Posts tagged Current Market Trends
One of the odder stories in a year of general strangeness in the capital markets is emerging markets. Contrary to the vast majority of expectations in the wake of last November’s presidential election, this asset class has been the darling of diversified portfolios in the year to date. The MSCI Emerging Markets index was up more than 28 percent YTD at the end of the third quarter – double the performance of the not shabby 14 percent logged by the S&P 500. Nor is the good news limited to equities; EM currencies have mostly risen against the dollar. Perhaps to underscore the weird irony of the situation the Mexican peso – the currency on the receiving end of all those nativist threats of security walls and trade wars and the like – has gained more than 15 percent against the dollar since January 1.
Reclaiming Lost Heights
In local currency terms, emerging markets equities reached all-time highs this year. In the dollar terms by which US-based investors measure their profits, though, EM stocks still have a bit of ground to make up from their peak during the great growth spurt of 2003-07. The chart below shows the MSCI EM Index (in dollar terms) for the past 15 years.
That 2003-07 run came courtesy of several factors unlikely to repeat themselves. These were the years of the great China boom: the country’s record-breaking surge to become the world’s second largest economy and largest producer / consumer of so many raw materials and finished goods happened in what seemed the blink of an eye. These years also witnessed what is likely to be the final phase of an extended commodities supercycle, which gave resource exporters like Russia and South Africa a few extra points of GDP growth to tack on. Emerging markets became synonymous with “growth” – often real GDP growth of the double digit variety.
Then it all came crashing down. The financial follies concocted in the quant labs of Wall Street and the City took down emerging and developed asset markets alike. The slow pace of growth in the ensuing global recovery has not been kind to many of those former growth market Wunderkinder. Brazil and Russia experienced deep recessions, South Africa and Turkey faced increasingly onerous repayment burdens on their outstanding dollar-denominated borrowings, and China has grappled with the complexities of managing stable currency and credit markets while still trying to hit their growth targets. Given all the challenges, perhaps the most surprising thing about that chart shown above is that this asset class didn’t fare worse than it did during those sideways years of 2010-16.
What Flavor Crisis This Decade?
So where do they go from here – and are investors wise or foolish to follow? One of the important things an investor should always keep in mind about emerging markets is their dynamism – in the sense that the composition of these economies changes more fluidly from year to year than their developed world counterparts. Their installed base of productive resources, their monetary policies and the consumption habits of their citizens are all vastly different today from what they were fifteen or twenty years ago.
That is important because it was precisely twenty years ago that emerging markets fell into one of their periodic traps that turn investors’ stomachs. A crisis in the baht, Thailand’s national currency, went viral and wreaked havoc on currencies and central bank balance sheets from Seoul to Jakarta and beyond. A year later Russia defaulted on its sovereign debt obligations, swallowing up local punters and rich world hedge funds alike. There is a “crisis a decade” school of thought among long-term EM observers, going back to the Latin American debt crises of the 1970s and 1980s to Asia and Russia in the 1990s, Argentina in the 2000s and on and on.
The practical effect of these crises is well-documented: never contained as a local affair, the pain spreads as investors treat their emerging market exposures as one asset class. Never mind if Argentina and Malaysia have almost nothing in common: they rise together and fall together in the capricious ebbs and flows of portfolio capital. For this reason, the asset class as a whole has been a long term loser. Since the beginning of 1990, the average annual return of the MSCI EM index has been about 1 percent lower than that of the S&P 500 – but the risk, measured by standard deviation, has been a full 8 percent higher. “No gain, lots of pain” sums up this portfolio contribution.
Traps Old and New
It would be unwise to project the failures of 1997-98 onto possible negative scenarios for the near future. EM central banks have become much more robust in terms of foreign exchange reserve defenses, and their vulnerability to developed market currencies is mitigated by a growing portion of local currency credit instruments to fund their domestic investment initiatives. Many emerging markets today look…well, less “emerging” and more mature than they did even a decade ago.
But with maturity comes a new set of challenges, and potentially new kinds of traps. Resource exporters like Russia and South Africa will remain vulnerable to a potential weak secular cycle in commodities. Countries whose primary source of competitive advantage is cheap labor are at risk in a world where AI threatens to upend traditional employment patterns in industry after industry. Technology is widening the gap between the handful of companies able to leverage leading-edge technology in their business models and the legions of stragglers struggling to keep up. These are all traps that could trip up countries and regions in that delicate transition from widespread poverty to wealth. And all of this is to say nothing of the lurking threat of protectionism and nationalist nativism from disgruntled voters and their political avatars in the US or the EU.
The developed world is not growing quickly, and this pattern is likelier than not set to continue. If the combined heft of emerging markets can unlock a formula for higher sustainable growth then these markets are worth keeping in strategic asset allocations – and one would expect the risk-return composition to be more favorable than it has been in the past. But these are still significant ifs. We believe investing in emerging markets will call for more nuance going forward, starting with the practice of not treating this widely diverse collection of markets as one asset class.
Another week, another string of record highs for U.S. equities. But this wasn’t just your normal “upward drift for no particular reason” set of days. It was an “upward drift for no particular reason AND a 20 year record smashed!” sequence of new highs. Yes, the last time the S&P 500 recorded six consecutive all-time records was in June 1997, back when the Spice Girls were telling us what we want, what we really, really want. And while prices continued their inexorable ascent, volatility continued to plumb new lows. The CBOE VIX index, the market’s so-called “fear gauge”, suggests that times have never been safer for equity investors: the index has closed below 10 more times in 2017 than in any other year since the VIX first launched in 1990.
The Great Risk Conundrum
This presents a conundrum: while the S&P 500 is more expensive than any other time in the past hundred years (the heights before the market crashes of 1929 and 2000 being the exceptions), it is also serenely placid. Contrast today’s environment with the stretch of market history leading up to the 2000 dot-com crash. The chart below shows the VIX index price trend from 1998 to the present.
The contrast between today and the late 1990s is noteworthy. The S&P 500 reached a then-all time high of 1527 in March 2000. As the above chart shows, though, the final two years of that bull market came with exceedingly high volatility. A VIX price of 20 or higher is considered to be a high risk environment; the index remained above that level for much of the final stretch of that raging bull market. In the mid-2000s the situation was different, but the VIX still was consistently trading at elevated levels well in advance of the 2008 crash.
See No Evil, Hear No Evil
During both of those earlier periods (i.e. 1998-2000 and 2006-2007) markets were jittery for a variety of reasons. Periodic pullbacks in the stock market reflected these concerns – in particular, the Russian debt default of 1998 that led to the collapse of hedge fund Long Term Capital Management, and then, in early 2007, the failure of two Bear Stearns mortgage-backed funds that turned out to be the canary in the coal mine for the broader financial system meltdown. In both cases, investors would eventually buy the dip and keep the damage contained, but markets would remain in an elevated state of nervousness until the bottom finally fell out.
The message the market sends today is entirely different; namely, that there is literally nothing out there in the big bad world that could have an adverse impact on risk asset markets. Arguably, the one single issue able to move investors to action (in a positive direction) for the past twelve months has been tax reform. This trend, which we highlighted in last week’s column, continues with a vengeance despite a lack of hard evidence that any kind of truly meaningful, broad-base reform will emerge out of the current Congress and White House. Apart from taxes, though, the market seems content to channel its inner Metallica and proclaim that “nothing else matters.”
Even if the “reflation trade” that springs from tax reform hopes dies out again – like it did back in February – we think it more likely than not that the market would simply revert to form and drift ever so gently upwards. Why wouldn’t it? The global economy, if not particularly inspiring, is at least in relative harmony with growth occurring in most major regions encompassing both developed and emerging markets. Not a single piece of headline macro data suggests that the current recovery cycle has peaked. Quite the opposite: when economies peak they tend to overheat, in the form of escalating prices and wages. This simply has not happened. As long as it doesn’t happen, the Fed and other central banks will have a great deal of latitude in guiding their balance sheets and policy actions back towards some semblance of normal.
Thus the “sunny skies” portion of today’s column title. The “swan songs” bit refers to the black swans – the unexpected events that can suddenly emerge from the murky sea of risk factors and knock Ms. Market off her game. We know from observing market behavior this year that the bar is high indeed for the kind of black swan that could have an impact. But the very definition of a black swan is something you can’t name because you have never seen it before – so you have no way of quantifying what it is before it happens. Presumably there will be such swans in our not too distant future. One or two such events could even be of such import as to keep market volatility elevated for longer, akin to that stretch of bull market between 1998 and 2000. Then – and perhaps only then – do investors’ thoughts turn seriously to questions of more defense in their allocation strategies.
Gentle reader, please indulge us our seeming obsession with the subject of inflation. Yes, we know that other macro metrics matter as well, but inflation is both the big mystery – as we discussed in last week’s column – and arguably the heavy hand pushing and pulling the market to and fro. Today we focus more on this “actionable” aspect of inflation. Or, to perhaps be more precise, we focus on the curious case of a market with the stars of an imagined reflationary surge sparkling in its eyes – in the very same week when yet another month’s reading informs us that a pick-up in inflation is nowhere to be seen in the real world.
Not Dead Yet
It really doesn’t take much, even after all this time. The so-called “reflation-infrastructure trade,” which financial pundits necessarily rebranded as the “Trump trade,” died an unofficial death back in the first couple months of the year. That’s about the time when the US dollar swooned at the feet of a soaring euro and Aussie dollar, and value stocks in sectors like financials and energy ceded the high ground to their growth counterparts in tech.
But 2017 is, if nothing else, the year of endless lives, whether it be multiple attempts to repeal and replace healthcare policy or the renewed insistence that hypergrowth-fueled inflation is just around the corner. “The Trump Trade Is Back!” screamed Bloomberg News on Wednesday, joined by a chorus of like headlines from Yahoo! Finance, Business Insider and others. Once again financial institutions and resource companies were the market darlings. Bond yields perked up. Even the beleaguered dollar took a victory lap or two. Mr. Market was ready to party like it’s late 2016.
A Framework of an Outline of a Plan
The catalyst for this week’s effervescence, of course, was the release on Wednesday of a tax reform framework. It wasn’t really a plan, because plans generally contain details about specific sources of revenues and costs over a defined time frame, grounded in plausible assumptions. The major assumption made by the authors of this framework is that it will somehow deliver anywhere from 3 to 6 percent (depending on whom in the administration you care to believe) in long-term sustainable growth.
Now, given that we have not experienced real GDP growth of that caliber for many decades, it would be reasonable to believe that a boost of that magnitude would beget more inflation, hence higher interest rates, hence the improved fortunes of banks and oil drillers and the like. Unfortunately for the credibility of the proposal’s framers, the plausibility of sustained growth at those levels is vanishingly low. The Fed’s median estimate of US long-term growth potential is 1.8 percent. Earlier this year the Congressional Budget Office estimated that if all the fiscal stimulus measures proposed at one time or another by the new administration (tax reform, infrastructure spend and all the rest) were successfully implemented, it could add one tenth of one percent to long term growth. So the Fed’s 1.8 percent would become 1.9 percent, hardly reason to break out the Veuve Cliquot.
Back in the Real World
Meanwhile Friday morning delivered yet another Debbie Downer data point to the market’s Pollyanna. The personal consumption expenditure (PCE) index, the Fed’s preferred inflation measure, came in for the month of August below consensus expectations at 0.1 percent. That translates to a 1.3 percent year-on-year gain, matching its lowest level for the past five years and well below the Fed’s elusive 2 percent target. We imagine this reality will likely show up again soon enough in the bond and currency markets (which also were the first to ditch the Trump trade back in February). But the stock market is a different animal. Is there enough wishful thinking to keep the reflation trade alive long enough to get through the tricky month of October and into the usually festive holiday trade mindset? Perhaps there is – money has to go somewhere, after all. At some point, though, reality bites back.
In our commentary last week we made brief mention of the surprising strength of foreign currencies versus the US dollar in the year to date. This week served up yet another helping of greenback weakness, and it is worth a closer look. Perhaps the most intriguing aspect of the dollar’s stumble is how broad based it is, across national economies with very different characteristics. Consider the chart below, which shows the value of two developed market currencies (Eurozone and United Kingdom) and two emerging markets (Brazil and India) versus the dollar.
Brevity of the Trump Trade
As the above chart shows, all four currencies (and just about all others not pictured here) fell sharply against the dollar in the immediate aftermath of the US presidential election last November. Recall that asset markets broadly and quickly coalesced around the notion of a “reflation-infrastructure trade,” premised on the belief that swift implementation of deep tax cuts and a torrent of infrastructure spending would spark inflation in the US and send interest rates sharply higher. Even today, there is no shortage of lazy punditry in the financial media reflexively blurting “Trump trade” every time the stock market turns higher.
But the currency markets long ago signaled the non-existence of the reflation pony in the back yard. In most cases, the foreign currencies’ upward trajectory began late last year or in the first month of 2017. Despite some localized setbacks (e.g. the latest shoe to drop in Brazil’s ongoing political scandal back in May), that upward momentum has continued and gained strength. Even in Great Britain, the negative sentiment surrounding the woeful state of Brexit negotiations has been outweighed by even stronger negative sentiment against the dollar.
Many Stories, One Sentiment
So what is behind this singular sentiment that seems to pervade all continents and economies in various stages of growth or disarray? How long is it likely to last? One of the most popular themes, certainly for much of the summer, has been the perception of stronger growth in the Eurozone. ECB Chair Mario Draghi’s comments on the better than expected growth trend back in late June immediately catalyzed another leg up against the dollar, not just for the euro but for other, seemingly unrelated, currencies. A new consensus set in that the ECB would begin tapering its bond purchases sooner than planned, and Eurozone rates would trend up accordingly.
That’s fine as far as it goes, but there would appear to be more to the story. First of all, the Eurozone may be growing slightly faster than expected, but it is hardly going gangbusters. In fact, the real GDP growth rates of the US, Eurozone and Japan are curiously symbiotic. Inflation in all three regions remains well below the 2 percent target of their respective central banks. And then there is the curious case of the euro’s recent strength even while bond yields have once again subsided. The chart below shows the YTD performance of the euro and yields on 10-year benchmark Eurozone bonds.
The spike in intermediate bond yields that followed from Draghi’s June comments has almost completely subsided back to where it was before that. Part of this, we imagine, is due to a more muted ECB posture recently, both at the Jackson Hole summit a couple weeks ago and in comments following the bank’s policy meeting this past week. The falling yields also have to do with a slightly more cautious tone that has crept into risk asset markets as investors take stock of geopolitical disturbances and the disruptive effects of the hurricanes that continue to make headlines in the southern US and Caribbean islands.
None of this would indicate to us that going bearish on the dollar is some kind of “fat pitch” trade, there for the obvious taking. In a world of relatively low growth, the US remains an economic leader in many key sectors from technology to financial services. It would only take a couple readings of higher inflation to bring back expectations for a third rate hike by the Fed and renewed commitment to balance sheet reduction. Recoveries elsewhere in the world are likewise not immune from setbacks that could necessitate a redoubling of stimulus.
That said, national currencies do, to some degree over time, reflect general sentiment towards the prospects of the home nation. Right now, it would be fair to say that those views are mixed, and not necessarily trending in the right direction, as concerns the US. Whether that leads to further dollar weakness or not is by no means certain, but it is increasingly a trend that cannot be ignored.
Talk of endurance is all the rage these days. Fall race season looms for runners and triathletes contemplating their next attempt at 26.2 or 140 or whatever mileage benchmarks await the end of the arduous training programs through which they (we!) have been slogging all these humid summer months. In markets, too, endurance is the word of the moment, and not just in stocks. Sure, we’re into the ninth year of the equity bull market that began in March 2009, which counts by most calculations as the second-longest running bull on record. But that pales in comparison to the granddaddy of all distance runners. The bond market produced yields in the stratospheric heights of 20-odd percent in 1981, then rallied as the Fed broke the back of double-digit inflation. We’ve been in a bond bull ever since.
New Challengers Emerge
Alongside these elite harriers we have a couple other asset classes looking to break through more modest distance goals. The long-beleaguered euro limbered up back in January and started to chase its longstanding nemesis, the US dollar. The euro is up around 16 percent versus the dollar year-to-date, a surprising turn of events for those caught up in the hype of the so-called “Trump trade” that followed the election last November. In commodity-land, copper and other industrial metals have gained more than 20 percent. While the China demand-fueled “supercycle” for commodities is deemed long dead, the future for a select group of metals, including copper, may well be bright if forecasts about the demand for lithium ion batteries (key components of electricity-operated vehicles) prove to be accurate. For the moment, non-US currencies and industrial metals are still microtrends, unproven at longer distances, but it will be worth keeping an eye on their progress.
A Flat & Forgiving Course
Distance runners tend to do their best work on predictable, smooth courses with a minimum of steep hills or unexpectedly rough, slippery terrain. Which brings us back to stocks and the nine-year bull. There really haven’t been too many Heartbreak Hills since the summer of 2011, when the simmering Eurozone crisis and the US debt ceiling fiasco took stocks into a vortex that stopped just short of a bear-level pullback of 20 percent. The tailwinds have come courtesy of the central banks and their monetary stimulus programs, along with an economy that has delivered steady, if modest, growth, an improved labor market and muted inflation. Corporate earnings have done well in this environment, so that even if stocks are expensive by most valuation standards (they are), they remain well below the bubble levels of the late dot-com era.
Now, anything can disrupt the equilibrium at any time. There are always risk factors lurking under the surface that, if actualized, would create havoc in asset markets. Think back to the longest bull on record: that of 1982-2000. Technicians would dispute our labeling this entire period a bull market, as it was punctured by the sudden cataclysm of Black Monday 1987, when the Dow and other major US indexes fell more than 20 percent in one day. We don’t think of the 1987 pullback as a bear market in the classic sense, though, because (a) it was entirely unrelated to broader economic trends, and (b) it was over almost as soon as it began. The 1987 event looked nothing like the last real bear market, a long stretch of misery that endured from 1968 to 1982. We bring this up because, based on everything we see in the economic and corporate profits landscape today, any potential pullback in the immediate future would more likely arise from the sudden emergence of a hitherto dormant risk factor than from a structural change in conditions. The course, in other words, remains flat and forgiving, but runners should always be aware that lightning can strike.
Even Ultramarathoners Tire Out
And that, in turn, brings us back to that superstar distance runner, the bond market. Because if anything could potentially make that flat course hillier and more unpredictable, it would be an end to the “lower for longer” assumption about bond yields that is baked into every asset class with a risk premium. The risk premium for any asset starts with interest rates; namely, the prevailing risk-free rate layered with additional quanta of risks deemed pertinent to the asset in question. Upsetting the applecart of low rates would reverberate throughout the capital markets in a uniquely pervasive way.
For now, the bond market would appear to still be a ways away from its last legs. Both the Fed and the ECB will likely try to provide reassuring guidance over the course of this fall as to how they plan to move towards a more “normal” monetary policy environment with a minimum of disruptive surprises. We don’t expect much disruption to ensue from the upcoming September meetings of either central bank. But we have to pay close attention to any unusual wobbles or other signs of fatigue along the way.