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President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
So here we are, with a full array of tricks and treats to test investors’ nerves as the month of October gets rolling. A quick brush-up for our clients and readers on the nature of pullbacks is in order.
Since the current bull market began in 2009 there have been 20 occasions (including the present) where the S&P 500 has retreated by 5 percent or more from its previous high (translating to roughly 2 per year). Of those 20 pullbacks, four met the definition of a technical correction, i.e. 10 percent or more from the high. On one occasion, in 2011, the index fell by more than 18 percent before recovering. As of the Thursday market close, the S&P 500 was down 6.9 percent from its September 20 record high of 2930.
These things happen. As we like to say, paraphrasing Tolstoy, every pullback is dysfunctional in its own special way. With the caveat that the final word on the current reversal has yet to be written, here are four observations we think are worth keeping in mind as this one plays out.
They Finally Got the Memo
As we wrote about in last week’s commentary, the market has been willfully slow, for a very long time, in accepting that the Fed really intends to raise rates consistent with its view of an economy gaining strength. Last week the bond market got the memo with a sudden midweek jump in intermediate yields. It seems that the bond market sat on the memo for a few days before passing it over to the stock market. In any case, we can say with a bit more confidence now that the memo has been received. Barring any significant changes in the macroeconomic landscape – which changes have yet to surface in the form of hard data – the reasonable expectation is for a final 2018 rate hike in December, followed by at least three in 2019.
More Bond Confusion Likely
Despite better alignment between market expectations and the Fed, we do foresee further confusion in fixed income, particularly with intermediate and long duration asset classes. Consider the multiple forces at work on the 10-year Treasury, a widely used proxy for intermediate-long bonds. Heightened inflationary expectations could push yields much higher. On the other hand, relatively attractive yields (compared to Eurobonds or Japanese government bonds, for example) could keep a lid on how high rates go. Any kind of emergent financial crisis could widen spreads between Treasuries, corporate bond and other fixed income classes.
During the economic growth cycle of the late 1990s, from 1995-2000, the average yield on the 10-year Treasury was 6.1 percent and it never fell below 4 percent. What should the “natural” yield be in the current growth cycle? Nobody, not the world’s leading economists and not the trader plugging buy and sell triggers into an algorithmic trading strategy, knows for sure. We’re likely to learn this from whatever we experience over the coming months, not from theoretical foresight.
Post-Sugar High Growth
Come December, we will lap the tax cuts implemented one year earlier. That will make 20 percent corporate earnings growth a thing of the past – a good part of the growth in earnings per share this year was based on the lower tax rate that flowed through to the bottom line of the corporate income statement. Right now, the consensus analyst group used by FactSet, a market research company, expects earnings per share growth for S&P 500 companies to be 7 percent in the first quarter of 2019. Now, the same consensus group predicts that top line sales for these companies in Q1 2019 will come to 6.9 percent. That tells us two things. First, it tells us that the overall global demand environment (reflected by sales) is not expected to worsen much from where it is currently. That’s good news.
The second thing it tells us is that analysts will be focusing obsessively on corporate profit margins in 2019. Sales growth is good, but in the long run sales without profits are not good. Closer parity between top line growth rates and trends further down the income statement suggests that companies will need to be increasingly creative in finding ways to make money, particularly if cost pressures (e.g. on raw materials and labor) continue to trend up.
How will this factor play out? The next few weeks will be very important as the Q3 2018 earnings season gets under way. Analysts will be digesting the most recent growth and profit numbers from corporate America. The narrative could shape up positively – more growth! – or negatively – peak margin! How you as an investor approach 2019 will have much to do with whether you think profit margins really have reached their Everest once and for all. There will be plenty of excitable commentary to that effect. We suggest tuning out the commentary and paying attention to the actual data.
As in, “market leaders going around in circles.” So far the industry sectors bearing the brunt of the October ’18 pullback are the ones that did the lion’s share of the lifting for the past couple years: tech, first and foremost, communications services and consumer discretionary. More broadly, growth stocks have been absolutely dominant for much of the latter period of this bull market. So it is reasonable to ask what might happen if the growth stock leadership falters.
We’ve seen this play out a couple times this year (see our previous commentaries here and here for additional insights on this topic). One of the considerations is that because the tech sector comprises about 25 percent of the total market cap of large cap US stocks, it has an outsize effect on overall direction. That works well when the sector is going up. But if, say, consumer staples stocks in total go up by as much as tech stocks go down, the net result is a down market (since consumer goods stocks make up less than 8 percent of the index). An orderly growth to value rotation might be a better outcome than outright confusion, but investors who have gotten used to the growth-led returns of recent years might be in for a disappointment.
So there’s a lot at play right now. As usual, there will be no shortage of “experts” claiming to understand precisely what it all means (as they claim, after the fact, how “obvious” it was that this pullback was going to happen at exactly this time for exactly this or that reason). As for us, we simply plan on doing what we always do. Study the data, think through the possible alternative outcomes based on the scenarios we have described here as well as others, and always remind ourselves of those numbers we cited at the beginning of this commentary. Pullbacks are a fixture of bull markets and they happen for any number of reasons, logical or not. Actual bear market reversals are much rarer events. In our opinion it is not time to call an end to this bull.
It doesn’t take much these days. “Pretty bad market today, huh?!” came one comment from a fellow runner during a muggy 5K outing on Thursday evening. Was it? Apparently so. Thursday’s S&P 500 posting of minus 0.82 percent was the biggest daily drawdown since the second half of June, when the index shed close to 3 percent for some vague reason long forgotten. None of this in any reasonable way qualifies as a pullback of note – we tend not to raise an eyebrow until the 5 percent threshold approaches. But after three months during which the market climbed as relentlessly as the humidity index in the Washington DC swamplands, even a modest pullback of less than 1 percent seems as rare as actual fall weather in this weirdest of October climes. Blame it on the bonds.
The catalyst for the Thursday downdraft in equities was a surge in bond yields that gained steam on the back of a couple economic reports on Wednesday – in particular, a thing called the ISM Non-Manufacturing Index, which rose more than the consensus outlook. That report, suggesting that activity in the services sector (which accounts for the lion’s share of total GDP) was heating up, set the stage for expectations about a gangbusters monthly jobs report on Friday. The 10-year Treasury yield shot up by 10 basis points (0.1 percent), which is huge for a single day movement. The 10-year yield is now at its highest level since 2011, as shown in the chart below.
That blockbuster jobs report, as it turned out, never happened. We got a headline unemployment rate of 3.7 percent that is the lowest since – kid you not – 1969, that groovy year of moon landings and Woodstock. But payroll gains, the most closely watched indicator, rose by considerably less than the expected 185K while wage growth came in right at expectations with a 2.8 percent gain. Overall, a mixed bag. Equities are roughly flat in tentative trading as we write this, while the 10-year Treasury yield continues its advance. The yield spread between 10-year and 2-year Treasuries, which earlier this year appeared on the tipping point of an inversion (in the past a reliable signal of an approaching recession), has widened to about 35 basis points.
This widening spread would be consistent with the ideas we communicated in last week’s commentary about increased inflationary expectations on the back of an ever-tightening labor market and price creep from higher tariffs on an expanded array of consumer products. So far the numbers – in particular today’s jobs data and last week’s Personal Consumption Expenditures (PCE) reading – don’t bear out the hard evidence. But the bond market could be adjusting its expectations accordingly.
Doing It On the QT
Or, maybe not. There were a couple technical factors at play this week as well, including a jump in the cost of hedging dollar exposure which had the effect of reducing demand for US Treasuries by foreign investors. This is not the first time that we have seen a sudden back-up in yields, only to dissipate in relatively short order. As for the fabled bond bull market that has endured since the early 1980s, well, there is certainly no shortage of times this has been pronounced dead, only to rise again and again.
Ultimately, of course, it all comes down to supply and demand. We know one thing with confidence – the Fed is out of the market as a buyer. While last week’s FOMC meeting didn’t produce much in the way of surprises, it did codify the understanding that the age of QT – quantitative tightening – is at hand. The Fed’s assessment of the economy is quite upbeat. The cadence of rate increases and balance sheet reduction is likely to continue well into 2019.
None of which necessarily suggests that intermediate and long term rates will surge into the stratosphere. If the domestic economy stays healthy then domestic assets should be attractive to non-US investors – an important source of demand that could keep yields in check. Indicators like corporate sales (growing at a brisk 8 percent or so) and sentiment among businesses and consumers (leading to increased spending and business investment) suggest that there is more to the current state of the economy than a fiscal sugar high from last December’s tax cuts. For the near term, our sense is that the positives continue to largely outweigh the potential negative X-factors. We may be okay in 2019 – but 2020 could be an entirely different story.
The Federal Open Market Committee (FOMC) meeting this week came and went without much ado. The 25 basis point rate hike was fully expected, the assessment of economic risks remained “balanced” (Fed-speak for “nothing to write home about”) and the dot plots continued to suggest a total of four rate hikes in 2018 and three more in 2019 (though the market has not yet come around to full agreement on that view). A small spate of late selling seemed more technical than anything else, and on Thursday the S&P 500 resumed its customary winning ways. All quiet on the market front, or so it would seem. We will take this opportunity to call up some words we wrote way back in January of this year, in our Annual Outlook:
“Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.”
That “rustle of leaves” may take the pictorial form of a gentle, but steady, downward drift.
Nine months later, we have a somewhat better sense as to how this year’s tentative weakness in the bond market may spill over into bigger problems for a wider swath of asset classes. It calls into one’s head a phrase little used since the 1970s: wage-price spiral. There’s a plausible path to this outcome. It will require some careful attention to fixed income portfolios heading into 2019.
What’s Wrong With Being Confident?
The path to a wage-price spiral event starts with a couple pieces of what, on the face of things, should normally be good news. Both consumer confidence and business confidence – as measured by various “sentiment” indicators – are higher than they have been at any time since the clock struck January 1, 2000. In fact sentiment among small business owners is higher by some measures than it ever has been since people started measuring these things. Now, monthly jobs numbers have been strong almost without exception for many years now, but the one number that has not kept pace with the others is hourly wages. That seems to be changing. The monthly cadence was 2.5 percent (year-on-year growth) for the longest time, but now has quietly ticked up closer to 2.8 – 2.9 percent. The evidence for this cadence breaking out sharply on the upside is thus far anecdotal, seen in various business surveys rather than hard monthly numbers, but if current overall labor market patterns continue, we will not be surprised to see those hourly wage growth figures comfortably on the other side of 3 percent by, say, Q1 of next year.
Enter the Trade War
The other side of the wage-price formula – consumer prices – is already starting to feel the effects of the successive rounds of tariffs that show no signs of abating as trade war rhetoric ascends to a new level. Tariffs make imports more expensive. While the earlier rounds focused more on intermediate and industrial products, the expansion of tariffs to include just about everything shipped out of China for our shores invariably means that traditional consumer goods like electronics, clothes and toys are very much in the mix now.
What retailers will try to do is to pass on the higher cost of imports to end consumers. And here’s the rub – if consumers are those same workers whose paychecks are getting fatter from the hot labor market, then their willingness to pay more at the retail check-out will be commensurately higher. Presto! – wage price inflation, last seen under a disco ball, grooving out to Donna Summer in 1979.
Four Plus Four Equals Uncertainty
Recall that the Fed is projecting four rate hikes this year (i.e. the three already in the books plus one in December) and then three more next year as a baseline outlook. A sharp uptrend in inflation, the visible measure of a wage-price spiral, would conceivably tilt the 2019 rate case to four, or perhaps even more, increases to the Fed funds target rate. Right now the markets don’t even buy into the assumption of three hikes next year, although Eurodollar futures spreads are trending in that direction. That gentle downward drift in the bond market we illustrated in the chart above could turn into something far worse.
Moreover, the wage-price outcome would very likely have the additional effect of steepening the yield curve, as increased inflationary expectations push up intermediate and long term yields. Normally safe, long-duration fixed income exposures will look very unpleasant on portfolio statements in this scenario.
The wage-price spiral outcome, we should remind our readers, is just one possible scenario for the months ahead. But we see the factors that could produce this inflationary trend as already present, if not yet fully baked into macro data points. From a portfolio management standpoint, the near-term priorities for dealing with this scenario are: diversification of low-volatility exposures, and diversification of yield sources. Think in terms of alternative hedging strategies and yield-bearing securities that tend to exhibit low correlation with traditional credit instruments. These will be very much in focus as we start the allocation planning process for 2019.
Usually when we append a chart to one of our commentaries, the aim is to shed light on a particular trend. Sometimes, though, the trend in question is actually the lack of a trend, and such is the case this week. Behold the chart below and call up your metaphor of choice: a plate of spaghetti (that multicolored kind with beet, spinach, squid ink etc.), a few tangled skeins of knitting yarn, an attempt at abstract art by a hung-over wannabee Picasso.
Up, Down, All Around
What to make of that tangled web? Healthcare has performed rather well, for no particular reason. Energy has fared poorly of late, despite oil prices near their best levels of the year, just off $80. Otherwise it’s up one day, down the next. Information technology, which has been the main driver of the market’s performance for the better part of the last 18 months, is actually trailing the benchmark index in the most recent three month period.
It’s as if Ms. Market wakes up every morning and flips a coin – heads for risk-on, tails for risk-off. There’s no discernable leadership theme. Remember the “value rotation that wasn’t” about which we wrote earlier in the summer? The forensic evidence is there – note the sharp drawdown in the blue line (representing technology) around the 7/30 time period, which then bounced back up almost immediately. There was no value rotation then, nor in the immediate period after Labor Day when tech fell again while defensive favorites like consumer staples and utilities jumped.
Nowhere Else to Go
What happens in the S&P 500 is increasingly important, because there are few other refuges for risk-on portfolios. For much of this year we had a strong leadership trend in domestic small cap stocks. The Russell 2000 small cap index is still ahead of the S&P 500 year to date, but the outperformance trend ran out of steam a couple months back, as the chart below shows.
We do see something of an uptrend in non-US stocks over the past couple weeks, but there are reasons for not being too excited about an imminent mean reversion of any meaningful duration here. Most of the juice in the MSCI EAFE (gold) and Emerging Markets (purple) in this recent trend is coming from a weaker dollar versus other currencies. That in itself is counterintuitive. US interest rates have been rising, with the 10-year Treasury now comfortably over 3 percent and the 2-year steadily continuing its ascent ahead of an expected rate hike when the Federal Open Market Committee meets next week. Higher interest rates are normally a bullish signal for the home currency, attracting investment income from abroad. But no – the dollar has confounded rational investors by retreating while interest rates rise. We illustrate this in the chart below.
Going back to that first chart with the chaotic sector spaghetti, we can be thankful that the overall directional trend of US large cap stocks remains resolutely upwards. Who cares what’s ahead and what’s behind, as long as everything more or less moves in the same positive direction – right? And to be clear, the broader story remains largely the same. Good job numbers, good growth, strong corporate sales and earnings – the narrative, like The Dude Lebowski, abides. But at some point one wants to see that tangle of price trends turn into a clearer picture with a rational supporting narrative. Is it finally time for value investors to come into the sunshine? Could a value trend sustain the bull market for another cycle before it gives up the ghost? Or is this just a phase of directionlessness before the tech giants reassert themselves for yet another gravity-defying cycle of outperformance? Stay tuned. And happy autumnal equinox!
Round numbers and anniversaries…the little human foibles so beloved of our financial chattering class. This past week, of course, marked the 10-year anniversary of the great collapse of the House of Lehman. No surprise, then, that the print and digital channels were all atwitter (pun partially intended) with reminiscing and ruminating about the crash and all that has happened since. There is a plentiful supply of topics, to be sure. Channeling the Mike Myers’ “Coffee Talk” character on SNL: “Negative interest rates led us to the other side of the Looking Glass. Tawk amuhngst yuh-selves.”
Supercalifragilistic S&P 500
One fact of life to which we and everyone else who manages money are highly attuned is the remarkable outperformance of US equities relative to the rest of the world over this time period. For a while in the early years of the recovery geographic asset classes traded off market leadership in the usual way, rewarding traditional asset class diversification strategies. But sometime in 2012 that all changed. US stocks went on a tear and haven’t looked back. The chart below shows the trajectory of the S&P 500 against broad market indexes for developed Europe, Asia and emerging markets from 2009 to the present.
That’s a huge delta. The S&P 500 cumulatively returned about twice what the non-US indexes earned over this nine and a half year span of time. The difference is even more profound when you adjust for risk. All three non-US indexes exhibited higher volatility (i.e. risk) than the US benchmark. The standard deviation of returns for the MSCI EM index was more than 19 percent, just under 18 percent for developed Europe and 14 percent for developed Asia, while it was just 12.3 percent for the S&P 500. Twice the return for much less risk…sounds like one of those free lunches that are supposed to never exist, doesn’t it?
What Goes Up…Right?
And that, of course, is the big question. Since we are trained to believe that free lunches only exist at picnics hosted by the tooth fairy and the Easter bunny, we look at that chart and wonder when the law of gravity will reassert itself. Asset class price patterns over a long enough time horizon typically revert to mean. What goes up eventually comes down.
But asset prices are not bound by the same fixed laws as those governing physical objects in actual space-time. Economists and financial market theorists may suffer from all the “physics envy” they want – it won’t make asset prices any more rational or predictable. In fact, the “higher risk, higher return” mantra fails in the case of emerging markets versus US stocks over even longer periods, going back to when the former became a sufficiently liquid tradable asset to be a candidate for long-term diversified portfolios.
Mean reversion tends to work best when the primary evaluation criterion is the relative valuation metric between two assets. If Company ABC has a price to earnings (P/E) ratio of 30 and Company XYZ, a competitor in the same industry, has a price to earnings ratio of 10, then investors would at some point expect the price of XYZ to rise relative to ABC. But increasingly we see evidence that daily market trading is not dominated by stock-specific valuation considerations but rather by macro narratives. Continued demand for US equities is simply driven by a better “story” according to this narrative – strong corporate financial results and an economy that is growing faster than elsewhere in the developed world. The same thinking says that the US is a safer bet than elsewhere if the worst-case scenario for a trade war plays out. ETFs and other passive investment vehicles afford the opportunity to take these kinds of broad bets without paying any attention to whether, say, Unilever (a Dutch company) has a more attractive valuation profile than US-domiciled Procter & Gamble.
There are plenty of individual assets in many non-US markets that look attractive on the basis of relative valuations. We do not sense, however, that we are at a clear and compelling turning point justifying a significant re-weighting of asset class weights among diverse geographies.