Posts published in January 2017
It would appear that a lesson in US civics might be in order for Mr. Market. Investors breathlessly followed the staccato blast of tweets and executive orders emanating from Week One at the White House, rekindling the reflation-infrastructure trade that had seemed, tentatively, to be starting to take off the rose-tinted glasses. An executive order does not an actual implemented policy make, and the vaunted sausage-making process of legislative accomplishment continues to be at odds with the market’s bobby-sox crush on all things Trump administration.
Meanwhile in the world of actual data, this morning we got a preliminary reading on Q4 real GDP growth. The headline number came in a bit below consensus: the quarter-on-quarter increase of 1.9 percent was about 30 basis points below expectations. That translates to an annual average growth rate of 1.6 percent, making 2016 the lowest-growth year since 2011. How do the latest data affect expectations for next year and beyond? We look at both the near-term implications and what we see as the longer-term growth headwinds fiscal stimulus will not likely solve.
Buy Now, Pay Later
The overall consensus of economist views on the US economy in the coming 1-2 years has ticked up measurably since the election. Not to the levels of four percent real growth promised on the White House website (or the credulous investor herds who appear to agree), but increasingly closer to three percent than two. Much of the incremental growth, according to the new consensus, would start to show up in the latter half of 2017 and more fully in 2018. It would be premised on the realization of at least some form of the fiscal stimulus measures being tossed around, most directly corporate tax reform and new infrastructure spending. Most economists, when asked, stress that the nature of uncertainty around any of these measures or their timing adds a level of uncertainty to their outlook. And many are careful to add that successful implementation of these policies in the short run could have deleterious knock-on effects, as higher trade and budget deficits accompanied by higher than expected inflation could likely push up interest rates and the US dollar, making exports less competitive and thus detracting from growth. There are indeed many moving parts to the growth equation, which is why we habitually argue for caution against reading too much optimism – or pessimism for that matter – into likely scenarios for any given set of policies.
All that Matters
Ultimately, though, what long-term investors should care about, more than whether fiscal stimulus measure X gets implemented and causes interest rates to do Y and the dollar to do Z, is whether economic productivity will ever get back on track. GDP growth is important, but ultimately the growth comes from only three sources: population growth, an increase in the percentage of the population in the labor force, or productivity (the ability to produce more goods and services for each hour of effort and cost). Forget about the first two. Population growth is anemic: 1.2 percent per year for the world and just 0.8 percent per year for the US. Meanwhile the labor force participation rate, which reached a peak of about 68 percent at the beginning of the 21st century, has slumped to less than 63 percent for a variety of structural and cyclical reasons (more retirees, lingering effects of the recession etc.).
That leaves productivity. Unfortunately, there’s not much good news here either. Average output per hour, the standard measure of productivity, was lower for the last ten years than it has been for any ten year period since 1950. The current calendar decade thus far has been even worse: the 0.72 percent average annual growth rate for the period since 2010 is only one quarter of the rate for the 1960s, the most productive decade to date.
Opinions vary on why this is so, from the “best growth is behind us” view of the likes of Robert Gordon (author of “The Rise and Fall of American Growth”) to techno-optimists like Thomas Friedman of the New York Times who imagine that the true value-creating capabilities of more recent innovations have yet to bake themselves into macroeconomic statistics (Friedman ascribes 2007 – the year the iPhone was introduced – as a pivotal year in world history sine qua non). A separate but likewise relevant question is whether a new bout of technology-inspired productivity, particularly if it were to come from the gains in robotics brought about by deep-learning methods of artificial intelligence, might be severely counterproductive in its effect on the labor market. Again – lots of moving parts to consider in the complex adaptive system that is our economy.
Now, a genuine burst of real productivity (of the non-job killing ilk) could potentially smooth out the rough edges of the fiscal overheating that would be the likely outcome of the kind of programs this administration appears to want to implement. That is, of course, if the protectionist dark side of these programs were, at the same time, to not materialize. All those things combined could be a recipe for sustainable growth. But we will need to see far more evidence that any of them are likely to transpire before we think about joining the growth bandwagon.
Fed-watching isn’t quite the sport it was one year ago. The investing herds these days tend to be more fixated on tweets than on dot-plots. Nonetheless, the FOMC will meet again in eleven days, and what they decide to do (or not do) in January and beyond will have an impact on fixed income portfolios. The consensus wisdom is that rates are likely to rise. But direction is only one aspect of managing interest rate exposure; the other is shape – as in shape of the yield curve. Short and intermediate term rates have done anything but move in lockstep over the past several years. We think it is a good time to step back and consider the variables that may be at play in influencing the shape of the curve in the coming months.
A very odd thing happened the last time the Fed engineered a sustained policy of rate increases. The chart below shows the Fed funds target rate going back to 2000, along with the 2-year and 10-year Treasury yields.
The Greenspan Fed began raising rates in June 2004, taking the Fed funds target rate from 1.0 percent to 5.25 percent over a two year period (the green dotted line on the chart shows this ascent). Short term market rates moved accordingly; the 2-year yield started moving up ahead of the Fed, probably due to the expectations game and a sense that economic recovery was at hand. Longer term rates, though, barely moved at all. In fact, by the time the policy action topped out, the yield curve was essentially flat between 2-year and 10-year maturities.
Greenspan pronounced himself confused by this and called it a “conundrum.” His successor Ben Bernanke had done his own homework, though, and figured out what was going on. Many central banks around the world, particularly in Asia, had been burned by the currency crisis of 1997 and subsequently embarked on disciplined programs of building up their foreign exchange reserves. Meanwhile China, which had emerged relatively unscathed from the ’97 crisis, had its own reasons for stockpiling FX reserves: it was a means of keeping its domestic currency from getting too expensive while the country’s value of exports soared. What are all those FX reserves comprised of? Treasury securities, mostly. So the Greenspan conundrum was nothing more than good old fashioned supply and demand; as foreign central banks built up ever-higher mountains of reserves, the demand kept Treasury prices up and yields down. The effect was more pronounced at the intermediate and long end of the curve, which tend to be less influenced by domestic monetary policy and more influenced by other economic variables.
As the above chart shows, the expectations game with short-term rates has had some crazy moments in the past few years. Note, first of all, that the 2-year did not follow the Fed funds rate all the way down to zero as the central bank responded to the 2008 recession and market crash. The 2-year hung around the one percent level for much of the time until the second half of 2010 – the time leading into when the Fed launched its second wave of quantitative easing. The 2-year finally converged with the Fed funds (the upper band of the zero – 0.25 percent range) after the Eurozone crisis and debt ceiling debacle of summer 2011.
But the expectations game began anew in 2013 when then-Chair Bernanke mused openly about tapering the QE activity, Since that time, despite a handful of reversals, the trend in short-term rates has been resolutely higher. Market expectations ran ahead of the Fed, falling back only in 2016 when the FOMC blinked on successive occasions and held off on rate increases.
Yellen and the Tweets
While short term rates moved decisively off their 2011 and 2013 lows, intermediate rates once again behaved very differently. The 10-year yield actually set an all-time low in 2016 – yes, that was the cheapest 10-year debt has ever been in the history of the American republic. Again, the culprit appears to be supply and demand. In an age of negative interest rates, the meager two percent yield is king. Demand from institutional investors like insurance companies and pension funds, pushed out of other sovereign markets from the Eurozone to Switzerland and Japan, allocated larger chunks to intermediate and long Treasuries.
What does this mean for the remainder of 2017? A rational assessment of short-term movements, based on where rates are today and assuming the Fed goes through with at least two more rate hikes over the year, is that short-term rates might nudge up another 50 basis points or so. At the short end of the curve we think floating rate exposure remains attractive as a defense, particularly if the expectations game gets ahead of itself again.
The bigger challenge lies in those intermediate exposures. Negative rates still persist in Swiss and Japanese 10-year paper, but intermediate Bunds have trended decisively higher in recent weeks. The reflation trade that took hold right after the US election has meanwhile pushed the 10-year Treasury within striking distance of three percent. If the first month or so of the new administration gives the market cause to wrap itself even more tightly around this theme, then it may be a very painful year for fixed income portfolios. On the other hand – and we tend to see this as a more likely possibility – if the Trump trade is already overextended then we would expect to see less drama in the middle and long end of the curve, and still-healthy demand from those yield-seeking institutions.
An orderly and gradual rate increase policy was no doubt at the top of Janet Yellen’s list of New Year wishes. The overall economic environment would seem ready to cooperate with that intention. But she will have to deal with the possibility that tweets will do more to shape the curve than will dot-plots.
Our Annual Market Outlook will be published next week. Please find below the Outlook’s Executive Summary.
• 2016 may earn a place in the record books as one of the strangest years in capital markets history. Very little that was expected at the beginning of the year happened, and much that was not expected came to pass as the year wore on. Risk asset markets lost their footing early with some data tremors from China, but soon channeled their inner Taylor Swift to “shake it off.” Ms. Swift’s imperative became, in fact, the mantra for the rest of the year. Britain decides to leave the European Union? Shake it off! Donald Trump shocks the entire world of political punditry with his out-of-right-field Electoral College Victory? Shake it off, and then party like it’s 1929! Shaky Italian financial institutions were of no concern, geopolitical instability merited little more than a shrug of Mr. Market’s shoulders. On the Friday before the U.S. election, the S&P 500 languished 4.7 percent below the all-time high set back in August. Two weeks later the benchmark index set four consecutive records (and has notched up another five since then). Meanwhile, volatility went and crawled under a rock: the CBOE VIX index, the market’s so-called “fear gauge”, plummeted to multi-year lows in the latter weeks of the year.
• Based on these developments, we see the market today as “priced for perfection.” It’s the opposite of Murphy’s Law – if something can go right, it will. Much of the momentum pushing the market higher in the last two months of 2016 came, in our opinion, from the release of animal spirits – a giddy running with the bulls after the confines of a relatively narrow trading corridor for much of the previous two years. The notional rationale for the bull run was the putative return of fiscal policy as an economic stimulant after the total dominance by monetary policy for the past six years. Corporate tax reform and infrastructure spending were the lead acts in the fiscal playbill – the first expected to add a sizable jolt to corporate earnings per share, the latter to somehow find its way to improving real GDP growth. Unsurprisingly, the main beneficiaries thus far of the so-called “reflation-infrastructure trade” (or, in vulgate prose, the “Trump bump”) have been financial institutions, along with energy, industrial materials and related sectors.
• Our main concern with the “priced for perfection” market is that many of the actual catalysts are anything but certain to happen. We are still one week away from the new administration’s first day, and there remain far more questions than answers in terms of what the new economic agenda will be, how it will be implemented, and what will get lost or watered down along the way. Corporate tax reform, in our view, does make sense if done properly – lower the statutory rate and widen the base by getting rid of the Rube Goldberg contraption of loophole goodies. Unfortunately, companies love those loopholes, via which the average S&P 500 company pays an effective tax rate closer to the mid-teens than to the statutory rate. As for infrastructure spend: most of it would likely come through tax incentives to private developers rather than new public works projects, and it is not obvious that, even if there were a handful of shovel-ready projects that would offer attractive enough returns for private developers to act on, there would be a direct connecting of the dots to GDP growth. In short, we believe the market is currently overbought.
• Overbought, though, does not necessarily imply the onset of a sharp and protracted reversal. Our 2017 base case does not envision a bear market, mostly because we do not see compelling evidence of any kind of looming economic downturn. In fact, if one strips out the noise of the last two months and the ongoing kerfuffle around the incoming administration, very little appears to have changed in regard to the underlying economic picture. GDP growth turned up in the third quarter to a quarter-on-quarter 3.5 percent and is expected to come in somewhere north of two percent when the Q4 number comes out later this month (which would be a strong increase from the 0.9 percent growth rate of 2015’s fourth quarter). Headline inflation is also expected to finally catch up to the Fed’s target of two percent, while jobs data has us very close to full employment. Wages continue to outpace inflation, which could in turn provide further upward momentum to consumer spending, the dominant component of GDP. These are favorable macro fundamentals and, we think, should hold the bears at bay for some time yet. More likely, we think, could be another year of corridor trading, with stocks still facing valuation headwinds on the upside while not offering a convincing rationale for investors to sell off wholesale.
• Corporate earnings will have a substantial role to play in determining how much upside there actually is in a market where conventional valuation measures like price-earnings and price-sales are at decade-plus highs. The price-sales ratio, as we noted in a recent weekly commentary, is a rounding error away from 2.0 times, which in turn is not too far from the all-time high of 2.36 times set at the peak of the late-1990s technology bubble. Corporate sales will likely continue to face the resistance of a strong U.S. dollar – though the greenback’s torrid pace has waned a little in the past couple weeks. At the bottom line of earnings per share, investors will be looking for double digit EPS growth to justify any kind of similar pace of price appreciation. But global demand, though arguably improved from where it was a couple years ago, remains below trend. At the same time, relatively weak business investment levels in recent quarters may limit operating leverage improvements that would shore up profit margins. On a fundamental level, at least, it is hard to make a convincing case for another year of double-digit growth in domestic stocks.
• In Europe, economic conditions steadily, if slowly, improved over the course of 2016. Real GDP growth in Germany for the year was the highest in five years. Deflation appears to have been avoided, and ECB stimulus measures will stay in effect until (at least) the end of this year. But the political situation in Europe is fragile and could be the source of further instability. Start with Italy, where a failed referendum late last year led to the resignation of Prime Minister Matteo Renzi. While the current caretaker government may last until the current parliamentary term ends in a little over a year, we can expect continued agitation from anti-establishment outsiders – notably the Five Star Movement – to keep earlier elections in play as a potential destabilizing variable this year. France and Germany are already going to the polls, and while the conventional wisdom still holds that (a) Angela Merkel will win her fourth term, and (b) Marine Le Pen will fail to garner enough support to win the second round and ascend to Versailles, conventional political wisdom has had a somewhat poor track record of late. At some point, whether this year or not, the patented EU approach of patching up problems and kicking the can down the road will reach the end of that road.
• China has been somewhat off the radar screen for a while, after all the drama around its currency devaluations in August 2015 and January 2016. Headline growth numbers mostly came in as expected last year, and the latent threat posed by a debt-GDP ratio still over 230 percent goes mostly unnoticed in the daily discourse. But the problems have not disappeared. Arguably the most revealing indicator of all not being entirely well in the world’s second largest economy is the steady pressure of capital outflows, resulting in a decline in foreign exchange reserves from over $4 trillion in 2015 to just over $3 trillion now. The People’s Bank of China, the central bank, has worked diligently to support the domestic currency through reserve sales (most of which consist of U.S. Treasury securities), but monthly outflows show little sign of abating. Meanwhile, the global economic fortunes of China along with other key emerging markets in Asia, Latin America and elsewhere hinge on the unknown outcome of potential protectionist policy coming out of Washington. It may be another volatile year for this asset class, where higher than average risks may not yield acceptably commensurate risk-adjusted returns.
• Along with the crazy spikes in financial and resource stocks late last year, soaring bond yields were the other notable talisman of the “reflation-infrastructure” trade. Both the 2-year Treasury note, a ready proxy for monetary policy expectations, and the intermediate 10-year note are comfortably at their twelve month highs, and the 2-year yield is higher than it has been at any time since 2009. Of course, one of the iconic images for 2016’s quirky scrapbook is the all-time low set by the 10-year yield in July (all-time low meaning “since the American Republic started issuing its own debt in the late 18th century” low). We do not expect to be revisiting that multi-century accomplishment anytime soon, and think it likelier than not that the secular bond bull that began in 1982 is close to its final days. Fixed income portfolios will likely be challenged in 2017. That being said, though, and notwithstanding expectations of multiple Fed moves this year, we do not see bond yields moving towards historical averages any time soon (the average yield on the 10-year bond over the past thirty years, for example, is 5.1 percent). As we noted above, economic conditions still appear not remarkably different from how they looked one year ago. The secular stagnation theme that many observers summarily discarded in the immediate aftermath of the Trump victory has not, in our view, lost its usefulness as a way to explain the lackluster pace of organic economic growth. However challenging, fixed income will continue to be a necessary component of diversified portfolios for risk management and income purposes.
• In summary, while we have profound concerns about how markets will evolve over the coming years – concerns we elaborate in more detail elsewhere in our Annual Outlook – our base case for 2017 attaches a relatively low likelihood to either a robust bull market or the onset of a multi-period bear market. High valuations will continue to rein in upside growth, according to this view, while the macroeconomic climate continues to slowly improve and corporate earnings should at least stay modestly positive, providing support against sustained drawdowns. However, we do regard our base case view as subject to a potentially more volatile dose of X-factors than normal, and the actualization of one or more of these unknown variables could profoundly impact our assumptions and cause us to reevaluate our expectations. We don’t expect a massive trade war to send the world back into nation-state fortresses of closed economies, for example. But merely having to articulate that this is a not-totally-out-there possibility raises the mercury on our X-factor measuring stick. Things that have simply not mattered much to markets in recent years – geopolitics being an excellent example – may force themselves back onto investors’ radar screens with real consequences. Our recommendation is simply this: plan for the likely, but imagine the unimaginable.
It’s a new calendar year, but markets continue to party like it’s late-2016. Remember Murphy’s Law? “If something can go wrong, it will” goes the old nostrum. U.S. equity markets, in the pale early dawn of 2017, exhibit what we could call the inverse of Murphy’s Law. “If something can go right, it will!” goes the happy talk.
Happy Talk Meets Sales & Profits
We’re about to get an indicative taste of how far these rose-tinted glasses will take us through the next twelve months. Earnings season is upon us. Analysts expect that earnings per share for last year’s fourth quarter will have grown by 2.81 percent from a year earlier, according to FactSet, a market research company. Stock prices grew by a bit more than that – 3.2 percent – over the same period, so valuation measures like price to earnings (P/E) and price to sales (P/S) edged up further still. In fact, the price to sales ratio is higher than it has ever been since the end of 2000, and within striking distance of the nosebleed all-time high reached at the peak of that bubble in March 2000. The chart below illustrates this trend.
Price to sales is a useful metric because it shines the spotlight on how much revenue a company generates – from sales of its goods and services – relative to the price of the company’s stock. We inhabit a world where global demand has been persistently below-trend for most of the time since the 2007-08 recession. Weaker demand from world consumer markets, along with the added headwind of a strong dollar, has impeded U.S. companies’ ability to grow their sales from year to year, and that in turn helps explain why stock prices have run so far ahead of revenue growth.
Knock Three Times on the Ceiling
While price to sales is important, investors generally tend to place more emphasis on the bottom line – earnings – than on the revenue metric. Some investors focus on past results, such as last twelve months, or full-cycle measurements like Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio. Others believe that forward-looking measures are more useful and pay closer attention to analysts’ consensus estimates for the next twelve months. By any of these measures the market is expensive. The Shiller CAPE ratio, for example, currently stands at 28.3 times. That’s higher than it has been any but two times in the last 137 years (yes, one hundred and thirty seven, that is not a typo). The CAPE ratio was higher in September 1929, before the Great Crash, and again in March 2000 before that year’s market implosion.
While CAPE is a useful reality check on the market, neither it nor any other metric is necessarily a useful timing tool. There is no reason to believe that the so-called “Trump trade,” based largely on Red Bull-fused animal spirits, will end on a specific date (all the silly chatter of the “sell the inauguration trade” aside). What particularly interests us as earnings season gets underway is whether – and this would be contrary to the trend of the last several years – the earnings expectations voiced by that consensus outlook actually squares with reality. Consider the chart below.
There’s a lot on this chart, so let’s unpack it piece by piece. Let’s start with the horizontal lines depicting two “valuation ceilings” which, over the past two years, have served as resistance levels against upward breakouts. The first such ceiling is defined by the S&P 500’s high water mark reached in May 2015. The index challenged that high several times over the next 14 months but consistently failed to breach it. Then Brexit happened. The post-Brexit relief rally in July 2016 powered the index to a succession of new highs before topping out in August. It then again traded in mostly sideways pattern through early fall up to Election Day. Of course, we know what happened next.
Hope Springs Eternal
Now we come to the second key part of the above chart, and the one to which we are most closely paying attention as we study the forward earnings landscape. The thick green and red dotted lines show, respectively, the last twelve months (LTM) and next twelve months (NTM) earnings per share for the S&P 500. In other words, this chart is simply breaking the P/E ratio into its component parts of price and earnings, using both the LTM and NTM figures.
So how do we interpret these LTM and NTM lines? Take any given day – just for fun, let’s say December 10, 2015. On that day, the NTM earnings per share figure was $125.79. If we could travel back in time to 12/10/15 and talk to those “consensus experts,” they would tell us that they expected S&P 500 EPS to be $125.79 one year hence, on December 10, 2016. But now look at the green line, showing the last twelve months EPS. What were the actual S&P 500 earnings in December ’16, twelve months after that $125.79 prediction? $108.86 is the right answer, quite a bit lower than the consensus brain trust had expected!
Why is this Kabuki theater of mind games between company C-suites, securities analysts and investors important? Look at the NTM EPS trend line, which has gone up steadily for the last year even as real earnings have failed to kick into growth mode. Right now, those gimlet-eyed experts are figuring on double-digit earnings growth for 2017. Double digit earnings growth would offer at least some justification for those decade-plus high valuation levels we described above. Is there a chance that reality will fall short of that rosy outlook? That is the question that should be on the mind of any investor at all concerned about the fundamentals of value and price.
Global demand patterns have yet to show any kind of a significant pick-up from recent years, though the overall economic picture continues to improve at least moderately. And the headwinds from a strong U.S. dollar do not appear to be set to abate any time soon. As we said above – and have said numerous times elsewhere – none of this means that the market is poised for a near-term reversal. Animal spirits can blithely chug along as long as there is more cash sitting on the sidelines ready to jump back in, or a sense that there is still a “Greater Fool” out there, yet, to come in and buy.
But pay attention to valuation, and specifically to whether double-digit earnings truly are just around the corner or yet another case of hope flailing against reality.