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Posts tagged Interest Rate Trends

MV Weekly Market Flash: Four Takeaways from the Pullback

October 12, 2018

By Masood Vojdani & Katrina Lamb, CFA

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So here we are, with a full array of tricks and treats to test investors’ nerves as the month of October gets rolling. A quick brush-up for our clients and readers on the nature of pullbacks is in order.

Since the current bull market began in 2009 there have been 20 occasions (including the present) where the S&P 500 has retreated by 5 percent or more from its previous high (translating to roughly 2 per year). Of those 20 pullbacks, four met the definition of a technical correction, i.e. 10 percent or more from the high. On one occasion, in 2011, the index fell by more than 18 percent before recovering. As of the Thursday market close, the S&P 500 was down 6.9 percent from its September 20 record high of 2930.

These things happen. As we like to say, paraphrasing Tolstoy, every pullback is dysfunctional in its own special way. With the caveat that the final word on the current reversal has yet to be written, here are four observations we think are worth keeping in mind as this one plays out.

They Finally Got the Memo

As we wrote about in last week’s commentary, the market has been willfully slow, for a very long time, in accepting that the Fed really intends to raise rates consistent with its view of an economy gaining strength. Last week the bond market got the memo with a sudden midweek jump in intermediate yields. It seems that the bond market sat on the memo for a few days before passing it over to the stock market. In any case, we can say with a bit more confidence now that the memo has been received. Barring any significant changes in the macroeconomic landscape – which changes have yet to surface in the form of hard data – the reasonable expectation is for a final 2018 rate hike in December, followed by at least three in 2019.

More Bond Confusion Likely

Despite better alignment between market expectations and the Fed, we do foresee further confusion in fixed income, particularly with intermediate and long duration asset classes. Consider the multiple forces at work on the 10-year Treasury, a widely used proxy for intermediate-long bonds. Heightened inflationary expectations could push yields much higher. On the other hand, relatively attractive yields (compared to Eurobonds or Japanese government bonds, for example) could keep a lid on how high rates go. Any kind of emergent financial crisis could widen spreads between Treasuries, corporate bond and other fixed income classes.

During the economic growth cycle of the late 1990s, from 1995-2000, the average yield on the 10-year Treasury was 6.1 percent and it never fell below 4 percent. What should the “natural” yield be in the current growth cycle? Nobody, not the world’s leading economists and not the trader plugging buy and sell triggers into an algorithmic trading strategy, knows for sure. We’re likely to learn this from whatever we experience over the coming months, not from theoretical foresight.

Post-Sugar High Growth

Come December, we will lap the tax cuts implemented one year earlier. That will make 20 percent corporate earnings growth a thing of the past – a good part of the growth in earnings per share this year was based on the lower tax rate that flowed through to the bottom line of the corporate income statement. Right now, the consensus analyst group used by FactSet, a market research company, expects earnings per share growth for S&P 500 companies to be 7 percent in the first quarter of 2019. Now, the same consensus group predicts that top line sales for these companies in Q1 2019 will come to 6.9 percent. That tells us two things. First, it tells us that the overall global demand environment (reflected by sales) is not expected to worsen much from where it is currently. That’s good news.

The second thing it tells us is that analysts will be focusing obsessively on corporate profit margins in 2019. Sales growth is good, but in the long run sales without profits are not good. Closer parity between top line growth rates and trends further down the income statement suggests that companies will need to be increasingly creative in finding ways to make money, particularly if cost pressures (e.g. on raw materials and labor) continue to trend up.

How will this factor play out? The next few weeks will be very important as the Q3 2018 earnings season gets under way. Analysts will be digesting the most recent growth and profit numbers from corporate America. The narrative could shape up positively – more growth! – or negatively – peak margin! How you as an investor approach 2019 will have much to do with whether you think profit margins really have reached their Everest once and for all. There will be plenty of excitable commentary to that effect. We suggest tuning out the commentary and paying attention to the actual data.

Leadership Circles

As in, “market leaders going around in circles.” So far the industry sectors bearing the brunt of the October ’18 pullback are the ones that did the lion’s share of the lifting for the past couple years: tech, first and foremost, communications services and consumer discretionary. More broadly, growth stocks have been absolutely dominant for much of the latter period of this bull market. So it is reasonable to ask what might happen if the growth stock leadership falters.

We’ve seen this play out a couple times this year (see our previous commentaries here and here for additional insights on this topic). One of the considerations is that because the tech sector comprises about 25 percent of the total market cap of large cap US stocks, it has an outsize effect on overall direction. That works well when the sector is going up. But if, say, consumer staples stocks in total go up by as much as tech stocks go down, the net result is a down market (since consumer goods stocks make up less than 8 percent of the index). An orderly growth to value rotation might be a better outcome than outright confusion, but investors who have gotten used to the growth-led returns of recent years might be in for a disappointment.

So there’s a lot at play right now. As usual, there will be no shortage of “experts” claiming to understand precisely what it all means (as they claim, after the fact, how “obvious” it was that this pullback was going to happen at exactly this time for exactly this or that reason). As for us, we simply plan on doing what we always do. Study the data, think through the possible alternative outcomes based on the scenarios we have described here as well as others, and always remind ourselves of those numbers we cited at the beginning of this commentary. Pullbacks are a fixture of bull markets and they happen for any number of reasons, logical or not. Actual bear market reversals are much rarer events. In our opinion it is not time to call an end to this bull.

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MV Weekly Market Flash: Bonds Away, We’re Okay

October 5, 2018

By Masood Vojdani & Katrina Lamb, CFA

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It doesn’t take much these days. “Pretty bad market today, huh?!” came one comment from a fellow runner during a muggy 5K outing on Thursday evening. Was it? Apparently so. Thursday’s S&P 500 posting of minus 0.82 percent was the biggest daily drawdown since the second half of June, when the index shed close to 3 percent for some vague reason long forgotten. None of this in any reasonable way qualifies as a pullback of note – we tend not to raise an eyebrow until the 5 percent threshold approaches. But after three months during which the market climbed as relentlessly as the humidity index in the Washington DC swamplands, even a modest pullback of less than 1 percent seems as rare as actual fall weather in this weirdest of October climes. Blame it on the bonds.

Goodbye, Inversion

The catalyst for the Thursday downdraft in equities was a surge in bond yields that gained steam on the back of a couple economic reports on Wednesday – in particular, a thing called the ISM Non-Manufacturing Index, which rose more than the consensus outlook. That report, suggesting that activity in the services sector (which accounts for the lion’s share of total GDP) was heating up, set the stage for expectations about a gangbusters monthly jobs report on Friday. The 10-year Treasury yield shot up by 10 basis points (0.1 percent), which is huge for a single day movement. The 10-year yield is now at its highest level since 2011, as shown in the chart below.

That blockbuster jobs report, as it turned out, never happened. We got a headline unemployment rate of 3.7 percent that is the lowest since – kid you not – 1969, that groovy year of moon landings and Woodstock. But payroll gains, the most closely watched indicator, rose by considerably less than the expected 185K while wage growth came in right at expectations with a 2.8 percent gain. Overall, a mixed bag. Equities are roughly flat in tentative trading as we write this, while the 10-year Treasury yield continues its advance. The yield spread between 10-year and 2-year Treasuries, which earlier this year appeared on the tipping point of an inversion (in the past a reliable signal of an approaching recession), has widened to about 35 basis points.

This widening spread would be consistent with the ideas we communicated in last week’s commentary about increased inflationary expectations on the back of an ever-tightening labor market and price creep from higher tariffs on an expanded array of consumer products. So far the numbers – in particular today’s jobs data and last week’s Personal Consumption Expenditures (PCE) reading – don’t bear out the hard evidence. But the bond market could be adjusting its expectations accordingly.

Doing It On the QT

Or, maybe not. There were a couple technical factors at play this week as well, including a jump in the cost of hedging dollar exposure which had the effect of reducing demand for US Treasuries by foreign investors. This is not the first time that we have seen a sudden back-up in yields, only to dissipate in relatively short order. As for the fabled bond bull market that has endured since the early 1980s, well, there is certainly no shortage of times this has been pronounced dead, only to rise again and again.

Ultimately, of course, it all comes down to supply and demand. We know one thing with confidence – the Fed is out of the market as a buyer. While last week’s FOMC meeting didn’t produce much in the way of surprises, it did codify the understanding that the age of QT – quantitative tightening – is at hand. The Fed’s assessment of the economy is quite upbeat. The cadence of rate increases and balance sheet reduction is likely to continue well into 2019.

None of which necessarily suggests that intermediate and long term rates will surge into the stratosphere. If the domestic economy stays healthy then domestic assets should be attractive to non-US investors – an important source of demand that could keep yields in check. Indicators like corporate sales (growing at a brisk 8 percent or so) and sentiment among businesses and consumers (leading to increased spending and business investment) suggest that there is more to the current state of the economy than a fiscal sugar high from last December’s tax cuts. For the near term, our sense is that the positives continue to largely outweigh the potential negative X-factors. We may be okay in 2019 – but 2020 could be an entirely different story.

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MV Weekly Market Flash: Wages, Prices and Rates

September 28, 2018

By Masood Vojdani & Katrina Lamb, CFA

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The Federal Open Market Committee (FOMC) meeting this week came and went without much ado. The 25 basis point rate hike was fully expected, the assessment of economic risks remained “balanced” (Fed-speak for “nothing to write home about”) and the dot plots continued to suggest a total of four rate hikes in 2018 and three more in 2019 (though the market has not yet come around to full agreement on that view). A small spate of late selling seemed more technical than anything else, and on Thursday the S&P 500 resumed its customary winning ways. All quiet on the market front, or so it would seem. We will take this opportunity to call up some words we wrote way back in January of this year, in our Annual Outlook:

“Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.”

That “rustle of leaves” may take the pictorial form of a gentle, but steady, downward drift.

Nine months later, we have a somewhat better sense as to how this year’s tentative weakness in the bond market may spill over into bigger problems for a wider swath of asset classes. It calls into one’s head a phrase little used since the 1970s: wage-price spiral. There’s a plausible path to this outcome. It will require some careful attention to fixed income portfolios heading into 2019.

What’s Wrong With Being Confident?

The path to a wage-price spiral event starts with a couple pieces of what, on the face of things, should normally be good news. Both consumer confidence and business confidence – as measured by various “sentiment” indicators – are higher than they have been at any time since the clock struck January 1, 2000. In fact sentiment among small business owners is higher by some measures than it ever has been since people started measuring these things. Now, monthly jobs numbers have been strong almost without exception for many years now, but the one number that has not kept pace with the others is hourly wages. That seems to be changing. The monthly cadence was 2.5 percent (year-on-year growth) for the longest time, but now has quietly ticked up closer to 2.8 – 2.9 percent. The evidence for this cadence breaking out sharply on the upside is thus far anecdotal, seen in various business surveys rather than hard monthly numbers, but if current overall labor market patterns continue, we will not be surprised to see those hourly wage growth figures comfortably on the other side of 3 percent by, say, Q1 of next year.

Enter the Trade War

The other side of the wage-price formula – consumer prices – is already starting to feel the effects of the successive rounds of tariffs that show no signs of abating as trade war rhetoric ascends to a new level. Tariffs make imports more expensive. While the earlier rounds focused more on intermediate and industrial products, the expansion of tariffs to include just about everything shipped out of China for our shores invariably means that traditional consumer goods like electronics, clothes and toys are very much in the mix now.

What retailers will try to do is to pass on the higher cost of imports to end consumers. And here’s the rub – if consumers are those same workers whose paychecks are getting fatter from the hot labor market, then their willingness to pay more at the retail check-out will be commensurately higher. Presto! – wage price inflation, last seen under a disco ball, grooving out to Donna Summer in 1979.

Four Plus Four Equals Uncertainty

Recall that the Fed is projecting four rate hikes this year (i.e. the three already in the books plus one in December) and then three more next year as a baseline outlook. A sharp uptrend in inflation, the visible measure of a wage-price spiral, would conceivably tilt the 2019 rate case to four, or perhaps even more, increases to the Fed funds target rate. Right now the markets don’t even buy into the assumption of three hikes next year, although Eurodollar futures spreads are trending in that direction. That gentle downward drift in the bond market we illustrated in the chart above could turn into something far worse.

Moreover, the wage-price outcome would very likely have the additional effect of steepening the yield curve, as increased inflationary expectations push up intermediate and long term yields. Normally safe, long-duration fixed income exposures will look very unpleasant on portfolio statements in this scenario.

The wage-price spiral outcome, we should remind our readers, is just one possible scenario for the months ahead. But we see the factors that could produce this inflationary trend as already present, if not yet fully baked into macro data points. From a portfolio management standpoint, the near-term priorities for dealing with this scenario are: diversification of low-volatility exposures, and diversification of yield sources. Think in terms of alternative hedging strategies and yield-bearing securities that tend to exhibit low correlation with traditional credit instruments. These will be very much in focus as we start the allocation planning process for 2019.

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MV Weekly Market Flash: The Cash Equivalent’s New, Old Look

July 20, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years.  After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread. 

Meet the New Spread, Same As the Old Spread

There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.

But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.

Welcome to the Jungle

Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.

As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.

Goodbye, TINA

What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.

Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.

The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.

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MV Weekly Market Flash: A World of Pain for Consumer Staples

May 25, 2018

By Masood Vojdani & Katrina Lamb, CFA

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It’s a very good thing for US large cap equity investors that consumer staples companies make up only 7.4 percent of the S&P 500’s total market cap, while the tech sector accounts for 25.4% of the index. The chart below shows why. 

Tech stocks have outperformed the market for most of the year to date, while consumer staples have experienced a miserable couple of quarters. Here’s where those market cap discrepancies really matter: the fact that tech stocks make up a quarter of the total index means that their performance “counts” for more (we explained this in one of our commentaries a couple months ago). So, even though the magnitude of underperformance for consumer staples is greater than that of tech’s outperformance, the heavyweight sector pulls up the broad market (the dotted red line represents the total S&P 500) and, for the moment anyway, keeps it in positive territory.

Weak Defense

So what’s going on with consumer staples? By one yardstick – market volatility – the sector might have been expected to outperform over the past couple months. Consumer staples has long been regarded as a defensive sector, i.e. one which tends to do better when investors get jittery. The logic is easy to follow. A volatile market signals uncertainty about the economy, which in turn leads to households tightening their budgets. So things like expensive vacations and designer labels (which would show up in the consumer discretionary sector) get the axe, but folks still have to buy toothpaste and breakfast cereal (which are manufactured, distributed and retailed by consumer staples companies like General Mills, Sysco and Costco).

But two technical corrections of more than 10 percent didn’t send investors flocking into defensive stocks. Other traditional defensives, such as utilities, also fared relatively poorly during this period. There is one driving variable common to a variety of traditional defensives, which is rising interest rates. But there are a couple others that are particularly relevant to the woes in consumer staples.

Hard Times for Dividend Aristocrats

The connection between interest rates and defensive stocks is fairly straightforward. These stocks tend to have higher dividend payouts than more growth-oriented shares. For example, the average dividend yield in the consumer staples sector is around 3.1 percent, compared to an average yield of 1.8 percent for the S&P 500 as a whole. The relative attraction of dividends diminishes when income yields on high quality fixed income securities (like Treasury bonds) increase. This relationship is then exaggerated to an even greater extent by the abundance of algorithmic trading strategies that mindlessly key off small changes in rates, sending cascades of buy and sell orders beyond what many would see as the actual fundamental value shift.

The Worst of Times

Two other variables with a particularly pernicious effect on consumer goods companies are inflation and changing demand patterns. These variables are closely related. While inflation is still relatively low by historical standards, it has ticked up in recent months. Cost inflation – basically, higher input costs for the raw materials and the labor that go into the manufacture of consumer goods – puts downward pressure on profit margins. If companies can pass those cost increases on down the value chain – i.e. from manufacturer to distributor to retailer to end consumer – then they can contain the effect of cost inflation. But that means, ultimately, having consumers willing to pay up for the staple items they buy from week to week. And this is where that second variable – demand patterns – comes into play.

Simply put, consumers have become pickier about what they buy and how they buy, and they have a far greater spectrum of choices from which to curate their own particular needs and preferences. Time was, the weekly shopping cart was pretty predictable in terms of the packaged goods with which Mom and Dad filled it up, and also where the shelves containing those goods were located. Established brands carried a premium that was a predictable source of value for the likes of Procter & Gamble, Coca-Cola or Kraft Foods. That brand premium value hasn’t disappeared – but it has become diluted through an often bewildering assortment of products, categories and messaging. The emotional tie between a consumer and a favorite brand dissipates when the products and the messaging are constantly changing, popping into and out of existence like quantum matter.

That dynamic makes it much harder, in turn, for companies to convince their customers to accept the passing on of cost inflation. The logical outcome is lower margins, which have been the wet blanket souring quarterly earnings calls this year. Unfortunately for the companies in this sector, these are not problems that are likely to disappear with the next turn in the business cycle. Even the elite leaders, such as P&G and Unilever, have daunting challenges ahead as they try to leverage their storied pasts into the unforgiving environment of today.

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