Posts published in September 2014
The S&P 500 is up by about 8% for the year to date, even after Thursday’s pullback (an increasingly rare one-day reversal of more than 1%). Meanwhile the EAFE index of developed international stocks is in the red for the year, and recently red-hot emerging markets have also given up more than 5% in the past several weeks. As always there are many factors at play, but one that stands out is the strength of the U.S. dollar, which continues to set new highs for the year against other major currencies. When the dollar rises relative to another currency, assets priced in the foreign currency lose value when expressed in dollar-denominated terms. As the chart below shows, other major developed and emerging currencies have taken a beating at the hands of the dollar recently.
It’s the Economy
What’s behind the greenback’s surge? A look at headline growth data tells an important part of the story. While the Eurozone and Japan are struggling to stay out of recession territory, the U.S. grew at 4.6% in the second quarter, according to the latest revision announced today. Unemployment has been trending down while inflation remains tame. Corporate earnings have been healthy as well. According to FactSet, a data research firm, earnings are projected to be 7.3% for the full year. Surprisingly – given the way consensus estimates normally compress as the event nears – this end-of-September estimate for FY2014 growth is higher than it was at the end of June. International flows into U.S. asset markets this year has been profound; the unexpected strength in U.S. Treasury bonds this year, for example, has been largely driven by foreign demand. The dollar, it would seem, is where everyone wants to be.
Room to Run
Nor does the rally appear to be at high risk of running out of steam (though it should be said that currency markets are highly volatile). Take the euro, for example, which has fallen about 8% from its twelve month high point reached in March of this year. At the current rate of 1.29 euros to the dollar the Eurozone currency is still about 8% higher than its five year low of 1.20. Some observers see a potential return to the EUR/USD parity that prevailed in 2002, when the currency came into existence as legal tender. Elsewhere, the ongoing weakness in key commodity prices from gold to crude oil, copper and wheat has taken a toll on resource-heavy currencies like the Australian dollar. And “policy divergence” is a phrase making its way into the financial discourse as the U.S. prepares to wind up its quantitative easing program while stimulus remains the name of the game in Europe, Japan and elsewhere.
No Free Lunch
While a strong dollar can be good for dollar-denominated risk assets, there are concerns about the effects an overheated currency can have on other parts of the economy. Quarterly earnings conference calls are brimming with talk of “FX headwinds” as managers explain why profits and sales have missed projected targets. A great many companies on the S&P 500 generate more than half their revenues in markets outside the U.S., and are thus exposed to weaker currencies. U.S. exports are also harmed by a rising dollar, as it increases the price of U.S. goods relative to those produced by other countries. Also, the dollar is attractive in part because investors expect interest rates to rise when the Fed begins to guide short term rates higher, which most predict will be sometime in 2015. Rising rates can be bad news for stocks and other assets (though they don’t necessarily have to be).
We continue to believe there is a good case to be made for maintaining overweight positions for U.S. assets in diversified portfolios. Nothing is set in stone, though, and currency market conditions are subject to rapid change. Diversification always matters, even when it appears to not work.
In the end the cooler heads prevailed. By a wider margin than the final polls had suggested, Scotland chose to remain in the United Kingdom. Turnout was over 85%, validating the outcome of a peaceful, democratic process. Unsurprisingly, this news has given yet another shot of cheer to the capital markets. So, one less X-factor in the mix, all is well and back to perpetually elevated asset prices, yes? No, not by a long shot. Scotland voted no, but it is increasingly likely that somewhere in Europe, in the not too distant future, a referendum on independence will succeed. The urge to secede is, sadly, alive and well.
The Scottish margin of 55-45 was decisive. Seen another way, though, nearly half the country thought it was a bad idea to stay part of a union that arguably has been a pretty good deal for most, over a period of three centuries. And this desire to upend longstanding political arrangements is hardly limited to the land of heather on the hillside. There are 37 active breakaway movements across Europe, and they suggest a geography more akin to the Schmalkaldic Wars of the 16th century than that of 21st century Project Europe. In the Spanish region of Catalan, momentum is gaining for an independence referendum in November. Bear in mind that unemployment in Spain is currently 24.5%, compared to just 6% in Scotland. The Spanish government rejects the constitutionality of any such referendum, but one can hear cries of “sí demà” (“yes tomorrow” in Catalan) on the streets of Barcelona.
The Age of Mistrust
Rationally, there would seem to have been little reason for the outcome in Scotland to be anything but a resounding choice to stay in the UK. Scotland has its own parliament, a result of the Scotland Act of 1998 that began a process of devolution. It controls its own healthcare, education and justice system, and collects its own taxes. Westminster has generally been amenable to passing increased governing responsibilities to Glasgow. Surely this is a preferable arrangement to the uncertainty and loss of leverage that would come with independence?
Independence movements are rooted in emotion, not reason. But they reflect a problem that reaches well beyond Europe’s borders: a fundamental mistrust of present-day institutions and the elite sliver of the world’s population that runs them. Modern nation-states came into being on the basis of shared ideas and ideals. Particularly in the developed world, though, good ideas for governance seem to be running thin. Our institutions continue to project an image of power – but so did the court of Versailles in 1788. We blithely dismiss the implications of independence movements at our own peril. Yesterday was a victory for sanity. But in Madrid, Milan and elsewhere, the governing class will need to do more to keep the breakaways from getting to yes.
Apple is a phenomenally successful company, and at $607 billion it is also the world’s most valuable enterprise. So it is probably not surprising that new product announcements would command Wall Street’s attention. But there is a level of showmanship and high drama to Apple’s product launches unparalleled in the annals of modern markets. The effect these feats of corporate kabuki have on the stock market should put the definitive nail in the coffin of the Efficient Market Hypothesis and the idea that the market is in any meaningful way rational.
Fanboys and Haters
This past Tuesday Apple convened a conference in its Cupertino hometown to announce a sequence of new offerings: new versions of the iPhone, a new payment application called Apple Pay, and its debut into the so-called “wearables” market with Apple Watch. How did the markets react? A picture says a thousand words.
“Don’t fall in love with a stock” is a timeless maxim, but one seemingly lost on the vast legions of Apple devotees as well as the less populous but still prominent haters of everything Jobs, Cook & Co. The skeptics had the upper hand as CEO Cook described the features of the new iPhone 6 and 6 Plus. Perhaps the market’s dour take on the new 4.7 and 5.5 inch screens is that they address a market where Apple’s rivals, notably Samsung, have an existing advantage. In any event, the bulls regrouped when Cook moved on to the second innovation, a payment system aimed at nothing less than consigning the credit card to the dustbin of economic history. Finally came the product tech blogs and fanboy sites have been chatting about for weeks: the Apple Watch. Some observers seemed to like it – the Financial Times correspondent Tim Bradshaw spent part of his liveblog coverage doing a selfie/demo of his Watch-adorned wrist. Oh, and U2 performed live! But Wall Street turned its nose up and the share price plummeted.
Intraday Ranges and Small Countries
Let’s put some quantitative context into that wild roller coaster of a price ride. The intraday spread between the high point reached after the Apple Pay announcement and the post-Watch low was 7.2%. Now, 7.2% of $607 billion is about $44 billion. By comparison the total Gross Domestic Product of Botswana is about $34 billion. Yes, more money changed hands in reaction to a single company’s product launch than the total economic worth of several dozen sovereign nations.
Did the net present value of Apple’s future cash flows really change by a magnitude of $44 billion in the space of an hour? After all, the fundamental value of any stock is nothing more or less than the sum total of the expected future cash generated by its assets, discounted at an appropriate cost of capital. Now, these new products will very likely make a significant contribution to Apple’s earnings for years to come. But there is plenty of uncertainty about the future for any business, including category-killing Apple. That uncertainty should in theory keep a lid on immediate changes in the stock price. But financial theory is often starkly at odds with financial practice.
The Wisdom of Crowds
Is there anything useful to be gained from this snapshot of the collective response to Apple’s new products? We do think the crowd got it right in one sense, which is that Apple Pay was probably the most interesting, and potentially game-changing, announcement of the day. Although the technical details are still coming out, one of the apparent features of this platform is a security function giving added protection to customers’ financial data. Neither Apple nor the merchant will collect user data during a transaction; payment approval will be transmitted by a unique code. Given the unsettling, and likely continuing, rise in cyber fraud, Pay could prove to be a very strong addition to the Apple product line.
But that remains to be seen. Apple is best known for sleek, engaging and user-addicting consumer technology. Apple Pay is a deviation from the standard playbook that Steve Jobs handed off to Tim Cook. We probably will not know for some time whether the crowds truly were wise in their insta-valuation of Apple Pay.
Weaker than expected employment data is the main item on today’s macroeconomic menu. August payrolls fell below the closely-watched 200,000 number for the first time since January; at 142,000, the payroll numbers stand in sharp contrast to recent GDP, manufacturing, consumer confidence and other data points suggesting a steady, if not necessarily barnstorming, economic recovery.
In the short term, risk asset markets may welcome a muted jobs picture as putting a stay on the Fed’s timetable for raising interest rates. But as usual the real story is deeper in the details, away from the statistical vicissitudes of a single monthly reading. The labor force participation rate continues to decline, and this decline presents concerns about the prospects for healthy long-term economic growth.
The Second Wave
There have been two major paradigm shifts in the U.S. jobs market since the end of the Second World War. The first was the acceleration of entry into the workplace by women, a trend which gained steam in the 1960s and reached a peak in the late 1990s. This trend explains to a very large extent the dramatic rise in the postwar civilian labor force participation rate, as seen in the chart below.
This chart also provides a clue about the second wave in employment trends, namely the beginning of a decline in the participation rate for both men and women. The current level of 62.8% is the lowest participation rate since the 1970s. The chart shows that there was a brief uptick from 2003 to 2007, in concert with the cyclical recovery following the 2001-03 recession. But in the post-2008 recovery we see, not only the lack of any uptick, but a pronounced acceleration of the decline. Simply put: fewer adult Americans are working today, as a percentage of the total adult population, than at any time in more than 35 years.
No Easy Narratives
There is a dominant narrative in the financial media about what is driving the participation rate decline: it boils down to the two words “jobless recovery”. Increasingly, though, that easy explanation seems at odds with other employment data. For example, today’s report not only served up a resumed downtick of the headline unemployment rate to 6.1% -- from the 2009 high of 10% -- but also a decline in the number of long-term unemployed (out of work for six months or more), which fell by 192,000. There were also fewer Americans wanting full-time work but only working part time. And year-on-year wage growth is 2.1% - not a windfall, but outpacing inflation. “People are opting out because there are no jobs” doesn’t seem to be the full answer.
It also doesn’t have anything to do with arcane classifications about who is and is not considered a member of the labor force. You’re in the labor force – at least according to the Bureau of Labor Statistics – if you have a salaried job, a part-time job, a few freelance gigs or even if you are unemployed but looking for work. To be considered a job seeker by the BLS literally means having put out a resume or phone call, or even asking a friend about a work opportunity, at least once in the last 30 days. If you’re in that 37.2% of the adult population not participating in the labor force, you really are taking no action at all to look for work.
Work and Growth
Whatever the reasons, a continuation of this opt-out trend poses some serious questions for long term growth. The growth equation in a capitalist economy has always been fairly straightforward: businesses produce things people need and want, they hire people to produce those things, and people spend the money they earn on the same things. The virtuous cycle periodically reverses when the economy overheats and lending tightens, but the long term structural trend is ever-upward. If fewer people choose to opt into this system it cannot grow at the same pace, or perhaps at all.
Those are long term concerns that are unlikely to have much impact on what asset markets do today or in the final fiscal quarter of 2014. But they are concerns that hang over the economy like a cloud – hard to define, but notably gray. The relationship between labor and capital has always been dynamic – but both components have always been necessary for growth. They still are, until people figure out how to live and survive without working.