There’s not much interesting going on in the stock market these days, even less so than in the August “dog days” of years past. Oh sure, the Dow breaks 22,000 and local news stations go into one of their predictable round-number happy dances (as if the Dow Jones Industrial Average were anything other than a quaint relic from the 19th century). The S&P 500 (a more useful proxy for the “stock market”) lazily drifts along, sporadically setting new highs on the gentle currents of decent corporate earnings and low, but fairly stable, macroeconomic growth. Volatility, that once-fearsome stalker of equity portfolios, seems to be on the cup of fossilizing into amber or the permafrost.
On the other hand, bonds – wow! Everyone’s talking about bonds, normally the portfolio slice over which investors don’t lose sleep. More specifically, everyone’s talking about what could happen to bond prices if central banks follow through on a combination of raising rates and reducing balance sheets. Safe to say that “Raise and Reduce” focuses Wall Street’s attention in the same crystal-clear way that “Repeal and Replace” engaged the gimlet eyes of health care activists in recent weeks. For much of 2017 to date, yields on longer-dated bonds like Treasuries and investment grade corporates have remained relatively subdued while rates at the short end of the yield curve have climbed in expectations of further rate hikes. But ever since Mario Draghi mused about the pace of recovery in the Eurozone in late July, intermediate bonds (in particular Bunds and other European issues) have been channeling much of that volatility that the stock market has lost. Investors reasonably want to know if their bond portfolios are safe.
History Compared to What?
The issue at hand is whether central banks will go ahead with all these “Raise and Reduce” plans. If they were to do so, and if intermediate and long term rates were to suddenly spike as a result, then all those supposedly safe bond portfolios would be in the crosshairs. The “bond bubble” you may have heard about if you tune into the financial news channels and their bespoke pundits contemplates this scenario. At some point, the argument will wind its way back to the phrase “historically low rates” to describe how, after plumbing the lowest levels in the history of the American republic a scant twelve months ago, there is nowhere for rates to go but up, and possibly up a lot.
But what exactly are these historical averages, we would ask, and how relevant are they to the current environment? Bond yields don’t exist in a vacuum; they generally are related to the rate of growth and, particularly, the rate of inflation in an economy. In this context, historical averages are misleading. The average rate of core inflation (consumer prices excluding the volatile sectors of energy and food) from 1960 to the present was 3.8 percent, and the corresponding average rate of real GDP growth was 3.0 percent. Over the same time period, average yields on the 10-year Treasury bond were 6.2 percent, clearly far above where they have trended for most of this decade.
Past Performance Indicative of Nothing in Particular
But this 57 year “history” is hardly homogeneous. The first half of the 1960s enjoyed the tailwind of a very unusual confluence of productivity growth and growing labor participation that began after the Second World War. Those trends had petered out by the early 1970s, replaced by lackluster growth and soaring inflation – the “stagflation” era that still gives central bankers nightmares and clouds their policy thinking. Growth resumed in the 1980s with the help of both household and corporate debt, then experienced a very brief spike in productivity in the late 1990s. An uneven pace of growth in the mid-2000s collapsed with the 2007-09 recession, leading us to the current era of slow growth, tepid wages and moderate consumer prices.
The chart below shows the GDP and inflation trends over this time period. If bond yields are supposed to reflect what the collective wisdom considers a reasonable reward for deferring consumption today for return tomorrow, then what does this past history tell us about where rates might reasonably be in the weeks and months ahead?
As we have argued numerous times in these pages, the case for long-term growth much above the current trend of around 2 percent is weak: none of the catalysts – population, labor force participation or productivity – are working in the right direction. What would drive sharply higher inflation, then? And in the absence of a genuine inflation threat, what would prompt central bankers – well aware of their status as practically the only relevant economic policymakers in the world today – to take draconian action to battle imaginary dragons?
One can never rule out the potential for human error, and central bankers of course are still only human. But we do not think that a collapse in bond prices arising out of intensely hawkish central bank maneuvers is a high or even moderate probability scenario as we chart out the final leg of 2017 market trends.
Over the past few months, we’ve had a number of conversations with clients that go something like this:
Client: Wow, these are crazy times, huh? Politics! Never seen anything like this!
Us: Yep, they sure are crazy times.
Client: So, why does the stock market keep going up? When should I be worried?
In today’s commentary we will address this concern, and explain why we believe that, whatever one thinks of the political dynamics playing out here at home or abroad, it probably is not a good idea to transpose these sentiments onto a view of portfolio allocation. Political risk is a real thing. But history has shown there to be very little causal relationship between momentous political events and movements in risk asset markets. Any market environment, whether bull or bear, is affected by tens of thousands of variables every day, many of which have little correlation with each other, and very few of which are easy to pinpoint and ascribe to prime mover status. We offer up a case study in support of this claim: the US stock market in the early 1970s that encompassed the Nixon Watergate scandal.
That Dreary Seventies Market
President Nixon resigned from office in August, 1974, shortly after it became clear that Congress was preparing to commence impeachment proceedings in the wake of the revelations about the Watergate crimes and attempted cover-up by the administration. As the chart below shows, the S&P 500 fell quite a bit during the month of August 1974, as well as before and after the Nixon resignation. But the chart also shows that there was a lot else going on at the same time.
The Nixon resignation remains to date the most consequential political scandal in modern American history. It had an earth-shaking effect on the political culture in Washington, leading to far-reaching attempts by lawmakers to restore the integrity of the systems and institutions the scandal had tarnished. As far as markets were concerned, though, Watergate was far down the list of events giving investors headaches. Following a historically unprecedented period of economic growth and rise in living standards over the prior two decades, the first five years of the 1970s witnessed two wrenchingly painful recessions, spiraling inflation and a gut-punch to household budgets in the form of OPEC’s 1973 oil embargo. The freefall in stocks that took place in 1973 and 1974, if it is to be tied to any specific catalyst, flows from the real dollars-and-cents impact of the embargo and the recession. Watergate, as important as it was as a political event, was little more than a blip on a radar screen already filled with bad news.
Tweets Come and Go, Markets Carry On
Which brings us back to today’s daily carnival of the bizarre from the banks of the Potomac Drainage Basin. While the tweets fly and the heads of the high priests of conventional wisdom explode, the economy…well, just chugs along at more or less the same pace it has for the past several years. Today’s initial Q2 GDP reading (2.6 percent, slightly below expectations) sets us up for another year of growth averaging somewhere around 2 percent. The labor market is healthy, there is neither hyperinflation nor deflation, and corporate earnings growth is trending close to double digits. No major world economy appears in imminent danger of a lurch to negative growth.
Yes, stock prices are expensive by most reasonable valuation measures. And yes, there is not much in the way of sector leadership momentum. But until and unless we see compelling signs of a shift away from this uncannily stable macro context, we see little evidence that Washington shenanigans will have much of an impact on stocks. At some point, those tens of thousands of global variables at play will deliver up a different set of considerations and necessitate new strategic thinking. Trying to time the precise market impact, as always, is a fool’s errand.
Investors with broad-based commodity exposure haven’t had much to cheer about in the year to date. The Bloomberg Commodity Index, for example, was down more than five percent at the end of the year’s first half. The main culprit? Crude oil prices, and the tendency for commodity indexes to be heavily weighted towards the oozy black stuff. That is for good reason: for more than a century, oil has been the world’s most important commodity, the magical elixir powering the modes of transport that arose from the invention of the internal combustion engine. George Bissell, a New York lawyer, in the 1850s succeeded in his obsessive quest to extract the flammable “rock oil” known to reside under the craggy outcrops of western Pennsylvania. Had he not, the world today would know Saudi Arabia merely as a nondescript, likely poor desert kingdom. Nobody would have ever cared about who shot J.R.
While oil continues to struggle with both demand and supply headwinds – the slow pace of global growth on the one hand and the growing importance of non-conventional drillers in supplying the marginal barrel to the market on the other – other commodities in indexes like the Bloomberg are doing just fine, thank you. Precious metals have registered decent single-digit gains, likewise industrial metals like copper and aluminum, and also agricultural staples such as corn and wheat. Of all these, though, there is an interesting larger story about one: copper. It’s not a story for today, as in “what’s hot for my portfolio in 2017?” – but there is a potentially growing narrative around longer term demand trends based on something that is being much talked about this year: the rise of the electronic vehicle.
Copper for EV-er
Electronic vehicles, or EVs, have been in the news recently with chatter around the planned forthcoming roll-out of the Tesla Model 3, the attempt to bring this company’s offerings out of the stratosphere and into the affordability range for the masses. Meanwhile, Volvo has announced its intention to produce only battery-powered or hybrid vehicle by 2019. Scarcely an auto producer in existence has not joined the chorus of paeans to an EV-imagined future.
How soon – and at what cadence – this becomes a reality has major implications for copper. This industrial metal figures into several key parts of the EV manufacturing process including, importantly, the lithium-ion batteries that power the vehicles. Various demand projections for lithium-ion batteries over the coming 10-15 years, assuming certain levels of consumer adoption, show eye-popping ramp-ups that, if remotely accurate, would strain the total volume of commercially mined copper available from current sources. Many of the world’s existing facilities are many decades old, so the race is on for those with wildcatter tendencies to locate new sources in politically stable regions of the world to cope with the potential demand explosion.
Devil Is In the Details
Of course, much of the speculation about the potential role of copper in the brave new world of EVs is just that – speculation. There is no consensus on exactly how much of the metal would be required once the production processes become standardized and cost-efficient along the lines of how automobile factories evolved in the first half of the 20th century. Nor is it at all clear that electronic cars and other vehicles will see the same type of rapid, widespread consumer adoption patterns that we have seen from other technology offerings in recent years.
That being said, one of the important things to always remember about investing is that, over time, the tectonic plates do shift. The past is not prologue to the future – and the storied past hundred years of oil may be a poor predictor of the future for “Texas tea.” It’s worth keeping an eye -- and perhaps a small ante at the table – on copper’s future fortunes.
Some foreign words don’t have English translations that do them justice. Take the German “Schadenfreude,” for example. “Delight at the expense of another’s misfortune” just doesn’t quite pack the same punch. The Russian word “smutnoye” also defies a succinct English counterpart to fully import its meaning. Confusion, vagueness, a troubling sense that something nasty but not quite definable is lurking out there in the fog…these sentiments only partly get at the gist of the word. Russians, who over the course of their history have grown quite used to the presence of a potential fog-shrouded malignance out there in the fields, apply the term “smutnoye” to anything from awkward social encounters, to leadership vacuums in government, to drought-induced mass famines.
Who’s In Control?
We introduce the term “smutnoye” to this article not for an idle linguistic digression but because it seems appropriate to the lack of clarity about where we are in the course of the current economic cycle, and what policies central banks deem appropriate for these times. Recall that, just before the end of the second quarter, ECB chief Mario Draghi upended global bond markets with some musings on the pace of the Eurozone recovery and the notion that fiscal stimulus, like all good things in life, doesn’t last forever. Bond yields around the world jumped, with German 10-year Bunds leading the way as shown in the chart below.
At the time we were skeptical that Draghi’s comments signified some kind of sea change in central bank thinking (see our commentary for that week here). But bond yields kept going up in near-linear fashion, only pulling back a bit after Janet Yellen’s somewhat more dovish testimony to the US Congress earlier this week. And it has not just been the Fed and the ECB: hints of a change in thinking at the apex of the monetary policy world can be discerned in the UK and Canada as well. The sense many have is that central bankers want to wrest some control away from what they see as an overly complacent market. That, according to this view, is what motivated Draghi’s comments and what has credit market kibitzers focused like lasers on what words will flow forth from his mouth at the annual central bank confab in Jackson Hole next month.
Hard Data Doves
In that battle for control, and notwithstanding the recent ado in intermediate term credit yields, the markets still seem to be putting their money on the doves. The Fed funds futures index, a metric for tracking policy expectations, currently shows a less than 50 percent likelihood of a further rate hike this year, either in September or later – even though investors know full well that the Fed wants to follow through with one. Does that reflect complacency? A look at the hard data – particularly in regard to prices and wages – suggests common sense more than it does complacency. Two more headline data points released today add further weight to the view that another rate hike on the heels of June’s increase would be misguided.
US consumer prices came in below expectations, with the core (ex food & energy) CPI gaining 0.1 percent (versus the expected 0.2 percent) on the month, translating to a year-on-year gain of 1.7 percent. Retail sales also disappointed for what seems like the umpteenth time this year. The so-called control group (which excludes the volatile sectors of auto, gasoline and building materials) declined slightly versus an expected gain of 0.5 percent. These latest readings pile on top of last month’s tepid 1.4 percent gain in the personal consumer expenditure (PCE) index, the Fed’s preferred inflation gauge, and a string of earlier readings of a similarly downbeat nature.
Why Is This Cycle Different from All Other Cycles?
In her testimony to Congress this week, Yellen made reference to the persistence of below-trend inflation. The Fed’s basic policy stance on inflation has been that the lull is temporary and that prices are expected to recover and sustain those 2 percent targets. But Yellen admitted on Wednesday that there may be other, as-yet unclear reasons why prices (and employee wages) are staying lower for longer than an unemployment rate in the mid-4 percent range would normally suggest. This admission suggests that the Fed itself is not entirely clear as to where we actually are in the course of the economic recovery cycle that is in its ninth year and counting.
Equity markets have done a remarkable job at shrugging off this lack of clarity. Perhaps, like those Russian peasants of old, they are more focused on maximizing gain from the plot of land right under their noses while ignoring the slowly encroaching fog. Perhaps the fog will lift, revealing reason anew to believe a new growth phase lies ahead. All that remains to be seen; in the meantime, “smutnoye” remains the word of the moment.
Hard to believe it, folks, but Year 2017 has already passed its halfway point. While many are still getting the most out of a holiday-interrupted week, at the beach or in the mountains or anywhere that the Twitterverse cannot find them, we will take this opportunity to contemplate what was, what is, and what may lie ahead in global asset markets.
Sweet and Sour
Perhaps the definitive image of markets for the first six months of the year was a contrast in shapes: the flattening contours of the Treasury yield curve on the one hand, and the upward-sloping progression of the stock market on the other. For much of this time, equity and fixed income investors seemed to be singing off two different hymn sheets: giddy expectations on the one hand and a dour read of the macroeconomic landscape on the other.
Going by the hard data alone, the bond mavens would seem to have the better arguments on their side. Headline data over the first two quarters largely underwhelmed, most notably in the area of prices and wages. Inflation readings, including the Fed’s favored personal consumption expenditure (PCE) gauge, have stayed south of the central bank’s two percent target. The labor market continues to raise more questions than it answers, with the unemployment rate suggesting we are very close to full employment, but tepid wage growth indicating none of the usual pressure that hiring firms experience in a tight labor market. That dynamic was present in this morning’s jobs report as well. Better than expected payroll gains brought the three month average up to 194,000 new jobs, but wage growth again came in below expectations.
Turning Point or Tantrum?
With that soft inflationary context in mind, we consider the recent gyrations in the bond market that has some observers predicting a sea change in yields in the months ahead. The fixed income kerfuffle was ignited by remarks by ECB Chair Mario Draghi last week, suggesting that Europe’s better than expected recovery may warrant moves to start winding down monetary stimulus. Whiffs of increased hawkish sentiment can be detected elsewhere in the central bank world, including the UK and Canada.
With inflation showing no signs of overheating, the Fed will not have a gun to its head to raise rates, nor will the ECB be forced to risk market volatility by accelerating any form of a taper in their bond buying program. But that very volatility is an issue on the table for the monetary mandarins. This week’s release of the June Fed minutes suggests that central bankers are at least somewhat nervous about yet another characteristic of 1H 2017 asset markets: the coexistence of elevated prices with almost no volatility. The Fed’s rate hike in June -- and a possible follow-on increase in September -- reflect at least in part an attempt to wrest control back from complacent markets. That complacency is well-founded; central banks have in recent years gone to great lengths to prop up asset prices. If investors sense an end to the Greenspan-Bernanke-Yellen put, we could expect volatility to return with a vengeance.
Brent Gold, Texas Tea
Another addition to the #thingswelearned category in the first half of 2017 is that OPEC is largely a spent force in exerting influence on oil prices. The cartel’s much-touted meeting last fall that produced a tangible production cut policy initially sparked a recovery in crude prices, but the recovery fizzled away as it became ever clearer that US non-conventional drillers, not OPEC, represent the marginal barrel of production. Supply dynamics suggest a secular trend for the range-based price movements of recent months, with the only question being where the lower end of that range will settle. On the demand side, the continuing reality of below-trend global output signals that the commodity super-cycle of the previous decade is unlikely to return any time soon. Resource companies may be in for an extended winter of discontent.
Much More in Store
These topics are just the tip of the iceberg: we have said nothing here about emerging markets, or risk spreads in investment grade & high yield bond markets, or the strangely underperforming dollar, or sector and geographic rotation among equity asset classes as another season of earnings gets under way. These are all issues of clear and present importance, and rest assured we will be covering them in the weeks ahead.
Meanwhile, enjoy what remains of the holiday week and be ready for interesting times ahead as summer eventually brings us to those tricky fall months that lie in wait.