Posts tagged Market Impact Events
Remember last Friday? Investors were in the sunniest of moods, with another month of robust job numbers on top of a better than expected first quarter GDP reading. Even productivity was improved, as we mentioned in our commentary last week (not that anyone was paying attention to the single most important economic growth measure). It was shaping up to be a merry, merry month of May…until late into the weekend when the Twitterverse called investors away from their barbeques to inform them that the trade war was back on the table. Uproar and consternation! Chinese markets, which were already open, quickly went pear-shaped and financial media outlets set up the talking points for the week.
Trade war? Wasn’t this as close to a done deal as these things get? The presumed cessation of hostilities between the US and China on trade was widely accepted by market participants as one of the two primary tailwinds for the 2019 rally in risk assets (the other being the Fed’s pivot on interest rates). By the time the S&P 500 hit a handful of new record highs in late April, a successful outcome to the long-festering trade dispute was conventional wisdom. The Chinese delegation, led by Vice-Premier Liu He, was due to arrive in Washington on May 9 for a round of talks which, if not necessarily definitive, were at least supposed to affirm the intention of both sides to reduce tensions and maintain support for global trade (through bland platitudes if not much else). Instead, those tweets by Trump late in the day on Sunday put new tariff threats back on the table and upended the conventional wisdom.
Jittery Algos, Jaded Humans
Two years into this administration, most cognitively-endowed human beings have learned a thing or two about digesting news from Twitter, particularly that which emanates from one particular account on Pennsylvania Avenue. The performance art of grandiose pronouncements which eventually dissolve into nothingness has become routine. This wasn’t entirely clear when the trade war first started to spook markets in early 2018. But the absence of tangible actions to match the rhetoric of the tweets, along with this administration’s obsession with where the Dow is on any given day, eventually made it clear to anyone paying attention that there wasn’t much in the way of bite behind the bark.
Algorithms, bereft of those cognitive abilities, are not so sanguine, which partly explains this week’s pullback (a natural pause following an extended bull run also being in the mix). The quantitative models powered by these algorithms make up the bulk of intraday trading volume. Many of them are wired to respond to –yes, really – stuff that comes out on Twitter. So the Sunday tweets begat the Monday blues. But even algorithms have a natural stopping point. As we write this on Thursday morning, the S&P 500 is around three percent off its recent high. That’s not much, especially considering that the blue chip index had racked up gains of almost 20 percent when it set the most recent high on April 30.
It’s much less, in fact, than would be the case if the collective wisdom of human and bot traders alike determined that an honest to goodness trade war was the most likely outcome of the current state of play. Fortunately, the evidence against that outcome remains compelling. It’s performance art, and as long as neither US nor Chinese negotiators want to explain to their constituencies (and, in our case, voters) why the economy collapsed on their watch it will likely remain thus.
In these weekly commentaries we periodically float “wild card” theories about the global economy. These are not outcomes we expect to happen, but alternatives with in our view a better than zero, less than fifty percent (more or less) probability. We do this not for the sake of near-term predictions, which are always silly, but as a way to identify potential ways your portfolios could be at risk. Some time late last summer we ran one of these outlier theories up the flagpole: the risk of an unexpected bounce in inflation. Now, you could say that inflation was about the last thing on anyone’s mind last fall when markets went into a funk over the prospects of lower or negative growth and observers worried about the Fed making a bad situation worse with higher interest rates. Since then, though, circumstances have changed. On the heels of a succession of outperforming economic data releases and the Fed’s embrace of dovish monetary policy, it is worth taking another look at the inflation wild card.
Where There’s Growth…
As recently as February, the economic consensus around Q1 real GDP growth was that it would barely scratch two percent, if it even managed to clock in above one percent. Today’s release by the Bureau of Economic Analysis put paid to that idea: the economy grew at a rate of 3.2 percent in the first quarter (this figure will be subject to two subsequent revisions before going into the books). Yes, there are some one-off quirks to this performance: inventory build-up by the private sector, higher exports and sharply lower imports probably won’t be sustainable trends. But personal consumption perked up nicely towards the end of the quarter and nonresidential business investment was also a positive contribution. On the heels of last month’s rebound in payroll gains, along with strong retail sales and durable goods orders, the stage would seem to be set for a near-term growth spurt.
…There Should Be Pricing Pressure
We have already seen pricing pressure work its way into corporate income statements. Companies across many key industry sectors are reporting cost pressure in their supply chains, particularly raw materials and transport costs. Wage pressures are also prevalent, which should not be surprising given the historically long run of positive monthly job creation numbers. The main concern analysts have expressed regarding these cost pressures is the effect on profit margins. If companies can’t pass on their cost increases to end customers, their own profits go down and so do their valuations.
But if consumer confidence, buoyed by rising wages and a still-tightening labor market, feeds into increased end-market demand, then companies have more leeway to pass their own intermediate goods inflation onto consumers. Voila – those consumer price indexes stuck forever just shy of two percent suddenly come to life. Again – we don’t yet see evidence of this happening. But it is plausible.
The Spoiler Argument
And if it were to come to pass…so what? Here’s the rub. Right now markets are priced for anything other than a renewed burst of inflation. The bond market has taken “Fed pivot” and run with it, now projecting a greater-than-not likelihood that the Fed will cut rates at least once before the end of the year. Well, guess what: if this vortex of higher than expected economic growth pushes up those consumer inflation numbers then we’re not going to see a rate cut. More likely we would see a yield curve steepening, leading to a repositioning of equity valuations as analysts go back and plug higher discount rates into their free cash flow valuation models. In the long run the repositioning might be good for markets (if investors think the higher growth is sustainable). In the short run it would likely be disruptive.
To repeat: this is a wild card scenario – a joker in the deck, not a most-likely outcome. But it’s worth keeping an eye on. It’s also worth keeping an eye on the Q1 productivity number when that comes out next week. One way (the only way, really) to marry higher growth with low to moderate inflation is through higher productivity and lower unit wage costs. We haven’t seen much of an uptick in productivity for many, many quarters. Now would be a good time for that to change.
New fiscal quarter and same old bull market, or so it would appear. Which probably should not come as much of a surprise, given the veritable absence of anything markets would find new and newsworthy. The Fed pivot has come and gone, the trade war turned out in the end to be a paper tiger, economic growth is slowing everywhere but still positive. Corporate earnings will be weaker than previous quarters but probably not as weak as the dramatically ratcheted-down estimates of Wall Street analysts. The old parlor trick of outperforming a low bar is back in full force! Meanwhile, the Brexit extension to the extension to the extension (which you, dear reader, will recall we predicted back in January) was agreed to during the same week that we got to see a picture of an actual black hole, in space. No coincidence, surely, between those two events.
The Rule of 145 Days
So the good times continue…depending on your perspective. Year to date? Things are great. The S&P 500 is up nearly 16 percent (in price terms) since the start of 2019, which is one of the best starts to a calendar year, ever. Moreover, the intraday tempo of this rally has been relatively calm, with only a small number of instances where the index moved by more than one percent from open to close.
If you step back and take a wider view, though, the picture looks a bit different.
That 16 percent calendar year gain looks a bit different in the context of what preceded it: not just the sharp pullback of last autumn but a much longer trading period going back to January 2018. Here’s what has happened since the S&P 500 reached a then-all time high on January 26 of that year. There was a technical correction, followed by an arduous 145-day climb to a new record high (in August), then a bit more upward momentum to the record high of 2930 set on September 20. 135 days have passed since then, and now we are within striking distance of yet another record high (maybe, who knows, when the day count hits 145 again).
What this means in actual performance terms is that the S&P 500, as of yesterday’s close, had gained a grand total of 0.5 percent from that January 26, 2018 peak. That’s cumulative, not annualized. Zero point five percent is not the stuff of a robust bull. Arguably, this sixteen month period represents a distinct phase of the great bull market that started in 2009: a phase we would term “wait-and-see.” The previous phase was the exceedingly non-volatile stretch from November 2016 to January 2018 (which phase certainly qualified for the moniker “robust”), and before that was the Mid-Decade Pause (another wait-and-see period) that came on the heels of the Fed’s ending its last quantitative easing program in 2014 and persisted through summer 2016.
That 2014-16 period may be instructive. Below we extend that same S&P 500 chart shown above to encompass a longer time period, where this bull market’s distinct phases are evident.
Of course, and contrary to our tongue-in-cheek section heading above, there is no such thing as a “rule of 145 days.” But it does feel like we might be getting close to the end of this particular phase of the bull as the market closes in on a new record high. The question, as always, is what comes next. Recall that in 2016 there was not much in the way of a compelling case to make that would have predicted the bull run of 2017. The bond market for much of this year has been suggesting that slower times are ahead. But the tea leaves, as always, are subject to multiple interpretations.
Well, the first quarter of 2019 is about to enter the history books, and it’s been an odd one. On so very many levels, only a couple of which will be the subjects of this commentary. To be specific: stocks and bonds. Here’s a little snapshot to get the discussion started – the performance of the S&P 500 against the 10-year Treasury yield since the start of the year.
Livin’ La Vida Loca
For an intermediate-term bond investor these are good times (bond prices go up when yields go down). For an equity investor these are very good times – the 2019 bull run by the S&P 500 is that index’s best calendar year start in 20 years. There are plenty of reasons, though, to doubt that the good times will continue indefinitely. Something’s going to give. The bond market suggests the economic slowdown that started in the second half of last year (mostly, to date, outside the US) is going to intensify both abroad and at home. The stock market’s take is that any slowdown will be one of those fabled “soft landings” that are a perennial balm to jittery nerves, and will be more than compensated by a dovish Fed willing to use any means available to avoid a repeat of last fall’s brief debacle in risk asset markets (on this point there is some interesting chatter circulating around financial circles to the effect that the equity market has become “too big to fail,” a piquant topic we will consider in closer detail in upcoming commentaries).
We have been staring at a flattening yield curve for many months already, but we can now dispense with the gerundive form of the adjective: “flattening” it was, “flat” it now is. The chart below shows the spread between the 10-year yield and the 1-year yield; these two maturities are separated by nine years and, now, about five basis points of yield.
Short term fixed rate bonds benefitted from the radical pivot the Fed made back in January when it took further rate hikes off the table (which pivot was formally ratified this past Wednesday when the infamous “dot plot” of FOMC members’ Fed funds rate projections confirmed a base case of no more hikes in 2019). But movement in the 10-year yield was more pronounced; remember that the 10-year was flirting with 3.25 percent last fall, a rate many observers felt would trigger major institutional moves (e.g. by pension funds and insurance companies) out of equities and back into fixed income). Now the 10-year is just above 2.5 percent. Treasuries are the safest of all safe havens, and there appears to be plenty of safe-seeking sentiment out there. The yield curve is ever so close to inverting. If it does, expect the prognostications about recession to go into overdrive (though we will restate what we have said many times on these pages, that evidential data in support of an imminent recession are not apparent to the naked eye).
What about equities? The simple price gain (excluding dividends) for the S&P 500 is more than 13 percent since the beginning of the year, within relatively easy striking distance of the 9/20/18 record high and more or less done with every major technical barrier left over from the October-December meltdown. “Pain trade” activity has been particularly helpful in extending the relief rally, as money that fled to the sidelines after December tries to play catch-up (sell low, buy high, the eternal plight of the investor unable to escape the pull of fear and greed).
The easy explanation for the stock market’s tailwind, the one that invariably is deployed to sum up any given day’s trading activity, is the aforementioned Fed pivot plus relaxed tensions in the US-China trade war. That may have been a sufficient way to characterize the relief rally back from last year’s losses, but we question how much more upside either of those factors alone can generate.
The Fed itself suggested, during Wednesday’s post-FOMC meeting data dump and press conference, that the economic situation seems more negative than thought in the wake of the December meeting. The central bank still appears to have little understanding of why inflation has remained so persistently low throughout the recovery, but finally seems to be tipping its hat towards the notion that secular stagnation (the phenomenon of lower growth at a more systemic, less cyclical level) may be at hand. This view would seem to be more in line with the view of the bond market than with that of equities.
As we said above – something’s gotta give. Will that “something” be a flat yield curve that tips into inversion? If so, what else gives? That will be something to watch as the second quarter gets underway.
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.