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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
Today is the first day of the last month of 2017, which means that predictions about asset markets in 2018 will be flying about fast and furious over the coming three weeks. As practitioners of the art and science of investment management ourselves, we know that quite a bit of work goes into the analysis that eventually finds expression in the “bonds will do X, stocks will do Y” type of formulations characteristic of these holiday season prognostications. A layperson might be excused, though, for concluding that all the market pros do is dust off last year’s report, or the year before, for that matter, and repackage it with the same observations. “Rates will rise because of the Fed, stocks will rise because of a stable economy and good earnings” worked for 2016 and it worked for 2017. Here’s visual proof: the price appreciation of the S&P 500 and the trend in the 2-year Treasury yield since December 2015:
It wasn’t linear, of course. There was the technical correction in early 2016 when both stocks and rates pulled back. Still, though, investors positioned for rising short term rates and steady gains in large cap domestic stock prices would have had little about which to complain over the past two years. Which, of course, brings us to the point of today’s commentary: is it Groundhog Day again, or does 2018 have something entirely different in store?
At the heart of this curious Groundhog Day phenomenon over the past couple years is the remarkable sameness in the broader macroeconomic environment. “Moderate GDP growth, with a healthy labor market and modest inflation” is a phrase you could have uttered on literally any given day over this period and been right. The only thing measurably different about 2017 was that this “Goldilocks” set of conditions was true not just of the US, but of almost any part of the developed (and much of the emerging as well) global economy. Adding the word “synchronized” to “moderate GDP growth” gives the phrase a distinct 2017 flavor. Thus, the good news for equities disseminated into non-US markets and finally gave investors some measure of reward for diversification.
There is almost nothing in the way of macro data points today suggesting a deviation from this “synchronized moderate growth” mantra. The major question mark, as we have discussed in other commentaries, is whether inflation will ever get in line with what the Fed’s models call for and rise above that elusive 2 percent target. Now, if inflation were to suddenly go pedal-to-the-metal, that could change assumptions about risk assets and blow up the Groundhog Day framework. In particular, an inflationary leap would likely send shockwaves into the middle and longer end of the bond yield curve, where rates have remained complacently low even while short term rates advanced. The 10-year yield is right around 2.4 percent today, almost exactly where it was at the beginning of the year and in fact not far from where it was at the beginning of 2016.
The sideways trajectory of the 10-year, in fact, supplies the explanation as to why stocks could rise so comfortably alongside the jump in short-term rates. While short term rates are closely correlated to the Fed’s monetary policy machinations, longer yields reflect a broader array of assumptions – including, importantly, assumptions about inflation. The flatness of intermediate rates suggests that bond investors expect economic growth to remain moderate, and inflation low. The bond market is not priced for a high inflation environment – which is reasonable, given the scant evidence that such an environment is imminent.
Can Stocks Keep Going?
So far, so good: the economic picture seems supportive of another Groundhog Day. What about stocks? There are still plenty of alternative paths for equities to travel in 2017 (and they are going kind of helter-skelter today on some breaking political news), but a solid double-digit performance would be a reasonable prognosis (the S&P 500 is up just under 20 percent on a total return basis for the year thus far). The current bull market is already the second longest historically, and valuations are stretched. Is there more room to run?
As we write this, the tax bill which has riveted the market’s attention for most of the past two weeks has not formally passed the Senate, nor been reconciled with the earlier House version to a final bill to send to the White House. But the odds of all that coming to pass are quite good. As we have noted before, the market’s obsession with taxes has little or nothing to do with fundamental economic growth. The non-partisan Joint Committee on Taxation said as much in the report it released late yesterday on the proposed bill’s likely economic impact: at best, contributing no more than about 0.1 percent to annual GDP growth over the next ten years.
But the market’s interest in the fate of the tax bill has little to do with long-term economics, and much to do with shareholder givebacks. To the extent that the bill results in tangible cash flow benefits for corporations in the next 1-2 years (and the quantification of such benefits remains quite variable), precedent informs us that the vast bulk of such gains would flow right back to shareholders in the form of buybacks and dividends. Buybacks and dividends don’t help the economy, but they most assuredly do help shareholders. That fact, alone, could supply enough of a tailwind to keep the bulls running long enough to grab the “longest duration” mantle.
Everything’s the Same, Until It Changes
So if you read a bunch of reports over the next couple weeks that sound incredibly similar to what you read a year ago, don’t rush to the judgment that its authors are lazily phoning it in. There remain very good reasons for the Groundhog Day framework for yet another year. Gains in stocks, an increase in short term rates alongside monetary policy moves, and longer term rates tempered by modest inflation are all plausible default-case scenarios.
But never forget that any scenario is just one out of many alternative outcomes. Market forces do not pay heed to the calendar year predilections of the human species. There is no shortage of factors out there that could upend the benign sameness of today’s conditions, and they will continue to demand our vigilance and readiness to adapt.
In this holiday-shortened week, our thoughts easily start to drift towards all the delicious, rich food we will be ingesting between now and early January when we wake up with newfound determination to go out and conquer the next marathon, or the first triathlon, or just the first visit in months to the nearest fitness center. With these sentiments in mind, let us invoke the theme of turkeys for this week’s missive. The metaphorical kind of turkey, as an easy stand in for “seemed like a good investment idea at the time, but…” Now, the year has been a generally benign one for most asset classes. But there were turkeys aplenty that caught investors off guard. Here is a random selection of three of the gems that have caught our eye over the past months.
#1: The Reflation-Infrastructure Trade
In a sense, many of the year’s turkeys flow from the granddaddy of them all, the “reflation-infrastructure trade” theme that caught fire literally within minutes of Trump giving his election night victory speech. The idea behind this trade was that a new, Republican-controlled government was going to unleash a flood of new money into the world through a combination of hefty tax cuts and massive spending from both the public and private sectors on new infrastructure projects. It’s fair to say that this trade caught the vast majority of the investment world by surprise, since almost nobody expected the Republicans to capture the White House (their victories in the House and Senate were rather more predictable). But the trade dominated the last two months of 2016, with the key beneficiaries being financial institutions (net interest margins!), resource and industrial companies (lots of new projects!), the dollar and intermediate-long interest rates (because, reflation!).
The trade wasn’t a turkey for anyone who took a wager on it from November 9 through New Year’s Day and then sold out. But the fundamental rationale for the trade, which was never strong to begin with, proved wildly off base. Core inflation never breached, let alone smashed through, the Fed’s 2 percent target level. A year later, low inflation continues to exist right alongside 4 percent unemployment. In fairness, nobody including the Fed’s Board of Governors knows with assurance why this is so. As for infrastructure, anyone who has paid any attention at all to Washington politics for the last couple decades would understand that public infrastructure spending has never been a priority item on Republican policy agendas. As for taxes – again, a passing knowledge of GOP politics would lead one to conclude that, yes, tax cuts would certainly be up for legislative action, but complex, actual tax reform that broadened the base (i.e. killing off corporate loopholes) while lowering statutory rates might be a bridge too far for a party beset by fractious differences among its own members, let alone those across the political aisle.
In any event, most elements of this trade, led by the US dollar, had fizzled out by late winter. Periodically talk of the reflation trade recurs, mostly because financial news anchors love to say “the Trump trade is back!” while grinning foolishly into the camera. Caveat emptor.
#2 The Return of Volatility
The twin surprises of 2016 – the Brexit vote in Britain and the US presidential election – set the stage for much chatter about the political land mines in store for the year ahead. Mostly the prognosticators looked to Europe, where the springtime calendar included potentially explosive elections in the Netherlands and France, to be followed in early fall with the German contest. Then there were the ever-present concerns about central banks weaning dependent investors off the easy QE money, a hard economic landing in China, the possibility of trade wars with an ascendant hyper-nationalist contingent in the White House and even the possibility of actual wars as tensions ratcheted between the US and North Korea.
All these events – and many more besides – had their various days of reckoning. Each day came and went with asset price volatility barely budging from all-time lows. The CBOE VIX index, a measure of volatility dubbed the “fear gauge” by investors, had fallen below a level of 10 (the lower the VIX, the less risk) only a handful of times between its launch in 1990 and 2016. The index has closed below 10 a grand total of 40 times in the year 2017 to date, making this the “safest” year by the VIX measure in 27 years. Meanwhile the intraday volatility of the S&P 500 index is lower this year than any time since 1963. Anyone long VIX risk – and for defensible reasons! – will be ruing that bet.
Interestingly, the European election with potentially the most far-reaching consequences for 2018 may well be the one deemed the safest bet – Germany. Chancellor Angela Merkel’s CDU/CSU party came first in the elections two months ago, but has since failed to secure a governing coalition with other representative parties. Political discord in Europe’s most stable power could signal much uncertainty ahead. So far, though, markets are as relaxed as ever.
#3 Another Bad Year for Emerging Markets
We finish out our gallery of turkeys with a look at emerging markets, a surprise 2017 darling. Now, the success of emerging market (both equities and debt) is in a way the flip side of that reflation-infrastructure trade. But we believe this to be a useful morality tale on the perils of asset allocation assumptions. Let’s consider the following. As portfolio managers were making their 2017 asset allocation decisions, late last year, two things about emerging markets were known to them.
First, the asset class had performed dismally, on a relative basis, for several years. While the S&P 500 went on a tear in 2012 and never looked back, EM equities had a very bumpy ride up and down, but mostly down. US large cap stocks passed their earlier historical highs in 2013, but emerging markets remained well shy of theirs in both dollar and local currency terms (they finally regained the high ground in local currency, but not dollar terms in 2017). In fact, on a risk-adjusted basis EM equities have produced negative value relative to blue chip US stocks on an annual average basis over the past 30 years. Any quantitative asset allocation model based on some variation of modern portfolio theory would have recommended deep underweights, or zero allocation, to emerging markets.
The second thing portfolio managers knew in December 2016 was that emerging markets were getting pummeled by the reflation-infrastructure trade. What reason would there have been to make a large allocation to this asset class? Well, to be sure, there are enough contrarians in the world who, at any given time, will put their chips on asset class X because asset class X has been out of favor for a while. Some managers did that, and were amply rewarded. But – and here is the key point – that decision boils down to a single variable: luck. Asset price trends will almost always exhibit mean reversion over time. But pinpointing the time – getting that inflexion point right – is a matter of luck. Emerging markets did well in 2017. They may well do so again in 2018 – or they may not. But questions about the long-term underperformance of this asset class are not answered by a single year’s outcome.
There will be much at stake in 2018. As always, we and our fellow practitioners in this industry will be diligently at work over the next several weeks to try and figure out how to be positioned for 2018 and beyond. Meanwhile we leave you with this sentiment: may the turkeys be on your dinner table, and not in your portfolios. Happy Thanksgiving!
There has been considerable chatter over the last week or two by observers and participants in the junk bond market. Prices for HYG, the iShares ETF that tracks the iBoxx US high yield bond index, started to fall sharply at the beginning of this month and continued through midweek this week, when investors mobilized for at least a modest buy-the-dip clawback. The chart below shows HYG’s price trend for 2017 year to date.
This performance has prompted the largest weekly investment outflows from the junk bond market in three years and sparked concerns among some about a potential contagion effect into other risk asset classes. It comes at a time when various markets have wobbled a bit, from industrial metals to emerging market currencies and even, if ever so briefly, the seemingly unshakeable world of large cap US equities. Is there anything to the jitters?
Pockets of Pain
We don’t see much evidence for the makings of a contagion in the current junk bond climate. First of all, the pain seems to be more sector- and event-specific than broad-based. While junk spreads in all industry sectors have widened in the month to date, the carnage has been particularly acute in the telecom sector (where average bond prices are down more than 3 percent MTD) and to a somewhat lesser extent the broadcasting, cable/satellite and healthcare sectors. The key catalyst in telecom would appear to be the calling off of merger talks between Sprint and T-Mobile, while a string of weak earnings reports have bedeviled media and healthcare concerns. High yield investors seem particularly inclined to punish weaker-than-expected earnings.
There gets to be a point, though, when spreads widen enough to lure in yield-starved investors from the world over. We have seen that dynamic already play out twice this year. As the chart above shows, high yield prices fell sharply in late February and late July, but were able to make up much of the decline shortly thereafter. So while pundits are calling November the “worst month of 2017” for junk debt, they are somewhat facetiously using calendar year start and end points that obscure the peak-to-trough severity of those earlier drops. We still have the better part of two weeks to go before the clock runs out on November, which is plenty of time for buy-the-dip to work its charms.
Bear in mind as well that there is very little in the larger economic picture to suggest a higher risk profile for the broader speculative-grade bond market. Rating agency Moody’s expects the default rate for US corporate issues to fall in 2018, from around 3 percent now to 2.1 percent next year. An investor in high yield debt will continue receiving income from those tasty spreads above US Treasuries (currently a bit shy of a 4 percent risk premium) as long as the issuer doesn’t default – so the default rate trend is an all-important bit of data.
About Those Investment Grades
Meanwhile, conditions in the investment grade corporate debt market continue to appear stable. The chart below shows yield spreads between the 10-year US Treasury note and investment grade bonds in the Moody’s A (A1 to A3) and Baa (Baa1 to Baa3) categories. Baa3 is the lowest investment grade rating for Moody’s.
Investment grade spreads today are a bit tighter than they were at the beginning of the year, and much closer than they were at the beginning of 2016, when perceived economic problems in China were inflicting havoc on global risk asset markets. In fact, investment grade corporate yields have been remarkably flat over the course of this fall, even while the 10-year Treasury yield gained almost 40 basis points in a run-up from early September to late October.
Investors remain hungry for yield and the global macroeconomic picture remains largely benign. Recent price wobbles in certain risk asset markets notwithstanding, we do not see much in the way of red flags coming out of the stampede out of junk debt earlier this week. A spike in investment grade spreads would certainly gain our attention, but nothing we see suggests that any such spike is knocking on the door.
Every industry sector has its own received wisdom. In the energy sector, the two pillars of conventional wisdom for much of the past eighteen-odd months could read thus: (a) crude oil will trade within a range of $40 to $60, and (b) the fates of crude prices and shares in energy companies are joined at the hip. Recently, though, both of these articles of wisdom have come under fire. Energy stocks, as measured by the S&P 500 energy sector index, are up by a bit less than 14 percent from their year-to-date low set in late August. But the shares came late to the party: Brent spot crude oil reached its year-to-date low two months earlier, in late June, and has jumped a whopping 45 percent since. At the end of October the benchmark crude crashed through that $60 upper boundary and has kept going ever since. Are more good times in store, or is this yet another false dawn in the long-beleaguered energy sector?
Whither Thou Goest
That energy shares and oil prices are closely correlated is not particularly surprising, and the chart below illustrates just how much in lockstep this pair of assets normally moves. The divergence in late June, when crude started to rally while E&P shares stagnated and then fell further, caught off guard many pros who trade these spreads.
Given that close correlation, anyone with exposure to the energy sector must surely be focused on one question: is there justification for crude oil to sustain its move above the $60 resistance level, thus implying lots more upside for shares? A few weeks ago the answer, more likely than not, was “no.” Long-energy investors, then, should take some comfort in a recent prognostication by Bank of America Merrill Lynch opining that $75 might be a “reasonable” cyclical peak. If that level, plus or minus a few dollars, is a reasonable predictor – and if the historically tight correlation pattern between crude and shares still holds – then investors in energy sector equities could have a very merry holiday season.
The Upside Case
Perhaps the most convincing argument for the energy bulls is that much of the recent strength in crude prices is plausibly driven by organic demand. The global economy is in sync, with two quarters in a row of 3 percent US real GDP growth along with steady performances in China, India and other key global import markets. The continuity of global growth may finally be delivering a more durable tailwind to resource commodities. Meanwhile, on the supply side inventories wax and wane, but the supply glut that dominated sentiment a year ago seems to have waned. And US nonconventional explorers have also taken a pause: rig counts and other measures of activity in the Permian Basin and other key territories have stalled out now for a number of months. Add to this picture the ongoing effects of the OPEC production cuts and the recent political tensions in Saudi Arabia, and there would appear to be a reasonable amount of potential residual upside.
Caveats Still Apply
On the other hand, though, the structural reality remains in place that those US nonconventional producers are the key drivers of the marginal price of a barrel of crude. The recent downsizing of rig counts and active drilling projects may well be temporary as E&P firms look to shore up their beaten-down margins. Most shale drillers can now turn a profit at prices well below the current spot market. It is only a matter of time – and price level – before the activity will ramp up again. And we’re talking mostly about short-cycle projects that can turn off and on more nimbly than the traditional long-cycle, high capital expenditure projects of old.
Crude prices may well have another $10 or more of upside, but they come with plenty of caveats. For the next couple months though, at least, energy equities would seem to offer a reasonably robust performance opportunity.
Like most of our fellow investment practitioners, we subscribe to a variety of daily market digests – those couple paragraphs at the market’s opening and closing bell that purport to tell us what’s up, what’s down and why. A brief summary of these digests over the course of 2017 might go something along the following lines: la la la la TAXES la la la la TAXES la la la…you get the picture. Not corporate earnings, certainly not geopolitics – nothing, it would seem, has the power to capture Mr. Market’s undivided attention quite the same way as potential changes to our tax code.
Well, this week is one of those times where the subject is front and center as Congress attempts to set the process in motion for some kind of tax “reform” before the end of the year. As we write this, more information is coming out about what the legislation may, and may not, ultimately include. We should note that it is far from certain that anything at all will be accomplished within this year. Taxes affect everyone in some way – individual and institution alike – and literally every item on the table will have its share of vocal backers and opponents. Over the coming weeks we will share further insights on these developments; our purpose today, though, is to consider at a more fundamental level the relationship between taxes, economic activity and markets.
Taxes and Growth
One of the central motivations for just about any attempt at tax reform is to stimulate economic growth. There are plenty of competing ideologies about this – and it matters for purposes of the discussion whether we are talking about the short term or the long term. But one reasonable question to ask would be how relevant a factor tax rates have been as an influencer of growth over the long term. The chart below illustrates year-on-year GDP growth in the US since 1950, along with the top marginal (individual) tax rate over the same period.
Top tax rates on wealthy individuals were very high – 91 percent in the 1950s and a bit lower (77 and then 70 percent after 1964) before coming down to 50 percent in the first wave of Reagan-era tax reform in the 1980s. Subsequently they have fluctuated between the high and the low 30s through the successive policies of the Clinton, Bush and Obama administrations. What conclusions could be drawn from the impact of alternative tax regimes on long term economic growth? In our opinion only one; namely, that any correlation between marginal tax rates and growth is very weak, at best. The high rates of GDP growth in the 1950s and 1960s took place neither because of nor in spite of high taxes, but for a whole host of other reasons based on global economic conditions at the time.
The same could be said when considering the economic growth spurt of the 1990s, after the Clinton administration had raised taxes in 1993: the growth happened because of many different variables at play, and taxes were at best a peripheral consideration. It is particularly important to keep this absence of causation or even correlation in mind when we are told by policymakers that any revenue lost from tax rate reduction will pay for itself from higher growth. That’s ideology – but the numbers simply aren’t there to back it up, and not for lack of ample data.
Taxes and Earnings
Individual tax rates are only part of the equation, of course. A big part of the market’s focus this year has been on corporate taxes. The statutory US corporate tax rate of 35 percent is high by world standards, so the argument goes that reducing this rate to something more competitive (with 20 percent being the number floated in the current version of the plan being floated by Congress) would be a powerful catalyst to grow US corporate earnings. How does this claim stack up?
At one level the math is fairly simple. Earnings per share, the most common number to which investors refer to measure the relationship between a company’s profits and its stock price (expressed as the P/E ratio), is an after-tax number. If Company XYZ paid 35 percent of its operating profits to the tax man last year, but this year Uncle Sam only gets 20 percent of those profits, then the other 15 percent is a windfall that goes straight to the bottom line (to be retained for future growth or paid out to shareholders at the discretion of Company XYZ’s management). That growth – all else remaining equal – will make XYZ’s shares seem more reasonably priced, hence, good for investors.
There are two things to bear in mind here. First, that tax windfall happens only once in terms of year-on-year growth comparisons. Once the new rate sets in, XYZ will get no future automatic tailwind from taxes (i.e., EPS growth will then depend on the usual revenue and cost trends that drive value). Second, the potential ongoing benefits from the lower tax rate (e.g. a larger number of economically viable investment projects) will depend on many factors other than the tax rate. It’s not irrelevant: taxes do figure into net present value and weighted average cost of capital, which in turn are common metrics for go / no-go decisions on new projects. But many other variable are also at play.
The other issue with regard to the statutory tax rate is that it is a fairly poor yardstick for what most companies actually pay in taxes. The mind-numbing complexity of the US tax code derives from the many deductions and loopholes and credits and other goodies that influential corporate lobbyists have won for their clients over the years. The influence of these groups is already on display: the US homebuilder industry, for example, has come out vehemently against some of the proposed changes being floated by policymakers. Time will tell how successful any new legislation will be at productively broadening the base (i.e. reducing the loopholes and exclusions).
So what’s the takeaway? There are many miles to go before the proposal coming out today arrives at any kind of legislative certainty. As managers of portfolios invested for long term financial objectives, our views on taxes focus largely on how they impact, or do not impact, key economic drivers over the long term. We will continue to share with you our views as this process continues.