In our commentary last week we made brief mention of the surprising strength of foreign currencies versus the US dollar in the year to date. This week served up yet another helping of greenback weakness, and it is worth a closer look. Perhaps the most intriguing aspect of the dollar’s stumble is how broad based it is, across national economies with very different characteristics. Consider the chart below, which shows the value of two developed market currencies (Eurozone and United Kingdom) and two emerging markets (Brazil and India) versus the dollar.
Brevity of the Trump Trade
As the above chart shows, all four currencies (and just about all others not pictured here) fell sharply against the dollar in the immediate aftermath of the US presidential election last November. Recall that asset markets broadly and quickly coalesced around the notion of a “reflation-infrastructure trade,” premised on the belief that swift implementation of deep tax cuts and a torrent of infrastructure spending would spark inflation in the US and send interest rates sharply higher. Even today, there is no shortage of lazy punditry in the financial media reflexively blurting “Trump trade” every time the stock market turns higher.
But the currency markets long ago signaled the non-existence of the reflation pony in the back yard. In most cases, the foreign currencies’ upward trajectory began late last year or in the first month of 2017. Despite some localized setbacks (e.g. the latest shoe to drop in Brazil’s ongoing political scandal back in May), that upward momentum has continued and gained strength. Even in Great Britain, the negative sentiment surrounding the woeful state of Brexit negotiations has been outweighed by even stronger negative sentiment against the dollar.
Many Stories, One Sentiment
So what is behind this singular sentiment that seems to pervade all continents and economies in various stages of growth or disarray? How long is it likely to last? One of the most popular themes, certainly for much of the summer, has been the perception of stronger growth in the Eurozone. ECB Chair Mario Draghi’s comments on the better than expected growth trend back in late June immediately catalyzed another leg up against the dollar, not just for the euro but for other, seemingly unrelated, currencies. A new consensus set in that the ECB would begin tapering its bond purchases sooner than planned, and Eurozone rates would trend up accordingly.
That’s fine as far as it goes, but there would appear to be more to the story. First of all, the Eurozone may be growing slightly faster than expected, but it is hardly going gangbusters. In fact, the real GDP growth rates of the US, Eurozone and Japan are curiously symbiotic. Inflation in all three regions remains well below the 2 percent target of their respective central banks. And then there is the curious case of the euro’s recent strength even while bond yields have once again subsided. The chart below shows the YTD performance of the euro and yields on 10-year benchmark Eurozone bonds.
The spike in intermediate bond yields that followed from Draghi’s June comments has almost completely subsided back to where it was before that. Part of this, we imagine, is due to a more muted ECB posture recently, both at the Jackson Hole summit a couple weeks ago and in comments following the bank’s policy meeting this past week. The falling yields also have to do with a slightly more cautious tone that has crept into risk asset markets as investors take stock of geopolitical disturbances and the disruptive effects of the hurricanes that continue to make headlines in the southern US and Caribbean islands.
None of this would indicate to us that going bearish on the dollar is some kind of “fat pitch” trade, there for the obvious taking. In a world of relatively low growth, the US remains an economic leader in many key sectors from technology to financial services. It would only take a couple readings of higher inflation to bring back expectations for a third rate hike by the Fed and renewed commitment to balance sheet reduction. Recoveries elsewhere in the world are likewise not immune from setbacks that could necessitate a redoubling of stimulus.
That said, national currencies do, to some degree over time, reflect general sentiment towards the prospects of the home nation. Right now, it would be fair to say that those views are mixed, and not necessarily trending in the right direction, as concerns the US. Whether that leads to further dollar weakness or not is by no means certain, but it is increasingly a trend that cannot be ignored.
Talk of endurance is all the rage these days. Fall race season looms for runners and triathletes contemplating their next attempt at 26.2 or 140 or whatever mileage benchmarks await the end of the arduous training programs through which they (we!) have been slogging all these humid summer months. In markets, too, endurance is the word of the moment, and not just in stocks. Sure, we’re into the ninth year of the equity bull market that began in March 2009, which counts by most calculations as the second-longest running bull on record. But that pales in comparison to the granddaddy of all distance runners. The bond market produced yields in the stratospheric heights of 20-odd percent in 1981, then rallied as the Fed broke the back of double-digit inflation. We’ve been in a bond bull ever since.
New Challengers Emerge
Alongside these elite harriers we have a couple other asset classes looking to break through more modest distance goals. The long-beleaguered euro limbered up back in January and started to chase its longstanding nemesis, the US dollar. The euro is up around 16 percent versus the dollar year-to-date, a surprising turn of events for those caught up in the hype of the so-called “Trump trade” that followed the election last November. In commodity-land, copper and other industrial metals have gained more than 20 percent. While the China demand-fueled “supercycle” for commodities is deemed long dead, the future for a select group of metals, including copper, may well be bright if forecasts about the demand for lithium ion batteries (key components of electricity-operated vehicles) prove to be accurate. For the moment, non-US currencies and industrial metals are still microtrends, unproven at longer distances, but it will be worth keeping an eye on their progress.
A Flat & Forgiving Course
Distance runners tend to do their best work on predictable, smooth courses with a minimum of steep hills or unexpectedly rough, slippery terrain. Which brings us back to stocks and the nine-year bull. There really haven’t been too many Heartbreak Hills since the summer of 2011, when the simmering Eurozone crisis and the US debt ceiling fiasco took stocks into a vortex that stopped just short of a bear-level pullback of 20 percent. The tailwinds have come courtesy of the central banks and their monetary stimulus programs, along with an economy that has delivered steady, if modest, growth, an improved labor market and muted inflation. Corporate earnings have done well in this environment, so that even if stocks are expensive by most valuation standards (they are), they remain well below the bubble levels of the late dot-com era.
Now, anything can disrupt the equilibrium at any time. There are always risk factors lurking under the surface that, if actualized, would create havoc in asset markets. Think back to the longest bull on record: that of 1982-2000. Technicians would dispute our labeling this entire period a bull market, as it was punctured by the sudden cataclysm of Black Monday 1987, when the Dow and other major US indexes fell more than 20 percent in one day. We don’t think of the 1987 pullback as a bear market in the classic sense, though, because (a) it was entirely unrelated to broader economic trends, and (b) it was over almost as soon as it began. The 1987 event looked nothing like the last real bear market, a long stretch of misery that endured from 1968 to 1982. We bring this up because, based on everything we see in the economic and corporate profits landscape today, any potential pullback in the immediate future would more likely arise from the sudden emergence of a hitherto dormant risk factor than from a structural change in conditions. The course, in other words, remains flat and forgiving, but runners should always be aware that lightning can strike.
Even Ultramarathoners Tire Out
And that, in turn, brings us back to that superstar distance runner, the bond market. Because if anything could potentially make that flat course hillier and more unpredictable, it would be an end to the “lower for longer” assumption about bond yields that is baked into every asset class with a risk premium. The risk premium for any asset starts with interest rates; namely, the prevailing risk-free rate layered with additional quanta of risks deemed pertinent to the asset in question. Upsetting the applecart of low rates would reverberate throughout the capital markets in a uniquely pervasive way.
For now, the bond market would appear to still be a ways away from its last legs. Both the Fed and the ECB will likely try to provide reassuring guidance over the course of this fall as to how they plan to move towards a more “normal” monetary policy environment with a minimum of disruptive surprises. We don’t expect much disruption to ensue from the upcoming September meetings of either central bank. But we have to pay close attention to any unusual wobbles or other signs of fatigue along the way.
It’s that time of year again. Here in the mid-Atlantic region we are getting the first taste of dry, cool nights in place of midsummer’s relentless humidity. High school cross country teams are running through our neighborhoods to get in some practice before the season’s official start in a few days. And, of course, investors across the land are wondering what mix of surprises are in store for the deviously tricky stretch of the calendar between Labor Day and Thanksgiving. The sense of expectation is palpable; it seems like an eternity since anything has penetrated the smug, self-satisfied forward motion of the S&P 500. Will the good times continue to roll?
There are of course many variables at play, and a broad spectrum of possible outcomes. We think these can be broadly divided into two high-level narratives: (a) nothing new here, carry on as before, or (b) signs of wear and tear in the long-running bull that could spell trouble. We look at each of these narratives in turn.
Narrative 1: Nothing New Under the Sun
Over the course of the year we have been treated to numerous explanations of what’s been going on in markets by the furrowed brows of CNBC analysts and their ilk. But when you stand back from all the earlier, furious rotation – into and then out of financials, into and then out of tech, into and then out of healthcare – the easiest explanation for the positive trends of 2017 is the near-absence of anything new. The US economy has been growing at a slow rate, with low inflation, a decent labor market and favorable corporate earnings, for most of the second decade of this century. Within the last year and a half or so our modest growth has been joined by that of Europe and Japan. There are no glaring trouble spots in emerging markets, with China and Southeast Asia reclaiming the lion’s share of global growth. The global economy appears serenely detached from the chaos of worldwide political dysfunction.
Almost no headline data points have challenged this macro-stability narrative thus far this year. And under the placid surface, of course, remain the central banks whose actions over the past six years have put a supportive floor under asset prices. Sure, there’s some debate now about how the Fed and the ECB steer their policies towards something more “normal,” whatever that is. But almost nobody expects that the bankers would sit back and watch from the sidelines should risk assets suddenly hit a nasty and sustained patch of turbulence. This attitude may appear complacent, but it is also entirely rational given all the evidence accrued over the past few years.
Narrative 2: Be Careful What You Wish For
Calm, gently upward-trending asset markets are an investor’s dream. But all dreams eventually end and the dreamer wakes up, remark observers skeptical that the Goldilocks conditions of the year to date can last much longer. Do the naysayers have anything substantial to present as evidence for a sea change in market trends, apart from simply repeating “no free lunches” ad nauseum?
Well, perhaps they do. As Exhibit 1, the Cassandras may trot out the performance of recent small and mid caps. Both the S&P 400 Mid Cap index and the S&P 600 Small Cap index are trading below their 200 day moving averages, more than 5 percent down from the year-to-date highs both attained in July. And while on the subject of 200 day averages – a subject about which we have had remarkably little to say for a very long time – the number of S&P 500 stocks trading below their 200 day averages is close to 50 percent. The current stage of the bull, in other words, is not particularly broad-based. A trend of narrowing outperformance has in the past been a frequent sign of impending market reversal (though, we should note, it is not particularly useful as a market timing measure).
The other evidence our skeptical friends may muster in support of the case for correction is the very absence of volatility so celebrated by the bulls. There was a stretch recently when the S&P 500 went 15 days in a row without moving more than 0.3 percent up or down – a 90-year record for low volatility. That serenity would appear to misprice the inherent risk in holding common shares – which, as any finance professor will happily tell you, represent a completely unsecured claim, junior to all other claims, on a company’s residual assets. When common stocks exhibit the volatility properties normally associated with fixed income securities, that would seem to indicate that the market has something wrong. Be careful what you wish for! And these arguments, of course, take place against the backdrop of a market more expensive, by traditional valuation measures, than any other than those of the bubbles of 1929 and 1999-2000.
The thing about each of these narratives is that they are entirely plausible. The worrying trends highlighted by the skeptics are believable and suggest caution…but so is the seemingly fixed-in-stone macroeconomic context of slow, reliable growth and benign conditions for corporate earnings. We also imagine that, if we do see a pullback or two of any size in the coming weeks, a quick, Pavlovian buy-the-dip response would be more likely than not. That in turn may afford some additional intelligence on whether conditions going forward appear wobbly enough to support building up some additional defenses.
Jackson Hole is, by all accounts, a lovely redoubt, high up in the Rocky Mountains of Wyoming. As has been the case every August since 1978, the monetary mandarins who set the agenda for the world’s central banks will dutifully traipse up to this hiking and skiing paradise next week for their annual economic symposium. The attention span of the global investment community will briefly train its attention on Jackson Hole, and not on account of the riveting topics on tap for keynote speeches and panel confabs. This year’s symposium title is “Fostering a Dynamic Global Economy,” an anodyne and, in this contentious day and age, somewhat wistful formulation. If nothing else, though, it at least rolls off the tongue more easily than last year’s unfortunate word salad of a lead line: “Designing Resilient Monetary Policy Frameworks for the Future.” Central banker says what?
Euron a Roll
No, investors’ interest in the proceedings will be strictly limited to whatever policy utterances may spring forth from the lips of bankers, none more so than European Central Bank chief Mario Draghi. A frisson of anticipation rippled in late June from Draghi’s musings about the stronger than expected pace of recovery in the Eurozone. These musings, not unlike Ben Bernanke’s “taper” kerfuffle of May 2013, sent bond markets and the euro into a tizzy as investors imagined the beginning of the end of Eurozone QE. The euro in particular went on a tear, as the chart below illustrates:
So much did the currency respond to fears of a more aggressive QE taper by the ECB that a strong euro has replaced a strong Eurozone as the central bank’s chief concern, as revealed by the most recent ECB minutes published this week. The euro’s strength puts regional companies at a competitive disadvantage for their exports, and complicates the ECB’s elusive target of 2 percent inflation. The characteristically cautious and incremental Draghi is thus likely to be on his guard to avoid any comments that could be interpreted by the market as hawkish policy leanings. Those tuning into the Jackson Hole proceedings may well come away with little more than the bland sentences peppered with bursts of arcane math that make up the majority of central bank speeches. More likely, investors will have to wait until the ECB’s next policy meetings in September and October for guidance on the timing of QE tapering.
The Smell of Fear
Concerns about the euro come at the same time as a smattering of long-dormant volatility comes back into risk asset markets. The CBOE VIX index has found a new home above 15 in recent days – still below the commonly accepted fear threshold of 20, but well above the sub-10 all-time lows it has plumbed for much of the past several months. Global stock indexes have experienced some attendant turbulence in the form of 1 percent-plus intraday pullbacks – fairly tame by historical norms but enough to re-ignite the chatter about the duration of this bull market, expensive valuations and all the rest.
It’s been awhile since shaky asset markets have tested central bankers’ nerves. Nor is there any clear indication that this late summer volatility will develop into anything more than a brief passing thunderstorm or two. But we have sufficient evidence from recent history that the policymakers do react to asset prices. They will likely be wary of pushing too hard for normalization policies (tapering on the part of the ECB, balance sheet reduction and further rate hikes for the Fed) if they sense that such moves will feed into already jittery capital markets.
Chances are that the only “hikes” on the agenda at Jackson Hole will be the kind involving nature’s beauty, not interest rates. We don’t expect much from Wyoming to be moving markets next week. But the central bankers still face a dilemma: how to proceed with the normalization they so want to accomplish when (a) market reactions could be troublesome, and (b) the urgency from a macroeconomic perspective is not clear and present. This will be one of the key contextual themes, we believe, heading into the fall.
Should you be concerned about the somewhat bumpy ride US stocks have encountered in the past couple days? Or is this a welcome chance to get in some long overdue bargain hunting before the S&P 500 resumes its lazy upward drift to a series of new highs?
The answer would depend, we imagine, on whether you see the unrest on the Korean peninsula – arguably the best go-to explanation for yesterday’s 1.45 percent pullback in the US benchmark index – as something genuinely serious and potentially destabilizing, or as little more than a spate of made-for-Twitter taunts that will, as these things generally do, settle down. As you contemplate this, bear in mind that most of the intense geopolitical flashpoints in history (notably including the 1962 Cuban Missile Crisis) have had relatively negligible impacts on asset returns in the months following the event. We have noted before that disaster doesn’t strike far more often than it does strike.
Caveat Bargain Hunter
That being said – and our instinctive proclivity towards bargain-hunting notwithstanding – there are some reasons entirely unrelated to geopolitics that merit some thought before doubling down on your equity market exposure. This comes back to a theme we have discussed extensively with clients in recent weeks, namely, the rather listless, leaderless nature of the market’s upward drift this summer. Consider the chart below, which shows the relative performance of the main S&P 500 industry sectors against the benchmark index for the year to date.
In this chart we draw particular attention to three sectors: technology, financials and energy. These are the three sectors that were the key drivers of profit growth in the just-concluded second quarter earnings season. Energy led the way with a triple-digit earnings rebound from the depths of the sector’s miserable 2016. Technology and financials both enjoyed double-digit earnings growth and the tech sector’s top line was strong as well, helped along by the benign tailwind of a weaker dollar against major trading partners.
With the exception of tech, though, these earnings haven’t translated into share price performance. Energy continues to be the market’s problem child, seemingly unable to convince investors that the current trough recovery in earnings is sustainable. Financials, of course, were the darling of the post-election reflation trade before that ill-conceived flight of fancy crashed and burned in this year’s first quarter. Banks and their ilk have trailed the benchmark since then. And tech, even though it maintains a solid performance lead this year, has shown itself to be vulnerable on several occasions, most notably with that big pullback in early June.
The apparent lack of attention paid to earnings extends to the level of individual stocks as well. A Financial Times article earlier this week reported on the market’s apparent failure to reward companies beating their Q2 earnings estimates, noting that “there has been little or no reward for companies reporting better than expected earnings per share and sales.” This observation fits in squarely with our contention that, while the market drifts higher in the absence of a compelling negative headwind, it lacks a sustaining theme. And without such a sustaining theme the market is, we believe, more vulnerable to the types of external shocks we have seen this week.
Labor Day Looms
As we write this before Friday’s market open, we have no crystal ball to tell us whether yesterday’s pullback will extend for a few more days (S&P 500 futures are about flat with 20 minutes to go before the open). We haven’t seen a multi-day pullback for more than a year and a half, but they do happen with some regularity. We think it more likely than not that the Korea kerfuffle will subside in due time, playground taunts from both heads of state kept in check by cooler heads. But the listless market will still be exposed to these kinds of periodic shocks, and they may come into sharper focus as the traditional back to school season approaches. Yesterday the VIX, the market’s “fear gauge”, shot up above 17 after weeks of historically low dormancy. Until we have another compelling, sustainable positive trend narrative, we should not be surprised to see more of these periodic, brief solar flares.