Posts tagged Global Economy
It’s that time of year again. Here in the mid-Atlantic region we are getting the first taste of dry, cool nights in place of midsummer’s relentless humidity. High school cross country teams are running through our neighborhoods to get in some practice before the season’s official start in a few days. And, of course, investors across the land are wondering what mix of surprises are in store for the deviously tricky stretch of the calendar between Labor Day and Thanksgiving. The sense of expectation is palpable; it seems like an eternity since anything has penetrated the smug, self-satisfied forward motion of the S&P 500. Will the good times continue to roll?
There are of course many variables at play, and a broad spectrum of possible outcomes. We think these can be broadly divided into two high-level narratives: (a) nothing new here, carry on as before, or (b) signs of wear and tear in the long-running bull that could spell trouble. We look at each of these narratives in turn.
Narrative 1: Nothing New Under the Sun
Over the course of the year we have been treated to numerous explanations of what’s been going on in markets by the furrowed brows of CNBC analysts and their ilk. But when you stand back from all the earlier, furious rotation – into and then out of financials, into and then out of tech, into and then out of healthcare – the easiest explanation for the positive trends of 2017 is the near-absence of anything new. The US economy has been growing at a slow rate, with low inflation, a decent labor market and favorable corporate earnings, for most of the second decade of this century. Within the last year and a half or so our modest growth has been joined by that of Europe and Japan. There are no glaring trouble spots in emerging markets, with China and Southeast Asia reclaiming the lion’s share of global growth. The global economy appears serenely detached from the chaos of worldwide political dysfunction.
Almost no headline data points have challenged this macro-stability narrative thus far this year. And under the placid surface, of course, remain the central banks whose actions over the past six years have put a supportive floor under asset prices. Sure, there’s some debate now about how the Fed and the ECB steer their policies towards something more “normal,” whatever that is. But almost nobody expects that the bankers would sit back and watch from the sidelines should risk assets suddenly hit a nasty and sustained patch of turbulence. This attitude may appear complacent, but it is also entirely rational given all the evidence accrued over the past few years.
Narrative 2: Be Careful What You Wish For
Calm, gently upward-trending asset markets are an investor’s dream. But all dreams eventually end and the dreamer wakes up, remark observers skeptical that the Goldilocks conditions of the year to date can last much longer. Do the naysayers have anything substantial to present as evidence for a sea change in market trends, apart from simply repeating “no free lunches” ad nauseum?
Well, perhaps they do. As Exhibit 1, the Cassandras may trot out the performance of recent small and mid caps. Both the S&P 400 Mid Cap index and the S&P 600 Small Cap index are trading below their 200 day moving averages, more than 5 percent down from the year-to-date highs both attained in July. And while on the subject of 200 day averages – a subject about which we have had remarkably little to say for a very long time – the number of S&P 500 stocks trading below their 200 day averages is close to 50 percent. The current stage of the bull, in other words, is not particularly broad-based. A trend of narrowing outperformance has in the past been a frequent sign of impending market reversal (though, we should note, it is not particularly useful as a market timing measure).
The other evidence our skeptical friends may muster in support of the case for correction is the very absence of volatility so celebrated by the bulls. There was a stretch recently when the S&P 500 went 15 days in a row without moving more than 0.3 percent up or down – a 90-year record for low volatility. That serenity would appear to misprice the inherent risk in holding common shares – which, as any finance professor will happily tell you, represent a completely unsecured claim, junior to all other claims, on a company’s residual assets. When common stocks exhibit the volatility properties normally associated with fixed income securities, that would seem to indicate that the market has something wrong. Be careful what you wish for! And these arguments, of course, take place against the backdrop of a market more expensive, by traditional valuation measures, than any other than those of the bubbles of 1929 and 1999-2000.
The thing about each of these narratives is that they are entirely plausible. The worrying trends highlighted by the skeptics are believable and suggest caution…but so is the seemingly fixed-in-stone macroeconomic context of slow, reliable growth and benign conditions for corporate earnings. We also imagine that, if we do see a pullback or two of any size in the coming weeks, a quick, Pavlovian buy-the-dip response would be more likely than not. That in turn may afford some additional intelligence on whether conditions going forward appear wobbly enough to support building up some additional defenses.
Some foreign words don’t have English translations that do them justice. Take the German “Schadenfreude,” for example. “Delight at the expense of another’s misfortune” just doesn’t quite pack the same punch. The Russian word “smutnoye” also defies a succinct English counterpart to fully import its meaning. Confusion, vagueness, a troubling sense that something nasty but not quite definable is lurking out there in the fog…these sentiments only partly get at the gist of the word. Russians, who over the course of their history have grown quite used to the presence of a potential fog-shrouded malignance out there in the fields, apply the term “smutnoye” to anything from awkward social encounters, to leadership vacuums in government, to drought-induced mass famines.
Who’s In Control?
We introduce the term “smutnoye” to this article not for an idle linguistic digression but because it seems appropriate to the lack of clarity about where we are in the course of the current economic cycle, and what policies central banks deem appropriate for these times. Recall that, just before the end of the second quarter, ECB chief Mario Draghi upended global bond markets with some musings on the pace of the Eurozone recovery and the notion that fiscal stimulus, like all good things in life, doesn’t last forever. Bond yields around the world jumped, with German 10-year Bunds leading the way as shown in the chart below.
At the time we were skeptical that Draghi’s comments signified some kind of sea change in central bank thinking (see our commentary for that week here). But bond yields kept going up in near-linear fashion, only pulling back a bit after Janet Yellen’s somewhat more dovish testimony to the US Congress earlier this week. And it has not just been the Fed and the ECB: hints of a change in thinking at the apex of the monetary policy world can be discerned in the UK and Canada as well. The sense many have is that central bankers want to wrest some control away from what they see as an overly complacent market. That, according to this view, is what motivated Draghi’s comments and what has credit market kibitzers focused like lasers on what words will flow forth from his mouth at the annual central bank confab in Jackson Hole next month.
Hard Data Doves
In that battle for control, and notwithstanding the recent ado in intermediate term credit yields, the markets still seem to be putting their money on the doves. The Fed funds futures index, a metric for tracking policy expectations, currently shows a less than 50 percent likelihood of a further rate hike this year, either in September or later – even though investors know full well that the Fed wants to follow through with one. Does that reflect complacency? A look at the hard data – particularly in regard to prices and wages – suggests common sense more than it does complacency. Two more headline data points released today add further weight to the view that another rate hike on the heels of June’s increase would be misguided.
US consumer prices came in below expectations, with the core (ex food & energy) CPI gaining 0.1 percent (versus the expected 0.2 percent) on the month, translating to a year-on-year gain of 1.7 percent. Retail sales also disappointed for what seems like the umpteenth time this year. The so-called control group (which excludes the volatile sectors of auto, gasoline and building materials) declined slightly versus an expected gain of 0.5 percent. These latest readings pile on top of last month’s tepid 1.4 percent gain in the personal consumer expenditure (PCE) index, the Fed’s preferred inflation gauge, and a string of earlier readings of a similarly downbeat nature.
Why Is This Cycle Different from All Other Cycles?
In her testimony to Congress this week, Yellen made reference to the persistence of below-trend inflation. The Fed’s basic policy stance on inflation has been that the lull is temporary and that prices are expected to recover and sustain those 2 percent targets. But Yellen admitted on Wednesday that there may be other, as-yet unclear reasons why prices (and employee wages) are staying lower for longer than an unemployment rate in the mid-4 percent range would normally suggest. This admission suggests that the Fed itself is not entirely clear as to where we actually are in the course of the economic recovery cycle that is in its ninth year and counting.
Equity markets have done a remarkable job at shrugging off this lack of clarity. Perhaps, like those Russian peasants of old, they are more focused on maximizing gain from the plot of land right under their noses while ignoring the slowly encroaching fog. Perhaps the fog will lift, revealing reason anew to believe a new growth phase lies ahead. All that remains to be seen; in the meantime, “smutnoye” remains the word of the moment.
Hard to believe it, folks, but Year 2017 has already passed its halfway point. While many are still getting the most out of a holiday-interrupted week, at the beach or in the mountains or anywhere that the Twitterverse cannot find them, we will take this opportunity to contemplate what was, what is, and what may lie ahead in global asset markets.
Sweet and Sour
Perhaps the definitive image of markets for the first six months of the year was a contrast in shapes: the flattening contours of the Treasury yield curve on the one hand, and the upward-sloping progression of the stock market on the other. For much of this time, equity and fixed income investors seemed to be singing off two different hymn sheets: giddy expectations on the one hand and a dour read of the macroeconomic landscape on the other.
Going by the hard data alone, the bond mavens would seem to have the better arguments on their side. Headline data over the first two quarters largely underwhelmed, most notably in the area of prices and wages. Inflation readings, including the Fed’s favored personal consumption expenditure (PCE) gauge, have stayed south of the central bank’s two percent target. The labor market continues to raise more questions than it answers, with the unemployment rate suggesting we are very close to full employment, but tepid wage growth indicating none of the usual pressure that hiring firms experience in a tight labor market. That dynamic was present in this morning’s jobs report as well. Better than expected payroll gains brought the three month average up to 194,000 new jobs, but wage growth again came in below expectations.
Turning Point or Tantrum?
With that soft inflationary context in mind, we consider the recent gyrations in the bond market that has some observers predicting a sea change in yields in the months ahead. The fixed income kerfuffle was ignited by remarks by ECB Chair Mario Draghi last week, suggesting that Europe’s better than expected recovery may warrant moves to start winding down monetary stimulus. Whiffs of increased hawkish sentiment can be detected elsewhere in the central bank world, including the UK and Canada.
With inflation showing no signs of overheating, the Fed will not have a gun to its head to raise rates, nor will the ECB be forced to risk market volatility by accelerating any form of a taper in their bond buying program. But that very volatility is an issue on the table for the monetary mandarins. This week’s release of the June Fed minutes suggests that central bankers are at least somewhat nervous about yet another characteristic of 1H 2017 asset markets: the coexistence of elevated prices with almost no volatility. The Fed’s rate hike in June -- and a possible follow-on increase in September -- reflect at least in part an attempt to wrest control back from complacent markets. That complacency is well-founded; central banks have in recent years gone to great lengths to prop up asset prices. If investors sense an end to the Greenspan-Bernanke-Yellen put, we could expect volatility to return with a vengeance.
Brent Gold, Texas Tea
Another addition to the #thingswelearned category in the first half of 2017 is that OPEC is largely a spent force in exerting influence on oil prices. The cartel’s much-touted meeting last fall that produced a tangible production cut policy initially sparked a recovery in crude prices, but the recovery fizzled away as it became ever clearer that US non-conventional drillers, not OPEC, represent the marginal barrel of production. Supply dynamics suggest a secular trend for the range-based price movements of recent months, with the only question being where the lower end of that range will settle. On the demand side, the continuing reality of below-trend global output signals that the commodity super-cycle of the previous decade is unlikely to return any time soon. Resource companies may be in for an extended winter of discontent.
Much More in Store
These topics are just the tip of the iceberg: we have said nothing here about emerging markets, or risk spreads in investment grade & high yield bond markets, or the strangely underperforming dollar, or sector and geographic rotation among equity asset classes as another season of earnings gets under way. These are all issues of clear and present importance, and rest assured we will be covering them in the weeks ahead.
Meanwhile, enjoy what remains of the holiday week and be ready for interesting times ahead as summer eventually brings us to those tricky fall months that lie in wait.
How much of an X-factor is European political risk in 2017? We got a partial answer (not much) from the outcome of the Dutch elections last month, which maintained the status quo even as the traditional center right and center left parties fared relatively poorly. We will get another drip-drip of insight this Sunday evening, as election officials tally up the results of the first round of voting in the French contest. There has been some nervous chatter among the pundits, mostly revolving around the scenario – unlikely but plausible – of a second round contest between Marine Le Pen and Jean Luc Mélenchon. Markets, however, appear unfazed. The euro is holding ground at around $1.07, and the spread on the French 10-year yield over the commensurate German Bund is 61 basis points, down from 78 in the wake of a flurry of Mélenchon-friendly polls last week. And, as the chart below shows, Eurozone equities are holding their outperformance gains versus the US S&P 500.
The “what, me worry?” vibe boils down to a singular view that the ultimate winner of the election will be centrist Emmanuel Macron, a former economics minister and investment banker who cobbled together a new political movement to challenge the loathed traditional parties of the Socialists and Republicans. Macron’s platform is in line with the technocratic sensibilities of EU policy institutions and the IMF, focused on the integrity of the EU and the Eurozone with incremental rather than radical policies for dealing with the region’s ongoing difficulties.
Should Macron ultimately prevail, the market’s current positioning could augur for more outperformance ahead. Economic numbers continue to give cheer; the latest PMI readings show both manufacturing and services at a six year high. Growth, inflation and employment trends all continue to move in a positive, if still modestly so, direction. Other political risks lurk, notably in Italy, but the capacity to surprise will be greatly diminished if the French contest plays out as expected.
Zut alors, c’est le surpris!
What if Macron doesn’t win? If for no other reason, 2016 was instructive in explaining the pitfalls of polls and the many random factors that can lead to an outcome other than the highest-probability one. What will markets do on Monday morning if the two candidates left standing are Le Pen and Mélenchon? The short answer, given where markets are priced today, would probably be a pullback of somewhere between 5 – 10 percent for regional equity indexes and a move to haven assets like US Treasuries and German Bunds. That is what happened after the shock delivered by the Brexit vote last June. That pullback, though, as you will recall, was brief and contained. Within weeks of Brexit, equity markets had rebounded and the S&P 500 finally set its first record high in 14 months.
In the long run, we believe a Le Pen or Mélenchon victory would be of enormous consequence for the EU, more so than Britain’s exit. The market’s apparent ability to breezily whistle past every potential calamity would be tested perhaps more than in other recent political risk events. But if we have learned anything about Europe in the last seven years, starting with the wheels coming off the Greek economy, it is that European policymakers are masters of the craft when it comes to kicking the can down the road.
At some point – whether it be from disgruntled citizens voting centrists out of office, a round of financial institution failures or something else – the original flaws of the single currency design will likely deal a potentially deadly blow. But we have no reason to believe that reckoning is any time soon. Our advice to our clients should not surprise any regular reader of this column: resist the impulse to make any rash positioning plays either in advance of or following Sunday’s outcome, or that of the second round in early May.
It is something of an annual tradition: at some point, usually in the middle of a humid and lazy Atlantic Seaboard August, we will write something about the “dog days” of summer in investment markets. You know – light trading volume and mostly listless price direction, occasionally punctuated by an exaggerated surge or plunge based on some rumor or stray macro data point. Well, this year the dog days have arrived early. A couple one percent-plus days – one down and one up, for reasons that are barely remembered – provided some color to an otherwise tepid month long on political headlines and short on directional action. As the second quarter gets underway, we consider what might – or might not – puncture the market’s smug haze of mellow.
The Beta Economy
The present occupant of 1600 Pennsylvania Avenue may fancy himself an alpha human, but the economy in which his administration finds itself is decisively beta. That’s not a bad thing, mind you. A beta economy means real growth somewhere around two percent – nothing like the alpha economy of the 1990s, but perfectly acceptable, with modest price inflation and a mostly healthy labor market. Much of the rest of the world is enjoying a similar beta vibe. GDP is actually a bit higher in the EU than it is at home, Japan is managing to stay out of recession, and China’s factories are humming along nicely with recent PMI readings for services and manufacturing comfortably above the growth threshold number of 50.
Importantly for investors, a beta economy supplies the most compelling reason not to get fooled by a momentary sell-off like the little one last week. With no sign of a recession in sight, at home or anywhere consequential abroad, there simply isn’t much of a case to make to run for the hills. But what about the upside? Can businesses crank out alpha earnings in a beta economy?
Those Elusive Double Digits
Q4 2016 earnings season is over, and the 5.1 percent growth registered by S&P 500 companies falls well within our definition of “beta,” in the context of the last couple decades of quarterly results. Surprisingly, 5.1 percent is also very close to what analysts were predicting last fall: the FactSet consensus of analyst projections on September 30 pegged Q4 earnings growth at 5.2 percent. Reasonable! But that same consensus group also gave their Q1 2017 estimates on that same day, and that number was a very alpha-like 13.9 percent. Do they still feel that way? Not so much – the revised Q1 consensus number as of today, right before the actual figures start to come out, is 9.1 percent.
That’s still not bad, but it’s not the double digits investors would prefer to see to validate those valuations nearing nosebleed territory. The last twelve months (LTM) P/E ratio touched 20 this week, a level last seen in the post-trough recovery following the 2001-02 recession. The price to sales (P/S) ratio, is at levels last seen in the heady final days of the dot-com bubble at the beginning of the 2000s. We have believed for some time that the “valuation ceiling” remains the biggest headwind to substantial upside gains. Of course, this view has taken quite a bit of flak of late from the ever-popular “reflation-infrastructure trade” that has dominated market chatter for the past five months. Which brings us to our final musing about Q2 market direction…whither the animal spirits?
Momentum Is Its Own Momentum, Until It’s Not
What market pundits continue to call the “Trump trade” has been durable, even as prospects for any kind of sweeping, historic tax reform and massive new spending on infrastructure build out – never an obvious outcome to begin with – have looked less and less likely. But, as we have noted elsewhere in recent commentaries, such upside as there has been for the past couple months really has less to do with those reflation-infrastructure themes than it does with plain old momentum and those robust animal spirits.
Consider industry sectors. Sector-wise, the Four Horsemen of the reflation trade that ignited after the election were financials, materials, industrials and energy. These also happen to be the four sectors trailing the market in 2017 year-to-date, while technology, healthcare and consumer discretionary have all outperformed. Tech and discretionary, in particular, seem like pretty reasonable places to be if you’re comfortable with that beta economy and looking for a low-impact way to continue participating in equities. This low-key sector rotation has kept the rally going even as the original theme behind it went stale.
The problem, of course, is what happens when momentum wanes, as it eventually does? The first thing to watch out for is signs of the return of volatility, which as we all know has been strangely absent for the duration of this most recent phase of the bull market. Even that one-day pullback last week failed to elicit much more than a shrug from the supine VIX index. The market’s vaunted “fear gauge” has stayed in a volatility valley well below 15 for the entire year thus far (compare that with an average level above 20 for the first two months of 2016).
We tend to pay less attention to the VIX’s occasional sharp peaks than to the mesas – those extended periods of baseline elevation around 15-17. A new mesa formation on the VIX would, in our opinion, raise the prospects of a sizable near-term pullback in the 5 – 10 percent range. At which time we could, mercifully, shake off the dog days and get into some desirable new positions at more reasonable values.