Posts published in June 2016
We have talked a great deal about the “corridor market” in our commentaries this year, observing that US large cap stocks have traded in a largely sideways patterns since the beginning of the fourth quarter of 2014. Over this time the S&P 500 has spent three quarters of its time – 76.4 percent to be exact – trading in roughly a 6 percent range between a ceiling of 2130 and a floor of 2000. The only deviations from the corridor have been three sharp downside moves: the Ebola freak-out in October 2014 and then the two technical corrections of August 2015 and January 2016. How much longer the market stays corridor bound is anybody’s guess, but we do have one noteworthy example of a decade-long stall-out. Put on your disco boots and wide lapels; we’re going back to the 1970s.
Right Back Where We Started From
The Maxine Nightingale song by that name came out in 1976, and it was true of the market as well. The S&P 500 started 1968 at a price level of 95. Eight years later, as 1976 opened, the index was…at 95. Right back where it started from, indeed. In fact, the S&P 500 would spend the rest of the ‘70s failing to sustain successive attempts to break out above 100 – the corridor ceiling of the day. On the downside, meanwhile, the index mostly managed to stay above 90, the two exceptions being the bear markets of 1968-70 and 1973-75. That made for a decade-long corridor of just 10 percent, illustrated by the chart below.
Now, there is no particular reason why stock price movements and trends in any one period should inform trends in other periods. Clearly much is different about markets and the world in general today as compared to 40-odd years ago. But we like to say that, while history does not repeat itself, it has a tendency to rhyme from time to time. There are some useful lessons to draw from the ‘70s; most importantly, in our view, of a transitional time between one economic order and another.
Consider that first major pullback, starting after the S&P 500 set an all-time high on November 29, 1968. For most of the 1950s and 1960s, the non-Communist world had enjoyed a return to international trade and cooperation after a devastating half-century of economic depression and two world wars. By 1968, though, the foundations underpinning this world order were starting to come undone. Inflation in the US was surging after a decade of growth and an unsustainable commitment to waging war in Vietnam. The US dollar, fixed at $35 per ounce of gold to promote stable terms of trade while the economies of Europe and Japan rebuilt their war-torn markets, was widely understood to be overvalued and incapable of maintaining its gold-equivalent value for much longer. That reckoning would come in August 1971 when President Nixon announced the end of gold-dollar parity.
Inflation was the chronic economic ill of the ‘70s. The second of the decade’s two bear markets came about with the OPEC oil production cuts of 1973 that resulted in a quintupling of oil prices in little more than a year. There were other reasons why stocks failed to sustain any breakout rallies for too long, but “stagflation” – economic growth that failed to keep up with price inflation – was the visible ailment as the economy transitioned from one accepted set of practices and institutions to something else – something not visible to observers of that age.
What inflation was to the 1970s, low growth and sagging productivity are to today’s market environment. Despite every stimulus effort of the Fed and other central banks around the world, economic growth remains stubbornly below the normal trend rates of the pre-2008 recession period. There is a palpable sense, too, that today’s stagnant incomes, reduced demand in major consumer markets and listless capital investment by businesses are outcomes of something more than the usual turning of the business cycle.
The crumbling of the Bretton Woods framework in the early 1970s eventually led to a new age of liberalized commerce, fueled by privatization, relaxed capital and trade regulations, and technology-driven innovations in consumer finance. This age produced an eighteen year run of near-uninterrupted growth in stock prices and a bull market in bonds that continues to this day.
What comes next, observers ask, as “trade” becomes a word of derision in political stump speeches and voters around the world seek easy answers (Brexit, populist authoritarian leaders) to the problems for which they hold the global elites, the beneficiaries of the post-1970s economic order, fully accountable? In the answer to that question may lie intelligence about the next sustained upside breakout. Meanwhile, that persistent corridor may be with us for a while yet.
It was almost three years ago to the day. On July 1, 2013, Croatia became the 28th country to join the European Union. “Joyous Croatia Joins Europe Amid a Crisis” ran the New York Times headline of that day. The article noted that the accession of the Balkan republic represented a “rare moment of satisfaction” for an EU beset by stagnant economic growth and a chronic financial crisis. Today there is little in the way of satisfaction or joy in Brussels, as Europeans digest the reality that their club is set to shrink in numbers for the first time since representatives from France, West Germany, Italy, Belgium, the Netherlands and Luxembourg met in a sumptuous room in the French foreign ministry in April 1951 to sign the Treaty of Paris. The British have spoken, and they plan to go it alone.
Of Polls and Pain Trades
Longstanding readers of our weekly commentary will be familiar with our general view on event-driven trades, which is easily boiled down to two simple words of advice: do nothing. The Brexit vote is a compelling case in point for this view. One week ago, poll numbers were showing a slight momentum trend towards “Leave,” risk asset markets were pulling back and volatility was up. Then, a new batch of polls over last weekend suggested that momentum was shifting back towards “Remain,” perhaps in the wake of the brutal shooting of Labor parliamentarian and strong Remain supporter Jo Cox. The momentum shifts in both cases were fairly tempered, with most poll-of-polls composites showing a likely outcome within statistical margins of error either way.
Of course, that did not stop the punters from placing their bets. As the week progressed those bets – now skewed heavily towards a “Remain” outcome, looked more and more like a sure thing. As markets closed for trading on Thursday, the odds as reflected in financial betting markets were over 95 percent for Remain (despite the fact that actual polls still showed nothing remotely that convincing). Global equities closed sharply higher, as did the pound sterling. Then the results came out. There will be pain trades aplenty today, and hopefully a useful reminder about the non-existence of free lunches. Sometimes “do nothing” really is the most prudent course of action.
There is still much that is unknown about the economic impact of Brexit; first and foremost, what specific kind of relationship the UK will have with the Continent going forward. Will Britain be part of a free trade area framework similar to what Norway has with the EU now? Or will there be some kind of customs arrangement for certain goods and/or services, similar to Turkey’s current arrangement? Or something altogether different? There would appear to be plenty of free-lunch thinking among Leave supporters who imagine they can somehow benefit from favorable trade with the EU while restricting the free movement of people (anti-immigration being perhaps the strongest motivating sentiment behind Brexit). Much was promised by the Leave campaign of a highly questionable nature.
That thinking is likely to be disabused by EU negotiators not inclined to be overly accommodating, lest Britain’s example set the stage for further referenda (chatter about France and a “Frexit” lit up the Twitterverse almost instantaneously following last night’s outcome). Article 50 of the Treaty of Lisbon sets forth (very briefly) the terms of disengagement from the union; at this point, all that is clear is that the time frame for leaving is two years. We don’t even know who Britain’s point person in the negotiations will be, as current prime minister David Cameron intends to step down in October. All of which is to say – we would caution against getting too deep into any one particular scenario ahead of even knowing opening gambits on the key issue of ongoing coexistence.
The View from the Corridor
Meanwhile, even today’s frothy market of pain trades and a spike in the VIX volatility index may not drive the S&P 500 below the floor of the corridor where it has been stuck for more than twenty months. So far, at least, the pullback in stocks is relatively contained while bond yields and currencies have also settled down from the more frenetic activity levels seen earlier in Europe, before US markets opened. There is essentially no doubt that central banks the world over are prepared to flood the markets with as much liquidity as they think necessary to stave off a collapse in asset prices (Fed funds futures markets, however improbably, even allow for a 10 percent chance that the FOMC’s next move will be a rate cut). The policy floor is firmly in place. Meanwhile, the next several months may prove even tougher for stocks on the upside, if uncertainty in Europe sets the stage for another strong run by the US dollar. We were just starting to see more corporate management teams gently guide sales and earnings up in expectation of more forgiving currency conditions. Stiffer currency headwinds imply more resistance at the valuation ceiling.
These conditions may change, of course, and we will be closely following the nuts and bolts of how Brexit plays out in the coming weeks. For now, though, we are comfortable with where our portfolios are positioned. We maintained a somewhat more defensive than usual position even as asset markets rallied strongly in March and April, with underweight positions in small caps and non-US stocks while favoring higher quality, dividend-paying large caps. We continue to maintain a modest cash buffer to augment a fixed income allocation of mostly high quality short and intermediate durations. That persistent corridor serves as a useful metaphor in our opinion: neither is it time to go into a super-defensive crouch, nor to let the bulls run rampant. Stay in, but stay cautious.
One week from today we will (probably) know the answer to the Big Question: Are they in or are they out? Britain votes on the future of its relationship with the European Union on June 23, deciding whether it wants to continue to be part of an organization it joined in 1973. While the vote is technically a referendum, not a binding obligation with legal force, a Leave vote would likely require the government to set the wheels in motion for a proposed exit within a two-year time frame. What the terms of any actual deal would look like remains unclear, despite the impression created by much handwringing this week that the economic pain of a Brexit is precisely quantifiable.
Most of the conversations we have had with clients over the past several weeks have, understandably, homed in on the practical implications of Brexit for their portfolios. From our standpoint, the playbook ahead of June 23 is very much in line with our usual advice about event-driven market movements, which is to say do nothing. Make no mistake, if the Leave vote prevails next week there is a very good chance of an immediate volatility spike in asset markets. Much of that volatility would likely be concentrated in ground zero exposures like the FTSE 100 stock index and the British pound, which could see double digit declines, but risk asset markets worldwide would be vulnerable.
The reason we advise our clients to do nothing in situations like this is that, far more often than not, the tempest surrounding the actual event blows over rather quickly. The volatility is driven mostly by short-term money positioned one way or another before the event and algorithms wired to react immediately upon the outcome being known. That flurry of activity will settle down as the winners lock in their gains and the losers bite the bullet on pain trades to cut their losses. Markets will then adjust over time as investors assess the practical implications of Britain outside the EU for the future cash flow generation potential of the companies in which they invest.
Here is one practical example of what we mean by separating the short-term tempest from the longer term market adjustment to new information. Much has been made this week of the spike in volatility for the pound sterling, with commentators noting that the risk spike is higher than anything seen since the 2008 market crash. But an excellent article in Bloomberg carefully points out what other pieces have glossed over: the volatility spike relates only to what traders expect in the next 30 days. In other words, while 30-day futures for the pound sterling are more volatile than those for the Russian rouble or Hungarian forint, one-year sterling futures are virtually unchanged. The market for sterling futures today is a textbook definition of an event tempest: rough seas today, calmness further ahead.
None of this is to say that Britain’s leaving the EU would be unimportant, or have no implications down the line. We are of the opinion that the Leave arguments are largely misguided and shaped more by emotion and fear than by real facts. To that end, our longer-term concern is less about how Britain finds its economic footing outside the EU, and more about how Brexit is part and parcel of a larger global trend – a backlash against trade and globalization in general that seeks refuge in – depending on where in the world one happens to be – appeals to nationalism, authoritarianism and populism. Such sentiments swirl about in locations from Peoria to Paris to the Philippines.
But trying to put a specific price on anything as vague and variable as anti-globalism is a fool’s errand. In a very practical sense we are not prepared to adjust our strategic allocation targets to various asset classes on the basis of events that may or may not transpire. Sometime in the future economic historians may look back at June 2016 as an important milestone towards a new world of less trade and weaker economies. Alternatively, they may write that the populist anger of this age finally forced global elites to wake up and meaningfully address key imbalances and inequalities feeding that anger. Either way, we will follow the same approach as always: evaluate the data as they come in and let the data, not ill-defined emotions, drive our ongoing portfolio decisions.
Today’s WMF is brought to you by the number 10. It’s the tenth day of the month, and it’s a day when 10-year debt is front and center on the capital markets stage. Switzerland and Japan have already crossed over into 10-year NIRP Wonderland, offering investors the curious opportunity to lock in losses for a whole decade. Now Germany is flirting at the event horizon; the yield on the 10-year Bund is just one basis point on the positive side of the line. One year ago all three benchmark yields were above zero, and Germany’s comfortably so. The chart below shows that the zero boundary, once breached, has proven difficult to cross back into normal territory.
Why do yields continue to plumb the depths? This comes down, as always, to a supply and demand question. In Europe, in particular, a big part of the problem lies on the supply side. The ECB is the big player (or, less charitably, the Greater Fool), but there are limits on its bond buying activities. Specifically, the ECB cannot purchase bond issues when their yields fall below the ECB’s own deposit rate, which is currently set at negative 40 basis points. That requirement cuts the ECB off from an increasingly large chunk of Eurozone debt; consider that the yield on German five year Bunds is now minus 0.43%. So further out the curve the ECB goes, and down come the yields.
Additionally, the ECB can purchase a maximum of one third of any individual bond issue, so it is constrained by the supply of new debt coming onto the market. Some observers estimate that the inventory of German debt for which the ECB is eligible to purchase will run out in a matter of months. If the ECB wants to continue monthly QE purchases according to its current program it will then have to consider (and persuade ornery German policymakers to agree to) changes to the current rules.
Meet the New Risks, Same as the Old Risks
Of course, technical issues of bond inventories and ECB regulations are not the only factors at play. The risk sentiment dial appears to be pointing somewhat back towards the risk-off end, if not for any particularly new set of reasons. Brexit polls continue to occupy the attention of the financial chattering class, with the vote looming in 13 days and a close result expected. Investors seem to be digesting last week’s US jobs report from a glass half-empty standpoint – slower payroll gains bad for growth, while improving wages mean higher labor costs which are bad for corporate earnings. Japan delivered up some negative headline numbers this week including an 11 percent fall in core machinery orders. Again, none of this is new (and for what it is worth, we continue to think it more likely that we will wake up on June 24 to find Britain still in the EU). But animal spirits appear to be laying low for the moment.
The Stock-Bond Tango
The recent risk-off pullback in overseas equity markets, though, is having less impact here at home. Yes, the S&P 500 is off today – but earlier in the week the benchmark index topped its previous year-to-date high and remains just a couple rally days away from last year’s all-time high. The really curious thing about this rally though – and why it is very much relevant to what is going on in global bond markets – is that recently stock prices and bond prices have moved largely in tandem. This weird tango has resulted in 10-year Treasury yields at a four-year low while stocks graze record highs. As the chart below shows, this is a highly unusual correlation.
This chart serves as a useful reminder that just because something hasn’t happened before doesn’t mean that it can’t happen. In fact, what is going on in US stocks and bonds is arguably not all that difficult to understand. Investors are in risk-off mode but are being pushed out of core Eurozone debt in a desperate search for any yield at all. US Treasury debt looks attractive compared to anything stuck on the other side of that NIRP event horizon. And that demand is largely impervious to expectations about what the Fed will or will not do. Short term Treasuries will bounce around more on Fed rumors, but the jitters will be less pronounced farther down the curve.
And stocks? There is plenty of commentary that sees a significant retreat as right around the corner. Perhaps that is true, perhaps not. Pullbacks of five or 10 percent are not uncommon and can appear out of nowhere like sandstorms in the desert. But – as we have said many times over in recent weeks – we do not see a compelling case to make for a sustained retreat into bear country. The economy does not appear headed for recession, money has to go somewhere, and negative interest rates have the continuing potential to turn bond buyers into stock buyers. If a pullback does happen over the summer, we are inclined to see it more as a buying opportunity than anything else.
Picasso’s 1932 painting “Girl Before a Mirror” is, like most of the artist’s work, open to wide and contentious speculation about “what it all means,” and in that sense it bears a likeness to today’s jobs report. Does the weak headline payroll number suggest an economy confronting its own dark mortality, like (perhaps) the girl in the painting? Put three art majors in front of the painting and you’re likely to get five opinions. The same appears to be true for economists as they look at the various discordant bits of the BLS report and try to piece it all together.
You have that bad payroll number (and downward revisions to previous months) alongside the best unemployment rate figure in nine years. There are meaningful improvements in the number of long-term unemployed, but the labor participation rate also fell for the second month in a row. Wages continue to make steady gains and remain ahead of both core and headline inflation – but shouldn’t wage growth be even higher at this stage of a recovery? The payroll numbers were impacted by a labor strike at Verizon, but that was not a big enough impact to offset the actual number falling more than 100,000 jobs short of consensus expectations. What is this disjointed picture trying to tell us? Or are we, like so many art critics, simply overthinking the importance and meaning of one single report?
A Bit More Pain with the Gains
What we can say for sure is that, almost halfway through 2016, the pace of payroll gains is weaker than it was for the past couple years. It was the rare month in 2014 and 2015 that failed to serve up at least 200,000 new jobs. When the number did fall short, stock indexes either rallied (Fed’s not going to raise rates!) or plunged (economy’s getting worse!) depending on what side of the bed Mr. Market woke up that morning. The average for the past three months, including the downward revisions to April and March, is 116,000. So the benchmark has come down. Even so, though, the current environment for jobs creation looks strong compared to the previous recovery in 2003-07, as shown in the chart below.
Not only is the current recovery the longest uninterrupted streak of positive jobs creation since the BLS started keeping records but, as shown in the chart above, the number of months with 200,000 jobs or more is higher and more consistent than it was in 2003-07. It may be natural, after such a long winning streak, for the pace to slacken off a bit. If the economy can manage to sustain a pace of more than 100,000 monthly payroll gains and continued steady wage improvement for at least another year or more, that would likely count as a win. For now, anyway, signs of a recession do not seem to be anywhere on the horizon.
However one chooses to interpret the payroll number, the labor participation rate leaves less room for creative opinionating. After showing some long-awaited signs of life in the first quarter of the year, the participation rate has fallen back down to 62.6 percent, just 0.2 percent above the decades-long low reached in September last year. Given that a lower participation rate means fewer people out actually looking for work, this trend also throws a bit of a wet blanket on that headline 4.7 percent unemployment rate. Remember that economic growth only happens when more people work or when more stuff gets produced for each hour of labor. With both the labor participation rate and the productivity rate in what appears to be a secular stagnation, the long-term growth question remains a mystery.
Of course, the conversation today and in the run-up to the next FOMC meeting in just 11 days will focus on what today’s numbers mean for interest rates. Our guess is that they mean very little. The Fed is likely more focused on the latest Brexit poll numbers than anything else as far as June is concerned, given their possible effect (however short term) on the all-important asset markets. There will then be a whole new batch of price, growth and jobs data to consider before July rolls around. Maybe it really is best to think of today’s jobs report as a Picasso painting – you can interpret it however you want, and your interpretation has no practical consequences in the real world.