MONTHLY STRATEGY REPORTJANUARY 2019

2018 AND THE PARADOX OF SCHRÖDINGER’S CAT

MONTHLY STRATEGY REPORT. JANUARY 2019

2018 AND THE PARADOX OF SCHRÖDINGER’S CAT 2

2018 AND THE PARADOX OF SCHRÖDINGER’S CAT

We have just closed the book on 2018, a year in which few assets provided refuge. While interest rates in Europe remain negative and nearly the entire yield curve offers sub-zero returns, all stock markets are in decline, with the exception if India and Brazil (when measured in local currency). In fixed income, credit indices also suffered. Even gold, known for being a safe haven, shed -2.4%.

The US stock market experienced its worst December since 1931. In fact, as illustrated in Graph 1, the correction recorded on the S&P 500 was the sharpest of the current growth cycle, which began in March 2009, prompting many to prepare expeditiously for the end of the longest cycle in the history of the US economy. Later in this report (pg. 7), we examine in depth why, despite the deterioration of indicators, we at Banca March believe the evidence is insufficient to confirm an end to the cycle in the immediate, much less over the course of the year. Our central scenario is one in which the economy will enter a period of transition, from the synchronised growth between regions we saw in the first half of 2018, to a slowdown with more disparity between geographic areas.

What is the impact on stock markets? Far from the profit upsurge expected by the consensus of analysts, the S&P 500 is assuming an implicit decline of -10.7% in the results of its companies in order for the P/E ratio to remain at its historical average. Even in Europe, where rate hikes have not yet been implemented and multiples nearer the average would be justified, the market is assuming an -11.6% dip in profits. Is not the punishment too harsh if we are simply witnessing a storm within a mature cycle?

At times like these it is worth remembering that, in any upward cycle, concerns emerge and the economy’s capacity to continue growing is called into question. For example, as illustrated in Table 2, we have experienced several “scares” in the last 10 years that were less drastic but significantly more protracted than the current one.

What were the causes? Although perhaps already forgotten by some… remember when US GDP contracted for two quarters in 2011? (As they were not consecutive, it did not formally constitute a recession.) Remember the devaluation of the Chinese yuan in 2015-2016, or when oil prices collapsed to USD 28/barrel, coinciding with Fed’s the first interest rate hike? Were these not legitimate causes for concern? Stock markets reacted even more sharply at the time, but ultimately the results were not cataclysmic.

2. S&P 500 DECLINES AND REBOUNDS Source: Bloomberg and Banca March

1. S&P 500 MAX. DECLINES AND REBOUNDS Source: Bloomberg and Banca March

ANALYSIS OF S&P 500 DECLINES IN THE CURRENT BULL MARKET (WEEKLY CLOSE)

CORRECTIONS > 5%

DURATION TO MINIMUMS

(NO. OF WEEKS)

% DECLINE FROM PEAK

REBOUND TO PEAK

(NO. OF WEEKS)

2009 Q3 4 -7.1% 22010 Q1 4 -6.9% 52010 Q3 10 -16.0% 182011 Q3 22 -17.0% 212012 Q2 9 -9.3% 112012 Q4 9 -7.2% 72014 Q3 4 -6.2% 22015 Q3 30 -12.3% 212018 Q1 10 -9.3% 202018 Q4 (ACTUAL) 13 -17.5%

AVERAGE 11.3 -10.1% 11.9MEDIAN 9.0 -9.3% 11.0

-20.0%

-17.5%

-15.0%

-12.5%

-10.0%

-7.5%

-5.0%

-2.5%

0.0%

500

1,000

1,500

2,000

2,500

3,000

3,500

09 10 11 12 13 14 15 16 17 18

Declines from peaks (%, left) S&P 500

MONTHLY STRATEGY REPORT. JANUARY 2019

2018 AND THE PARADOX OF SCHRÖDINGER’S CAT 3

The lack of confidence indicated by markets contrasts with the current situation of the global economy. Despite the slowdown that began in the second quarter of the year, it is important to bear in mind that growth reached 3.7% in 2018 and we expect global GDP to increase by 3.4% in 2019, consistent with the average of the last 50 years. Moreover, corporate results remain strong and, although the effect of Trump’s tax reform will recede and last year’s +23.9% is not sustainable, the analyst consensus expects +8% for the US and +9.5% for Europe and emerging markets, with EBITDA margins of 20%.

This sharp discrepancy between markets and the real economy, this apparent existence of two parallel universes, is a paradox that is difficult to sustain in the long term and seems more germane to the field of quantum physics than economics.

One of the fundamental principles of quantum mechanics is superposition, which theorises that subatomic particles—like electrons—can occupy two places simultaneously. It is akin to recognising that the current decoupling of financial markets and the economy could be extended indefinitely.

In the current situation, we must not ignore the signs of an economic slowdown. In addition to our concerns about the deterioration of credit spreads and consumer confidence expectations (which prompted us to reduce equity exposure in July), we must take into account a new adverse factor, China’s December PMI, which—for the first time in two years—entered contraction territory. But if we were to follow only a single indicator of the many we track, it would be the slope of the US yield curve. As illustrated in Graph 3 (and though not absolutely infallible; see red arrows), the difference between the 10-year and the 3-month bond rate invariably inverts before the start of a recession in the US, indicating that short-term rates have exceeded the growth expectations of their long-term counterparts.

In recent weeks, between the Federal Reserve rate hikes and the decline of the 10-yr. bond IRR to 2.65%, the slope of the curve is quickly losing strength and is already at 0.25%, but it is best to refrain from anticipating events for several reasons: i) even the 10yr.-3m. curve is fallible; ii) in light of the situation, will the Fed become more accommodative going forward? iii) to what extent does altering the term premium reduce prediction capacity? iv) after a curve inversion, recessions are not automatic. As Graph 4 illustrates, historically, recessions materialise 8-13 months after a curve inversion.

There is an interesting similarity between this indicator and the thought experiment conducted by the physicist, Erwin Schrödinger, in 1935. For the Nobel laureate, the subatomic realm was one thing, while macroscopic entities—like cats or handbags—were quite another. Schrödinger proposed enclosing a cat inside an opaque box with a flask

3. SLOPE OF THE US 10YR./3M Source: Bloomberg and Banca March

4. MONTHS TO RECESSION AFTER CURVE INVERSION

Source: Bloomberg and Banca March

85

14

0

8

15

8

23

17

10

4

13

24

5

10

15

20

25

RECESSIONDEC. 1969

RECESSIONDEC. 2007

RECESSIONMAR. 2001

RECESSIONJUL. 1990

RECESSIONJUL. 1981

RECESSIONJAN. 1980

RECESSIONNOV. 1973

3M-10YR 2YR-10YR 2YR-10YR AVG.3M-10YR AVG.NBER RECESSION CURVE SLOPE (3M VS. 10YR)

MONTHLY STRATEGY REPORT. JANUARY 2019

2018 AND THE PARADOX OF SCHRÖDINGER’S CAT 4

of poison. After a period of time, the probability that the cat was dead was 50%, the same likelihood that a device designed to release the poison into the box had not been activated and the cat was still alive. Based on quantum theory and the superposition property of quantum states, the cat is both alive and dead at the same time, since it can occupy two different states simultaneously. The paradox occurs when the box is opened to check on the cat: the action of the observer determines the outcome and the quantum superposition ends; now the cat is either alive or dead.

The similarities between the current climate and this experiment are clear: the box is the economy, the cat represents equities, the poison needs no explanation, and the observer is the yield curve that determines the course of the market.

To conclude, Table 5 illustrates that, despite the performance of the stock market in recent weeks, the cat… or rather equities have historically performed well in the final phases of a cycle.

Joan Bonet MajóDirector of Market Strategies

5. TABLE 5: S&P 500 PRE-RECESSION TRENDS

Source: Bloomberg and Banca March

13-24 MONTHS

1-24 MONTHS

7-12 MONTHS

1-12 MONTHS

1-6 MONTHS

MONTHS W/O

RECESSION

JULY 1953 - MAY 1954 17.0 9.9 6.7 -1.6 -19.4 15.3

AUGUST 1957 - APRIL 1958 16.7 8.2 -11.4 -2.3 19.9 20.8

APRIL 1960 - FEBRUARY 1961 40.2 18.4 12.4 0.8 -6.1 16.0

DECEMBER 1969 - NOVEMBER 1970 9.6 0.2 -10.1 -13.3 -15.0 5.5

NOVEMBER 1973 - MARCH 1975 19.3 7.4 -10.0 -6.2 -6.6 6.3

JANUARY 1980 - JULY 1980 0.1 2.3 7.2 6.4 3.8 3.0

JULY 1981- NOVEMBER 1982* - - 45.2 10.9 -11.6 1.6

JULY 1990 - MARCH 1991 20.8 15.8 25.5 14.9 5.8 14.0

MARCH 2001 - NOVEMBER 2001 16.6 4.5 10.7 -2.8 -23.9 12.7

DECEMBER 2007 - JUNY 2009 8.5 8.6 18.9 8.0 -5.6 3.7

AVG. RETURN SINCE 1950 16.5 8.4 9.5 1.5 -5.9 9.9

* Period coinciding with the previous recession