Like most of our fellow investment practitioners, we subscribe to a variety of daily market digests – those couple paragraphs at the market’s opening and closing bell that purport to tell us what’s up, what’s down and why. A brief summary of these digests over the course of 2017 might go something along the following lines: la la la la TAXES la la la la TAXES la la la…you get the picture. Not corporate earnings, certainly not geopolitics – nothing, it would seem, has the power to capture Mr. Market’s undivided attention quite the same way as potential changes to our tax code.
Well, this week is one of those times where the subject is front and center as Congress attempts to set the process in motion for some kind of tax “reform” before the end of the year. As we write this, more information is coming out about what the legislation may, and may not, ultimately include. We should note that it is far from certain that anything at all will be accomplished within this year. Taxes affect everyone in some way – individual and institution alike – and literally every item on the table will have its share of vocal backers and opponents. Over the coming weeks we will share further insights on these developments; our purpose today, though, is to consider at a more fundamental level the relationship between taxes, economic activity and markets.
Taxes and Growth
One of the central motivations for just about any attempt at tax reform is to stimulate economic growth. There are plenty of competing ideologies about this – and it matters for purposes of the discussion whether we are talking about the short term or the long term. But one reasonable question to ask would be how relevant a factor tax rates have been as an influencer of growth over the long term. The chart below illustrates year-on-year GDP growth in the US since 1950, along with the top marginal (individual) tax rate over the same period.
Top tax rates on wealthy individuals were very high – 91 percent in the 1950s and a bit lower (77 and then 70 percent after 1964) before coming down to 50 percent in the first wave of Reagan-era tax reform in the 1980s. Subsequently they have fluctuated between the high and the low 30s through the successive policies of the Clinton, Bush and Obama administrations. What conclusions could be drawn from the impact of alternative tax regimes on long term economic growth? In our opinion only one; namely, that any correlation between marginal tax rates and growth is very weak, at best. The high rates of GDP growth in the 1950s and 1960s took place neither because of nor in spite of high taxes, but for a whole host of other reasons based on global economic conditions at the time.
The same could be said when considering the economic growth spurt of the 1990s, after the Clinton administration had raised taxes in 1993: the growth happened because of many different variables at play, and taxes were at best a peripheral consideration. It is particularly important to keep this absence of causation or even correlation in mind when we are told by policymakers that any revenue lost from tax rate reduction will pay for itself from higher growth. That’s ideology – but the numbers simply aren’t there to back it up, and not for lack of ample data.
Taxes and Earnings
Individual tax rates are only part of the equation, of course. A big part of the market’s focus this year has been on corporate taxes. The statutory US corporate tax rate of 35 percent is high by world standards, so the argument goes that reducing this rate to something more competitive (with 20 percent being the number floated in the current version of the plan being floated by Congress) would be a powerful catalyst to grow US corporate earnings. How does this claim stack up?
At one level the math is fairly simple. Earnings per share, the most common number to which investors refer to measure the relationship between a company’s profits and its stock price (expressed as the P/E ratio), is an after-tax number. If Company XYZ paid 35 percent of its operating profits to the tax man last year, but this year Uncle Sam only gets 20 percent of those profits, then the other 15 percent is a windfall that goes straight to the bottom line (to be retained for future growth or paid out to shareholders at the discretion of Company XYZ’s management). That growth – all else remaining equal – will make XYZ’s shares seem more reasonably priced, hence, good for investors.
There are two things to bear in mind here. First, that tax windfall happens only once in terms of year-on-year growth comparisons. Once the new rate sets in, XYZ will get no future automatic tailwind from taxes (i.e., EPS growth will then depend on the usual revenue and cost trends that drive value). Second, the potential ongoing benefits from the lower tax rate (e.g. a larger number of economically viable investment projects) will depend on many factors other than the tax rate. It’s not irrelevant: taxes do figure into net present value and weighted average cost of capital, which in turn are common metrics for go / no-go decisions on new projects. But many other variable are also at play.
The other issue with regard to the statutory tax rate is that it is a fairly poor yardstick for what most companies actually pay in taxes. The mind-numbing complexity of the US tax code derives from the many deductions and loopholes and credits and other goodies that influential corporate lobbyists have won for their clients over the years. The influence of these groups is already on display: the US homebuilder industry, for example, has come out vehemently against some of the proposed changes being floated by policymakers. Time will tell how successful any new legislation will be at productively broadening the base (i.e. reducing the loopholes and exclusions).
So what’s the takeaway? There are many miles to go before the proposal coming out today arrives at any kind of legislative certainty. As managers of portfolios invested for long term financial objectives, our views on taxes focus largely on how they impact, or do not impact, key economic drivers over the long term. We will continue to share with you our views as this process continues.
The current bull market in US equities, the pundits tell us, is the second-longest on record. That may sound impressive, given that domestic stock exchange records go back to the late 19th century. But it doesn’t even hold a candle to the accomplishments of the current bull market in bonds. The bond bull started in 1981, when the 10-year US Treasury yield peaked at 15.84 percent on September 30 of that year. It’s still going strong 36 years later, and it’s already one for the record books of the ages.
According to a recent staff working paper by the Bank of England, our bond bull is winning or placing in just about every key measurement category going back to the Genoese and Venetian financial economies of the European Middle Ages. Lowest risk-free benchmark rate ever – gold medal! The 10 year Treasury yield of 1.37 percent on July 5, 2016 is the lowest benchmark reference rate ever recorded (as in ever in the history of money, and people). The intensity of the current bull – measured by the compression from the highest to the lowest yield – is second only to the bond bull of 1441-81 (what, you don’t remember those crazy mid-1400s days in Renaissance Italy??). And if the bull can make it another four years it will grab the silver medal from that ’41 bull in the duration category, second only to the 1605-72 bond bull when Dutch merchant fleets ruled the waves and the bourses.
Tales from the Curve
But does our bull still have the legs, or is the tank running close to empty? That question will be on the minds of every portfolio manager starting the annual ritual of strategic asset allocation for the year ahead. Let’s first of all consider the shape of things, meaning the relative movements of intermediate/long and short term rates.
We’ve talked about this dynamic before, but the spread between the two year and ten year yields is as tight as it has been at any time since the “Greenspan conundrum” of the mid-2000s. That was the time period when the Fed raised rates (causing short term yields to trend up), while the 10-year and other intermediate/long rates stayed pat. It was a “conundrum” because the Fed expected their monetary policy actions would push up rates (albeit at varying degrees) across all maturities. As it turned out, though, the flattening/inverting yield curve meant the same thing it had meant in other environments: the onset of recession.
An investor armed with data of flattening yield curves past could reasonably be concerned about the trend today, with the 10-year bond bull intact while short term rates trend ever higher. However, it would be hard to put together any kind of compelling recession scenario for the near future given all the macro data at hand. The first reading of Q3 GDP, released this morning, comfortably exceeded expectations at 3.0 percent quarter-on-quarter (translating to a somewhat above-trend 2.3 percent year-on-year measure). Employment is healthy, consumer confidence remains perky and most measures of output (supply) and spending (demand) have been in the black for some time. Whatever the narrowing yield curve is telling us, the recession alarms are not flashing orange, let alone red.
Where Thou Goest…
So if not recession, then what? Leave aside for a moment the gentle undulations in the 10-year and focus on the robust rise in the 2-year. There’s no surprise here – the Fed has raised rates four times in the past 22 months, and short term rates have followed suit. Historically, the 2-year yield closely tracks Fed funds, as the chart below shows.
The upper end of the Fed funds target range is currently 1.25 percent, while the 2-year note currently yields 1.63 percent (as of Thursday’s close). What happens going forward depends largely on that one macro variable still tripping up the Fed in its policy deliberations: inflation. We have two more readings of the core PCE (the Fed’s key inflation gauge) before they deliberate at the December FOMC meeting. If the PCE has not moved up much from the current reading of 1.3 percent – even as GDP, employment and other variables continue trending strong – then the odds would be better than not the Fed will stay put. We would expect short term rates, at some point, to settle perhaps a bit down from current levels into renewed “lower for longer” expectations.
But there’s always the chance the Fed will raise rates anyway, simply because it wants to have a more “normalized” Fed funds environment and keep more powder dry for when the next downturn does, inevitably, happen. What then with the 10-year and the fabulous centuries-defying bond bull? There are plenty of factors out there with the potential to impact bond yields other than inflationary expectations. But as long as those expectations are muted – as they currently are – the likelihood of a sudden spike in intermediate rates remains an outlier scenario. It is not our default assumption as we look ahead to next year.
As to what kept the bond bull going for 40 years in the 1400s and for 67 years in the 17th century – well, we were not there, and there is only so much hard data one can tease out of the history books. What would keep it going for at least a little while longer today, though, would likely be a combination of benign growth in output and attendant restraint in wages and consumer prices. Until another obvious growth catalyst comes along to change this scenario, we’ll refrain from writing the obituary on the Great Bond Bull of (19)81.
And the band plays on. Some random convergence of factors could conceivably interrupt and reverse today’s upward push in the S&P 500 before the benchmark index ends with its seventh straight record close…but those would likely be bad odds to take. Yesterday was the 30 year anniversary of 1987’s Black Monday, when stocks tanked by more than 20 percent in a single day. Financial pundits, with not much better to do, spent much of the day in college dorm-style bull sessions with each other, speculating about whether 10/19/87 could ever happen again. It certainly didn’t happen yesterday, even though lower overnight futures injected a frisson of excitement into the morning chatter that dissipated as the afternoon yielded a predictable recovery and small gain for share prices.
We feel for those journalists – it’s tough being a financial commentator these days! Nothing ever happens except for the market shrugging off any potentially disruptive event, while displaying brief spasms of ecstasy whenever the subject of tax cuts percolates to the top of the daily news feed. Now the chatter is homing in on what may well be the only remaining story of any note (from the market’s perspective) before the end of the year: the identity of the new Fed chair when Janet Yellen’s term ends next January. A decision is supposedly forthcoming in the next couple weeks (the incumbent administration suggests it will be before November 3). Our sense is that, regardless of who among the short-listed candidates is tapped, the impact on markets will likely be negligible.
If It Ain’t Broke…
There are two issues at stake here: first, who the winning candidate will be, and second, how that candidate would actually govern once ensconced in the Eccles Building. There are currently five names under consideration. On a spectrum from dove to hawk they read as follows: current Fed governor Jerome (Jay) Powell, current Fed chair Janet Yellen, former Fed governor Kevin Warsh, Stanford University economist John Taylor, and current Trump advisor Gary Cohn. Let’s say right off the top that we see next to no chance that Cohn will draw the winning ticket; among insiders close to the decision process, his name appears to still be in the mix for cosmetic reasons only.
That leaves four. Two, Powell and Yellen herself, reliably fall into the camp of “stay the course” – their votes on FOMC policy decisions, after all, are publicly documented and widely known. Speculation this week has Powell as the overall front-runner with considerable support both from the administration’s inner circle and among both Republican and Democratic senators who will be involved in the confirmation process. There would be a rational logic for Trump to ultimately thumbs-up Powell: in so doing, he would be making the safest choice for business as usual, while still getting to theatrically crow to his base that he dumped the Obama-era Fed head.
…Don’t Fix It
Just because Powell’s star seems ascendant this week, though, does not mean that the two more hawkish choices of Warsh or Taylor are out of the picture. This is not an administration known for predictably rational decision making. So what happens then? Speculation is particularly focused on John Taylor, the Stanford professor whose “Taylor rule” – a mathematical formulation of the responsiveness of interest rates to inflation and other economic inputs – suggests that rates should currently be higher than they are. Would a Taylor Fed necessarily mean a dramatic acceleration of rate hikes and attendant balance sheet normalization?
Perhaps not. It’s worth remembering that a Taylor Fed would be looking at the same data as the Yellen Fed, and that data include inflation readings, the danger-zone indicators of which are conspicuously absent. The Taylor rule is not immune to the inflation conundrum with which the Fed’s other analytical models have struggled. It’s also worth remembering that the Fed chair still has to take into account the positions of the other FOMC voting members. Whoever the new chair is, he or she will not be any less interested in building consensus towards unanimous decisions than past chairs. That’s how stable monetary policy is conducted.
The global economy is largely in sync with low to moderate growth, decently functioning labor markets and modest levels of inflation. That’s the real context in which stock prices can keep drifting up with no sizable upside headwinds. We think it is unlikely that, come 2018, a new Fed will be tempted to push their luck with policies that could choke off the growth before its time. For these reasons we think it unlikely that the identity of the new Fed chair will stand in the way of a business-as-usual mood in the market that, barring something currently unforeseen, could carry into and through the upcoming holiday season.
One of the odder stories in a year of general strangeness in the capital markets is emerging markets. Contrary to the vast majority of expectations in the wake of last November’s presidential election, this asset class has been the darling of diversified portfolios in the year to date. The MSCI Emerging Markets index was up more than 28 percent YTD at the end of the third quarter – double the performance of the not shabby 14 percent logged by the S&P 500. Nor is the good news limited to equities; EM currencies have mostly risen against the dollar. Perhaps to underscore the weird irony of the situation the Mexican peso – the currency on the receiving end of all those nativist threats of security walls and trade wars and the like – has gained more than 15 percent against the dollar since January 1.
Reclaiming Lost Heights
In local currency terms, emerging markets equities reached all-time highs this year. In the dollar terms by which US-based investors measure their profits, though, EM stocks still have a bit of ground to make up from their peak during the great growth spurt of 2003-07. The chart below shows the MSCI EM Index (in dollar terms) for the past 15 years.
That 2003-07 run came courtesy of several factors unlikely to repeat themselves. These were the years of the great China boom: the country’s record-breaking surge to become the world’s second largest economy and largest producer / consumer of so many raw materials and finished goods happened in what seemed the blink of an eye. These years also witnessed what is likely to be the final phase of an extended commodities supercycle, which gave resource exporters like Russia and South Africa a few extra points of GDP growth to tack on. Emerging markets became synonymous with “growth” – often real GDP growth of the double digit variety.
Then it all came crashing down. The financial follies concocted in the quant labs of Wall Street and the City took down emerging and developed asset markets alike. The slow pace of growth in the ensuing global recovery has not been kind to many of those former growth market Wunderkinder. Brazil and Russia experienced deep recessions, South Africa and Turkey faced increasingly onerous repayment burdens on their outstanding dollar-denominated borrowings, and China has grappled with the complexities of managing stable currency and credit markets while still trying to hit their growth targets. Given all the challenges, perhaps the most surprising thing about that chart shown above is that this asset class didn’t fare worse than it did during those sideways years of 2010-16.
What Flavor Crisis This Decade?
So where do they go from here – and are investors wise or foolish to follow? One of the important things an investor should always keep in mind about emerging markets is their dynamism – in the sense that the composition of these economies changes more fluidly from year to year than their developed world counterparts. Their installed base of productive resources, their monetary policies and the consumption habits of their citizens are all vastly different today from what they were fifteen or twenty years ago.
That is important because it was precisely twenty years ago that emerging markets fell into one of their periodic traps that turn investors’ stomachs. A crisis in the baht, Thailand’s national currency, went viral and wreaked havoc on currencies and central bank balance sheets from Seoul to Jakarta and beyond. A year later Russia defaulted on its sovereign debt obligations, swallowing up local punters and rich world hedge funds alike. There is a “crisis a decade” school of thought among long-term EM observers, going back to the Latin American debt crises of the 1970s and 1980s to Asia and Russia in the 1990s, Argentina in the 2000s and on and on.
The practical effect of these crises is well-documented: never contained as a local affair, the pain spreads as investors treat their emerging market exposures as one asset class. Never mind if Argentina and Malaysia have almost nothing in common: they rise together and fall together in the capricious ebbs and flows of portfolio capital. For this reason, the asset class as a whole has been a long term loser. Since the beginning of 1990, the average annual return of the MSCI EM index has been about 1 percent lower than that of the S&P 500 – but the risk, measured by standard deviation, has been a full 8 percent higher. “No gain, lots of pain” sums up this portfolio contribution.
Traps Old and New
It would be unwise to project the failures of 1997-98 onto possible negative scenarios for the near future. EM central banks have become much more robust in terms of foreign exchange reserve defenses, and their vulnerability to developed market currencies is mitigated by a growing portion of local currency credit instruments to fund their domestic investment initiatives. Many emerging markets today look…well, less “emerging” and more mature than they did even a decade ago.
But with maturity comes a new set of challenges, and potentially new kinds of traps. Resource exporters like Russia and South Africa will remain vulnerable to a potential weak secular cycle in commodities. Countries whose primary source of competitive advantage is cheap labor are at risk in a world where AI threatens to upend traditional employment patterns in industry after industry. Technology is widening the gap between the handful of companies able to leverage leading-edge technology in their business models and the legions of stragglers struggling to keep up. These are all traps that could trip up countries and regions in that delicate transition from widespread poverty to wealth. And all of this is to say nothing of the lurking threat of protectionism and nationalist nativism from disgruntled voters and their political avatars in the US or the EU.
The developed world is not growing quickly, and this pattern is likelier than not set to continue. If the combined heft of emerging markets can unlock a formula for higher sustainable growth then these markets are worth keeping in strategic asset allocations – and one would expect the risk-return composition to be more favorable than it has been in the past. But these are still significant ifs. We believe investing in emerging markets will call for more nuance going forward, starting with the practice of not treating this widely diverse collection of markets as one asset class.
Another week, another string of record highs for U.S. equities. But this wasn’t just your normal “upward drift for no particular reason” set of days. It was an “upward drift for no particular reason AND a 20 year record smashed!” sequence of new highs. Yes, the last time the S&P 500 recorded six consecutive all-time records was in June 1997, back when the Spice Girls were telling us what we want, what we really, really want. And while prices continued their inexorable ascent, volatility continued to plumb new lows. The CBOE VIX index, the market’s so-called “fear gauge”, suggests that times have never been safer for equity investors: the index has closed below 10 more times in 2017 than in any other year since the VIX first launched in 1990.
The Great Risk Conundrum
This presents a conundrum: while the S&P 500 is more expensive than any other time in the past hundred years (the heights before the market crashes of 1929 and 2000 being the exceptions), it is also serenely placid. Contrast today’s environment with the stretch of market history leading up to the 2000 dot-com crash. The chart below shows the VIX index price trend from 1998 to the present.
The contrast between today and the late 1990s is noteworthy. The S&P 500 reached a then-all time high of 1527 in March 2000. As the above chart shows, though, the final two years of that bull market came with exceedingly high volatility. A VIX price of 20 or higher is considered to be a high risk environment; the index remained above that level for much of the final stretch of that raging bull market. In the mid-2000s the situation was different, but the VIX still was consistently trading at elevated levels well in advance of the 2008 crash.
See No Evil, Hear No Evil
During both of those earlier periods (i.e. 1998-2000 and 2006-2007) markets were jittery for a variety of reasons. Periodic pullbacks in the stock market reflected these concerns – in particular, the Russian debt default of 1998 that led to the collapse of hedge fund Long Term Capital Management, and then, in early 2007, the failure of two Bear Stearns mortgage-backed funds that turned out to be the canary in the coal mine for the broader financial system meltdown. In both cases, investors would eventually buy the dip and keep the damage contained, but markets would remain in an elevated state of nervousness until the bottom finally fell out.
The message the market sends today is entirely different; namely, that there is literally nothing out there in the big bad world that could have an adverse impact on risk asset markets. Arguably, the one single issue able to move investors to action (in a positive direction) for the past twelve months has been tax reform. This trend, which we highlighted in last week’s column, continues with a vengeance despite a lack of hard evidence that any kind of truly meaningful, broad-base reform will emerge out of the current Congress and White House. Apart from taxes, though, the market seems content to channel its inner Metallica and proclaim that “nothing else matters.”
Even if the “reflation trade” that springs from tax reform hopes dies out again – like it did back in February – we think it more likely than not that the market would simply revert to form and drift ever so gently upwards. Why wouldn’t it? The global economy, if not particularly inspiring, is at least in relative harmony with growth occurring in most major regions encompassing both developed and emerging markets. Not a single piece of headline macro data suggests that the current recovery cycle has peaked. Quite the opposite: when economies peak they tend to overheat, in the form of escalating prices and wages. This simply has not happened. As long as it doesn’t happen, the Fed and other central banks will have a great deal of latitude in guiding their balance sheets and policy actions back towards some semblance of normal.
Thus the “sunny skies” portion of today’s column title. The “swan songs” bit refers to the black swans – the unexpected events that can suddenly emerge from the murky sea of risk factors and knock Ms. Market off her game. We know from observing market behavior this year that the bar is high indeed for the kind of black swan that could have an impact. But the very definition of a black swan is something you can’t name because you have never seen it before – so you have no way of quantifying what it is before it happens. Presumably there will be such swans in our not too distant future. One or two such events could even be of such import as to keep market volatility elevated for longer, akin to that stretch of bull market between 1998 and 2000. Then – and perhaps only then – do investors’ thoughts turn seriously to questions of more defense in their allocation strategies.