It was Game On week. No, not the NCAA basketball tournament with its annual goody-bag of Cinderella stories and humble pie for top seeds, but the opening salvo of the elections in Europe about which we’ve all been chattering since the beginning of the year. What message will those discontented bodies politic in the fraying Eurozone send to global markets? Vox Populi rising, or more of the same?
Nee, Non, Nein
“Nothing here, move on” might be an appropriate response to this week’s contest in the Netherlands, and indeed much of the post-election commentary focused on the singular Nee – Dutch for No – served up by the voters to anti-immigrant polemicist and Freedom Party (PVV) head Geert Wilders. A stunning 82 percent of the citizenry turned out (dream on, America!) to give Mr. Wilders the thumbs-down and enable incumbent Mark Rutte and his VVD party to form a new government. This outcome fits rather neatly into a long-held view that, while disgruntled Europeans may register their unhappiness in polls and in the less consequential votes for the EU representatives they send to Brussels, they will heed their better angels when voting in their own national governments. Historians will point out that ethnocentric populism, while always present, has never managed to crack the high 30s in percentage terms over more than a century of national electoral contests. In this reading of the current environment, the Dutch “Nee” is likely to be followed by a French rejection of Marine Le Pen in favor of centrist Emmanuel Macron, and a vote for more of the same in Germany when Angela Merkel seeks her fourth term. Certainly these would have to be considered the default outcomes in the absence of any new news.
The Math of Discontent
A closer read of the Dutch outcome, though, tells a somewhat different story and one that would appear to be well in line with broader trends both within and without the Old Continent. The PVV – Wilder’s party – didn’t actually lose parliamentary seats but rather gained five. The big losers of the night, by the math of seat gains or losses, were the two establishment parties. PM Rutte’s PVV lost eight seats (though still retaining its position as the largest single party). But the PVV’s coalition partner, the Dutch Labor Party (PvdA) lost a stunning 29 seats. That adds up to a net loss of 37 for the Establishment. It also serves up yet more evidence that the traditional European left (think Britain’s beleaguered Labor Party or France’s Socialists with a 4 percent favorability rating) is in a death spiral.
Meanwhile three “alternative” parties – the left-leaning, Europhile D66 and Green List and the center-right, quasi-populist CDA, picked up 23 seats between them. Adding Geert Wilder’s 5 seats means that a non-Establishment alternative, split roughly between pro and anti EU sentiment, will play an outsize role in the new government. With no clear mandate for either bailing out of the EU/Eurozone or doubling down on open borders and free trade, the result is likely to be a lack of clear direction one way or the other. This outcome much more resembles the recent past than it does some bold new step forward. Populism may have its limits, but so does globalism.
Mr. Market’s Quiet Genius
For the past couple months we have spilled a great deal of ink on the pages of this column finding fault with the so-called “reflation-infrastructure” trade that appeared to be based on little other than hope and animal spirits. But we are starting to see a little method in the apparent madness of the markets. No – there is no infrastructure pony out back with a Christmas bow around its neck. There never was. Just as in Europe, our own policy engine is stuck in second gear, and not just on account of the apparent own goals the current administration and Congress keep making. Ours, too, is a body politic divided, and those divisions are, so far at least, keeping in check any decisive movement juggernaut in one given direction.
And that suits Mr. Market just fine, thank you very much. Hey – economies are doing pretty much okay on their own, here at home, in Europe, Japan and much of the emerging world. Citizens are disgusted with their governments for some very valid reasons. The less interference we get from misguided policymakers, goes this line of thinking, the better. No action is good action. Continued improvement in jobs and wages, with a modest but not frenetic pick-up in prices, all in the context of real GDP growth of two percent or a bit more – that’s enough for now. Enough to keep corporate earnings growing at least in the mid-high single digits. These may not be the best of times, but neither are they the worst. As long as things remain more or less as they are, this bull market can perhaps enjoy an extended sunset rather than suffering an abrupt end.
One of the great debates among the economic literati in recent years has been whether the subpar growth trends of late are cyclical or more long term in nature. The bearish long term view goes by the name “secular stagnation,” with advocates including former Treasury secretary Lawrence Summers making the case for a world stuck in a rut of anemic capital investment and lackluster demand. Two years ago, secular stagnation seemed like a pretty good theory to explain the deflation trap threatening to ensnare the Eurozone, zero-bound interest rates in the US, and many former growth darlings in emerging markets falling into low single digit or negative growth.
Macro headlines today tell a rather different story. In the US jobs, wages, prices and consumer confidence are all trending uniformly higher, as indicated in the chart below.
Meanwhile, Eurozone inflation has bounced back and even Japan is enjoying a relatively unusual run of positive growth. Most Asian economies are performing decently, if not necessarily spectacularly, while erstwhile basket cases Brazil and Russia seem to have gotten through the worst of their travails. Is it time to put a fork in the secular stagnation theory and call it done? Asset markets certainly seem to think so; today’s valuation levels can only appear reasonable if premised on the imminent resumption of historical-trend growth. But before we read last rites and sing Psalm 23 over the corpse of secular stagnation, we need to supply an answer to the question of what forces are present to drive that historical-trend growth.
The term “secular stagnation” is not new; it was coined in 1938 by prominent US economist Alvin Hansen. If you are familiar with US economic history you will recall that 1938 was the trough year of the second sharp pullback of the Great Depression: not as deep as the earlier one that bottomed out in 1932 but still painful, with unemployment at 20 percent and a steep decline in US population growth. Hansen looked around him and saw no way out; the world was locked into that dreaded feedback loop where businesses invest less because they expect continued lower demand, and households spend less because there are fewer jobs. Secular stagnation, in other words.
As we know now, of course, the world didn’t turn out that way at all. Instead, the onset of the Second World War unleashed a torrent of economic growth to supply the war effort, and after the war the US, as the sole economic superpower, ushered in a glorious thirty year period of steady and sustainable growth. The secular stagnation theory was laid to rest, until its resurrection by Larry Summers et al in the 2010s.
Attractive Economy Seeks Feisty Catalyst for Growth, Good Times
The headline economic data shown in the chart above are promising, but they are not yet sufficient to return secular stagnation to the box where it rested from 1939 to 2010. While the circumstances that produced the magnificent growth from the late 1940s to the early 1970s are complex and varied, the growth drivers themselves are easy to pinpoint. First, a return to population growth after the anomalous decline of the Depression years. Second, growth in labor force participation as returning war veterans went into a booming job market (and were later joined by a rising level of participation by women). Finally – and most importantly – was growth in productivity, or efficiency gains in how much output businesses could produce for each hour worked.
Are we on the cusp of another productivity boom? The data do not yet point to one. The chart below shows US productivity trends, along with the labor force participation rate, for the last thirty years. Both of these growth indicators remain decisively below-trend.
Some argue that the innovations of recent years will be that much-sought catalyst desired by the global economy. Expansive pundits talk of the Holy Trinity of the Three Industrial Revolutions: the steam engine of the late 18th century, electricity and the internal combustion engine a century later, and the smartphone in the early 21st century. Perhaps history does move in such well-tempered cycles; alternatively, perhaps the culture of growth that grew up around the first two Industrial Revolutions will be seen by future historians as a delightful anomaly rather than an inevitable forward march of progress. Time will tell whether this third iteration can deliver the goods.
The heady cocktail of animal spirits and hope that is the so-called reflation-infrastructure trade has many fans, but perhaps none more so than the monetary policymaking committee of the Bank of Japan. One of the first casualties of last year’s big November rally was the yen, which plummeted in value against the US dollar. That plunge was just fine, thank you very much, in the mindset of Marunouchi mandarins. A weak yen would make Japanese exports more competitive, while the continuation of easy money and asset purchases at home would finally create the conditions necessary for reaching that long-elusive 2 percent inflation target.
Lo and behold, the latest price data show that Japan’s core inflation rate rose 0.1 percent year-on-year in January, the first positive reading in two years. Only 1.9 percent more to go! Expectations of stimulus-led growth, continued weakness in the yen and a return to brisker demand both at home and in key export markets have led Morgan Stanley’s global research team to name Japan as the stock market with the most attractive prospects for 2017.
Patience Has Its Limits
Beleaguered long-term investors in Japan’s stock market would be more than happy to see Morgan Stanley’s prognostications come true – but they have heard this siren song before. The Nikkei 225 stock index reached a record high of just under 40,000 on the last trading day of 1989. As the chart below shows, things have been pretty bleak since those halcyon bubble days when the three square miles of Tokyo’s Imperial Palace were valued by some measures as more expensive than the entire state of California.
If the Morgan spivs are right about Japanese shares, and keep being right, it will represent a decisive break from a struggle of more than two decades for the Nikkei to sustain a level greater than 50 percent of that all-time high value. Prior to 2015, the Nikkei had failed to even touch that 20,000 halfway point at any time since March 2000 (which, as you will recall, was when the US NASDAQ breached 5,000 just before the bursting of the tech bubble). 2015 represented the high water mark of investor expectations for “Abenomics” – the three-pronged economic recovery program of Prime Minister Shinzo Abe – to deliver on its promises of sustained growth. Those expectations stalled out as the macro data releases kept pointing to more of the same – tepid or negative growth and the failure of needed structural reforms to take root. Japan’s problems, as anyone who has studied the long-term performance of the one-time Wunderkind of the world economy will tell you, are deep and very hard to dislodge.
No Really, It’s Different This Time
Abe is not the first prime minister to apply stimulus in an effort to shake the economy out of its lethargy. Massive public works programs have been a hallmark of the past quarter century. Over this time, yields on the 10-year benchmark Japanese Government Bond (JGB) have never risen above 2 percent (including during periods when yields on US and European sovereigns were at 6 percent or higher). The 10-year yield’s trajectory is shown (green trend line) on the chart above. No amount of stimulus, it would seem, was enough to convince Japanese households to go out and spend more in anticipation of rising prices and wages.
So what is it about the current environment that could induce Japanese share prices to break the 50 percent curse for once and all? We would imagine the answer to be: not much. While it is true that both the US and Europe look set to continue a modest uptrend in growth and demand (with or without the reflation jolt catalyzing all those animal spirits), Japanese companies are not necessarily positioned to benefit – certainly not in the way they did in the very different economy of the 1970s-80s when “Japan as Number One” was required reading for MBAs and corporate executive suites. While they have arguably become more shareholder-friendly in recent years, as evidenced by higher levels of share buybacks and the like, corporate business practices remain largely traditional and hidebound. Just a decade ago, these companies blew a once-in-a-lifetime chance to ride the wave of the great growth opportunity that was China – in their own back yard.
There is no magic formula for growth. In a country with an old and declining population (and extremely strict limits on immigration), a supernova-like burst of productivity is the only plausible route to real, organic improvement. Until then, that barrier of 20,000 in the Nikkei may continue to be a tough nut to crack.
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.