Posts published in February 2016
Since setting a multi-year low on February 11 the S&P 500 has enjoyed a robust relief rally, gaining 6.7 percent through the 2/25 close. The rally has garnered plenty of skepticism, but there are some impressive aspects. It has been fairly broad, with seven of the ten major industry sectors posting gains of more than six percent. Consumer discretionary – an important sector given its central role as a driver of GDP growth – is up more than nine percent since that February 11 low. Industrials and tech have also done well: the SPDR Exchange Traded Funds for those two sectors (XLI and XLK) gained 7.5 percent and 6.9 percent respectively in the same time period. This rally is not, as some observers have argued, simply a dead cat bounce for oversold energy and financial shares.
The technical damage is far from repaired: the index is still almost four percent below its 200 day moving average, for example. But it has managed to break through both the fifty day moving average and a key resistance threshold level of 1950. Since the 2/11 low the index has closed up by more than one percent five times, and down by more than one percent just once. Reasonable people might want to know: is the pain over? Despite the positive attributes, we would caution against settling too comfortably into the good vibes. Plenty of headwinds remain.
Volatility’s Two Faces
For starters, let’s take a closer look at those one percent-plus days we mentioned in the last paragraph. There have been a lot of them this year. Twenty three, to be exact, which is about sixty five percent of the total number of trading days thus far in 2016. By comparison, the index experienced a daily gain or loss of one percent or more just fifteen percent of the time in both 2013 and 2014. In 2011, the last year in which a pullback of a similar magnitude to this year’s took place, the market registered a gain or loss of one percent about thirty eight percent of the time.
To be sure, we are not inclined to assume that the volatile patterns of the year’s first two months will be sustained for the next ten. Other risk measures like the CBOE VIX index and the S&P 500’s rolling thirty day standard deviation have come down substantially over the past two weeks. But those daily lurches of one percent or more are symptomatic of environments driven largely by events rather than fundamentals. The unhealthy correlation between equity gains and oil prices hasn’t gone away. Off-the-cuff remarks by Venezuelan oil officials appear able to drive intraday prices more than durable goods reports or GDP revisions. What the headlines giveth, the headlines taketh away. There is no way of knowing which way tomorrow’s headlines will galvanize animal spirits.
An Earnings & Valuation Ceiling?
Not that anybody is paying much attention to the fundamentals today, but they are likely to present a formidable obstacle to overcome at some point if the current rally continues. The S&P 500 currently trades at a 15.9 times multiple to projected next twelve months’ (NTM) earnings. That is roughly the same multiple at which it traded in late 2014. At the beginning of 2012, as the index was embarking on a vigorous three year expansion rally, the P/E ratio was 11.6 times NTM earnings. Valuations today are not in bubble territory, but neither are they cheap or even average (the average NTM P/E for the last ten years is 13.9 times). Analysts’ expectations for 2016 full year earnings are predicated on a strong pickup in the second half of the year after posting declines in the first half. If the consensus turns out to be rosier than reality – as often happens – then valuations will be even more expensive.
In this kind of environment we recommend paying more attention to risk-adjusted return than to absolute outperformance. A mix of a modest amount of cash and exposure to low-correlated strategies like market neutral or merger arbitrage, while underweighting riskier equity styles, can be a sensible approach for long term diversified portfolios to ride out the volatility while still being positioned to participate in upside growth.
Amid the volatility and daily event fetishes that have driven asset markets hither and yon this year, the US economy continues to steadily plod along. The data points are a mixed bag: missed GDP and productivity numbers here, consumer confidence and retail gains there. But the overall picture is relatively healthy. Importantly, there are some bright spots in the long-elusive area of wage and price gains. Hourly wage growth was, in fact, the one positive takeaway in an otherwise unimpressive jobs report at the beginning of this month. Now this morning’s January inflation report shows prices growing slightly ahead of consensus. Core inflation (excluding food and energy) is up 2.2 percent on a non-seasonally adjusted year-on-year basis, its highest level in four years.
The oil price collapse has kept the all-inclusive headline inflation number well below core inflation for the past year and a half. That may be changing. The energy index component of today’s CPI report was negative 6.5 percent – the lowest decline since November 2014. Year-on-year headline CPI for January was twice the December level: 1.4 percent up from 0.7 percent. The chart below illustrates the recent trend in prices. If oil prices manage to stabilize, we can expect to see the headline number converge ever closer to core CPI.
Stay, Raise or Cut?
It is somewhat ironic that the next FOMC meeting concludes on March 16, the very same day on which the BLS will release the February CPI data. It is not totally implausible to imagine that headline CPI will be close to or even at that magic 2 percent threshold when FOMC members peruse the 8:30 am BLS release that day. They will already have digested new information on personal consumption expenditure (PCE – 2/26) and hourly wages (3/4) by then. Recent data on retail sales, industrial production, capacity utilization and consumer confidence indicate the potential for an upside surprise in those PCE and wage numbers.
On balance the news is net-positive for the economy, but that may not translate to a much-desired adrenaline boost for the stock market. The Fed is not sitting on the “horns of a dilemma”, as the fella said, but on the shaky tripod of a trilemma. Should they stand pat with rates where they are now? Push ahead with another 25 basis point hike as a sign of confidence in the economy’s continued recovery? Or – and this is highly unlikely but at least in the realm of possibility given global developments – contemplate a reversal? Interest rate policy divergence among leading economies has not gone down well with markets since the Fed’s last move in December. The global stampede towards the Pleasure Island of negative interest rates makes the Fed’s decision all the more tricky, irrespective of the conclusions they would normally draw from domestic data.
El Niño and Mr. Market
Lurking behind this policy trilemma is a capital market environment that perhaps resembles nothing more than US East Coast weather patterns this winter. We’ve had heat waves along with record levels of snowfall here in the nation’s capital, and temperatures that fluctuate from frigid to tropical seemingly overnight (we woke up in the teens today and are preparing for upper sixties tomorrow). That’s intraday volatility worthy of the S&P 500 – which registered three consecutive days of gains over one percent earlier this week after falling by more than one percent in three of the previous five days. Now, to be sure, we have not yet seen the displays of outright panic that so often accompany pullback environments. In the first eleven trading days of August 2011 the market gained or lost more than four percent five times. And the maximum peak-trough drawdown to date remains far short of the minus 19 percent low point of the 2011 event. So far.
But the threat of a deeper downturn lurks behind every X-factor that pops into and out of existence each day. The FOMC explicitly called out their concerns in January’s post-meeting communiqué, referring to the “global economic and financial developments” keeping them up at night. It is a pretty good bet that these “developments” are not going away between now and March 15-16. If more US economic data surprise on the upside between now and then, it is going to be a very difficult call for Chairwoman Yellen & Co.
It’s just a natural continuation of conventional monetary policy, say the central bankers who have unleashed the hounds of negative interest rate policy – NIRP – into the capital markets. The Swedish Rijksbank is the latest to join the club, setting the key bank overnight repo rate at minus 0.5 percent. Even stranger than the rate itself was the accompanying announcement, part of which read thus: “Growth in the Swedish economy is high and unemployment is falling, which suggests that inflation will rise in the period ahead”.
Got that? Sweden’s economy, in fact, is growing at a clip of around 3.5 percent, or more than twice that of the Eurozone. If US GDP were growing by anything close to that rate it’s a pretty sure bet that Janet Yellen & Co. would be hiking rates with nary a second thought. What possible reason could there be for Sweden, then, to send rates below zero? “Global uncertainty” was the phrase the Rijksbank deployed in that same press release, along with a vague reference to recent inflationary weakness. “Everybody else is doing it” seems to be the underlying context, though, and that has the makings of a potentially dangerous trend.
Wonderland Not So Wonderful
We took note in this column a couple weeks back of the Bank of Japan’s joining Club NIRP. Now, as with any easy money policy, two key motivating incentives for negative rates are a weaker currency (to improve trade conditions) and higher domestic asset prices. How’s that working out for Japan so far? Consider the chart below, showing recent trend performance in the Japanese yen and the Nikkei 225.
In fact, the currency and the stock market have both done exactly the opposite of what the BoJ would have hoped. The Nikkei 225 has fallen by more than sixteen percent since the beginning of February, while the yen has strengthened by 8 percent against the dollar. Oops. The point to make here is simply this: NIRP is not, as claimed, simply an extension of the conventional easy money continuum. It is a whole new territory, an unknown land where the normal rules of finance do not necessarily apply. That NIRP is going viral around the globe is, in our opinion, cause for considerable concern.
Here Be Dragons
There are many facets to our concern about the NIRP contagion. A central one is its impact on the financial sector. The fruits of this impact are already visible in the form of a global bear market for the shares of financial institutions. Banks have to hold a certain fraction of their liquid assets in the form of central bank reserves. When the cost of holding these reserves goes up they need to make up the difference elsewhere, either in raising lending rates (counterproductive to growth) or in venturing into riskier lending areas (counterproductive to risk-adjusted capital adequacy). Again – a key objective of any easy money policy is to funnel money back into the economy via bank lending and accelerate its velocity. All the quantitative easing of the last six years has failed to accomplish this objective. It seems a great stretch to imagine that, suddenly, credit demand is going to materialize out of nowhere in response to negative rates. The banks, meanwhile, will have to figure out how to adjust their business models to remain profitable.
The reasoning behind NIRP is also flawed in terms of its capital markets objectives. Negative interest rates have spread into a widening swath of fixed income instruments, primarily (though not exclusively) government bonds. Five year German Bunds currently trade at negative yields, as does the Swiss ten year note. That’s right – if you buy a Swiss government bond and hold it to maturity you are guaranteed to lose money. What NIRP does, then, is to take low-risk assets and make them riskier – a complete perversion of standard capital market theory.
No Country for the Prudent Investor
Bear in mind that institutional investors like pension funds and insurance companies are required by their investment policy statements to hold sizable percentages of low-risk assets in their portfolios. Part of the NIRP objective is to make safer assets less attractive to stimulate purchases of riskier assets like stocks. But a prudently managed pension fund cannot simply take itself out of short term bonds and dump the money into small cap stocks. In this way, again, NIRP is counterproductive.
Finally, NIRP could potentially achieve the opposite of what it wants in terms of guiding inflation back up to those elusive 2 percent central bank targets. Think again about that ten year Swiss government bond we discussed a couple paragraphs above. Nominal bond yields are comprised of two sections: an expected real return (i.e. what the investor expects to earn from the investment after inflation); and inflationary expectations. Say for example that a certain ten year bond yields five percent and that inflation is expected to run at two percent for the next ten years. So that bond’s real return would be three percent and the inflation expectations component would be two percent. Easy math.
In light of that example, what does a yield of negative 30 basis points (about where the Swiss ten year is today) tell us about investor expectations? Only that for a rational investor to hold that security, the investor would have to believe that the most likely price trend for the next ten years would be deflation. If the average price of goods and services in the economy were to fall by one percent annually for the next ten years then it would make sense to invest in a bond, the slight negative return of which would still preserve purchasing power. Of course, deflation is exactly what financial policymakers want to avoid.
Expectations matter in explaining economic behavior and outcomes. The advanced-math models central bankers use in arriving at policy decisions have been shown to be demonstratively poor in accounting for the expectations factor. Want proof? Go back to that chart showing what the yen and the Nikkei 225 did in the aftermath of the BoJ’s NIRP decision. Expectations matter, and central banks ignore them at their – and our – peril.
China’s slowdown, cash-strapped emerging markets, the negative interest rate contagion – news from the world economy has been almost uniformly negative for much of the past twelve months. The bright spot amid the gloom has been the relatively upbeat US economy, the strength of which finally convinced the Fed to nudge up interest rates last December. At that time, based on the available data, we concurred that a slow liftoff was the right course of action. But a growing number of macroeconomic reports issued since call that decision into question. From productivity to durable goods orders to real GDP growth, indications are that the pace of recovery is waning. Not enough to raise fears of an imminent recession, but enough to stoke the flames of negative sentiment currently afflicting risk asset markets around the world.
Mary Mary Quite Contrary, How Does Your Economy Grow?
Jobs Friday may be the headline event for macro data nerds, but in our opinion Productivity Wednesday was the more significant event of the week. The Bureau of Labor Statistics release this past midweek showed that fourth quarter 2015 productivity declined by three percent (annualized) from the previous quarter. Now, productivity can be sporadic from quarter to quarter, but this week’s release is part of a larger trend of lackluster efficiency gains.
As measured by real GDP, an economy can only grow in three ways: population growth, increased labor force participation, or increased output per hour of labor – i.e. productivity. Unfortunately, none of these are trending positive. The chart below offers a snapshot of current labor, productivity and growth trends.
Labor force participation (upper right area of chart) has been in steep decline for the past five years – an outcome of both the jobs lost from the 2007-09 recession and the retirement of baby boomers from the workplace. This decline has helped keep the headline unemployment rate low (blue line in the bottom left chart) and also explains in part the anemic growth in hourly wages over this period. This trend is unlikely to reverse any time soon. If real GDP growth (bottom right chart) is to return to its pre-recession normal trendline, it will have to come from productivity gains. That is why the current trend in productivity (upper left chart) is of such concern.
Of Smartphones and Sewage
The last sustained productivity surge we experienced was in the late 1990s. It is attributed largely to the fruits of the Information Age – the period when the innovations in computing and automation of the previous decades translated into increased efficiencies in the workplace. From 1995 to 2000 quarterly productivity gains averaged 2.6 percent on an annual basis. The pace slackened in the first decade of the current century. In the first five years of this decade – from 2010 to the present – average quarterly productivity growth amounted to just 0.6 percent – more than three times slower than the gains of the late 1990s.
Is that all we can expect from the Smartphone Age? Or are we simply in the middle of an innovation gap – a period in between technological breakthroughs and the translation of those breakthroughs to actual results? It is possible that a new growth age is just around the corner, powered by artificial intelligence, virtual reality and the Internet of Things, among other inventions. It is also possible that the innovations of our day simply don’t pack the same punch as those of other ages. Economist Robert Gordon makes a version of this argument in his recent book The Rise and Fall of American Growth. Gordon points to the extraordinary period of growth our country experienced from 1870 to 1970 – growth delivered largely thanks to the inventions of electricity and the internal combustion engine – and argues that this was a one-off anomaly that we should not expect to continue indefinitely. What would you rather live without – your Twitter feed and Uber app, or indoor plumbing?
We don’t necessarily agree with Gordon’s conclusion that nothing will ever again rival electricity and motorized transport as an economic growth driver. But we do believe that the growth equation is currently stuck, and the headline data we have seen so far this year do nothing to indicate its becoming unstuck. Long term growth is not something that drives day-to-day fluctuations in asset prices. But its absence is a problem that is increasingly part of the conversation about where markets go from here. Stay tuned for more Productivity Wednesdays.