Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
Contrarian investors come in all shapes and sizes, but they all share a variation of this basic way of looking at the world: when the crowd looks one way, it pays to look the other. Today there is an undisputed crowd looking one way -- the Trump reflation-infrastructure trade that shows scant signs of fading, despite a bit of a pause in US equity share gains this week. And there are plenty of good reasons -- we believe -- for looking in other directions, the arguments for which we have set out on these pages in weeks past. But where? This week we consider the merits of one of the least popular asset classes in recent times: European equities.
Europe: The Macro Case
On the face of it, there would seem to be not much to recommend Europe from a top-down analysis of the variables at play. Last year’s Brexit vote hangs over the Continent; while the general consensus remains that Britain’s exit will hurt its own economy more than that of Europe’s, the devil will be in the details of how the parties agree to implement Article 50. Plus, of course, the upcoming elections in France and Germany, and the still-potential wild card of early elections in Italy - will shine a light on the fissures created by anti-establishment sentiment. All this while rattled national leaders and EC technocrats listen for the next approaching Scud missile in the form of a late-night tweet from the other side of the Atlantic.
Valid points, all. On the other hand, the economic health of the region is arguably stronger than it has been since the recession began nearly ten years ago. One of the first macro headlines of note this year was a 1.7 percent reading for consumer price inflation in Germany. Additionally, Eurozone producer prices climbed 1.6 percent year-on-year through the end of December last year. A meaningful part of the jump comes from energy prices; nonetheless, building inflationary pressures would seem to indicate that Europe has moved well and truly back from the deflation trap that seemed all but certain to engulf the region just two years ago. Two cheers, perhaps, for Mario Draghi and his knack for jawboning equity and debt markets.
Moreover, while the upcoming elections could indeed put added stress on the integrity of the common currency region, there is a plausible argument to make against that outcome. Consider the French election, where a victory by far-right populist Marine Le Pen would send shock waves to Brussels. Recently the world learned that the til-now front runner in that race, conservative Francois Fillon, is embroiled in a financial scandal involving fake parliamentary jobs for his wife and children. Apparently nepotism is still a cause for scandal over there - who knew?
The knee-jerk reaction to that news would plausibly be fear that Le Pen, running second in the polls, would vaunt to front-runner status. But wait! The Fillon scandal appears to have worked first and foremost to the benefit of Emmanuel Macron, an independent candidate with a moderate center-left platform who has surged to front-runner status. A Macron win would shake up France’s ossified political system, but arguably in a productive way less likely to be a direct threat to Eurozone integrity. Add to that the likelihood of Angela Merkel winning her fourth term later in the year, and suddenly the Great European Crack-up of 2017 looks less probable.
Europe: the Micro Case
What about the bottom-up view? Well, the obvious place to start would be the valuation gap between US shares and their European counterparts. According to Thomson Reuters Datastream, the twelve month forward P/E multiple for the Euro Stoxx 600, a regional benchmark, is less than 15 times. The forward P/E for the S&P 500, on the other hand, is over 17 times. Now, there have been reasons a-plenty to attach higher valuations to US companies in recent years. Nonetheless, when whole asset classes go out of favor there are usually some very good names that get unfairly tarnished with the macro discount brush.
One area where some contrarians may have been seen fishing about recently is for shares of companies with a significant portion of their revenues derived from outside Europe, particularly in North America or China & Southeast Asia. Remember that for every Procter & Gamble there is a Unilever, for every Exxon Mobil a Royal Dutch Shell. And some of the world’s leading industrial materials concerns -- a sector particularly embraced by the Trump trade crowd -- hail from Europe, among them Germany’s Heidelberg Cement and France’s Lafarge. If you really have to play the infrastructure trade, why not play it with more attractively-valued shares?
The Currency Factor
For a dollar-denominated investor, Europe has been a disappointment for many, many years, and one of the main reasons for that has been the secular bull run of the US dollar. The consensus outlook for the dollar remains strong, mostly due to the imagined outcome of a sequence of interest rate hikes in the US while the Eurozone continues to feed its monetary stimulus program. Every percentage gain by the dollar against the euro is a percentage taken away from the price performance of EU shares in local currency terms. For most of the past eight years, that has been a daunting obstacle.
Again, though, if those EU inflation headlines continue into a trend it is likely to, at the least, put upward pressure on intermediate and long benchmark yields in the Eurozone, which in turn would provide some support to the euro. Back in the US, we continue to see the pace of rate increases by the Fed proceeding gradually and below-trend for some time to come (this squares with our view that the tidal wave of net new infrastructure spending is more a creation of hyperactive investor imaginations than actual likely policy in 2017). With the dollar hovering just a few points above euro parity, there is at least a reasonable case to make that the dollar’s bull run may settle back a bit from its recent pace -- indeed, we saw perhaps a preliminary sign of this with the greenback’s weak January trend.
None of this means that European equities are a fat-pitch obvious source of value. But in a world of expensively priced assets, sometimes it pays to get into the heads of the contrarians and see what they are thinking. We will continue to send reports from this corner of the market as we assess alternative opportunities over the coming weeks and months.
It would appear that a lesson in US civics might be in order for Mr. Market. Investors breathlessly followed the staccato blast of tweets and executive orders emanating from Week One at the White House, rekindling the reflation-infrastructure trade that had seemed, tentatively, to be starting to take off the rose-tinted glasses. An executive order does not an actual implemented policy make, and the vaunted sausage-making process of legislative accomplishment continues to be at odds with the market’s bobby-sox crush on all things Trump administration.
Meanwhile in the world of actual data, this morning we got a preliminary reading on Q4 real GDP growth. The headline number came in a bit below consensus: the quarter-on-quarter increase of 1.9 percent was about 30 basis points below expectations. That translates to an annual average growth rate of 1.6 percent, making 2016 the lowest-growth year since 2011. How do the latest data affect expectations for next year and beyond? We look at both the near-term implications and what we see as the longer-term growth headwinds fiscal stimulus will not likely solve.
Buy Now, Pay Later
The overall consensus of economist views on the US economy in the coming 1-2 years has ticked up measurably since the election. Not to the levels of four percent real growth promised on the White House website (or the credulous investor herds who appear to agree), but increasingly closer to three percent than two. Much of the incremental growth, according to the new consensus, would start to show up in the latter half of 2017 and more fully in 2018. It would be premised on the realization of at least some form of the fiscal stimulus measures being tossed around, most directly corporate tax reform and new infrastructure spending. Most economists, when asked, stress that the nature of uncertainty around any of these measures or their timing adds a level of uncertainty to their outlook. And many are careful to add that successful implementation of these policies in the short run could have deleterious knock-on effects, as higher trade and budget deficits accompanied by higher than expected inflation could likely push up interest rates and the US dollar, making exports less competitive and thus detracting from growth. There are indeed many moving parts to the growth equation, which is why we habitually argue for caution against reading too much optimism – or pessimism for that matter – into likely scenarios for any given set of policies.
All that Matters
Ultimately, though, what long-term investors should care about, more than whether fiscal stimulus measure X gets implemented and causes interest rates to do Y and the dollar to do Z, is whether economic productivity will ever get back on track. GDP growth is important, but ultimately the growth comes from only three sources: population growth, an increase in the percentage of the population in the labor force, or productivity (the ability to produce more goods and services for each hour of effort and cost). Forget about the first two. Population growth is anemic: 1.2 percent per year for the world and just 0.8 percent per year for the US. Meanwhile the labor force participation rate, which reached a peak of about 68 percent at the beginning of the 21st century, has slumped to less than 63 percent for a variety of structural and cyclical reasons (more retirees, lingering effects of the recession etc.).
That leaves productivity. Unfortunately, there’s not much good news here either. Average output per hour, the standard measure of productivity, was lower for the last ten years than it has been for any ten year period since 1950. The current calendar decade thus far has been even worse: the 0.72 percent average annual growth rate for the period since 2010 is only one quarter of the rate for the 1960s, the most productive decade to date.
Opinions vary on why this is so, from the “best growth is behind us” view of the likes of Robert Gordon (author of “The Rise and Fall of American Growth”) to techno-optimists like Thomas Friedman of the New York Times who imagine that the true value-creating capabilities of more recent innovations have yet to bake themselves into macroeconomic statistics (Friedman ascribes 2007 – the year the iPhone was introduced – as a pivotal year in world history sine qua non). A separate but likewise relevant question is whether a new bout of technology-inspired productivity, particularly if it were to come from the gains in robotics brought about by deep-learning methods of artificial intelligence, might be severely counterproductive in its effect on the labor market. Again – lots of moving parts to consider in the complex adaptive system that is our economy.
Now, a genuine burst of real productivity (of the non-job killing ilk) could potentially smooth out the rough edges of the fiscal overheating that would be the likely outcome of the kind of programs this administration appears to want to implement. That is, of course, if the protectionist dark side of these programs were, at the same time, to not materialize. All those things combined could be a recipe for sustainable growth. But we will need to see far more evidence that any of them are likely to transpire before we think about joining the growth bandwagon.
Fed-watching isn’t quite the sport it was one year ago. The investing herds these days tend to be more fixated on tweets than on dot-plots. Nonetheless, the FOMC will meet again in eleven days, and what they decide to do (or not do) in January and beyond will have an impact on fixed income portfolios. The consensus wisdom is that rates are likely to rise. But direction is only one aspect of managing interest rate exposure; the other is shape – as in shape of the yield curve. Short and intermediate term rates have done anything but move in lockstep over the past several years. We think it is a good time to step back and consider the variables that may be at play in influencing the shape of the curve in the coming months.
A very odd thing happened the last time the Fed engineered a sustained policy of rate increases. The chart below shows the Fed funds target rate going back to 2000, along with the 2-year and 10-year Treasury yields.
The Greenspan Fed began raising rates in June 2004, taking the Fed funds target rate from 1.0 percent to 5.25 percent over a two year period (the green dotted line on the chart shows this ascent). Short term market rates moved accordingly; the 2-year yield started moving up ahead of the Fed, probably due to the expectations game and a sense that economic recovery was at hand. Longer term rates, though, barely moved at all. In fact, by the time the policy action topped out, the yield curve was essentially flat between 2-year and 10-year maturities.
Greenspan pronounced himself confused by this and called it a “conundrum.” His successor Ben Bernanke had done his own homework, though, and figured out what was going on. Many central banks around the world, particularly in Asia, had been burned by the currency crisis of 1997 and subsequently embarked on disciplined programs of building up their foreign exchange reserves. Meanwhile China, which had emerged relatively unscathed from the ’97 crisis, had its own reasons for stockpiling FX reserves: it was a means of keeping its domestic currency from getting too expensive while the country’s value of exports soared. What are all those FX reserves comprised of? Treasury securities, mostly. So the Greenspan conundrum was nothing more than good old fashioned supply and demand; as foreign central banks built up ever-higher mountains of reserves, the demand kept Treasury prices up and yields down. The effect was more pronounced at the intermediate and long end of the curve, which tend to be less influenced by domestic monetary policy and more influenced by other economic variables.
As the above chart shows, the expectations game with short-term rates has had some crazy moments in the past few years. Note, first of all, that the 2-year did not follow the Fed funds rate all the way down to zero as the central bank responded to the 2008 recession and market crash. The 2-year hung around the one percent level for much of the time until the second half of 2010 – the time leading into when the Fed launched its second wave of quantitative easing. The 2-year finally converged with the Fed funds (the upper band of the zero – 0.25 percent range) after the Eurozone crisis and debt ceiling debacle of summer 2011.
But the expectations game began anew in 2013 when then-Chair Bernanke mused openly about tapering the QE activity, Since that time, despite a handful of reversals, the trend in short-term rates has been resolutely higher. Market expectations ran ahead of the Fed, falling back only in 2016 when the FOMC blinked on successive occasions and held off on rate increases.
Yellen and the Tweets
While short term rates moved decisively off their 2011 and 2013 lows, intermediate rates once again behaved very differently. The 10-year yield actually set an all-time low in 2016 – yes, that was the cheapest 10-year debt has ever been in the history of the American republic. Again, the culprit appears to be supply and demand. In an age of negative interest rates, the meager two percent yield is king. Demand from institutional investors like insurance companies and pension funds, pushed out of other sovereign markets from the Eurozone to Switzerland and Japan, allocated larger chunks to intermediate and long Treasuries.
What does this mean for the remainder of 2017? A rational assessment of short-term movements, based on where rates are today and assuming the Fed goes through with at least two more rate hikes over the year, is that short-term rates might nudge up another 50 basis points or so. At the short end of the curve we think floating rate exposure remains attractive as a defense, particularly if the expectations game gets ahead of itself again.
The bigger challenge lies in those intermediate exposures. Negative rates still persist in Swiss and Japanese 10-year paper, but intermediate Bunds have trended decisively higher in recent weeks. The reflation trade that took hold right after the US election has meanwhile pushed the 10-year Treasury within striking distance of three percent. If the first month or so of the new administration gives the market cause to wrap itself even more tightly around this theme, then it may be a very painful year for fixed income portfolios. On the other hand – and we tend to see this as a more likely possibility – if the Trump trade is already overextended then we would expect to see less drama in the middle and long end of the curve, and still-healthy demand from those yield-seeking institutions.
An orderly and gradual rate increase policy was no doubt at the top of Janet Yellen’s list of New Year wishes. The overall economic environment would seem ready to cooperate with that intention. But she will have to deal with the possibility that tweets will do more to shape the curve than will dot-plots.