So, everything’s back to normal, right? The sharp pullback that began with the hourly wage number exactly two weeks ago has assumed its usual V-shape, with 5 straight trading days in the green following the technical correction level of minus 10.2 percent reached on February 8. Just like that silly Ebola freak-out back in 2014, this one looks like it will pass over, a brief squall yielding back to calm seas without so much as a full day spent below the 200-day moving average.
Yields Go North, Dollar Goes South
The good news, for those who prefer their equities portfolios neither shaken nor stirred, is that the continuing rise in bond yields is failing to inject fear into risk-on asset classes. The 10-year Treasury yield broke through 2.9 percent on Wednesday, even as the S&P 500 recorded yet another intraday gain of more than 1 percent. Those inflationary fears would seem tempered, even though Wednesday’s news cycle also served up a core CPI growth number a bit higher than consensus expectations. For the moment, anyway, the stock market seems comfortable enough with higher rates.
Which brings us to today’s big question: what is up with the US dollar? The chart below shows the downward trajectory of the dollar against the euro over the past six months, during which period the 10-year yield soared from just over 2 percent to the recent 2.9 percent.
All else being equal, rising rates should make the home currency more, not less attractive. Investors prefer to invest where returns are higher. Moreover, the dominant economic narrative around the US for the past half-year or so has been positive: above-trend growth, strong corporate earnings and high levels of business and consumer confidence. What’s not to love? Yet, even while the spread between the 10-year Treasury and the 10-year German Bund is 0.45 percent wider than it was six months ago the euro, as seen in the chart above, has soared against the dollar. And the pace has only accelerated since the beginning of 2018. Yes, the dollar jumped ever so briefly as a safe haven mentality took hold two weeks ago, but it fell back just as quickly – even while the 10-year yield reached new 4-year highs.
Supply and Demand, Yet Again
We’re starting to feel like Econ 101 professors around here lately, given how often the phrase “supply and demand” shows up in our commentaries and client conversations. We think it may be the single most important catchphrase for 2018, and in it lies a plausible explanation for that odd relationship between the dollar and bond yields. The supply-demand road inevitably leads back to China.
China’s central bank buys US government debt – lots of it. Chinese foreign reserves exceed $3 trillion, and the vast bulk of those reserves exist in the form of US government securities. Two things happen when Chinese monetary authorities (or any other foreign institution) buy US paper, all else being equal. First, the price goes up, and thus the yield, which moves in the opposite direction of the price, goes down. Second, the dollar goes up because Treasuries are a dollar-denominated asset. You see, it really is all about those supply and demand curves.
Recent evidence (including a weak Treasury auction last week) suggests that Chinese Treasury purchases are somewhat lower than they have been in recent years. That rumor back in early January, though quickly disputed, may have a kernel of truth to it. Foreign buyers indeed may have less appetite for Uncle Sam’s IOUs. Maybe they expect more inflation down the road (which would assume higher nominal rates). Maybe other factors are afoot. Whatever the reasons, reduced demand from non-US sources would indeed have the likely effect of pushing up rates and pushing down the dollar at the same time.
If this is the case, then we may be in for more bumpiness in equities. The S&P 500 digested the move to 2.9 percent very smoothly. We may see in the coming weeks whether the story plays out the same way at 3 percent or more. There will be a truckload of Treasuries coming down the road as we borrow to fund all that new spending and those tax cuts. More supply, in other words, potentially chasing less demand.
Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.
The Expectations Game
The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.
What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.
Algos Travel in Packs
There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.
On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.
The Case for Promise
So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.
This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.
The Debt Factor
Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.
Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.
Longtime readers of our research and commentary know that we spend quite a bit of time dwelling on the economic metric of productivity. Our reason for that is straightforward: in the long run, productivity is the only way for an economy to grow in a way that improves living standards. Curiously, the quarterly report on productivity issued by the Bureau of Labor Statistics generally fails to grab the kind of headlines the financial media readily accord to unemployment, inflation or GDP growth. So there is an excellent chance that today’s release showing a drop of 0.1 percent in productivity growth for Q4 2017 (and a downward revision for the Q3 number) didn’t show up in your daily news digest. And while one quarter’s worth of data does not a trend make, the anemic Q4 reading fits in with a larger question that bedevils economists; namely, whether all the innovation bubbling around in the world’s high tech labs will ever percolate up to deliver a new wave of faster growth.
Diminishing Returns or Calm Before the Wave?
The chart below shows the growth rate of US productivity over the past twenty years. A burst of relatively high productivity in the late 1990s and early 2000s faded into mediocrity as the decade wore on. After the distortions (trough and recovery) of the 2007-09 recession, the subsequent pattern has for the most part even failed to live up to that mid-2000s mediocrity.
There are two main schools of thought out there about why productivity growth has been so lackluster for the past 15 years. The first we could call the “secular stagnation” view, which is the idea that we have settled into a permanently lower rate of growth than that of the heyday of 25 years or so following the Second World War. The second school of thought is the “catch-up” argument, which says that scientific innovations need time before their charms fully work their way into the real economy. Readers of our annual market outlooks may recall that we closely examined the secular stagnation argument back in early 2016, while the catch-up philosophy occupies several pages of the 2018 outlook we published last week.
The most persuasive evidence made by the catch-up crowd is that both previous productivity waves – that of the late ‘90s – early 00s shown in the above chart and the longer “scale wave” that ran from the late 1940s to the late 1960s – happened years after the invention of the scientific innovations that powered them. Most economists ascribe a significant impact to the products of the Information Age – hardware, software and network communications – in explaining the late 1990s wave. But those products started to show up in business offices back in the early 1980s – it took time for them to make an actual impact. According to this logic, it should not be surprising that the potentially momentous implications of artificial intelligence, deep machine learning, quantum computing and the like have yet to show that they make a real difference when it comes to economic growth.
Productivity and Inflation
The economic implications of productivity tend to be longer term rather than immediate – that is probably why they don’t merit much coverage on the evening news when the BLS numbers come out. After all, the economy is not going to stop growing tomorrow; nor will millions of jobs disappear in one day if another productivity wave comes along with the potential to make all sorts of service sector jobs redundant (a point we make in our 2018 outlook if you’re interested). The lack of immediacy can make productivity debates seem more like armchair theory than like practical analysis.
But productivity (or its lack) does have a lot to do with a headline number very much in the front and center of the daily discourse: inflation. What the BLS is reporting in the chart above is labor productivity: in other words, the relationship between how much stuff the economy produces and how much it costs to pay for the labor that produces that stuff. If compensation (wages and salaries) goes up, while economic output goes up by a smaller amount, then effectively you have more money chasing fewer goods and services – which is also the textbook definition of inflation.
In fact, the BLS notes in its Q4 productivity release that higher compensation was indeed the driving factor behind this quarter’s lower productivity number. Bear in mind that unemployment is currently hovering around the 4 percent level (this is being written before the latest jobs report due out Friday morning), and anecdotal evidence of upward wage pressures is building. An upward trend in unit labor costs (the ratio between compensation and productivity) has the potential to catalyze inflationary pressures.
Keep all this in mind as we watch the 10-year Treasury inch ever closer towards 3 percent. As we noted in our annual outlook, it makes sense to watch the bond market to understand where stocks might be going. And anything related to inflation bears close monitoring to understand what might be happening in the bond market.
Something odd has been going on underneath the main headlines in investment markets over the past twelve months. The big story, of course, is how everything has gone up from US stocks to emerging market bonds to industrial metals, fossil fuels and more. All that is true -- and yet, there has been an unusual lack of correlation between the price movements of asset classes that normally track very closely.
Take equities, for example. In most years, the correlations between different equity asset classes, from US style classes to non-US developed and emerging markets, have been very close. Think of a horse race, with all the horses coming out of the gate together and basically running in the same direction at very similar speeds. This past year, though, the correlations between these asset classes have been very weak -- less like horses out of the gate, and more like letting a bunch of cats out of a box to wander around as each one sees fit.
2017’s Odd Math
Exhibit A is emerging markets. In 2017 emerging market equities rose, and so did the S&P 500. But statistically speaking, there was virtually no correlation between the two asset classes. The statistical measure of correlation is a spectrum from 1.0 (perfect positive correlation) to minus 1.0 (perfect negative correlation). A correlation of 0.0 suggests no tangible connection between whatever moved each individual asset over the time period measured -- each marched to its own set of influences.
In 2017 the correlation between the S&P 500 and the MSCI Emerging Markets index was 0.04 -- zero, for all intents and purposes. The average correlation over the past 5 years for these two asset classes was 0.59 -- statistically relevant positive correlation. 2017 was an anomaly. What the correlation tells us is that the fact of the S&P 500 and MSCI EM both going up that year was more coincidental than it was explained by similar driving factors.
An even odder pairing of wandering assets is seen in the US style classes of growth and value. The average correlation between the Russell 3000 Growth index and the Russell 3000 Value index over the past 5 years was 0.87 -- a very strong positive correlation. For 2017 the correlation was 0.23 -- still positive, but very weak. Correlation that weak between these two assets would make any covariance measures -- like alpha and beta -- statistically useless.
PMs Love Wandering Cats
An astute investor might say: So what? All those equity classes rose in 2017. Do I care how closely two assets are correlated? The answer is yes. It is important because portfolio managers make allocation decisions based in part on the correlation properties of the assets they include in a diversified portfolio. And for these managers, a bunch of wandering cats is actually much more attractive for portfolio inclusion than eight horses running in lockstep. The property of low correlation with other asset classes is value-additive; all else being equal, the manager would prefer combining emerging markets with the S&P 500 when the correlation is zero as opposed to when it is 0.6 or more.
So the key question is this: Did something change so structurally in 2017 as to suggest that correlations between historical birds of a feather (e.g. style and geographic equity asset classes) are moving to a lower plateau? Or are the wandering cats a one-off phenomenon, with the customary high correlations set to return in due course?
We’ll have to see what the numbers tell us as 2018 moves along. In the meantime, we will be testing out some hypotheses. One hypothesis is that the growth in passive investing -- primarily through ETFs -- is a catalyst for lower correlations. ETFs make it easier to trade asset classes wholesale, as opposed to the emphasis on individual stocks employed by traditional active managers. It’s entirely possible that this could lead to more pronounced variations between asset classes as the passive strategies, driven by more frequent short-term trading volumes, propel them in different directions on different days.
Now, why that would have only shown up in 2017 is another question, without a convincing answer. We’ll have a better sense of that a few months down the road. Expect to hear more about this from us as the year progresses.
We will be publishing and distributing our Annual Outlook next week, a 24-page opus reflecting not only our analysis of the quotidian variables likely to be at play in the economy over the coming twelve months, but also a commentary on today’s world in a larger historical context. Meanwhile, we will use the opportunity of this week’s regular commentary to share with you the executive summary from the forthcoming Outlook, to give you an advance look of what you will read in further detail next week.
• “Moderate growth, low inflation, improving labor market”: this would have been a reasonable way to characterize US economic trends in 2013. And in 2014, 2015 and 2016. So it was not exactly an earth-shaking surprise when 2017 delivered…yes, moderate growth, low inflation and a still-improving labor market, if the latter slowed down just a bit in net new job creation. Tracking the macroeconomy has become something akin to watching daily episodes of Seinfeld. Not much of any consequence ever happens, and every now and then some amusing diversion appears to briefly engage one’s attention. Try as we might to unearth some new piece of information suggesting the approaching end of this placid state of affairs, we cannot. The data say what the data say. 2018, for the moment, looks set to deliver more of the same.
• The key difference between 2017 and earlier years in this recovery cycle was that the rest of the developed world came on board. Organic demand and consumer confidence perked up in the Eurozone, Britain managed to at least temporarily forestall a reckoning with the consequences of Brexit, Japan stayed positive while ex-Japan Asia Pacific countries did just fine. China, meanwhile, met its growth benchmarks by initially going back to the tried and true mix of debt-sourced spending on infrastructure and property. Beijing reversed course midyear, though, with a concerted program to reduce borrowing and recommit to economic rebalancing (this coincided with a further consolidation of power by President Xi Jinping). Elsewhere in emerging Asia and beyond, concerns about looming trade wars faded and domestic assets, including long-beleaguered currencies, perked up for a winner of a year. Again – while there are plenty of geopolitical variables that could form into tangible threats at any time – the basic macroeconomic variables appear stable. Markets ignored geopolitics last year, we expect them to do the same in the year ahead.
• Calendar-gazers are filling up the airwaves with the observation that the current recovery – from July 2009 to the present – is one of the longest on record. If we manage to avoid a recession between now and May, the current growth cycle will move ahead of that of 1961-70 as the second-longest, trailing only the ten years of good times from 1991 to 2001. To those nervously ticking off elapsed calendar days we offer two ripostes. First, markets and economies don’t pay attention to calendars, which are entirely a human construct. Second, there are potentially valid reasons why the current uptrend could go on for longer. From 2009 to 2014, arguably the main force behind continued growth was the Fed and its quantitative easing mechanics that flooded the world with money. Only more recently has the growth started to look more traditional – more like actual improvements in business and consumer sentiment begetting a virtuous cycle of increased supply feeding increased demand. If anything, the perky demand trends we see today more resemble those of an early than of a late stage in the cycle. The uniqueness of that multi-year experiment in unorthodox monetary policy may make comparisons with other growth periods less meaningful.
• So if the default assumption is that 2018 will be a year of very few changes to the presiding macroeconomic trends, what alternative scenarios could upend the base case? The key X-factor, we believe, is the one that nobody from Fed governors to that fellow holding court at the end of the bar completely understands; namely, the curious absence of inflation. The inflation rate has fallen short of the Fed’s explicit target of 2 percent throughout the entire recovery to date (when excluding the volatile categories of energy and foodstuffs). This despite the dramatic fall in the unemployment rate from 10 percent at its peak to just 4.1 percent today. The economic models built over the decades following the Second World War baked in the fundamental assumption of a trade-off between inflation and employment: be prepared to sacrifice one in pursuit of the other. That assumption has not held up at all in recent years. But before pronouncing last rites on the Phillips Curve, we again draw your attention to our observation in the previous bullet point: the kind of growth one normally sees early in a recovery cycle may only now be showing up. If so, then a sudden surge of higher than expected inflation would not be entirely implausible.
• The second alternative scenario that could disrupt the smooth sailing of most capital markets asset classes would be, perhaps, the other end of the spectrum from a growth-fueled resurgence of inflation. The Fed intends to raise rates again this year – three times if the stated expectations of the FOMC’s voting members are to be believed – and to begin winding down the balance sheet that grew to $4.5 trillion over the course of the QE years. These intentions reflect a confidence that the economy is fully ready to stand on its own two feet – which confidence, of course, proceeds from those same steady macro trends we described a few bullet points ago. But there is still a chance, and not necessarily a small one, that today’s bubbly sentiment is ephemeral and will dissipate once the crutch of monetary policy is finally and conclusively removed. Specifically, not one of the three structural drivers of long-term growth – population, labor force participation and productivity – are demonstrably stronger now than they were two years ago when we devoted some number of pages in our Annual Outlook to the concept of secular stagnation. There may be less to the current growth uptick than meets the eye. If so, a Fed misstep on the pace of unwinding easy money – too much, too soon – could be the trigger that boots the Goldilocks economy to the exit door.
• What both those alternative scenarios – an unexpected inflation surge and a Fed policy fumble – have in common is the potential to wreak havoc on credit markets. From an asset markets perspective, credit markets hold the key to how virtually any asset class – debt, equity or alternative – will perform. Here’s why. The risk-free rate – in general practice the yield on intermediate / long Treasury notes – is employed in just about every standard asset valuation model. All else being equal, an increase in interest rates has the effect of decreasing the present value of future cash flows. Asset managers will reprice their models if reality outstrips expectations about yields. A likely ripple effect resulting from a Treasury rate repricing would be widened risk spreads (affecting, for example, corporate investment grade and high yield bonds), a pullback in equity prices and a commensurate uptick in volatility. Whether the riskier conditions persist would be situation-specific, but there would very likely be at least some damage done.
• Again, we view these as alternative scenarios to be a more benign base case. Even if one of the other were to come to pass, though, it would not necessarily start the clock on a countdown to the end of this long bull market. For that to occur, we believe one of three events would have to emerge: a full-blown recession (which is different in nature from a periodic surge in inflation), a crisis such as the implosion of the financial system that led to the 2008 crash, or the outbreak of an actual hot war somewhere in the world that significantly involved the US and/or other large powers. The risk of any of these things happening in 2018 is not zero, but we would ascribe a probability of less than 25 percent to any of them.
• US equity valuations are stretched, particularly for the large cap growth segment of the total market that has consistently outperformed over the past several years. Relying on relative valuations alone would potentially lead investors to other areas, like Europe or emerging markets, that still have some catching up to do even after a strong performance in 2017. In the long run valuations matter – there is no coherent way to view a share price as anything other than the present value of a series of future cash flows. In the short run, valuations don’t always matter. Relative geographic performance in 2018 will be subject to other influences, not least of which will be the direction of the US dollar.
• The dollar was one of the big surprise stories of 2017. Long before equity shares in financial institutions or resource companies snapped out of their “reflation-infrastructure trade” myopia, the US currency had done a U-turn from its rapid post-election ascent. The dollar fell by nearly 10 percent against a basket of other major currencies last year, and that soft trend has continued thus far into 2018. Currency strength was a major force driving performance for developed and emerging market equities and debt last year. Whether a reprise of that trade is in store for the year ahead depends – again – on that tricky combination of alternative economic scenarios. If US interest rates rise substantially, with the ECB and the BoJ at the same time proceeding more cautiously, then a stronger dollar would be a rational expectation as investors pursue higher yields. That outcome is not set in stone, however. Major foreign investors – most notably China – may look to diversify their foreign exchange assets if their perception of US risk changes, which would, all else being equal, have a negative effect on the dollar.
• Commodities may stand on the other side of the dollar’s fortunes. A weaker dollar makes commodities more affordable in other currencies; that, along with the return of strong organic demand, may supply a tailwind to a range of energy and industrial commodities. But oil, which has recently surged to its highest levels in three years, remains vulnerable to the prospect of increased shale production in the US. As with currencies, there are many factors at play that could work either for or against key commodity classes.
• In conclusion, we could sum up the essence of our views thus: Things Don’t Change, Until They Do. The benign tailwinds of moderate, steady global growth will not last forever. Neither we nor anyone else can point with certainty to the date when the sea change happens. What we can do is pay close attention to the things that matter more. Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.