Posts published in October 2016
It has been called the window into the soul of the modern economy; the headline macroeconomic data point against which all others are measured. Many claim that Gross Domestic Product fails to capture a large part of what actually constitutes progress in the living standards of human beings around the world, yet there are as of yet no widely accepted methodologies for a more comprehensive measure. So the brainchild of economist Simon Kuznets, GDP’s founding father back in the dark days of 1937, remains our best proxy for the contribution of individuals, businesses and government entities to our economic well-being. All this by way of saying that today’s third quarter GDP release (preliminary) showed a pleasing upside turn after a disappointing first half of 2016. While the quarterly 2.9 percent spurt gives further support to the likelihood of a December Fed funds rate hike, though, today’s report sheds little light on the continuing mystery of where all the growth has gone.
The Trend Is Not Your Friend
Quarterly GDP releases are subject to considerable variance as they go through the iterative process of revisions before the final number is etched into the record books. We focus instead on the bigger picture: how strong is economic growth today, more than six years into the current economic recovery, relative to where it has been at a similar point in previous recovery cycles? The chart below shows year-on-year GDP growth for each quarter (for example, 3Q2016 compared to 3Q2015) from 1950 to the present.
In this context, the most remarkable thing about the current (2009 – present) recovery is that it has only once even grazed the long term real growth average for the past sixty six years of 3.25 percent. In other words, the current growth trend is far and away the weakest of any recovery cycle in the post-World War II economy. Now, this recovery came off the worst economic downturn since the Great Depression. But compare the rate of recovery in the first post-recession years of 2009-10 to that of 1983-84. Then, after the wrenching double-dip recession that spanned 1980-82, year-on-year GDP growth rates ran in the high single digits before settling down to a comfortable trend rate in the four to five percent range. The booming economy of the 1990s was characterized by fewer extreme outliers, but a consistent run rate above the long term average. But growth in the 21st century, thus far, bears little resemblance to its 20th century counterpart.
The Mystery Lies Not in GDP
The long term growth mystery is not why GDP has been so persistently low. That is relatively easy to answer. Economic output – which is what GDP measures – is a fairly simple formulation: the aggregate number of hours employed by working hands to produce things, and the value of things those hands can produce for each hour worked. That formulation, in turn, depends on just three things: (a) growth in the overall population; (b) growth in the percentage of the population employed in the labor force; and (c) the productivity of the labor force.
For example, a significant contributing factor to the strong GDP growth of the 1980s was the rise of labor force participation as a percentage of total population. That trend was driven primarily by the large scale entry of women into the full-time work force – a one-off growth phenomenon that peaked in the early 1990s.
By contrast, the underlying driver of growth in the booming 1990s was a resurgence of productivity, as earlier technological innovations facilitated the ability for workers to produce more in each hour worked than they had before. This was partly due to the delayed impact of 1970s-era technologies like personal computers, and partly due to business process innovations like supply chain optimization and integrated enterprise resource planning.
Productivity, Where Art Thou?
The mystery underlying today’s anemic growth rate is all about productivity; specifically, why it is not only below trend but has actually been negative for much of the recent recovery period. The chart below shows the thirty year trend in labor productivity alongside the concurrent decline in the labor force participation rate.
This decline in labor force participation and chronically low productivity are all we need to know to understand why GDP remains so persistently below trend – and why periodic upside surprises like today’s Q3 release don’t shed much light on the bigger picture. One quarter of brisk goods exports and business investment in structures – the catalysts for today’s outperformance – does not a sustainable growth trend make. What we do not know – the mystery in other words – is if and when any of the innovations of the past decade will show up in the form of higher productivity. The answer to that riddle will likely determine whether GDP ever finds its way back to those brisker 20th century norms.
The third quarter number – with whatever revisions happen between now and then – will be the most recent growth data point for the Fed to consider when they weigh the prospect of a rate hike in December. Assuming no negative surprises between now and then – either surprises from other headline macroeconomic numbers or a major pullback in risk asset markets – odds are good they will go ahead with a 0.25% move. We believe that will be the right thing to do. But this larger growth question will persist beyond December and will, in our opinion, be a major factor at play in shaping market performance in 2017.
It’s enough to make one sort of miss those crazy Octobers when goblins and other malevolent spirits wreak havoc on asset markets. Remember 2014? A weird flash crash in U.S. Treasury yields spooked investors already jittery about the Ebola virus making sensational front page headlines. The S&P 500 fell to just short of a technical correction in intraday trading before rebounding sharply as it became clear that there was no “there” there. A vigorous Santa rally carried the U.S. bellwether index up to a then-all time high right before the end of the year.
Mario Wins the Toss, Elects to Defer
At least that gave us something to write about. October 2016 thus far is a fine month for those who value calm and serenity, but for market scribes it is notably bereft of attention-grabbing headline events. Share trading volume this month on the New York Stock Exchange is somewhat below its average daily levels back in August. August, for heaven’s sake! It would appear that stock markets are catching the soporific vibes of the central banks they so assiduously follow, most recently the European Central Bank. On Thursday, ECB Chairman Mario Draghi summed up deliberations of the body’s governing council thus: We’ll talk again in six weeks. Ciao!
The ECB has a raft of unsolved problems, but this week was apparently not the time to provide any guidance as to their progress. Markets widely expect the bank will extend the current program of monthly €80 billion purchases beyond the current termination date of March 2017. However, the ECB’s rules on asset eligibility are at odds with the actual supply of viable paper in the market. Those rules probably will have to change in order to facilitate a meaningful extension of the program. Such change in turn will require agreement from the council’s German and other northern European hawks. Draghi’s deference to the December meeting likely stems from a lack of consensus today as to how to remedy asset eligibility rules to facilitate an extension of QE beyond March.
Earnings: Low Bar Well Cleared
Meanwhile, the third quarter earnings season is, rather predictably, serving up a nice dollop of upside surprises. With a bit more than 20 percent of S&P 500 companies reporting to date, both top-line revenues and mid-bottom line profits are mostly outperforming analysts’ expectations heading into the season. We expect that, when all is said and done, the average EPS growth number will be slightly positive as compared to the minus 2.6 percent consensus number projected a couple weeks back.
Yet, while upbeat earnings reports have helped a handful of individual names thus far, those low share volume figures and lackluster price drift for the S&P 500 overall indicate that, for the moment anyway, earnings season is not serving as much of a catalyst for a broad-based rally. Shares remain expensive by traditional valuation metrics, as we have frequently pointed out in these pages. Investors still have a more skeptical take on companies’ forward guidance projections, and headwinds including the dollar and weak foreign demand haven’t gone away. Until guidance announcements provide more evidence of a near-term future of double-digit EPS growth, a couple of quarters clearing a very low bar probably won’t do much to shake off the lethargy.
When Nothing Becomes Something
We still have six weeks to go before that next ECB conference, and even longer to wait for the white smoke to appear from the Eccles Building in Washington D.C. signifying the Fed’s next move. Six weeks is a long time for “nothing” – as reflected by sideways prices, low volatility and vanishingly thin trading – to continue. Some technical indicators including shorter term moving averages and 52-week highs vs. lows suggest some top-heaviness. While we don’t see any obvious lurking threats that could move from potential to kinetic (yes, including the U.S. election which, as we have pointed out before, is largely baked into current price levels), the current quiet does strike us as too quiet.
Often it is not one thing, but rather a random confluence of several things, which gives rise to sharp price reversals. The example we provided above of the October ’14 correction illustrates this well: a sudden data point anomaly (the Treasury yield flash crash), amidst a raft of vaguely disquieting, uncorrelated event headlines and a new wave of commodity price drawdowns, converged to trigger sell signals from trading program algorithms. More often than not, these turn out to be short-lived tempests. It’s been awhile since we had one, though.
To alternately channel-flip between cable TV’s political shows and its business & markets fare is to see a tale of two Americas. On the one there is fever-pitch intensity about, apparently, the end of the world as we know it. On the other, the blood pressure levels of financial news anchors are sedate as they dispense the day’s economic headlines. Risk asset indexes are drifting their way more or less benignly through a season that, in years past, has offered up more tricks than treats. Other than a sentiment that political risk is more or less fully baked into the cake, as we have noted in several recent commentaries, what are the key contributing factors to the apparent glass-half-full sentiment? As always there are many factors at play, but prominent among them is a renewed run of the bulls in oil.
The Soothing Balm of Texas Tea
After stabilizing in the first quarter of this year, crude oil spent much of the ensuing time bouncing between a floor of $40 and a ceiling of $50 per barrel. It managed to test both ends of that range in the month of August, buffeted by conflicting data about persistently high inventory levels, on the one hand, and rumors of a forthcoming production freeze, on the other. Unusually, given OPEC’s notable string of recent failures to achieve anything of substance at their periodic get-togethers, the September 26 meeting on the sidelines of an energy conference in Algeria managed to win the day. A tentative production freeze agreement sent oil prices soaring.
True – the framework production freeze deal announced after that meeting would amount to less than one percent of OPEC’s current output of 33 million barrels per day. Also true – there are still plenty of details regarding individual OPEC member obligations that have to be worked out for the freeze, targeted for November, to take place. But the details do not appear to have fazed investors. Oil producers are taking advantage of the spike in futures prices as far out as December 2018, where prices for Brent delivery are up 36 percent. Spot prices are sustaining their levels above the earlier resistance ceiling of $50. More tellingly, as seen in the chart below, risk spreads between corporate bonds in the oil & gas exploration and production (E&P) sector are less than half what they were in February.
To Market, To Market
While there have been plenty of recent false dawns in the beleaguered exploration & production economy, capital markets seem to be giving the current environment a tentative vote of confidence. Just this past week saw the return of investor interest to the E&P IPO market. Extraction Oil & Gas, a U.S. producer, filed for a $633 million offering of new shares that ended up being priced above the investment bankers’ target expectations. This represents the first initial public offering since 2014; meanwhile, the volume of secondary offerings (i.e. issuance of new equity by companies already in the public market) is $26 billion, making 2016 a record year. Even junk bond investors are sticking their toes back in the water, with a spate of new issues in September amounting to over $1.8 billion.
This flurry of financing activity in the oil & gas E&P sector helps overall market sentiment in a couple ways. First, the opportunity for firms to raise new debt and equity capital allows them to repair their balance sheets and reduce the likelihood of default. And those more forgiving risk spreads shown in the chart above also make the burden of carrying new debt less onerous. So, companies that have made it through the wilderness of the last couple years may be less likely to fold in the coming months or years even if, as expected, oil prices remain well below their highs reached in the middle of 2014.
The Permian Way
Second, at least some of that newly-raised money will be used to purchase new equipment and services as projects become economically viable again. The sharp downturn in energy sector capital expenditures has been a major factor in the dismal performance of the business investment component of Gross Domestic Product in recent quarters. An upturn in activity here should raise confidence in 2017 GDP, which in turn will allay occasional murmurings of a coming recession heard in some corners of the financial commentariat. And there should be more projects to fund than there would have been a couple years ago. Cost structures for U.S. exploration & production companies have fallen by about 40 percent on average during the downturn. Practically speaking, this means that a project that two years ago would have been profitable only with crude oil trading higher than $60 is now profitable at $40 oil. This is especially true in the Permian Basin of West Texas, widely regarded as the most opportunity-rich geography of the domestic oil & gas market and a major investor draw.
There are plenty of risks remaining in the oil & gas sector, and one could argue that investors pouring money into these opportunities now are doing so with rose-tinted glasses. Whether that turns out to be true or not, the perception of stability and improvement in the sector now is, we believe, helping to grease the wheels of risk asset markets heading into the final stretch of the year. A yawningly boring October, should it continue for stocks and other risk assets, may be the tastiest treat of all for investors’ Halloween bags.
“Money never sleeps, pal” said Gordon Gekko to his young protégé Bud Fox in the 1987 hit movie Wall Street. That sentiment rings ever more true nearly 30 years later; money not only never sleeps, but it races around in a hyper-caffeinated 24/7 frenzy from time zone to time zone, trading platform to trading platform, algorithm to algorithm.
Last evening around 7pm Eastern time, as Wall Streeters piled into their favorite happy hour watering holes, latte-gulping currency pros in Singapore and Hong Kong watched an unnerving spectacle unfold in the early hours of their trading day. The British pound sterling had been under pressure all week, slipping from $1.30 on Monday to what seemed to be a support level around $1.26 on Thursday. Just after 7:00 am Singapore/Hong Kong time, that support level crumbled and the pound plunged more than 6 percent in the space of two minutes to a low of $1.18. The chart below illustrates the suddenness and the severity of the latest addition to the annals of “flash crashes.”
As of this writing, trading authorities in Asia (where most trading in the pound at the time was taking place) and London maintain they have not pinpointed the cause of the flash crash. Sporadic volume and a multiplicity of private, proprietary trading platforms may make it difficult to identify the cause of the price spasm. It is possible the problem originated with one of those unfortunately-named “fat finger” trades – market jargon for a data input mistake in the volume or price of an order. At some point – traders on the scene seem to be pointing to when the price moved below $1.24 – it would appear plausible to lay blame on those algorithms primed to pull the trigger at certain volatility thresholds. Algorithm-driven programs dominate intraday trading volumes across a wide swath of asset and derivative markets from currencies to equities, commodities and bonds. The laws of supply and demand dictate that, when a trigger price unleashes a flood of orders, seemingly irrational but very explainable volatility ensues.
Crisis à la Hollande-aise
Not everyone is ready to lay all the blame for this particular flash crash at the feet (such as they are) of the machines. As we noted above, the pound was under pressure in the days leading up to the event, notably along the contours of a hardening turn of sentiment regarding Brexit. UK Prime Minister Theresa May gave a tough talk at the Conservative Party conference this past week clearly aimed at a political, rather than a business, audience. While there is still a vast gulf of time between today and the beginning of Brexit negotiations next March, markets widely interpreted May’s words as indicative of a “hard Brexit” – more of a clean break with the Continent than a Norway-style preferred trade arrangement with a few compromises on contentious areas like immigration.
French President François Hollande added his own thoughts about “hard Brexit” Thursday evening. At a dinner with EU Commission President Jean-Claude Juncker, another hardliner on Brexit negotiations, Hollande stressed that a tough stance was crucial to the very survival of the EU’s fundamental principles. The main point about this speech was the timing of its publication in the Financial Times: a few minutes after 7 am Singapore/Hong Kong time, or M-minute for the flash crash. Programmers have long since mastered the art of translating the digital sentences of online news reports into 1s and 0s for their trading programs, so presumably the Hollande comments could have piled onto and inflamed the already-negative sentiment.
Welcome to the World of Event Risk
Whatever the make-up of factors involved in the pound’s flash crash, this much we know with a high degree of confidence. Asset markets today are driven by discrete events far more than they are by anything else. And technology facilitates the amplification of these events so that what might have been a price movement of one percent back in days of old can easily turn into an instantaneous gyration of five percent or more today. Those are the necessary facts of today’s capital markets.
Events stretch ahead through 2017 as far as the eye can see. Aside from Brexit, there are elections in Germany and especially France next year that could have a major impact on those “fundamental principles” of the EU – particularly if France’s far right Marine Le Pen outperforms. There will likely be reckonings aplenty at the OK Corrals of the Bank of Japan, the ECB and the Fed. And there are no doubt a handful of “unknown unknowns” about which nobody is talking now that will flash onto trading screens over the course of next year.
As last night’s flash crash instructs, a price movement that wildly overshoots the likely material impact of the event in question does correct itself in short order, which is why our default position on event outcomes is not to trade into them. That being said, though, there were plenty of trades executed within those two minutes of panic that reflected genuine investor sentiment on the value of the pound sterling. Is the investor who dumped a pile of sterling at $1.18 a sorry chump or a cold-eyed assessor of Britain’s post-EU future, waiting to cash in his chips at $1.10? The “if/else” logic of future events will supply the answer. The problem with the “1 or 0” outcome of these events, though, is that they make farcical work of predicting the odds.