Posts by the Contributor
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
Hard to believe it, folks, but Year 2017 has already passed its halfway point. While many are still getting the most out of a holiday-interrupted week, at the beach or in the mountains or anywhere that the Twitterverse cannot find them, we will take this opportunity to contemplate what was, what is, and what may lie ahead in global asset markets.
Sweet and Sour
Perhaps the definitive image of markets for the first six months of the year was a contrast in shapes: the flattening contours of the Treasury yield curve on the one hand, and the upward-sloping progression of the stock market on the other. For much of this time, equity and fixed income investors seemed to be singing off two different hymn sheets: giddy expectations on the one hand and a dour read of the macroeconomic landscape on the other.
Going by the hard data alone, the bond mavens would seem to have the better arguments on their side. Headline data over the first two quarters largely underwhelmed, most notably in the area of prices and wages. Inflation readings, including the Fed’s favored personal consumption expenditure (PCE) gauge, have stayed south of the central bank’s two percent target. The labor market continues to raise more questions than it answers, with the unemployment rate suggesting we are very close to full employment, but tepid wage growth indicating none of the usual pressure that hiring firms experience in a tight labor market. That dynamic was present in this morning’s jobs report as well. Better than expected payroll gains brought the three month average up to 194,000 new jobs, but wage growth again came in below expectations.
Turning Point or Tantrum?
With that soft inflationary context in mind, we consider the recent gyrations in the bond market that has some observers predicting a sea change in yields in the months ahead. The fixed income kerfuffle was ignited by remarks by ECB Chair Mario Draghi last week, suggesting that Europe’s better than expected recovery may warrant moves to start winding down monetary stimulus. Whiffs of increased hawkish sentiment can be detected elsewhere in the central bank world, including the UK and Canada.
With inflation showing no signs of overheating, the Fed will not have a gun to its head to raise rates, nor will the ECB be forced to risk market volatility by accelerating any form of a taper in their bond buying program. But that very volatility is an issue on the table for the monetary mandarins. This week’s release of the June Fed minutes suggests that central bankers are at least somewhat nervous about yet another characteristic of 1H 2017 asset markets: the coexistence of elevated prices with almost no volatility. The Fed’s rate hike in June -- and a possible follow-on increase in September -- reflect at least in part an attempt to wrest control back from complacent markets. That complacency is well-founded; central banks have in recent years gone to great lengths to prop up asset prices. If investors sense an end to the Greenspan-Bernanke-Yellen put, we could expect volatility to return with a vengeance.
Brent Gold, Texas Tea
Another addition to the #thingswelearned category in the first half of 2017 is that OPEC is largely a spent force in exerting influence on oil prices. The cartel’s much-touted meeting last fall that produced a tangible production cut policy initially sparked a recovery in crude prices, but the recovery fizzled away as it became ever clearer that US non-conventional drillers, not OPEC, represent the marginal barrel of production. Supply dynamics suggest a secular trend for the range-based price movements of recent months, with the only question being where the lower end of that range will settle. On the demand side, the continuing reality of below-trend global output signals that the commodity super-cycle of the previous decade is unlikely to return any time soon. Resource companies may be in for an extended winter of discontent.
Much More in Store
These topics are just the tip of the iceberg: we have said nothing here about emerging markets, or risk spreads in investment grade & high yield bond markets, or the strangely underperforming dollar, or sector and geographic rotation among equity asset classes as another season of earnings gets under way. These are all issues of clear and present importance, and rest assured we will be covering them in the weeks ahead.
Meanwhile, enjoy what remains of the holiday week and be ready for interesting times ahead as summer eventually brings us to those tricky fall months that lie in wait.
Investors who like nice, clean narratives keep getting flummoxed by the global economy’s refusal to serve up steady sequences of consistent data points. This was a week, after all, when bond markets around the world took a Super Mario-sized beating in the wake of the ECB chairman’s musings about recovery and reflation in the Eurozone. The bond carnage even spilled into the seemingly Teflon stock market on Thursday. And yet, where did it all end? In the US, the latest reading on personal consumption expenditures (PCE), the Fed’s go-to inflation gauge, posted a weaker than expected year-on-year growth rate of 1.4 percent (both headline and ex-food & energy) on Friday. That same day the latest Eurozone flash CPI showed a 1.3 percent year on year gain, in line with expectations but down from the previous month. Reflation? Or could the bond market just possibly have jumped the gun a tad?
Phillips Curve to Nowhere
The May inflation numbers are, of course, representative of just one month. But there is very little in the longer term trend to suggest that this mythic reflation is anywhere on the horizon. The chart below shows the headline and core (ex-food & energy) PCE along with the US unemployment rate trend for the past five years.
The Fed pays closest attention to the core PCE rate (the green solid line) because it excludes the volatile categories of food and energy, and thus presents a steadier picture of underlying trends. As the chart shows, core PCE has fallen over the past five years from a high of 1.9 percent to the current level of 1.4 percent. Not once during this period has this rate surpassed the Fed’s desired target of 2.0 percent (the headline number was briefly above 2 percent, almost entirely on account of a commensurate rise in oil prices).
While prices have largely gone nowhere over this period, the complexion of the labor market has changed considerably. The unemployment rate (red dotted line) was over 8 percent in June 2012, and currently resides at 4.3 percent. Private nonfarm payrolls have made gains every single month over this period, the longest streak since the Bureau of Labor Statistics started recording this data shortly after the end of the Second World War. Normally, economists would expect this brisk pace of labor market growth to put upward pressure on wages and consumer prices. The Phillips Curve, bane of every Econ 101 student, came into existence to quantify this relationship, but its explanatory powers would appear to have diminished to the point of irrelevance.
Low Growth, Lowflation
When the “reflation trade” theme became the dominant market sentiment at the end of last year we expended a considerable number of words musing about just where all this growth was supposed to come from. Even the most wildly optimistic assumptions about a new bout of pro-growth fiscal policies from Washington, in our opinion, was not likely to change the basic growth equation: declining population growth, a smaller percentage of the population in the labor force and chronically low productivity together comprise a speed limit on how fast the economy can grow. If and when productivity were to return, it would quite plausibly come at the expense of jobs, as nonlinear advances in artificial intelligence and deep machine learning make real inroads into companies’ business operations. Why should we expect to see a major bout of reflation if this is the case?
This week’s bond market activity was significant. We are far from convinced that it marked the start of a paradigm shift away from the low rate environment of the past few years. The Fed may well raise rates again this year – it really, really wants to, and absent a major deviation from headline macro trends it could probably do so without too much risk of collateral damage. But unless some catalyst that we don’t see today shows up to push prices significantly higher, the urgency for the Fed to act again (or the ECB to start tapering) just won’t be there. And we are always just one unexpected market crisis away from the Greenspan-Bernanke-Yellen put coming out of the desk drawer and back into action.
It may be as good a sign of the times in which we live as any: in the space of five business days, Argentina (1) stunned global credit markets with a $2.75 billion 100-year bond (yes, a bond that will come due long after all of us reading this article have gracefully shuffled off this mortal coil), and (2) saw the Argentine peso fall to a record low after MSCI declined to upgrade the country’s equity market from frontier to emerging market status. This seeming contradiction in fortunes comes at a time when emerging market equities hang on as one of the best asset class performers of the year, while investors have plowed more than $35 billion into developing market bond funds. Are there still opportunities here, or is the EM glow due for one of its not infrequent fizzles?
Unlikeliest of Success Stories
Pundits cheerleading the emerging market story were few and far between as 2017 got underway. After the surprise outcome of last November’s US election the asset class fell 6.4 percent through year-end, along with everything else on the flip side of the “Trump trade.” EM assets – debt and equity alike – were imagined to be in for a period of protracted weakness as US interest rates and inflation soared to the fanciful revving up of a $1 trillion tsunami of infrastructure spend. A better square on which to place your growth-and-risk-seeking chips, it would have seemed, was US small cap stocks. As it turned out, though, EM equities, currencies and bond prices all rallied. The chart below shows a 12-month snapshot of the MSCI EM stock index, denominated both in local currency and in US dollars.
Yield: What Matters Most
One of the factors -- not the only one, but key nonetheless -- explaining the updraft in EM equities is currency. After being pummeled by the US dollar more or less constantly since 2015, key emerging market currencies from the renminbi to the Indian rupee, Mexican peso and Russian ruble stepped on the gas after their post-Trump trade declines. That currency strength, in turn, is of a part with the remarkable push by global investors into emerging credit markets. For this there is an easy explanation. The investing world is on a collective, frantic search for yield in a world awash in central bank stimulus. Yield is the Holy Grail of the second decade of the 21st century.
Why was that 100-year Argentine bond deal thoroughly oversubscribed? Because investors could not resist the temptation of a 7.91 percent yield. Same goes for Russia, which unloaded $3 billion worth of 10- and 30-year Eurobonds into the markets this week (4.25 and 5.25 percent yields, respectively). Does it matter that Argentina has defaulted on its debt five times since 2000? Does anyone remember Russia’s bailing on its sovereign debt obligations in 1998, sending the propeller-head mavens of Long Term Capital Management and their backers to the poor house? Not today, not in a world of yield above all else.
Lower for Longer, or Tantrum 2.0?
The punters who scooped up the Russian and Argentine paper this week may well be vindicated for their boldness if the market’s view on the Fed turns out to be right. That view – the opposite of the reflation trade that had everyone so excited last year – is that low inflation and anemic wage growth are here to stay for the foreseeable future, just as they have been for most of the duration of the slow-growth recovery to date. If inflation and wages fail to kick in over the next several months, even with labor market conditions that according to many should suggest full employment, then it is quite possible that the FOMC will hold off even on the one further cut they have in their sights this year. That would potentially keep the dollar from embarking on another punishing rally, and the quest for yield would continue (pushing bond prices ever lower).
Then again, there is an alternative, quite valid argument to make that the low levels of volatility in asset markets today are woefully mispricing the amount of latent risk that could be unleashed at any time. It’s worth noting that many of the EM currencies that have been doing so well of late have run into some headwinds recently. The Brazilian real took a tumble back in May when the newest batch of political scandal headlines hit the wires. The ruble and the renminbi are both well off their recent highs, while the rupee and the Mexican peso are marking time in a relatively narrow corridor. The year’s gains to date have been impressive. Experienced EM investors know that they are anything but certain to last.
Investors tend to be predisposed to a “follow the leader” mentality -- to latch onto a narrative that purports to explain why company ABC or sector XYZ is running out ahead of the pack. Unfortunately for those in search of a leadership theme on the cusp of the summer of ’17, there really isn’t one anymore. There was one until last week: the mega cap stocks led by Facebook, Amazon, Alphabet (Google) and Apple took the helm back in the first quarter as the “reflation trade,” the previous narrative, faltered. The chart below shows the ascendance of these FAGA stocks when financials, the reflation trade’s leader, turned south in March (represented by XLF, the SPDR ETF). The chart also shows the carnage of June 8, when those high flying mega caps suddenly got pummeled on an otherwise nondescript trading day. They have continued to struggle in the days since.
The fizzling out of the reflation trade (or the “Trump bump” in the vulgate) as a leadership theme is easy to understand. The financial sector led that narrative, along with materials, industrials and (for a while late last year) energy. The premise was that a burst of pro-growth fiscal policy, headlined by tax reform, deregulation and a massive infrastructure stimulus would unleash an inflationary tsunami. Financial institutions would benefit from improved net interest margins, while industrial producers and resource firms would ride the infrastructure bandwagon. That premise, never particularly strong in a reality-based sense to begin with, looked increasingly like a bad bet as the legislative degree of difficulty presented itself to a team of political novices. Financials and other reflation-theme names topped out in early March and the broader market drifted for a spell.
FAGA (the aforementioned mega cap stocks) and their fellow travelers in the tech sector picked up where the Trump trade left off. What was the narrative driving this leadership rotation? Little, in our opinion, other than a general go-to argument that these enterprises are part of an elite cohort able to deliver consistently fast top-line growth in a world of modest economic prospects. The FAGA trade is sort of a lazy, modern take on the “Nifty Fifty” of days yore: in the absence of any other overarching narrative, go with the brand-name leaders of the day. And what, exactly, was the catalyst for that mass exodus from FAGA on June 8? Again, nothing that is glaringly obvious. Pundits put forth the “crowded trade” theme, which may be as good a reason as any. But they are not especially overvalued; Apple still trades at a P/E discount to the broader market, and the P/E premia of the other three FAGA names to the S&P 500 are well below their highs for the past five years.
Whatever the reasons were for bailing from tech on June 8, it is by now evident that it was not a one-day event; the sector has underperformed in the days since, as the above chart illustrates. The question now turns to the prospects for the broader market absent another leadership story. Candidates for such a story are rather scarce. The many ills plaguing the retail sector again came into sharp relief this week when supermarket chain Kroger’s radically cut its earnings outlook and saw its stock price get beaten down more than 18 percent. Healthcare waxes and wanes amid a fog of fundamental, sector-specific uncertainties. Financials face the headwinds of lower than expected inflation and the attendant opinion by many that the Fed was mistaken to move ahead with its rate cut this week.
The antidote for the confusion is TINA – There Is No Alternative. Forget the Trump trade, or tech stocks, or any other leadership narrative. It’s enough, this argument goes, to stay in the market when there are no compelling reasons to get out. As long as there is growth, however modest, and as long as there are central banks with the means to limit the downside, there should be no need to start building up the cash position. That logic has served investors well to now. But watch those narrowing spreads between short and intermediate term bonds. They don’t necessarily signal anything in terms of a major market shift. But they are not moving in the right direction.
Ah, to be alive at a time when “hey, did that really just happen?” can be the go-to phrase of any given day. To be perfectly honest, we did not give much more than a perfunctory review to the news some time back that UK prime minister Theresa May was calling a snap election in a bid to strengthen her Tory Party’s majority in Parliament. May’s insistent mantra of “steady and calm” seemed much more in keeping with the mood of the moment than the unpredictable antics of Labor leader Jeremy Corbyn, unloved even by much of his own party’s senior figures.
But while the good citizens of Washington, DC were filling up the local bars at 10 am for the much-hyped James Comey testimony, our British friends across the pond went to the polls and delivered yet another insouciant slap in the face of conventional wisdom. May’s Conservatives failed to gain a parliamentary majority, while Corbyn’s Labor Party bagged a sizable number of new seats and all sorts of other counterintuitive things happened… suffice it to say that “Democratic Union Party of Northern Ireland” was probably NOT on the tip of your tongue before now.
Does Someone Need a Time Out?
As of this moment the only hard data point we can affirm is that Britain has a “hung parliament,” meaning that no single party has a majority of seats from which to form a government. The most likely outcome, from the initial flurry of horse trading, will be a coalition between the Tories and Northern Ireland’s DUP, which also picked up a couple seats on Thursday night. But that is not definite; observers expect at least an attempt by Labor to form its own coalition. May’s own future as head of her party is anything but certain, and there is a better than average chance we will see another election called before the end of the year.
What this means for Brexit is also spectacularly unclear. What seems apparent, though, is that the “hard Brexit” approach favored by May, expressed by the sentiment that no deal (i.e. a nasty divorce) is better than a bad deal, is headed for the dustbin of history. Brexit is not off the table – Article 50 has been invoked and the game is afoot – but in the fog of confusion produced by the election outcome, some kind of a time-out may be in the cards.
L’Europe, En Marche!
Britain’s position vis à vis Article 50 negotiations is made more difficult still by the marked contrast of fortunes across the Channel. In his brief tour of duty as France’s president Emmanuel Macron has established himself as a strong leader whose En Marche (forward!) party – which did not even exist 14 months ago – is positioned to capture an historic majority of parliamentary seats in this weekend’s upcoming regional legislative elections (so many elections, so little time to cover and process them!). The Old Continent, plagued for so long by political sclerosis and the travails of the single currency region, suddenly looks ascendant under the M&M (Merkel & Macron) leadership star.
A stronger economy, though still not equally dispersed among all regions, may help the pro-EU center solidify its recent gains at the expense of far right populism. A more vibrant Europe will likely have the effect of making a decisive Brexit even less appealing to the nearly half of Britons who would still prefer to remain. Now, it is very difficult to tease out any kind of a clear Brexit message from the confusion of Westminster seats gained and lost on Thursday night. But with ten days to go before formal Article 50 negotiations are set to begin, a British negotiating team that has given short shrift to the many complex details to be worked out in the split would be well advised to take a deep breath and – perhaps – buy some additional time before engaging the battle.
It is said that the Battle of Waterloo was won on the playing fields of Eton. Today’s Old Etonians, and their negotiating team peers, would do well to consult instead Sun Tzu -- on when to engage, and when to pull back and reassess.