Posts published in February 2017
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
Contrarian investors come in all shapes and sizes, but they all share a variation of this basic way of looking at the world: when the crowd looks one way, it pays to look the other. Today there is an undisputed crowd looking one way -- the Trump reflation-infrastructure trade that shows scant signs of fading, despite a bit of a pause in US equity share gains this week. And there are plenty of good reasons -- we believe -- for looking in other directions, the arguments for which we have set out on these pages in weeks past. But where? This week we consider the merits of one of the least popular asset classes in recent times: European equities.
Europe: The Macro Case
On the face of it, there would seem to be not much to recommend Europe from a top-down analysis of the variables at play. Last year’s Brexit vote hangs over the Continent; while the general consensus remains that Britain’s exit will hurt its own economy more than that of Europe’s, the devil will be in the details of how the parties agree to implement Article 50. Plus, of course, the upcoming elections in France and Germany, and the still-potential wild card of early elections in Italy - will shine a light on the fissures created by anti-establishment sentiment. All this while rattled national leaders and EC technocrats listen for the next approaching Scud missile in the form of a late-night tweet from the other side of the Atlantic.
Valid points, all. On the other hand, the economic health of the region is arguably stronger than it has been since the recession began nearly ten years ago. One of the first macro headlines of note this year was a 1.7 percent reading for consumer price inflation in Germany. Additionally, Eurozone producer prices climbed 1.6 percent year-on-year through the end of December last year. A meaningful part of the jump comes from energy prices; nonetheless, building inflationary pressures would seem to indicate that Europe has moved well and truly back from the deflation trap that seemed all but certain to engulf the region just two years ago. Two cheers, perhaps, for Mario Draghi and his knack for jawboning equity and debt markets.
Moreover, while the upcoming elections could indeed put added stress on the integrity of the common currency region, there is a plausible argument to make against that outcome. Consider the French election, where a victory by far-right populist Marine Le Pen would send shock waves to Brussels. Recently the world learned that the til-now front runner in that race, conservative Francois Fillon, is embroiled in a financial scandal involving fake parliamentary jobs for his wife and children. Apparently nepotism is still a cause for scandal over there - who knew?
The knee-jerk reaction to that news would plausibly be fear that Le Pen, running second in the polls, would vaunt to front-runner status. But wait! The Fillon scandal appears to have worked first and foremost to the benefit of Emmanuel Macron, an independent candidate with a moderate center-left platform who has surged to front-runner status. A Macron win would shake up France’s ossified political system, but arguably in a productive way less likely to be a direct threat to Eurozone integrity. Add to that the likelihood of Angela Merkel winning her fourth term later in the year, and suddenly the Great European Crack-up of 2017 looks less probable.
Europe: the Micro Case
What about the bottom-up view? Well, the obvious place to start would be the valuation gap between US shares and their European counterparts. According to Thomson Reuters Datastream, the twelve month forward P/E multiple for the Euro Stoxx 600, a regional benchmark, is less than 15 times. The forward P/E for the S&P 500, on the other hand, is over 17 times. Now, there have been reasons a-plenty to attach higher valuations to US companies in recent years. Nonetheless, when whole asset classes go out of favor there are usually some very good names that get unfairly tarnished with the macro discount brush.
One area where some contrarians may have been seen fishing about recently is for shares of companies with a significant portion of their revenues derived from outside Europe, particularly in North America or China & Southeast Asia. Remember that for every Procter & Gamble there is a Unilever, for every Exxon Mobil a Royal Dutch Shell. And some of the world’s leading industrial materials concerns -- a sector particularly embraced by the Trump trade crowd -- hail from Europe, among them Germany’s Heidelberg Cement and France’s Lafarge. If you really have to play the infrastructure trade, why not play it with more attractively-valued shares?
The Currency Factor
For a dollar-denominated investor, Europe has been a disappointment for many, many years, and one of the main reasons for that has been the secular bull run of the US dollar. The consensus outlook for the dollar remains strong, mostly due to the imagined outcome of a sequence of interest rate hikes in the US while the Eurozone continues to feed its monetary stimulus program. Every percentage gain by the dollar against the euro is a percentage taken away from the price performance of EU shares in local currency terms. For most of the past eight years, that has been a daunting obstacle.
Again, though, if those EU inflation headlines continue into a trend it is likely to, at the least, put upward pressure on intermediate and long benchmark yields in the Eurozone, which in turn would provide some support to the euro. Back in the US, we continue to see the pace of rate increases by the Fed proceeding gradually and below-trend for some time to come (this squares with our view that the tidal wave of net new infrastructure spending is more a creation of hyperactive investor imaginations than actual likely policy in 2017). With the dollar hovering just a few points above euro parity, there is at least a reasonable case to make that the dollar’s bull run may settle back a bit from its recent pace -- indeed, we saw perhaps a preliminary sign of this with the greenback’s weak January trend.
None of this means that European equities are a fat-pitch obvious source of value. But in a world of expensively priced assets, sometimes it pays to get into the heads of the contrarians and see what they are thinking. We will continue to send reports from this corner of the market as we assess alternative opportunities over the coming weeks and months.