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Katrina Lamb, CFA
Head of Investment Strategy & Research
Katrina Lamb’s international investment industry career spans more than 25 years and includes both buy and sell side experience. She specializes in the research, analysis, and evaluation of the capital markets opportunities that... Full Bio
Asset markets have settled into a gentler pattern in recent days, erasing a sizable portion of the losses suffered during the first five or so weeks of the year. The rising tide has extended to that most battered of asset classes: emerging markets. This asset class has been the big underperformer among equities for more than a year now, ending 2013 with a loss even as the S&P 500 gained more than 30%.
With relative valuations so low, many market participants see a potentially attractive buying opportunity in the works. Our views are a bit more tempered: while we would not necessarily be surprised by a spurt of outperformance in the near term, we think the fundamentals argue for proceeding with caution.
For the better part of the 21st century emerging markets have been the global economy’s growth engines; in many years enjoying double-digit real GDP growth. Millions of Brazilians, Chinese, Indonesians and Indians ascended into a rapidly expanding middle class, bringing prosperity not only to local businesses but to S&P 500 titans as well. Many of the largest U.S. companies earn more than half their revenues and profits from their overseas activities. But recently, the growth trend has markedly slowed down. Brazil’s real GDP growth in 2013 was a paltry 2.2%. Turkey, which as recently as 2011 was growing at a double digit clip, is looking at potentially sub-1% real growth this year. Even India, one of the strongest emerging markets, is languishing in mid-single digits.
Flight of the Creditors
Debt was always lurking under the surface during the heady growth years. Foreign creditors were more than happy to lend to emerging markets businesses and consumers, much of which was in hard currencies. As external debt rose on emerging corporate balance sheets, other troubling data points like inflation and swelling trade deficits appeared as well. In sharp contrast to the sub-2% inflation rates seen in most developed economies, price index gains are currently more than 6% in Brazil, Russia and India. A more extreme case is Turkey, where an inflation rate of 11% helped spark a credit market exodus that spread to South Africa, Russia, India and Brazil. As creditors fled, local currency rates plunged, making those debt-laden balance sheets even more onerous.
The China Question
Looming over the whole emerging markets debate is China. The world’s second largest economy continues to grow: its 2013 GDP rate of 7.7% was the largest among the 42 major developed and emerging markets tracked weekly by the Economist Intelligence Unit. What concerns investors, though, is where most of the growth is coming from. China’s leaders have committed to rebalancing the economy away from investment (much of which is speculative rather than productive in nature) in favor of more domestic consumption. Consumer spending accounts for just 35% of China’s GDP, as compared to 70% in the U.S. But that rebalancing will be tricky, involving a cooling off of the country’s overheated financial system as well as unpopular political decisions.
These are some of the key issues giving us pause in regard to emerging markets. We remain underweight in the asset class, and will remain so until we have more evidence of the case for growth. That evidence will need to include some indication that Xi Jinping and his economic policy team are successfully maneuvering their way through the China rebalancing challenge.
On February 3rd the S&P 500 experienced its most severe pullback since the period from May 21 – June 24, 2012. Oddly, the magnitude of the pullback was exactly the same to within two decimal points: -5.76% in each case. Here at MVCM we use 5% as a marker for a pullback worth recording in our records of peak-to-trough movements going back to 1951. If the S&P 500 rallies by 5% or more without falling below the 2/4 close, then these Bobbsey Twins pullbacks will each merit a small, slightly amusing shout-out in the time-honored annals of Wall Street weirdness.
U.S. equities indexes may indeed bounce back for another rally, but we will not be surprised to see a return to more pullbacks, with greater magnitudes, than has been the case in recent years. The return of the periodic 10% correction, something we have not seen since 2011, is likelier to happen if something else comes back to the market that has been AWOL for a while: volatility.
Been Away For So Long
The above chart is something we have shared before with our Market Flash community: the volatility gap that has persisted almost without pause for the past two years. The CBOE VIX index, fondly referred to as the “fear gauge” by Street pros, had an average closing price of 14.2 in 2013 versus the long term average of 20.2 going back to the index’s inception in 1990 (a higher VIX price means more volatility). Even 2012, a relatively tame year with no 10%-plus corrections, had an average VIX level of 17.8. Those spectacular returns of 2013 came with relatively little risk.
In finance, as in other walks of life, what goes down eventually comes back up. Volatility will return; the question is whether that return is imminent or whether U.S. equities still have a couple big rallies left in them. We are increasingly of the opinion that the return will be sooner rather than later.
(Macro) Event Planning
One thing seems evident: we’re in one of those event-driven environments where meta-narratives rise organically out of the swamp of macroeconomic data points, corporate earnings releases and global goings-on in places like China, Turkey and Brazil. The meta-narrative of late has been decidedly negative. Emerging markets currency crises have prolonged the pain for investors with long exposure to what are looking less and less like the “growth engines” of several years ago. That in turn has concentrated attention on the greatest growth engine of all, China. Concerns have bubbled under the surface for several years now about whether the world’s second largest economy can pull off the feat of defusing a potential credit bubble while rebalancing its growth away from increasingly speculative investment towards a healthier level of domestic consumption. The numbers coming out of China always must be taken with a measure of skepticism; nonetheless, a China-centered shock would have the potential to scorch a wide swath of asset class terrain.
Still Not Cheap
Meanwhile, the latest pullback has knocked about a point off the S&P 500’s next twelve months (NTM) P/E ratio, as seen below. But a pullback of a bit less than 6% doesn’t make for a screaming bargain when it comes on the back of a year of 30%-plus gains. At 14.4x, the NTM P/E is still above its 10-year average of 13.9x.
Indeed, the market’s recent success may amplify the negative tone of the prevailing narrative. With few investors expecting equities to deliver anything as spectacular as last year’s gains – especially the record-breaking risk-adjusted returns – and corporate earnings doing little more than to (mostly) beat downward-revised expectations, there may be an enthusiasm gap between the Pollyannas on one side and the Cassandras on the other.
So where does our -5.76% pullback go from here? Well, the S&P 500 closed 1.2% higher on Thursday, its biggest gain for the year to date. What that says about tomorrow, or next week, is anybody’s guess. But whether our scribes record -5.76% in the MVCM Pullback Annals or not, we are prepared for a volatile ride in 2014.
In the State of the Union address given on January 28th President Obama introduced the world to ‘MyRA’, a new retirement savings vehicle intended to help the middle class save for their future. This is commendable: a retirement gap of six trillion dollars exists between what Americans should be saving and what they are saving, and this gap must be addressed. How effectively does MyRA get to the heart of this very complex and multi-layered issue? In our opinion, not very effectively.
In his speech Obama stated, “It’s a new savings bond that encourages folks to build a nest egg. MyRA guarantees a decent return with no risk of losing what you put in.” The White House’s factsheet specifies that this vehicle would be available to joint households earning up to $191,000 with initial investments allowed to be as little as $25, annual contributions may be up to $5,500 a year (same as for an IRA), and the account may reach a maximum of $15,000 before being rolled into a commercial account. As he stated in his speech, contributors will be ensured principal safety by a safety bond backed by the US government.
What makes MyRA likely to be the savings vehicle that will close that large retirement savings gap? How will this plan change the saving habits of millions of Americans and offer them a better retirement in a way that other savings plans like IRAs and 401(k)s have not been able to do? President Obama emphasized the risk-free nature of the surety bond. But is the fear of losing principal the central reason for the lack of retirement savings? In our opinion, the answer is no: there are other, bigger fundamental issues at play.
At the heart of the issue are two factors: a lack of adequate education regarding good financial habits; and the simple behavioral economics of human beings. The majority of the audience that the MyRA is targeting doesn’t save because they don’t know how to make an effective financial plan towards a long term goal like retirement. Our experience from working with employer-sponsored retirement plans is that most people lack even the most basic knowledge about investing and because they don’t know where to begin, they don’t take action.
Many of these people are working long hours just to keep their heads above water and they view learning how to make effective investment decisions as a commitment for which they simply don’t have the time. The investment choices available today can also be overwhelming, from growth funds to fixed income assets, a great number plan employees with whom we work tell us that they see these investing choices as both intimidating and confusing, leading them to simply turn their backs to the task of doing so. They don’t need a surety bond; they need education and good information.
In many cases, we have also seen that employees don’t invest their money towards retirement because they only vaguely understand what benefit it will bring them. Human nature dictates that people live in the ‘here and now.’ The idea that they will need to save X amount of dollars to sustain their lifestyle for the many years they will live in retirement is a less immediate concern.
This is what we mean by behavioral economics, and it plays a big role in the retirement savings crisis. When it comes to financial decisions, people don’t make rational choices. We are wired to compartmentalize our financial decisions – we don’t think about how spending $4 on a cup of coffee will impact all the other financial decisions we could have made with that $4. In this equation, it is generally the immediate needs that take precedence, and the more distant ones that ultimately suffer.
The Obama administration is correct: there is a vast savings problem in our country. Calling out this problem in a high-profile event like the State of the Union is a step in the right direction. However, the right questions aren’t being asked and the roots of the problem are being misdiagnosed. This misdiagnosis was evident in this part of the President’s remarks: “…offer[ing] every American access to an automatic IRA on the job, so they can save at work just like everyone in this chamber can.” It is unlikely that a new savings vehicle will by itself be the solution to the problems faced by millions of Americans confronting this substantial retirement gap. Most Americans aren’t in a position to save in the way that the President hopes for and there are several more steps that must be taken to address and remedy these fundamental issues before many people can even be shown the doors to said chamber.
This week we got two seemingly contrasting readings on the state of play in early 2014, and what may be in store for investors, businesses and households this year. The stock market pulled back, with the S&P 500 extending its loss for the year to date north of 4% by early Friday morning trading. The U.S. economy, on the other hand, produced another positive data point, with the first reading of 4Q GDP coming in at 3.2%.
This is less odd than it may seem, and very much consistent with our base case scenario for the year. The stock market is expensive, even with the recent pullback, and prone to potentially more bouts of selling. The fundamental economic picture, though, continues to show more promise than reasons for fear. That may not be enough to produce another year of double-digit equity returns. It may be enough, though, to make a good case against things getting too negative for long-equity portfolios.
GDP By The Numbers
A look at the chart below shows three consecutive quarters for GDP above the critical 2% level. Economists believe that the economy needs to grow at a clip of 2.5% or better to generate net new jobs (i.e. where job growth outstrips population growth). A string of readings above this level increases the potential for the unemployment rate to fall for the right reason – new job creation – rather than the wrong reason of decreased labor force participation. That wrong reason was the driving force in last month’s surprise fall from 7% to 6.5%.
Let’s look at where the growth came from, because there are some interesting storylets below the top line. The biggest contributor was consumer spending, accounting for 2.3% of the total. That’s unsurprising: in Shopaholic Nation, consumer expenditures typically make up about 70% of GDP. What is unusual is the next largest line item on the national account: net trade. The balance of exports over imports contributed 1.3%. This dovetails with the decreasing U.S. trade deficit we described in a previous Market Flash, but still is surprising given weakness in emerging markets and a stronger U.S. dollar. Net housing and business investment was up a modest 0.6%.
Take That, Government Shutdown!
So add up all those figures – 2.3%, 1.3% and 0.6% - and you get 4.2%. So why did GDP only grow by 3.2%? The wet blanket on the party was government spending, which subtracted 1% from the equation. Remember last October? The shutdown, the flirtation with disaster as posturing policymakers played chicken with the government budget and with the debt ceiling? That proved to be the weak link. The good news, though, is that even with this fiscal drag the economy was still able to grow by more than 3%. The even better news is that there is likely to be less fiscal drag this year than last. Congress managed to reach a budget deal by the end of last year, and this year even the partisan muckrakers may be a bit more tempered in their actions ahead of the November midterms.
Where Do All The Profits Go?
There are a couple cautionary notes in the generally positive picture, though. First, this reading is subject to revisions. That could impact the seemingly-too-rosy net trade numbers. Second, business investment results are not particularly impressive. Half of business investment came from inventories, as opposed to investment in new productive assets. Profits for U.S. businesses have been robust for many years, so what are they doing with all that money? Anyone who follows quarterly corporate earnings announcements knows the answer: it’s going back to shareholders in the form of share buybacks and dividends. The dividend payout ratio at a number of large S&P 500 firms is over 100%. That means the firms pay out 100% of their net earnings in the form of dividends and buybacks, and then borrow more money to pay out even more! Why not, the thinking goes, given today’s low interest rates?
Push Me, Pull You
Finally, this latest uplifting data point brings the Fed’s rate policy back into the picture. Short term rates soared after the Fed’s December meeting on doubts about whether the extended forward guidance target was realistic in a faster-growing economy. Then rates fell sharply after the surprisingly negative jobs report in early January. Now they may rise again, then they may fall again in a credit market version of push me – pull you. We need to keep a close eye on this. But on balance, we will prefer to see a stronger economic picture continue to take root. Heaven forbid, that might actually take us back to a world where equity fundamentals matter more than the word “taper”.
Bond yields plunging. Defensive, high dividend stocks holding firm as riskier exposures sharply weaken. Emerging markets bloodbath. If it were not for the frigid temperatures plaguing the East Coast, it might seem like we’re back in the summer of 2011, with investors scurrying into whatever safe havens they could find amidst the tempest. Is it Risk On / Risk Off version 2.0?
Revisiting the Law of Round Numbers
Last fall we wrote a piece on the weird magic of round numbers: namely, the S&P 500 and the Down Jones Industrial Average breaching the nice round figures of 1800 and 16,000 respectively. We noted that oftentimes, indexes take a while to reach escape velocity after breaking through a round number resistance level. So while 1800 and 16,000 were resistance barriers in autumn 2013, they are playing the role of support level today. As of this writing the Dow is flirting with 16,000 while the S&P 500 is trading around 1805. By the time we post this, we will see whether the support level has held or been breached. That could give us some insight into what might be happening in the days ahead.
Death, Taxes and Market Corrections
From our perspective, having been in this business for several decades, periodic market pullbacks are as dependable as those other two more well-known inevitabilities. Considering that the S&P 500 gained over 32% in 2013, a correction of sorts is not the most surprising thing in the world. Right now the market is about 2% off its December 31 high. Corrections of between 2-5% are typical of pullbacks in a larger growth market environment, whereas a range of 10-20% is more indicative of a building bear trend. Sometimes, though, the bear doesn’t gain traction. Looking back to that turbulent summer of 2011, U.S. indexes did retreat by about 20%, but rallied strongly from the October 1 trough to recover all the lost ground by early 2012. There have been no 10% or more retreats since, and only a handful more than 5%.
A January Effect?
One thing vexing the bulls is the timing of this pullback. January has a history of being a more active than usual month both in terms of volume and market direction. The first month of the year saw price gains of 5% in 2013 and 4.3% in 2012, while the 5% drop in January 2000 and 6.1% retreat in the first month of 2008 were the canaries in the coal mine for the dismal periods to follow. Of course, it doesn’t always work that way. A 3.5% drop in the S&P 500 in January 2010, and negative 2.5% reading in 2005, were followed by positive performance for the full calendar year. Still, it’s a good idea not to completely discount notions like the January effect, because human behavioral quirks around calendars are as hardwired into the markets as those round number oddities.
Watch the Earnings
It’s still relatively early in earnings season, but the general tone is more negative than positive. Large names like IBM and Procter & Gamble have disappointed, while positive “surprises” – when companies release earnings that beat analyst expectations – are fewer in number and less in scale than in recent quarters. We remain of the opinion that markets are expensive at current valuation levels, but not in bubble territory. A 2-5% pullback may be all it takes to shake a bit of froth out and then stabilize. But we need to remain vigilant and let the data inform what we do (and do not do) in the coming days and weeks.