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“It’s not deterministic, but I like being macro aware.”
-Merger Arb PM, San Francisco

Keith and I landed late last night on what now feels like a redeye from two days of client and prospective client meetings in San Francisco. The above quote was from a PM at a large hedge fund who’s been around long enough to respect cycles. 

As head of their smid-cap biotech effort as well, he’s probably analyzed more “secular growers” than most. This catchy distinction did not prevent him from agreeing back in our October meeting that #Quad4 was not good for that particular subsector or its associated style factors (i.e. smid-cap, growth, momentum, high beta) and he outperformed because of it. 

Back to the Global Macro Grind

One of my favorite aspects of this job is getting to travel around and learn from some of the most thoughtful and/or experienced investors. I’m always in awe of how incredibly bright our client base is and how much value their respective processes add to their client’s portfolio(s). 

There’s something to be said about the collegial nature an unconflicted, uncompromised peer-to-peer discussion – no doubt a competitive advantage of ours due to Keith’s wealth of experience on the buyside and the structure of our firm (i.e. no banking, trading, or asset management). We’re not there to generate fees from transactions or, worse, reverse engineer how to front-run your strategy. 

Indeed, the only thing Keith and I want to accomplish when we show up to your office slightly fatter with slightly more grey hair than the last time we met is to help make you “macro aware”. With The Machine forcing investors to adjust their exposures faster and more fervently than ever before, the amount of alpha waiting around to be captured by investors from just sequencing the growth, inflation, and [corporate] profits cycles has never been greater. 

Keith and I have done ~65 meetings and conference calls with clients and prospective clients in the YTD and the two most important topics in which we’ve helped cultivate “macro awareness” around are: 

  1. Why the stock market can’t keep ripping higher on a US-China Trade Deal
  2. Why the “Shanghai Accord 2.0” will perpetuate further upside from there

With respect to #1:

  1. Investors would be remiss to assume that trade concerns are the primary driver of the domestic and global growth slowdowns.
  2. In fact, you could make the case that front-running tariff implementation was actually a boon to the global economy as recently as Q4, when US Merchant Inventories growth averaged a cycle-high of +6.74% YoY on the heels of cycle-high Chinese Export growth of +18.7% YoY in OCT (now tracking at +0.2% as of DEC). US and Chinese Import growth peaked at +9.5% YoY and +25.2% YoY in SEP and OCT, respectively, before plunging to +3.2% by NOV (US) and -3.1% by DEC (China).
  3. Indeed, the number one, two, and three reasons for the aforementioned slowdowns is simply because the global economy are cycling steepening comparative base effects. Said simply, the global economy is still lapping the tough comps born out of the original Shanghai Accord, the impact of which was unequivocally boosted by US corporate tax reform. China’s comps peak here in Q1, while the US’s peak in Q3, which, per our comparative base effects model backtests for the respective economies, suggests there’s a 73% probability that Chinese economic growth crashes to its nadir 1Q19E and a 78% probability domestic economic growth persistently decelerates over the next few quarters

Both those outcomes would occur if Trump and Xi grew up best buds in Trump’s hometown of Queens, NY or if they spent years cohabitating in Xi’s cave together. Math is math. 

With respect to #2: 

  1. LOL! What Shanghai Accord 2.0? We can’t find anything in the data to suggest a policy initiative of this size and scope is actually occurring. Sure, Trump’s new BFF Jay Powell wilted like a flower over the past ~6 weeks and the PBoC has no doubt stepped up liquidity provision on the mainland, but we have not seen much evidence of said liquidity flowing through key transmission mechanisms.
  2. Specifically, Chinese Bank Loan growth is still hovering in the same +12.5% YoY to +13.5% YoY range we’ve seen over the prior two years as of DEC. The growth rate of Total Assets of Financial Institutions is still making new lows as of Q3 at +7.0% YoY. Recall that both of the aforementioned indicators TRENDED at annual growth rates of +15% to +16% during the original Shanghai Accord.
  3. With so many “cool” acronyms floating around the mainland like OMO, MTLF, DFES, etc., why do we even bother tracking something so obvious as bank loans/total assets? While our research would garner more eyeballs if we discussed more sexy indicators, banks really matter to the Chinese financial system. Specifically, China has a Private Nonfinancial Sector Credit-to-GDP Ratio of 206%, of which 157 percentage points (or 78%) comes from banks. Those figures are 151%/51%/34% and 164%/89%/55% for the US and Eurozone, respectively.

Having done this for a decade now, I’m well aware of the institutionalized insecurity born out of investors living in perpetual fear of data they can’t see. Fortuitously, we can track the growth rate of Nonbank Finance in China (aka “Shadow Banking”) and that hit a new “secular low” of -10.5% YoY in DEC.

If Chinese authorities were serious about reflating their economy, they wouldn’t be so keen to persist with their deleveraging initiatives. 

All told, we remain of the view that any Trade Deal was a sell-the-news event because subsequent data would do nothing more than confirm that the domestic and global growth, inflation, and profits cycles were going to continue doing what they always do – cycle. 

With the S&P 500 set to have its first down week since late December, the same “macro aware” investors who outperformed in Q4 appear to be on the precipice of another heaping helping of alpha – just in time for a likely multi-quarter earnings recession here in the US

Oh yeah, one more feature of the original Shanghai Accord that its bastardized cousin lacks are easy comps for a US earnings recovery. Recall that S&P 500 EPS growth troughed at -8.0% YoY in 1Q16 during a broad-based earnings recession that spanned 7 of 11 sectors. It didn’t take much to get US corporate profits off those lows, but the confluence of the Shanghai Accord and US corporate tax reform perpetuated the most logarithmic ascent in S&P 500 EPS ever recorded

As the analysis below shows, it won’t take much EBIT margin degradation from rising wages and a stronger dollar (on an annualized basis) to see S&P 500 EPS growth trend down -5% to -8% here in 2019E against those comps

Me: “No one has any idea how bad earnings growth could be this year – not even the most sophisticated CFOs. Who even models down earnings to begin with?”

Merger Arb PM: “You’re right, no one. Everyone just builds in incremental improvement, quarter after quarter, into their models.”

Room: [erupts in laughter] 

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 2.61-2.77% (bearish)
SPX 2 (bearish)
VIX 15.00-20.52 (bullish)
USD 94.82-96.58 (bullish)
Oil (WTI) 51.66-55.45 (bearish)
Gold 1 (bullish) 

Keep your head on a swivel,


Darius Dale
Managing Director

Macro Aware - How Low Can Corporate Earnings Go