Posts tagged Current Market Trends
It’s a very good thing for US large cap equity investors that consumer staples companies make up only 7.4 percent of the S&P 500’s total market cap, while the tech sector accounts for 25.4% of the index. The chart below shows why.
Tech stocks have outperformed the market for most of the year to date, while consumer staples have experienced a miserable couple of quarters. Here’s where those market cap discrepancies really matter: the fact that tech stocks make up a quarter of the total index means that their performance “counts” for more (we explained this in one of our commentaries a couple months ago). So, even though the magnitude of underperformance for consumer staples is greater than that of tech’s outperformance, the heavyweight sector pulls up the broad market (the dotted red line represents the total S&P 500) and, for the moment anyway, keeps it in positive territory.
So what’s going on with consumer staples? By one yardstick – market volatility – the sector might have been expected to outperform over the past couple months. Consumer staples has long been regarded as a defensive sector, i.e. one which tends to do better when investors get jittery. The logic is easy to follow. A volatile market signals uncertainty about the economy, which in turn leads to households tightening their budgets. So things like expensive vacations and designer labels (which would show up in the consumer discretionary sector) get the axe, but folks still have to buy toothpaste and breakfast cereal (which are manufactured, distributed and retailed by consumer staples companies like General Mills, Sysco and Costco).
But two technical corrections of more than 10 percent didn’t send investors flocking into defensive stocks. Other traditional defensives, such as utilities, also fared relatively poorly during this period. There is one driving variable common to a variety of traditional defensives, which is rising interest rates. But there are a couple others that are particularly relevant to the woes in consumer staples.
Hard Times for Dividend Aristocrats
The connection between interest rates and defensive stocks is fairly straightforward. These stocks tend to have higher dividend payouts than more growth-oriented shares. For example, the average dividend yield in the consumer staples sector is around 3.1 percent, compared to an average yield of 1.8 percent for the S&P 500 as a whole. The relative attraction of dividends diminishes when income yields on high quality fixed income securities (like Treasury bonds) increase. This relationship is then exaggerated to an even greater extent by the abundance of algorithmic trading strategies that mindlessly key off small changes in rates, sending cascades of buy and sell orders beyond what many would see as the actual fundamental value shift.
The Worst of Times
Two other variables with a particularly pernicious effect on consumer goods companies are inflation and changing demand patterns. These variables are closely related. While inflation is still relatively low by historical standards, it has ticked up in recent months. Cost inflation – basically, higher input costs for the raw materials and the labor that go into the manufacture of consumer goods – puts downward pressure on profit margins. If companies can pass those cost increases on down the value chain – i.e. from manufacturer to distributor to retailer to end consumer – then they can contain the effect of cost inflation. But that means, ultimately, having consumers willing to pay up for the staple items they buy from week to week. And this is where that second variable – demand patterns – comes into play.
Simply put, consumers have become pickier about what they buy and how they buy, and they have a far greater spectrum of choices from which to curate their own particular needs and preferences. Time was, the weekly shopping cart was pretty predictable in terms of the packaged goods with which Mom and Dad filled it up, and also where the shelves containing those goods were located. Established brands carried a premium that was a predictable source of value for the likes of Procter & Gamble, Coca-Cola or Kraft Foods. That brand premium value hasn’t disappeared – but it has become diluted through an often bewildering assortment of products, categories and messaging. The emotional tie between a consumer and a favorite brand dissipates when the products and the messaging are constantly changing, popping into and out of existence like quantum matter.
That dynamic makes it much harder, in turn, for companies to convince their customers to accept the passing on of cost inflation. The logical outcome is lower margins, which have been the wet blanket souring quarterly earnings calls this year. Unfortunately for the companies in this sector, these are not problems that are likely to disappear with the next turn in the business cycle. Even the elite leaders, such as P&G and Unilever, have daunting challenges ahead as they try to leverage their storied pasts into the unforgiving environment of today.
Yes, it’s already May. Three days into the year’s fifth month, we are pleased to say we have not yet had to listen to the first seasonal “sell in May and go away” pronouncement by a stupidly grinning CNBC pundit. It’s coming, though, as surely as May flowers follow April showers. Meanwhile, as equities tread water between the support and resistance levels that were the subject of last week’s commentary, we are giving a second look to one of the key drivers of the default macro narrative: the synchronized global growth theme. In the crosshairs of this analysis is the Eurozone. The Cinderella story of 2017, with a growth trajectory in line with that of the US, seems to be morphing back into one of the dowdy stepsisters.
The Return of La Malaise
We’ve been here of course, before. The economy of the single currency zone experienced an existential crisis in 2011 as Greece’s debt debacle threatened to spread to other troubled “periphery” markets like Italy, Spain and Portugal. Mario Draghi brought it back from a near-coma with his “whatever it takes” avowal in June 2012 and the subsequent introduction of the ECB’s quantitative easing program. But growth languished until a surprising run of data last year. Production output, service sector growth, employment and confidence improved across the region. Inflation, which two years earlier seemed poised to sink into a deflation trap, rebounded and made the ECB’s 2 percent target seem almost reasonable. With Japan also joining in the fun, by the second half of last year the world’s major developed economies seemed almost to be growing in lockstep. “Global synchronized growth” became the go-to shorthand for explaining last year’s good times in risk asset markets.
But real Eurozone GDP growth for the first quarter, released yesterday, came in at 0.4 percent, the lowest quarterly figure in eighteen months. Today, the flash estimate of core inflation (excluding the energy and food & beverage sectors) shows consumer prices growing at just 0.7 percent – not exactly within striking distance of that elusive 2 percent target. As this is the first reading of the data, the jury is still out on what is driving the slowdown (or, for that matter, whether this is just a one-off bump in the road or the onset of something more prolonged).
Euro Up, Euro Down
One possible culprit for the return of stagnation is the currency. In December 2016, at the height of the “Trump trade” follies that took control of investor brains, one euro bought just $1.04. Parity was surely around the corner. Instead, the euro went off on a tear, surging to $1.20 by last fall and then as high as $1.25 earlier this year. The simple rule of thumb is that a strong currency is a drag on an economy’s net exports because it makes those exports less price-competitive on world markets. That drag takes time to show up in actual figures, though, so it is possible that a yearlong appreciation of the euro is finally starting to show up in the GDP data.
If currency is the culprit – and we don’t have enough data yet to arrive at a firm conclusion – then we may get a signal in the not too distant future that the stagnation won’t last for long. The dollar has surged against most major currencies, including the euro, since the middle of April. The euro is back down below the $1.20 threshold. The trend reversal is indicated in fairly striking fashion in the chart below. This shows a side-by-side comparison of the MSCI EU equity index in US dollar (left) and euro (right) terms over the last three months.
The “divergence” trade that many had predicted more than a year ago, with a growing gulf between tighter monetary policy in the US and still-accommodative measures in Europe (and Japan) may be coming into its own. A stronger dollar would be a key presumption of the divergence trade, along with widening spreads between US and Eurozone benchmark yields (the 10-year German Bund yield is around 15 percent off its recent high while the 10-year Treasury is close to its highest levels since 2014).
It is quite possible, of course, that the euro’s trajectory is not the main story when it comes to the question of what may be pushing Europe’s economy out of sync with US growth trends. Not much was ever actually fixed following the 2011-12 crisis – most policy issues and questions about member states’ economic obligations to each other were just kicked down the road to be reckoned with later. The time for reckoning may be at hand. Breaking up the “global synchronized growth” narrative is about the last thing an already jittery market environment needs.
The unseen world is a very strange place. Quantum mechanics, the physics that describes the way things work at the subatomic level, has been validated as a scientific theory again and again since its discovery in the early 20th century. Quantum mechanical laws perfectly describe the workings of literally everything electronic and technology-related in our lives. For all its mainstream applications, though, the implications of quantum mechanics are positively exotic.
Particles exist here, there and everywhere. Pairs of entangled particles instantaneously affect each other across light years of distance. Single photons display wave interference patterns until observed, at which point the wave collapses into a particle with a definitive position in space. This act of observation informs the standard explanation taught to students of quantum physics. Known as the Copenhagen theory, after the home of pioneering scientist Niels Bohr, it posits that all matter exists in a state of superposition (i.e. here, there and everywhere) until observed, at which point it collapses into recognizable forms like trees, cute puppies and Bloomberg workstations. Don’t try to understand the deeper meaning of the Copenhagen theory. Bohr and his fellow pioneers didn’t. “Just shut up and calculate” is how they, and those following, have instructed every new generation of fresh-faced (and confused) physics students.
Don’t Look Now
The subtext of the Copenhagen theory – that observation creates its own reality – resonates in the present day world of stock market volatility. It has come as a painful lesson to investors who came late to the low-volatility party of late 2017 and took bets that the calm seas would carry on. The chart below shows the price trend for the CBOE VIX, the market’s so-called “fear gauge,” over the past twelve months.
When the VIX jumps in price, as it did towards the end of January, it implies a higher risk environment for equities. To look at the above chart is to surmise that something earth-shaking caused risk to jump nearly overnight as the calendar turned from January to February. And, yet, what actually happened? A jobs report showed that hourly wages had ticked up slightly more than expected in the previous month (2.9 percent versus the consensus estimate of 2.6 percent). An “inflation is back!” meme went viral and off to the races went the VIX. Pity the poor punter holding XIV, an exchange-traded note (ETN) designed to profit from a calm VIX. That ill-fated security lost 94 percent – not a typo – of its value in one day, and the ETN’s fund manager announced that the fund would shut down as a result.
Ninety four percent. On account of one lousy wages number. How could this happen? The answer, dear reader, lies in the observer. Risk is a statistical property, a measurement of variance in price. But – as we can see from securities like that poor XIV – it is also an object, a monetized claim. And that has deep implications for equity and other asset markets.
Goodhardt’s Law and the VIX
Charles Goodhardt was an economist who in 1975 made the following observation: “Once a measure becomes a target, it loses the very properties that made it a good gauge to begin with.” Goodhardt’s Law could also be called the Copenhagen Theory of Market Risk. Once you treat risk – volatility – as an object of buying and selling rather than just as a passive statistical measure, you distort what that measure is telling you. Referring back to the chart above, the world did not change in any meaningful way between Friday, February 2 and Monday, February 5. No macroeconomic statistic other than that one random wage number suggested that the economy had changed in any radical way. And yet if you held an asset on Friday morning betting on things staying more or less the same, you were wiped out by the end of the day the next Monday (even though things had more or less stayed the same). Fundamental risk hadn’t changed. But the perception – the observation – of risk created the reality of a 94 percent price drop.
This fact has profound implications for asset markets. The measurement of risk is absolutely fundamental to the models that have informed the construction of portfolios since Harry Markowitz and William Sharpe pioneered the concepts of mean-variance analysis in the 1950s and 1960s. When that measurement ceases to be a “good gauge,” in Goodhardt’s formulation, the ability to arrive at informed valuations for many other assets is itself at risk. Modern Portfolio Theory is the name given to Markowitz’s and Sharpe’s legacy. Increasingly, though, that legacy has to navigate a postmodern financial marketplace.
In the stock market, as in life, all is not equal. In the case of the S&P 500, the inequality derives from that simplest of mathematical formulas: share price times number of shares outstanding – i.e., market capitalization. The importance of any industry sector – from the standpoint of its influence on the total market – is simply a function of the market caps of all the companies in that sector added up. Simply put: the larger the market cap of an individual company or industry sector, the more impact their price movements have on the broader index.
Market Cap Economics 101
Investors have been getting a crash course in market cap economics over the past several weeks as the most dominant sector – and that sector’s most dominant constituents – have battled some unusually strong headwinds. Information technology – one of ten primary industry sectors in the S&P 500 – makes up just under 25 percent of that benchmark index’s total market cap. That is by far the largest single sector: financial institutions, the second largest, make up just 14.3 percent of total market cap at current values. Moreover, the four largest companies in the S&P 500 tech sector – Apple, Alphabet, Facebook and Microsoft – account for 11.1 percent of the total. Add in Amazon – widely considered a tech company although formally listed in the consumer discretionary sector – and you have five companies with a collective market cap of 14.1 percent of the S&P 500 – nearly as much as the entire financial sector. That explains why the following chart has so many investors on edge today:
The main tale of woe has centered around just one of these behemoths, Facebook, which is caught in the crosshairs of a rapidly evolving controversy over its data privacy policies. The story of Cambridge Analytica, a secretive data firm with an affinity for right wing politics and a 2016 mission to help get Trump elected, has been given thorough coverage in mainstream media outlets and does not need rehashing here. The issue is why this story, which at first glance would appear to be company-specific, has thrown such a wet blanket over the entire sector. As the chart above shows, the decline of the tech powerhouses in late January and early February was more or less in line with the market, while the sector’s decline in March has been relatively far more severe.
The answer is that, while Facebook has one business model, Alphabet (Google) another and Apple another still, issues like data privacy and network effects (which can potentially lock in users and lead to concerns about monopolistic practices) affect all the so-called “major platform companies.” In a sense, these recent developments are the flip side of the very reason for which investors have been in love with these companies for so long. Their platforms have radically changed the way a majority of Americans go about spending their days and nights. Actively managed investment funds, seeking that elusive (and probably illusory) “alpha” to beat the market, have swarmed into the so-called “FAANG” stocks like moths to a flame in the belief that these platforms are nearly impervious to competitive challenge.
Beware the Grim Regulator
If the tech heavies have in the recent past seemed like a free lunch, the recent travails are a reminder that free lunches don’t exist. Readers of US economic history know that the best laid plans of monopolists past have been dashed by regulatory push-back. It is by no means clear that a grim reaping is in store for the platform companies, but neither is it clear that they will continue to be given free reign to operate with no fundamental changes to their business models. As global companies, they are at the mercy not only of regulators at home, but arguably more antagonistic ones in the EU and elsewhere. It may be a stretch to imagine Facebook as a regulated utility (a theory which has surprisingly garnered considerable recent press coverage), but it’s worth remembering that strange things do sometimes happen.
In a practical sense, the uncertainty around tech adds a variable to the volatility equation that has become a constant companion in 2018. The CBOE VIX has not fallen below 15 since the original spike in early February, and currently hovers just around 20, the level considered to be a high-risk threshold. We’re seeing lots of those strange days when stock indexes spike up in morning trading and then plummet in the trading day’s final 30 minutes – signs of a jittery market with knee-jerk algorithms calling the shots.
Amid all of this, there is still little in the way of change to the dominant narrative of steady positive growth, a strong jobs market, solid corporate earnings and inflation kept in check. That may be sufficient to yet hold the downside in check. But those volatility variables, including the fog of uncertainty around that market cap-dominant tech sector, are keeping us very busy with our scenario analytics as the year’s second quarter beckons.
Readers of a certain age might remember a perennial favorite among the many outstanding skits performed by late-night TV host Johnny Carson (hi, kids! – ask your parents or their parents). Playing a manic movie review host named Art Fern, Carson would suddenly display a spaghetti-like road map and start giving inane directions to somewhere, leading to the gag: “And then you come to – a fork in the road” at which moment he points to a space on the map where an actual, eating utensil-style fork is crudely taped over the incoherent network of roads. Ah, kinder, simpler, Twitter-less times, those were.
The fork in the road was a key theme of our annual outlook a couple months ago (no match for Art Fern in wit or delivery, but still…). Are we heading down one path towards above-trend growth powered by an inflationary catalyst, or another one characterized by the kind of below-trend, muted growth to which we have become accustomed in this recovery cycle thus far? For now, the data continue to point to the latter.
No Seventies Show, This
Carson’s heyday as host of the Tonight Show was in the 1970s, that era of cringe-worthy hairstyles, mirror balls and chronic stagflation. When the Bretton Woods framework of fixed currencies and a gold exchange standard fell apart in the early years of the decade it freed countries from their exchange rate constraints and encouraged massive monetary stimulation. The money supply in Britain, to cite one example, grew by 70 percent in 1972-73 alone. More money chasing the same amount of goods is the classic recipe for inflation, which is exactly what happened. OPEC poured flames on the fire when, as a geopolitical show of strength, it raised crude oil prices by a magnitude of five times in late 1973. A crushing global recession soon followed as industrial output and then employment went sharply into reverse, with countries unable to stimulate their way out of the mess caused by inflation.
A popular delusion in the immediate wake of the 2016 US presidential election was that some modern day variation of that early-70s stimulus bonanza was about to flood the economy with hyper-stimulated growth. Interest rates and consumer prices would soar as the new administration tossed out regulations, slashed taxes, lit a fire under massive public infrastructure and induced companies to kick their production facilities into high gear. The “reflation-infrastructure trade” flamed out a couple months into 2017 (though CNBC news hosts never got tired of hopefully invoking the shopworn “Trump trade is back!” mantra for months afterwards, every time financial or materials shares had a good day).
Herd-like investor tendencies aside, though, there was – and to an extent there continues to be – a case to make for the return of higher levels of inflation. Economies around the world are growing more or less in sync, which should push both output and prices higher. Taxes were indeed slashed – the one piece of the reflation trade puzzle that actually transpired – and as a result the consensus estimates for US corporate earnings have moved sharply higher. And yet, the numbers keep telling us something different.
Secular Stagnation Then, and Now
When we say “numbers” we refer generally to the flow of macroeconomic data about growth, production, consumption, labor, prices et al, but we’ve been paying particular attention to inflation. The core (excluding food and energy) Personal Consumption Expenditure (PCE) index, which is how the Fed gauges inflation, has been stuck around 1.5 percent for seemingly forever. This past Tuesday gave us a fresh reading on the core Consumer Price Index (CPI), the one more familiar to households, holding steady at 1.8 percent. We also got another lackluster reading on retail sales this week, suggesting that consumption (the largest driver of GDP growth) is not proceeding at red-hot levels. And last week’s jobs report showed only a modest pace of hourly wage gains despite a much larger than expected increase in payrolls. These numbers all seem to point, at least for now, towards the path of below-trend growth. Perhaps the bond market agrees with this assessment: the yield on the 10-year Treasury has been cooling its heels in a tight range between 2.8 – 2.9 percent for the past several weeks.
The economist Alvin Hansen coined the phrase “secular stagnation” back in the late 1930s, at a time when it seemed that long term growth lacked any catalyst to kick it in to a higher gear. We know what happened next. The war came along and rekindled productive output, followed by the three decades of Pax Americana when we ruled the roost while the rest of the world rebuilt itself from the ashes of destruction. Former Treasury Secretary Lawrence Summers brought the term “secular stagnation” back into popular use earlier in this recovery cycle. The numbers seem to tell us that this remains the default hypothesis.
But the story of the late 1930s reminds us that all a hypothesis needs to knock it off the “most likely” perch is the introduction of new variables and resulting new data. Foremost among those variables would be productivity (hopefully productivity from benign sources, and not from hot geopolitical conflict). It may well be that we have not yet arrived at that “fork in the road” but are still somewhere else on Art Fern’s indecipherable road map – and that a new productivity wave will pull us off the path of secular stagnation. The data, though, aren’t helping much in signaling when, where, and how that might happen.