Posts published in January 2015
Volatility is back. For most of the past two years we have enjoyed a comfortable world of low risk & high returns. Stocks rose steadily with little drama save for an occasional pullback in the neighborhood of 5% with an immediate V-shaped recovery. This environment started to change last fall. Baseline volatility began trending up from its summer lows, and those brief Alpine spikes that look so dramatic on vol charts occurred with more frequency. The chart below illustrates the shift in the volatility landscape over this period, using the CBOE VIX index as a risk proxy.
Measuring Fear (1): Baseline (Normal) Volatility
We look at two things when evaluating volatility trends. First is the baseline trend. This is a measure of “normal” volatility – where it trades most of the time when the market isn’t collectively freaking out about something. The chart above shows that baseline vol trended flat to lower for most of the nineteen months between January 2013 and July 2014. Through early to mid-summer last year the VIX trended down close to historical lows before reaching a trough in early July. Since then the trend in baseline vol has been upward and gathering steam. Even through last year’s turbulent October pullback, baseline vol was not far from – and mostly below – the two year average of 14.4. But it has remained firmly above that average throughout the entire month of January.
Measuring Fear(2): Peak-20 Days
The other metric we consider is peak performance. These are the abnormal days when something – be it a piece of unexpected news or a rogue algorithm or the popular delusions of crowds – sends volatility soaring. We call these “peak-20 days” when the index under observation is the VIX, referring to a closing price of 20 or higher. What we care about are (a) the frequency of peak-20 days; and (b) the magnitude of the peaks. Again, the above chart shows two distinctly different climates. There were only four peak-20 days from the beginning of 2013 through midsummer last year. There have been sixteen peak-20 events in the seven months since. January looks set to establish a new high mark. If the VIX stays above 20 through the 1/30 close today, it will be the seventh peak-20 day for the month, or more than 30% of total trading days. At the same time, the highs are higher. The peak of 26.3 reached last October was the highest since June 2012, just before Mario Draghi bailed out the Eurozone with his “whatever it takes” pronouncement.
Vol Today, Gone Tomorrow?
Volatility is a notably flighty metric; it can appear out of nowhere only to be gone in the blink of an eye. But there are some valid reasons why the current bout of risk may stick around for longer than it has in recent times. There is also a reasonable difference of opinion as to whether higher volatility implies a down year for stock markets or a potential “melt-up”, with money coming off the sidelines for a last, frenetic grasp at returns before this secular bull trend comes to an end.
On the negative side we have the current OK Corral square-off between the Fed and the bond market. If the bond market is right – if current yields are a good indicator of intermediate term price and growth trends – then today’s volatility picture could portend tears for traders. On the other hand, European QE, an export tailwind for euroland exporters and a low rate-led recovery in emerging markets, coupled with more or less okay headline numbers in the U.S., could be the recipe for a last hurrah – party like it’s 1999! Either way, it may time to learn to love the vol.
Shock and awe? That would be the right term to apply to the Swiss National Bank when it lifted the floor off the Swiss franc’s conversion rate against the euro last week. Any time currencies trade up or down in high double digits in the course of a single day should qualify in the annals of capital markets S&A.
Mario Draghi and the European Central Bank? Not so much. The announcement of the €60 billion quantitative easing program, to last at least through September 2016, was impressive to be sure, but it was also widely expected. European equities rallied, yields compressed and the euro continued its descent against the dollar, but all in modest single digits. What remains to be seen is whether Helicopter Mario’s efforts will bear fruit in bringing about a meaningful change in direction to the Euro area’s beleaguered economies. What seems likely, in the near to intermediate term, is a continuation of the Dire Straits Economy on both sides of the Atlantic. Money for nothing and your bonds for free.
Incredible Shrinking Yields
Your value equation as a fixed income investor is pretty simple. You want to preserve purchasing power. You want to be compensated for deferring until tomorrow the consumption opportunities of today. And you want an additional something in exchange for whatever risks come with the investment. That’s basically it. Now, consider the sovereign yield trends over the last three years in two countries – the U.S. and Spain – in the chart below.
How times have changed. Three years ago the spread between the 10 year Treasury and the 10 year Spanish sovereign was more than 5% - reasonable, it would seem, given the considerable risk prevailing at the time that the Eurozone would break up and Spain, as one of the troubled peripheral economies, would be adrift in a storm of Biblical proportions. Today the spread is negative – Spain’s benchmark debt yields less than the U.S. The same is true for almost every other Eurozone country. Yields are low and continue to shrink. What does this tell us about that fixed income value equation – purchasing power protection, the time value of money and risk spreads?
Deflation Trumps All
Mostly, it seems to tell us that bond investors have a very dim view of the prospects for growth, anywhere in the world. The negative spreads between Treasuries and Euro area debt have very little to do with relative risk factors and almost everything to do with the distorting effects of deflationary expectations on traditional valuation models. Deflation turns the first two components of the value equation – purchasing power and time value – on their heads. If inflation is zero or lower you don’t lose purchasing power. If prices are actually going to be cheaper tomorrow than they are today then you don’t need any extra inducement to defer consumption. If today’s yields reflect a rational consensus about future economic prospects, that consensus apparently is that there’s not going to be much growth, anywhere, anytime soon.
What About the Growth Narrative?
But isn’t that consensus out of line with the growth story, at least in the U.S.? We had real GDP growth of 5% in the 3rd quarter last year and 4.6% in the quarter before that. The last time we had real growth at that level was in 2003 – when the 10 year Treasury was yielding around 4% and inflation was 2%. Unemployment is lower today than it was in 2003. All chatter about a “new normal” notwithstanding, is 3%-plus real GDP growth truly compatible with sub-2% intermediate term interest rates?
There is no certain answer to that question, but as long as inflation remains all but invisible it would probably be a good idea to let the bond market lead this dance. Rates in Europe may not be far from their lower bounds, but there is still room on the downside. After all, even at a 1.4% nominal yield, real rates are still higher in Spain, where inflation is negative, than they are in the U.S. And if recent history serves as any guide, we can expect quite a bit of that QE money tossed out of the ECB’s fleet of helicopters to land in asset markets in the U.S., including Treasuries.
“Rates will Rise” was the mantra at the beginning of 2014. “Lower for Longer” seems an appropriate corollary for the current times.
2014 was a year of both higher job growth and consumer confidence, which in turn helped boost retail sales for most of the year. A post-recession high for December consumer confidence, in conjunction with lower gasoline prices, should be a winning combination for more discretionary spending amongst consumers. However, the retail sales data that came out on Wednesday showed a -0.9% decline as well as a downwards revision to the previous release of the strong November numbers from a 0.7% advance to 0.4%.
This brings about the biggest drop in retail sales since last January. Not surprisingly, gasoline stations had the largest decline among the retail sectors with a -6.5% drop (falling oil prices mean gas stations are making less money). We would expect a gas windfall to produce a big bump in middle class spending, but consumers’ savings at the pump don’t seem to be translating into spending elsewhere yet.
The retail sectors that grew in the month of December are arguably the more “staple-like” sectors: food and beverage, furniture and home furnishing, and health and personal care. In contrast, some of the hardest hit retail sectors were clothing stores, motor vehicles, and electronic stores.
Let’s step back from the December figure and consider the larger context. Over the past five years retail sales have grown steadily, while the household savings rate has declined slightly. In 2014 savings fell somewhat more notably, but at the same time the rate of retail sales growth tapered off and in fact was lower than at any time since the end of the recession. This could be a sign that households are doing things with their savings other than going to the mall – paying down debt, perhaps. That may be the signal we are seeing from the December retail number. It also may tie into the stagnation in wage growth we highlighted in last week’s market flash.
Another factor to consider is that maybe the American consumer’s behavior is beginning to change. As noted above, retail sales growth for the year is the lowest that we have seen since we were in the midst of a recession in 2009, which is especially interesting considering that 2014 has been the best recovery year since the recession ended. And although we saw one of the most successful Black Fridays of all time this past November, consumers – and even retailers – showed a noted (if perhaps only anecdotal) reversal in attitude towards the overt commercialism of the day. More and more shoppers are forgoing the mall for their computers to shop, and the holiday season cash cow – where retailers have traditionally made the majority of their yearly earnings – is changing. How this change will impact the broader economy is still a work in progress.
Monthly leading indicators can provide a good spot check on the economy, but are oftentimes misleading as they are subsequently revised and provide a data snapshot of just one month. All in all, we don’t feel that December’s disappointing retail sales numbers are anything to fret over, but we shouldn’t ignore them completely. Traditionally consumer spending drives the US economy as the highest component of GDP. If consumer habits are indeed changing, the very basis of the economy and the way it operates will likely be changing along with it.
The monthly jobs report came out this morning, telling us that U.S. nonfarm payrolls added 252,000 new able bodies to the workforce. Meanwhile the headline unemployment number dropped to 5.6%, the lowest since June 2008. This would appear to be good news, indicating that the growth narrative for the U.S. economy remains intact. But there are some soft spots lurking below the cheery headlines. Indeed, the net effect of today’s report may be to give the Fed further pause before moving ahead with a rate hike.
Money…That’s What I Want
What is missing from the jobs equation is wage growth. Average hourly earnings decreased slightly in December to $24.57/hour. For the year as a whole average wage growth more or less tracked inflation. Purchasing power on balance was neither lost nor gained. Weak wage growth indicates that there is still considerable slack in the economy, despite the headline growth signals. Employers appear to be under very little pressure to respond to wage demands, even with an unemployment rate 1.1% lower than it was one year ago. In the absence of upward pressure from rising wages it is difficult to see what could spark any significant inflationary pressures. Household budgets remain unchanged; families merely reallocate spending priorities (or use savings at the gas pump to pay down more debt) rather than increasing consumption. This, arguably, gives Chairwoman Yellen et al more room to hold off on rates should they feel the need to.
Maybe the Bond Market is Right, After All
This muted-inflation environment seems to be what the bond market expects. Consider the current yield on the 10 year Treasury as compared to headline and core (ex-gas and groceries) inflation. The chart below shows the relationship between nominal yields and inflation over the past twenty years:
The narrow spread between yields and inflation suggests that the collective wisdom of the bond market, such as it may be, has a very dim view of growth prospects for at least the intermediate term. After all, if the incremental investor is willing to accept a nominal yield of 2% - about where the 10-year currently trades – that investor is apparently not losing sleep over loss of purchasing power. If you think the Fed funds rate will sit over 3% in several years’ time then it makes little sense to hold a long-dated asset and clip 2% coupons every year. Of course this is all subject to change – one would expect to see yields spike northward in light of any new data confirming stronger growth. But for now that catalyst has not manifested – and today’s jobs report is likely to do little to change that perception. Indeed, the 10 year yield has subsided yet again in the immediate wake of the jobs report.
PPR: Productivity and Participation Rate
Growth comes about in two ways: from a growing population with a steady or increasing percentage of labor force participation, or from productivity (more goods and services produced per capita). But another data point in today’s jobs report reaffirms the disquieting trend of decreasing labor force participation. The participation rate for December was 62.7%, its lowest level in past thirty years. The chart below plots labor force participation against productivity (output per hour) over this time period.
There are a variety of explanations for the decreased participation, from discouraged workers to a higher number of retirees. It’s not all about retiring boomers, though – as Michael McDonough tweeted this morning, the labor participation rate for the 65 and over contingent has actually increased slightly over the past decade (purple line on the chart). We at least want to see this trend stabilize before getting too excited about growth prospects.
The productivity story is not all bad – after all, low growth in wages translates to lower unit labor costs, which translates to higher productivity. Looking ahead, though, we should hope that these successive waves of “disruptive efficiencies” touted by Silicon Valley wags really help boost increased output of goods and services.
Revelers around the world are still shaking out the post-New Year’s Eve cobwebs, but ECB Chairman Mario Draghi rang in the year with words of sober clarity. Deflationary risk in the Eurozone is significantly higher than it was six months ago, Draghi told the German Handelsblatt, and may require “measures at the beginning of 2015” to confront the challenge. Markets are widely interpreting “measures” to mean a full-blown quantitative easing for the Eurozone. The euro continues its downward trend, hovering just above 1.20 to the dollar, in the year’s first day of trading. Yields on key benchmark Eurozone bonds continue their race to the bottom.
Meanwhile, On the Other Side of the Pond…
The world seen by Janet Yellen from her office in the Eccles Building, the Fed’s Washington DC headquarters, is starkly different from that described by the ECB’s Draghi. Having wound down QE, the Fed is now faced with the challenge of charting a low-drama course to higher rates. The difference between Draghi’s world and Yellen’s world is clear in the chart below. This shows the direction of the U.S. 2 year Treasury over the past twelve months versus that of the German 2 year Bund:
Short term rates in the U.S. finished 2014 not far from their 52-week high marks, while 2 year Bunds established new 52-week lows. German short term rates have been below zero since August – yes, negative interest rates are an established feature of the new monetary order in Europe. In their parallel worlds Draghi and Yellen each face considerable challenges: the ECB chair must convince markets that policy coordination in the fractious Eurozone is achievable, while Yellen must avoid spooking the markets into the kind of tantrum that her predecessor Ben Bernanke unleashed when he uttered the word “taper” in May of 2013.
What Flavor of QE?
Even if markets expect European QE to be established, the question remains as to what variety is going to be effective. Broadly speaking there are two ways to carry out a quantitative easing policy. The approach undertaken by the ECB to date, through mechanisms like the Long Term Refinancing Operations (LTROs) launched in early 2012, relies on bank intermediation. The idea is that banks are supposed to take cheap money, turn around and lend it out to businesses in need of capital for growth. In practice, though, a greater slice of the LTRO funds remained on the banks’ balance sheets than went into new loan creation. In a low-demand, low-growth environment like the Eurozone there is only so much stimulus that can be applied through bank intermediation.
The other way to accomplish QE is to take a page from the Fed, and inject the stimulus money directly into the economy via open market asset purchases. A comparison of headline numbers between the U.S. and the Eurozone would seem to support this as the preferred approach: on the basis of GDP, employment, retail sales, manufacturing and any number of other figures, the U.S. economy’s trajectory over the past several years has been superior to that of the Old Continent. But such comparisons may also be misleading. There is no clear consensus as to how much of the U.S. recovery may be attributed to QE, the range of views extending from “a fair bit” to “none whatsoever”. QE by itself is unlikely to be a magic bullet: fiscal and other regional and national policies need to also be growth-oriented. That is no easy feat in the 19-member Eurozone.
Faction Before Blood
Perhaps the most difficult roadblock the ECB’s Draghi faces in harmonizing the right flavor of QE with supportive national policies is that of the deep-seated rifts between Europe’s economic policy factions; most notably, the austerity faction led by Germany and other “Northern” nations, and the stimulus faction popular among disgruntled voters in countries where 20%-plus unemployment remains the norm – and that cuts across a wide swath of diverse territories and national identities.
Both the austerity faction and the stimulus faction put forth spirited arguments for their side’s merits versus the other. The austerity argument – that it is folly to deal with a problem of too much debt by creating yet more debt – is logically compelling. But the stimulus camp perhaps holds the trump card: until deflation risk is tamed for once and for all, other approaches will not bring the region back to health before more wrenchingly harsh standard of living declines have played out.
For the U.S., these factional battles are much more than a parlor game to be observed at a distance. Our economy is strong, but not so strong as to be unaffected by the travails of our major trading partners. An aggressive QE approach by the ECB is, we believe, likely to be in our best interests. It may also make it easier for Fed chair Yellen to maneuver her policy ship with the agility necessary to minimize collateral damage in asset markets as rates start to rise. On the policy front, it promises to be a high-stakes 2015.