Posts published in March 2017
It is something of an annual tradition: at some point, usually in the middle of a humid and lazy Atlantic Seaboard August, we will write something about the “dog days” of summer in investment markets. You know – light trading volume and mostly listless price direction, occasionally punctuated by an exaggerated surge or plunge based on some rumor or stray macro data point. Well, this year the dog days have arrived early. A couple one percent-plus days – one down and one up, for reasons that are barely remembered – provided some color to an otherwise tepid month long on political headlines and short on directional action. As the second quarter gets underway, we consider what might – or might not – puncture the market’s smug haze of mellow.
The Beta Economy
The present occupant of 1600 Pennsylvania Avenue may fancy himself an alpha human, but the economy in which his administration finds itself is decisively beta. That’s not a bad thing, mind you. A beta economy means real growth somewhere around two percent – nothing like the alpha economy of the 1990s, but perfectly acceptable, with modest price inflation and a mostly healthy labor market. Much of the rest of the world is enjoying a similar beta vibe. GDP is actually a bit higher in the EU than it is at home, Japan is managing to stay out of recession, and China’s factories are humming along nicely with recent PMI readings for services and manufacturing comfortably above the growth threshold number of 50.
Importantly for investors, a beta economy supplies the most compelling reason not to get fooled by a momentary sell-off like the little one last week. With no sign of a recession in sight, at home or anywhere consequential abroad, there simply isn’t much of a case to make to run for the hills. But what about the upside? Can businesses crank out alpha earnings in a beta economy?
Those Elusive Double Digits
Q4 2016 earnings season is over, and the 5.1 percent growth registered by S&P 500 companies falls well within our definition of “beta,” in the context of the last couple decades of quarterly results. Surprisingly, 5.1 percent is also very close to what analysts were predicting last fall: the FactSet consensus of analyst projections on September 30 pegged Q4 earnings growth at 5.2 percent. Reasonable! But that same consensus group also gave their Q1 2017 estimates on that same day, and that number was a very alpha-like 13.9 percent. Do they still feel that way? Not so much – the revised Q1 consensus number as of today, right before the actual figures start to come out, is 9.1 percent.
That’s still not bad, but it’s not the double digits investors would prefer to see to validate those valuations nearing nosebleed territory. The last twelve months (LTM) P/E ratio touched 20 this week, a level last seen in the post-trough recovery following the 2001-02 recession. The price to sales (P/S) ratio, is at levels last seen in the heady final days of the dot-com bubble at the beginning of the 2000s. We have believed for some time that the “valuation ceiling” remains the biggest headwind to substantial upside gains. Of course, this view has taken quite a bit of flak of late from the ever-popular “reflation-infrastructure trade” that has dominated market chatter for the past five months. Which brings us to our final musing about Q2 market direction…whither the animal spirits?
Momentum Is Its Own Momentum, Until It’s Not
What market pundits continue to call the “Trump trade” has been durable, even as prospects for any kind of sweeping, historic tax reform and massive new spending on infrastructure build out – never an obvious outcome to begin with – have looked less and less likely. But, as we have noted elsewhere in recent commentaries, such upside as there has been for the past couple months really has less to do with those reflation-infrastructure themes than it does with plain old momentum and those robust animal spirits.
Consider industry sectors. Sector-wise, the Four Horsemen of the reflation trade that ignited after the election were financials, materials, industrials and energy. These also happen to be the four sectors trailing the market in 2017 year-to-date, while technology, healthcare and consumer discretionary have all outperformed. Tech and discretionary, in particular, seem like pretty reasonable places to be if you’re comfortable with that beta economy and looking for a low-impact way to continue participating in equities. This low-key sector rotation has kept the rally going even as the original theme behind it went stale.
The problem, of course, is what happens when momentum wanes, as it eventually does? The first thing to watch out for is signs of the return of volatility, which as we all know has been strangely absent for the duration of this most recent phase of the bull market. Even that one-day pullback last week failed to elicit much more than a shrug from the supine VIX index. The market’s vaunted “fear gauge” has stayed in a volatility valley well below 15 for the entire year thus far (compare that with an average level above 20 for the first two months of 2016).
We tend to pay less attention to the VIX’s occasional sharp peaks than to the mesas – those extended periods of baseline elevation around 15-17. A new mesa formation on the VIX would, in our opinion, raise the prospects of a sizable near-term pullback in the 5 – 10 percent range. At which time we could, mercifully, shake off the dog days and get into some desirable new positions at more reasonable values.
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.
It was Game On week. No, not the NCAA basketball tournament with its annual goody-bag of Cinderella stories and humble pie for top seeds, but the opening salvo of the elections in Europe about which we’ve all been chattering since the beginning of the year. What message will those discontented bodies politic in the fraying Eurozone send to global markets? Vox Populi rising, or more of the same?
Nee, Non, Nein
“Nothing here, move on” might be an appropriate response to this week’s contest in the Netherlands, and indeed much of the post-election commentary focused on the singular Nee – Dutch for No – served up by the voters to anti-immigrant polemicist and Freedom Party (PVV) head Geert Wilders. A stunning 82 percent of the citizenry turned out (dream on, America!) to give Mr. Wilders the thumbs-down and enable incumbent Mark Rutte and his VVD party to form a new government. This outcome fits rather neatly into a long-held view that, while disgruntled Europeans may register their unhappiness in polls and in the less consequential votes for the EU representatives they send to Brussels, they will heed their better angels when voting in their own national governments. Historians will point out that ethnocentric populism, while always present, has never managed to crack the high 30s in percentage terms over more than a century of national electoral contests. In this reading of the current environment, the Dutch “Nee” is likely to be followed by a French rejection of Marine Le Pen in favor of centrist Emmanuel Macron, and a vote for more of the same in Germany when Angela Merkel seeks her fourth term. Certainly these would have to be considered the default outcomes in the absence of any new news.
The Math of Discontent
A closer read of the Dutch outcome, though, tells a somewhat different story and one that would appear to be well in line with broader trends both within and without the Old Continent. The PVV – Wilder’s party – didn’t actually lose parliamentary seats but rather gained five. The big losers of the night, by the math of seat gains or losses, were the two establishment parties. PM Rutte’s PVV lost eight seats (though still retaining its position as the largest single party). But the PVV’s coalition partner, the Dutch Labor Party (PvdA) lost a stunning 29 seats. That adds up to a net loss of 37 for the Establishment. It also serves up yet more evidence that the traditional European left (think Britain’s beleaguered Labor Party or France’s Socialists with a 4 percent favorability rating) is in a death spiral.
Meanwhile three “alternative” parties – the left-leaning, Europhile D66 and Green List and the center-right, quasi-populist CDA, picked up 23 seats between them. Adding Geert Wilder’s 5 seats means that a non-Establishment alternative, split roughly between pro and anti EU sentiment, will play an outsize role in the new government. With no clear mandate for either bailing out of the EU/Eurozone or doubling down on open borders and free trade, the result is likely to be a lack of clear direction one way or the other. This outcome much more resembles the recent past than it does some bold new step forward. Populism may have its limits, but so does globalism.
Mr. Market’s Quiet Genius
For the past couple months we have spilled a great deal of ink on the pages of this column finding fault with the so-called “reflation-infrastructure” trade that appeared to be based on little other than hope and animal spirits. But we are starting to see a little method in the apparent madness of the markets. No – there is no infrastructure pony out back with a Christmas bow around its neck. There never was. Just as in Europe, our own policy engine is stuck in second gear, and not just on account of the apparent own goals the current administration and Congress keep making. Ours, too, is a body politic divided, and those divisions are, so far at least, keeping in check any decisive movement juggernaut in one given direction.
And that suits Mr. Market just fine, thank you very much. Hey – economies are doing pretty much okay on their own, here at home, in Europe, Japan and much of the emerging world. Citizens are disgusted with their governments for some very valid reasons. The less interference we get from misguided policymakers, goes this line of thinking, the better. No action is good action. Continued improvement in jobs and wages, with a modest but not frenetic pick-up in prices, all in the context of real GDP growth of two percent or a bit more – that’s enough for now. Enough to keep corporate earnings growing at least in the mid-high single digits. These may not be the best of times, but neither are they the worst. As long as things remain more or less as they are, this bull market can perhaps enjoy an extended sunset rather than suffering an abrupt end.
One of the great debates among the economic literati in recent years has been whether the subpar growth trends of late are cyclical or more long term in nature. The bearish long term view goes by the name “secular stagnation,” with advocates including former Treasury secretary Lawrence Summers making the case for a world stuck in a rut of anemic capital investment and lackluster demand. Two years ago, secular stagnation seemed like a pretty good theory to explain the deflation trap threatening to ensnare the Eurozone, zero-bound interest rates in the US, and many former growth darlings in emerging markets falling into low single digit or negative growth.
Macro headlines today tell a rather different story. In the US jobs, wages, prices and consumer confidence are all trending uniformly higher, as indicated in the chart below.
Meanwhile, Eurozone inflation has bounced back and even Japan is enjoying a relatively unusual run of positive growth. Most Asian economies are performing decently, if not necessarily spectacularly, while erstwhile basket cases Brazil and Russia seem to have gotten through the worst of their travails. Is it time to put a fork in the secular stagnation theory and call it done? Asset markets certainly seem to think so; today’s valuation levels can only appear reasonable if premised on the imminent resumption of historical-trend growth. But before we read last rites and sing Psalm 23 over the corpse of secular stagnation, we need to supply an answer to the question of what forces are present to drive that historical-trend growth.
The term “secular stagnation” is not new; it was coined in 1938 by prominent US economist Alvin Hansen. If you are familiar with US economic history you will recall that 1938 was the trough year of the second sharp pullback of the Great Depression: not as deep as the earlier one that bottomed out in 1932 but still painful, with unemployment at 20 percent and a steep decline in US population growth. Hansen looked around him and saw no way out; the world was locked into that dreaded feedback loop where businesses invest less because they expect continued lower demand, and households spend less because there are fewer jobs. Secular stagnation, in other words.
As we know now, of course, the world didn’t turn out that way at all. Instead, the onset of the Second World War unleashed a torrent of economic growth to supply the war effort, and after the war the US, as the sole economic superpower, ushered in a glorious thirty year period of steady and sustainable growth. The secular stagnation theory was laid to rest, until its resurrection by Larry Summers et al in the 2010s.
Attractive Economy Seeks Feisty Catalyst for Growth, Good Times
The headline economic data shown in the chart above are promising, but they are not yet sufficient to return secular stagnation to the box where it rested from 1939 to 2010. While the circumstances that produced the magnificent growth from the late 1940s to the early 1970s are complex and varied, the growth drivers themselves are easy to pinpoint. First, a return to population growth after the anomalous decline of the Depression years. Second, growth in labor force participation as returning war veterans went into a booming job market (and were later joined by a rising level of participation by women). Finally – and most importantly – was growth in productivity, or efficiency gains in how much output businesses could produce for each hour worked.
Are we on the cusp of another productivity boom? The data do not yet point to one. The chart below shows US productivity trends, along with the labor force participation rate, for the last thirty years. Both of these growth indicators remain decisively below-trend.
Some argue that the innovations of recent years will be that much-sought catalyst desired by the global economy. Expansive pundits talk of the Holy Trinity of the Three Industrial Revolutions: the steam engine of the late 18th century, electricity and the internal combustion engine a century later, and the smartphone in the early 21st century. Perhaps history does move in such well-tempered cycles; alternatively, perhaps the culture of growth that grew up around the first two Industrial Revolutions will be seen by future historians as a delightful anomaly rather than an inevitable forward march of progress. Time will tell whether this third iteration can deliver the goods.
The heady cocktail of animal spirits and hope that is the so-called reflation-infrastructure trade has many fans, but perhaps none more so than the monetary policymaking committee of the Bank of Japan. One of the first casualties of last year’s big November rally was the yen, which plummeted in value against the US dollar. That plunge was just fine, thank you very much, in the mindset of Marunouchi mandarins. A weak yen would make Japanese exports more competitive, while the continuation of easy money and asset purchases at home would finally create the conditions necessary for reaching that long-elusive 2 percent inflation target.
Lo and behold, the latest price data show that Japan’s core inflation rate rose 0.1 percent year-on-year in January, the first positive reading in two years. Only 1.9 percent more to go! Expectations of stimulus-led growth, continued weakness in the yen and a return to brisker demand both at home and in key export markets have led Morgan Stanley’s global research team to name Japan as the stock market with the most attractive prospects for 2017.
Patience Has Its Limits
Beleaguered long-term investors in Japan’s stock market would be more than happy to see Morgan Stanley’s prognostications come true – but they have heard this siren song before. The Nikkei 225 stock index reached a record high of just under 40,000 on the last trading day of 1989. As the chart below shows, things have been pretty bleak since those halcyon bubble days when the three square miles of Tokyo’s Imperial Palace were valued by some measures as more expensive than the entire state of California.
If the Morgan spivs are right about Japanese shares, and keep being right, it will represent a decisive break from a struggle of more than two decades for the Nikkei to sustain a level greater than 50 percent of that all-time high value. Prior to 2015, the Nikkei had failed to even touch that 20,000 halfway point at any time since March 2000 (which, as you will recall, was when the US NASDAQ breached 5,000 just before the bursting of the tech bubble). 2015 represented the high water mark of investor expectations for “Abenomics” – the three-pronged economic recovery program of Prime Minister Shinzo Abe – to deliver on its promises of sustained growth. Those expectations stalled out as the macro data releases kept pointing to more of the same – tepid or negative growth and the failure of needed structural reforms to take root. Japan’s problems, as anyone who has studied the long-term performance of the one-time Wunderkind of the world economy will tell you, are deep and very hard to dislodge.
No Really, It’s Different This Time
Abe is not the first prime minister to apply stimulus in an effort to shake the economy out of its lethargy. Massive public works programs have been a hallmark of the past quarter century. Over this time, yields on the 10-year benchmark Japanese Government Bond (JGB) have never risen above 2 percent (including during periods when yields on US and European sovereigns were at 6 percent or higher). The 10-year yield’s trajectory is shown (green trend line) on the chart above. No amount of stimulus, it would seem, was enough to convince Japanese households to go out and spend more in anticipation of rising prices and wages.
So what is it about the current environment that could induce Japanese share prices to break the 50 percent curse for once and all? We would imagine the answer to be: not much. While it is true that both the US and Europe look set to continue a modest uptrend in growth and demand (with or without the reflation jolt catalyzing all those animal spirits), Japanese companies are not necessarily positioned to benefit – certainly not in the way they did in the very different economy of the 1970s-80s when “Japan as Number One” was required reading for MBAs and corporate executive suites. While they have arguably become more shareholder-friendly in recent years, as evidenced by higher levels of share buybacks and the like, corporate business practices remain largely traditional and hidebound. Just a decade ago, these companies blew a once-in-a-lifetime chance to ride the wave of the great growth opportunity that was China – in their own back yard.
There is no magic formula for growth. In a country with an old and declining population (and extremely strict limits on immigration), a supernova-like burst of productivity is the only plausible route to real, organic improvement. Until then, that barrier of 20,000 in the Nikkei may continue to be a tough nut to crack.