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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
Financial markets move to the metronome of data, but not only data. Optics and perception also factor into the equation. Experience tells us that perception can quite easily become reality. Thousands of trader-bots are primed on any given day to lurch this way and that, often on the basis of no more than the parsed verbiage of a Fed speech or a “presidential” tweet. Sometimes the waves generated by those bots cross each other and cancel out. Other times they all find themselves going in the same direction and create a tsunami.
When “Buy the Dip” Met “Sell the Rally”
Many of the headline data points continue to suggest that there is little reason to worry. The latest batch of jobs data came out this morning and were not way out of line with expectations – net positive payroll gains and a steady, but not overheated, pace for wage growth. In public statements Fed chair Powell projects confidence about growth prospects heading into next year. But other indicators are flashing yellow, if not necessarily red. Oil prices suggest a tempered demand outlook. Fed funds futures contracts are sharply backing away from the presumption of three rate increases next year and perhaps even a shift back to rate cuts in 2020. The picture for global trade remains as opaque as it has been for much of the year, leading to reductions in 2019 global growth estimates by the IMF.
With that in mind, it seems increasingly plausible that the current volatility in risk asset markets is something different from the other occasional pullbacks of the past few years. This one is more grounded in the perception that an economic slowdown is ahead. Not “tomorrow” ahead or “next January” ahead, but quite plausibly sometime before the calendar closes on 2019. What we’re seeing in this pullback (for the time being, anyway) is a roughly balanced approach to buying the dips at support levels and selling into relief rallies at the resistance thresholds. Having made it through a negative October without the bottom falling out, the animal spirits to propel a sustained upside rally are thus far being kept in check. Perception is running ahead of actual data, as it frequently does.
Pick Your Flavor
None of this means that a slowdown (or worse) is absolutely, definitely in store in the coming months. But if it seems like an increasingly probable outcome, how does one prepare? There is never any shortage of blow-dried heads in the media to tell you that “when the economy does X the market does Y” with “Y” being whatever pet theory its proponent is hawking on the day. The problem is that there is no statistical validity to any kind of pattern one might discern between slow or negative growth in the economy and the direction of stock prices. There simply aren’t enough instances for an observation to be meaningful. The US economy has technically been in recession just five times since 1980 (two of which were arguably one event, the “double-dip” recession of 1980-81). There’s no statistical meaning to a sample size of n=5, just like flipping a coin five times does not give you the same insight that flipping a coin 10,000 times does.
The last three recessions occurred, respectively, in 1990, 2001 and 2008. The chart below shows the trend in real GDP growth and share price movements in the S&P 500 over this period.
Here is what jumps out from the above chart: the pullback in the stock market during the relatively mild recession of 2001 was much more severe than the one that accompanied the deeper recession of 1990. Consider: 2001 barely even made it into the history books as a technical recession (the story of how recessions become official makes for an interesting article in and of itself – stay tuned for our 2019 Annual Outlook this coming January!) Yet the bloodbath in stocks was a sustained bear market over nearly three years. By contrast, the market fell just short of, and never technically went into, a bear market during the 1990 recession. 2001 was closer in terms of damage done to the Big One, the Great Recession of 2008.
Here is where we come back to our favorite hobby horse: inferring useful meaning from past instances is misguided, because each instance has its own miserable set of unique variables, like every unhappy family in “Anna Karenina.” Before the 2001 recession happened, you will recall, the high-flying technology sector crashed in a stunning mess of shiny dot-com valuations. A financial crisis – a crisis born of nosebleed asset valuations – precipitated a minor contraction in the real economy. And of course in 2008 it was another financial crisis, this one deeper and holding practically the entire global credit market in its grasp, that begat the near-depression in the economy that followed.
We think of 2001 and 2008 as “recession-plus,” where the “plus” factor arguably contributes more to the severity of the pullback in risk assets than do the macroeconomic numbers relating to jobs, GDP, prices and sales. It was no fun for investors as those numbers turned south in 1990, but the pain was relatively shallow and short-lived. Not so for the multi-year tribulations of 2001 and 2008.
Now, there is no clear path from where we stand today to either a 1990-esque standalone recession, a more severe situation driven by exogenous factors, or just a simple slowdown in growth. Or even (though less likely) a second wind of the growth cycle driven by a yet-unseen burst of productivity. Nor has perception, while currently trending negative, yet become reality. We imagine those bot-generated waves will collide and cancel out a few more times before the trend becomes more sustainably directional. Meanwhile, planning for alternative scenarios is the priority task at hand.
In the canons of Fed Scripture there was the Greenspan put, which begat the Bernanke put, which begat the Yellen put, and the Governors saw that it was good, and the Governors rested on the seventh day. And then came Jerome Powell, and the put was no more. Or was it?
You’ve Got a Friend at the Fed
For those not steeped in the arcane speech patterns of those who inhabit and/or observe the goings-on in the Eccles Building, the “Fed put” is the widely-held assumption among investors and traders that whenever risk asset markets get choppy, the Fed will be there to ease the pain with a fresh punch bowl of easy money.
Case in point: in the early months of 2016, just after the Fed had raised rates for the first time since the 2008 recession, global equities took a hit from some negative economic data from China. Now, nobody in the Yellen Fed at the time ever actually came out and said “the S&P 500 fell more than 10 percent, so we’re going shelve the rate hikes for a while.” But investors could draw their own conclusions – rates did stay on the shelf, not rising again until the end of 2016, a full year after the first increase.
For much of the current recovery cycle the colloquial Fed put was part and parcel of the formal monetary stimulus policy to get the economy back on its feet. Encouraging investors to shift out of low-risk assets like government bonds and into riskier things like equities was a central feature of the system. But those days are over. When stocks lurched into a downturn back in early October it seemed that the market finally got the memo – the FOMC (Federal Open Market Committee, the Fed’s monetary policy decision arm) had raised rates again in the September meeting, were on track to do so again in December, and Fed chair Powell was quoted in a speech as saying that current rates were still far away from the neutral interest rate. The economy’s doing well, corporate earnings are fine, no need to keep the training wheels on…right? Investors seemed to think otherwise, and Red October was on.
A Lighter Shade of Neutral
Let’s go back to that Powell comment about the neutral rate, because it figures very much into what the market has been up to this week. First of all, what exactly is the “neutral” rate of interest? Glad you asked, because even the cerebral Fed folk themselves can’t give you a clear answer. It’s supposed to be whatever rate of interest is neither stimulative (too low) nor restrictive (too high). The various members of the FOMC have their own ideas, which fall out into a range of about 2.5 to 3.5 percent based on the most recent “dot plot” assumptions the Fed releases periodically after the FOMC meets.
On Wednesday this week, Powell once again referenced the neutral rate. This time, though, rather than saying that rates were currently “far away” from neutral, he said they were “just below” the range of neutral rate estimates. The market went into a tizzy again, but this time in a good way with major indexes jumping more than 2 percent. And so the excited chatter resumed…is that a Powell put we see out there? We may well be wrong about this, but we tend to think not.
Do the Math
Currently, the Fed funds rate is in a target range of 2.0 to 2.25 percent, which puts rates…well, just like Powell said, “just below” the range of neutral rate estimates. The chart below illustrates this.
But why did investors obsess over those two words “just below?” Here’s how the math works. The midpoint of the current Fed funds range is 2.125 percent (i.e., halfway between the floor of 2 percent and ceiling of 2.25 percent). The FOMC generally likes to see the effective rate (i.e. the actual market rate banks charge each other for overnight loans) somewhere close to the midpoint.
So, to get that midpoint rate above the 2.5 percent lower boundary of the neutral rate range would require two additional rate hikes (presumably one later this month and one sometime next year). To get to the midpoint of the neutral range, a more likely outcome, would require three or four additional rate hikes to get to 2.875 percent or 3.125 percent (i.e., either side of the 3.0 percent midpoint neutral rate).
Three or four additional increases…wait, isn’t that what the Fed has already signaled it plans to do? Why, yes! One in December and then two or three in 2019 is the default assumption coming out of FOMC press releases and commentary since at least the middle of this year. So why all the fuss? Parsing what exactly Powell meant by “far away” or “just below” or any other combination of two words would seem silly, if the math seems obviously the same as it has been for months already.
One reason given for all the investor excitement was that Powell’s comments on Wednesday came right on the heels of another blast of word salad from the nation’s chief Twitterer complaining about the Fed and higher interest rates. Was the Fed chief bending the knee to Trump like so many other seemingly reasonable people have in the past two years? Is the Fed put back in the policy bowl because Trump wants low interest rates?
While one can never say never in this day and age, we see very little likelihood that the head of the Federal Reserve, charged among other things with maintaining the independence of the central bank, would immerse himself into the middle any political imbroglio. The timing may have seemed strange, but there just is no factual basis in which to read any kind of political message from Powell’s speech. He did say that there is no “preset” path for rates – which is what the Fed always says. Data about the health of the global economy will inform the pace of interest rate policy. If growth appears to be slowing or going into reverse then there will likely be fewer rate hikes, while if the pace continues to hum along at current levels there is no reason to assume anything other than the four rate hikes already baked into policy expectations.
We’ll get a preview of whether our analysis is correct or not in just a few short weeks when the FOMC meets for the last time this year. There are just a handful of macro data points coming out between now and then, and barring a very unexpected surprise either from the labor market or consumer price readouts, we don’t see anything to suggest the December Fed funds increase won’t happen. Hopefully Mr. Market will be able to figure this out in a relatively drama-free fashion.
It’s not Thanksgiving week over in London, but British prime minister Theresa May is likely in a mood to give thanks anyway. The object of May’s thankfulness would be the spectacle of hardline Eurosceptics in her own Tory party, led by the decidedly odd duo of Boris Johnson and Jacob Rees-Mogg, doing their best impression of a rafter of turkeys cluelessly scampering this way and that in a ham-fisted effort to unseat the PM and torpedo the much-unloved Brexit deal she is trying to sell to Parliament.
A Comedy of Errors
The tragi-comical mess that is Brexit has percolated in and out of the news since the referendum nearly two and a half years ago produced the shocking (at the time, not so much any more) decision to quit the EU. With the Article 50 deadline of March 2019 looming, the recent headlines have been decidedly unkind to just about anyone involved with the negotiation process, most of all from the UK side. Concerns about the potential global impact of a no-deal crash-out from the EU have joined other festering concerns – about tech stocks, interest rates, China and others – to keep market sentiment on the side of risk-off. As we write this, the S&P 500 is hovering just at the technical correction threshold of a 10 percent decline from its last high (reached on September 20). If the May government collapses in the coming weeks, which is not a zero-probability event, then confidence may be shaken further still.
Under the frothy headlines, though, there is at least a case to make that the worst outcome will be avoided. Amid all else going on in the world right now, we think it is worth one’s time to understand where things currently stand on Brexit and why they might not be quite as dire as they seem – why, in other words, Theresa May might truly be in a thankful mood.
The Artlessness of the Deal
Exceedingly few kind words, to be sure, have been penned about the deal currently up for approval. A “rotten prawn” opined British journalist Quentin Letts in a recent Washington Post opinion piece (the piece is also notable for likening PM May to an “Atlantic mollusk” in a way that was actually meant as a compliment). The deal keeps the UK in a threadbare customs union with the EU that at once displeases Remainers (stuck in limbo is worse than being part of the EU) and Leavers (stuck in limbo is worse than the clean break that was voted for in 2016). It gives discretion to Brussels over future decisions about the very contentious and seemingly intractable issue of the Northern Ireland border. In the minds of not a few observers it is nothing short of a transfer of decision-making power on a great many issues from the British Parliament to the European Commission.
The Worst Option, Except for All the Others
Rotten prawn though it may be, the May deal has gained some important sources of support including Bank of England head Mark Carney, leaders in the UK business community and establishment media organs such as the Financial Times and Economist. The common theme being that, as bad as this deal may be, it is infinitely preferable to an abrupt ejection from the EU next March with no Plan B. The real-world implications of a hard, no-deal Brexit have not, in any meaningful way, been manifestly evident to date. The pound sterling today is just 15 percent weaker versus the US dollar than it was right before the Brexit vote happened. The FTSE 100 stock index has gained about 10 percent since June 2016 – much less than the S&P 500, say, but still positive. Headline macroeconomic numbers from jobs to inflation and GDP have also held up reasonably well – again, not going gangbusters but neither going into recession.
A hard Brexit, many believe, would be the end of these relative good times and the beginning of something much worse. The Bank of England plans to back up its support for the May deal next week with a more detailed assessment of the economic consequences of an abrupt Brexit crash-out. Paramount in the minds of those supporting the deal is the transition period it provides – anywhere from two to four years – after Article 50 kicks in next March for both sides to work out a detailed agreement for trade and economic cooperation. Wait, you say, wasn’t that what they were supposed to be doing for the last two years? Fair point – but an “extended transition period” is actually what the EU does best – it kicks the can down the road to be fixed at some future date. Meanwhile, businesses and investors at least have the assurance of continuity for a measurable period of time.
Vox Populi, Redux?
There is a certain cunning logic to that kick-the-can trick in the EU playbook: things can change, maybe to the extent that a final decision on Brexit will never be made. Currently there is quite a bit of chatter in Britain about a so-called “People’s Vote” (good marketing!) that would effectively revisit the entire premise of Brexit. Voters in this scenario would have three options: choose the May deal currently on the table, choose a hard Brexit along the lines of what Johnson, Rees-Mogg and the rest of the Tory turkeys claim to want (the details of which are, to be charitable, foggy), or choose…to stay in the EU. While the notion of a second referendum has been bandied about since the immediate aftermath of the first one, this People’s Vote idea seems to have quite a bit of cross-over support from erstwhile Leavers and Remainers. According to at least one recent poll on the topic, the cohort preferring to remain in the EU was 54 percent. Recall that in the original vote 48 percent supported Remain, 52 percent were for Leave.
So could the whole unseemly mess just go away, like a bad dream that finally dissipates with morning’s light? That would not necessarily be the way to bet, nor would it solve the very real, very partisan divide among Britons about their place in Europe and the world at large. Sadly, we are too far down the road of populism and blinkered, tribal nation-first thinking in too many parts of the world for that toothpaste to go back into the tube. But there are three possible, practical alternatives in front of the UK today. Of the three, one would very likely deliver a great deal of economic pain within a very short period of time. Either of the other two would be far more palatable – and could helpfully reassure global markets that the world’s humans have not yet completely gone off their rockers.
We wish all of you and your families a very happy Thanksgiving.
Earlier this fall we coined the phrase “sector spaghetti” to describe a phenomenon we observed in the US equity market, namely the absence of any sector leadership. The small concentration of tech shares that have driven performance for the lion’s share of this bull market started to fall sharply back in July as investors reacted badly to underwhelming earnings announcements from Facebook and others (underwhelming, perhaps, only in the febrile expectations of the analyst community, but still…). Without leadership by the enterprises that dominate the S&P 500’s total market value, the various industry sectors waxed and waned, their combined trajectories looking like a tangled pile of cooked pasta dumped on a kitchen counter. Hence, sector spaghetti.
Oh, and just how impactful was that “small concentration” of tech shares? Consider this: according to the Economist magazine, just six stocks – Alphabet (Google), Amazon, Apple, Facebook, Microsoft and Netflix – have accounted for 37 percent of the rise in value of all stocks on the S&P 500 since 2013. Think about those two numbers: 6 and 37. That’s a huge impact for such a tiny cohort.
A Picture Emerges
The spaghetti factor has cleared a bit, thanks to the pullback beginning in October that brought the S&P 500 to flirt with a technical correction on a couple occasions. A general risk-off sentiment has set in, and with it a rotation of sorts into the traditional defensive sectors including consumer staples, healthcare and utilities. The chart below illustrates the recent trend of these three sectors versus the erstwhile growth leaders of information technology, communications services and consumer discretionary.
The problem with this defensive rotation becomes clear when you look at the dotted red line in the above chart. That represents the price trend for the index itself. As you can see, it is much closer in proximity to the lagging growth sectors than to the outperforming defensives. The reason for which, of course, is the outsize influence those market cap-heavy sectors exert on the overall market: the three growth leaders account for more than 40 percent of total index market cap, compared to just over 25 percent for the three defensive sectors (energy, financials, industrials, materials and real estate make up the index’s remaining balance). A rotation out of tech is a rotation with a steep uphill climb.
What Is Tech, Anyway?
The “tech sector” is sort of a misnomer, to the point where the index mavens at Standard & Poor’s undertook a major restructuring of the S&P indexes earlier this year to better segment the various enterprises whose primary business falls somewhere on the value chain of the production, distribution and/or retailing of technology-related goods and services. The restructuring was helpful, to a point. For example, Apple, Facebook and Microsoft are all constituents of the information technology sector, but Alphabet (Google) and Netflix both fall under the newly-defined communications services sector.
But it is only helpful up to a point. Take the case of Amazon which, despite being a company entirely built on a technology platform without which it would not be a business at all, has always been and remains a member of the consumer discretionary industry sector. In fact Amazon, Microsoft and Alphabet are all industry leaders in the multi-billion dollar business of cloud computing services, yet all three are in different industry sectors.
More broadly, though, it is actually hard to think of any industry sector where “technology” in one form or another is NOT a core component of the industry’s competitive structure. Financial services companies compete in the fintech arena, while hundred year-old industrial concerns are in a race to grab leadership in the Internet of Things, whatever that winds up being. Even sleepy utilities, traditionally loved almost solely for their high dividend payouts, are scrambling to convince investors they are on top of the evolution to “smart grids” (another catchy name that mostly has yet to demonstrate an actual present-day revenue model).
The point is that technology is all-pervasive. But actual ownership of much of that technology remains highly concentrated – in the hands of those same companies responsible for a large chunk of this bull market’s gains. Any rotation out of those companies into something else is going to need a pretty compelling narrative to deliver commensurate returns. For starters, investors will be hoping next week for a second helping of strong holiday shopping results alongside their turkey and stuffing.
There were lots of think pieces leading into the US midterm elections earlier this week. We didn’t contribute to the genre, mostly because there is nothing statistically meaningful to say about an event with a very small sample size (n = 10, if you want to go all the way back to 1982 for your midterms data set) and lots of variables highly specific to each observance. Not that shoddy statistics ever got in the way of mainstream financial punditry…but we digress. In any case, the day came and went with relatively few real surprises of note. The “known unknowns” of the midterms now join the headline macroeconomic and corporate earnings trends as “known knowns” propelling what might be expected to be a net-positive narrative while the clock runs down on 2018. Always allowing, of course, for the sudden appearance of an “unknown unknown” to spoil the applecart (and thanks to Donald Rumsfeld for his contribution to the lexicon of predictive analytics).
Good Cheer and Relief?
The relief rally that began last week would seem to have some seasonal tailwinds to carry it further. The holiday retail season gets underway in a couple weeks, and it is shaping up to be a decent one. The latest batch of job numbers released at the end of last week suggest that higher wages are finally catching up to the rest of the good cheer in labor market data points. Consumer prices are still in check, despite the gradual encroachment of new tariffs onto consumer goods shelves. A good showing between Black Friday, Cyber Monday and the ensuing week or two could keep investors focused on the growth narrative.
Potential headwinds to that growth narrative are also at play, however. The Fed will meet again in the middle of December and is expected to raise rates for the fourth time this year. That by itself is not new news. In their little-publicized (non-press conference) meeting this week the FOMC reiterated confidence in the economy’s growth trajectory, which sets the stage for next month’s likely increase to the Fed funds target rate. What the Cassandra side of the investor world has in its crosshairs now is the US budget deficit, which is positioned to climb above $1 trillion in the near future.
Again – not a new fact, as this figure was well known when the Republicans implemented their sweeping corporate tax cuts one year ago. What is known with more certainty now, though, is that the higher levels of debt servicing that accompany this swelling budget deficit will happen at the same time as interest rates are heading off the floor towards levels closer to historical norms. Now, the newly known fact of a split Congress may mitigate some of the debt concerns – after all, further fiscal profligacy is unlikely in a Congress that will be hard pressed to get even the simplest pieces of legislation passed. And some optimists still maintain (without much in the way of supporting evidence) that the net effect of the tax cuts will be an unleashing of business productivity. But the debt servicing issue has the potential to be a decisive influence on US credit markets heading into 2019, which could mean trouble for risk assets.
The Big Unknown
Now we come to the part of the discussion where the specific risk factors become harder to pin down, but have the potential to overwhelm conventional wisdom. We’re talking about politics – world politics, to be sure, not just US politics. Assets in developed markets typically ignore, or at least give very short shrift to, socio-political developments. Even singular events that at the time seemed momentous – the Cuban missile crisis and the Kennedy assassination in the early 1960s come to mind – scarcely had any effect on prevailing stock market trends. The same goes for Watergate – the losses sustained by US stocks in the summer of 1974 were largely in line with the broader forces at play in a secular bear market that lasted from 1969 to 1982.
Markets don’t ignore these events because they are Pollyanna whistling her merry tune – they ignore them on the basis of a well-grounded assumption that the political institutions of modern developed nation-states are robust enough to withstand the impact of any single imaginable happening. The institutions though – and we are speaking here primarily of the US, the EU and the latter’s soon-to-be divorced partner across the English Channel – are being challenged in ways unknown since the post-Second World War Bretton Woods framework came into being.
How could the further dissolution of Western institutions affect investment portfolios? One can speculate, but with little in the way of hard data for modeling alternative scenarios. It may well be that nothing much impedes on investor sentiment in 2019 beyond the usual store of data regarding economic growth and corporate sales & profits. Those numbers may be strong enough to keep the good times rolling for a while longer. But the tension will likely form at least a part of the contextual background. However the numbers end up, we do not expect calm seas along the way.