Posts published in May 2016
It’s that time of year again. On the cusp of Memorial Day weekend, the shopworn adage reliably rears its head: Sell in May, Go Away? Like most Wall Street folklore this ever-present refrain, a compulsive go-to theme for the financial pundit class, holds a kernel of relevance inside a fog of statistical unreliability. Sure, if you tally up seasonal price trends over the last handful of decades, you will see an average pattern of relative underperformance during summer’s dog days as compared with the rest of the calendar year. Whether the average trend rings true in any given year, however, is little more than a statistical dart throw.
That disclaimer aside, this year it is hard to avoid the looming presence of Sell in May this particular year. We have just passed the one year anniversary of the S&P 500’s all-time high close of 2130 on May 21, 2015. Anyone who sold in May a year ago is unlikely to rue the decision, having managed to avoid a few stomach-churning days last August and a few more in the first weeks of this year while with zero opportunity cost. As noted in recent MVF commentaries, the benchmark index has made a few summit attempts at 2130 but come up short each time. With each failed ascent, investor uncertainty and unease about the market’s future direction increases…or does it?
Postcards from the Valley
One measure of investor sentiment is global equity fund flows, and by that measure investors do appear uncertain. More than $100 billion has flowed out of equity funds since the beginning of the year, with more than $9 billion exiting stock funds in the last week alone. Sell in May, indeed! The sharp V-shaped correction and recovery that spanned the first quarter presumably spooked many. Fears ranging from China’s debt burden to a British exit from the EU, to weak corporate earnings and the weird US political circus remain more or less unabated.
Another common risk benchmark, though, tells a different story. The CBOE VIX index, the market’s so-called “fear gauge,” appears, well, not so fearful at all. Consider the chart below.
The VIX (the solid blue line in the chart) is in one of its low-energy valleys, after being elevated above its long term average for most of the first quarter. Current levels are lower – meaning less risky – than at any time since the first of the two recent stock market corrections hit last August. Of course, the VIX is prone to sudden changes of heart – witness the huge spike last August in the wake of a surprise devaluation of the Chinese renminbi.
Time for a Breakout?
The disconnect between risk as reflected in the VIX and that seen in equity fund outflows may converge one way or the other as a new consensus emerges about the timing of the next Fed rate hike. A spate of recent (unofficial) statements by FOMC members (this commentary is being written before a Janet Yellen speech planned for later this afternoon) suggests that the next move could be coming sooner than markets had earlier anticipated. Could Fed action be the catalyst that moves stock indexes out of their eighteen month sideways pattern – and if so, what is the more likely direction of that breakout?
Predicting near-term market moves is a fool’s errand, but we would caution against leaping to the immediate conclusion that a rate hike in June or (perhaps more likely) July will necessarily send stocks south. Indexes have been firm and largely upbeat with the mercury’s recent rise on the Fed funds futures thermometer. After all, if the move does happen it will reflect increased confidence on the part of the Fed that recent upward trends in wage and price data are more sustainable than they had indicated following the March and April FOMC meetings.
And if it does turn into a bust and markets go south again? Well, we don’t call the floor of that trading corridor a “policy floor” for no reason. The Fed has made it abundantly clear to every woman, man and child in America that it will throw everything it has and more at asset markets to keep them from falling too far. Don’t pin all your hopes on a fast and furious rally – but don’t get overly defensive either. It’s still sound advice to not fight the Fed.
Japan was in the news this week mostly for the upside surprise in first quarter GDP; at 1.7 percent, the real growth rate was well ahead of expectations and a reversal of the 4Q2015 contraction. Will better-than-expected growth temper some of the recent chatter about more aggressive foreign currency intervention to bring down the yen? Will Prime Minister Abe go ahead with a second consumption tax hike next April, despite the negative fallout of the previous increase in the tax two years ago? Is domestic consumption, which drove the improved GDP numbers, here to stay, or will these numbers prove as fleeting as April cherry blossoms when the first revision comes out?
Important questions, all. But another news bulletin from Tokyo came to our attention this week, causing us to ponder whether there is anything truly surprising left in the world. The Bank of Japan (BoJ) is gearing up to be one of the largest shareholders in Corporate Japan, with the launch of a new series of exchange traded funds (ETFs) designed explicitly by and for the BoJ. Meet Haruhiko Kuroda, BoJ Governor and hedge fund spiv.
Biggest Shareholder in the Room
For some time now, the Bank of Japan has been a player in the ETF market. Up until recently this activity was generally under the radar, and entailed mostly plain vanilla ETFs that track major blue chip stock indexes like the Nikkei 225. But the volume of purchases has grown steadily over the past couple years, such that the BoJ is now the beneficial owner of about 55 percent of the total volume of Japanese ETFs. That makes it a larger shareholder in Japanese companies than either BlackRock or Vanguard, two of the largest passive index investors in the world. In fact, the BoJ is one of the top 10 shareholders, on the basis of size of holdings, in 200 out of the 225 companies listed on the blue chip Nikkei index. In financial markets parlance, the BoJ is already the “Tokyo Whale.”
But today’s launch of two new ETFs takes the central bank’s involvement in the business of Japan to an entirely new level. These ETFs, dubbed “Human and Physical Capital Funds”, are not your typical plain-Jane ETFs designed to passively track a benchmark index. Companies selected for inclusion in the ETFs will have to meet certain standards of compliance with BoJ policy goals. These include more cash deployed into new business investment and increased wages for company employees. In other words, the central bank is trying to induce companies to do more to stimulate Japan’s economy, by holding out the carrot of buying (and thus lifting the price of) its shares.
“Human and Physical Capital” is the New Smart Beta
The methodology is thus somewhat analogous to the factor-investing approach pursued by so-called “smart beta” strategies. But most smart beta strategies are at least premised on the idea that whatever factors they employ – minimum volatility, momentum, enhanced dividends or whatever else – have some demonstrable success case as value-added factors. There is no empirical evidence to suggest that a factor fund based on a set of explicit central bank stimulus goals would be a worthwhile investment. After all, high labor costs and outsize capital expenditures are generally rather poor predictors of stock price outperformance.
And that is a problem for the Bank of Japan, because legally it cannot purchase more than 50 percent of any individual ETF. Other investors will have to pony up for the remaining 50 percent of these Human & Physical Capital Funds. Japan does have some very large institutional investors in the public sector, including the massive $1.7 trillion Japan Post and the Government Pension Investment Fund – so there could be some concerted aligning of investment policy statements to support the BoJ. Private sector investors, though, may see little reason to make targeted investments in companies whose corporate strategy decisions owe more to central bank pressure than to actual economic opportunities.
Reductio Ad Absurdum
That leads to the larger question of why any central bank should ever become so closely intertwined with the stock market. It is one thing to buy up bonds in the secondary market, as all central banks with quantitative easing programs have been doing for the past seven years. But stocks and bonds are fundamentally different capital instruments, and the big difference is that equity investing correlates to corporate ownership.
We noted above that the Bank of Japan is already one of the top 10 shareholders in the vast majority of Nikkei 225 companies. Institutional shareholders play an important role in corporate governance, which in turn influences the specific strategic and operational decisions companies – private sector companies! – make about how to generate future cash flows from the asset base in place. Having a government-related entity (whether or not nominally independent of other government agencies) as a potentially decisive voice in this regard is troubling. What happens if a company in the Human and Physical Capital Fund builds a factory to produce products for which there is insufficient market demand? Does the central bank step in and place orders for Company ABC’s widgets because nobody else wants them?
It sounds patently absurd. Then again, until recently it would have struck any reasonable person as absurd that central banks would be masquerading as hedge funds. Yesterday’s absurdities would appear to be today’s norms.
Americans love to shop, and as our shopping habits go, so goes the economy. Such is the conventional wisdom, in any case. Consumer spending has consistently accounted for around 70 percent of our gross domestic product (GDP) for many decades now. Every so often, though, a narrative takes hold to challenge the conventional wisdom. Consumers are “going small” (1970s), or “rejecting excess” (early 1990s, pretty funny in hindsight) or “repairing household finances” (post-2008 recession). There is often a grain of truth in the contrarian narrative. Somehow, though, we just go right on spending. This week we saw both sides of the narrative. A string of Q1 earnings reports in the retail sector cast a pall over the market and sparked renewed speculation about the vanishing consumer. Then, Friday morning delivered up a new batch of data from the Commerce Department showing that overall April retail sales grew by 1.4 percent (month-to-month), the briskest pace in over a year and comfortably ahead of expectations. Is this just one outlier data point, or are rumors of the consumer’s demise greatly exaggerated?
Follow the Wages
We are generally not ones to make a big to-do about one monthly number. As the chart below shows, monthly retail sales have bounced around quite a bit over the past three years, and in recent months the pace has lagged the average for the overall period.
But an improved outlook for consumer spending habits does not strike us as surprising in view of other recent headline data. Last week’s jobs report, while underwhelming in terms of payroll gains, showed a healthy uptick in wage gains; in fact wages are growing at a notably faster pace than overall inflation. Consumer confidence indicators have also been robust; the latest University of Michigan Consumer Sentiment Index release also came out today and was well ahead of expectations. And the headline retail number was not unduly skewed by volatile sectors like automobiles or building materials; the core retail sales figure, which excludes autos, gas and building materials, was up 0.9 percent for the month against expectations of a 0.4 percent gain.
High Street Hangover
Brick-and-mortar retail outlets garner a great deal of focus during earnings season, mostly because they have long served as an easy go-to touchstone for retail sentiment. But high street retailers are not the force they once were. The multiline retail segment of the S&P 500 consumer discretionary index, which includes much-followed Macy’s, Kohl’s, Nordstrom and Target, accounts for only 4.3 percent of the total market value of all consumer discretionary segments. By comparison, the internet retail segment makes up 18 percent of the total consumer discretionary index – most of which can be ascribed to category-busting Amazon. That company’s record earnings release last week presaged the line item in today’s Commerce Department report showing that online retail sales grew by double digits on a year-on-year basis from last April.
As the economy continues to recover – and particularly as the brisk pace of job creation finally translates into the long-expected pickup in wage growth – it should be reasonable to expect retail spending to continue trending positive. In any given quarter the fruits of that pickup may be spread unevenly around the stock price performance of competitors in mainline, specialty and online retailing. Why is Gap down in the mid-twenties so far this year while Urban Outfitters, a peer in the specialty retail space, is enjoying a nice year to date return of just under 20 percent? Maybe there is something enduring about the latter’s move to further diversify and optimize its revenue mix, maybe not. Consumers may be fickle, asset markets even more so.
Over time, we expect the broad-based paradigm shift into online will put increased pressure on all business models, with a resulting competitive winnowing out among winners and losers. But the American consumer appears to be very much alive and, as far as we can see, inclined to keep spending in one form or another.
In September 2010 the US economy lost 52,000 jobs, according to the Bureau of Labor Statistics report released on the first Friday of the following month. Why is that important? Because September 2010 was the last month in which we had negative job creation. Ever since – and periodic breathless exhortations of imminent jobs-killing Armageddon to the contrary – the economy has registered net positive jobs creation each and every month. The period from October 2010 to April 2016 is, in fact, the longest uninterrupted period of jobs creation since the end of the Second World War.
One Month Giveth, One Month Taketh Away
It is important to keep this long-term context in mind when mulling over the particular details of a monthly BLS report. Always remember that what is reported in any given month is not a fixed number, but a statistical best guess within what can be a fairly wide margin of error. Investors fixate on each month’s number in relation to the consensus expectation ahead of the release, but it is much more useful to pay attention to multi-period trends.
With that caveat in mind, the headline numbers in today’s report were a bit disappointing, with payroll gains of 160,000 against expectations of 200,000, along with downward revisions to the March and February gains. The unemployment rate held steady at 5 percent. Other BLS takeaways including the long-term jobless number and involuntary part-time workers were little changed.
The bright spot was wages. Average hourly wage gains of eight cents from the previous month translate to year-on-year growth of 2.5 percent. That’s a brisker pace than any of the main price inflation indicators; both the headline Consumer Price Index and the Fed’s favorite Personal Consumption Expenditure indicator are below two percent while core CPI, excluding energy and food prices, is 2.2 percent at last read. This month’s wage gains suggest that overall price trends are heading north. Janet Yellen has been somewhat dismissive of recent data in her public comments, but the Fed will have to take the current cadence of inflation into account as they weigh policy options ahead of the June FOMC meeting. Given the market’s expectations for zero interest rate action in June, there could be potential surprises in store.
What Are All the Workers Doing?
While it’s nice to see more people going to work and getting inflation-beating pay raises, we still don’t have a good answer to the question of why their hours of toil are not adding more to economic growth. Once every quarter we have a Productivity Wednesday preceding Jobs Friday, and this week was the appointed Wednesday for Q1 results. They were unimpressive, continuing a longstanding spell of weak productivity relative to historical norms. For the first quarter of 2016 productivity declined by one percent (annualized), following a 1.7 percent decline for the fourth quarter of 2015. The average gain for the last decade remains below one percent, far weaker than the 2.3 percent average for the post-Second World War period.
Productivity matters a great deal to our economic well-being; its chronic absence was the dominant theme of our annual market outlook back in January. Simply put, an economy only grows if (a) the population of working citizens grows or (b) each worker produces more output for each hour worked than he or she did for the previous period. Absent either of these two things happening, the economy won’t grow. With the population growth rate in long-term decline, productivity growth is the only game in town. Economists have not yet been able to solve the puzzle of why all the technological advancements of the last 15-odd years have not materialized into tangible growth. Perhaps, opine some, we are simply in a lull between innovation and commercial realization.
Then again perhaps we are, as Robert Gordon argues in his fascinating recent book “The Rise and Fall of American Growth,” past the peak of secular economic growth and unlikely to see it again in our lifetimes. Gordon’s argument is that the two most important inventions of the last 150 years – electricity and the internal combustion engine – have already contributed the lion’s share of the average annual growth we enjoyed from the last two decades of the 19th century on. The current productivity trend gives some weight to Gordon’s arguments.
We do not agree with Gordon’s view that nothing will ever rise to the same level of importance as those two 19th century inventions; the nature of any paradigm shift that radical is that it cannot even be imagined before it happens. More prosaically, though, we would like to see more bounce in forthcoming Productivity Wednesdays. Month after month of job creation is nice, but it won’t last forever unless all those new positions do more to improve overall economic output.