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.
Last month, White House press secretary Sean Spicer instructed us that the 235,000 payroll gains recorded for the month of February were a direct and unambiguous consequence of the “surge in economic confidence and optimism that has been inspired since [Donald J. Trump’s] election.” This month it would appear we are back to “fake” job numbers, as the latest batch of data from the Bureau of Labor Statistics not only revised last month’s figure down by 16,000 souls, but the March total of 98,000 came in well below analysts’ expectations of 180,000 new hires.
Equally silly are attempts on the one hand to take credit for one single month’s data point, and on the other hand to point to that of another month as a harbinger of failure (or fake, for that matter). A wave of statistical fluctuation – otherwise known as the “margin of error” – accompanies all economic data releases and means that the variation between what actually happened and what the number shows can be wide indeed. There is no reason to expect that the overall labor market picture is either better off or worse off when considering the two data points from this month and last. More importantly, though, the popular obsession with “The Number,” as the monthly payroll gains figure has come to be known – says little about the real state of affairs in the world of employment.
Who’s In, Who’s Out?
What’s the “natural” rate of unemployment? This is a term economists use to try and define what employment would look like in a theoretically stable economy, i.e. in some sort of harmonious equilibrium between jobs, wages and consumer prices. While nobody can pin down exactly what this rate would be in the messier economy of the real world, chances are that the current unemployment rate of 4.5 percent is not all that far away. The chart below shows the unemployment rate trend over the past 25 years, along with the labor force participation rate, another useful employment metric that adds an important perspective to the longer term structural picture.
The 4.5 percent figure in today’s BLS release is the lowest since the middle of 2007, and the above chart clearly illustrates (green line, left y-axis) the dramatic improvement in overall employment since the 2008 recession. But astute observers will notice something odd about the recent trend. When the unemployment rate skyrocketed during the Great Recession, the labor force participation rate (red line, right y-axis) started to fall sharply. But the participation rate kept falling steadily even as employment perked up, and is still more or less directionless even in the current favorable environment. How should we interpret this trend? In other words, who’s out of the labor market forever, and who’s potentially back in if sufficiently enticed (e.g. by better wages, benefits etc.)?
Back to Work, or Off to the Links
The labor force participation rate reflects several important structural trends. One, of course, is the natural increase in the number of retirees as baby boomers activate their retirement accounts and head off for 18 holes or catamaran vacations or whatever. That this rate has fallen from its peak at the end of the 1990s is not surprising, as the first cohort of boomers hit their sixties shortly thereafter. But the accelerated drop in participation from 2008 obviously includes as well the millions of jobs lost from the recession. The absence of a clear reversal in this trend would seem to indicate that, despite the steady pace of new job creation since 2010 – the longest uninterrupted streak of monthly net payroll gains since the BLS started keeping track of this – a meaningful percentage of those jobs lost during the last decade remain unaccounted for. This is true even when you strip out the retiree cohort on one side and young full-time students on the other. The employment-to-population ratio for the cohort aged 25 to 54 – peak working ages – also remains well below its peak reached in 2000.
Wages and Prices
These structural metrics matter, because an increase in the percentage of working Americans to the total population is one way an economy grows. For that red line in the above chart to become a reliable uptrend probably depends mostly on how much more upside there is in real wage growth. Average hourly earnings grew this past month in line with the recent trend level of about 2.7 percent year-on-year. That’s still higher than monthly consumer inflation, but recent strength in the CPI has narrowed the gap. Real purchasing power increases will continue to depend on wage growth outpacing price growth.
Much of the chatter in financial markets recently has been about the notion that the same animal spirits gripping investors of late will motivate business owners and management teams to sweeten the pot and attract scores of new hires, in anticipation of some wonderful new era of growth. Every month we get a new read from the BLS on the state of things (with the statistical variabilities mentioned above), and each data point gives us another piece of a giant and complex puzzle. What we do know is that none of the measures of long term growth – not the rate of population growth, not the percentage of the population actively in the labor force, and not the productivity rate –validate the assumptions behind those animal spirits. Until they do, we must remain skeptical. And see what goodies next month brings.
It is something of an annual tradition: at some point, usually in the middle of a humid and lazy Atlantic Seaboard August, we will write something about the “dog days” of summer in investment markets. You know – light trading volume and mostly listless price direction, occasionally punctuated by an exaggerated surge or plunge based on some rumor or stray macro data point. Well, this year the dog days have arrived early. A couple one percent-plus days – one down and one up, for reasons that are barely remembered – provided some color to an otherwise tepid month long on political headlines and short on directional action. As the second quarter gets underway, we consider what might – or might not – puncture the market’s smug haze of mellow.
The Beta Economy
The present occupant of 1600 Pennsylvania Avenue may fancy himself an alpha human, but the economy in which his administration finds itself is decisively beta. That’s not a bad thing, mind you. A beta economy means real growth somewhere around two percent – nothing like the alpha economy of the 1990s, but perfectly acceptable, with modest price inflation and a mostly healthy labor market. Much of the rest of the world is enjoying a similar beta vibe. GDP is actually a bit higher in the EU than it is at home, Japan is managing to stay out of recession, and China’s factories are humming along nicely with recent PMI readings for services and manufacturing comfortably above the growth threshold number of 50.
Importantly for investors, a beta economy supplies the most compelling reason not to get fooled by a momentary sell-off like the little one last week. With no sign of a recession in sight, at home or anywhere consequential abroad, there simply isn’t much of a case to make to run for the hills. But what about the upside? Can businesses crank out alpha earnings in a beta economy?
Those Elusive Double Digits
Q4 2016 earnings season is over, and the 5.1 percent growth registered by S&P 500 companies falls well within our definition of “beta,” in the context of the last couple decades of quarterly results. Surprisingly, 5.1 percent is also very close to what analysts were predicting last fall: the FactSet consensus of analyst projections on September 30 pegged Q4 earnings growth at 5.2 percent. Reasonable! But that same consensus group also gave their Q1 2017 estimates on that same day, and that number was a very alpha-like 13.9 percent. Do they still feel that way? Not so much – the revised Q1 consensus number as of today, right before the actual figures start to come out, is 9.1 percent.
That’s still not bad, but it’s not the double digits investors would prefer to see to validate those valuations nearing nosebleed territory. The last twelve months (LTM) P/E ratio touched 20 this week, a level last seen in the post-trough recovery following the 2001-02 recession. The price to sales (P/S) ratio, is at levels last seen in the heady final days of the dot-com bubble at the beginning of the 2000s. We have believed for some time that the “valuation ceiling” remains the biggest headwind to substantial upside gains. Of course, this view has taken quite a bit of flak of late from the ever-popular “reflation-infrastructure trade” that has dominated market chatter for the past five months. Which brings us to our final musing about Q2 market direction…whither the animal spirits?
Momentum Is Its Own Momentum, Until It’s Not
What market pundits continue to call the “Trump trade” has been durable, even as prospects for any kind of sweeping, historic tax reform and massive new spending on infrastructure build out – never an obvious outcome to begin with – have looked less and less likely. But, as we have noted elsewhere in recent commentaries, such upside as there has been for the past couple months really has less to do with those reflation-infrastructure themes than it does with plain old momentum and those robust animal spirits.
Consider industry sectors. Sector-wise, the Four Horsemen of the reflation trade that ignited after the election were financials, materials, industrials and energy. These also happen to be the four sectors trailing the market in 2017 year-to-date, while technology, healthcare and consumer discretionary have all outperformed. Tech and discretionary, in particular, seem like pretty reasonable places to be if you’re comfortable with that beta economy and looking for a low-impact way to continue participating in equities. This low-key sector rotation has kept the rally going even as the original theme behind it went stale.
The problem, of course, is what happens when momentum wanes, as it eventually does? The first thing to watch out for is signs of the return of volatility, which as we all know has been strangely absent for the duration of this most recent phase of the bull market. Even that one-day pullback last week failed to elicit much more than a shrug from the supine VIX index. The market’s vaunted “fear gauge” has stayed in a volatility valley well below 15 for the entire year thus far (compare that with an average level above 20 for the first two months of 2016).
We tend to pay less attention to the VIX’s occasional sharp peaks than to the mesas – those extended periods of baseline elevation around 15-17. A new mesa formation on the VIX would, in our opinion, raise the prospects of a sizable near-term pullback in the 5 – 10 percent range. At which time we could, mercifully, shake off the dog days and get into some desirable new positions at more reasonable values.
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.