It may be as good a sign of the times in which we live as any: in the space of five business days, Argentina (1) stunned global credit markets with a $2.75 billion 100-year bond (yes, a bond that will come due long after all of us reading this article have gracefully shuffled off this mortal coil), and (2) saw the Argentine peso fall to a record low after MSCI declined to upgrade the country’s equity market from frontier to emerging market status. This seeming contradiction in fortunes comes at a time when emerging market equities hang on as one of the best asset class performers of the year, while investors have plowed more than $35 billion into developing market bond funds. Are there still opportunities here, or is the EM glow due for one of its not infrequent fizzles?
Unlikeliest of Success Stories
Pundits cheerleading the emerging market story were few and far between as 2017 got underway. After the surprise outcome of last November’s US election the asset class fell 6.4 percent through year-end, along with everything else on the flip side of the “Trump trade.” EM assets – debt and equity alike – were imagined to be in for a period of protracted weakness as US interest rates and inflation soared to the fanciful revving up of a $1 trillion tsunami of infrastructure spend. A better square on which to place your growth-and-risk-seeking chips, it would have seemed, was US small cap stocks. As it turned out, though, EM equities, currencies and bond prices all rallied. The chart below shows a 12-month snapshot of the MSCI EM stock index, denominated both in local currency and in US dollars.
Yield: What Matters Most
One of the factors -- not the only one, but key nonetheless -- explaining the updraft in EM equities is currency. After being pummeled by the US dollar more or less constantly since 2015, key emerging market currencies from the renminbi to the Indian rupee, Mexican peso and Russian ruble stepped on the gas after their post-Trump trade declines. That currency strength, in turn, is of a part with the remarkable push by global investors into emerging credit markets. For this there is an easy explanation. The investing world is on a collective, frantic search for yield in a world awash in central bank stimulus. Yield is the Holy Grail of the second decade of the 21st century.
Why was that 100-year Argentine bond deal thoroughly oversubscribed? Because investors could not resist the temptation of a 7.91 percent yield. Same goes for Russia, which unloaded $3 billion worth of 10- and 30-year Eurobonds into the markets this week (4.25 and 5.25 percent yields, respectively). Does it matter that Argentina has defaulted on its debt five times since 2000? Does anyone remember Russia’s bailing on its sovereign debt obligations in 1998, sending the propeller-head mavens of Long Term Capital Management and their backers to the poor house? Not today, not in a world of yield above all else.
Lower for Longer, or Tantrum 2.0?
The punters who scooped up the Russian and Argentine paper this week may well be vindicated for their boldness if the market’s view on the Fed turns out to be right. That view – the opposite of the reflation trade that had everyone so excited last year – is that low inflation and anemic wage growth are here to stay for the foreseeable future, just as they have been for most of the duration of the slow-growth recovery to date. If inflation and wages fail to kick in over the next several months, even with labor market conditions that according to many should suggest full employment, then it is quite possible that the FOMC will hold off even on the one further cut they have in their sights this year. That would potentially keep the dollar from embarking on another punishing rally, and the quest for yield would continue (pushing bond prices ever lower).
Then again, there is an alternative, quite valid argument to make that the low levels of volatility in asset markets today are woefully mispricing the amount of latent risk that could be unleashed at any time. It’s worth noting that many of the EM currencies that have been doing so well of late have run into some headwinds recently. The Brazilian real took a tumble back in May when the newest batch of political scandal headlines hit the wires. The ruble and the renminbi are both well off their recent highs, while the rupee and the Mexican peso are marking time in a relatively narrow corridor. The year’s gains to date have been impressive. Experienced EM investors know that they are anything but certain to last.
Investors tend to be predisposed to a “follow the leader” mentality -- to latch onto a narrative that purports to explain why company ABC or sector XYZ is running out ahead of the pack. Unfortunately for those in search of a leadership theme on the cusp of the summer of ’17, there really isn’t one anymore. There was one until last week: the mega cap stocks led by Facebook, Amazon, Alphabet (Google) and Apple took the helm back in the first quarter as the “reflation trade,” the previous narrative, faltered. The chart below shows the ascendance of these FAGA stocks when financials, the reflation trade’s leader, turned south in March (represented by XLF, the SPDR ETF). The chart also shows the carnage of June 8, when those high flying mega caps suddenly got pummeled on an otherwise nondescript trading day. They have continued to struggle in the days since.
The fizzling out of the reflation trade (or the “Trump bump” in the vulgate) as a leadership theme is easy to understand. The financial sector led that narrative, along with materials, industrials and (for a while late last year) energy. The premise was that a burst of pro-growth fiscal policy, headlined by tax reform, deregulation and a massive infrastructure stimulus would unleash an inflationary tsunami. Financial institutions would benefit from improved net interest margins, while industrial producers and resource firms would ride the infrastructure bandwagon. That premise, never particularly strong in a reality-based sense to begin with, looked increasingly like a bad bet as the legislative degree of difficulty presented itself to a team of political novices. Financials and other reflation-theme names topped out in early March and the broader market drifted for a spell.
FAGA (the aforementioned mega cap stocks) and their fellow travelers in the tech sector picked up where the Trump trade left off. What was the narrative driving this leadership rotation? Little, in our opinion, other than a general go-to argument that these enterprises are part of an elite cohort able to deliver consistently fast top-line growth in a world of modest economic prospects. The FAGA trade is sort of a lazy, modern take on the “Nifty Fifty” of days yore: in the absence of any other overarching narrative, go with the brand-name leaders of the day. And what, exactly, was the catalyst for that mass exodus from FAGA on June 8? Again, nothing that is glaringly obvious. Pundits put forth the “crowded trade” theme, which may be as good a reason as any. But they are not especially overvalued; Apple still trades at a P/E discount to the broader market, and the P/E premia of the other three FAGA names to the S&P 500 are well below their highs for the past five years.
Whatever the reasons were for bailing from tech on June 8, it is by now evident that it was not a one-day event; the sector has underperformed in the days since, as the above chart illustrates. The question now turns to the prospects for the broader market absent another leadership story. Candidates for such a story are rather scarce. The many ills plaguing the retail sector again came into sharp relief this week when supermarket chain Kroger’s radically cut its earnings outlook and saw its stock price get beaten down more than 18 percent. Healthcare waxes and wanes amid a fog of fundamental, sector-specific uncertainties. Financials face the headwinds of lower than expected inflation and the attendant opinion by many that the Fed was mistaken to move ahead with its rate cut this week.
The antidote for the confusion is TINA – There Is No Alternative. Forget the Trump trade, or tech stocks, or any other leadership narrative. It’s enough, this argument goes, to stay in the market when there are no compelling reasons to get out. As long as there is growth, however modest, and as long as there are central banks with the means to limit the downside, there should be no need to start building up the cash position. That logic has served investors well to now. But watch those narrowing spreads between short and intermediate term bonds. They don’t necessarily signal anything in terms of a major market shift. But they are not moving in the right direction.
Ah, to be alive at a time when “hey, did that really just happen?” can be the go-to phrase of any given day. To be perfectly honest, we did not give much more than a perfunctory review to the news some time back that UK prime minister Theresa May was calling a snap election in a bid to strengthen her Tory Party’s majority in Parliament. May’s insistent mantra of “steady and calm” seemed much more in keeping with the mood of the moment than the unpredictable antics of Labor leader Jeremy Corbyn, unloved even by much of his own party’s senior figures.
But while the good citizens of Washington, DC were filling up the local bars at 10 am for the much-hyped James Comey testimony, our British friends across the pond went to the polls and delivered yet another insouciant slap in the face of conventional wisdom. May’s Conservatives failed to gain a parliamentary majority, while Corbyn’s Labor Party bagged a sizable number of new seats and all sorts of other counterintuitive things happened… suffice it to say that “Democratic Union Party of Northern Ireland” was probably NOT on the tip of your tongue before now.
Does Someone Need a Time Out?
As of this moment the only hard data point we can affirm is that Britain has a “hung parliament,” meaning that no single party has a majority of seats from which to form a government. The most likely outcome, from the initial flurry of horse trading, will be a coalition between the Tories and Northern Ireland’s DUP, which also picked up a couple seats on Thursday night. But that is not definite; observers expect at least an attempt by Labor to form its own coalition. May’s own future as head of her party is anything but certain, and there is a better than average chance we will see another election called before the end of the year.
What this means for Brexit is also spectacularly unclear. What seems apparent, though, is that the “hard Brexit” approach favored by May, expressed by the sentiment that no deal (i.e. a nasty divorce) is better than a bad deal, is headed for the dustbin of history. Brexit is not off the table – Article 50 has been invoked and the game is afoot – but in the fog of confusion produced by the election outcome, some kind of a time-out may be in the cards.
L’Europe, En Marche!
Britain’s position vis à vis Article 50 negotiations is made more difficult still by the marked contrast of fortunes across the Channel. In his brief tour of duty as France’s president Emmanuel Macron has established himself as a strong leader whose En Marche (forward!) party – which did not even exist 14 months ago – is positioned to capture an historic majority of parliamentary seats in this weekend’s upcoming regional legislative elections (so many elections, so little time to cover and process them!). The Old Continent, plagued for so long by political sclerosis and the travails of the single currency region, suddenly looks ascendant under the M&M (Merkel & Macron) leadership star.
A stronger economy, though still not equally dispersed among all regions, may help the pro-EU center solidify its recent gains at the expense of far right populism. A more vibrant Europe will likely have the effect of making a decisive Brexit even less appealing to the nearly half of Britons who would still prefer to remain. Now, it is very difficult to tease out any kind of a clear Brexit message from the confusion of Westminster seats gained and lost on Thursday night. But with ten days to go before formal Article 50 negotiations are set to begin, a British negotiating team that has given short shrift to the many complex details to be worked out in the split would be well advised to take a deep breath and – perhaps – buy some additional time before engaging the battle.
It is said that the Battle of Waterloo was won on the playing fields of Eton. Today’s Old Etonians, and their negotiating team peers, would do well to consult instead Sun Tzu -- on when to engage, and when to pull back and reassess.
Every profession has its core mantra. The mandarins of medicine solemnly invoke the Hippocratic oath (first of all, do no harm). “Equality under the law” say the Doctors of Jurisprudence. In the practice of investment management, generations of money men and women since the 1930s have been trained thus: “in the long run, value outperforms growth.” The value effect has gone through some iterations since Benjamin Graham and David Dodd bestowed their masterpiece “Security Analysis” on the investment world in 1934, but it has largely stood the test of time. It’s not a difficult premise to grasp: buying stocks whose price is relatively cheap when compared to certain fundamental valuation measures – like book value, cash flow or net earnings – is on average a better long term investment approach than favoring the more expensive stocks that get red-hot and then flame out just as quickly.
Anomaly, or New Normal?
So far in 2017, value investors are taking cold comfort in the time-tested wisdom of their philosophy. The Russell 3000 Value index, a broad-market measure of value stocks, is up 2.50 percent for the year to date. Its counterpart, the Russell 3000 Growth index, is up a whopping 13.68 percent. That is the kind of performance gap that will make the most lackadaisical of investors do a double-take when their quarterly statements show up in the mail. And their value fund managers are reliving the nightmare that was the late 1990s, when ticky-tack dot-coms regularly crushed “old economy” stocks and made instant (if very short-lived) experts out of amateur punters the nation over.
Now, we all know that it is inadvisable to draw larger conclusions from a relatively small time window. But the value effect’s failure to stick the landing extends much further than the current market environment. The chart below shows the relative performance of these same two Russell value and growth indexes over the past fifteen years.
These fifteen years encompass multiple market cycles, from the depths of the dot-com crash to the commodity boom cycle of the mid-2000s, then the 2008 market crash and subsequent recovery (which itself contains at least three sub-cycles). As the chart shows, investors who stuck with a growth discipline performed substantially better than their value counterparts over the course of this period.
The Fleetingness of Factors
Is the value effect dead? Or is it “just resting,” like the Norwegian blue parrot in the Monty Python sketch? When we look at the long-term durability of factors, we tend to follow the methodology of prior generations in using a 30 year window of analysis. When Eugene Fama and Kenneth French (then at the University of Chicago) produced their groundbreaking analysis in 1992 of the value effect and the small cap effect (“The Cross Section of Expected Stock Returns”, published in the Journal of Finance), 30 years was the duration of their time series. Fama and French concluded that both value (defined as low market-to-book value) and small market capitalization were long-term outperformers relative to the broad market.
Looking back 30 years from today, value still retains a small edge over growth, while small cap appears to have lost the performance edge that Fama and French reported. The chart below shows the performance of the Russell 3000 Value and Growth, along with the Russell 2000 Small Cap index, over this 30 year period from 1987 to the present.
Value stocks (the blue dot just up and to the left of the broad market benchmark) returned 9.99 percent per annum on average over this 30 year period, which amounts to 0.21 percent more than the broad market. Now, 21 basis points per annum is nothing to sneeze at, particularly as it came with slightly less volatility. But, as the earlier 15 year performance chart showed, growth stocks have outperformed consistently over virtually the entirety of the period from 2009 to the present. The 1992 insights of Fama and French do appear to have diluted somewhat over time.
It’s too early to pronounce the value effect as dead. But factors – even the most durable ones – are never a guaranteed win. Today’s investors on the receiving end of pitches by “smart beta” managers – those sexy factor-based approaches that are currently all the rage – should always remember what is in our opinion the only investment mantra worth its salt: “there is no such thing as a free lunch.”
Another week, another record for stocks. Sadly for those of us inclined to jump at “buy the dip” opportunities, the window now appears to bangs shut almost before we even know it’s open. It took a mere five trading days to fully atone for last Wednesday’s mini-squall, with two new all-time highs following in quick succession. C’mon stockpickers, haven’t you ever heard the phrase “sell in May?” Throw us bargain hunters a bone or two!
Bond Bears, Beleaguered
Whatever is in the water in equity-world still has not made it over to the more subdued climes of fixed income. While the S&P 500 is just shy of eight percent in price appreciation this year, the yield on 10 year Treasury securities ambles along in the neighborhood of 2.25 percent, well below where it started the year and further still below the 52 week high of 2.6 percent. The chart below illustrates the alternative mentalities driving stock and bond trends this year.
The dourness is showing up in other credit markets as well. Average rates for 30 year mortgages finished this week at their lowest level for the year. Long-dated Eurodollar futures contracts, which reflect what traders think Libor levels will be up to 10 years in the future, indicate that we should expect a world of low inflation and low real interest rates well into our senescent years. The “10-2 spread” – the difference between intermediate and short term yields that we discussed in some detail a couple weeks back – is narrower than at any time since last November’s election. Reflation trade, we hardly knew ye!
On one level, the bond market’s lackadaisical drift is not all that surprising. It dovetails with the relentless monotony of an overall macroeconomic narrative that – at least according to the usual “hard” data points of labor, prices and output – has barely changed over the past twelve months. Low growth and restrained inflation are entirely consistent with sub-3 percent 10 year yields (unsurprisingly, the forecasting mandarins at banks such as JP Morgan and Goldman Sachs have lowered their 2017 expectations accordingly). The shiny veneer of the reflation trade has been wiped clean to reveal the same old undercoat of modest growth, with no evidence of a productivity-driven catalyst to bring the growth trend closer to the norms of decades past. Yes, the world’s major economies are aligned to a remarkable extent in their growth trajectories – GDP growth rates are trending in near-lockstep in the US, Europe and Japan. That alignment alone, though, does not suggest some emergent property to drive the trend higher.
And then there was the other dog that didn’t bark this week to send yields soaring. The minutes from the FOMC’s last meeting earlier this month made their way into public hands on Wednesday, offering a peek into the Fed’s thinking about starting to wind down its $4.5 trillion balance sheet in the coming months (the vast majority of which is in the form of Treasuries and mortgage backed securities). This winding down, many have noted, will involve some fancy footwork on the Fed’s part to avoid the kind of tantrums that sent bond markets into a tizzy back in 2013.
As it happened, though, the minutes gave little indication of anything other than that the Fed feels comfortable getting the process underway sometime in 2017. There’s also a question about how much “winding down” will actually happen. A recent study by the New York Fed suggests that a “normalized” balance sheet of $2.8 trillion should be achieved by 2021. Now, in 2010, before the second and third quantitative easing programs kicked in, the Fed had about $2.1 trillion on its balance sheet. So “winding down” would not mean going back to anything close to earlier “normal” balance sheet levels. Higher for longer. Tantrum fears may once again be somewhat overblown.
Red Bull and Tech Stocks
So what’s still driving equities? “No reason to sell” is about as good an answer as any, and that sentiment was clear in the market’s quick snap-back from last week. Tech stocks continue to lead the way while the former reflation trade darlings – financials, industrials and materials – lag. We appear to have reached the point where politics and global events are utterly irrelevant to market movements (the VIX’s retreat from last Wednesday’s spike was even brisker than the stock market recovery). Q2 earnings are expected to be decent, no recessions as far as the eye can see…what’s not to love? As Jo Dee Messina would say – “it’s a beautiful day, not a cloud in sight so I guess I’m doin’ alright.” For now, at least.