Five Questions for Global Investing in 2020
1 Will a trade deal foster more
between the U.S. and China?
Over the course of 2019, stock prices were inordinately sensitive to any news (or tweets!) regarding U.S. and China trade negotiations. The S&P 500 returned more than 18% since June thanks largely to completion of the “Phase One” agreement. Markets’ seemingly monomaniacal focus on trade news was actually quite rational. Virtually all of the slowdown in global GDP growth, from 4% in early-2018 to roughly 2% at the end of 2019, could be attributed to the trade war; global trade volumes explain more than 80% of the variation in global industrial orders and business sentiment over that period (Figure 1).
Trade Explains Virtually All of the Global Slowdown1
The costs of the U.S.-China trade war were quickly transmitted to the rest of the global economy through value chains—complex, cross-border production networks that have come to dominate global trade. China’s massive trade surplus with the U.S. is actually the mirror image of trade deficits that China runs with its suppliers: Korea, Germany, Japan, etc. (Figure 2). In many cases, China must first import more than $70 of components, parts, and other equipment from these economies for every $100 of products ultimately exported to the U.S.
Will the Phase One agreement prove to be the breakthrough implied by the surge in asset prices? This agreement represents the “end of the beginning” to a much broader dialogue that also includes questions of market access, state subsidies and industrial policy, and even territorial claims and domestic politics. There is no obvious limit to the range of issues that this (or future) Administration(s) could raise, nor do we know the full extent of the policy levers either side might pull in the search for a tactical advantage. It has never been clear, for example, how seriously the Administration considered some of the more provocative actions on its policy menu, such as barring Chinese firms from U.S. public listings, nor has it been easy to distinguish hardball negotiating tactics from a more genuinely hawkish turn in policy.2
Expansion of Global Trade System Predicated on Complex Value Chains3
The depth and complexity of the issues dividing U.S. and Chinese policymakers do not suggest that a Phase Two or Three agreement will be reached any time soon. And no one should be expecting that, particularly not in an election year. Instead, the question for 2020 is whether the Phase One agreement ushers in a period of more constructive engagement, where interlocutors pledge to resolve disputes through an increase in bilateral trade and investment rather than the erection of new barriers.
A trade war need not result in an economic decoupling. The U.S. economic confrontation with Japan that started in 1981 with voluntary restraints on auto imports quickly morphed into a wide-ranging dialogue that touched on virtually every aspect of the bilateral relationship and structure of the Japanese economy.4 While negotiations were at times rocky—including the imposition of 100% tariffs on $300 million of Japanese exports to the U.S. in 1987—they resulted in much deeper economic and financial ties, with bilateral trade and investment growing faster than both countries’ GDP (Figure 3).
U.S.-Japan Trade War Was Resolved Through Exponential Growth in Bilateral Trade Volumes; Will U.S.-China Economic Integration Increase?5
Bilateral trade between the U.S. and China dropped by 15% in 2019.6 While anticipated U.S. agricultural exports should ensure that year-over-year growth turns positive in 2020, the economic rebound anticipated by asset prices requires a genuine turn from estrangement towards constructive engagement, not just token gestures.
2 Will India rebound from its
For years, India’s investment environment balanced alluring macroeconomic fundamentals against a labyrinth of odd conventions, quirky market participants, and often difficult-to-navigate regulations. Structural reforms launched following Narendra Modi’s May 2014 general election victory were designed to end this trade-off by reducing red tape and making it easier to invest and operate in India. Unfortunately, GDP growth slowed materially in their wake, from 8% in 2015-16 to just 5% at the end of 2019.7 Is this the short-term pain that investors should gladly accept for long-run gain? Or is there something more fundamentally wrong with the growth model?
While much of the rest of the world can point to the trade war and its chilling effects on corporate investment to explain their slowdown, India is one of the few economies largely insulated from its effects. Manufacturing’s contribution to GDP is 45% lower than in other Asian economies (Figure 4) and India’s share of global exports is 66% below its share of output – both indicative of a relatively closed economy with limited participation in the complex value chains so affected by tariffs.8
India Insulated from Trade and China9
India’s disconnected nature is precisely what makes it so attractive from a portfolio perspective. As much of the rest of Asia has become integrated with China and its value chains, economic activity and returns have become more correlated across the region. India has become one of the few places where investors could obtain diversifying growth and idiosyncratic returns. But rather than zig while the rest of the global economy zagged, private consumption weakened, domestic investment rates declined, and the economy-wide return on incremental capital fell by over 600 basis points since demonetization, insolvency, and tax reform were enacted in 2016-17 (Figure 5).10
Drop in India’s Investment Rates and Economy-wide Returns11
Of these policy changes, the Insolvency and Bankruptcy Code (IBC) of 2016 perhaps best captures the short-term pain but longer-term promise of structural reforms. In most economies, the core corporate finance problem is one of governance: the incentives of the managers of publicly-listed corporations are imperfectly aligned with those of the broadly-diffused shareholder base. The main deficiency in India’s system, by contrast, is the dominance of a distinctive class of shareholders (generally referred to as “promoters”) that enjoys the upside of equity while also retaining the de facto senior claim on the assets of the business.12 The IBC was designed to eliminate this implicit capital structure hybridization by forcing insolvent businesses into an efficient and time-bound resolution process that honors the de jure prioritization of claims.
While the IBC’s implementation has been imperfect and contentious, its effects have been obvious: average recoveries for creditors have more than tripled, time to recovery has declined from 4.3 to 1.6 years, and the number of insolvency resolution cases has risen nearly ten-fold.13 Of course, this sharp rise in insolvencies has also introduced significant adjustment costs, as banks and businesses recognize losses that had heretofore been hidden, depressing both credit availability and investment demand. So while the IBC is the right medicine for the ills specific to India’s system, questions about the size of the dose will persist until the economy rebounds, potentially undermining the broader reform project.
3 Will the euro zone embrace fiscal expansion?
The fourth President of the European Central Bank (ECB), Christine Lagarde, is the first without an academic background in monetary economics. That is not a bug but a feature of her appointment. Monetary policy in the euro zone is a spent force. Rates will remain low indefinitely, but there is little hope that new unconventional policies will succeed where others—quantitative easing, longer-term refinance operations, forward guidance, negative interest rates, etc. —have failed. A reckoning for the limits of monetary policy is long overdue, and Lagarde’s appointment looks to be an important step in this process.
In Lagarde’s first speech as ECB President, monetary policy was treated like a sideshow, accounting for just 12% of the discussion of policies to boost euro zone growth (and some of this space was used to question whether negative interest rates did more harm than good).14 The rest of the speech was a plea to policymakers to rely more heavily on fiscal policy and internal market reforms, including a capital markets union, the single market in services, and the digital single market. Lagarde delivered much the same message in the press conference following her first Governing Council meeting, arguing that “it takes many to actually dance the economic ballet that would deliver on price stability but also employment and growth (emphasis added).”15 If policymakers want faster growth, they need to look to Brussels and national capitals rather than to Frankfurt.
Lagarde has not come to destroy the law and prophets but to fulfill them. This isn’t a rethink of policy but its logical extension. The cost of public debt and deficits ultimately depends on interest rates. Consequently, the promise of easy monetary policy today is not its ability to stimulate incremental private spending, but the fiscal space it creates for euro area governments to reduce tax burdens and boost investment in new technology and infrastructure. Lagarde is just asking that policymakers internalize the implications of persistently low interest rates and adjust policy accordingly.
When the Maastricht Treaty that governs euro area fiscal policy was agreed in 1992, the economies that eventually adopted the euro spent 4.7% of their combined GDP on debt service (Figure 6). Last year, these costs were 65% lower (just 1.5% of GDP) despite a combined public debt level that was 20% higher (85% of GDP compared to 70% in 1992). While a 3% of GDP deficit threshold may have made sense when interest rates averaged 6.5%, as in 1992, it does not when effective interest rates average less than 2% and are set to decline as outstanding bonds mature and get refinanced into today’s ultra-low (and in many cases, negative) rates. And with interest rates (negative in real terms) persistently lower than GDP growth rates (low, but positive in real terms), more fiscal space should open in the future.
Lower Interest Rates Have Sharply Reduced Europe’s Debt Service Burden
These figures are not skewed by Germany; finance space has opened uniformly across Europe. In 1992, Italy spent over 11% of national income servicing its debt. Last year, debt service costs amounted to just 3.5% of Italian GDP (a 68% decline) even though gross public debt had grown by 20% to 132% of GDP (Figure 7). When Maastricht was agreed, a government with debt service costs as low as Italy’s today would have been a paragon of fiscal virtue.
The European economy is badly in need of improved fiscal and monetary policy coordination. Lagarde’s ballet metaphor is apt and one she is likely to keep pressing throughout 2020.
What Italian Debt Crisis?
4 How does the Fed really feel about low inflation?
Both the Federal Open Market Committee (FOMC) and futures markets expect that policy rates will remain on hold in 2020—a rare moment of aligned expectations over the course of a decade when market participants have persistently (and correctly) anticipated that future policy would be easier than forecast by the central bank. Most observers anticipate slight upward pressure on rates in 2020, with the 10-year Treasury yield expected to finish 2020 above 2% (from 1.88% currently) as economic activity strengthens and inflation firms.16
While a neutral policy stance makes sense in the context of current conditions and expectations, a “path dependent” approach to monetary policy would be biased towards additional rate cuts in 2020. Prices in the U.S. today are about 5% lower, on average, than they would be if the Fed managed to hit its 2% inflation target over the past decade (Figure 8). While the Fed has repeatedly emphasized that it treats deviations from this target symmetrically—i.e. the Fed should be equally comfortable with inflation at 2.5% or 1.5%—both past policy actions and rhetoric suggest that policy remains tilted towards suppressing inflation rather than allowing it to rise to target.
Prices 5% Below Where They “Should” Be Based on Fed’s Inflation Target17
As a result of this apparent asymmetry, the Fed formally launched a review of its “Monetary Policy Strategy, Tools, and Communication Practices” in November 2018.18 While the ostensible purpose of the review was to strengthen the Fed’s operating framework in light of structural changes observed since 2012, the unstated impetus for the rethink is the fear that the Fed’s current approach invites “Japanization.” If central banks are too focused on fighting inflation, the reasoning goes, they become inattentive to the risks of falling inflation expectations, which can be even more costly, on balance, as policy rates drift towards zero.
Equilibrium Rates Have Declined by 200bp Over the Past 20 Years19
Equilibrium interest rates have fallen due to changes in demographics and technology, which have increased desired savings relative to investment demand (Figure 9) and made spending decisions less sensitive to a given decline in rates. Older societies generate more lenders and fewer borrowers, resulting in a surplus of household savings relative to demand for mortgages, auto loans, and other residential investment. The digital age is also far less capital-intensive than the industrial age that preceded it, which means less capex and more corporate savings.
Strong Dollar Strengthens Case for Rate Cuts 20
In light of these changes, the Fed is right to be concerned that the current policy framework is unduly slanted towards raising rates at the first signs of price pressures. As has become clear in Japan and Europe, when average inflation rates fall towards 1%, monetary policy becomes incapable of generating the deeply negative real rates necessary to spur additional spending in today’s economy. Interest rates and inflation remain trapped near zero and the central bank’s inflation target loses credibility.
A central bank determined to avoid this experience would not only tolerate inflation somewhat above its 2% target, but actively cut rates if inflation remains below 2%. This is especially true when exchange rates are incorporated into the analysis, as the dollar sits near an all-time high on a trade-weighted basis and the U.S. net international investment position has fallen to an all-time low of -$11 trillion as the value of dollar liabilities increase relative to foreign currency assets (Figure 10). Perhaps 2020 will be the year that the Fed becomes more dovish that the market.
5 Is value investing dead?
There is no empirical “fact” in finance better documented than the “value premium”—the finding that the returns on “cheap” stocks tend to exceed those of “expensive” stocks over time. 21 If assets are priced cross-sectionally on the basis of their expected growth rates, 22 then “cheap” assets could only systematically outperform their “expensive” counterparts if investors systematically overpay for growth. Indeed, available data confirm that the “value premium” arises precisely because the valuations of “growth stocks” tend to be much higher, on average, than what could ultimately be justified by their realized (i.e. actual) earnings outperformance.
After Underperforming Value Stocks by Over 600bp Annually in the Prior 83 Years, Growth Stocks Have Outperformed by ~500bp Over the Past Decade23
The Same Results are Obtained when Sorting Stocks by Price/Earnings Ratios… 24
So while it has generally paid to be a skeptic, buying what’s stodgy and old rather than what’s shiny and new, the past decade has turned this “value investing” paradigm on its head. In the ten years since the end of the Great Recession, the best-performing portfolios have been those that held the most expensive stocks. After underperforming “value” stocks by an average of 600bp per year between 1926 and 2009, growth stocks have outperformed value stocks by nearly 500bp per year since then (Figures 11-13), finally providing the additional compensation necessary to compensate for the greater risk of longer-horizon equity.
…or Price/Free Cash Flow 25
Have investors gotten better at forecasting growth and calibrating valuations accordingly? No. Any earnings growth shortfall has been offset by the progressively higher valuations paid for the fastest-growing businesses. Growth stocks are now priced above their prior peaks in an absolute sense (Figure 14) and are more than twice as expensive on a relative basis as has been the case historically (Figure 15).
Growth has Never Been More Expensive: The Top 20% of Stocks Priced at ~80x TTM Earnings; Well Above Prior High Water Mark 26
Growth Stocks 2.25x as Expensive on Relative Basis as Historic Average 27
Investors’ preference for growth was also reflected in the IPO market in 2019, where profitable businesses accounted for just 18% of new listings, the lowest share in history (Figure 16). In many cases, these listings involved “Unicorns” whose prodigious sales growth distracted investors from huge operating losses. On average, public markets paid 47% more for these businesses than private investors (Figure 17), exposing the “private markets are more expensive” canard and further increasing the absolute and relative values of the “growthiest” companies in the stock market.
Is this a bubble? The similarities to 1999-00 are too striking to not ask the question. The nearly infinite scalability of “virtual” businesses can generate an optimism that supersedes cold rationality. If an investor is convinced that an asset is going to be worth $10 in a decade, it is easy to justify paying $2 for it today even if $1 is the appropriate price, after accounting for risk. But such optimism may not support asset prices indefinitely. When a company’s growth rate falls from 20% to 5%, it is not only the terminal earnings that fall relative to expectations, but also the multiple that the market assigns to those earnings. The resulting nonlinearities create massive potential losses for investors, with every 100bp drop in the growth rate generating a progressively steeper decline in returns.
Fewer IPOs Involve Profitable Businesses than Ever Before28
Public Markets Assign Higher Market Values, Valuation Ratios to Unicorns
Of course, it could also be that persistently negative real interest rates have fundamentally altered investment dynamics. If growth is the only way to hit return targets, investors may have no choice but to “pay up” for growth companies no matter their relative valuations. So while the underlying logic of value investing has never been stronger, growth is likely to remain integral to portfolios. The key differentiator may be investors’ ability to discern the true disruptors and accelerate portfolio company growth through replicable strategies and global networks.
About the Author
Jason Thomas is a Managing Director and Head of Global Research at The Carlyle Group, focusing on economic and statistical analysis of Carlyle portfolio data, asset prices and broader trends in the global economy. He is based in Washington, DC.
Mr. Thomas serves as Economic Adviser to the firm’s corporate Private Equity, Real Estate and Credit Investment Committees. His research helps to identify new investment opportunities, advance strategic initiatives and corporate development, and support Carlyle investors.
Prior to joining Carlyle, Mr. Thomas was Vice President, Research at the Private Equity Council. Prior to that, he served on the White House staff as Special Assistant to the President and Director for Policy Development at the National Economic Council. In this capacity, Mr. Thomas served as primary adviser to the President for public finance.
Mr. Thomas received a BA from Claremont McKenna College and an MS and PhD in finance from George Washington University, where he studied as a Bank of America Foundation, Leo and Lillian Goodwin Foundation, and School of Business Fellow.
Mr. Thomas has earned the chartered financial analyst designation and is a Financial Risk Manager certified by the Global Association of Risk Professionals.
- 1. Carlyle Analysis of CPB World Trade Monitor, November 2019; Ifo Institute for Economic Research; Economic and Social Research Institute Japan; Bloomberg; November 2019.
- 2. White House Weighs Blocking Chinese Companies from U.S. Exchanges, The New York Times, September 27, 2019.
- 3. OECD; World Integrated Trade Solution (WITS) Database.
- 4. C.f. Wolff, A.W. (2017), “The U.S.-Japan Relationship and American Trade Policy,” Columbia Business School.
- 5. U.S. Department of Commerce, August 2019.
- 6. U.S. Census Bureau, December 2019.
- 7. Reserve Bank of India, 2019-20 Fiscal Year Forecast.
- 8. OECD, Global Value Chains. IMF, 2019 WEO Database.
- 9. World Bank WDI Database; IMF Department of Trade Statistics; October 2019.
- 10. IMF, 2019 WEO Database.
- 11. IMF WEO Database, April 2019; India Ministry of Statistics, October 2019.
- 12. Pant, M. and M. Pattanayak, (2010), “Corporate Governance, Competition and Firm Performance: Evidence from India,” Journal of Emerging Market Finance.
- 13. Ravi, S. (2019), “Insolvency and Bankruptcy Code: Paradigm Shift and Further Reform,” Governance Now.
- 14. Lagarde, C. (2019), “The future of the euro area economy,” November 22, 2019.
- 15. Lagarde, C. (2019), Introductory Statement, December 12, 2019.
- 16. Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters, Q4-2019.
- 17. Bureau of Economic Analysis, December 2019.
- 18. C.f. https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications.htm
- 19. Carlyle; Organization for Economic Co-Operation and Development; U.S. Bureau of Labor Statistics; U.S. Bureau of Economic Analysis; IMF WEO Database, July 2019.
- 20. U.S. Bureau of Economic Analysis
- 21. As measured by ex-ante valuation ratios such as price-to-earnings, price-to-book, price-to-free cash flow, etc.
- 22. After accounting for observable differences in risk.
- 23. Carlyle Analysis; Center for Research in Securities Prices. Kenneth French Data Library.
- 24. Carlyle Analysis; Center for Research in Securities Prices. Kenneth French Data Library.
- 25. Carlyle Analysis; Center for Research in Securities Prices. Kenneth French Data Library.
- 26. Carlyle Analysis; Center for Research in Securities Prices. Kenneth French Data Library.
- 27. Carlyle Analysis; Center for Research in Securities Prices. Kenneth French Data Library.
- 28. Carlyle; Jay R. Ritter, University of Florida: IPO Updated Statistics December 31, 2018.; S&P Capital IQ IPO Data, July 2019.
Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information.
References to particular portfolio companies are not intended as, and should not be construed as, recommendations for any particular company, investment, or security. The investments described herein were not made by a single investment fund or other product and do not represent all of the investments purchased or sold by any fund or product.
This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.