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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
One of the odder stories in a year of general strangeness in the capital markets is emerging markets. Contrary to the vast majority of expectations in the wake of last November’s presidential election, this asset class has been the darling of diversified portfolios in the year to date. The MSCI Emerging Markets index was up more than 28 percent YTD at the end of the third quarter – double the performance of the not shabby 14 percent logged by the S&P 500. Nor is the good news limited to equities; EM currencies have mostly risen against the dollar. Perhaps to underscore the weird irony of the situation the Mexican peso – the currency on the receiving end of all those nativist threats of security walls and trade wars and the like – has gained more than 15 percent against the dollar since January 1.
Reclaiming Lost Heights
In local currency terms, emerging markets equities reached all-time highs this year. In the dollar terms by which US-based investors measure their profits, though, EM stocks still have a bit of ground to make up from their peak during the great growth spurt of 2003-07. The chart below shows the MSCI EM Index (in dollar terms) for the past 15 years.
That 2003-07 run came courtesy of several factors unlikely to repeat themselves. These were the years of the great China boom: the country’s record-breaking surge to become the world’s second largest economy and largest producer / consumer of so many raw materials and finished goods happened in what seemed the blink of an eye. These years also witnessed what is likely to be the final phase of an extended commodities supercycle, which gave resource exporters like Russia and South Africa a few extra points of GDP growth to tack on. Emerging markets became synonymous with “growth” – often real GDP growth of the double digit variety.
Then it all came crashing down. The financial follies concocted in the quant labs of Wall Street and the City took down emerging and developed asset markets alike. The slow pace of growth in the ensuing global recovery has not been kind to many of those former growth market Wunderkinder. Brazil and Russia experienced deep recessions, South Africa and Turkey faced increasingly onerous repayment burdens on their outstanding dollar-denominated borrowings, and China has grappled with the complexities of managing stable currency and credit markets while still trying to hit their growth targets. Given all the challenges, perhaps the most surprising thing about that chart shown above is that this asset class didn’t fare worse than it did during those sideways years of 2010-16.
What Flavor Crisis This Decade?
So where do they go from here – and are investors wise or foolish to follow? One of the important things an investor should always keep in mind about emerging markets is their dynamism – in the sense that the composition of these economies changes more fluidly from year to year than their developed world counterparts. Their installed base of productive resources, their monetary policies and the consumption habits of their citizens are all vastly different today from what they were fifteen or twenty years ago.
That is important because it was precisely twenty years ago that emerging markets fell into one of their periodic traps that turn investors’ stomachs. A crisis in the baht, Thailand’s national currency, went viral and wreaked havoc on currencies and central bank balance sheets from Seoul to Jakarta and beyond. A year later Russia defaulted on its sovereign debt obligations, swallowing up local punters and rich world hedge funds alike. There is a “crisis a decade” school of thought among long-term EM observers, going back to the Latin American debt crises of the 1970s and 1980s to Asia and Russia in the 1990s, Argentina in the 2000s and on and on.
The practical effect of these crises is well-documented: never contained as a local affair, the pain spreads as investors treat their emerging market exposures as one asset class. Never mind if Argentina and Malaysia have almost nothing in common: they rise together and fall together in the capricious ebbs and flows of portfolio capital. For this reason, the asset class as a whole has been a long term loser. Since the beginning of 1990, the average annual return of the MSCI EM index has been about 1 percent lower than that of the S&P 500 – but the risk, measured by standard deviation, has been a full 8 percent higher. “No gain, lots of pain” sums up this portfolio contribution.
Traps Old and New
It would be unwise to project the failures of 1997-98 onto possible negative scenarios for the near future. EM central banks have become much more robust in terms of foreign exchange reserve defenses, and their vulnerability to developed market currencies is mitigated by a growing portion of local currency credit instruments to fund their domestic investment initiatives. Many emerging markets today look…well, less “emerging” and more mature than they did even a decade ago.
But with maturity comes a new set of challenges, and potentially new kinds of traps. Resource exporters like Russia and South Africa will remain vulnerable to a potential weak secular cycle in commodities. Countries whose primary source of competitive advantage is cheap labor are at risk in a world where AI threatens to upend traditional employment patterns in industry after industry. Technology is widening the gap between the handful of companies able to leverage leading-edge technology in their business models and the legions of stragglers struggling to keep up. These are all traps that could trip up countries and regions in that delicate transition from widespread poverty to wealth. And all of this is to say nothing of the lurking threat of protectionism and nationalist nativism from disgruntled voters and their political avatars in the US or the EU.
The developed world is not growing quickly, and this pattern is likelier than not set to continue. If the combined heft of emerging markets can unlock a formula for higher sustainable growth then these markets are worth keeping in strategic asset allocations – and one would expect the risk-return composition to be more favorable than it has been in the past. But these are still significant ifs. We believe investing in emerging markets will call for more nuance going forward, starting with the practice of not treating this widely diverse collection of markets as one asset class.
Another week, another string of record highs for U.S. equities. But this wasn’t just your normal “upward drift for no particular reason” set of days. It was an “upward drift for no particular reason AND a 20 year record smashed!” sequence of new highs. Yes, the last time the S&P 500 recorded six consecutive all-time records was in June 1997, back when the Spice Girls were telling us what we want, what we really, really want. And while prices continued their inexorable ascent, volatility continued to plumb new lows. The CBOE VIX index, the market’s so-called “fear gauge”, suggests that times have never been safer for equity investors: the index has closed below 10 more times in 2017 than in any other year since the VIX first launched in 1990.
The Great Risk Conundrum
This presents a conundrum: while the S&P 500 is more expensive than any other time in the past hundred years (the heights before the market crashes of 1929 and 2000 being the exceptions), it is also serenely placid. Contrast today’s environment with the stretch of market history leading up to the 2000 dot-com crash. The chart below shows the VIX index price trend from 1998 to the present.
The contrast between today and the late 1990s is noteworthy. The S&P 500 reached a then-all time high of 1527 in March 2000. As the above chart shows, though, the final two years of that bull market came with exceedingly high volatility. A VIX price of 20 or higher is considered to be a high risk environment; the index remained above that level for much of the final stretch of that raging bull market. In the mid-2000s the situation was different, but the VIX still was consistently trading at elevated levels well in advance of the 2008 crash.
See No Evil, Hear No Evil
During both of those earlier periods (i.e. 1998-2000 and 2006-2007) markets were jittery for a variety of reasons. Periodic pullbacks in the stock market reflected these concerns – in particular, the Russian debt default of 1998 that led to the collapse of hedge fund Long Term Capital Management, and then, in early 2007, the failure of two Bear Stearns mortgage-backed funds that turned out to be the canary in the coal mine for the broader financial system meltdown. In both cases, investors would eventually buy the dip and keep the damage contained, but markets would remain in an elevated state of nervousness until the bottom finally fell out.
The message the market sends today is entirely different; namely, that there is literally nothing out there in the big bad world that could have an adverse impact on risk asset markets. Arguably, the one single issue able to move investors to action (in a positive direction) for the past twelve months has been tax reform. This trend, which we highlighted in last week’s column, continues with a vengeance despite a lack of hard evidence that any kind of truly meaningful, broad-base reform will emerge out of the current Congress and White House. Apart from taxes, though, the market seems content to channel its inner Metallica and proclaim that “nothing else matters.”
Even if the “reflation trade” that springs from tax reform hopes dies out again – like it did back in February – we think it more likely than not that the market would simply revert to form and drift ever so gently upwards. Why wouldn’t it? The global economy, if not particularly inspiring, is at least in relative harmony with growth occurring in most major regions encompassing both developed and emerging markets. Not a single piece of headline macro data suggests that the current recovery cycle has peaked. Quite the opposite: when economies peak they tend to overheat, in the form of escalating prices and wages. This simply has not happened. As long as it doesn’t happen, the Fed and other central banks will have a great deal of latitude in guiding their balance sheets and policy actions back towards some semblance of normal.
Thus the “sunny skies” portion of today’s column title. The “swan songs” bit refers to the black swans – the unexpected events that can suddenly emerge from the murky sea of risk factors and knock Ms. Market off her game. We know from observing market behavior this year that the bar is high indeed for the kind of black swan that could have an impact. But the very definition of a black swan is something you can’t name because you have never seen it before – so you have no way of quantifying what it is before it happens. Presumably there will be such swans in our not too distant future. One or two such events could even be of such import as to keep market volatility elevated for longer, akin to that stretch of bull market between 1998 and 2000. Then – and perhaps only then – do investors’ thoughts turn seriously to questions of more defense in their allocation strategies.
Gentle reader, please indulge us our seeming obsession with the subject of inflation. Yes, we know that other macro metrics matter as well, but inflation is both the big mystery – as we discussed in last week’s column – and arguably the heavy hand pushing and pulling the market to and fro. Today we focus more on this “actionable” aspect of inflation. Or, to perhaps be more precise, we focus on the curious case of a market with the stars of an imagined reflationary surge sparkling in its eyes – in the very same week when yet another month’s reading informs us that a pick-up in inflation is nowhere to be seen in the real world.
Not Dead Yet
It really doesn’t take much, even after all this time. The so-called “reflation-infrastructure trade,” which financial pundits necessarily rebranded as the “Trump trade,” died an unofficial death back in the first couple months of the year. That’s about the time when the US dollar swooned at the feet of a soaring euro and Aussie dollar, and value stocks in sectors like financials and energy ceded the high ground to their growth counterparts in tech.
But 2017 is, if nothing else, the year of endless lives, whether it be multiple attempts to repeal and replace healthcare policy or the renewed insistence that hypergrowth-fueled inflation is just around the corner. “The Trump Trade Is Back!” screamed Bloomberg News on Wednesday, joined by a chorus of like headlines from Yahoo! Finance, Business Insider and others. Once again financial institutions and resource companies were the market darlings. Bond yields perked up. Even the beleaguered dollar took a victory lap or two. Mr. Market was ready to party like it’s late 2016.
A Framework of an Outline of a Plan
The catalyst for this week’s effervescence, of course, was the release on Wednesday of a tax reform framework. It wasn’t really a plan, because plans generally contain details about specific sources of revenues and costs over a defined time frame, grounded in plausible assumptions. The major assumption made by the authors of this framework is that it will somehow deliver anywhere from 3 to 6 percent (depending on whom in the administration you care to believe) in long-term sustainable growth.
Now, given that we have not experienced real GDP growth of that caliber for many decades, it would be reasonable to believe that a boost of that magnitude would beget more inflation, hence higher interest rates, hence the improved fortunes of banks and oil drillers and the like. Unfortunately for the credibility of the proposal’s framers, the plausibility of sustained growth at those levels is vanishingly low. The Fed’s median estimate of US long-term growth potential is 1.8 percent. Earlier this year the Congressional Budget Office estimated that if all the fiscal stimulus measures proposed at one time or another by the new administration (tax reform, infrastructure spend and all the rest) were successfully implemented, it could add one tenth of one percent to long term growth. So the Fed’s 1.8 percent would become 1.9 percent, hardly reason to break out the Veuve Cliquot.
Back in the Real World
Meanwhile Friday morning delivered yet another Debbie Downer data point to the market’s Pollyanna. The personal consumption expenditure (PCE) index, the Fed’s preferred inflation measure, came in for the month of August below consensus expectations at 0.1 percent. That translates to a 1.3 percent year-on-year gain, matching its lowest level for the past five years and well below the Fed’s elusive 2 percent target. We imagine this reality will likely show up again soon enough in the bond and currency markets (which also were the first to ditch the Trump trade back in February). But the stock market is a different animal. Is there enough wishful thinking to keep the reflation trade alive long enough to get through the tricky month of October and into the usually festive holiday trade mindset? Perhaps there is – money has to go somewhere, after all. At some point, though, reality bites back.
Where’s the inflation? That question has lurked behind most of the major headline stories about macroeconomic trends this year. Jobless rate falls to 4.3 percent. Where’s the inflation? GDP growth revised up to 3 percent. Where’s the inflation? The Fed has an official dual mandate of promoting price stability and the maximum level of employment achievable in a stable price environment. By all available measures, our central bank policymakers would appear to be living up to their mandate in spades. Inflation has remained subdued for pretty much the entire run of the recovery that began in 2009. Over the same time, unemployment has come crashing down from a post-recession high of 10 percent to the gentle undulations of 4 percent and change from month to month. And therein lies the problem, or rather the riddle that neither the Fed nor the rest of us can answer convincingly: why hasn’t a robust jobs recovery reignited inflation?
Math, Models and Markets
Those of us who do not hold Ph.D. degrees in economics from the nation’s most prestigious universities at least have one advantage over those maven economists on the Fed Open Market Committee: we can freely speculate about the perplexing absence of inflation. Here at MVF we have our own views, largely proceeding from the larger issue of long term growth that has been the central subject of our in-depth research for much of the past three years. The catalysts that drive growth over successive business cycles – productivity and labor force participation – have both chronically underperformed for many years. Quite simply, we may have reached a point of diminishing returns on the commercial innovations that powered a historically unique run of growth through the middle and mid-late portion of the last century. Without that growth, we shouldn’t expect wages and prices to do as they did before.
Which is fine for us to say, because – see above – we are not doctorate-level trained economists. But Janet Yellen is, and so are most of her colleagues. And unlike us, they do not have the freedom to brainstorm and speculate about what’s keeping inflation from showing up. All they have are models. Models with months, quarters and years of data providing quantitative insights into the relationship between the labor market and consumer prices. Models written in beautiful mathematical formulations, the legacy of giants who inhabited the “freshwater” (University of Chicago) and “salt water” (MIT and Harvard University) centers of economic research in the years after the Second World War. Models premised on the hyper-rational choices of economic actors, models that do not actively incorporate variables about capital and financial markets but that assume that money is just “there.”
Follow the Dots…Not
The models say that a higher uptrend in inflation is consistent with where the labor market is. Accordingly, the “dot plot” predictions by FOMC members continue to assume one more rate hike this year (most likely December) and three more next year. This despite the fact that the core personal consumption expenditure (PCE) rate that the Fed uses as its inflation gauge remains, at 1.4 percent, well below the Fed’s 2 percent target. Fixed income markets, though, continue to largely ignore FOMC dots (despite some of the usual post-event spasms after Wednesday’s press release). There remain about 100 basis points of difference between what the Fed thinks is a “normal” long term trend for the Fed funds rate (closer to 3 percent) and what the bond market thinks (closer to 2 percent).
In a nutshell, the bond market, and analysts such as ourselves, look at inflation trends and say, why rush? The Fed says, because the models say we have to act. If the models are right, there could be some very nasty shocks in fixed income markets that spill over into risk assets like equities. But for the rest of us, with our parlor game speculations about how the relationship between prices and jobs today may simply not be as statistically robust as it used to be, it is difficult indeed to spot the hard evidence supporting a major bout of inflation on the horizon.
The equity market bulls had been running for more than five years. Over this time interest rates had come down dramatically, inflation was muted and most every fiscal quarter delivered a reasonably predictable uptick in real GDP growth. Markets had weathered a spate of political and financial scandals, as well as occasionally unnerving geopolitical flashpoints. All in all, there seemed to be no particular reason to complain or worry as summer transitioned to fall. Yet investors were edgy. A certain element of caution held in check what should have been giddy times on Wall Street, as if traders and investment bankers, contemplating their seven and eight figure bonuses, couldn’t shake the feeling that it was all a bit unreal. It’s quiet in here, said the young MBAs at Morgan and Salomon to each other as they stared at the monochrome numbers flashing silently on their Quotrons. It’s too quiet.
The previous paragraph could easily be imagined as some future market historian recalling the strange bull market of 2017 – up to the last sentence, anyway. Salomon Brothers is long deceased, and the cathode ray tubes of yesteryear’s Quotrons lie dormant in landfills, patiently awaiting the archaeologists of future millennia. No, the year in question is 1987. On October 19 of that year, a sudden flash of lightning made a direct hit on US equity markets. Major market indexes fell more than 20 percent in one day – the technical definition of a bear market. On October 20, market pros stumbled around the canyons of lower Manhattan asking: What happened?
Thirty years on, another generation of markets pros -- contemplating another secular bull amid low interest rates, steady economic growth and uncomfortably subdued volatility – asks a different question: could it happen again?
A Bear By Any Other Name
The chart below provides a quick snapshot of the Black Monday carnage – and the quick recovery thereafter.
That vertigo-inducing plunge on October 19 put the stock market squarely in bear territory, after a bull run that began in August 1982. But look how quickly the market recovered. By July of 1989 the S&P 500 had regained its pre-crash high. This new bull would go on running for more than a decade, ending only with the bursting of the tech bubble in 2000. For this reason, even though the 1987 market crash was technically a bear market event, we describe it in conversations with clients more as a disruption in the Great Growth Market that ran for 18 years (from 1982 to 2000). We think it is important to make this distinction. Secular bear markets, like the 14 years between 1968 and 1982, call for specific portfolio strategies. But there is very little that one can do about a sudden pullback like Black Monday. To respond to that question we identified above – could a 1987-style event happen again? – our answer is yes. Most certainly it could, and in the next couple paragraphs we will share our thoughts as to why. But a pullback based on some one-off exogenous risk factors – however steep – is not the same thing as a true bear market.
Portfolio Insurance: “Algo” Trading’s Beta Version
So what caused Black Monday? It took quite a while for the market experts of the day to put the pieces of the puzzle together, but in the end they identified the culprit: portfolio insurance. This seemingly benign term encapsulated an approach to institutional portfolio management that involved computer-driven signals to act as warning bells when market conditions appeared risky. Sound familiar? It should, because the crude hedging strategies that made up portfolio insurance circa 1987 were the ancestors of today’s ultra-sophisticated quantitative strategies known by those in the game as “algo” (for “algorithm”) trading.
If you look at the chart above you will see that, a few days before Black Monday, the stock market moved meaningfully lower after soaring to new record highs. For a combination of reasons involving the rate of change in the market’s advances and declines, underlying volatility and a few other factors, the portfolio insurance triggers kicked in and began selling off positions to build hedges. On October 16, the Friday before the crash, the S&P 500 pulled back more than 5 percent as the hedging begat more hedging. On Monday morning the sell orders cascaded in, but there were no buyers. That’s what brought about the carnage.
Peaks and Troughs
Given how much money is currently invested in the offspring of portfolio insurance, the really interesting question is not “could it happen again?” but rather “why hasn’t it happened more often?” For one thing, the ’87 crash did bring about some institutional reforms – operational circuit-breakers and the like – to try and minimize the damage a tidal wave of one-directional orders could bring about. These safeguards have worked on a number of occasions.
For another, the vast diversity of quantitative strategies itself is a kind of check and balance. Every algo program has its own set of triggers: buy when the German Bund does X, sell when Janet Yellen says Y, write a bunch of straddles when China’s monthly FX reserve outflows top $100 million. Put all these out there in the capital markets and they act sort of like the ocean when the peak of one wave collides into the trough of another – they cancel each other out. But that is reassuring only up to a point. It is not hard to imagine that a perfect storm of signals could converge and send all the algo triggers moving in the same direction – everyone wants to sell, no one wants to buy. Crash!
Lessons from the Crash
So, if such a perfect storm were to happen and blindside portfolios with massive short term losses, are there lessons to be learned from 1987? Quite so. It should be clear from the above chart that the worst thing an investor could have done on October 20, 1987 would have been to sell in a panic. In fact, those of us who have been at this long enough to remember the day (and do we ever!) recall that Wall Street’s trading rooms were never more frenzied with buy orders than in the weeks after Black Monday. Portfolio managers may not have yet known exactly why the crash happened – but they knew that the macroeconomic context hadn’t changed, that there were no new geopolitical crises, and that stocks with stratospheric P/E ratios after a long bull run were suddenly super-cheap. That, largely, is what explains the quick recovery, explains why 1987 was not a “real” bear market and explains why, all else remaining more or less unchanged, the prudent response to an out-of-the-blue event is to stay disciplined.