Posts tagged Global Economy
The current bull market in US equities, the pundits tell us, is the second-longest on record. That may sound impressive, given that domestic stock exchange records go back to the late 19th century. But it doesn’t even hold a candle to the accomplishments of the current bull market in bonds. The bond bull started in 1981, when the 10-year US Treasury yield peaked at 15.84 percent on September 30 of that year. It’s still going strong 36 years later, and it’s already one for the record books of the ages.
According to a recent staff working paper by the Bank of England, our bond bull is winning or placing in just about every key measurement category going back to the Genoese and Venetian financial economies of the European Middle Ages. Lowest risk-free benchmark rate ever – gold medal! The 10 year Treasury yield of 1.37 percent on July 5, 2016 is the lowest benchmark reference rate ever recorded (as in ever in the history of money, and people). The intensity of the current bull – measured by the compression from the highest to the lowest yield – is second only to the bond bull of 1441-81 (what, you don’t remember those crazy mid-1400s days in Renaissance Italy??). And if the bull can make it another four years it will grab the silver medal from that ’41 bull in the duration category, second only to the 1605-72 bond bull when Dutch merchant fleets ruled the waves and the bourses.
Tales from the Curve
But does our bull still have the legs, or is the tank running close to empty? That question will be on the minds of every portfolio manager starting the annual ritual of strategic asset allocation for the year ahead. Let’s first of all consider the shape of things, meaning the relative movements of intermediate/long and short term rates.
We’ve talked about this dynamic before, but the spread between the two year and ten year yields is as tight as it has been at any time since the “Greenspan conundrum” of the mid-2000s. That was the time period when the Fed raised rates (causing short term yields to trend up), while the 10-year and other intermediate/long rates stayed pat. It was a “conundrum” because the Fed expected their monetary policy actions would push up rates (albeit at varying degrees) across all maturities. As it turned out, though, the flattening/inverting yield curve meant the same thing it had meant in other environments: the onset of recession.
An investor armed with data of flattening yield curves past could reasonably be concerned about the trend today, with the 10-year bond bull intact while short term rates trend ever higher. However, it would be hard to put together any kind of compelling recession scenario for the near future given all the macro data at hand. The first reading of Q3 GDP, released this morning, comfortably exceeded expectations at 3.0 percent quarter-on-quarter (translating to a somewhat above-trend 2.3 percent year-on-year measure). Employment is healthy, consumer confidence remains perky and most measures of output (supply) and spending (demand) have been in the black for some time. Whatever the narrowing yield curve is telling us, the recession alarms are not flashing orange, let alone red.
Where Thou Goest…
So if not recession, then what? Leave aside for a moment the gentle undulations in the 10-year and focus on the robust rise in the 2-year. There’s no surprise here – the Fed has raised rates four times in the past 22 months, and short term rates have followed suit. Historically, the 2-year yield closely tracks Fed funds, as the chart below shows.
The upper end of the Fed funds target range is currently 1.25 percent, while the 2-year note currently yields 1.63 percent (as of Thursday’s close). What happens going forward depends largely on that one macro variable still tripping up the Fed in its policy deliberations: inflation. We have two more readings of the core PCE (the Fed’s key inflation gauge) before they deliberate at the December FOMC meeting. If the PCE has not moved up much from the current reading of 1.3 percent – even as GDP, employment and other variables continue trending strong – then the odds would be better than not the Fed will stay put. We would expect short term rates, at some point, to settle perhaps a bit down from current levels into renewed “lower for longer” expectations.
But there’s always the chance the Fed will raise rates anyway, simply because it wants to have a more “normalized” Fed funds environment and keep more powder dry for when the next downturn does, inevitably, happen. What then with the 10-year and the fabulous centuries-defying bond bull? There are plenty of factors out there with the potential to impact bond yields other than inflationary expectations. But as long as those expectations are muted – as they currently are – the likelihood of a sudden spike in intermediate rates remains an outlier scenario. It is not our default assumption as we look ahead to next year.
As to what kept the bond bull going for 40 years in the 1400s and for 67 years in the 17th century – well, we were not there, and there is only so much hard data one can tease out of the history books. What would keep it going for at least a little while longer today, though, would likely be a combination of benign growth in output and attendant restraint in wages and consumer prices. Until another obvious growth catalyst comes along to change this scenario, we’ll refrain from writing the obituary on the Great Bond Bull of (19)81.
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.
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.