Posts published in November 2016
We’ve seen this before. Well, not this, exactly. History doesn’t repeat itself, but it does rhyme from time to time. Periodically, over the past while, we have floated the idea that the bull market we’ve been in since 2009 won’t sing its swan song until we have had a good, old-fashioned melt-up. Here we are, in October of last year, musing over the possibility of a melt-up getting underway before the end of the year. We were premature, to say the least. But every dog has its day, and the evidence would now appear to be in that the melt-up has arrived.
Use That In a Sentence, Please
We will consider what this means for the rest of this year and, more significantly, what we might expect next year. First of all, though, definitions are in order. We consider a “melt-up” to be a spasm of mostly irrational giddiness in the course of a secular (multi-year) bull market, with money coming off the sidelines as investors late to the party try to grab a piece of the bull. A melt-up does not necessarily imply the end of a secular bull; the spasm may end with a technical correction and then a resumption of growth at a modest clip more in line with actual fundamentals. That happened to a certain extent in fall 2007, when indexes roared back to new records after a sharp late-summer fall, corrected again in early 2008, then sputtered along in a modest growth pattern prior to collapsing outright in September 2008. The Roaring Nineties, on the other hand, ended in a spectacular melt-up prior and right up to falling apart in early 2000.
Nice Words, and Magical Thinking
This year’s melt-up is referred to in shorthand as the “Trump Bump,” among other inane monikers. In fact, though, the good times started rolling a couple days before the election. The S&P 500 bottomed out the Friday before Election Week, then got a positive jolt the next Monday on word from FBI Director James Comey that there was no “there” there regarding that last twitch of the interminable Clinton email scandal. On Election Night, as we all know, overnight futures plummeted as the contours of a Trump victory took shape. Sentiment then turned sharply positive as a few nice words from the President-elect soothed nerves and it gradually dawned on investors that Washington would henceforth be a one-party town with a fondness for tax cuts and deregulation. Trump’s infrastructure call-out in his speech was icing on the cake, though largely insubstantial as we discussed in some detail last week. Et voilà, the melt-up was underway in earnest.
The Shelf-Life of a Melt-Up
How long do melt-ups last? And is there reason to believe that the fundamentals will justify another growth phase once the sugar high wears off? These are the questions investors will want to consider as they make their portfolio allocation choices for the year ahead.
Timing these things, of course, is fraught with uncertainty. No two market environments are exactly alike. What we can say at this point is that the trend reversal has gained sea legs in a number of asset classes over the past couple weeks. Momentum can be its own tailwind – in fact, momentum feeding off itself is the basic essence of a melt-up (or its twin, the melt-down). So whether the run-up in industrial metals or bank stocks is overblown, as we suggested was the case in last week’s post, may not make much difference in the coming weeks.
Add to this cocktail the holiday season that is now upon us, and the potential for some at least halfway decent early returns from the Black Friday – Cyber Monday retail continuum, and you may well have the makings of a go-go rally extending through year’s end. Yes – there is a very high probability of a Fed rate hike next month, but that is already baked into the cake. Fed funds futures markets ascribe a near-100 percent likelihood to a 25 basis point hike, so its execution will be an unlikely trend-buster (in fact, it would likely be more unsettling if the Fed were to balk again).
How far the good times continue into 2017 is another matter entirely. Even under one-party rule, Washington is in our opinion unlikely to serve up the kind of hyped-up fiscal policy investors seem to be banking on today. The ballyhooed infrastructure plan looks ever less like stimulative public works and ever more like a handful of tax credits for well-connected utilities and construction interests. After all is said and done, we believe, the relatively expensive market valuations of today will still make it hard to justify much fundamentals-related upside potential next year. That will be particularly true for large cap firms if they continue to face the headwinds of a strong dollar.
The market narrative has shifted. But not enough has changed to convince us that a new era of real, sustainable growth is back. There will be plenty of challenges on hand whenever this melt-up plays out.
We wish all our clients and friends a very happy and restful Thanksgiving.
The Efficient Market Hypothesis, one of the cornerstones of modern financial theory, argues that asset prices always reflect every single shred of information available to investors. Such information, aver EMH’s acolytes, is instantaneously processed by investors through a rational, omniscient, net present value-weighted assessment of probability-weighted future outcomes. Any mispricing between assets and their real underlying value is instantaneously arbitraged away; there are never any $20 bills lying on the street as a free lunch to passers-by.
If the EMH worked as advertised, then the reaction to last week’s presidential election by fixed income yields and industrial metals would have been…well, in our view, not particularly interesting. Instead, the reaction was eye-catching indeed, as shown in the chart below, which forces the question. Do those spikes in copper prices and the 10-year Treasury yield reflect a hyper-rational pricing of all information available to thinking women and men? Or, rather, are they those proverbial $20 bills fluttering along the pavement?
Runnin’ Down a Dream
The meme that took hold almost as soon as Trump uttered the word “infrastructure” in his victory speech was “infrastructure-reflation trade.” Anyone watching the futures market saw this meme go viral as Tuesday morphed into Wednesday. The idea behind this whiplash in different asset classes appears to be: a torrent of federal spending cascading into US infrastructure projects, piling billions onto the federal deficit and igniting an inflationary heatwave. Bond yields would rise (inflation), and industrial metals prices would soar (demand). If this outcome were highly likely, then EMH would be doing its job just fine as assets instantaneously absorbed the news and repriced.
But a more truly rational assessment, in our opinion, would be that this infrastructure-reflation scenario is very, very unlikely to happen. Infrastructure has not been and will continue not to be a top priority for Congressional Republicans. Even if an infrastructure bill were to make its way through the legislative sausage factory, it would be in the end a very watered down version of anything Trump may have promised on the campaign trail. Even then, there would be a significant lag between the passage of any such bill and the formalization of “shovel-ready” projects to be on the receiving end of the funds. Even then, the net impact on headline macroeconomic data points like jobs or consumer prices would very likely be muted for the foreseeable future.
In short, we believe the “infrastructure-reflation trade” is little more than a mirage, a knee-jerk reaction more than a rational expression of future outcomes, and unlikely to be the kind of paradigm momentum shift in asset class trends many observers continue to believe is happening.
Tax Cuts Trump Public Works
The 2016 election does mean one-party rule, and this means an ability to push through economic policy in a way that the gridlocked Washington, DC could not achieve for most of the past eight years. But behind the smiling façade put up in public there are, by our reckoning, two distinct power factions in the Republican Congress with which the incoming administration will have to horse trade. There is Paul Ryan, the House Speaker who probably better than anyone else in Washington knows exactly what he wants to accomplish in the way of economic policy this year. These goals are simple and widely known: tax cuts for the wealthy, and far-reaching deregulation & de-funding with an emphasis on the financial, health care and energy sectors. “Ryanism” is in essence the core fiscal agenda that has motivated Republicans and their conservative donors & lobbyists since the Reagan era. We expect early policymaking to focus nearly exclusively on these issues.
The second power faction, then, are the legislators on Ryan’s right wing flank, the self-styled Freedom Caucus. This bloc would pose a further obstacle to any infrastructure bill that might come out of horse trading between Ryan’s team and the new White House. While the Freedom Caucus is arguably animated more by cultural issues than economic policy, they are strenuously opposed in principle to government spending outside of narrowly-defined defense obligations. The Freedom Caucus is where the “reflation” part of that infrastructure-reflation trade goes to die. Reflation would necessitate the large-scale creation of new, debt-financed money. The votes simply would not be there. The more hard-line caucus members are likely to push hard for dramatic spending cuts even to offset the imminent tax cuts, and there won’t be much left after that for offsetting massive public works projects.
Of course, infrastructure can also fall into the private domain, and there is much animated chatter about private-public cooperation to mitigate the impact of projects on the federal budget. But major infrastructure areas like roads and bridges, that are badly in need of upgrade, generally fall out of the purview of private money, because they do not offer commercially competitive returns. It is unclear how much practical infrastructure could realistically be funded from private investment sources.
Trumpism in the Age of Ryan
None of this is to say that the incoming administration will not have an impact on economic policy choices; by this point it should be clear to everyone that Donald Trump should not be underestimated. The President-elect knows his base; he understands what motivates the legions of voters in Wisconsin, Pennsylvania and Michigan who turned up on Election Day for him. And he will have to show some love to this base. Nothing would render Trumpism a mere historical sideshow than a belief taking hold that their leader is a sell-out who will give the donors and DC elites the keys to the kingdom while they, the base, continue to get the short end of the stick.
To that end, optics will require the new economic policy to be perceived as something more than just the wholesale implementation of Paul Ryan’s narrow agenda of millionaire tax cuts and deregulation. But, as we noted in our commentary last week, the new team is likely to tread cautiously in its first months of occupying the White House. They will perhaps be more likely to find their red meat for the base in other areas – immigration and socio-cultural flashpoints, for example – and more or less let Ryan and Congress hash out and implement their economic agenda.
All of which is to say that, in our opinion, those investors who have been chasing up industrial metals prices and dumping intermediate bonds in these first days of the new order are likely chasing mirages.
In this space last week we presented a case for “guarded optimism” in risk asset markets, regardless of the outcome of the presidential election. Then the Tuesday Surprise happened. It would be reasonable for one to ask us whether we are still of that cautiously optimistic view we expressed one week ago, and that will be our theme this week.
Sound and Fury
First of all, let us be crystal clear about one thing. When the subject of politics comes up in any of our weekly commentaries, our discussion is limited to how we perceive the directional impact of political events on equities and other risk asset markets. Donald Trump’s Electoral College victory has major potential implications for the U.S. and the world at many levels. Both of us have our own personal views about the outcome. But our focus here, as it is with any subject we present in these pages, is simply to share with our clients and other readers our assessment of how this development may affect their long-term investment portfolios.
As of today, our view is very little changed from where it was one week ago. Yes – futures markets plummeted through circuit-breaker levels as the results trickling in from North Carolina and Florida illuminated Trump’s path to 270. And yes – a few inclusive-sounding words by the President-elect, delivered in a relatively calm, measured tone in the wee hours of the morning, succeeded in reversing those overnight losses ahead of a Wednesday rally. That’s short-term noise, and while we could see more of that play out over the next couple weeks, we do not see as likely any sustained directional trend one way or the other proceeding from the simple fact of Trump’s victory.
Beyond the short-term sound and fury, we see three critical questions that could set the tone of markets in the first half of next year and beyond. First, will the new administration insert itself into Fed Chair Janet Yellen’s realm of monetary policy in a way that upsets central bank-dependent asset markets? Second, how will the economic priorities of Team Trump impact particular industry sectors and, by extension, the sales and earnings prospects of publicly traded companies? Third, will those same economic priorities live up to the often inflammatory, dangerous rhetoric on foreign trade that came up in the course of the campaign?
The Last Democrat
Among her other claims to fame, Janet Yellen now has the dubious distinction of being the last Democrat in Washington, D.C. with any meaningful power. The President-elect’s personal distaste for her is well-known and was featured prominently in the campaign’s closing ad messages. We think it unlikely, though, that the new president would play footsie with a possible market crash by taking concrete action in his first year to limit the Fed’s ability to independently execute monetary policy. Yellen’s term expires in January 2018, and odds are better than not that she will be replaced then by a Republican Fed head. Trump would have little to gain, and a great deal to lose, by stirring up trouble in the Eccles Building any time before then.
That is not to say that the risk of a White House – Fed confrontation does not exist as a possible 2017 surprise. In particular, it will be interesting to see how Trump and his new economic advisors react if, as expected, the Fed reactivates its rate hike program starting in December. Notoriously unpredictable as a candidate, it remains to be seen how restrained Donald Trump will be as president. We will be studying the tea leaves of formal policy speeches and off-the-cuff Twitter remarks alike in the coming weeks to get a better sense; for the time being, anyway, we would expect a more pragmatic approach to relations with the Fed at least within the next twelve months.
The Return of Fiscal Policy?
One of the first ways we expect 2017 to be unlike every one of the last eight years is that fiscal policy – i.e. actual legislative action targeting areas of economic stimulus – will be a real part of the conversation. In 2009 the Republican Congressional leadership more or less designed a tactical program around denying the Obama administration opportunities to implement economic policy. They didn’t always succeed – most notably in the 2009 stimulus package responding to the Great Recession and then in the 2010 passage of the Affordable Care Act – but by the time of Obama’s reelection in 2012 fiscal policy was by and large not a viable part of the economic equation. That has changed with the looming imminence of one-party rule. When we hear various ideas floated around – infrastructure spending, corporate tax reform, and stimulus programs for coal and other non-renewable energy sources are examples currently making the rounds – we have to assume they can actually become law and have an impact for better or worse.
One practical consequence of this is that sector picking may be back in vogue, as armies of quants tinker around with algorithms designed to follow the direction of putative fiscal policy initiatives. We already see signs of how this will play out; just since Wednesday morning, for example, the healthcare sector has been cleaved into subsectors with very distinct, uncorrelated trading patterns. Republicans on the Hill are baying for an immediate repeal of the Affordable Care Act, with little sense of what if anything is to replace it. That exposes health insurers to much uncertainty. On the other hand, expectations of an ultra-light regulatory touch are boosting the shares of drug manufacturers and biotech firms.
Trade or No Trade?
Ultimately, corporate earnings will depend on far more than U.S. fiscal policy. The IMF revised its estimates for global growth next year down in its most recent quarterly assessment. Both output and demand remain below historical norms in most developed as well as emerging markets. Weak foreign demand and a strong U.S. dollar are likely to continue to weigh on earnings and profit margins. That was going to be true regardless of who won on Tuesday night. Both campaigns took a relatively hard line against global trade; again, though, the fact that the executive and legislative branches all went Republican means that – to be blunt about it – if the new administration wants to start a trade war then it will be well within the realm of possibility to implement protectionist legislation.
Somewhat along the lines of our thinking that Trump would not likely rush into an immediate monetary policy confrontation with Janet Yellen, we think it less than probable that he would strike up a trade confrontation with China as an opening economic policy salvo. We have to imagine that somewhere in his economic transition team are voices to convince him of the unfavorable cost-benefit equation of such action.
There will be plenty of pressure from outside Washington to live up to his campaign rhetoric, however. It is not lost on anyone, least of all on traditional conservative free-traders who populate D.C. redoubts like the American Enterprise Institute and the Heritage Foundation, that the margin for Trump’s victory was delivered by voters who have largely been on the losing side of the global economy’s distribution of fortunes. The President-elect will soon enough have to confront the dilemma of pro-trade, pro-growth policy versus the strong protectionist impulses of the newly-empowered working class Republican base.
So there they are: monetary policy, fiscal stimulus and approach to trade are the three open questions at the top of our list of priorities. As we said last week, connecting the dots between the current direction of macroeconomic trends and corporate sales & earnings – i.e. the overall narrative that long predated the election – offers enough grist for at least a cautiously optimistic take on asset markets as 2017 gets underway. Whether we stand by that view as the year progresses will depend in no small part on how we see the evidence shaping up to provide answers to these three questions.
The most contentious U.S. presidential election in modern history is approaching its dramatic conclusion, and the media discourse is saturated with breathless prognostications of doom and gloom. Even the stock market has gotten in on the act, with the S&P 500 retreating eight days in a row and flirting with a 5 percent pullback from the record high of 2190 set way back in the middle of August. Trumpkins and Clintonistas alike (not to mention “Pox on Both Houses” malcontents) see a Dark Ages v2.0 on tap if their candidate fails to snag 270 Electoral College votes next Tuesday. Strange times, these.
The Devil’s in the Data
And then there are the data. Actual numbers, lovingly compiled by earnest toilers at the Bureau of Labor Statistics and the Bureau of Economic Analysis and various other Bureaux in our fair land, reflecting how the economy is doing through the prism of job creation, price trends, consumer habits and much else. These numbers have painted a fairly consistent picture for the past couple years: moderate but below-trend growth, a weak recovery in wages and prices, stable spending patterns and improving consumer confidence. One important trend that appears to be solidifying is that of real wage growth.
Below today’s headline jobs number of 161,000 new payroll gains (which itself is notable in extending the post-Second World War record number of consecutive monthly jobs gains) is the 2.8 percent year-on-year growth in average hourly wages. This is not an outlier; wage growth in recent months has consistently outpaced inflation, whether measured by headline or core (ex food & energy) CPI or by the Fed’s preferred Personal Consumption Expenditures (currently 1.7 percent).
Real wage growth indicates that, after all those months of falling unemployment and new payroll gains, the labor market is tightening along the lines of historical norms. Those gains should help push consumer prices further towards the 2 percent target rate as a higher chunk of household earnings finds its way into spending on staple and discretionary goods and services. That, in turn, should be good news for GDP, about 70 percent of which derives from consumer spending. This is the virtuous circle that has driven past periods of economic growth.
One Cheer for Productivity
Sustained economic growth, as we never tire of pointing out, derives from growth in the overall population, or from an increase in the percentage of the population at work, or from improved productivity per average hour worked. That third option is critical, and economists have been puzzled by the chronic recent failure of the economy to achieve meaningful gains in productivity. In fact, productivity as measured by the BLS had decreased for three consecutive quarters leading up to the release this past Thursday (given the importance of this metric to overall growth, why is there no celebrated Productivity Thursday, along the lines of the popular Jobs Friday nerdfest?).
In any case, Q3 productivity surprised to the upside, growing 3.1 percent against expectations of 1.7 percent. That’s good! But of course it is only one quarter, so too early to break out the Veuve Cliquot. The other good thing about productivity, though, is that productivity gains help businesses leverage their operational expenses, including labor expenses. Improving productivity, all else being equal, should enable businesses to accommodate wage increases (see above) while maintaining or even improving profit margins.
Connecting the Dots from Macro to Earnings
Maintaining those profit margins will be extremely important for businesses as they try to work themselves out of the recent funk in corporate earnings. Average earnings had fallen for five consecutive quarters heading into the current (3Q16) earnings season. With about 85 percent of S&P 500 companies reporting, it appears the negative streak will come to an end: expectations now are for 2.6 percent EPS growth, as opposed to the minus 2.6 percent expected at the beginning of the quarter. That’s all well and good, but investors are keen to see a return to the double-digit earnings growth environment of years past. Productivity gains will need to continue to offset the effects of a tighter labor market.
Meanwhile, the headwind effect of the U.S. dollar should be expected to continue if, as likely, the Fed goes ahead with a resumption of its rate hike program come December. And while the virtuous cycle of stronger demand may take root here at home, there are still too many pockets of weakness and uncertainty in other geographic markets where large U.S. companies manufacture and sell. In short: an improved U.S. economy won’t be of much help to domestic share prices unless the dots between macro and earnings can be connected.
The Human Effect
Our optimism will thus remain guarded until we see more evidence of an improved economy having a measurable impact on business performance. Which brings us back to the topic that opened this commentary – the upcoming election. Is there any substance to those abundant prophesies of the imminent apocalypse? Or, in other words, how much actual damage could politicians create to choke off any nascent improvement in our little economic garden?
We must, of course, be cognizant of the profound dissatisfaction registered by many voices – not just here at home but around the world – against political structures and other perceived elite institutions. The dissatisfaction certainly influences the policy discourse and shapes how political leaders present themselves and their policy intentions. But we remain of the view that, regardless of what configuration of Democrats and Republicans win their races next Tuesday, the more extreme elements of their platforms will have a very hard time finding their way into actual law.
History has shown that ill-conceived human intervention can have a real, long-term negative impact on a society’s standard of living. History also shows, though, that revolutions don’t happen far more often than they do happen. We may live in strange times, but we do not see them as strange to the extent of Petrograd 1917 or Paris 1789. Until we have reason to think otherwise, we remain guardedly optimistic.