Posts published in July 2015
Yes, it is already that time of the year. August is upon us, otherwise known as the dog days of summer. This is the season of potato salad, beach volleyball and light-volume trading sessions on equities exchanges. Those light volumes have a habit of cutting short hard-earned vacations as random unexpected events pop into existence and cause exaggerated price swings. Are we due for another August of surprises, or will the relatively benign sideways market that has prevailed for the last seven months carry us gently into September?
Dog Days By the Numbers
The numbers tell us: volatile Augusts are not just another fanciful chestnut of Wall Street mythology. For the last quarter century, August has been the most negative month of the year on average (as measured by the price return from 7/31 to 8/31 each year from 1990 through 2014). The average August return for this period was -1.49 percent versus an average overall monthly return of 0.67 percent. August had two of the 10 worst monthly returns of any month during this period, and five of the top 25. By comparison October, that ghoulishly famous month of tricks and treats, made only one appearance (2008, of course) in the Worst 25 months over this quarter century span (which time period, of course, does not include the carnage of Octobers past in 1987 and 1929). So yes, August has earned its reputation as the month where the best laid plans of R&R go to die.
All Eyes on September
Two years ago, the event keeping investors off the beaches was the “taper tantrum” – the largely irrational spike in bond yields that followed from then-Fed Chairman Bernanke’s musing over a possible curtailing of QE3. Now the chatter is all about the real thing – an actual rate hike program for the first time since the sequence of 17 consecutive increases from 2004-06. The Fed has studiously avoided making specific time commitments even as the consensus forms around a likely increase before the end of the year. Coming into today’s 2Q GDP report, the question was whether the program would start in September or December.
According to the Bureau of Economic Analysis, real GDP grew 2.3 percent in the second quarter. That was slightly below consensus estimates, but at the same time the BEA revised first quarter GDP growth from the previous -0.2 percent estimate to a haler 0.6 percent. Still, this year’s Q2 is a far cry from the 4.6 percent growth we saw a year ago, also coming off a seasonally challenged Q1. How does this information affect the likely timing of a September rate move? A scan of financial media headlines this morning reveals a healthy dose of “economy bounces back” narratives. We, however, believe that if the needle has moved at all today it has moved closer to a December start.
Time Is On Their Side
What the Fed has said time and again is that it will raise rates when it is good and ready, based on the data, and not before. Inflation remains below two percent, there is still slack in the labor market and capacity utilization hovers in the low 70s. In other words, there is no gun to the head. We believe a 2Q GDP number in excess of three percent would have been the needle-mover closer to a September event, but such was not the case.
Then there are all those other things that could spook the market and cause the dog days to live up (down?) to their reputation. Volatility has been relatively muted throughout the Greece and China dramas of the past several weeks. But if something comes out of left field in the next four weeks and sends the S&P 500 into a five percent-plus reversal, expect that to weigh further still against any moves by Yellen & Co. to move up the starting gate.
To Our Clients:
We have heard from a number of you over the past several weeks with questions about what is happening in the markets – whether there is potentially cause for concern given some recent developments, and what else may be having an impact on your portfolio between now and the end of the year. In this letter we will share with you some observations that are contributing to our market view and decision framework.
Act I: The Year to Date
For an opening act, let us shine a bright light on what has been a rather unusual several months. In late April, benchmark German interest rates experienced a sudden and unexpected surge of more than 700%. June and the advent of summer brought with it a default by Greece on a loan payment to the IMF, raising the probability of a Greek exit from the Eurozone with unknown consequences. Finally, China’s high-flying domestic stock market got a little too close to the sun and collapsed, giving up more than 40% over the latter half of June before stabilizing as a result of massive government intervention.Yet for all that action, the one remarkable characteristic of US equities during this time has been a distinct lack of conviction. Consider the chart below, which shows the performance of the S&P 500 stock index in the year to date.
The S&P ended 2014 around a price level of 2080 (indicated by the dark gray dotted horizontal line). Following a very volatile January and then a strong breakout rally in February, the benchmark index has mostly traded in a range in more or less equal distances above and below the year-to-date break-even level. For the last five months, nothing has been able to catalyze a sustained upside or downside directional movement. What is causing this stubborn lack of conviction?
We believe the upside resistance tracks back to a main theme raised in our Annual Outlook back in January: namely, that after a three year run in which stock price gains far outpaced growth in corporate earnings, those earnings were likely to act as a limit on price growth. The May 21 high water mark for the S&P 500 this year represents about a 4.3% total year to date return, which is not too far away from consensus projections for fiscal year 2015 earnings per share growth for the companies which make up the index. The upside directional headwinds, then, may be mostly about earnings.
On the downside we see a similar phenomenon: there has not been a single pullback this year of a peak-to-trough magnitude of 5% or more, and for the most part the reversals have found support at key technical indicators like the 100 and 200 day moving averages. Now, part of the downside resilience is arguably event-driven – neither China’s stock collapse nor the Greek debt crisis resulted in a worst-case outcome. More broadly, though, we do not see a compelling bear case for US equities. The low likelihood of a near-term recession, along with a sense that the key prevailing risk threats are outside the US, help make the case for downside support.
Act II: The Year Ahead
Keeping to the theme of events impacting market performance, perhaps the most significant development that has yet to play out in the second half of the year is the Fed’s decision on interest rates. This event is of particular interest to diversified portfolios with significant yield exposures – for example to high dividend stocks, convertible bonds and REITs. Generally speaking, exposure to these asset classes makes sense in a world of near-zero interest rates. They have been, and continue to remain, an important part of our asset allocation strategy. Recently, though, there has been a very close inverse correlation between short-term movements in interest rates and the price performance of enhanced-yield assets. The chart below provides one such illustration, showing the year-to-date performance of high dividend stocks compared to the yield on the 10-year Treasury note.
We believe the Fed is likely to make its initial move on interest rates sometime between September and December, with the timing depending mainly on the growth, inflation and employment data points that come in between now and then. So, it would be reasonable to ask what we are planning to with our enhanced-yield exposures in a rising rate environment.
To answer the question we need to consider the larger picture. Short-term traders are focused entirely on the first rate hike – as illustrated by the above chart – but that is not the right focus for the long term portfolios under our management. What kind of economic environment do we expect to prevail over the intermediate term – in the next two to three years? The base case scenario driving our investment decisions is an environment of low growth in the US and other developed markets, and a continuation of below-trend growth in emerging markets. This scenario envisions a very gradual pace of interest rate increases, with the Fed ever ready to suspend a rate increase program if low positive growth turns flat or negative. We believe that enhanced-yield assets will continue to play an important role in this environment, as yields on high dividend stocks, REITs, Master Limited Partnerships and other similar assets are likely in these circumstances to remain attractive relative to high quality fixed income issues. We also believe that the underperformance of enhanced-yield assets in 2015 is partially a case of “sell the rumor, buy the news”. Once the first rate hike takes place and the world does not come to an end as a result, we expect phenomena like the “dividend-rate trade” to subside.
There are of course many other variables at play that we continue to monitor closely. We will continue to share our thoughts with you as and when our views adapt to evolving market realities.
Well, that was quite a week. Not often do we see the human frailties behind the bland policy statements, but raw emotions were on full display as European policymakers scraped together a 12th-hour deal to – for now – keep Greece in the Eurozone. By all accounts Prime Minister Alexis Tsipras was raked over the coals as representatives of the creditors vented in turn over the chronic misbehavior of the Greeks. But the real ire showed itself not to be that of the North-South variety – old news – but the clear philosophical divisions at the core of Project Europe. We don’t imagine we have seen the last of the endless bailout requests coming from Athens – not by a long shot. But the more interesting story – and potentially the one more consequential for asset markets in the coming months – is whether the Eurozone can regain the stature and credibility it lost over the past weekend. It has its work cut out.
The Talented Mr. Tsipras
The creditor side’s loss of the moral high ground can be seen in the respective public opinion fates of the two principal faces of the drama this week, Greek PM Tsipras and German Chancellor Angela Merkel. Recall that, just one week earlier, the Greek citizenry had delivered a resounding “No” to the austerity measures contained in the most recent proposal, which “No” extended to any deal without explicit conditions for debt relief. The deal to which a bleary-eyed Tsipras agreed in the early hours of Monday morning (just in time for the stock markets!) contained even more severe measures to raise taxes, slash pensions and even make Greek bakers compete with each other with fewer government protections. It included no assurances of debt relief. And it insisted on a hugely accelerated timetable for implementation of these measures as a requirement for proceeding with the financial relief needed to reopen the cash-starved Greek banks.
And yet, Mr. Tsipras not only managed to shepherd all these tough measures through Parliament with a 229-64 margin, but also won the backing of 70% of the population for his handling of the negotiations. Say what you will about the seemingly inept performance of the Tsipras team during the negotiations – the man does have his finger on the pulse of his country. Even Germany’s leading periodicals grudgingly acknowledged that Mr. Tsipras is likely to be showing up as Greece’s key man at the negotiating tables for some time to come.
For Every Borrower, a Lender
The week’s PR consensus was far less kind to German Chancellor Angela Merkel, whose name showed up repeatedly next to phrases like “return to old nationalist grudges” and “darkest moments of the last century” – not phrases with which any German politician would wish to be associated. There was broad agreement that the final terms of the deal went above and beyond what could be considered reasonable austerity measures, and reflected instead misplaced moralism and vindictiveness on the creditors’ part. Ironically, this managed to do what five years of negotiations had not; to bring into the mainstream the argument that Greece alone does not bear responsibility for where we are today – that for every borrower there is a lender, and that a large number of those lenders reside in Frankfurt. Unfortunately, this reality shines a cold light on the very structure of the single currency union which, in hindsight, seemed fated to bring these borrowers and lenders together.
The single currency zone envisioned by the architects of Project Europe was never the ultimate objective itself, but rather it was intended to be a natural reflection of political union – a unified Europe that had successfully overcome the national identities that too often in the past had resulted in bloodshed. It was a stirring vision indeed, but not a realistic one. For all the ways in which it has converged, Europe remains a continent of distinct languages, cultures and – yes – approaches to economics. Greece, to give one example, will never share a common view of inflation with Germany, a country still haunted to this day by the extreme hyperinflation of 1922-23. A united Europe with a united currency was a laudable vision. But when the Eurozone was launched in 1999 it imposed a unity that was well before its time. Consider the following chart, which shows the benchmark 10-year sovereign bonds for Germany and Spain from 1993 – 2003: the years leading up to and after the euro’s launch:
Historically Spanish debt traded at a sizable spread to Germany’s issues, reflecting quite naturally the different compositions of the two economies and the relative risks inherent therein. As the chart shows, the spread converged to zero with the introduction of the single currency. As for Spain, so for all other so-called peripheral economies including, yes, Greece. Who wouldn’t go out to tap the debt markets under these conditions?
On the other side of the equation, Germany’s economic choices in the years following the costly reunification between East and West Germany were more focused on restoring national fiscal and trade balances than on anything elsewhere on the Continent – again reflecting a deep-seated national loathing of deficits and inflation. The result was a growing current account surplus that – in the absence of sufficient domestic demand – found a natural destination in loans to Greece, Spain, Portugal et al. It was a natural road from there to here.
Beware the Spirit of 1919
John Maynard Keynes was part of the British delegation to the Versailles peace conference in 1919 that dealt with reparations from the destruction of the First World War. His dismay at the self-serving policy positions of the national negotiating parties led to his publishing “The Economic Consequences of the Peace” – which turned out to be an alarmingly cautionary tale. Now – today is not 1919, and our policymaking institutions are, for all their faults, superior to those that repeatedly botched the opportunities of the 1920s. But Europe is in a fragile position in the wake of this week’s events, with divisions and resentments laid bare. If the single currency region is to succeed – and we believe it is in the interests of the global economy that it does succeed – we will need to see more effort applied to fixing the parts of the system presenting the biggest barriers to real unity. The fractured financial system should be the first project on this list. A system of fiscal transfers between Eurozone states could prove a better safeguard against future defaults than the current flawed system of patchwork bailouts. If Greece can be a part of this system, then all the better. If not, then it is now time to move on.
The more things change, the more they stay the same. A week that started off with a surprising and spine-tingling “OXI” – No – from Greece’s citizens, amidst much animated chatter among the punditry about the inconvenience of the democratic process to orderly asset markets, ended with yet another application of aloe balm and Band-Aids to defer the hard decisions to a later date. From Athens to Shanghai to the great chamber of transactional irrelevance that is the physical floor of the New York Stock Exchange, this week demonstrated once again that the signature characteristic of capitalism in the 21st century is the ability to defer to tomorrow those issues that are too daunting to take on today. Call it the “Mañana Doctrine”. Tomorrow is always a day away.
Athens: From “OXI” to “Oh, Okay”
“…there’s only so long you can ask people to vote for impoverishment today based on promises of a better tomorrow that never arrives” -- Mark Blyth and Cornel Ban, “Austerity vs. Democracy in Greece”, Foreign Affairs January 29, 2015.
Apparently, “only so long” is long enough for yet another round of bailouts for an economy that appears to have no prospects of recovery whatsoever. Greek citizens voted “No” on Sunday and by the middle of this week the consensus among those following the unfolding events was: no bailout, no emergency funding, let Greece deal with the consequences while the ECB and the European Commission figure out how to contain any collateral damage. But late Thursday, in a matter of hours, the framework of yet another bailout deal emerged – yet another Phoenix from the ashes of Eurozone unity. There is not yet a done deal, though investors are certainly acting as if the icing has already been applied to the cake and little EU and Greece flags inserted atop thereof.
In the end it was the Hellenes who blinked first, dropping their demand for concrete language about reducing the unsustainable debt load. Now they will accept virtually all the austerity measures roundly rejected last weekend, as a “good faith effort” to start a discussion about debt reduction. Otherwise, nothing has changed. Germany still insists that the Greeks channel their inner House of Lannister and promise that all debts will be paid. Greece still can’t function as a viable stand-alone economy, within or without the Eurozone. European Commission and ECB functionaries still can’t conceive of a world without endless summits, conceptual frameworks and plenary sessions. And the single currency zone looks ever more like the wobbling gold standard of the late 1920s.
Shanghai and Shenzhen: What’s Mandarin for “Kabuki”?
Once upon a time, in a capital marketplace far, far away, common share prices were thought to reflect the future cash flow-generating potential of a company’s installed asset base. How quaint. Consider China’s domestic A share market, where likely fewer than 20 percent of the enthusiastic retail investors showing up at local exchanges (Humans! Physical exchange buildings!) to bid up shares earlier this year had any notion of the relationship between cash flows and share prices. Spurred on by explicit government support, popular delusions and the madness of crowds (to paraphrase Charles Mackay) these domestic investors bid up the Shenzhen Composite index by 122 percent from January 1 to June 12 of this year. Then it all came tumbling down, to a low point 40 percent below the 6/12 high water this past Wednesday. Think about that for a moment: after losing more than the S&P 500 lost in that annus horribilis of 2008, the Shenzhen Composite was still up in mid-double digits for the year to date.
But 40 percent reversals aren’t supposed to happen in the everyone-gets-a-trophy world of postmodern asset markets. The authorities in Beijing went into overdrive to prove that Communist policymakers can tame the wild stock market beast, shutting off as many escape valves as possible. This was not only to keep people from selling more shares, but to actually mandate brokerage firms to “get out there and Buy…Buy…Buy!” in their best imitation of the characters Randolph and Mortimer Duke from “Trading Places”. Well, it worked…to a point. Back-to-back rallies have produced an 8% gain for Shenzhen and 11% for Shanghai – the two main domestic exchanges – since Wednesday’s low point. Investors the globe over are predictably thrilled. Meanwhile, more than 1,400 stocks, or about half the total number of listed companies, are suspended from trading (lest anyone actually want to sell out of them). A flurry of restrictions from Beijing has made selling shares in any major way practically impossible. The notion of “natural floor” obviously has no resonance in the lexicon of China’s financial mandarins. Of course, a buyer’s market with no sellers is also a fairly implausible concept. We do not count ourselves among the choir of the credulous – much as we are often fans of “buy the dip”, China is in our opinion an exposure to avoid while the OK Corral stand-off between mandarins and market forces plays out.
The Incredible Shrinking NYSE
With all the kerfuffle going on elsewhere in the world, the fact that the New York Stock Exchange shut down for four hours on Wednesday seems almost un-newsworthy. Time was, of course, that turning the lights off on America’s Stock Exchange would have been a riveting event. But – contrary to all those stock photos of sad traders with face in hands framed by a sea of red numbers – nothing much really happens on the floor of the NYSE any more. On the same day that technology problems brought down the servers at United Airlines and the Wall Street Journal, the NYSE went dark and…nobody cared. Trades were routed through NASDAQ or another exchange with nary a disruption to the day’s proceedings. Problem solved! say the Pollyannas, noting that our multiple advanced technology platforms act as back-up to ensure that what once would have been a genuine crisis is no more thus.
That’s true, as far as it goes. Having alternative channels through which to route orders was definitely helpful, particularly given that the day the NYSE went down was the same as the high point of fear over Greece and China – a day when a real system failure in US equities could have been devastating. But any technology failure like this reminds us of what is perhaps the most high-probability, as yet-unrealized threat lurking in the market; namely, the potential for a system failure brought on by cyberterrorism. As both private sector and government systems around the globe fall victim to the techniques of highly sophisticated hackers, this risk demands continual vigilance and recovery preparations.
We are pleased the week is ending on a positive note, with most US share indexes more or less close to where they started the week and Europe’s bourses substantially higher. But at the same time we believe the problems which begat a volatility spike this week will continue to loom large. As we have noted in recent commentaries, we see the risks as being higher outside the US, and in the intermediate term this should work to the benefit of US shares relative to those of non-US developed or emerging markets. For the next few weeks, though, it may be a bumpy ride in all markets.
Yesterday, Greece’s citizens resoundingly rejected the most recent proposal by the country’s creditors to implement new austerity measures in exchange for continued financial assistance. The size of the “no” vote was a surprise to observers of the situation and leaves Greece’s economic future, and its continued participation in the single currency union, very much in doubt. We continue to follow the unfolding events closely, and are using this Technical Market Comment to share our views and outlook with you.
The Situation As It Now Stands
The most pressing question in the next several days will be whether the European Central Bank (ECB) will continue to provide emergency financing to Greece’s beleaguered banking system. Greek banks closed last week after the ECB’s Governing Council put a cap of €89 billion on its emergency credit line. The ECB is expected to announce sometime after it meets today whether it will increase the amount of emergency funding it provides to Greece. Yesterday’s vote is expected to move sentiment among Governing Council members closer to the hard line position of Germany. The bottom line, though, is that without some form of continued support the Greek banking system could very well be insolvent by the end of this week. This would further extend the pain of the worst economic collapse not related to war that any country in Europe has suffered in the last 125 years.
The ECB will also be a key player in what many EU policymakers see as a more important concern than Greece’s economic future; namely, how to prevent the situation from being a Continent-wide contagion that poses a deeper threat to global asset markets. To help calm nerves the central bank could accelerate the pace of the bond-buying program announced earlier this year. One fact that may temper panic among investors is the relatively low level of exposure to Greece held by other European financial institutions. In a briefing note last Friday, Barclays Bank estimated that the total exposure of all Eurozone countries to Greece amounts to less than 3.5% of the region’s total GDP, and that only a fraction of that amount is held directly by its financial institutions.
Finally, while Greeks voted “no” in the referendum, it remains unclear what exactly they voted for. The majority of polls continue to indicate most Greeks want to remain in the Eurozone. And their support for Prime Minster Tsipras and the ruling Syriza party, whose credibility was enhanced by the referendum, would not be likely to last if the country faces bankruptcy. Early indications are that Tsipras and his team are returning to the negotiating table with renewed seriousness – a position underscored by the resignation this morning of controversial finance minister Yanis Varoufakis. Greece is expected to propose new bailout terms at an EU summit meeting on Tuesday.
Our View and Outlook
We expect short-term asset movements will be largely event-driven and influenced by how alternative scenarios play out. One can never rule out a worst-case scenario, but we do not see such a scenario – involving a viral collapse of peripheral Eurozone debt markets and an ensuing sharp reversal in global equities – as the most likely outcome. The market response in the immediate aftermath of Sunday’s vote has been relatively muted, with most European bourses down by less than 1%, the S&P 500 trading more or less flat, and peripheral Eurozone bond yields up a bit but nowhere near danger-zone levels. Most observers, ourselves included, expect to see negotiations muddle along even as the probability increases of an eventual Greek exit from the single currency.
We do see elevated risks, but we also believe the risks are more prevalent outside the US – not only in Europe, but also in China where monetary authorities are trying to stabilize a sharp pullback on domestic stock exchanges. International sentiment could certainly spill over into US equities, but we would expect any such pullback to be relatively brief and within the 5-10 percent range of a technical correction as opposed to a more sustained structural reversal. Economic data continue to reflect growth, with good consumer activity indicators, a decent (if not barnstorming) June jobs report and expectations for 2Q real GDP growth above 3 percent.
We believe the Fed remains on track to begin gradually raising interest rates as early as September. However, the Fed will not be forced into a rate hike if developments between now and September suggest otherwise. The economy is not overheating, inflation remains somewhat below the 2 percent long term target, and this gives the FOMC plenty of leeway to defer action on rates if need be, while adhering to its dual mandate of stable prices and full employment.
If we do experience a pullback in US equities sometime in the coming weeks, we would be inclined to view it more as an attractive buying opportunity than a signal to take on a more defensive strategic position. In any event, our current action plan is simply to stay disciplined and closely attentive to the situation as it continues to unfold.