Posts tagged Market Impact Events
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
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.
2016 has been a rough year for the predictive sciences. The two marquee debacles, of course, were the Brexit vote in June and then the U.S. presidential election in November. On both occasions, the polls said one thing – with varying but largely robust degrees of confidence – while the outcomes said another. “The polls failed us” went the refrain of a chorus of observers in the aftermath of June 23 and November 8.
But when we say that “predictions were the year’s biggest loser” do we necessarily mean the polls? Or, rather, was the real culprit the folly of those who use predictive data to make their own prognostications about event outcomes, and the likely ensuing market reactions? If you’re a long-time reader of our commentary, you probably know where we’re going with this. Event-driven investors were tripped up by predictive folly in 2016. If we were to make our own prediction it would be this: they will be tempted to trip up again in the year ahead. We hope the events of 2016 will be an incentive for fewer to bite at the tempting apple of predictions and odds.
The Law of Small Numbers
Predictions necessarily derive from sample sets – a (if done right) random subset of a larger population or process. Polls are one example of a sample set – a slice of the likely voting predilections of a larger population. Coin tosses are another sample set, with each toss representing a sliver of a larger process that generates a defined outcome of either heads or tails. Students of the science of probability and statistics learn certain rules about the handling of sample sets; unfortunately, those rules tend to get lost in the noise of media coverage of events with probabilistic outcomes. Look no further than those two headline events of Brexit and Trump, and the Law of Small Numbers.
Media outlets tend to present poll samplings as a probability-weighted outcome. When an article says that the likelihood of Britons voting to remain in the EU is about 90 percent, or that Hillary Clinton’s chances of winning the White House are 85 percent, those sound like pretty good odds, right? So when Britain decides to bail on Europe and Donald Trump scoops up more than 270 votes in the Electoral College – well, the polls failed, didn’t they?
Not so fast. Let’s revisit that notion of sample sets. A fair toss of a coin has a 50 percent chance of coming up heads or tails. If you toss a coin ten times you would expect to see five heads and five tails. But if you’ve ever tried this out, you know that any discrete sequence of ten coin tosses may show something wildly different: seven heads, or ten tails, or any other combination. If you tossed that coin 100,000 times you would almost certainly record a number of heads (or tails) vanishingly close to 50.0 percent. That’s called the Law of Large Numbers.
But within that sequence of 100,000 tosses will be smaller handfuls of ten heads in a row, or nine tails and one head, or something else. That’s called the Law of Small Numbers, which says that the connection between underlying probabilities and observed results is much weaker when the sample size is small.
Why should you care? Because the outcome of a single event, like a referendum or a presidential election, is roughly analogous to tossing a coin a small number of times. You’re more likely than not to see the expected outcome. But there is a meaningful probability that you will see a different outcome. If you could simulate the presidential election 100,000 times (heaven forbid), you would probably see a Clinton victory closely aligned with what the polling data predicted. But the real world only offered up one simulation, and that was the actual outcome on November 8.
If Not One, then Zero
The Law of Small Numbers is what drives us to consistently advise our clients against playing the odds with individual events. Think about what happened to bond yields, the U.S. dollar and industrial commodities immediately after the election: they all spiked. Granted, an inflation trade trend of sorts was already underway, but the outcome of the election amplified it. Had the election gone the other way, it is unlikely that we would have seen those hockey-stick charts for copper and the 10-year yield that we featured in our commentary a couple weeks ago.
In other words, these individual events have discrete, binary outcomes. Yes / no, one / zero, win / lose. And not just for referenda or elections. “Production freeze / no production freeze” was the event headlining this week, as a tortuously arrived-at thumbs-up for an OPEC deal sent crude prices soaring by nine percent on Wednesday (what would they have done if the deal had fallen through?). For just about every such macro event there are highly sophisticated futures markets predicting the odds. And there are plenty of willing investors lining up to bet on the action, misunderstanding the predictive science to believe that the likelihood of their being on the wrong side of the trade is vanishingly low. The odds, they believe, are ever in their favor.
If nothing else, we hope that the colossal predictive fails of 2016 will have the positive effect of dissuading more investors from parting with their money in this fashion.
Events Aplenty in 2017
We don’t even have to look ahead to 2017; just within the next seven days we will have a critically important referendum (on Sunday) in Italy, the outcome of which is likely to have an outsize directional impact on Italian (and regional Eurozone) financial stocks, and then the FOMC statement next Wednesday where a rate hike is expected. Next year there are elections in France and Germany. Not to mention, of course, decisions about U.S. economic policy that will either validate or not (we think not) the “reflation-infrastructure trade” so breathlessly covered by the financial media over the past three weeks.
As a matter of course, we necessarily pay attention to all these events as they get folded into the overall picture of the global economy and capital markets. But rather than taking predictive bets on any given outcome, we ask how that outcome impacts the larger, constant concerns of organic growth, profitability and asset quality that in the long run are the most important determinants of stock price performance. Truth be told, our assessment of trends in global supply and demand, based on consumer expenditures, business investment and the like, has not changed much over the course of the last several months.
We will have more to say about our views when we publish our annual market outlook in January. For now, though, we will stay diversified and resist the temptation to push the envelope too far in any one direction in response to – or in expectation of – individual event outcomes.
The Efficient Market Hypothesis, one of the cornerstones of modern financial theory, argues that asset prices always reflect every single shred of information available to investors. Such information, aver EMH’s acolytes, is instantaneously processed by investors through a rational, omniscient, net present value-weighted assessment of probability-weighted future outcomes. Any mispricing between assets and their real underlying value is instantaneously arbitraged away; there are never any $20 bills lying on the street as a free lunch to passers-by.
If the EMH worked as advertised, then the reaction to last week’s presidential election by fixed income yields and industrial metals would have been…well, in our view, not particularly interesting. Instead, the reaction was eye-catching indeed, as shown in the chart below, which forces the question. Do those spikes in copper prices and the 10-year Treasury yield reflect a hyper-rational pricing of all information available to thinking women and men? Or, rather, are they those proverbial $20 bills fluttering along the pavement?
Runnin’ Down a Dream
The meme that took hold almost as soon as Trump uttered the word “infrastructure” in his victory speech was “infrastructure-reflation trade.” Anyone watching the futures market saw this meme go viral as Tuesday morphed into Wednesday. The idea behind this whiplash in different asset classes appears to be: a torrent of federal spending cascading into US infrastructure projects, piling billions onto the federal deficit and igniting an inflationary heatwave. Bond yields would rise (inflation), and industrial metals prices would soar (demand). If this outcome were highly likely, then EMH would be doing its job just fine as assets instantaneously absorbed the news and repriced.
But a more truly rational assessment, in our opinion, would be that this infrastructure-reflation scenario is very, very unlikely to happen. Infrastructure has not been and will continue not to be a top priority for Congressional Republicans. Even if an infrastructure bill were to make its way through the legislative sausage factory, it would be in the end a very watered down version of anything Trump may have promised on the campaign trail. Even then, there would be a significant lag between the passage of any such bill and the formalization of “shovel-ready” projects to be on the receiving end of the funds. Even then, the net impact on headline macroeconomic data points like jobs or consumer prices would very likely be muted for the foreseeable future.
In short, we believe the “infrastructure-reflation trade” is little more than a mirage, a knee-jerk reaction more than a rational expression of future outcomes, and unlikely to be the kind of paradigm momentum shift in asset class trends many observers continue to believe is happening.
Tax Cuts Trump Public Works
The 2016 election does mean one-party rule, and this means an ability to push through economic policy in a way that the gridlocked Washington, DC could not achieve for most of the past eight years. But behind the smiling façade put up in public there are, by our reckoning, two distinct power factions in the Republican Congress with which the incoming administration will have to horse trade. There is Paul Ryan, the House Speaker who probably better than anyone else in Washington knows exactly what he wants to accomplish in the way of economic policy this year. These goals are simple and widely known: tax cuts for the wealthy, and far-reaching deregulation & de-funding with an emphasis on the financial, health care and energy sectors. “Ryanism” is in essence the core fiscal agenda that has motivated Republicans and their conservative donors & lobbyists since the Reagan era. We expect early policymaking to focus nearly exclusively on these issues.
The second power faction, then, are the legislators on Ryan’s right wing flank, the self-styled Freedom Caucus. This bloc would pose a further obstacle to any infrastructure bill that might come out of horse trading between Ryan’s team and the new White House. While the Freedom Caucus is arguably animated more by cultural issues than economic policy, they are strenuously opposed in principle to government spending outside of narrowly-defined defense obligations. The Freedom Caucus is where the “reflation” part of that infrastructure-reflation trade goes to die. Reflation would necessitate the large-scale creation of new, debt-financed money. The votes simply would not be there. The more hard-line caucus members are likely to push hard for dramatic spending cuts even to offset the imminent tax cuts, and there won’t be much left after that for offsetting massive public works projects.
Of course, infrastructure can also fall into the private domain, and there is much animated chatter about private-public cooperation to mitigate the impact of projects on the federal budget. But major infrastructure areas like roads and bridges, that are badly in need of upgrade, generally fall out of the purview of private money, because they do not offer commercially competitive returns. It is unclear how much practical infrastructure could realistically be funded from private investment sources.
Trumpism in the Age of Ryan
None of this is to say that the incoming administration will not have an impact on economic policy choices; by this point it should be clear to everyone that Donald Trump should not be underestimated. The President-elect knows his base; he understands what motivates the legions of voters in Wisconsin, Pennsylvania and Michigan who turned up on Election Day for him. And he will have to show some love to this base. Nothing would render Trumpism a mere historical sideshow than a belief taking hold that their leader is a sell-out who will give the donors and DC elites the keys to the kingdom while they, the base, continue to get the short end of the stick.
To that end, optics will require the new economic policy to be perceived as something more than just the wholesale implementation of Paul Ryan’s narrow agenda of millionaire tax cuts and deregulation. But, as we noted in our commentary last week, the new team is likely to tread cautiously in its first months of occupying the White House. They will perhaps be more likely to find their red meat for the base in other areas – immigration and socio-cultural flashpoints, for example – and more or less let Ryan and Congress hash out and implement their economic agenda.
All of which is to say that, in our opinion, those investors who have been chasing up industrial metals prices and dumping intermediate bonds in these first days of the new order are likely chasing mirages.