Posts published in December 2014
As 2014 comes to an end we naturally ponder the year that was and the trends that shaped the investment narrative. There are plenty of contenders for story of the year honors, from the plunge in energy prices to the return of geopolitics and the soaring U.S. dollar. We would argue, though, that interest rates were, are, and will continue to be a driving force in their impact on a broad spectrum of asset classes. In this post we consider how rates confounded expectations over the past twelve months, and how they did not.
“Rates will go up in 2014” gelled into the collective mindset of Wall Street in the wake of the Fed’s December 2013 announcement that it would begin tapering its QE3 bond buying program. Bond managers of all stripes set shorter duration targets, expecting that yields on intermediate and long term issues could soar. Indeed, the benchmark 10-year Treasury yield had jumped more than 1.25% in a torrid run from May to September, supplying a real-world case study to support the short duration bet. But as it turned out, the bet backfired. As the chart below shows, short term yields (represented here by the 2-year Treasury note) did rise – substantially – in 2014. But the price of the 10-year Treasury rallied, and its yield fell from more than 3% to just above 2% in early December.
The World Is Flat
The above chart serves as a useful reminder that interest rate theory and the real world don’t always coincide. Specifically, duration strategies need to take into account, not just the potential direction of rates but also the shape of the yield curve. The curve flattened in 2014 as short term rates rose while longer term rates fell. The divergence was most pronounced on two occasions; first, during May and June when the 2-year rallied sharply while the 10-year drifted lower; and, second, in the aftermath of the mid-October equity markets pullback when short term rates soared while the 10-year yield fell to its lowest year to date level. As it turned out, rate hike expectations did drive yields higher – for shorter term securities that would in any case be more directly affected by a Fed increase. But other supply and demand factors were at play in keeping a lid on intermediate and long term yields.
2% Is The Charm
Arguably the most impactful of those other supply and demand factors was the relative appeal of U.S. rates when compared to other developed market sovereigns. 2% seems paltry unless compared with yields in the sub-1% range, where most of Europe and Japan have been this year. Consider the chart below, showing the relative yield trends of the U.S. and French 10-year benchmarks over the past five years.
The negative spread between U.S. and French issues has persisted for well over a year, but it is not typical in the context of longer historical norms. In 2014 it had the effect of supplying the answer to the question on everyone’s mind at the beginning of the year: who will pick up the slack once the Fed stops buying bonds. Foreign buyers more than made up for the reduced demand brought about by tapering. Coupled with periodic haven retreats in the face of geopolitical disruptions, the relative charms of 2% have been enough to keep the 10-year from following the 2-year upwards.
The resilience of European yields is due in no small part to continued expectations that Europe’s dire economic conditions will require a more full-throated QE program from the ECB than has been the case to date. Indeed, we see a more robust Eurozone stimulus program as fairly likely sometime in the first half of 2015. It’s not a given, though, and there are plenty of variables at play that could impede ECB Chairman Mario Draghi from delivering the goods expected by the market. A sentiment change away from Eurozone QE, and/or perceptions of elevated risk among peripheral sovereigns could bring an end to sub-1% Europe. What the lessons of 2014 teach is that, when it comes to rates, policy and yield we should expect the unexpected. Be prepared for rates to go up in 2015. Be prepared, as well, for alternative scenarios.
Over the past several weeks we have considered various scenarios for capital market performance in 2015 among various asset classes. For U.S. equities we have converged on a base case that sees continued upside in price performance, but with that upside more or less limited by earnings growth. In other words, if earnings were to grow in the upper single digit range as is the current consensus, we would expect to see similar growth for stock prices. While we believe this case to be reasonable, there are other ways 2015 could unfold. We consider one of those alternatives in this article: a late-stage bull rally, or “melt-up”.
The Case for Earnings
The reasoning behind our thinking for the earnings-led rally is nicely encapsulated in the chart below. This shows that over the past three years stocks have grown at a much faster clip than earnings: the S&P 500 has appreciated by 71% over this time while earnings per share (EPS) for S&P 500 constituent companies have grown at a more modest rate of 18%.
With these numbers in mind, let us consider why our base case posits earnings growth as the likely key driver of stock price performance in 2015. In essence, a company’s stock price is nothing more than a reflection of the potential future value of all its cash flows. It’s not terribly difficult to value these potential future cash flows using time-tested techniques like discounted cash flow models. In theory, the net present value of all these future cash flows, expressed on a per-share basis, should exactly equal the company’s stock price.
The real world is messier than theory, though, so we use metrics like the price to earnings (P/E) ratio as a shorthand way to gauge value. The P/E tells us how much investors are willing to pay for each dollar of net income the company earns. As the above chart illustrates, over the past three years investors have been willing to pay ever more for that same dollar of earnings – that is why stock prices have risen more than three times as fast as the underlying earnings. The P/E ratio for the S&P 500 is higher than it has been at any time since 2004. Margins – income as a percentage of sales – are at historic highs. But those sales have grown at fairly modest rates relative to historical norms. If the top line – sales – is growing at only 2-3%, which is typical for many large cap U.S. stocks, then profit margins must continually improve (e.g. through cost-cutting and business process efficiencies) to support bottom line growth in the 6 – 10% range that has been characteristic of the past several years. We think EPS growth in excess of 5% is reasonable to expect, but see a less compelling case for double digit upside.
So: an expensive P/E multiple, and single digit EPS growth in the context of a benevolent macroeconomic environment argues for stock price growth more or less in line with those mid-upper single digit earnings. It seems reasonable. But there are other variables at play that could produce a different outcome. Enter animal spirits.
The Case for Animal Spirits
John Maynard Keynes coined the phrase “animal spirits” to reflect the less rational, more emotional side of investing and economic decision making – specifically, the emotions of fear and greed that habitually drive market price trends. It is safe to say that the animal spirit presiding over the second half of 2014 has been the bull. The chart below shows the S&P 500 price performance for this period, and a couple things here are instructive.
First, we have seen the market appreciate by about 6% over this period. But, impressively, this appreciation has come with three fairly significant pullbacks in July, October and December. Each pullback turned out to be incredibly short-lived, with the V-shaped recovery ever steeper. In the most recent December event the pullback was over almost before anyone could actually register that it was happening.
This kind of daily trading pattern indicates a growing level of volatility that was missing for most of 2013 and the first half of this year. Such volatility is sometimes the precursor to a late stage bull market – “melt-up” is the favored industry jargon. Melt-ups happen when money that has been sitting on the sidelines – cash, fixed income portfolios, hedge funds with neutral or short equity positions – comes flooding into high-performing stock markets. This happened in the late stages of the 1990s growth market, when everyone and her grandmother wanted a piece of the dot-com action.
A 2015 melt-up would imply the P/E multiple expansion that our base case discounts. It would probably benefit some of the traditionally riskier asset classes like small caps and emerging markets, as well as beaten-down commodities like oil, natural gas and industrial metals. It would probably require some macroeconomic and geopolitical tailwinds: improvement, or at least no significant worsening, of troubled economies in Europe and Japan, a resumption of trend growth in China, relatively little material fallout from Russia’s ongoing weakness, and a continuation of the positive U.S. economic narrative. And the specter of rising rates could be a catalyst to pull in money parked in fixed income asset classes.
To be clear, our default case remains earnings-led growth with little or no multiple expansion. But market conditions suggest that a melt-up is entirely possible. We remain on the lookout for any attendant tactical opportunities that may present themselves.
Not too many people were paying much attention as the curtain raised on Act I of Greece’s financial drama. That was back in the fall of 2009. World equity markets were recovering from the Crash of 2008, and market pundits had weightier issues on their mind than the woes of a small equity market on the periphery of the European Union. Between October and December of that year Athex, the benchmark Greek stock index, fell a bit more than 22%. It didn’t’ stay off the radar screen for long. As is often the case, stock prices proved to be a leading indicator of deeper, more structural economic issues. As we know now, Act II of the Greek drama played out between 2010-12, bringing the entire Eurozone within a whisper of breaking up. Greece’s exit from the Union – the so-called “Grexit” – seemed to be a given. That this scenario did not play out is a testament to the power of words – specifically the three words uttered in June 2012 by ECB Chairman Mario Draghi that the central bank would do “whatever it takes” to maintain the integrity of the single currency region.
Fast forward to December 2014. Once again Athens is bucking the trend of a generally positive year for stocks, falling more than 20% in just the last three days. That adds up to a decline of nearly 40% from the 52-week high reached in March of this year. The chart below illustrates the carnage.
Snap to It
Share price movements don’t always have directly identifiable causes, but it’s fairly easy to point the finger at the culprit behind this week’s downward spiral. On Tuesday Greek prime minister Antonis Samaris announced a surprise snap election for the Greek presidency. The president is the head of state but serves largely as a figurehead, so one might think that a snap election is no big deal. But by calling for the election the government has opened up the possibility for a vote of no confidence that could lead directly to a general election – a very consequential outcome indeed. The ruling party – a coalition of Mr. Samaris’s center-right New Democracy Party and the socialist Pasok Party – has been more or less successful at keeping Greece on track with the terms of an austerity program agreed to in exchange for a bailout led by the so-called “troika” of the International Monetary Fund, European Central Bank and European Commission. The status quo would be in jeopardy, though, if the opposition Syriza Party were to prevail in a general election. Syriza, led by the charismatic and anti-austerity Alexis Tsipiris, won the largest block of seats for Greece in the European Parliament elections held earlier this year.
Mostly Quiet (for now) on the Periphery
For now, the damage appears to be largely contained within Greece itself. While benchmark borrowing costs in the country have soared to over 8%, sovereign debt in other peripheral countries such as Spain and Italy remains largely unchanged. Indeed, Spain’s 10 year benchmark bond currently yields 1.9%, less than the U.S. 10 year Treasury. The fear, of course, is that these low debt levels are unsustainable, and that Act III of Greece’s crisis will resemble Act II by spilling over Peloponnesian borders into neighboring lands. That would very likely force the hand of the ECB to take more drastic stimulus measures – and there is no uniformity of agreement that such measures would be able to deliver the remedies necessary to maintain harmony in the Eurozone.
Drama in Three Acts, or Five?
We have shared our general concerns about Europe for quite some time on these pages, and this week’s drama in Greece reinforces those concerns. We do not believe that the integrity of the single currency zone is as threatened as it was in late 2011, or that peripheral spreads are on the verge of soaring upwards. The ECB’s Draghi remains committed to the Eurozone and he still has dry powder to deploy if need be. But the structural case for Europe remains weak. Until we see more fundamental signs of life – in areas like employment and consumer prices – we remain underweight in our exposure to the Continent’s asset markets. Meanwhile, we will be paying close attention to the outcome of next week’s snap election and its potential consequences.
A quick glance at recent headlines in the world’s second largest economy doesn’t reveal much in the way of good cheer. There is the recent collapse of Shanxi Platinum Assemblage Investment, one of the so-called “shadow banks” that figure prominently in real estate and other speculative ventures. Many China watchers have concerns about price weakness in the property sector (which in turn could be a catalyst for more shadow bank failures). Headline growth has been running below trend. And a soaring dollar makes commodities like copper and aluminum more expensive for the world’s leading consumer of industrial raw materials.
But the negative vibes are certainly nowhere to be seen in China’s equity markets. The Shanghai Composite Index, shown in the chart below, has been on a tear, rising nearly 30% since the end of October. That’s right: 30% in a bit over one month. Since the middle of the summer the index has soared 46%.
A Retail Affair
What’s driving these manic animal spirits, particularly in the absence of compelling macroeconomic data points? Some observers point to the recent launch of Stock Connect, a new platform making it possible to trade directly in China shares from Hong Kong. Stock Connect is part of a larger effort on the part of Chinese financial policymakers to broaden participation in the country’s equity markets. Up to now it has been difficult for most investors to directly access China shares, particularly the closely restricted domestic A Shares leaving mutual funds or ETFs as the default vehicle of choice.
But Stock Connect alone is unlikely to be a sufficient explanation for such a powerful rally. The Financial Times reports today that retail brokerage account openings in China have tripled since May. A possible reason for this, the article notes, is diminishing confidence in other traditional investment types including bonds, real property and gold. Relatively modest valuations in many Chinese shares is another possible driver. Broad retail investor participation is also underscored by average daily trading volume some 5 times higher than long-term averages.
Bubble, Bubble, Toil and Trouble…
When any asset appreciates by nearly 50% over six months it is natural to wonder how much longer the good times can last. One potential red flag is an unusually large amount of net outflows from China ETFs. The South China Morning Post notes in an article today that the CSOP FTSE China A50 ETF, a vehicle for investing in China A Shares, saw net outflows of $845 million in the two weeks to the end of August, while outflows at a second FTSE A Shares ETF ran to $585 million last week (out of $9.7 billion in net asset value). Now, a partial explanation for the outflows may relate back to Stock Connect, with investors shifting out of ETFs and into direct investments in shares. But it may also reflect a lack of conviction that there is much gas left in this rally.
…Or More Room to Run?
That being said, it is by no means a given that shares in China are headed for a sharp drawdown. Historically, neither macroeconomics nor valuation metrics have much in the way of correlation with equity price trends. The Shanghai Composite has indeed been a relatively lackluster performer recently, and even after the current rally the index is off the five year high marks reached in 2010. While there may be more upside ahead, though, one could easily make the case that prudence argues on the side of waiting for a pullback or two before building up any long overlays in Chinese equities.