Posts published in April 2015
It’s been a good couple weeks to be on the long side of a crude oil futures contract. Animal spirits were in full force Thursday as hedge funds and others poured into the market, driving Brent crude futures to their highest level for the year to date. As the chart below shows, this is the second upside breakout of significance this year, pushing the 50-day moving average back above the 100-day average for the first time since they inverted last August. That may be good for some near term technical momentum. But does this rally have the fundamental legs to keep pushing up, or are we headed for another push me-pull you reversal similar to what happened in March?
The Rig is Up
Some prominent industry voices are confident that the sub-$50 oil of January is firmly and finally in the rear-view mirror. At the FT Commodities Global Summit in Switzerland this week former BP chief Tony Hayward opined that prices could reach $80 in the not-to-distant future. That would leave more than 20% of additional upside achievable from today’s levels, and that appears to be what the hedge funds are betting on. The argument for this view is a near-term combination of slightly improved demand and declining production, in particular from the shale drillers. For example, the active rig count in the US this month is about half what it was late last year. The Energy Department expects a decline in US crude production later this year from the current level of 9.4 million barrels/day. This is essentially the card Saudi Arabia played at the November OPEC meeting last year – price the more expensive producers out of the market and grab share.
The bullish case is by no means universal, however. Exhibit A in the doubters’ case is US inventory levels, which are higher than they have been at any time in the last 80 years. It is also not entirely clear how much demand is perking up, despite some recent upward revisions in demand forecasts. Growth is slowing in China and remains subdued in Europe. At a more structural level, though, measures like rig count do not tell a complete story about the production landscape in the US. The technology for unconventional drilling is evolving rapidly. As it evolves, the cost threshold for profitable production comes down. And the life cycle of shale extraction is typically shorter than it is for conventional wells – about 60-70% depletion in the first year. That arguably gives producers the ability to turn production off and on more quickly in response to changing price and demand trends. Indeed, a recent New York Times article makes a decent case for the US replacing OPEC as the world’s swing producer.
So what do all these crosswinds mean for prices? Perhaps the most appealing scenario is a reduction of volatility as crude benchmarks settle into a range-bound pattern, with a floor supported by tempered rates of production and upside capped by inventories and improving cost economics for US producers. We do not necessarily disagree with Mr. Hayward’s assessment of $80 oil as reachable, but we think it plausible that this could be the upper boundary of a $70-80 range for the near to intermediate term. Of course there are plenty of other variables at play. Iranian capacity could be a factor depending how the recent framework agreement plays out. The impact of the situation in Yemen is currently being felt. There are valid upside and downside scenarios for global demand. Net-net, though, we can see a reasonable path to the seventies.
In one corner, the Beantown Bruiser. In the other, the Show-Me State Slayer. Let the policy rumble begin!
It has been yet another week of all Fed, all the time. This week’s will they-won’t they chatter took the form of a policy square-off between St Louis Fed President James Bullard and his Boston Fed counterpart Eric Rosengren. Mr. Bullard looks into the future and sees "boom times ahead" – so it’s time to raise rates. Not so fast, counters Mr. Rosengren. The economy is “still too weak” to take action, he argues, with neither labor market conditions nor inflation trends making a convincing enough case to start raising rates.
Rosengren and Bullard are this week’s public faces for what appears to be a genuine fault line in the Fed Open Market Committee. The March FOMC meeting minutes released on April 8 revealed several members seeing an economy strong enough to start raising rates in June, with others looking at the same data and seeing no pressing need to go rushing in. So which is it – boom times or a still-unsteady patient?
Recent macroeconomic headlines certainly have not presented an unambiguously clear picture. The March jobs report brought to a screeching halt a year’s worth of monthly payroll gains in excess of 200,000. Fourth quarter GDP was also somewhat disappointing at 2.2%, and this year’s cold winter is tempering expectations for the coming Q1 reading. The IMF chimed in this week with downward revisions to its global growth projections for the next two years. None of this sounds very much like Bullard’s “boom times”.
On the other hand, today’s release of the March Consumer Price Index would appear to indicate steady, if not necessarily rapid, progress towards the Fed’s 2% target. Energy prices kept the year-on-year headline number muted, but core inflation (excluding energy and food prices) inched up to 1.8% y-o-y. Retail sales turned higher in March after a couple weak readings earlier this year. Consumer confidence reached a post-recession high in February. Bullard also notes that under prior Fed policies, rates would have already started to go up.
Brave New World
Prior policies may not be altogether relevant, though, given the uncertain terrain of the new landscape. Even if global growth manages to best the IMF’s lowered expectations, it will still be modest by historical standards. Then there is the other great unknown; namely, how asset markets will react. The IMF, which seems to have woken up on the wrong side of the bed this week, mused that a rate hike could ignite a “super taper tantrum” even more extreme than the wild and crazy ride the ten year Treasury took in 2013, soaring from 1.6% to 3% over a four month period that year. A super tantrum doesn’t sound like anything that would be good for assets generally.
It also may not be the most likely outcome. Yellen’s Fed has found game in its communications skills. It is hard to imagine that even a June hike would be a jaw-dropping surprise. Other market forces – a global savings glut, negative yields in Europe – could also keep a lid on rates particularly further down the yield curve. By the time the FOMC meets in June, we expect the data will be more clear as to whether the recent softness was mostly about weather or indicative of more structural weakness. If it’s “boom times ahead”, then let rates reflect accordingly.
If you parked a chunk of cash in emerging markets equities at the beginning of this year, you are probably giving yourself a pat on the back for your keen investment acumen. While the S&P 500 struggles on either side of break-even for the year to date, the MSCI Emerging Markets index is up a brisk 8% for the same period. And since most broader EM indexes are still well below their recent and all-time highs, one might argue that there is plenty of room for more upside. That may well be – short-term market movements seldom bear any resemblance to rationality. But economic fundamentals reveal a cloudier picture, something more structural than the usual peaks and valleys of animal spirits that drive capital flows into and out of the developing world.
Growth Engines No More
The growth question is at the top of concerns nearly everywhere in the global economy. Nowhere is this more so than in the countries recently known as the world’s growth engines. The chart below shows real GDP trends for the past five years in the four core EM economies of China, India, Russia and Brazil.
Growth is below trend in all four countries. China and India continue to do comparatively well – most countries would be thrilled to post GDP numbers in the 5-7% range. But China in particular faces a stiff set of challenges as investment, which has been the country’s principal growth driver, is slowing amid growing fears of a severe contraction in property values. Meanwhile, the dismal state of affairs in Brazil and even more so in Russia should make it clear that treating these four countries – the BRICs – as anything remotely like a single asset class theme is misguided. The problems in the BR of BRIC – brrr indeed – appear structural rather than cyclical.
Currencies and Capital Flows
The relentless upward pace of the US dollar is a problem for emerging markets in several ways. The strong dollar is driving near-record levels of EM capital outflows, which exceeded a quarter of a trillion dollars in the fourth quarter of 2014 and continue apace so far this year. For resource exporters like Russia, Brazil and Malaysia, the pain from exiting capital is exacerbated by continuing weakness in commodities prices. Meanwhile, countries with high levels of dollar-denominated debt are falling into the trap of fewer resources with which to make increasingly expensive payments. A recent report by McKinsey notes that emerging markets collectively accounted for 47% of the $49 trillion increase in debt outstanding through the end of 2013. Not all of that is dollar-denominated, of course. But, generally lacking the ability to conduct international trade in their own currencies, emerging markets are at the mercy of the dollar. There is not much mercy to be found there these days.
Breakup of an Asset Class
The chart below shows the boom-and-bust pattern of emerging markets equities (iShares ETF ticker EEM) over the past three years, a period in which it has spent roughly proportional amounts of time above and below its 200 day moving average.
As the chart shows, the current price remains well below the previous highs of September 2014 and January 2013. And that last-three-years 9/14 high itself is almost 20% below the record high for EEM reached in October 2007. There may be enough momentum to propel the current rally further, but we would be inclined to proceed with caution. As we noted above, emerging markets really is no longer a single asset class. Going forward, we see more value in addressing this section of our portfolios in its component parts. Asia remains promising despite some potential road bumps along the way from China. Brazil will likely continue to be a drag on Latin America, but other regional economies including Mexico are still worth a look. As for Russia – “nyet” for the foreseeable future. Russian equities are actually going gangbusters this year. But that is coming off the trough of last year’s meltdown, and in a context where almost nothing looks good as far as the eye can see.
Happy 2Q2015! A new quarter means another earnings season, and this may be one of the most impactful ones in recent memory. In the larger context of a weakening macroeconomic picture, punctuated by today’s lackluster jobs report, earnings are likely to weigh heavily on the near-term fortunes of asset indexes. From where we sit, the river runs swift with dangerous currents. We look first at the macro context, then the unfolding earnings picture, and conclude with thoughts about navigating the approaching rapids.
Jobs, Prices and Rates
The “consensus economist” contingent was caught like so many deer in the headlights this morning. The Bureau of Labor & Statistics brought forth a dismal report from what has hitherto been the go-to place for good news: the jobs market. 126,000 payroll gains for March, plus a net downward revision of 69,000 for January and February, does not a case for growth make. Wage growth remained more or less where it has been, just barely keeping up with (low) inflation. The good news, such as it is, from a bad jobs number is yet another reason to believe the Fed will push the rate decision further back towards the end of the year at the earliest. Normally that is like a sprinkling of catnip on traders’ Meow Mix. But S&P 500 futures retreated 20 points in the wake of the BLS report. We will have to wait and see how the numbers marinate over the weekend before markets reopen on Monday.
Negative Earnings or Low-Bar Theatrics?
Meanwhile, earnings season is set to open with expectations of negative average EPS for the S&P 500. Now, a big chunk of the gloom derives from just one sector, energy. According to FactSet, energy companies are poised to see EPS declines of 64%, with the pain shared among exploration & production names and service & equipment providers alike. But the 4.6% overall projected EPS decline is not from energy alone; six of the ten major sectors are expected to register in the red. Positive EPS growth is expected only in four sectors: healthcare (leading the way with 10.8% projected growth), consumer discretionary, industrials and financials.
The key theme of our Annual Market Outlook this past January was the importance of earnings as a leash on stock prices after three years of a robust multiple expansion rally. That leash seems to be giving large cap US stocks little roaming room on the upside, and a negative earnings quarter is unlikely to be of much help. However, we should be mindful of the theatrical element to the quarterly earnings event. At the beginning of this year, the consensus outlook for 1Q2015 EPS growth was 4.2% year-on-year. So the consensus has ratcheted down by 8.8% from then to now. That may be a sufficiently low bar for companies to do what they do best: exceed diminished expectations.
There is some evidence of a sector rotation at hand. Healthcare and even more so technology stocks, lately solid outperformers, have taken some hits in the past couple weeks; meanwhile the long-suffering energy sector seems to be finding a floor. In fact XLE, the SPDR ETF, has outperformed healthcare proxy XLV over the past 30 days. It may be a good time to add a bit to underweight energy exposures. But we are not convinced a full-blown rotation is at hand; rather, we are more inclined to look beyond generic sectors or geographies to names with the right mix of growth, profitability and asset quality as we head into choppy waters.