Posts tagged Geopolitics & Markets
Over the past few months, we’ve had a number of conversations with clients that go something like this:
Client: Wow, these are crazy times, huh? Politics! Never seen anything like this!
Us: Yep, they sure are crazy times.
Client: So, why does the stock market keep going up? When should I be worried?
In today’s commentary we will address this concern, and explain why we believe that, whatever one thinks of the political dynamics playing out here at home or abroad, it probably is not a good idea to transpose these sentiments onto a view of portfolio allocation. Political risk is a real thing. But history has shown there to be very little causal relationship between momentous political events and movements in risk asset markets. Any market environment, whether bull or bear, is affected by tens of thousands of variables every day, many of which have little correlation with each other, and very few of which are easy to pinpoint and ascribe to prime mover status. We offer up a case study in support of this claim: the US stock market in the early 1970s that encompassed the Nixon Watergate scandal.
That Dreary Seventies Market
President Nixon resigned from office in August, 1974, shortly after it became clear that Congress was preparing to commence impeachment proceedings in the wake of the revelations about the Watergate crimes and attempted cover-up by the administration. As the chart below shows, the S&P 500 fell quite a bit during the month of August 1974, as well as before and after the Nixon resignation. But the chart also shows that there was a lot else going on at the same time.
The Nixon resignation remains to date the most consequential political scandal in modern American history. It had an earth-shaking effect on the political culture in Washington, leading to far-reaching attempts by lawmakers to restore the integrity of the systems and institutions the scandal had tarnished. As far as markets were concerned, though, Watergate was far down the list of events giving investors headaches. Following a historically unprecedented period of economic growth and rise in living standards over the prior two decades, the first five years of the 1970s witnessed two wrenchingly painful recessions, spiraling inflation and a gut-punch to household budgets in the form of OPEC’s 1973 oil embargo. The freefall in stocks that took place in 1973 and 1974, if it is to be tied to any specific catalyst, flows from the real dollars-and-cents impact of the embargo and the recession. Watergate, as important as it was as a political event, was little more than a blip on a radar screen already filled with bad news.
Tweets Come and Go, Markets Carry On
Which brings us back to today’s daily carnival of the bizarre from the banks of the Potomac Drainage Basin. While the tweets fly and the heads of the high priests of conventional wisdom explode, the economy…well, just chugs along at more or less the same pace it has for the past several years. Today’s initial Q2 GDP reading (2.6 percent, slightly below expectations) sets us up for another year of growth averaging somewhere around 2 percent. The labor market is healthy, there is neither hyperinflation nor deflation, and corporate earnings growth is trending close to double digits. No major world economy appears in imminent danger of a lurch to negative growth.
Yes, stock prices are expensive by most reasonable valuation measures. And yes, there is not much in the way of sector leadership momentum. But until and unless we see compelling signs of a shift away from this uncannily stable macro context, we see little evidence that Washington shenanigans will have much of an impact on stocks. At some point, those tens of thousands of global variables at play will deliver up a different set of considerations and necessitate new strategic thinking. Trying to time the precise market impact, as always, is a fool’s errand.
Investors tend to be predisposed to a “follow the leader” mentality -- to latch onto a narrative that purports to explain why company ABC or sector XYZ is running out ahead of the pack. Unfortunately for those in search of a leadership theme on the cusp of the summer of ’17, there really isn’t one anymore. There was one until last week: the mega cap stocks led by Facebook, Amazon, Alphabet (Google) and Apple took the helm back in the first quarter as the “reflation trade,” the previous narrative, faltered. The chart below shows the ascendance of these FAGA stocks when financials, the reflation trade’s leader, turned south in March (represented by XLF, the SPDR ETF). The chart also shows the carnage of June 8, when those high flying mega caps suddenly got pummeled on an otherwise nondescript trading day. They have continued to struggle in the days since.
The fizzling out of the reflation trade (or the “Trump bump” in the vulgate) as a leadership theme is easy to understand. The financial sector led that narrative, along with materials, industrials and (for a while late last year) energy. The premise was that a burst of pro-growth fiscal policy, headlined by tax reform, deregulation and a massive infrastructure stimulus would unleash an inflationary tsunami. Financial institutions would benefit from improved net interest margins, while industrial producers and resource firms would ride the infrastructure bandwagon. That premise, never particularly strong in a reality-based sense to begin with, looked increasingly like a bad bet as the legislative degree of difficulty presented itself to a team of political novices. Financials and other reflation-theme names topped out in early March and the broader market drifted for a spell.
FAGA (the aforementioned mega cap stocks) and their fellow travelers in the tech sector picked up where the Trump trade left off. What was the narrative driving this leadership rotation? Little, in our opinion, other than a general go-to argument that these enterprises are part of an elite cohort able to deliver consistently fast top-line growth in a world of modest economic prospects. The FAGA trade is sort of a lazy, modern take on the “Nifty Fifty” of days yore: in the absence of any other overarching narrative, go with the brand-name leaders of the day. And what, exactly, was the catalyst for that mass exodus from FAGA on June 8? Again, nothing that is glaringly obvious. Pundits put forth the “crowded trade” theme, which may be as good a reason as any. But they are not especially overvalued; Apple still trades at a P/E discount to the broader market, and the P/E premia of the other three FAGA names to the S&P 500 are well below their highs for the past five years.
Whatever the reasons were for bailing from tech on June 8, it is by now evident that it was not a one-day event; the sector has underperformed in the days since, as the above chart illustrates. The question now turns to the prospects for the broader market absent another leadership story. Candidates for such a story are rather scarce. The many ills plaguing the retail sector again came into sharp relief this week when supermarket chain Kroger’s radically cut its earnings outlook and saw its stock price get beaten down more than 18 percent. Healthcare waxes and wanes amid a fog of fundamental, sector-specific uncertainties. Financials face the headwinds of lower than expected inflation and the attendant opinion by many that the Fed was mistaken to move ahead with its rate cut this week.
The antidote for the confusion is TINA – There Is No Alternative. Forget the Trump trade, or tech stocks, or any other leadership narrative. It’s enough, this argument goes, to stay in the market when there are no compelling reasons to get out. As long as there is growth, however modest, and as long as there are central banks with the means to limit the downside, there should be no need to start building up the cash position. That logic has served investors well to now. But watch those narrowing spreads between short and intermediate term bonds. They don’t necessarily signal anything in terms of a major market shift. But they are not moving in the right direction.
It was Game On week. No, not the NCAA basketball tournament with its annual goody-bag of Cinderella stories and humble pie for top seeds, but the opening salvo of the elections in Europe about which we’ve all been chattering since the beginning of the year. What message will those discontented bodies politic in the fraying Eurozone send to global markets? Vox Populi rising, or more of the same?
Nee, Non, Nein
“Nothing here, move on” might be an appropriate response to this week’s contest in the Netherlands, and indeed much of the post-election commentary focused on the singular Nee – Dutch for No – served up by the voters to anti-immigrant polemicist and Freedom Party (PVV) head Geert Wilders. A stunning 82 percent of the citizenry turned out (dream on, America!) to give Mr. Wilders the thumbs-down and enable incumbent Mark Rutte and his VVD party to form a new government. This outcome fits rather neatly into a long-held view that, while disgruntled Europeans may register their unhappiness in polls and in the less consequential votes for the EU representatives they send to Brussels, they will heed their better angels when voting in their own national governments. Historians will point out that ethnocentric populism, while always present, has never managed to crack the high 30s in percentage terms over more than a century of national electoral contests. In this reading of the current environment, the Dutch “Nee” is likely to be followed by a French rejection of Marine Le Pen in favor of centrist Emmanuel Macron, and a vote for more of the same in Germany when Angela Merkel seeks her fourth term. Certainly these would have to be considered the default outcomes in the absence of any new news.
The Math of Discontent
A closer read of the Dutch outcome, though, tells a somewhat different story and one that would appear to be well in line with broader trends both within and without the Old Continent. The PVV – Wilder’s party – didn’t actually lose parliamentary seats but rather gained five. The big losers of the night, by the math of seat gains or losses, were the two establishment parties. PM Rutte’s PVV lost eight seats (though still retaining its position as the largest single party). But the PVV’s coalition partner, the Dutch Labor Party (PvdA) lost a stunning 29 seats. That adds up to a net loss of 37 for the Establishment. It also serves up yet more evidence that the traditional European left (think Britain’s beleaguered Labor Party or France’s Socialists with a 4 percent favorability rating) is in a death spiral.
Meanwhile three “alternative” parties – the left-leaning, Europhile D66 and Green List and the center-right, quasi-populist CDA, picked up 23 seats between them. Adding Geert Wilder’s 5 seats means that a non-Establishment alternative, split roughly between pro and anti EU sentiment, will play an outsize role in the new government. With no clear mandate for either bailing out of the EU/Eurozone or doubling down on open borders and free trade, the result is likely to be a lack of clear direction one way or the other. This outcome much more resembles the recent past than it does some bold new step forward. Populism may have its limits, but so does globalism.
Mr. Market’s Quiet Genius
For the past couple months we have spilled a great deal of ink on the pages of this column finding fault with the so-called “reflation-infrastructure” trade that appeared to be based on little other than hope and animal spirits. But we are starting to see a little method in the apparent madness of the markets. No – there is no infrastructure pony out back with a Christmas bow around its neck. There never was. Just as in Europe, our own policy engine is stuck in second gear, and not just on account of the apparent own goals the current administration and Congress keep making. Ours, too, is a body politic divided, and those divisions are, so far at least, keeping in check any decisive movement juggernaut in one given direction.
And that suits Mr. Market just fine, thank you very much. Hey – economies are doing pretty much okay on their own, here at home, in Europe, Japan and much of the emerging world. Citizens are disgusted with their governments for some very valid reasons. The less interference we get from misguided policymakers, goes this line of thinking, the better. No action is good action. Continued improvement in jobs and wages, with a modest but not frenetic pick-up in prices, all in the context of real GDP growth of two percent or a bit more – that’s enough for now. Enough to keep corporate earnings growing at least in the mid-high single digits. These may not be the best of times, but neither are they the worst. As long as things remain more or less as they are, this bull market can perhaps enjoy an extended sunset rather than suffering an abrupt end.
Fiscal policy is where all the cool kids hang out now, as we noted in last week’s commentary. But the monetary policy nerds at the Fed got at least a modicum of attention this week as the dots settled on the Fed funds plot chart Wednesday afternoon. As was widely expected, the meeting resulted in a 0.25 percent target rate hike and some meaningful, if subtle, changes to the 2017 outlook. Three policy actions are on tap for next year, and this time the market seems to take this outlook seriously. Chair Yellen & Co. expect the recently favorable trends in output growth and employment to continue, while expecting to see headline prices reach the two percent target by 2018. These observations appear to be largely irrespective of what does or does not happen with all the hyped-up fiscal policy that has been driving markets of late. Be well advised: monetary policy will still matter, quite a bit, in 2017. It will have an impact on many things, not least of which will be the opportunity set of fiscal policy choices.
Divergent Today, Insurgent Tomorrow
Market watchers on Wednesday made much of the (temporary, as it turns out) pullback in stock indexes in post-FOMC trading. But the real action, as has often been the case in the last six weeks, was in the bond market. The yield spike is noteworthy in absolute terms, but even more striking on a relative basis. Consider the chart below, showing the spread between the 2-year U.S. Treasury note and its German Bund counterpart.
Short-term U.S. rates are at 52-week highs while German rates are at their 2016 lows. The spread between the two is wider, at 2.07 percent, than it has been at any time since 2003. Remember divergence? That was the big theme in the discourse one year ago, when the Fed followed through on its 2015 policy action last December. The Eurozone and Bank of Japan were full steam ahead with their respective stimulus programs as the Fed prepared to zag in the other direction. Then markets hit a speed bump in January, the Fed backed off any further action and rates came back down. As the above chart shows, U.S. and German short-term rates followed a more or less similar trajectory for most of the year.
But divergence is back with vengeance. Holders of U.S. dollar-denominated assets will be pleased, as the euro gets pushed ever closer to parity. Policy divergence leads to dollar insurgence. On the negative side, that insurgence looks set to redouble the FX headwinds that have clipped corporate top line revenue growth for much of the past two years. That, in turn, will make it challenging to achieve the kind of double-digit earnings growth investors are banking on to justify another couple laps of the bull market.
Three Times the Charm?
What we took away from Chair Yellen’s post-meeting press conference was a sense that the Fed’s world view has changed only modestly amid all the hoopla of the post-election environment. She took pains to note that the outlook shift to three possible rate changes in 2017 does not reflect a seismic change in thinking among the dot-plotters, but an incremental shift reflecting a somewhat more positive take on the latest growth, employment and price data.
And fiscal policy? Yellen could hardly avoid the topic; it was the point of the vast majority of the questions she fielded from the press. Over the course of her tenure at the Fed she has spoken many times of the need for monetary and fiscal policy to complement each other at appropriate times in the business cycle. This, however, may not be one of those times. Consider her comment in response to one question: “So I would say at this point that fiscal policy is not obviously needed to help get us back to full employment.” For the moment, at least, and in the absence of any tangible data to suggest otherwise, the Fed does not appear to be giving undue attention to the fiscal variable.
As Location Is To Real Estate, Productivity Is to Growth
Chair Yellen did make a point of emphasizing what kind of fiscal policy she does like: namely, that which directly helps boost productivity. That’s a point you have heard us make in this space ad nauseum, so it was good to hear it from the Eccles Building. What kind of fiscal policy could that be? Education, jobs and skills training programs and improving the quality of installed capital used by American workers were specifically called out by the Fed chair. Of course, there is no clarity of any kind that such productivity-friendly programs will make it through the legislative sausage factory. One can always hope, though.
Happy (Fiscal) Holidays
Opinions among the politico-financial commentariat appear to be converging on the basic idea that “fiscal policy is the new monetary policy.” Out with the obsession over FOMC dot-plots, in with infrastructure! Does a more robust fiscal policy, if in fact implemented, presage a structural bump-up in GDP? The stock market seems to think so, with a strangely high degree of conviction, as illustrated in the chart below.
This chart, one of our periodic favorites, shows what we like to call the “risk gap” between stock prices (the solid blue line showing S&P 500 price performance for the past two years) and volatility (the green dotted line shows the CBOE VIX index, the market’s so-called “fear gauge”). The wider the risk gap, the more complacent the market. As of late the gap has turned into a chasm, with stock prices setting all-time highs on a near-daily basis while the fear gauge slumbers at or near recent lows, and well below the threshold of twenty indicating a high-risk environment.
The takeaway from the chart would appear to be this: not only are we absolutely, positively going to get a bracing jolt of stimulative fiscal policy in the near future, but that new policy is going to translate into higher GDP growth, higher wages and prices, and who knows what else. Maybe a groundbreaking new proof for Fermat’s last theorem?
If you kept your nerve during the seven day run-up to last month’s election (where you see that big stock price dip and brief spike in the VIX), then you are no doubt pleased as punch that Mr. Market decided to react thus. But you may also be concerned about whether this reaction is a rational assessment of the impact of future fiscal policy, or alternatively a sugar high that will leave in its wake a sensation not unlike overindulging in Krispy Kremes.
Three Pillars of Fiscal Wisdom
The fiscal policy measures being lobbed around Washington think tanks and spin rooms these days fall into three broad categories: taxes, regulations and infrastructure. Call them the Three Pillars of fiscal policy in Paul Ryan’s brave new world of one-party rule. As we noted above, the market’s near-immediate response to the prospect of the Three Pillars was ebullient optimism. This attitude is partly understandable. After all, we have had to endure eight years of gridlock in Washington during which very little got done. Central banks, which did all the heavy lifting during this time, are understandably receptive to the prospect of some burden-sharing.
But two questions pose themselves. First, how much of whatever comes out of the abstract Three Pillars and into actual policy will be stimulative? Second, as Fed Chair Yellen herself has asked, how much stimulus does the economy even need? Job growth is close to what economists typically regard as “full employment.” Moreover, despite a somewhat weaker wage figure in the last batch of jobs numbers, hourly earnings have trended above core and headline inflation for the last year. GDP in the third quarter was above expectations, and even the long-beleaguered, all-important productivity number beat expectations in Q3. These are not exactly conditions screaming out for a redoubling of stimulus (though, to the point made by many central bankers, when it does become time for more stimulus in the future, it would be preferable for the burden to be shared between monetary and fiscal sources).
Given that the economy is, in fact, not falling off a cliff, by nature austerity-loving Republicans in the House are likely to push back on initiatives that add significantly to the budget deficit. Tax cuts will always be a priority over new spending on the right-hand side of the Congressional aisle. Of the Three Pillars, tax cuts are probably the most likely to be first out of the gate. But even here, as we read the (admittedly confusing) tea leaves of current chatter, the outcome is not likely to be as simple as was the last batch of significant cuts under George Bush. Not only individual and corporate taxes are under consideration, but some kind of a value-added sales tax as well, as a partial offset measure. Strangely a VAT tax – generally considered regressive – seems to have a measure of Democratic support.
We will have quite a bit to say about the progress, or lack thereof, of the Three Pillars in forthcoming commentaries. Where we always want to take the discussion, though, is back to how these measures ultimately connect to anything that drives actual cash flows for publicly traded companies. Connecting these dots is what helps us understand whether there is anything fundamental behind temporal stock price movements or not.
Right now our assessment tends more towards the “not.” That “risk gap” illustration above strikes us as being unsustainable. Either volatility will pick up at some point – most likely as the pre-inauguration honeymoon winds down and the real business of governing looms large – or markets will resume the kind of drift patterns along a trading corridor such as we saw for much of 2015 and 2016.
A period of corridor drift could be preceded by a sizable pullback of five to ten percent, such as the ones we experienced in August 2015 and January 2016. We tend to think that such a pullback would more likely be the result of an external surprise – another plunge in the renminbi, say, or even a geopolitical shock from a global trouble-spot – rather than anything directly connected with the still-healthy U.S. economy. While we don’t see the makings of a sustained downturn ahead, it is worth remembering that stock price valuations remain at decade-plus highs.
Only a sharp upturn in corporate earnings in the coming quarters will supply the justification needed to be comfortable with those high valuations. That upturn, should it come, will be the result of continuing improvements in productivity and a revival of global demand. Not from a fiscal stimulus program that may or may not happen.