Volatility has been conspicuously absent from asset markets for most of 2013. Even during the brief pullback from late May to late June volatility levels didn’t come anywhere near where they have been during other flashpoints over the past several years. It’s been an unusually calm summer – but whether the gentle breezes of low volatility and rising asset prices continue to blow into the fall is up for debate. Here are some things that are on our radar screens as we look ahead.
The Fed: Who, What and When?
Markets this year have cared more about Ben Bernanke’s lexical propensities than about fundamentals. Right now there are three unknowns with which investors have to contend: Who is going to be leading the Fed after Bernanke retires in January, what is the plan for winding down the QE stimulus programs, and when – over what time period – will that plan be enacted? That’s a lot to digest. Of the two top candidates for the job, current Fed Board of Governors vice chairwoman Janet Yellen is seen as fairly close to Bernanke in outlook and temperament, while former Treasury Secretary Larry Summers has at times been critical of the effectiveness of monetary stimulus. The winding up of QE will require a deft balancing of prudent policy and market expectations.
Fundamentals in Focus
The uncertainty around Fed policy is shifting investor focus back to those fundamentals. We’re about 80% of the way through the second quarter earnings season and the results have been decidedly mixed. Apple gave a nice boost to the market when it made its numbers, but elsewhere in Big Tech the story has been disappointing. Median earnings per share growth for the companies that make up the S&P 500 technology sector came in at -8.1% for the quarter, versus analyst consensus expectations of -1.1%. In fact the only sectors to beat EPS growth expectations for the quarter so far are financials, healthcare and utilities. The economic recovery continues to show strength, but many companies are finding the sales and earnings growth climate to be challenging.
DC Dysfunction…It’s Ba-ack
It seems like ages since we watched clueless policymakers wrangle over the fiscal cliff, but unfortunately we are likely to be treated to more reckless brinksmanship this fall when that dreaded debt ceiling comes up again. The opening salvos are not promising, and if anything the political landscape appears even less conciliatory now than it was in the immediate aftermath of Obama’s re-election. If there’s one thing that could spark another spike in the VIX and a reversal of fortunes for equities it’s probably going to come from Washington.
With the S&P 500 up more than 20% for the year to date and earnings misses so far failing to make much of a dent in sentiment we continue to see strength in most areas of US equities and some potential for relative gains from certain non-US sectors. But we remain cognizant of the potential bumps in the road.
Hedge funds are back in the news this week. The latest Master of the Universe to be scorched by the sun and come crashing back to earth is Steven Cohen. Cohen, the sole proprietor of $15 billion hedge funds SAC, is in the crosshairs of a major insider trading scandal that has already taken down many of his closest colleagues. It seems that years of 30%-plus returns required a little extra “sauce” – yet another reminder to those who believe in free lunches and tooth fairies that if something looks too good to be true, it probably is. But while the humbled rogues are the ones who make the headlines, some real problems affect a much broader swath of hedge funds and indeed other asset classes that have long styled themselves as “alternatives” – as offering a refuge from the traditional world of stocks and bonds.
Liquidity: A Blessing and a Curse
We normally think of liquidity as a good thing. Liquid markets make it easier to buy and sell assets with confidence that the price you see is the price you get. But at the same time, the liquidity that comes from easier access – which has happened successively with historically low-correlation assets like commodities, REITs and now hedge strategies – makes it more likely that those assets will correlate more closely to traditional stocks and bonds.
Think of it this way: commodities used to be accessible only to investors with the means and the knowledge to invest directly in futures contracts – a small number of souls indeed. Now anyone with $500 can purchase a commodities ETF on eTrade. Hedge funds, too, have moved into the world of regulated mutual funds. That’s good for enabling more investors to build diversified portfolios: the catch is that those diversification benefits diminish when assets trade more on whether or not Ben Bernanke says “tapering” and less on the fundamental merits of individual assets or business cycle considerations.
More Fishermen, Fewer Fish
You can see this effect in the numbers. Over the last five years the correlation between the HFRI Fund of Funds Index and the S&P 500 has been 0.76 (where 1.0 represents perfect positive correlation). By contrast this value was 0.32 in the five years from 1991 to 1996. Even more strikingly, the correlation between the Dow UBS Commodity index and the S&P 500 was 0.02 in the 1991-96 period – basically implying no correlation at all – and had shot up to 0.81 by 2008-13. It is not a mere coincidence that the first ETF launched in 1993 and has since grown to a market worth nearly $1.5 trillion in total assets.
This makes it harder for intrepid money managers to discover untapped nooks and crannies in the global capital markets. It’s like a pond teeming with fish: a few folks stumble upon it, cast their lines and hook one fish after another. Then word gets out, the hordes descend and the fish disappear. The money managers find it increasingly hard to prove their prowess in delivering alpha. Some – like SAC – turn to more desperate measures to create the illusion of success, and fall hard when their luck runs out.
Sentiment in risk asset markets has taken a sharp turn for the better in 2013 year to date, and the bulls are making a rather compelling case that the good times may roll on for awhile yet. The S&P 500 surged to yet another record level on a jetstream-strength tailwind of $19.7 billion of net new assets poured into global equity funds. That’s the most since June 2008, as good a sign as any that the fear-greed pendulum has well and truly crossed the full horizon. That being said, the funds flow has been unusually concentrated. Of that $19.7 billion a full $17.5 billion went into US funds, and $6.5 billion into one single asset – the SPDR S&P 500 exchange traded fund (SPY). No wonder the S&P 500 is proving to be such a formidable benchmark for active money managers to beat this year.
Bye Bye Bonds
The gains in equities have come at the expense of bond funds, which saw $700 million of net outflows. Most of the outflows relate to rate-sensitive areas like US governments and investment grade corporates, along with emerging markets funds, while high yield funds saw sizable net inflows. That is not altogether surprising, as high yield bonds often exhibit trading patterns closer to equities than to other bond asset classes. This week’s bond exodus didn’t do much to move the needle on broad market yields, though. In fact the 10 year yield has generally trended downwards over the week, staying just below 2.5% as Friday trading approached the close.
Banks Rock, Techs Lag
With around 25% of the S&P 500 companies reporting on 2Q performance thus far the picture is a bit more mixed than the general euphoria of weekly funds flows. Financials are leading the way and tech, laden down by Apple, is bringing up the rear. The financial sector overall is showing earnings growth of 24.3%, highest overall for the second quarter in a row. In fact when you take financials out of the equation the blended earnings growth rate for the S&P 500 overall falls from 1.1% to -3.5%. Big names like Citigroup, JP Morgan and Bank of America have provided much of the strength, and interestingly the consumer finance subsector is the strongest overall. Rock on, US credit card users.
Apple as Albatross
If giant banks are a blessing to the financial sector, one behemoth is proving to be a curse on the tech sector. That would be Apple, the largest company by market cap on the S&P 500. Earnings growth for S&P technology companies is -9.4% based on current consensus expectations, but if you take Apple out of the equation that jumps to only -6.9%. Perhaps most ominously, sales of iPads are projected to fall 14% over the next year. The iPad Mini is experiencing some stiff competition in that space from Amazon’s Kindle, among other factors. Proving yet again that when it comes to tech, yesterday’s darlings can find it challenging to sustain the high expectations that come with being #1.
The phrase “BlackBerry Panic” gained currency back in the dark days of 2008. It was a wry, very apt touchstone for how policymakers kept one nervous eye on the flashing screens of their smartphones while trying to figure out how to save the financial world from ruin. Well, it’s 2013 now. BlackBerries are well on their way to becoming quaint relics of a time gone by, and financial Armageddon is not looming directly overhead. But whether from a high resolution iPad 4 or a sleek Samsung Galaxy, the daily upticks and downticks of asset prices continue to jump out of cyberspace and into the attention spans of Ben Bernanke and his Board of Governors colleagues.
After the sharp run-up in bond yields and a (relatively minor) correction in US equities, Bernanke used his microphone time this week to belabor the point that there is no definition of “tapering” in the dictionary that equates to “imminent rate hike”. Markets got the point. The S&P 500 clawed back all of its June losses and then some, closing out July 11 at 1672. The 10-year Treasury yield fell back below 2.6%, and the VIX Volatility index – Wall Street’s “fear gauge” – crawled meekly back below 13 after surpassing 22 in late June. So the gods are in Valhalla and all’s right with the world?
Beware the Net Outflows
Not necessarily. It’s perfectly understandable why Bernanke wants to jawbone markets, particularly bond yields. The surge from 1.6% to 2.7% on the 10 year note was overblown and not justified by credit market fundamentals. But investor behavior is not rational, and an outcome of selling begetting more selling could inflict real damage on business decisions around hiring, capital investment and the like. Hence Bernanke’s deliberate spelling out the difference between tapering and an actual change in interest rate policy.
Kick the Habit…But Not Yet
But the subtext to this is that once again the policy goalposts are susceptible to being moved. Since the announcement of QE3 last year the oft-quoted benchmark for economic improvement was an unemployment rate of 6.5%. Now some of the more dovish Fed governors are floating 6.0%, or maybe something else instead. “We’ll know it when we see it”, one supposes the governors to be saying to each other in their private conversations. Meanwhile, keep the punchbowl spiked so that assets don’t do something crazy like go off and respond to actual, real supply and demand dynamics.
Waiting for Capitalism
Amid the nervous chatter in the past several weeks there have been not a small number of voices expressing pleasure in the expectation that these real-world fundamentals might be on the horizon again. Sure, there might be a few months or more of unpleasant adjustment, but then the patient will be able to stand on its own two feet again. Credit markets can reflect the equilibrium between borrowers and savers without the Great Nanny hovering overhead with $85 billion worth of monthly injections. We’re not there yet. When Ben Bernanke switches off his smartphone and sits down to make policy without wondering where the Dow’s at, or how much net outflow took place in bond mutual funds this week, then we’ll be a bit closer to letting capital markets do what they do best – to discover their own prices and values.
They conferred in elegant conference rooms in the classical-style École des Beaux Arts building that houses the Federal Reserve Board, to discuss the problems created by years of pumping cheap money into the economy. The need for that cheap money is no longer a present day reality, they said. In anticipation of a resumption of economic growth we must raise interest rates from the recent low levels that have never been seen in the history of our Republic – a 1.6% yield on the 10 year Treasury! The policymakers acted accordingly, and a 30 year macro bear market for interest rates ensued.
Coming Full Circle
No, that is not a speculative musing about the future, but a recitation of actual US economic history. The year was 1951. The cheap money was the legacy of an economic depression and, more recently, the cost of financing the country’s involvement in the Second World War. The US was the world’s sole economic superpower and its only viable source of growth, but the monetary policymakers of the day knew that real growth could not come on the back of cheap money. No free lunch they said, rates have to rise. And rise they did, with the 10-year yield going from 1.6% after the war to 15.4% by 1981.
Now we have come full circle. After five years of historically cheap money investors are looking at the bond market, and nightmarish visions of that 1951 Treasury Accord are dancing in their heads. With one day left in the second quarter the Barclays US Aggregate Bond index has returned -2.43% since April 1. The exit doors are jammed with fleeing moneyfolk – in the last four weeks $23.7 billion has left the bond market via net mutual fund outfllows, the most since the days of indiscriminate panic selling in October 2008. By comparison the S&P 500 is up by 3.4% for the quarter even after the recent 5.8% correction.
The Gathering Storm?
That frenetic selling is not helping bonds regain ground. When investors pile out of an asset the managers who run funds holding those assets have to sell to redeem the exiting investors. That selling drives prices down further, leading to more investors getting out, and a vicious circle ensues. There’s a bit of that going on now – quite honestly there is not a compelling case to make on the basis of economic fundamentals for the 10 year yield to jump from 1.6% to 2.6% in just five weeks. We imagine it likelier than not that cooler heads will prevail in the near term. But we have glimpsed the shadow of the bear, if not yet the bear itself.
Unfortunately there’s not much in the way of safe houses in today’s environment. Bonds are down, stocks are off their highs, commodities are faring poorly and there is great carnage in emerging markets. If we are headed towards renewed growth, as we continue to believe is the likeliest scenario, then presumably this too will pass. But it’s not a good time for the queasy or the faint of heart.