of the US economy throughout 2017 and kept anticipating an economic slowdown or even a recession. This time, market volatility was related more to the fear of rising inflation rather than an approaching economic slowdown.
Deciphering earnings season
Usually, sell side analysts reach the optimistic peaks of their expectations right before each earnings season, gradually lowering them as reality sets in. This earnings season is proving to be a very unusual one, amplifying this pattern with an unprecedented number of upward estimate revisions due to the improving economy, expected effects of lower taxes or the effect of foreign cash repatriation by US companies and resulting stock buybacks, increased M&A or reinvestment in accelerating growth.
As it frequently happens, the widespread analysts’ optimism might prove to be somewhat too optimistic. The effects of changes in the tax law make the vast majority of company earnings a lot more difficult to interpret, with many companies reporting beneficial adjustments due to the new tax law and others taking large write-offs. It will most likely take at least one or possibly two quarters for everybody to fully understand and adjust to the new corporate taxation environment. So far, with approximately half of the companies reporting, earnings revisions point to increasingly positive expectations for the rest of the year, but suddenly rising interest rates may challenge some industries and sectors. Several industrial companies are already making noises about increased pricing for materials and domestically oriented consumer companies are adjusting their margin expectations due to a combination of the weak US dollar and rising interest rates.
Systematic desensitization
As we have seen throughout 2017, the 24/7 news cycle has continued to provide a steady stream of noise out of Washington. Despite the Washington DC circus’ complete domination of the news cycle, so far it has not negatively affected consumer confidence or business expectations. The loosening of the regulatory environment and lower corporate taxes created an animal spirits effect that is driving the economy for the time being. The combination of constant anxiety producing news and gradually improving economy creates a situation where emotional response to the news will likely diminish, similar to what is achieved in the systematic desensitization therapy.
At the same time, significant Washington related risks remain, especially with a recent introduction of tariffs for imported washing machines and solar energy cells and panels. Further import tariffs, the potential for US withdrawal from NAFTA or WTO, a trade war with China or any other current business partners remain and are increasingly more realistic. The recent purely political change of the Fed chair also increases risks of the FOMC moving to a more hawkish monetary policy. With a solid historical track record of over or under reacting to the evolving economic environment, any changes in the FOMC are a cause for concern.
The Wall
The Berlin Wall divided the city on August 13, 1961. It came down on November 9th, 1989 – 28 years, 2 months and 28 days ago which is exactly as long as it lasted.
Together with the rise of the Solidarity movement in Poland in 1980, the dismantling of the Berlin Wall is one of the most significant moments in the recent history of Europe. Despite the Berlin Wall coming down and the expansion of European Union, the former Eastern Bloc countries remain behind an economic wall. With the exception of the Czech Republic, their economic output remains below 65% of the 15 Western European EU members. None of these countries are considered full democracies. With the rise of nationalistic right-wing parties, Poland was ranked 53rd (right below Ghana) in the Economist’s 2017 Democracy Index, while Hungary shared the 56th rank with Lesotho.
After Brexit, the risks of further divisions within Europe remain elevated. Thanks to Brexit, the European Union has an opportunity to evolve, increasing its economic and political integration. While the UK was always opposed to such integration, the push towards further EU integration might not extend to all of its recent members. Hungary and especially Poland with its bizarre conflicts with the EU and the West, risk remaining on the outside of Western Europe, further limiting their political and economic integration with the West and becoming progressively isolated and exposed to the increasingly assertive Russia.
Bargain hunting
After a long period of subdued economic growth combined with rising equity markets, many companies and equity indices seem fully valued. Recent evidence of an accelerating rate of economic growth will put pressure on rising inflation expectations. The recent market selloff is likely to readjust some of those valuations, but not all companies will be able to thrive in the new higher interest rate and higher inflation environment. In such an environment, I see active individual stock selection focused on identifying the most attractive companies for the evolving economy as a necessary tool for managing equity investments.