Posts published in April 2014
Sometimes a picture can convey a thousand words, encapsulate an entire story. Consider the chart shown below. It shows a ten year comparison of the Italian 10-year government bond yield with the Italian unemployment rate.
The chart shows that while unemployment in Italy is far and away at a ten year high, the yield on the benchmark Italian government bond is far and away at a ten year low. Almost 13% of the population – and a much, much larger percentage of the population of young working-age adults – are out of work and looking for work. The Italian economy is in a precarious state. And yet, investors are buying Italian bonds at a torrid pace.
Italy is by no means the only country where sovereign debt weirdness runs rampant. Greece recently came back to the capital markets with a bond issue. The country is essentially insolvent and plagued by political dysfunction (to put it mildly) – but that does not seem to be a problem for Europe’s credit market investors. Spain and Portugal both have 10-year yields under 4%, while more than half of their populations in the 20-30 year age brackets are out of work. It seems hard to make a compelling case for how this will end well. The question to ask – looking at that jaw-dropping chart above – is why peripheral European bonds are looking so attractive. Is this a bubble on the cusp of bursting, or is there a plausible reason why investors are so full of the Mediterranean spirit? Let’s briefly retrace the Eurozone’s trajectory from two years ago to the present.
Whatever It Takes 2.0
The current phase of the Eurozone’s economic journey started in July 2012, with arguably the three most famous words pronounced on the Continent since veni, vidi, vici. “Whatever.It.Takes” said European Central Bank Chairman Mario Draghi, adopting a U.S. Fed-style openness to unconventional means to keep asset prices from falling into oblivion. Several months earlier the Economist magazine, a normally sober publication not given to breathless hyperbole, had predicted the collapse of the single currency region. Draghi’s three-word proclamation banished those fears, and peripheral bond yields began their journey from double digits to today’s gentle levels.
Investors now expect to be compensated for their faith in Draghi. With inflation in most of Europe hovering around zero, expectations are steadily building that the ECB will step in with a new monetary stimulus program. Such a program would likely have the immediate effect of sending bond yields lower. A Eurozone QE may not resemble the one currently being tapered down in the U.S., but the general consensus is that holding Italian paper at 5% or Spanish notes at 3.5% would be a good trade (at least for a while) if a stimulus program were to be announced.
Another Country Heard From
But there is no guarantee that a no-holds-barred Euro QE is in the offing. As is so often the case in Eurozone financial policymaking, any such program would have to first clear a significant hurdle: Germany. The inflation-averse Bundesbank shows little indication of undue concern over current price levels. Mario Draghi has a much tougher, more politically contentious path to enacting policy than does his counterpart Janet Yellen at the Fed.
All of which is to say that now would seem to be a spectacularly bad time to be pouring funds into the European bond market. We have stayed away from this sector for some time now, and we will continue to happily forego any yield-enhancement opportunities coming out of this sector of the credit markets.
Japan’s stock market is bringing up the rear this year. The MSCI Japan index is down -7.6%, lowest among the developed economies this index tracks. Selling pressure on Japanese shares was in full throttle during the first half of April; not coincidentally, perhaps, this period also represented the beginning of a rise in Japan’s consumption tax on goods and services from 5% to 8%. Long-time Japan watchers could be forgiven for seeing a consumer-dampening tax as the last thing this deflation-challenged economy needs. But there are some indications that prospects in this long-beleaguered economy may be turning brighter.
Green Shoots for Abenomics
One indicator that at least some things are going right is the consumer price index: at 1.4%, Japan’s CPI sits squarely between those of Germany (1.2%) and the US (1.6%). For the first time in a very long time, the three major developed economies of the US, Eurozone and Japan are all targeting the same 2% baseline for prices. Arguably, Japan may be closer to reaching that goal than the Eurozone, where sagging prices have turned up the heat on European Central Bank Chairman Mario Draghi to contemplate some additional monetary stimulus.
The labor situation also looks sunnier in Japan than in Europe. The unemployment rate currently stands at 3.7%, which is a far cry from the double digit levels plaguing many Eurozone nations. In Greece, for example, a staggering 60% of the labor force under the age of 30 is unemployed. Beyond the headline number, though, there is mounting evidence that wages are rising: more than 100 of the largest companies in Japan have recently announced wage hikes for their employees, and hourly rates for part-time work are going up as a tightening labor market decreases the number of applicants per part-time work offering.
A Long Way To Go
A sustained economic recovery in Japan could make for a compelling investment story. The Nikkei 225 stock index is currently worth about 35% of its peak value reached 24 years ago, so there is plenty of upside potential. But if Japan is really going to turn the corner on this quarter century of malaise, there will have to be some deep and fundamental changes made to a business culture which over the years has become sclerotic. Overly cautious boardrooms have squandered the opportunity for Japan’s enterprises – for many years the most globally competitive anywhere in Asia – to capitalize on growth in China and elsewhere in the region. Ponderous bureaucracies still interfere too much in the day to day workings of key industry sectors. Cultural attitudes still resist opening up to foreign labor, which could provide an energy boost to this ageing population.
Japan has done it before. In the Meiji Restoration of the late 19th century it created a modern industrialized economy literally from scratch. Time will tell if it can pull off a similar feat to be competitive in the 21st century.
Our brains are wired to seek explanations for things - to weave a sensible narrative around events in the hope of making them seem less random or threatening. We see this play out every time a reporter stares at us assuredly from behind the anchor desk and tells us that “the stock market did X today because of "Y”. “Y” could be the release of Fed meeting minutes, or Russian troops amassing on the border of Ukraine, or a Chinese bond auction failure. It doesn’t really matter what the day’s headline is; the news anchor is crafting a story out of the millions of random buy and sell orders flashing in trading system centers around the world. The stories may help us process information, but there are limits to how much light they can really shed on the goings-on of the capital markets.
Cyclicals and Defensives
One of the recurring favorites of Wall Street storydom is how various industry sectors and investment styles perform at different stages of the business cycle. The rule of thumb is that defensive sectors tend to do well when the economy turns down; conversely, cyclicals have a history of outperformance during times of economic strength. Slowdowns favor value-oriented stocks, where dividends contribute significantly to total return. Growth stocks are the leaders during the good times. Or so the story goes.
Time for a Value Story?
Consider the last twelve months; we show here below the performance of US large cap value and growth equities.
The chart shows a seemingly nice, tidy style trend. Growth stocks decisively took command in summer 2013 and led the market’s rally through January 2014. That trend started to run out of steam in February and went into sharp reversal last month, with value back in the ascendant. How closely does this trend track the business cycle from last summer through the present?
Quite a lot, perhaps, at least on the surface. During the fourth quarter of 2013, a series of macroeconomic data built a case for stronger than expected growth. The Fed’s December Board of Governors meeting ended with a decision to begin tapering the QE program, another sign of confidence in economic recovery. Markets rallied strongly through the end of the year. But the New Year presented headwinds. Jobs data painted a mixed picture: lower unemployment, but less-than-stellar payroll gains. A harsh winter took a toll on much of the country. Russia amassed troops on the Ukrainian border. This would seem to paint a compelling value/defensive narrative.
More Than Meets the Eye
If you look closely enough at the underlying data in any given market trend, though, you are likely to see more complexity than the top-line narrative would suggest. Consider that the top-performing sector during that growth run in the second half of 2013 was healthcare, traditionally considered to be one of the more defensive sectors. Or that the cyclical materials and consumer discretionary sectors were strongest during the February pullback.
Moreover, with the harsh winter behind us, the US economic picture for the rest of the year continues to look relatively upbeat. Economists have lowered their expectations for first quarter earnings, but expectations for the full calendar year are in the high single digits – hardly indicative of a burgeoning slowdown.
Certain growth sectors do indeed seem to be reversing – much of the decline in major US indexes this week has come from the tech and biotech sectors. But that may be more about investors rebalancing their portfolios – buying the losers and selling the winners – than it is about any meta “return to value” narrative. If there is a sector story, maybe it is simply this: mean reversion happens. Every now and then it’s time for something to mean-revert up, and something else to mean-revert down. It’s not a very colorful story, to be sure. But letting the data speak for themselves may be a better way to invest than trying to guess what the next big-picture story will be.
Michael Lewis, the ex-Salomon Brothers trader turned investigative author, has always had a particular sweet spot for the world of finance. His knack for shining a bright light into the obscure, murky corners of Wall Street was on display again this week with the publication of Flash Boys. In the crosshairs of Lewis’s investigative storytelling this time was the little known, but very influential, world of high frequency trading (HFT).
The Evolution of Modern Markets
Critics of HFT point to its existence as a proxy for all that has gone wrong in securities markets – from being the oil which greases the wheels of productive investment to a giant casino where the house enjoys even better odds than in Las Vegas. There is more than a kernel of truth to this view. On the other hand, HFT is a logical outcome of the two forces that, more than any others, have shaped the fabric of modern markets: the steady pace of deregulation and the explosion of technology. These two forces collided in the early 1970s. The financial world was beginning to comprehend the power of Moore’s law (the inverse relationship between cost and capacity in data storage). Meanwhile the Bretton Woods framework for stable exchange rates was collapsing, the regulation-lite Euromarkets were taking off, and the era of fixed commissions was ending on the New York Stock Exchange.
The Value of a Microsecond
A frenzy of innovation ensued in all manner of financial products. As markets globalized, traders increasingly saw speed as one of their most important sources of competitive advantage. Getting an order from a trading floor to an exchange and back faster than your competitors got you a slightly better price at execution. For any given trade the advantage could amount to mere pennies or even less. But those pennies turn into millions of dollars when tens of thousands of trades are at play every day. As the technology improved, it became no longer a game of seconds, but of milliseconds (a thousandth of a second) and microseconds (a millionth of a second).
No More Men in Funny Colored Jackets
What happens when you place a trade? The image most people have is of an order being routed to the floor of a stock exchange, where burly men in brightly colored jackets and badges holler and wave their arms in strange ways to make the trade. That is an outdated image. Human floor traders have largely been replaced by black boxes in climate-controlled data centers strategically located near the world’s major financial centers. High frequency trading accounts for more than 65% of the daily trade orders whizzing in and out of these black boxes along glass fiber optic lines at light speed. Now, the revelations in Lewis’s latest book may spur action to rein in some of the most egregious byproducts of HFT. But it is not hard to imagine that somewhere, well outside of the public eye, some group of extremely smart, tech-savvy individuals is busy developing and testing the next big thing.