Posts tagged Global Economy
One of the great debates among the economic literati in recent years has been whether the subpar growth trends of late are cyclical or more long term in nature. The bearish long term view goes by the name “secular stagnation,” with advocates including former Treasury secretary Lawrence Summers making the case for a world stuck in a rut of anemic capital investment and lackluster demand. Two years ago, secular stagnation seemed like a pretty good theory to explain the deflation trap threatening to ensnare the Eurozone, zero-bound interest rates in the US, and many former growth darlings in emerging markets falling into low single digit or negative growth.
Macro headlines today tell a rather different story. In the US jobs, wages, prices and consumer confidence are all trending uniformly higher, as indicated in the chart below.
Meanwhile, Eurozone inflation has bounced back and even Japan is enjoying a relatively unusual run of positive growth. Most Asian economies are performing decently, if not necessarily spectacularly, while erstwhile basket cases Brazil and Russia seem to have gotten through the worst of their travails. Is it time to put a fork in the secular stagnation theory and call it done? Asset markets certainly seem to think so; today’s valuation levels can only appear reasonable if premised on the imminent resumption of historical-trend growth. But before we read last rites and sing Psalm 23 over the corpse of secular stagnation, we need to supply an answer to the question of what forces are present to drive that historical-trend growth.
The term “secular stagnation” is not new; it was coined in 1938 by prominent US economist Alvin Hansen. If you are familiar with US economic history you will recall that 1938 was the trough year of the second sharp pullback of the Great Depression: not as deep as the earlier one that bottomed out in 1932 but still painful, with unemployment at 20 percent and a steep decline in US population growth. Hansen looked around him and saw no way out; the world was locked into that dreaded feedback loop where businesses invest less because they expect continued lower demand, and households spend less because there are fewer jobs. Secular stagnation, in other words.
As we know now, of course, the world didn’t turn out that way at all. Instead, the onset of the Second World War unleashed a torrent of economic growth to supply the war effort, and after the war the US, as the sole economic superpower, ushered in a glorious thirty year period of steady and sustainable growth. The secular stagnation theory was laid to rest, until its resurrection by Larry Summers et al in the 2010s.
Attractive Economy Seeks Feisty Catalyst for Growth, Good Times
The headline economic data shown in the chart above are promising, but they are not yet sufficient to return secular stagnation to the box where it rested from 1939 to 2010. While the circumstances that produced the magnificent growth from the late 1940s to the early 1970s are complex and varied, the growth drivers themselves are easy to pinpoint. First, a return to population growth after the anomalous decline of the Depression years. Second, growth in labor force participation as returning war veterans went into a booming job market (and were later joined by a rising level of participation by women). Finally – and most importantly – was growth in productivity, or efficiency gains in how much output businesses could produce for each hour worked.
Are we on the cusp of another productivity boom? The data do not yet point to one. The chart below shows US productivity trends, along with the labor force participation rate, for the last thirty years. Both of these growth indicators remain decisively below-trend.
Some argue that the innovations of recent years will be that much-sought catalyst desired by the global economy. Expansive pundits talk of the Holy Trinity of the Three Industrial Revolutions: the steam engine of the late 18th century, electricity and the internal combustion engine a century later, and the smartphone in the early 21st century. Perhaps history does move in such well-tempered cycles; alternatively, perhaps the culture of growth that grew up around the first two Industrial Revolutions will be seen by future historians as a delightful anomaly rather than an inevitable forward march of progress. Time will tell whether this third iteration can deliver the goods.
The heady cocktail of animal spirits and hope that is the so-called reflation-infrastructure trade has many fans, but perhaps none more so than the monetary policymaking committee of the Bank of Japan. One of the first casualties of last year’s big November rally was the yen, which plummeted in value against the US dollar. That plunge was just fine, thank you very much, in the mindset of Marunouchi mandarins. A weak yen would make Japanese exports more competitive, while the continuation of easy money and asset purchases at home would finally create the conditions necessary for reaching that long-elusive 2 percent inflation target.
Lo and behold, the latest price data show that Japan’s core inflation rate rose 0.1 percent year-on-year in January, the first positive reading in two years. Only 1.9 percent more to go! Expectations of stimulus-led growth, continued weakness in the yen and a return to brisker demand both at home and in key export markets have led Morgan Stanley’s global research team to name Japan as the stock market with the most attractive prospects for 2017.
Patience Has Its Limits
Beleaguered long-term investors in Japan’s stock market would be more than happy to see Morgan Stanley’s prognostications come true – but they have heard this siren song before. The Nikkei 225 stock index reached a record high of just under 40,000 on the last trading day of 1989. As the chart below shows, things have been pretty bleak since those halcyon bubble days when the three square miles of Tokyo’s Imperial Palace were valued by some measures as more expensive than the entire state of California.
If the Morgan spivs are right about Japanese shares, and keep being right, it will represent a decisive break from a struggle of more than two decades for the Nikkei to sustain a level greater than 50 percent of that all-time high value. Prior to 2015, the Nikkei had failed to even touch that 20,000 halfway point at any time since March 2000 (which, as you will recall, was when the US NASDAQ breached 5,000 just before the bursting of the tech bubble). 2015 represented the high water mark of investor expectations for “Abenomics” – the three-pronged economic recovery program of Prime Minister Shinzo Abe – to deliver on its promises of sustained growth. Those expectations stalled out as the macro data releases kept pointing to more of the same – tepid or negative growth and the failure of needed structural reforms to take root. Japan’s problems, as anyone who has studied the long-term performance of the one-time Wunderkind of the world economy will tell you, are deep and very hard to dislodge.
No Really, It’s Different This Time
Abe is not the first prime minister to apply stimulus in an effort to shake the economy out of its lethargy. Massive public works programs have been a hallmark of the past quarter century. Over this time, yields on the 10-year benchmark Japanese Government Bond (JGB) have never risen above 2 percent (including during periods when yields on US and European sovereigns were at 6 percent or higher). The 10-year yield’s trajectory is shown (green trend line) on the chart above. No amount of stimulus, it would seem, was enough to convince Japanese households to go out and spend more in anticipation of rising prices and wages.
So what is it about the current environment that could induce Japanese share prices to break the 50 percent curse for once and all? We would imagine the answer to be: not much. While it is true that both the US and Europe look set to continue a modest uptrend in growth and demand (with or without the reflation jolt catalyzing all those animal spirits), Japanese companies are not necessarily positioned to benefit – certainly not in the way they did in the very different economy of the 1970s-80s when “Japan as Number One” was required reading for MBAs and corporate executive suites. While they have arguably become more shareholder-friendly in recent years, as evidenced by higher levels of share buybacks and the like, corporate business practices remain largely traditional and hidebound. Just a decade ago, these companies blew a once-in-a-lifetime chance to ride the wave of the great growth opportunity that was China – in their own back yard.
There is no magic formula for growth. In a country with an old and declining population (and extremely strict limits on immigration), a supernova-like burst of productivity is the only plausible route to real, organic improvement. Until then, that barrier of 20,000 in the Nikkei may continue to be a tough nut to crack.
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
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.
Way back in the middle of July, we wrote about what investors might expect come September. With the year’s ninth month drawing to a close, we pulled up that piece to see how our midsummer musings actually panned out. It concluded with the idea that, while surprises may percolate up for a temporary disruption, the TINA syndrome rules – There Is No Alternative when it comes to equities, and particularly large cap, domestic U.S. equities.
There could be worse ways to sum up this past month. Central bankers spoke (and spoke, and spoke), OPEC doyennes hung out and chatted on the sidelines of an energy conference in Algiers, and derivatives traders frowned at their book of business with Deutsche Bank. Markets overall were a bit more volatile than in August, which is to say that they actually registered a pulse. But the S&P 500 opened the month at a level of 2170. With four-plus hours of trading left before month-end, the index is – guess where? 2170! Alles ruhig -- All quiet on the large cap front.
…and the Red Queen’s On Her Head
The above chart is an old favorite we like to update and trot out when our point is to show how little has changed over the past couple years. For most of this two year period U.S. large cap stocks, here represented by the S&P 500, traded in a fairly well-defined corridor between price levels of 2,000 and 2,130. That corridor was punctuated twice on the downside by the pullbacks of August 2015 and January 2016. The ceiling was finally breached this July in a frenetic post-Brexit rally. Since then, the old ceiling has become the new floor in an even narrower (as yet) corridor. Briefly put: those events that – from the standpoint of an observer in July – could have catalyzed a major market move wound up not having much impact at all. The expectations bar keeps rising for the capacity of anything to truly shake up this market. This week’s talking points – Deutsche Bank, oil and the U.S. election – are no exceptions.
Deutsche Doesn’t Rhyme with Lehman (or AIG)
While diversified equity portfolios are generally doing fine, pity the poor sort with a bag full of Deutsche Bank stock. That name has plunged 62 – yes, 62 – percent from its 52-week high set last October. The large German concern has long been seen to have a comparatively thin capital cushion and a rather complex book of business making a straightforward asset-liability analysis difficult. Negative sentiment about the bank gained steam with a U.S. Justice Department announcement that it intended to seek $14 billion in penalties for the bank’s role in mis-selling mortgage backed securities. A terse statement by Angela Merkel’s government to the effect that Germany has no intention to supply any capital injections to Deutsche or any other troubled domestic bank ahead of next year’s federal elections ramped up the bears and led to a spate of Lehman/AIG circa 2008 analogies. The analogies are poor, starting with the notion that the Justice Department would go all-out to claw that $14 billion in full regardless of any potential market fallout. On the German side, the idea of hundreds of millions of euros in domestic deposits left to hang in the wind in an election year is somewhat farcical. We do have larger concerns about the health of the Eurozone banking system. But we don’t see much likely collateral damage from Deutsche’s current woes.
One Night in Algiers
“We’re ba-a-a-ck!” was the underlying message of various OPEC nabobs from the sidelines of an energy conference in Algeria’s capital city this week, with Iran’s oil minister lauding an “exceptional decision” made by the cartel. While crude oil prices did jump up mid-single digits as a result of the happy talk, there is little to suggest that a production freeze of 240,000 – 700,000 barrels per day (the putative range under consideration) will by itself sort out the supply-demand imbalances that are still working themselves out in world markets. As always when the contentious agendas of OPEC members collide – particularly those of Saudi Arabia and Iran – the details will be sufficiently devilish to cast doubt on the efficacy of any outcome. As far as equity markets were concerned, in any event, the Algerian goings-on merited little more than a casual side-glance.
Blue, Red, Back to Bed
We were pleased to see a Barron’s article this morning titled “Does the Market Care Who Wins in November?” Readers of our weekly commentary will not be surprised to learn that the article answers this question with an emphatic “No.” Even better, for empiricists such as ourselves, was that the article went on to cite an actual academic study, conducted by the American College of Financial Services, that supplies data in support of this argument. What the study says, in essence, is that in a multi-variate world, a single event like a political election will be lost in a multitude of other variables, mostly monetary factors, that will more actively influence the market’s direction.
Take it from us, you’ll never hear a CNBC news anchor intone the phrase “multi-variate world.” We would strongly suggest committing that phrase to memory, though, and calling it to mind every time you run into someone with a “strategy” for how to invest ahead of the election.