Three years ago, one could have driven a fleet of semitrailers through the open space between the 2 year and the 10 year US Treasury benchmark note yields. While there still is some distance between the two, it would be somewhat more amenable to a single row of Priuses (Prii?) passing through. As the chart below shows, the shorter term note, which is generally more directly responsive to Fed policy, remains very close to its five year high. The intermediate 10 year yield, by contrast, has meandered along a largely directionless trajectory.
Untangling Policy, Demand and Expectations
The path of shorter term yields, for which the 2 year note is a useful proxy, is not hard to understand. The Fed began to make noises about tapering its QE policy in 2013 and then moved to a regime of reasonably explicit forward guidance on rates in 2015, resulting in the first increase at the end of that year. Despite falling sharply during the turmoil of early 2016, the 2 year resumed its upward path as conditions settled down and the case for a steady, if not spectacular, pace of economic recovery settled in as the default narrative. One should expect short term yields to continue tracking upwards in the absence of a reversal of the Fed’s stated intentions to keep raising rates.
For much of this time, the 10 year benchmark marched to a different drummer. Foreign demand was a key determinant of the consistently subdued yields experienced over this time – a trend that confounded no small number of bond pros. Rather than breaching 3 percent, as many expected, the 10 year actually set an all-time low – as in “since the founding of the American Republic all-time low” – in the immediate aftermath of Brexit.
The November election and the emergence of the so-called “reflation trade” brought about a shift in expectations, such that both intermediate and short yields moved largely in tandem. This was, as you will recall, when the prevailing mindset among investors imagined dramatic changes to the tax code and a sweeping new program of public spending on infrastructure. The spread between the 10 year and the 2 year in the weeks leading up to the election was mostly below 100 basis points, and it has not strayed very far from that level since.
Mind the Gap
The question now, of course, is whether there is still enough oomph in those reflationary expectations to send the 10 year into higher territory with a resulting steepening of the curve. This would be the putatively logical case to make for one who still believes there’s an infrastructure/tax reform pony out back with the capability to deliver the economic growth bump (however short-lived that might be) that is the administration’s central economic talking point. This view would consider the recent string of so-so hard data releases (including today’s six-of-one-half-dozen-of-the-other retail sales and inflation results) to be temporary and primed for near-term growth.
On the other hand, if the gap narrows still further – if the spread falls back into double digits as short term rates inch up while intermediates hold steady or fall again – investor brains could fall prey to the dark sentiments of an flat or inverted yield curve. That outcome would likely serve as a validation for those opining that bond yields represented the “smart view” while equity valuations soared on little more than a wing and a prayer.
The $4.5 Trillion Dollar Question
In the midst of all this is one very important and highly unpredictable variable: when and how the Fed plans to begin drawing down the $4.5 trillion balance sheet it racked up over the course of three quantitative easing programs. Observers will pay closer than usual attention to the forthcoming release of the FOMC’s minutes (scheduled for May 24) from its most recent policy meeting, scouring the language for clues about their intentions. The conventional wisdom is that the Fed believes there will eventually come a time when it needs to take rates back to zero and possibly launch another bout of QE. Having the dry powder to launch such a plan will necessitate a meaningful balance sheet reduction in the meantime. The tricky part, of course, will be to pull of this maneuver without roiling asset markets in so doing. Given the preternatural calm prevailing in risk asset markets currently, any hiccup could turn into a negative catalyst. Fed members will need to be practicing their triple-axel techniques to pull this off.
It’s Jobs Friday, always a fun day for financial pundits as they craft ways to put a defining, click-friendly metaphor on the latest signal of health (or lack thereof) in the labor market. This month’s winning metaphor is that staple of kids’ birthday parties, the bouncy house. “US jobs growth bounces back” says the Financial Times. Adam Samson, the FT reporter whose byline is attached to that article, appears to be on the same cosmic wavelength as Patricia Cohen of the New York Times, whose lead headline today reads – wait for it – “U.S. Job Growth Bounces Back”. The style manuals of the FT and NYT – U.S. or US? Jobs plural or singular? Caps or no caps in the headline? – were on full display. Over at the Wall Street Journal they seem to have quietly retired the “Jobs Friday Live Blog” of times past, but the WSJ’s team of economists nonetheless has a massive “Everything You Need to Know” section on the April jobs report. Indeed, to the credit of those featured, that is one exhaustive parsing of the BLS release.
If Productivity Fell and Nobody Heard It, Did It Still Fall?
Not every macroeconomic headline gets the popular-kid treatment of the monthly BLS release, of course. Consider the financial headlines just yesterday, May the Fourth (insert nerdy Star Wars reference here). Yesterday was Productivity Thursday. Ha-ha, of course it wasn’t, because there was basically no coverage of the only economic data point that actually has the capability to deliver sustained growth. What did yesterday’s headlines focus on? Postmortem commentary on the FOMC’s meeting pointing to a June rate hike…the final pre-election debate between Macron and Le Pen over in France…the sausage makers on Capitol Hill hastily throwing together a gambit on the 18 percent of the US economy represented by health care. Important stories, all. Meanwhile, nonfarm labor productivity fell 0.6 percent for the first quarter, well below the consensus expectation of 0.1 percent and yet another lackluster contribution to a chronically underperforming long term trend.
Stop Us If You’ve Heard This One Before
Everyone talks about growth; the notion that the economy will be stronger in the future than it is today is literally the single animating notion behind the capitalist impulse to defer the benefits of a dollar today for the payoff of that dollar’s growth over a defined period of time. But talking about growth without focusing on productivity is like talking about why you just came down with a nasty cold without considering the fact that you recently went out for a walk in the snow barefoot, in shorts and a t-shirt. That is what makes the absence of Productivity Thursday so conspicuous, and why the obsessive focus on monthly payroll gains appears so misplaced.
If anything, the leading number of Jobs Friday should be the labor force participation rate. That nudged down to 62.9 percent from last month’s 63 percent. It remains far below the peak of more than 67 percent reached at the end of the 1990s. Why is this number important? All together now…long term growth is a function of three variables: overall population growth, growth in the number of people working as a percentage of total population, and productivity (how much gets produced for every hour of effort invested).
For most of human history the only variable that mattered was population growth. If that were still true, we would have to content ourselves with annual GDP growth around 0.7 percent, which happens to be the most recent annual rate of population growth. We have little reason to believe that labor force participation is going to improve anytime soon: both demographics and job-replacing technology will see to that. Which leaves productivity, and which is why Productivity Thursday deserves its rightful place at the cool table in the cafeteria of macroeconomic data. Yes, those payroll numbers are useful. But with the unemployment rate at 4.4 percent one might wonder why participation remains stagnant and wage growth is still relatively subdued. Productivity Thursday could help shed some light here.
Another Friday, another “hard” piece of data that comes in shy of expectations. The Bureau of Economic Analysis released the first estimate of Q1 2017 real GDP growth, and the 0.7 percent quarter-on-quarter growth rate was a bit below economists’ consensus estimate of one percent. As a standalone data point this does not tell us very much. There will be two further revisions that could increase (or reduce) this first estimate. Q1 is notoriously subject to seasonal factors; for example, a warmer than average winter resulted in lower utility consumption by households, which in turn had a slowing effect on personal consumption expenditures. The first quarter of 2016 also produced sub-one percent growth, but that perked up to more robust levels as the year played out. As always, one data point doth not a trend make.
That being said, today’s release will do little to shed light on the mysterious “hard versus soft” debate that has been a staple on the menu of financial gabfests this year. The GDP number comes on the heels of two other underwhelming “hard” macro releases of recent Fridays past: headline inflation below the Fed’s two percent target, and March payroll gains falling short of 100,000. By contrast, a number of “soft” numbers reflecting sentiment among consumers and small business owners have being going gangbusters; by some estimates consumer confidence is higher than it has been any time since the tech bubble peak in 2000. The upbeat sentiment has served for many in the commentariat as an easy go-to explanation for the stock market’s bubbly performance in the year to date (our own take on the market is a more mundane assessment of momentum feeding on itself, more or less impervious to outside catalysts).
Hard, Hard Road
The sentimental bullishness may yet converge into the subdued hard numbers, but it’s not a given. Take retail sales, which posted a modest gain in February and then fell in March. Now, with consumer sentiment being so jazzed up, shouldn’t some of that effervescence be showing up in the actual spending numbers? You can’t blame the weather for this one: those balmy February days should have been mall and DIY store magnets. In fact, the poor showing of retail sales throughout the first quarter was as good a sign as any that GDP might come up short. Seventy percent of growth in output is driven by consumer spending. If consumers aren’t walking the walk, then all the happy talk in the world isn’t going to move the growth needle.
And Now for the Ugly
Behind all these month-to-month metrics we use to measure the economy’s health is the grim reality that long-term growth remains challenged by three major headwinds: declining population growth, a smaller percentage of the population at work in the labor force, and anemic levels of total factor productivity. Of those three headwinds, the only one that can plausibly deliver growth as we know it is productivity. It was the unique convergence of productivity advances with baby boom demographics that delivered the amazing, historically unprecedented growth rates of the 1950s and 1960s. The demographics are no longer in our favor, so to have any growth at all we will need to see some material evidence that all the technology innovations of the last 10 to 15 years can deliver a new, sustained dose of productivity gains. Until that happens, we should not expect to see the kind of go-go growth being promised by some who should know better (ahem, Treasury Department tax plan crafters). At some point, sooner rather than later, this reality will likely make itself known in the soft data as much as the hard.
How much of an X-factor is European political risk in 2017? We got a partial answer (not much) from the outcome of the Dutch elections last month, which maintained the status quo even as the traditional center right and center left parties fared relatively poorly. We will get another drip-drip of insight this Sunday evening, as election officials tally up the results of the first round of voting in the French contest. There has been some nervous chatter among the pundits, mostly revolving around the scenario – unlikely but plausible – of a second round contest between Marine Le Pen and Jean Luc Mélenchon. Markets, however, appear unfazed. The euro is holding ground at around $1.07, and the spread on the French 10-year yield over the commensurate German Bund is 61 basis points, down from 78 in the wake of a flurry of Mélenchon-friendly polls last week. And, as the chart below shows, Eurozone equities are holding their outperformance gains versus the US S&P 500.
The “what, me worry?” vibe boils down to a singular view that the ultimate winner of the election will be centrist Emmanuel Macron, a former economics minister and investment banker who cobbled together a new political movement to challenge the loathed traditional parties of the Socialists and Republicans. Macron’s platform is in line with the technocratic sensibilities of EU policy institutions and the IMF, focused on the integrity of the EU and the Eurozone with incremental rather than radical policies for dealing with the region’s ongoing difficulties.
Should Macron ultimately prevail, the market’s current positioning could augur for more outperformance ahead. Economic numbers continue to give cheer; the latest PMI readings show both manufacturing and services at a six year high. Growth, inflation and employment trends all continue to move in a positive, if still modestly so, direction. Other political risks lurk, notably in Italy, but the capacity to surprise will be greatly diminished if the French contest plays out as expected.
Zut alors, c’est le surpris!
What if Macron doesn’t win? If for no other reason, 2016 was instructive in explaining the pitfalls of polls and the many random factors that can lead to an outcome other than the highest-probability one. What will markets do on Monday morning if the two candidates left standing are Le Pen and Mélenchon? The short answer, given where markets are priced today, would probably be a pullback of somewhere between 5 – 10 percent for regional equity indexes and a move to haven assets like US Treasuries and German Bunds. That is what happened after the shock delivered by the Brexit vote last June. That pullback, though, as you will recall, was brief and contained. Within weeks of Brexit, equity markets had rebounded and the S&P 500 finally set its first record high in 14 months.
In the long run, we believe a Le Pen or Mélenchon victory would be of enormous consequence for the EU, more so than Britain’s exit. The market’s apparent ability to breezily whistle past every potential calamity would be tested perhaps more than in other recent political risk events. But if we have learned anything about Europe in the last seven years, starting with the wheels coming off the Greek economy, it is that European policymakers are masters of the craft when it comes to kicking the can down the road.
At some point – whether it be from disgruntled citizens voting centrists out of office, a round of financial institution failures or something else – the original flaws of the single currency design will likely deal a potentially deadly blow. But we have no reason to believe that reckoning is any time soon. Our advice to our clients should not surprise any regular reader of this column: resist the impulse to make any rash positioning plays either in advance of or following Sunday’s outcome, or that of the second round in early May.
From the beginning of January to the beginning of March, the S&P 500 set a total of 13 new record highs. Twelve of them happened after January 20, which no doubt made for an unhappy crowd of “sell the Inauguration” traders. Since March 1, though, it’s been all crickets. The benchmark index is a bit more than two percent down from that March 1 high, with the erstwhile down and out defensive sectors of consumer staples and utilities outperforming yesterday’s financial, industrial and materials darlings.
More interesting than the raw price numbers, though, is the risk-adjusted trend of late. To us, the remarkable thing about the reflation trade – other than investors’ boundless faith in the pony-out-back siren song of “soft” data – was the total absence of volatility that accompanied it. The reflation trade reflected a complacency that struck us as somewhat out of alignment with what was actually going on in the world. In the past several days, though, the CBOE VIX index – the market’s so-called “fear gauge” – has ticked above 15 for the first time since last November’s election. Half a (pre-holiday) week doth not a trend make – and the VIX is still nowhere near the threshold of 20 that signifies an elevated risk environment – but there may be reason to suspect that the complacency trade has run its course.
Equity markets have been expensive for some time, with traditional valuation metrics like price-earnings (P/E) and price-sales (P/S) higher than they have been since the early years of the last decade. But they remain below the nosebleed levels of the dot-com bubble of the late 1990s…unless you add in a risk adjustment factor. Consider the chart below, showing Robert Shiller’s cyclically adjusted P/E ratio (CAPE) divided by the VIX. The data run from January 1990 (when the VIX was incepted) to the end of March 2017.
When adjusted for risk this way, the market recently has been more expensive than it was at the peak of both earlier bubbles – the dot-com fiesta and then the real estate-fueled frenzy of 2006-07. The late 1990s may have been devil-may-care as far as unrealistic P/E ratios go, but there was an appropriate underpinning of volatility; the average VIX level for 1998 was a whopping 25.6, and for 1999 it was 24.4. Quite a difference from the fear gauge’s tepid 12.6 average between November 2016 and March of this year.
Killing Me Softly
In our era of “alternative facts” it is perhaps unsurprising that the term “soft data” took firm root in the lexicon of financial markets over the past months. The normal go-to data points we analyze from month to month – real GDP growth, inflation, employment, corporate earnings and the like – have not given us any reason to believe some paradigm shift is underway. Meanwhile the soft platitudes of massive infrastructure build-out and historical changes to the tax code have ceded way to the hard realities of crafting legislature in the highly divisive political environment of Washington. Survey-based indicators like consumer or business owner sentiment, which have been behind some of the market’s recent era of good feelings, are not entirely useless, but they don’t always translate into hard numbers like retail sales or business investment.
The good news is that the hard data continue to tell a reasonably upbeat story: moderate growth in output here and abroad, a relatively tight labor market and inflation very close to that Goldilocks zone of two percent. This should continue to put limits on downside risk and make any sudden pullback a healthy buying opportunity. But we believe that further overall upside will be limited by today’s valuation realities, with an attendant likelihood that investors will return their attention to quality stocks and away from effervescent themes. And, yes, with a bit more sobriety and a bit less complacency.