Posts published in August 2016
People, and markets, get fidgety in late August. It’s the time of year when summertime fun turns into tedium. Kids are actually looking forward to getting back into the school routine. Asset markets, meanwhile, jump at any tidbit of event-driven news that can make the time to Labor Day weekend pass by more quickly. Today’s distraction of choice was Fed Chair Janet Yellen’s speech at the annual Jackson Hole monetary policy confab. Did financial media pundits really want to hear about the contribution of the new IOER (interest paid on excess reserves) policy to the Fed’s ability to steer the Fed funds rate? Of course not! But they did want to spend a few minutes mining Yellen’s speech for any trace of a hint of a possible “live” meeting in September, i.e. one with a rate hike on the table.
That hint, predictably, remains as elusive as the Yeti. Bond yields spiked very briefly when the phrase “case for an increase in the federal funds rate has strengthened in recent months” tumbled onto the CNBC news banner. But asset indexes of all stripes, from stocks to bonds to currencies and volatility, soon realized that there was nothing new under the sun in terms of specific rate timing. Dog days tedium resumed.
For those whose investment horizons extend beyond the next one or two FOMC meetings, though, there is plenty in Janet Yellen’s thoughtful and probing words worth mulling over, and worth being concerned about.
The Politics of September
Before we focus on the longer term picture emerging from Yellen’s speech, though, we should get the business of September out of the way. There has been a great deal of renewed speculation this week about the possibility of a live move when the FOMC meets on September 20-21.
We have argued several times recently about the highly unlikely nature of any such move. Nothing said by any Fed personalities this week, up to and including today’s speech, changes our view on this for the following simple reason. In the absence of inflationary threats, with continued softness in domestic capital formation and weak foreign demand (the biggest drags on this morning’s underwhelming 1.1 percent GDP revision, called out by Yellen specifically), nobody’s feet are held to the fire for an immediate rate hike. On the other hand, 9/21 is just a few days away from the first Presidential debate in the most highly charged, toxic political environment of recent memory. Yellen’s Fed is a cautious Fed, and a conflict averse Fed that will likely not insert itself into the politics of the moment – as a rate hike would almost certainly do – without an immediately urgent reason to do so. We stand by our view.
Where Do We Go From Here?
We’re not sure if Yellen was actually channeling the Alan Parsons Project song “Games People Play” when she made “where do we go from here” – the opening line of that song – the subtitle of the most important part of her speech today. But the tone of this part of the speech was, in our opinion, quite in line with the somewhat dark musings of that 1980 song. “Games people play, you take it or you leave it / Things that they say just don’t make it right / If I promise you the moon and the stars would you believe it / Games people play in the middle of the night.”
Yellen appears to envision a world where an expanded toolkit of creative, envelope-pushing monetary policy solutions must be ever at the ready to “respond to whatever disturbances may buffet the economy.” Such policies could, in the future, not just retain quantitative easing as a firefighting tool for the next economic recession, but actually expand the range of assets targeted in a future QE program. Expand to what? We already have a preview of such a world in Japan, where the Bank of Japan is the country’s largest institutional shareholder via its outright purchases of domestic equities. Of course, she says, nothing of the sort is in any way on the table for immediate action by the Fed, but a bevy of such alternative approaches are very much part of the research effort underway in anticipation of future conditions requiring more than the current batch of approved measures.
A Little Help, Please?
The other thing one cannot help but see in Yellen’s musings here is a well-deserved frustration over the apparent inability of any other policymaking entities to lend a hand in addressing today’s economic challenges. To wit: “…these tools [monetary policy] are not a panacea…policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.” That, as we read it, is a polite way of saying that a bit less dysfunction in other parts of the government could make it possible for the Fed to not have to distort the natural workings of asset markets in moving the economy towards positive growth. Finally, she concludes that nothing can replace good old-fashioned organic productivity growth as a way for the economy to deliver actual, meaningful improvements in the standard of living: “…as a society we should explore ways to raise productivity growth.”
To sum up: there is very little in today’s Jackson Hole speech that should change the calculus for what the Fed may or may not do before the end of the year. We fail to see any likely case for live action in the political cauldron of September. December is simply too far away to even speculate: all it would take would be for one more technical correction in the interim – a pullback of 10 percent or more in the S&P 500 or an out-of-the-blue spike in bond yields – to take a holiday hike off the table. Yellen speculates that there is a “70 percent chance that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year,” a non-prediction which of course does not preclude the possibility that rates may not move at all or even go down again.
But most of the portfolios under our management have a time horizon well beyond the next handful of FOMC meetings, and to that end Yellen’s longer term concerns are our concerns. Political dysfunction and persistent underperformance in productivity growth loom large indeed as forces that keep us up at night. Where do we go from here?
Remember the Flash Crash of 1962? Of course you don’t. Neither do we. But it happened. On May 28th, 1962 the S&P 500 plunged 6.7 percent in a single day, seemingly out of the blue. Concerned investors noted immediately that this was the biggest single day retreat in the stock market since 1933, with more shares changing hands than since those panicky October days of the Great Crash of 1929. No shortage of commentators at the time wrote about the near inevitability of a sustained period of panic selling.
Pretenders to the Bear
That chronic downturn never happened, of course. The Flash Crash of ’62 came and went. A few weeks later saw the end of the ephemeral bear market that spanned December 1961 – June 1962 and the resumption of a long-running macro bull environment. That “bear” had no material impact on the economy and no lasting effect on anyone’s memory save small clusters of Wall Street vets swapping yarns about the olden days over Old Fashions at Harry’s Bar. It was, in our lexicon, a pretend bear.
So why are we taking the trouble to write about the 1962 event today, 54 years later? Our theme this week takes direct aim at the incessant chatter in today’s environment about the “length” of the current bull market and whether investors should be worried that the bull has run its course. We use the example of the Flash Crash of ’62, along with a handful of other pretend bears and near-misses, to argue that the entire technical construct of a bear market is arbitrary and has nothing to do with where the stock market is in the context of a long term macro environment.
In other words, there may be plenty of things about which to worry in regard to the current market. The rate of economic growth, the limits of central bank monetary policy and the prospects for corporate earnings are all legitimate causes for concern. The fact that – at seven years, five months and counting – this is one of the longest “bull markets” on record is not a legitimate cause for concern.
A Macro Framework
Since the end of the Second World War there have been four macro environments for US equities. There was the Great Postwar Boom of 1949 – 1968, followed by the Stagnation Bear of 1968 – 1982. Then we had the Great Moderation of 1982 – 2000, which finally ushered in the Time of Troubles that ran from 2000 to at least 2009 and possibly longer. Hold that thought, as we will come back to it at the end of this piece.
This framework is key to how we at MVF Research think about markets. It is our frame of reference for growth and non-growth (gap) environments much more than is the arbitrary construct of a 20 percent pullback from the previous high, which is the conventional industry definition of a “bear” market. Consider that postwar boom environment of 1949-68. There were three conventional bear markets over that span of time: a 21.5 percent pullback from August ’56 to October ’57, then the aforementioned six month retreat of 28 percent from December ’61 to June ’62 that included the Flash Crash, and finally another 22.2 percent drop from February to October, 1966. Of those three bear markets only one – the fourteen month stretch over 1956-57 – coincided with an actual recession.
That last point is important. What we can learn from the past is that the worst sustained market environments – the ones where investors really do benefit from added downside protection – tend to coincide with genuine problems in the broader economy. In 1962 there were few signs of economic stress, while in 1966 you had the first slight signs of the overheating that would lead to massive inflation a few years later. Investors who stayed put during this period came out fine; the S&P 500 gained a cumulative 178 percent from the 1957 market bottom to the 1968 peak.
Perhaps no example serves better as an admonishment against pretend bears, though, than October 1987.
The Roaring Eighties
The Great Moderation ran from August 1982 to March 2000. Over this time period the S&P 500 returned a staggering and unprecedented 1,391 percent in cumulative price accumulation (which does not even include the return from dividends paid over the period). But this span of 17 years and 8 months does not technically qualify as the “longest bull market on record.” It was broken up once in 1987 by a technical (read: pretend) bear, and experienced two near-misses with a 19.9 percent pullback in 1990-91 and another of 19.3 percent in 1998. In fact, if you were to use intraday highs and lows rather than closing prices, then both the 1990 and the 1998 events counted as bears.
The 1987 event, of course, was driven by the one-day freak crash of October 19. This was of an even bigger magnitude than that of May 28, 1962; major indexes closed down more than 20 percent from where they opened. All told, the S&P 500 would lose 33.5 percent from peak to trough. But it was all over less than four months after it started. And – like the instances of 1962 and 1966 – there was little in the way of macroeconomic data to suggest a sea change from the generally favorable growth conditions that prevailed at the time. In fact the next recession would not happen for another three years (and it turned out to be mild one).
The Benefit of Hindsight
Now we come back to the present environment. When we look at past market environments we can comfortably put start and end dates around them; the passage of time affords us that opportunity. For example, we know today that the difference between 1966 and 1968 was that only the latter pullback was accompanied by a real change in the economy that precipitated more than a decade of stagnation and a real, as opposed to pretend, bear market. We know that the 1929 market crash had an immediate effect on the economic decisions of businesses and consumers, with industrial production falling by double digits within a matter of weeks, while the 1987 crash barely registered in the real economy.
We know that because of where we stand today relative to those events. An investor in October 1987 or October 1929 (or May 1962 for that matter) had no such luxury, of course, and neither do we as we ponder where markets go from August 2016. We can’t even define where we are today relative to that framework for macro environments we described earlier. Are we in the beginning stages of a new third macro growth environment, a successor to the Postwar Boom and the Great Moderation? Or are we still in the Time of Troubles, with the other shoe yet to drop when the world’s central banks run out of ammunition? We do not yet have the luxury of hindsight with which to offer up a definitive answer to that question. There were plenty of false dawns during the 14 year Stagnation Bear and another interregnum during the 2003-07 phase of the Time of Troubles.
What we do know, though, is that while the world economy is in a slow-growth phase it is still, by and large, growing. We do not see evidence for the US heading into recession, or for the Eurozone to get sucked into a deflationary spiral. We are in a much more managed economic environment than that of the liberalizing 1980s and 1990s, but so far, at least, managed monetary policy has managed to keep potential crises at bay.
We know that pullbacks are a regular part of the market landscape, and sometimes these pullbacks can push over that arbitrary 20 percent threshold into technical bear territory. In the absence of compelling evidence to the contrary, though, we will have a general tendency to see such pullbacks more likely than not as pretend bears. The fact that the current bull has run since March 2009 means essentially nothing to us as any kind of a signal. Our job is the hard work of piecing together disparate data into a composite view of where we may be in the larger macro context. Real bear markets happen rarely. We do not yet see the data telling us we are entering another one.
As July came to a close the chatter among oil price watchers in the financial media was about the onset of “bear market territory” as Brent crude prices fell some 20 percent from their recent June highs. That might have been newsworthy were the asset in question Dow Jones or Nasdaq stocks. But crude oil? Another day, another radical price swing. There had already been four corrections of 10 percent or more, followed by snapbacks of an equal or greater magnitude, between the beginning of the year and Valentine’s Day. More recently, spot Brent crude prices spiked by nearly 20 percent between early May and early June as US production continued to slow, outages in Canada, Nigeria and Libya hit supply volumes, and Saudi Arabia promised its OPEC peers that it would not flood the markets with new product in efforts to grab new market share.
Reality Bites Back
Just one month later, reality proved to be somewhat different from June’s rosy picture. Saudi production in July spiked to a record level of 10.67 million barrels per day, contrary to its earlier promises of restraint. The Middle East is baking in a massive heat wave, with temperatures spiking over 120 degrees and air conditioners cranking up and straining local energy company supplies. Elsewhere, though, demand in key markets including the US, China and India waned. A big contributing factor to waning demand has been record high downstream inventory levels. In recent years, oil refineries in the US and elsewhere turned up gasoline production volumes as low prices pushed consumers back into their beloved gas guzzlers of yore. This has resulted in record inventories for the refiners and thus reduced demand for new crude supplies.
Finally, in addition to higher Saudi supply and lower global demand, the supply cuts from outages in Nigeria and elsewhere abated and volumes kicked back into gear as those situations resolved themselves. Hedge fund managers took stock of these developments in late July and decided they didn’t like what they saw. Brent crude plummeted from over $45 to $40 from July 21 to August 2 as speculators reversed their earlier optimistic bets. Market commentators channeled their best inner Yogi Berra to proclaim “déjà vu all over again” as prices failed to sustain an upside breakout. The negative view was subsequently reinforced by a new International Energy Agency report, published earlier this week, forecasting 2017 demand levels to be lower than previously expected.
Hope Springs Eternal
Those factors – continuing record levels of production alongside weaker global demand and in particular a downstream inventory glut – would appear to be fairly stiff headwinds. So what accounts for the 10 percent price spike since August 2 and, in particular, the 5 percent jump in Brent October futures that happened yesterday? Stop us if you’ve heard this one before…a possible OPEC production freeze! We got a news tidbit from OPEC at the beginning of this week that there would be an “informal” meeting of cartel ministers on the sidelines of an unrelated energy industry conference scheduled to take place in September. That sparked an immediate bump in spot and futures markets.
Then came the IEA report, mentioned above, with its dour outlook on demand, to temper animal spirits. Never fear! On Thursday, comments from Saudi energy minister Khalid al Falih were “mistakenly” released to journalists, in which the minister expressed his belief that coordinated action among OPEC members could help balance oil market conditions. Yes, you have indeed heard this one before. There was a similar amount of hype and speculation leading up to the OPEC meeting in Doha, Qatar, back in April. As with yesterday’s remarks, there were plenty of conditionals and weasel-words in the pre-Doha communiqués, and in the end nothing got done at that meeting. No freeze, no productions cuts, no nothing.
We are highly skeptical that anything more lasting will be accomplished on the sidelines of September’s sideline confab, either. Even if OPEC’s beleaguered small-nation producers managed to convince the Saudis to go ahead and back a production freeze – a very big and unlikely if – we would not see that as having a dominant and lasting effect on the structural supply / demand problems the industry continues to face. Meanwhile, integrated oil producers continue to wrestle with the double-whammy of low price realizations upstream and strained margins downstream. Big Oil continues to face an environment of Big Problems.
It has been, to say the least, an exceedingly strange summer in the world of risk asset markets. Alongside a near-daily stream of general news items suggesting that the basic rules of the world as we have long known them no longer apply – from the price of money to the usefulness of an economic union to the mechanisms of political parties and so on – alongside this theater of the bizarre has been one of the most placid summers in recent memory for capital markets. Put the UK FTSE or the S&P 500 on the cover of Alfred E. Neuman’s Mad Magazine with a smugly cheesy “what, me worry?” grin and you have the mood of the moment. Intrepid event risk hunters must feel tempted to throw in the towel, head for the hills or the shore, and wake up again in a month. Those still holding onto the notion that something – anything! – may have the ability to shake markets out of their complacency could do worse than look at the brewing trouble spot of Italy’s financial system.
In 1472 Christopher Columbus was still 20 years away from setting sail for the New World. England was still engulfed in the Wars of the Roses. In the principalities of northern Italy, though, the cornerstones of modern finance were being laid with the emergence of a structured, institutional market for borrowing and lending. One of the institutions founded that year, Banca Monte dei Paschi di Siena, is still in existence and as such is the world’s oldest bank. But prospects for another half-millennium of life are anything but certain. After a stress test last week showed Monte dei Paschi to have negative capital adequacy under simulated adverse conditions, the storied institution and its regulators are scrambling for a solution to avoid an ignominious end. As the chart below shows, detailing the bank’s stock price for the last year versus the MSCI Italy stock index, investors are anything but confident in their prospects.
Monte dei Paschi’s troubles are those of the entire Italian banking sector writ large: an unsustainably high level of nonperforming loans supported by unacceptably low levels of provisional reserves. The IMF estimates the size of Italy’s bad loans to be €360 billion. That is a whopping 18 percent of the country’s total volume of loans outstanding. Loan loss provisions – the reserves banks set aside to cover bad debts – are estimated to be capable of absorbing less than half that amount, leaving a €200 billion overhang on the financial system. The IMF quite rightly considers Italy’s banking system, and Monte dei Paschi in particular, to be a significant risk to global growth.
Italian for “Kick the Can”
This being Europe, of course, there is no shortage of effort being applied to prevent Italy’s bad debt problem from forcing any kind of drastic action in the here and now. There are no easy options, however, and that is partly due to some quirks in the Italian banking system. In Italy millions of retail investors – ordinary households like you and me – own debt issued by Italian banks in their savings portfolios. This makes it difficult for policymakers to contemplate a “bail-in” – a rescue plan in which the shareholders and junior creditors of the rescued institution suffer losses. Attempts to orchestrate an earlier bail-in in Italy for a handful of smaller banks was met with widespread protests and even one suicide. Matteo Renzi, Italy’s prime minister who has staked his political future on a referendum on constitutional reform this October, wants to avoid a bail-in at all costs.
The problem is that new EU rules implemented at the start of this year insist on such bail-in provisions for any recapitalization of a troubled corporation or financial institution involving state aid. EU policymakers, particularly those of a less forgiving nature in Berlin and Brussels, would be loath to bend the rules so soon after their implementation. As a result, creative minds have concocted a plan that would potentially recapitalize Monte dei Paschi with €5 billion in new capital and spin €9 billion in bad debt out into a “bad bank” arrangement, all funded by private sector investors. The deal, as it emerges, will be shopped to investors later this year. Interested parties hope that will be enough time to calm frayed nerves and avert another chapter in the ongoing Eurozone financial crisis.
Alfredo E. Uomonuovo
Investors in Italian sovereign debt appear uninclined to see any major event risk in Italy’s financial sector woes. Perhaps unsurprisingly for this summer of Alfred E. Neuman, the 10 year Italian benchmark bond yield is close to a three year low, as shown in the chart below.
In fact, Italian bond risk spreads relative to safe haven German Bunds have remained nearly unchanged in the six weeks or so since the Brexit shock, and a similar pattern holds for other peripheral Eurozone debt. The signal to investors would thus appear to be “no event risk here, carry on.” And it may well be that the proposed recap plan for Monte dei Paschi succeeds and keeps the wolves at bay for yet another spell of time. At the same time, though, the situation in Italy should serve as a reminder that Europe’s economic troubles are not over, and the future of the single currency union is not a given. The banking sector will not fundamentally improve until economic conditions on the Continent facilitate an environment where some measure of normal borrowing and lending activity can occur. In this most unruffled of capital market summers, one is always well advised to remember that calm seas can give way to tempests in the blink of an eye. Kicking the can down the road is fine, but all roads have an end.