Financial Outlook March 2019

Few days ago I posted a quote from Howard Marks, I thought it was very appropriate for the moment we live in. The most relevant being: "few things as risky as the widespread belief that there is no risk."

What changed since the last financial scenario? Those were the words starting the financial outlook last month. The answer then, the same as now: Nothing, or actually the data of the real economy worsened even more. In Europe major countries are flirting with recession, China tries to inflate injecting liquidity without achieving better results, In Japan the BOJ said it will do whatever is necessary to try to avoid their current stagnation turning into a full blown depression, and in the US retail sales data for the last quarter of 2018 (reported late because of the government shut down) were worse than expected, but thanks to net exports, GDP beated expectations, delaying the slowdown for the next quarter.

The Fed keeps its dovish narrative regarding monetary policy, while the ECB the PBOC and the BOJ showed that they are willing to continue applying whatever stimulus is necessary, despite the saturated market and diminishing returns.

The reality of financial stimuli is that they accelerate recovery when the economy is emerging from a deflationary recession and excess liquidity can find idle capacity available to mobilize and stimulate growth. Applied at the end of one of the longest expansive cycles in history (US), with the economy close to full employment, these policies alter the perception of risk, favoring the creation of financial bubbles, and if they reach the consumer, and he chooses to keep spending, it might favor high inflation.

I want to return to the credit cycle which I mentioned in previous articles. Of all the economic-financial cycles, it deserves special attention, because of its inevitability, its extreme volatility and the opportunities it offers to attentive investors.

The process is simple:

• The economy moves into a period of prosperity.
• Providers of capital thrive, increasing their capital base.
• Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
• Risk averseness disappears.
• Financial institutions move to expand their businesses— that is, to provide more capital.
• They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.

At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. “The worst loans are made at the best of times.” This leads to capital destruction— that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

When this point is reached, the up-leg described above— the rising part of the cycle— is reversed.

• Losses cause lenders to become discouraged and shy away.
• Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
• Less capital is made available— and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
• Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
• This process contributes to and reinforces the economic contraction.

At this point the cycle can begin to revert again, existing idle capacity and projects with high yields together with a high credit capacity might be found. Potential returns begin to attract the attention of new capitals, and in this way they begin to feed the recovery.

Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.

At what point in the credit cycle do you think we are, and at what point do you think the monetary policies being carried out by the main central banks are effective?

So, what are we going to get? Will they reverse the deceleration of the global economy or contribute to the creation of financial bubbles?

Results of the companies that make up the S&P 500 went from 24% growth at the peak to 11% in the last quarter. And in the next the year-on-year comparison is going to get harder thanks to the tax incentives of last year.

If you still want to invest at the pace of hopeful tweets about US-China trade negotiations (which started appearing in November), and with the peace of mind that the FED will have your back, let me repeat what Warren Buffett wrote in its annual letter to investors.

Buffet: immediate prospects for purchases of companies are not good, prices are sky-high for business possessing decent long-term prospects.

Another related quote from Howard Marks: “Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them... Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.”

I know that since December the S&P and the Nasdaq have skyrocketed at breakneck speed, but the S&P/Gold and the S&P/TLT show that those who in October turned to gold or US bonds not only increased their capital, but also they avoided the discomfort of enduring a very strong pitfall in December. For me, that’s what being a good investor is all about, as opposed to reacting frantically to flashy headlines or blindly beta-chasing the market.

For March 2019:

• Metals: Maintain exposure to metals or mining companies: I continue with a bullish perspective, they have shown good behavior since the end of November when I mentioned that they were one of the few "cheap" assets. Caution below 1250 area.
• US Indices: Those who did not sell, this great rebound is an excellent sales opportunity. Personally I remain short, with the SPX above 2850 I will surely leave the position to go short at a later time. I don’t see reasonable reasons that can push the markets higher.
• Bonds: Low risk only: Risk-off means sell risky assets such as stocks and bonds of countries with lower ability to pay and seek refuge in the usual places: US bonds, German bonds, Japanesse Bonds.