Posts tagged Market Impact Events
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.
It was Game On week. No, not the NCAA basketball tournament with its annual goody-bag of Cinderella stories and humble pie for top seeds, but the opening salvo of the elections in Europe about which we’ve all been chattering since the beginning of the year. What message will those discontented bodies politic in the fraying Eurozone send to global markets? Vox Populi rising, or more of the same?
Nee, Non, Nein
“Nothing here, move on” might be an appropriate response to this week’s contest in the Netherlands, and indeed much of the post-election commentary focused on the singular Nee – Dutch for No – served up by the voters to anti-immigrant polemicist and Freedom Party (PVV) head Geert Wilders. A stunning 82 percent of the citizenry turned out (dream on, America!) to give Mr. Wilders the thumbs-down and enable incumbent Mark Rutte and his VVD party to form a new government. This outcome fits rather neatly into a long-held view that, while disgruntled Europeans may register their unhappiness in polls and in the less consequential votes for the EU representatives they send to Brussels, they will heed their better angels when voting in their own national governments. Historians will point out that ethnocentric populism, while always present, has never managed to crack the high 30s in percentage terms over more than a century of national electoral contests. In this reading of the current environment, the Dutch “Nee” is likely to be followed by a French rejection of Marine Le Pen in favor of centrist Emmanuel Macron, and a vote for more of the same in Germany when Angela Merkel seeks her fourth term. Certainly these would have to be considered the default outcomes in the absence of any new news.
The Math of Discontent
A closer read of the Dutch outcome, though, tells a somewhat different story and one that would appear to be well in line with broader trends both within and without the Old Continent. The PVV – Wilder’s party – didn’t actually lose parliamentary seats but rather gained five. The big losers of the night, by the math of seat gains or losses, were the two establishment parties. PM Rutte’s PVV lost eight seats (though still retaining its position as the largest single party). But the PVV’s coalition partner, the Dutch Labor Party (PvdA) lost a stunning 29 seats. That adds up to a net loss of 37 for the Establishment. It also serves up yet more evidence that the traditional European left (think Britain’s beleaguered Labor Party or France’s Socialists with a 4 percent favorability rating) is in a death spiral.
Meanwhile three “alternative” parties – the left-leaning, Europhile D66 and Green List and the center-right, quasi-populist CDA, picked up 23 seats between them. Adding Geert Wilder’s 5 seats means that a non-Establishment alternative, split roughly between pro and anti EU sentiment, will play an outsize role in the new government. With no clear mandate for either bailing out of the EU/Eurozone or doubling down on open borders and free trade, the result is likely to be a lack of clear direction one way or the other. This outcome much more resembles the recent past than it does some bold new step forward. Populism may have its limits, but so does globalism.
Mr. Market’s Quiet Genius
For the past couple months we have spilled a great deal of ink on the pages of this column finding fault with the so-called “reflation-infrastructure” trade that appeared to be based on little other than hope and animal spirits. But we are starting to see a little method in the apparent madness of the markets. No – there is no infrastructure pony out back with a Christmas bow around its neck. There never was. Just as in Europe, our own policy engine is stuck in second gear, and not just on account of the apparent own goals the current administration and Congress keep making. Ours, too, is a body politic divided, and those divisions are, so far at least, keeping in check any decisive movement juggernaut in one given direction.
And that suits Mr. Market just fine, thank you very much. Hey – economies are doing pretty much okay on their own, here at home, in Europe, Japan and much of the emerging world. Citizens are disgusted with their governments for some very valid reasons. The less interference we get from misguided policymakers, goes this line of thinking, the better. No action is good action. Continued improvement in jobs and wages, with a modest but not frenetic pick-up in prices, all in the context of real GDP growth of two percent or a bit more – that’s enough for now. Enough to keep corporate earnings growing at least in the mid-high single digits. These may not be the best of times, but neither are they the worst. As long as things remain more or less as they are, this bull market can perhaps enjoy an extended sunset rather than suffering an abrupt end.
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.
Fiscal policy is where all the cool kids hang out now, as we noted in last week’s commentary. But the monetary policy nerds at the Fed got at least a modicum of attention this week as the dots settled on the Fed funds plot chart Wednesday afternoon. As was widely expected, the meeting resulted in a 0.25 percent target rate hike and some meaningful, if subtle, changes to the 2017 outlook. Three policy actions are on tap for next year, and this time the market seems to take this outlook seriously. Chair Yellen & Co. expect the recently favorable trends in output growth and employment to continue, while expecting to see headline prices reach the two percent target by 2018. These observations appear to be largely irrespective of what does or does not happen with all the hyped-up fiscal policy that has been driving markets of late. Be well advised: monetary policy will still matter, quite a bit, in 2017. It will have an impact on many things, not least of which will be the opportunity set of fiscal policy choices.
Divergent Today, Insurgent Tomorrow
Market watchers on Wednesday made much of the (temporary, as it turns out) pullback in stock indexes in post-FOMC trading. But the real action, as has often been the case in the last six weeks, was in the bond market. The yield spike is noteworthy in absolute terms, but even more striking on a relative basis. Consider the chart below, showing the spread between the 2-year U.S. Treasury note and its German Bund counterpart.
Short-term U.S. rates are at 52-week highs while German rates are at their 2016 lows. The spread between the two is wider, at 2.07 percent, than it has been at any time since 2003. Remember divergence? That was the big theme in the discourse one year ago, when the Fed followed through on its 2015 policy action last December. The Eurozone and Bank of Japan were full steam ahead with their respective stimulus programs as the Fed prepared to zag in the other direction. Then markets hit a speed bump in January, the Fed backed off any further action and rates came back down. As the above chart shows, U.S. and German short-term rates followed a more or less similar trajectory for most of the year.
But divergence is back with vengeance. Holders of U.S. dollar-denominated assets will be pleased, as the euro gets pushed ever closer to parity. Policy divergence leads to dollar insurgence. On the negative side, that insurgence looks set to redouble the FX headwinds that have clipped corporate top line revenue growth for much of the past two years. That, in turn, will make it challenging to achieve the kind of double-digit earnings growth investors are banking on to justify another couple laps of the bull market.
Three Times the Charm?
What we took away from Chair Yellen’s post-meeting press conference was a sense that the Fed’s world view has changed only modestly amid all the hoopla of the post-election environment. She took pains to note that the outlook shift to three possible rate changes in 2017 does not reflect a seismic change in thinking among the dot-plotters, but an incremental shift reflecting a somewhat more positive take on the latest growth, employment and price data.
And fiscal policy? Yellen could hardly avoid the topic; it was the point of the vast majority of the questions she fielded from the press. Over the course of her tenure at the Fed she has spoken many times of the need for monetary and fiscal policy to complement each other at appropriate times in the business cycle. This, however, may not be one of those times. Consider her comment in response to one question: “So I would say at this point that fiscal policy is not obviously needed to help get us back to full employment.” For the moment, at least, and in the absence of any tangible data to suggest otherwise, the Fed does not appear to be giving undue attention to the fiscal variable.
As Location Is To Real Estate, Productivity Is to Growth
Chair Yellen did make a point of emphasizing what kind of fiscal policy she does like: namely, that which directly helps boost productivity. That’s a point you have heard us make in this space ad nauseum, so it was good to hear it from the Eccles Building. What kind of fiscal policy could that be? Education, jobs and skills training programs and improving the quality of installed capital used by American workers were specifically called out by the Fed chair. Of course, there is no clarity of any kind that such productivity-friendly programs will make it through the legislative sausage factory. One can always hope, though.
2016 has been a rough year for the predictive sciences. The two marquee debacles, of course, were the Brexit vote in June and then the U.S. presidential election in November. On both occasions, the polls said one thing – with varying but largely robust degrees of confidence – while the outcomes said another. “The polls failed us” went the refrain of a chorus of observers in the aftermath of June 23 and November 8.
But when we say that “predictions were the year’s biggest loser” do we necessarily mean the polls? Or, rather, was the real culprit the folly of those who use predictive data to make their own prognostications about event outcomes, and the likely ensuing market reactions? If you’re a long-time reader of our commentary, you probably know where we’re going with this. Event-driven investors were tripped up by predictive folly in 2016. If we were to make our own prediction it would be this: they will be tempted to trip up again in the year ahead. We hope the events of 2016 will be an incentive for fewer to bite at the tempting apple of predictions and odds.
The Law of Small Numbers
Predictions necessarily derive from sample sets – a (if done right) random subset of a larger population or process. Polls are one example of a sample set – a slice of the likely voting predilections of a larger population. Coin tosses are another sample set, with each toss representing a sliver of a larger process that generates a defined outcome of either heads or tails. Students of the science of probability and statistics learn certain rules about the handling of sample sets; unfortunately, those rules tend to get lost in the noise of media coverage of events with probabilistic outcomes. Look no further than those two headline events of Brexit and Trump, and the Law of Small Numbers.
Media outlets tend to present poll samplings as a probability-weighted outcome. When an article says that the likelihood of Britons voting to remain in the EU is about 90 percent, or that Hillary Clinton’s chances of winning the White House are 85 percent, those sound like pretty good odds, right? So when Britain decides to bail on Europe and Donald Trump scoops up more than 270 votes in the Electoral College – well, the polls failed, didn’t they?
Not so fast. Let’s revisit that notion of sample sets. A fair toss of a coin has a 50 percent chance of coming up heads or tails. If you toss a coin ten times you would expect to see five heads and five tails. But if you’ve ever tried this out, you know that any discrete sequence of ten coin tosses may show something wildly different: seven heads, or ten tails, or any other combination. If you tossed that coin 100,000 times you would almost certainly record a number of heads (or tails) vanishingly close to 50.0 percent. That’s called the Law of Large Numbers.
But within that sequence of 100,000 tosses will be smaller handfuls of ten heads in a row, or nine tails and one head, or something else. That’s called the Law of Small Numbers, which says that the connection between underlying probabilities and observed results is much weaker when the sample size is small.
Why should you care? Because the outcome of a single event, like a referendum or a presidential election, is roughly analogous to tossing a coin a small number of times. You’re more likely than not to see the expected outcome. But there is a meaningful probability that you will see a different outcome. If you could simulate the presidential election 100,000 times (heaven forbid), you would probably see a Clinton victory closely aligned with what the polling data predicted. But the real world only offered up one simulation, and that was the actual outcome on November 8.
If Not One, then Zero
The Law of Small Numbers is what drives us to consistently advise our clients against playing the odds with individual events. Think about what happened to bond yields, the U.S. dollar and industrial commodities immediately after the election: they all spiked. Granted, an inflation trade trend of sorts was already underway, but the outcome of the election amplified it. Had the election gone the other way, it is unlikely that we would have seen those hockey-stick charts for copper and the 10-year yield that we featured in our commentary a couple weeks ago.
In other words, these individual events have discrete, binary outcomes. Yes / no, one / zero, win / lose. And not just for referenda or elections. “Production freeze / no production freeze” was the event headlining this week, as a tortuously arrived-at thumbs-up for an OPEC deal sent crude prices soaring by nine percent on Wednesday (what would they have done if the deal had fallen through?). For just about every such macro event there are highly sophisticated futures markets predicting the odds. And there are plenty of willing investors lining up to bet on the action, misunderstanding the predictive science to believe that the likelihood of their being on the wrong side of the trade is vanishingly low. The odds, they believe, are ever in their favor.
If nothing else, we hope that the colossal predictive fails of 2016 will have the positive effect of dissuading more investors from parting with their money in this fashion.
Events Aplenty in 2017
We don’t even have to look ahead to 2017; just within the next seven days we will have a critically important referendum (on Sunday) in Italy, the outcome of which is likely to have an outsize directional impact on Italian (and regional Eurozone) financial stocks, and then the FOMC statement next Wednesday where a rate hike is expected. Next year there are elections in France and Germany. Not to mention, of course, decisions about U.S. economic policy that will either validate or not (we think not) the “reflation-infrastructure trade” so breathlessly covered by the financial media over the past three weeks.
As a matter of course, we necessarily pay attention to all these events as they get folded into the overall picture of the global economy and capital markets. But rather than taking predictive bets on any given outcome, we ask how that outcome impacts the larger, constant concerns of organic growth, profitability and asset quality that in the long run are the most important determinants of stock price performance. Truth be told, our assessment of trends in global supply and demand, based on consumer expenditures, business investment and the like, has not changed much over the course of the last several months.
We will have more to say about our views when we publish our annual market outlook in January. For now, though, we will stay diversified and resist the temptation to push the envelope too far in any one direction in response to – or in expectation of – individual event outcomes.