Posts published in June 2015
“These arguments are not arguments against the gold standard as such. That is a separate discussion which I shall not touch here. They are arguments against having restored gold in conditions which required a substantial readjustment of all our money values”.
– John Maynard Keynes, The Economic Consequences of Mr. Churchill (1925).
In Search of Lost Time
For decades it was the most solid measurable quantity in the world of global finance: £3.17s.9d per oz. of 11/12 fine gold. From 1870 to 1914 that calculation was the price of entry into the privileged club of nations favored to trade their goods and services across borders in the most globalized economy the world had witnessed to then. Being a member in good standing of this club meant subsuming all other economic and monetary decisions to the only one that mattered: maintaining full convertibility of the national currency into gold at that sterling-denominated value. The price of anything else – other commodities, labor wages – could and did fluctuate by wild amounts as economic fortunes waxed and waned. But gold and currency exchange rates stayed fixed.
World War I smashed Europe’s existing order, and with it the classical prewar gold standard. For monetary policymakers dealing with the Continent’s postwar chaos, nothing was seen as more urgent than restoring gold’s primacy to bring back order and harmony. In 1925 Britain, led by then-Chancellor of the Exchequer Winston Churchill, made the fateful decision to restore gold at the prewar convertibility rate. That decision – as Keynes’ prescient remarks in the aftermath of the decision foretold – would weaken Britain’s export competitiveness and compromise its economic position generally for the remainder of the decade, with fateful consequences indeed.
The decision to return to prewar gold was a result of blinkered thinking; British policymakers were unable to comprehend the uselessness of the old system in a vastly different world. Sometimes the status quo is worth fighting for, but other times it is better to move on and let the chips fall where they will. As we resignedly read through the latest “developments” in the endless saga of Greece’s negotiations with its creditors, we are hopeful that the consequences of 1925 are figuring into this generation of policymakers’ thought process.
Athens Says “La-la-la-la-la”
That last statement is not meant to be glib, or to disparage the attempt to fight for the integrity of the single currency Eurozone. To paraphrase Keynes, we see this not as an argument about the euro standard as such. It is an argument about the terms under which the standard should be maintained. From reading the tea leaves in the communiqués over the past several days, this is exactly the argument that is causing the negotiations to drag on as long as they are. Indications are that at least a handful of negotiators are already more focused on the practical problem of managing fallout from a “Grexit” than they are about incremental concessions to narrow the still-considerable gulf between the two sides.
For their part, the Greeks’ hardline stance on pension cuts and tax increases seems to reflect similar considerations over whether, in the end, they are prepared to subjugate every other economic consideration to the rules of the euro standard club. Whether or not this weekend produces some kind of patch-up fix that releases the next €7.2 billion tranche of bailout funding, so as to avoid imminent default, the economic fortunes of Greece are set to remain miserable for a long time to come. One can argue that these fortunes would turn much, much worse upon leaving the euro and returning to a wildly devalued drachma. Greece’s financial policymakers would have to choose from a set of highly unappealing policy choices. At least, though, the choices would be theirs and not those of Brussels or Berlin.
The gold standard may have lasted for longer than it did if policymakers had been more willing to adapt the system’s old rigidities to changing conditions – for example, to allow for greater use of banknotes alongside gold to meet reserve requirements, as argued during the Genoa Conference of 1922. Likewise, we believe the euro standard has a better chance of surviving if it can adapt and evolve. If a “Grexit” were to force the Eurozone to take another sober look at its own hard choices – for example the urgently needed reforms to streamline its fractious banking system – the result could be net-positive.
Clearly some of those at the negotiating table are leaning towards this train of thought. We’ll see where it shakes out over the weekend – and just to repeat what we have stated in previous commentaries, if talks collapse and beget market turmoil in the short term, we are prepared to stay put, look for buying opportunities and keep our eyes on the longer game.
Britney Spears and ‘N Sync were blowing up the charts, President Clinton was dominating the headlines in a most unfortunate way, and households all across the country were lovingly attending to their pet Furbys. 1998 seems a world away from that which we inhabit today, seventeen years later. Yet the economic headlines, if not exactly repeating, do seem to rhyme a bit. There are some history lessons here worth bearing in mind as our attention turns to managing our portfolios through the second half of this year.
Here We Go
In 1998 we were well into the multi-year bull market in US equities that began in 1995, but there were serious concerns elsewhere in the world that investors feared would spill over and spoil our party. Following the collapse of the Thai baht in the summer of 1997, East Asian currencies fell by as much as 80 percent against the US dollar over the next year. Their stock markets were likewise pummeled as foreign portfolio capital made a mad scramble for the exit. The S&P 500, shown in the chart below, was stuck in a three month rut as the 1998 calendar flipped to June. It would enjoy an upside breakout through the first half of July, but more ugliness lay in store.
Summertime ended early for traders in 1998 with word that Russia was defaulting on its sovereign debt. Russian government bonds (GKOs) with their generous yields were a favorite asset holding among foreign investors. After the Russian government liberalized the GKO market in 1997, foreigners grabbed around 30 percent of the total market. The likes of Goldman Sachs and Morgan Stanley opened Moscow offices and competed furiously for mandates, right up to the end of the party on August 17 when the government announced its intention to default.
Nowhere was the demise of the Russian bond market felt with more dismay than in the plush offices of Long Term Capital Management, the prominent hedge fund run by ex-Salomon Brothers star trader John Meriwether and options guru Myron Scholes, one half of the Black-Scholes formula that begat the modern derivatives industry. LTCM’s exposure to Russia led to its bankruptcy and – foreshadowing the Lehman Brothers menace of ten years later – fears of an industry-wide contagion. The specter of a bear market loomed, and indeed the 20% peak-to-trough threshold was tested in early October.
…and Shock Absorbers
As we all know now, that bear never got traction. Policymakers and bankers figured out how to put LTCM out of its misery without taking the rest of the industry down with it. All hailed Messrs. Greenspan, Rubin and Summers as the “Committee to Save the World”. With the US economy continuing to hum along nicely and with continuing problems elsewhere in the world, US stocks once again looked like a pretty good comparative bet. The party would roar along for a couple more years, until “Oops! I did it again” would come to describe the vibe in the worlds of both pop music and capital markets in 2000. Investors who bailed out in the late 1998 turmoil missed out on another 59% of capital gains from the 10/8 trough to the March 2000 peak.
Lessons for Today
What can the 1998 experience tell us about today? Clearly the world is a different place. The US economy is growing, with low unemployment and tame inflation, but it is not growing at anything like the pace of the late 1990s. Still, the US continues to look pretty good compared with other parts of the world. The Greek crisis could yet throw cold water on the recent spate of relative good news in the Eurozone. China’s domestic stock market is a bubble showing an unhealthy uptick in volatility, as seen in the chart below.
The Shenzhen A Share index booked a year-to-date gain of 122 percent on June 12, but experienced back-to-back losses of 3.5 percent and 5.9 percent over the last two trading days. China – which comprises about 25 percent of the MSCI Emerging Markets index – has done the lion’s share of the lifting in pulling EM stocks up this year. A collapse in Chinese equities would be likely to bring the rest of the asset class down with it. The herd effect of portfolio capital that tanked emerging markets in 1997-98 is alive and well.
Greece and/or China could be a catalyst for the long-expected pullback in US stocks. The S&P 500 has not closed 10% or more below the last peak since 2011. But – and here is where we see the usefulness of the 1998 parallel – any such pullback is in our opinion likely to play out relatively quickly and present the potential for further gains before this bull fully plays out. Investors have to put their money somewhere. If the rest of the world looks more unsettling than our home market – and this in the context of a bond market that is, if anything, harder to navigate than equities – we do not see a compelling script for a secular bear in US stocks. Navigating pullbacks requires discipline, but history shows there can be rewards for those who keep their emotions in check.
Interest rates are once again the trending topic as anticipation for the Fed’s June policy meeting next week grows. Last week we considered the potential impact of a Fed rate hike on equities and the possibility of a pullback. This week we shift the focus to what the Fed action might mean for your fixed income portfolio. Back at the beginning of the year, most economists predicted that the Fed would decide to raise rates in June – meaning next week. But after a string of weak economic data the consensus was pushed back, possibly even to next year. That being said, recent data including nonfarm payrolls and this week’s retail sales have been strong. A September rate move looms large, meaning that it is important to make sure that the fixed income portion of your portfolio is positioned accordingly.
Investors say Junk Bonds are indeed “Junk”
An article in the Financial Times this week focused on outflows in high yield bond ETFs since the beginning of June, citing rising rates as a driver. This does not necessarily mean that you should get rid of your high yield exposure in anticipation of rising rates. High yield (or junk) bonds have been found in the past to be less interest rate sensitive than other investments. Rising rates can indicate an improving economy, which in turn means a better environment for companies with poor credit ratings (those companies are the ones issuing high yield bonds). For these and other reasons, junk bonds tend to trade more like equities than bonds – the Barclays US Corporate High Yield Bond Index is 74% correlated to the S&P 500 versus only a 16% correlation to the Barclays US Aggregate Bond Index over the past five years.
In fact, for much of the past year high yield prices have actually moved in the same direction as benchmark interest rates. As rates fell through the second half of last year, junk prices fell as well. When rates rose on the back of good economic news in February of this year, high yield prices performed well. Where this pattern broke decisively was just a couple weeks ago, when the 10-year yield spiked and junk bonds tanked. In other words, if recent outflows are being driven by rate perceptions, that would seem to be more of an anomaly than the “junk bonds fall when rates rise” rule suggested by the Financial Times’ article.
There are two sides to every coin, and more risks to take into account than the directions of interest rates. Call risk affects any bond with call features, and this includes the vast majority of high yield bonds. Most high yield bonds have a maturity of 10 years but are callable at 5 years. In a falling rate environment these bonds tend to get called because the borrowers can then reissue the same bond with a lower interest rate, meaning their borrowing costs fall. In a rising rate environment the opposite will happen – the bond won’t get called because it would have to be reissued at a higher duration. Investors holding callable bonds can get the worst of both worlds – lower duration when rates fall and higher (i.e. more negative price sensitivity) when rates rise. When positioning portfolios for a rising rate environment it is important not to ignore the implications of call risk.
Ever heard the disclosure “past performance is not indicative of future results”? The above chart illustrates why that regulatory disclosure is always worth keeping in mind. Even though junk bonds have historically performed more in line with equity markets than with fixed income, over the past eight months the correlation has been spottier than usual. Junk bonds mirrored equities until October, when stocks experienced a deep pullback. High yield followed stocks down, but then kept falling while the S&P 500 pulled a stunning V-shaped recovery.
Why the divergence? A considerable number of junk bond issuers are energy exploration and production companies, and the energy sector led the broader market down as oil prices were plunging. So even though the S&P 500 enjoyed a sharp recovery, investors dumped high yield bonds fearing a rise in energy-related default risk. A similar story happened back in 1999 and 2000: during the period of high volatility leading up to the implosion of the tech sector in 2000 (which also happened to be when a rate hike program was in place) junk bonds had a negative return and underperformed other asset classes.
When in Doubt, Diversify
Because it has been awhile since the last Fed policy decision to raise rates (eleven years to be exact), it is difficult to predict how the scenario will play out this time. The more recent data we have on rate hikes happened in the context of a 30 year macro bull market for bonds. If we are about to enter a secular rising rate environment (and we don’t know for sure if this is the case), the most recent comparable data we have to work of off is from 1951 – 1981 – it is safe to say that the world is vastly different now than it was back then. Quite possibly, we are entering into a whole new world of rising rates.
There are some logical assumptions we can make, though. Investments that are less interest rate sensitive (as indicated by shorter effective durations) are more likely to perform better in a rising rate environment. High yield bonds fall into this category, but as we saw above there really are no guarantees. It is more prudent to adjust your allocation accordingly in different market environments rather than to either eliminate an asset class altogether or double down on the one you think (based on past performance) likely to do best.
Floating rate debt, short-term fixed rate issues, agency & non-agency mortgage backs and asset backed securities can potentially help immunize your exposure to interest rate risk. As noted above, don’t forget about call risk. The bottom line is that when the terrain is uncharted, a well-diversified portfolio is likely to be the best way to avoid missteps.
Rate hike chatter is back front and center in the wake of this morning’s relatively strong jobs numbers. Payroll additions exceeded expectations while hourly wages, which historically correlate closely with Fed policy, also ticked up ahead of consensus. Today’s data do not make for a complete picture, and the Fed will probably wait to digest the Q2 GDP release before putting a definitive mark on the rate hike calendar. But it is fair to say that the odds of September-time frame action have improved with today’s release.
So we have a potentially volatile cocktail made up of the Fed, Eurozone bonds gone wild, and an expensive, sideways-trading stock market looking for direction. Are these the ingredients for a hefty pullback in US stocks? We would not rule out the possibility. We would also not be inclined to run for the hills were such a pullback to happen. A brief look at market history will explain why.
Pullbacks, Bulls and Bears
A reversal of 5 percent or more in the stock market is a headline-grabbing event, engendering a climate of fear. Most of the time, though, the fear is overblown. We define a “pullback event” as a reversal of 5 percent or more, followed by a recovery of 5 percent or more. Since 1950 there have been 177 such pullback events on the S&P 500, or about one every four and a half months on average. Occasionally the pullback led to a broader bear market environment, notably in the double recessions of the early 1970s, the 2000-02 tech collapse and then the Great Recession of 2008-09. Most pullbacks, though, were relatively shallow and brief. The chart below illustrates the price performance of the S&P 500 since 1950, with the vertical grey bands indicating US economic recessions.
What this chart illustrates is that major pullbacks outside of recession-related bear market environments are anomalies. The most severe of these anomalies was the Crash of 1987, when US stocks dropped more than 20% in a single day. The events which drove that crash were largely unrelated to prevailing economic fundamentals, and would have been very difficult to predict ahead of the event. As deep as that reversal was, though, shares had recovered their losses and set new highs within one year. In a similar vein, markets tumbled on two non-recession related occasions in the 1960s and once in the latter stage of the 1990s bull market. Since the 2009 market bottom there have been two relatively significant events – a 16 percent reversal from April to July in 2010, and a 19 percent drop from July to October in 2011. Even in the latter instance, though, the market bounced back to a new high just three months after hitting bottom.
Growth Does Not Cause Bear Markets
So what does all this mean for today? Isn’t it possible that a pullback sometime this summer or fall could lead to a larger bear market? It is possible, of course. There are thousands of variables at play in the market every day, any combination of which could potentially bubble up to the surface at any time, cause havoc and eventually drag the economy into recession. What we think highly unlikely, though, is that a rate hike per se would usher in a prolonged period of misery. If a rate hike happens, it will happen because the Fed is convinced that underlying economic growth is strong enough to merit a rate hike. And economic growth is not a catalyst for a bear market.
Yesterday, IMF head Christine Lagarde warned the Fed not to raise rates in 2015, citing “too much uncertainty” in the global environment and darkly opining that the Fed’s credibility would be on the line if it were to unwisely move ahead. We understand the sentiments driving Mme. Lagarde’s comments, but believe they are misplaced. The Fed’s mandate is to guide US monetary policy towards the objectives of stable prices and full employment. It is not to placate jittery market sentiment around the world. If the data suggest that a measured rate hike is the appropriate policy for this mandate, then that is the right thing to do. Have faith in markets to adjust accordingly.
And if stocks do freak out and retreat by 5 or 10 percent? More likely than not, that would be welcome news for opportunity-starved value investors, ourselves included.