It hasn’t been quite the V-shaped recovery of many pundit prognostications. The S&P 500 briefly entered technical correction territory last month, and flirted ever so coquettishly with the 200-day moving average, a key technical trend variable. The ensuing relief rally has seen a couple peaks, but is still climbing the wall back to the record close of 2872 reached on January 26. A month and a half may not seem like a long time – and it’s really not a long time, in the great scheme of things. But other recent pullbacks have done a better job at channeling their inner Taylor Swifts to “shake it off.” The chart below show the pace of the current recovery (leftmost diagram) compared to the brief pullbacks experienced after 2016’s Brexit vote (middle) and the mini-freakout over Ebola in 2014 (right).
So at 42 days, we’re a bit behind the brisk pace of the Brexit (30 days) and Ebola (27 days) pullback-recovery events. But it’s not too much of a stretch to imagine the S&P 500 finding itself scaling the rest of that wall to 2872 in the not so very distant future. Over the course of the current recovery, investors have learned to build an impressive immunity to what one might consider to be bad news. In a sense this is an acquired habit, courtesy of the world’s major central banks.
It Was Just Nine Years Ago Today, Ben Bernanke Taught the Band to Play
Speaking of the “current recovery,” today is its nine year anniversary! Three cheers for the bull. On March 9, 2009 US equity markets hit rock-bottom, more than 50 percent down from their previous highs in the largest market reversal since the Great Depression. Investors in early 2009 were catatonic – many who had managed to keep their heads during the freefalls in September and October of the previous year finally capitulated in March, fearing there was potentially no bottom for risk assets.
Those who held off the demons of fear one last time were rewarded mightily as stocks found solid ground and began the long trek back. But it was not exactly easy street for those first tentative years. 2010 witnessed a handful of significant pullbacks and lots of angst. In 2011 the market flirted with bear territory (20 percent or more down) when the Eurozone crisis accelerated and the US Congress came ever so close to defaulting on the national debt. Other potential black swans lurked in the following years, from government shutdowns to the crash in oil prices to fears of a hard landing in China.
But as each news cycle came and went investors learned to stop worrying. Credit for this learned behavior can confidently be laid at the feet of Ben Bernanke, Mario Draghi, Haruhiko Kuroda and Janet Yellen, along with a supporting cast of dovish policymakers in their respective central banks. The “central bank put” was solidly in the money and increased in value throughout the recovery, even as the US Fed started to lead the way out of monetary Eden as it ended quantitative easing and began to raise rates. The investor calculus was simple: things will work out, and if they don’t, the banks will step in and bail us out. This way of thinking finally led to that unreal calm in the markets in 2017. Even the wackiest of political shenanigans failed to make an imprint on investors trained to embrace the Panglossian assurance of the best of all possible worlds for risk assets.
O Brave New World, That Hath Such Creatures In It
If the central bank put is the magic formula for maintaining calm, what to make of the tea leaves from recent statements by Yellen’s successor, Jerome Powell? The new Fed chair has been largely unimpressed by the recent market volatility and appears to see no reason for soothing bedtime stories to global investors. That should be a good sign: if the economy is doing well on its own, then markets should be able to take in stride the upward movement in interest rates and inflation that one would expect to follow from rising corporate sales and earnings. Nonetheless, it is a brave new world from the recent past.
Taken this way, it makes sense to ascribe the February pullback to nothing of any particular importance. The pullback started with a jobs report that showed wages growing at a 2.9 percent annual rate, higher than the recent trendline of 2.5 percent or so (though not particularly hot by historical standards). Trump threw some new fire on the flames last week with the unexpected announcement of punitive new tariffs on steel and aluminum. But the ingrained tendency to remain calm has largely prevailed. The general thinking on tariffs seems to be that they will fail to ignite an all-out hot trade war. Meanwhile, this morning’s jobs report had a double helping of good news, with a whopping 313,000 payroll gains alongside an underwhelming (therefore good!) average wage gain of 2.6 percent.
What if the wisdom of the crowd is wrong? What if dysfunctional politics and misguided fiscal policymaking still do matter? What if that productivity boom that is supposed to arrive any day now fails to show up, relegating the world economy to sub-par growth as far as the eye can see? Will there be another incarnation of the central bank put? Will it be as effective as it was for the last nine years? All questions without answers, for now. For the time being, though, it would appear that the news cycle will continue to leave investors unimpressed, where the smell of bad news must mean there’s a pony nearby. Your portfolio should enjoy this while it lasts.
What a difference a year makes. For Exhibit A, consider the upcoming election this weekend in Italy. Wait, what? There’s an election in Italy this weekend? Must’ve missed that one…what with steel tariffs, Jared Kushner, incoherent crossfire between Trump and his own party on the issues of the day…only so much information one can consume, no?
The Way We Were
Other urgent media cross-currents notwithstanding there is, in fact, a national election in Italy this coming weekend. You would have known about it had it happened a year ago. Remember that time of slumbering volatility and gently ascending risk asset markets? Misty water-colored memories…There was an election in the Netherlands a year ago. The Netherlands is quite a bit smaller than Italy, GDP-wise, and it would be fair to venture that a not insignificant number of Americans would be hard-pressed to locate it on a map.
But for a few weeks in late winter last year the attention of global investors was focused on the outcome of elections in the land of dikes and canals. As in, it was about the only event on the radar screen that punters thought might unsettle the market’s placid waters, if it looked like the far right, anti-EU populist party would carry the day. It didn’t. A short time later the same singular focus turned to France (a larger country, the capital of which more Americans could probably name correctly).
Again, the far right threat failed to materialize as Marine Le Pen went down and Emmanuel Macron ascended as A New Hope (or, to the cynics, The Last (Classic Liberal) Jedi). The world resumed not caring about European elections. Oddly, the one the chattering class barely paid attention to, assuming the outcome was a given, was the German vote last September that produced a chaotic mess still in the process of being figured out six months later. The wisdom of crowds.
Two Matteos and a Clown Walk Into a Bar…
Which brings us to today, with Decision Italy about to happen amid a chaos of economic and geopolitical forces slamming markets this way and that with all the force of the Nor’easter currently having its gusty way with the DC region. Most of the same issues that concerned investors last year are very much front and center in this contest: neo-populism, anti-EU and single currency sentiment, hostility towards Middle East and North African immigration and, in this particular case, some disturbing reminders of Italy’s fascist history in the platforms of some of the leading political movements. The difference between this and last year’s elections is that a positive outcome – in the sense of being good for the EU, good for liberal democracy, bad for Russian meddlers – is actually the least likely one to happen.
That positive outcome would involve a decisive victory by the incumbent center-left Democratic Party (PD), which would probably mean the return of former prime minister Matteo Renzi, a EU-friendly technocrat inclined towards global free trade and the integrity of the single currency Eurozone. But the PD, similar to the fate of other established European center-left parties, has dropped precipitously in the polls. The likelihood of their winning a governing majority is vanishingly slim.
Enter the other two characters in our set-up to a bad joke: Matteo Salvini, the head of the far-right Northern League, and Silvio Berlusconi, the eternal court jester and sometime-leader of the Italian political scene. Berlusconi has cobbled together a right-leaning coalition between his own Forza Italia movement, Salvini’s League, a neo-fascist Brothers of Italy party and a southern alliance that calls itself “We’re With Italy” (if nothing else, Italy wins the Colorful Naming of Political Parties award). This unsavory coalition is the only political grouping with a reasonable chance at gaining majorities in either or both of the upper-house Senate or lower-house Chamber of Deputies come Sunday. If that happens, the next prime minister could very well be Mr. Salvini, who has personally referred to the euro as a “crime against humanity” and represents a movement founded on a northern Italian separatist agenda.
Chaos Has a Lean and Hungry Look
Slightly more likely than an outright win by the right is a hung election in which nobody gets a majority. That outcome could have the modest saving grace of keeping the current prime minister, the PD’s caretaker Paolo Gentiloni, at the helm for awhile longer while the various interests try to cobble together a grand coalition. But this result also does not bode well for the country or for regional stability. Italy’s debt to GDP ratio is already 130 percent, and the various public programs floated by the parties most likely to be in some form of power stand to add considerably more. Italy’s borrowing costs will be challenged as the ECB steps back from its full-throttle support of European bond markets. Global bond markets are already nervous this year; another Eurozone crisis would inflame an already investor-unfriendly environment. A competent response to economic challenges from any side looks unlikely.
For many months we have cited the “global macroeconomic context” as the main reason why we do not believe that a serious market reversal is right around the corner. The numbers continue to support that view today, despite the obvious return of long-dormant volatility among risk asset classes. But we also have to pay attention to the canaries in the coal mine – the factors that could loom ever larger as the current cycle plays out.
We know that much of the financial media world’s attention today is focused on the steel tariffs announced by Trump yesterday, and the (likely not unrelated) growing indications that the wheels are coming off this administration. Ultimately it will likely take more than one or two fumbling own goals to really take the nine year bull off its course. But there is evidence of a mosaic of chaos around the world – potentially including another Eurozone crisis, potentially including a China whose leader now possesses something close to absolute dictatorial powers, potentially including a whole new level of sophistication in global cyberterrorism. This mosaic of chaos is not (yet) showing up in macroeconomic headlines or in the steady stream of strong corporate earnings. But it is a mosaic we cannot ignore.
Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500.
How to Speak Kabuki
Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.
The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.
Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.
This Time Is (Sort of) Different
Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.
Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.
That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.
Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).
More to Life than Taxes
Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.
Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.
Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.
So, everything’s back to normal, right? The sharp pullback that began with the hourly wage number exactly two weeks ago has assumed its usual V-shape, with 5 straight trading days in the green following the technical correction level of minus 10.2 percent reached on February 8. Just like that silly Ebola freak-out back in 2014, this one looks like it will pass over, a brief squall yielding back to calm seas without so much as a full day spent below the 200-day moving average.
Yields Go North, Dollar Goes South
The good news, for those who prefer their equities portfolios neither shaken nor stirred, is that the continuing rise in bond yields is failing to inject fear into risk-on asset classes. The 10-year Treasury yield broke through 2.9 percent on Wednesday, even as the S&P 500 recorded yet another intraday gain of more than 1 percent. Those inflationary fears would seem tempered, even though Wednesday’s news cycle also served up a core CPI growth number a bit higher than consensus expectations. For the moment, anyway, the stock market seems comfortable enough with higher rates.
Which brings us to today’s big question: what is up with the US dollar? The chart below shows the downward trajectory of the dollar against the euro over the past six months, during which period the 10-year yield soared from just over 2 percent to the recent 2.9 percent.
All else being equal, rising rates should make the home currency more, not less attractive. Investors prefer to invest where returns are higher. Moreover, the dominant economic narrative around the US for the past half-year or so has been positive: above-trend growth, strong corporate earnings and high levels of business and consumer confidence. What’s not to love? Yet, even while the spread between the 10-year Treasury and the 10-year German Bund is 0.45 percent wider than it was six months ago the euro, as seen in the chart above, has soared against the dollar. And the pace has only accelerated since the beginning of 2018. Yes, the dollar jumped ever so briefly as a safe haven mentality took hold two weeks ago, but it fell back just as quickly – even while the 10-year yield reached new 4-year highs.
Supply and Demand, Yet Again
We’re starting to feel like Econ 101 professors around here lately, given how often the phrase “supply and demand” shows up in our commentaries and client conversations. We think it may be the single most important catchphrase for 2018, and in it lies a plausible explanation for that odd relationship between the dollar and bond yields. The supply-demand road inevitably leads back to China.
China’s central bank buys US government debt – lots of it. Chinese foreign reserves exceed $3 trillion, and the vast bulk of those reserves exist in the form of US government securities. Two things happen when Chinese monetary authorities (or any other foreign institution) buy US paper, all else being equal. First, the price goes up, and thus the yield, which moves in the opposite direction of the price, goes down. Second, the dollar goes up because Treasuries are a dollar-denominated asset. You see, it really is all about those supply and demand curves.
Recent evidence (including a weak Treasury auction last week) suggests that Chinese Treasury purchases are somewhat lower than they have been in recent years. That rumor back in early January, though quickly disputed, may have a kernel of truth to it. Foreign buyers indeed may have less appetite for Uncle Sam’s IOUs. Maybe they expect more inflation down the road (which would assume higher nominal rates). Maybe other factors are afoot. Whatever the reasons, reduced demand from non-US sources would indeed have the likely effect of pushing up rates and pushing down the dollar at the same time.
If this is the case, then we may be in for more bumpiness in equities. The S&P 500 digested the move to 2.9 percent very smoothly. We may see in the coming weeks whether the story plays out the same way at 3 percent or more. There will be a truckload of Treasuries coming down the road as we borrow to fund all that new spending and those tax cuts. More supply, in other words, potentially chasing less demand.
Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.
The Expectations Game
The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.
What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.
Algos Travel in Packs
There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.
On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.
The Case for Promise
So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.
This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.
The Debt Factor
Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.
Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.