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MV Weekly Market Flash: Our 2018 Investment Thesis

January 19, 2018

By Masood Vojdani & Katrina Lamb, CFA

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We will be publishing and distributing our Annual Outlook next week, a 24-page opus reflecting not only our analysis of the quotidian variables likely to be at play in the economy over the coming twelve months, but also a commentary on today’s world in a larger historical context. Meanwhile, we will use the opportunity of this week’s regular commentary to share with you the executive summary from the forthcoming Outlook, to give you an advance look of what you will read in further detail next week.

• “Moderate growth, low inflation, improving labor market”: this would have been a reasonable way to characterize US economic trends in 2013. And in 2014, 2015 and 2016. So it was not exactly an earth-shaking surprise when 2017 delivered…yes, moderate growth, low inflation and a still-improving labor market, if the latter slowed down just a bit in net new job creation. Tracking the macroeconomy has become something akin to watching daily episodes of Seinfeld. Not much of any consequence ever happens, and every now and then some amusing diversion appears to briefly engage one’s attention. Try as we might to unearth some new piece of information suggesting the approaching end of this placid state of affairs, we cannot. The data say what the data say. 2018, for the moment, looks set to deliver more of the same.

• The key difference between 2017 and earlier years in this recovery cycle was that the rest of the developed world came on board. Organic demand and consumer confidence perked up in the Eurozone, Britain managed to at least temporarily forestall a reckoning with the consequences of Brexit, Japan stayed positive while ex-Japan Asia Pacific countries did just fine. China, meanwhile, met its growth benchmarks by initially going back to the tried and true mix of debt-sourced spending on infrastructure and property. Beijing reversed course midyear, though, with a concerted program to reduce borrowing and recommit to economic rebalancing (this coincided with a further consolidation of power by President Xi Jinping). Elsewhere in emerging Asia and beyond, concerns about looming trade wars faded and domestic assets, including long-beleaguered currencies, perked up for a winner of a year. Again – while there are plenty of geopolitical variables that could form into tangible threats at any time – the basic macroeconomic variables appear stable. Markets ignored geopolitics last year, we expect them to do the same in the year ahead.

• Calendar-gazers are filling up the airwaves with the observation that the current recovery – from July 2009 to the present – is one of the longest on record. If we manage to avoid a recession between now and May, the current growth cycle will move ahead of that of 1961-70 as the second-longest, trailing only the ten years of good times from 1991 to 2001. To those nervously ticking off elapsed calendar days we offer two ripostes. First, markets and economies don’t pay attention to calendars, which are entirely a human construct. Second, there are potentially valid reasons why the current uptrend could go on for longer. From 2009 to 2014, arguably the main force behind continued growth was the Fed and its quantitative easing mechanics that flooded the world with money. Only more recently has the growth started to look more traditional – more like actual improvements in business and consumer sentiment begetting a virtuous cycle of increased supply feeding increased demand. If anything, the perky demand trends we see today more resemble those of an early than of a late stage in the cycle. The uniqueness of that multi-year experiment in unorthodox monetary policy may make comparisons with other growth periods less meaningful.

• So if the default assumption is that 2018 will be a year of very few changes to the presiding macroeconomic trends, what alternative scenarios could upend the base case? The key X-factor, we believe, is the one that nobody from Fed governors to that fellow holding court at the end of the bar completely understands; namely, the curious absence of inflation. The inflation rate has fallen short of the Fed’s explicit target of 2 percent throughout the entire recovery to date (when excluding the volatile categories of energy and foodstuffs). This despite the dramatic fall in the unemployment rate from 10 percent at its peak to just 4.1 percent today. The economic models built over the decades following the Second World War baked in the fundamental assumption of a trade-off between inflation and employment: be prepared to sacrifice one in pursuit of the other. That assumption has not held up at all in recent years. But before pronouncing last rites on the Phillips Curve, we again draw your attention to our observation in the previous bullet point: the kind of growth one normally sees early in a recovery cycle may only now be showing up. If so, then a sudden surge of higher than expected inflation would not be entirely implausible.

• The second alternative scenario that could disrupt the smooth sailing of most capital markets asset classes would be, perhaps, the other end of the spectrum from a growth-fueled resurgence of inflation. The Fed intends to raise rates again this year – three times if the stated expectations of the FOMC’s voting members are to be believed – and to begin winding down the balance sheet that grew to $4.5 trillion over the course of the QE years. These intentions reflect a confidence that the economy is fully ready to stand on its own two feet – which confidence, of course, proceeds from those same steady macro trends we described a few bullet points ago. But there is still a chance, and not necessarily a small one, that today’s bubbly sentiment is ephemeral and will dissipate once the crutch of monetary policy is finally and conclusively removed. Specifically, not one of the three structural drivers of long-term growth – population, labor force participation and productivity – are demonstrably stronger now than they were two years ago when we devoted some number of pages in our Annual Outlook to the concept of secular stagnation. There may be less to the current growth uptick than meets the eye. If so, a Fed misstep on the pace of unwinding easy money – too much, too soon – could be the trigger that boots the Goldilocks economy to the exit door.

• What both those alternative scenarios – an unexpected inflation surge and a Fed policy fumble – have in common is the potential to wreak havoc on credit markets. From an asset markets perspective, credit markets hold the key to how virtually any asset class – debt, equity or alternative – will perform. Here’s why. The risk-free rate – in general practice the yield on intermediate / long Treasury notes – is employed in just about every standard asset valuation model. All else being equal, an increase in interest rates has the effect of decreasing the present value of future cash flows. Asset managers will reprice their models if reality outstrips expectations about yields. A likely ripple effect resulting from a Treasury rate repricing would be widened risk spreads (affecting, for example, corporate investment grade and high yield bonds), a pullback in equity prices and a commensurate uptick in volatility. Whether the riskier conditions persist would be situation-specific, but there would very likely be at least some damage done.

• Again, we view these as alternative scenarios to be a more benign base case. Even if one of the other were to come to pass, though, it would not necessarily start the clock on a countdown to the end of this long bull market. For that to occur, we believe one of three events would have to emerge: a full-blown recession (which is different in nature from a periodic surge in inflation), a crisis such as the implosion of the financial system that led to the 2008 crash, or the outbreak of an actual hot war somewhere in the world that significantly involved the US and/or other large powers. The risk of any of these things happening in 2018 is not zero, but we would ascribe a probability of less than 25 percent to any of them.

• US equity valuations are stretched, particularly for the large cap growth segment of the total market that has consistently outperformed over the past several years. Relying on relative valuations alone would potentially lead investors to other areas, like Europe or emerging markets, that still have some catching up to do even after a strong performance in 2017. In the long run valuations matter – there is no coherent way to view a share price as anything other than the present value of a series of future cash flows. In the short run, valuations don’t always matter. Relative geographic performance in 2018 will be subject to other influences, not least of which will be the direction of the US dollar.

• The dollar was one of the big surprise stories of 2017. Long before equity shares in financial institutions or resource companies snapped out of their “reflation-infrastructure trade” myopia, the US currency had done a U-turn from its rapid post-election ascent. The dollar fell by nearly 10 percent against a basket of other major currencies last year, and that soft trend has continued thus far into 2018. Currency strength was a major force driving performance for developed and emerging market equities and debt last year. Whether a reprise of that trade is in store for the year ahead depends – again – on that tricky combination of alternative economic scenarios. If US interest rates rise substantially, with the ECB and the BoJ at the same time proceeding more cautiously, then a stronger dollar would be a rational expectation as investors pursue higher yields. That outcome is not set in stone, however. Major foreign investors – most notably China – may look to diversify their foreign exchange assets if their perception of US risk changes, which would, all else being equal, have a negative effect on the dollar. 

• Commodities may stand on the other side of the dollar’s fortunes. A weaker dollar makes commodities more affordable in other currencies; that, along with the return of strong organic demand, may supply a tailwind to a range of energy and industrial commodities. But oil, which has recently surged to its highest levels in three years, remains vulnerable to the prospect of increased shale production in the US. As with currencies, there are many factors at play that could work either for or against key commodity classes.

• In conclusion, we could sum up the essence of our views thus: Things Don’t Change, Until They Do. The benign tailwinds of moderate, steady global growth will not last forever. Neither we nor anyone else can point with certainty to the date when the sea change happens. What we can do is pay close attention to the things that matter more. Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.

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MV Weekly Market Flash: Exuberance and Edginess

January 12, 2018

By Masood Vojdani & Katrina Lamb, CFA

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The S&P 500 has appreciated 3.6 percent in price terms in the first eight days of trading this year. It seems highly unlikely that the index will match this pace for the year’s remaining 242 trading days, so it’s reasonable to wonder what’s going to happen next. It’s always a fool’s errand to predict the timing and magnitude of future price movements; for clues, though, one’s best bet would probably be to follow the bond market. Amid all the exuberance in equities, there is a palpable edginess in the once staid world of fixed income. That edginess was on full display for a few hours Wednesday morning. A rumor floated out that China’s monetary authorities (who also happen to be the world’s principal consumers of US Treasury debt) were considering scaling back their purchases of US sovereigns, presumably as a cautionary move to diversify the composition of their foreign exchange reserves. Bond yields spiked immediately, and the 10-year yield shot up perilously close to last year’s high mark of 2.63 percent. That’s also the 10-year’s peak yield since the crazy days of 2013’s “taper tantrum” – remember those good times? The chart below shows the 10-year yield trend over the past five years. 

At the Mercy of Supply and Demand

Wednesday’s mini-panic dissipated soon enough; the 10-year yield fell back and remains, as we close out the week, around 5 to 8 basis points below that 2.63 percent threshold (a handful of bond pros out there believe markets will all go haywire if that threshold is breached, for reasons with which we don’t necessarily agree). The Chinese put out an anodyne denial of any intentions to scale back Treasury purchases. The S&P 500, which Wednesday morning futures indicated could suffer a meaningful pullback, briskly resumed its winning ways. And all the while volatility has remained in the fetal position which has been its custom for the last year.

But that hair-trigger reaction to the China rumor underscored just how antsy the bond market is right now, and how exposed it is to the basic laws of supply and demand. Bear in mind that intermediate and long term bond prices are subject to many variables, while short term bonds tend to much more closely track the Fed. One of the key drivers keeping yields in check for the past several years has been robust demand from overseas – robust enough to make up for the reduction in demand at home when the Fed ended its quantitative easing program. If international investors turn sour on US credit – for whatever reason, be it inflationary concerns, a bearish outlook on the dollar or even jitters over our chaotic politics – that has the potential to push yields well past the notional 2.63 percent ceiling. A subsequent move towards 3 percent would not be out of the question.

Visions of 1994 Dancing In Their Heads

The bond market angst has its own mantra: “Remember 1994!” That, of course, was the year the Greenspan Fed surprised the markets with an unexpectedly aggressive interest rate policy, starting with a rate hike nobody was anticipating in February of that year. Investors will remember 1994 as being a particularly roller-coaster one for stocks, as the surprise rate hikes caught an ebullient bull market off guard. The chart below illustrates the volatile peaks and valleys experienced by the S&P 500 that year.

Now, the conventional wisdom in 2018 is that the Fed will do its utmost to avoid the kind of surprises the Greenspan Fed engineered over the course of 1994 (which included a surprise 50 basis point hike in the middle of the year). But investors are also cognizant of the reality that there are new faces populating the Open Market Commission, which of course will feature a new chair in the person of Jerome Powell. All else being equal, the new Fed is likely to proceed cautiously and not risk unnerving markets with a policy surprise. But all else may not be equal, particularly if we get that inflationary surprise we’ve been discussing in a number of these weekly commentaries. Then, a new Fed trying to get its sea legs may face the urgency of making decisions amid a tempest not of its own making.

We’ve had some reasonably benign price numbers come out this week: core producer and consumer prices largely within expectations. Bond investors appear relieved – yields have been fairly muted yesterday and today even while equities keep up their frenetic go-go dance routine. But there is not much complacency behind the surface calm.

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MV Weekly Market Flash: Bomb Cyclones and Melt-Ups, Hello 2018!

January 5, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Sometimes the New Year starts off with a genteel slowness, allowing folks to ease their way back into the normal routine of things after the holidays. Sometimes, though, the New Year accelerates from zero to eighty in the space of barely a day. 2018 seems a likely candidate for that latter description. Not that any of the headline events thus far appear much different from those that dominated 2017 -- crazy weather, even crazier politics and a stock market that seems to only know how to go one way -- this is continuity, not change. It’s the tempo that’s different -- more frenetic, as if a marathon runner suddenly broke into a 100 meter sprint pace. Heaven help us if we have this much breaking news to digest for each of the next 51 weeks.

Let the Good Times Roll

The nascent economic headlines of 2018 could be summed up with a single folksy refrain: “and the skies are not cloudy all day.” Business confidence indicators are close to decades-long highs, global GDP is predicted to come in around 3.7 percent, and US corporate earnings are positioned for a year of double-digit growth. The first job numbers out this morning were a bit slow on payroll gains, but wage growth stayed predictably on-trend at 2.5 percent.

Perhaps more significant than earnings, which represent the company’s bottom line net profit, is the outlook for top-line sales. After languishing for years at near-flat levels, sales for S&P 500 companies this year are estimated to grow in mid-to-high single digits. Sales are in many ways a more useful economic measure than earnings, as they are less affected by all the arcane accounting gimmicks that pile up as one goes down each line of the income statement. Strong sales suggest that global demand is back in a meaningful way. Most importantly for investors, sales and earnings growth can provide a steady tailwind for continued gains in share prices.

The Market’s Post-QE Life

Is that rosy economic and earnings picture strong enough to withstand the final coda on supportive monetary policy? So far, so good -- the Fed has managed to wind down QE and raise rates a few times without upsetting any apple carts. Investors will be watching the final acts of monetary stimulus play out in several venues this year. While the Fed plans to continue with rate hikes and to get on with reducing its balance sheet, the ECB will need to provide clarity on timing for winding down QE, and even Japan is expected to start applying the brakes on its expansive embrace of the Japanese Government Bond market.

Assuming that the overall macro/earnings picture doesn’t change much from what the numbers tell us today, we do not see any particular reason why an orderly winding down of global monetary stimulus should be disruptive to financial markets. The caveat to this, as we have discussed on numerous occasions, is that a sudden resurgence of inflation in wages and consumer prices could pressure the Fed to take more dramatic action, which would likely result in a radical repricing of bonds and, by extension, most risk asset classes.

The Dollar Conundrum

One asset that has not fared well thus far this year is the world’s reserve currency. The US dollar fell against most of its major trading currency partners this week, sending the euro back up over $1.20 while the pound sterling and Aussie dollar also rallied. Investors appear curiously bearish on the greenback. Strong corporate earnings and expected higher bond yields from Fed action should make dollar-denominated assets attractive. There does not appear to be a single compelling narrative to explain dollar weakness, with opinions varying from uncertain domestic politics ahead of the November midterm elections to a vague sense of “better opportunities elsewhere.”

We do not necessarily share the bearish consensus on the dollar. Washington shenanigans, for all their train wreck-like “must-look” qualities, are likely to have little impact on actual economic activity. As for “elsewhere” -- well, there are plenty of risks where those other opportunities may lie. Europe’s optimistic headlines aside, there are plenty of challenges ahead both economic and political for the currency union. China is once again intent on reining in the highly leveraged sectors of the economy that it had to turn to again last year for hitting GDP growth targets. And the world trade picture is anything but assured in a world wrestling with still-potent nationalist-populist sentiments.

Watch the Numbers, Not the Pundits

All that being said, we are not quite ready to join the growing chorus of Cassandras in pundit-land warning that the bubble is nigh. Equity valuations are stretched, no doubt about it. Bargains are hard to come by. But a bubble will only truly form if share prices accelerate much faster than underlying earnings. In other words, the sprint we have seen in share gains from January 2 to today is most likely unsustainable, but a measured pace of growth over the coming months is achievable. If investors get too carried away by animal spirits and the January melt-up continues, we could expect a reversal to potentially follow. But if the larger economics & earnings picture hasn’t changed, we would expect any such reversal to be short and not indicative of a more prolonged reversal.

One way or the other, it’s likely to be an interesting year, probably at times for better and at times for worse.

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MV Weekly Market Flash: Groundhog Day in December

December 1, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Today is the first day of the last month of 2017, which means that predictions about asset markets in 2018 will be flying about fast and furious over the coming three weeks. As practitioners of the art and science of investment management ourselves, we know that quite a bit of work goes into the analysis that eventually finds expression in the “bonds will do X, stocks will do Y” type of formulations characteristic of these holiday season prognostications. A layperson might be excused, though, for concluding that all the market pros do is dust off last year’s report, or the year before, for that matter, and repackage it with the same observations. “Rates will rise because of the Fed, stocks will rise because of a stable economy and good earnings” worked for 2016 and it worked for 2017. Here’s visual proof: the price appreciation of the S&P 500 and the trend in the 2-year Treasury yield since December 2015: 

It wasn’t linear, of course. There was the technical correction in early 2016 when both stocks and rates pulled back. Still, though, investors positioned for rising short term rates and steady gains in large cap domestic stock prices would have had little about which to complain over the past two years. Which, of course, brings us to the point of today’s commentary: is it Groundhog Day again, or does 2018 have something entirely different in store?

Macro Boringness

At the heart of this curious Groundhog Day phenomenon over the past couple years is the remarkable sameness in the broader macroeconomic environment. “Moderate GDP growth, with a healthy labor market and modest inflation” is a phrase you could have uttered on literally any given day over this period and been right. The only thing measurably different about 2017 was that this “Goldilocks” set of conditions was true not just of the US, but of almost any part of the developed (and much of the emerging as well) global economy. Adding the word “synchronized” to “moderate GDP growth” gives the phrase a distinct 2017 flavor. Thus, the good news for equities disseminated into non-US markets and finally gave investors some measure of reward for diversification.
But, Inflation!

There is almost nothing in the way of macro data points today suggesting a deviation from this “synchronized moderate growth” mantra. The major question mark, as we have discussed in other commentaries, is whether inflation will ever get in line with what the Fed’s models call for and rise above that elusive 2 percent target. Now, if inflation were to suddenly go pedal-to-the-metal, that could change assumptions about risk assets and blow up the Groundhog Day framework. In particular, an inflationary leap would likely send shockwaves into the middle and longer end of the bond yield curve, where rates have remained complacently low even while short term rates advanced. The 10-year yield is right around 2.4 percent today, almost exactly where it was at the beginning of the year and in fact not far from where it was at the beginning of 2016.

The sideways trajectory of the 10-year, in fact, supplies the explanation as to why stocks could rise so comfortably alongside the jump in short-term rates. While short term rates are closely correlated to the Fed’s monetary policy machinations, longer yields reflect a broader array of assumptions – including, importantly, assumptions about inflation. The flatness of intermediate rates suggests that bond investors expect economic growth to remain moderate, and inflation low. The bond market is not priced for a high inflation environment – which is reasonable, given the scant evidence that such an environment is imminent.

Can Stocks Keep Going?

So far, so good: the economic picture seems supportive of another Groundhog Day. What about stocks? There are still plenty of alternative paths for equities to travel in 2017 (and they are going kind of helter-skelter today on some breaking political news), but a solid double-digit performance would be a reasonable prognosis (the S&P 500 is up just under 20 percent on a total return basis for the year thus far). The current bull market is already the second longest historically, and valuations are stretched. Is there more room to run?

As we write this, the tax bill which has riveted the market’s attention for most of the past two weeks has not formally passed the Senate, nor been reconciled with the earlier House version to a final bill to send to the White House. But the odds of all that coming to pass are quite good. As we have noted before, the market’s obsession with taxes has little or nothing to do with fundamental economic growth. The non-partisan Joint Committee on Taxation said as much in the report it released late yesterday on the proposed bill’s likely economic impact: at best, contributing no more than about 0.1 percent to annual GDP growth over the next ten years.

But the market’s interest in the fate of the tax bill has little to do with long-term economics, and much to do with shareholder givebacks. To the extent that the bill results in tangible cash flow benefits for corporations in the next 1-2 years (and the quantification of such benefits remains quite variable), precedent informs us that the vast bulk of such gains would flow right back to shareholders in the form of buybacks and dividends. Buybacks and dividends don’t help the economy, but they most assuredly do help shareholders. That fact, alone, could supply enough of a tailwind to keep the bulls running long enough to grab the “longest duration” mantle.

Everything’s the Same, Until It Changes

So if you read a bunch of reports over the next couple weeks that sound incredibly similar to what you read a year ago, don’t rush to the judgment that its authors are lazily phoning it in. There remain very good reasons for the Groundhog Day framework for yet another year. Gains in stocks, an increase in short term rates alongside monetary policy moves, and longer term rates tempered by modest inflation are all plausible default-case scenarios.

But never forget that any scenario is just one out of many alternative outcomes. Market forces do not pay heed to the calendar year predilections of the human species. There is no shortage of factors out there that could upend the benign sameness of today’s conditions, and they will continue to demand our vigilance and readiness to adapt.

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MV Weekly Market Flash: The Turkeys of 2017

November 22, 2017

By Masood Vojdani & Katrina Lamb, CFA

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In this holiday-shortened week, our thoughts easily start to drift towards all the delicious, rich food we will be ingesting between now and early January when we wake up with newfound determination to go out and conquer the next marathon, or the first triathlon, or just the first visit in months to the nearest fitness center. With these sentiments in mind, let us invoke the theme of turkeys for this week’s missive. The metaphorical kind of turkey, as an easy stand in for “seemed like a good investment idea at the time, but…” Now, the year has been a generally benign one for most asset classes. But there were turkeys aplenty that caught investors off guard. Here is a random selection of three of the gems that have caught our eye over the past months.

#1: The Reflation-Infrastructure Trade

In a sense, many of the year’s turkeys flow from the granddaddy of them all, the “reflation-infrastructure trade” theme that caught fire literally within minutes of Trump giving his election night victory speech. The idea behind this trade was that a new, Republican-controlled government was going to unleash a flood of new money into the world through a combination of hefty tax cuts and massive spending from both the public and private sectors on new infrastructure projects. It’s fair to say that this trade caught the vast majority of the investment world by surprise, since almost nobody expected the Republicans to capture the White House (their victories in the House and Senate were rather more predictable). But the trade dominated the last two months of 2016, with the key beneficiaries being financial institutions (net interest margins!), resource and industrial companies (lots of new projects!), the dollar and intermediate-long interest rates (because, reflation!).

The trade wasn’t a turkey for anyone who took a wager on it from November 9 through New Year’s Day and then sold out. But the fundamental rationale for the trade, which was never strong to begin with, proved wildly off base. Core inflation never breached, let alone smashed through, the Fed’s 2 percent target level. A year later, low inflation continues to exist right alongside 4 percent unemployment. In fairness, nobody including the Fed’s Board of Governors knows with assurance why this is so. As for infrastructure, anyone who has paid any attention at all to Washington politics for the last couple decades would understand that public infrastructure spending has never been a priority item on Republican policy agendas. As for taxes – again, a passing knowledge of GOP politics would lead one to conclude that, yes, tax cuts would certainly be up for legislative action, but complex, actual tax reform that broadened the base (i.e. killing off corporate loopholes) while lowering statutory rates might be a bridge too far for a party beset by fractious differences among its own members, let alone those across the political aisle.

In any event, most elements of this trade, led by the US dollar, had fizzled out by late winter. Periodically talk of the reflation trade recurs, mostly because financial news anchors love to say “the Trump trade is back!” while grinning foolishly into the camera. Caveat emptor.

#2 The Return of Volatility

The twin surprises of 2016 – the Brexit vote in Britain and the US presidential election – set the stage for much chatter about the political land mines in store for the year ahead. Mostly the prognosticators looked to Europe, where the springtime calendar included potentially explosive elections in the Netherlands and France, to be followed in early fall with the German contest. Then there were the ever-present concerns about central banks weaning dependent investors off the easy QE money, a hard economic landing in China, the possibility of trade wars with an ascendant hyper-nationalist contingent in the White House and even the possibility of actual wars as tensions ratcheted between the US and North Korea.

All these events – and many more besides – had their various days of reckoning. Each day came and went with asset price volatility barely budging from all-time lows. The CBOE VIX index, a measure of volatility dubbed the “fear gauge” by investors, had fallen below a level of 10 (the lower the VIX, the less risk) only a handful of times between its launch in 1990 and 2016. The index has closed below 10 a grand total of 40 times in the year 2017 to date, making this the “safest” year by the VIX measure in 27 years. Meanwhile the intraday volatility of the S&P 500 index is lower this year than any time since 1963. Anyone long VIX risk – and for defensible reasons! – will be ruing that bet.

Interestingly, the European election with potentially the most far-reaching consequences for 2018 may well be the one deemed the safest bet – Germany. Chancellor Angela Merkel’s CDU/CSU party came first in the elections two months ago, but has since failed to secure a governing coalition with other representative parties. Political discord in Europe’s most stable power could signal much uncertainty ahead. So far, though, markets are as relaxed as ever.

#3 Another Bad Year for Emerging Markets

We finish out our gallery of turkeys with a look at emerging markets, a surprise 2017 darling. Now, the success of emerging market (both equities and debt) is in a way the flip side of that reflation-infrastructure trade. But we believe this to be a useful morality tale on the perils of asset allocation assumptions. Let’s consider the following. As portfolio managers were making their 2017 asset allocation decisions, late last year, two things about emerging markets were known to them.

First, the asset class had performed dismally, on a relative basis, for several years. While the S&P 500 went on a tear in 2012 and never looked back, EM equities had a very bumpy ride up and down, but mostly down. US large cap stocks passed their earlier historical highs in 2013, but emerging markets remained well shy of theirs in both dollar and local currency terms (they finally regained the high ground in local currency, but not dollar terms in 2017). In fact, on a risk-adjusted basis EM equities have produced negative value relative to blue chip US stocks on an annual average basis over the past 30 years. Any quantitative asset allocation model based on some variation of modern portfolio theory would have recommended deep underweights, or zero allocation, to emerging markets.

The second thing portfolio managers knew in December 2016 was that emerging markets were getting pummeled by the reflation-infrastructure trade. What reason would there have been to make a large allocation to this asset class? Well, to be sure, there are enough contrarians in the world who, at any given time, will put their chips on asset class X because asset class X has been out of favor for a while. Some managers did that, and were amply rewarded. But – and here is the key point – that decision boils down to a single variable: luck. Asset price trends will almost always exhibit mean reversion over time. But pinpointing the time – getting that inflexion point right – is a matter of luck. Emerging markets did well in 2017. They may well do so again in 2018 – or they may not. But questions about the long-term underperformance of this asset class are not answered by a single year’s outcome.

There will be much at stake in 2018. As always, we and our fellow practitioners in this industry will be diligently at work over the next several weeks to try and figure out how to be positioned for 2018 and beyond. Meanwhile we leave you with this sentiment: may the turkeys be on your dinner table, and not in your portfolios. Happy Thanksgiving!

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