Posts tagged Risk
2011, 2012, 2015…ah, memories of summertime Eurozone crises past. On the cusp of the summer of ’18 it would appear not entirely unreasonable to imagine that we are due for another languid spell of troubled waters across the Atlantic. Political dysfunction in the southern periphery was on full display this week, first with Italy’s fumbling attempt to form a new government and then with a no-confidence vote shoving Spanish PM Mariano Rajoy out of office in favor of Socialist Party leader Pedro Sanchez. Word is that Rajoy sat out the parliamentary hearings leading to his ouster, choosing to spend those eight hours in a Madrid restaurant instead. Respect.
Oh, and the US went ahead and imposed steel and aluminum tariffs on the EU, leading EU trade commissioner Cecilia Malmstrom to pronounce a “closed door” on EU-US trade liberalization talks. Abandon hope, ye bourbon drinkers of Europe. The euro continued its slide while investors hugged onto German Bunds like a Steiff bear, illustrated in the charts below.
The big drama this week, of course, came courtesy of Italian president Sergio Mattarella as he gave a Roman thumbs-down to the cabinet submitted by the recent populist partnership of the Five Star Movement and Northern League (see here for our analysis last month of the implications of this partnership). The move caught investors by surprise and Italian bond yields soared (the blue line in the leftmost chart above).
It may seem counterintuitive that Mattarella’s move sparked a negative market reaction. After all, his opposition to the cabinet slate was focused on the proposed finance minister Paolo Savona, an outspoken critic of the single currency union. The resulting impasse with the FSM/League coalition led to a proposed caretaker government led by Carlo Cottarelli, a former IMF official. That sounds awfully market-friendly…but no, investors read this as a resurgence of the “in or out” question that last reared its head with the Greek financial crisis of July 2015. The thinking was that Mattarella’s technocratic move would give a new tailwind to the Northern League (which indeed has seen a sizable bump in the polls this week) and could result in a more decisive victory for the “out” faction in another round of elections this fall. Suddenly “Quitaly” was the new “Brexit.”
Trouble Ahead, Trouble Behind
The Mattarella tempest resolved itself just in time for markets to breathe a tempered sigh of relief and not pay attention to the no-confidence vote brewing over in Spain. The FSM/League coalition came back with an “acceptable” candidate for finance minister, Giovanni Tria (a political economy professor), Mattarella gave the green light, and all appears ready to proceed apace. Italian assets recovered some lost ground. The can appears safely kicked down the road once again, and now we can all relax and start watching the World Cup, right?
Perhaps not. There are challenges aplenty for this new, not entirely stable coalition government in Italy – on domestic debt levels, on immigration, and – yes – on the general relationship with Brussels, which is hardly amicable to begin with. And while observers don’t see much in the way of market ripples coming from the recent events in Spain, the fact remains that the no-confidence vote there came about due to revelations of political corruption and a slush fund operated by senior members of former PM Rajoy’s Popular Party – another blow to Establishment credibility. The new government led by the Socialists includes an unwieldly array of coalition partners including nationalist Basque and Catalonian factions and the far-left Podemos Party – so there is hardly a unifying ideology there.
In fact, very little about Europe’s political environment looks stable. Nationalist and borderline fascist blocs control much of the eastern periphery of the EU, Germany’s “grand coalition” is struggling, and all the while thorny issues with Brexit persist on the western front. The economy has reverted to slow-growth mode, the ECB is trying to navigate its way out of its monetary stimulus obligations, and now Brussels needs to rally the troops around a united response to those ill-advised US tariffs.
It may be summertime, but the living would appear to be anything but easy.
There are weeks when covering financial markets is interesting and engaging, where all sorts of macroeconomic variables and corporate business models demand analysis and discerning judgment for their potential impact on asset prices. And then there are weeks like this week, when none of those things seem to matter. “OMG Trump’s going to start a trade war and everything is going to be terrible” frets Ms. Market, just before the opening bell at 9:30 am. “No, silly, nothing’s going to happen, it’s just boys being boys, talking tough as always” say Ms. Market’s girlfriends while taking away her double espresso and offering some soothing chamomile tea instead. And so it goes, back and forth, up and down, day after tiresome day.
Soya Bean Farmers for Trump
We continue to believe that an all-out trade war between the US and its major trading partners is an unlikely scenario. But it has now been just shy of two months since the first announcement by the US administration of proposed new tariffs on steel and aluminum. The war of words, at least, shows no sign of fading into the background. Attention must be paid.
Moreover, the contours of the dispute have narrowed and hardened. Recall that the original steel and aluminum tariffs were comprehensive, drawing responses from all major trading partners. This week’s tough trade talk has been a much more bilateral affair between the US and China, starting with the formalization of $50 billion in new tariffs announced by the US on April 2. China promptly responded with its own countermeasures: $50 billion including major US exports like soya beans – a move that would go straight to the wallets of farmers in Trump-friendly rural America. Now here we are, on Friday morning, with the stakes raised to $100 billion after the latest US White House release. $100 billion represents about 20 percent of the total value of US imports from China. It would necessarily include many of the consumer products Americans buy – potentially suggesting a catalyst for higher inflation.
What Are Words For?
The message from the administration’s policy voices, such as they exist, to world markets has been essentially this: ignore our blustery words, they’re just harmless morsels of red meat for our rabid political base. All these tariff proposals, according to this line of thought, are just opening gambits for negotiation. Nobody really wants a trade war. This message was persuasive enough to bring Ms. Market out of her early morning funk on Wednesday. What was shaping up to be another one of those disheartening two percent-plus intraday plunges reversed course and finished north of one percent in the green column. We’ll see if the sweet talk is able to work its magic again today, with the S&P 500 back on the fainting couch during morning trading.
The other reason why markets may be inclined to not read too much into the playground tough talk is that actually executing a trade war would be far more complex than simply reading off lists of products and associated tariffs. The global economy truly is interlocked. What this means in practice is that trade is not anywhere nearly as simple as “China makes X, US makes Y and Germany makes Z.” Companies have invested billions upon billions of dollars in intricate value chains that start with basic raw inputs, go through multiple levels of manufacturing, wholesaling and retailing, and involve many different countries throughout the process. Dismantling these value chains, while theoretically possible, would result in an economy barely recognizable to the employees and consumers who have become used to them.
The earnings season for the first quarter is about to get underway, and it looks to be a barnstormer. FactSet, a research company, estimates that earnings per share for S&P 500 companies will grow around 17 percent year-over-year on average, which would make it the strongest quarter in more than 5 years (and, rationally, provide a nice tailwind for stock price valuations). The vast majority of these companies have absolutely no interest in being conscripted as foot soldiers in a trade war, and they will be sure to make their voices heard through plenty of influential lobbying channels. On the US side, at least, there is nothing remotely like a unified “team” suited up to do trade battle – and if they were to push the envelope further, they would almost certainly encounter more unity and clarity of purpose on the Chinese side.
In the end, the trade hawks in the administration may find a way to make do with a few cosmetic, harmless face-saving “wins” while quietly retreating from the battlefield. Meanwhile, though, we may have to put up with a few more of these irrational weeks in the market. Oh well. At least it’s springtime.
The S&P 500 has appreciated 3.6 percent in price terms in the first eight days of trading this year. It seems highly unlikely that the index will match this pace for the year’s remaining 242 trading days, so it’s reasonable to wonder what’s going to happen next. It’s always a fool’s errand to predict the timing and magnitude of future price movements; for clues, though, one’s best bet would probably be to follow the bond market. Amid all the exuberance in equities, there is a palpable edginess in the once staid world of fixed income. That edginess was on full display for a few hours Wednesday morning. A rumor floated out that China’s monetary authorities (who also happen to be the world’s principal consumers of US Treasury debt) were considering scaling back their purchases of US sovereigns, presumably as a cautionary move to diversify the composition of their foreign exchange reserves. Bond yields spiked immediately, and the 10-year yield shot up perilously close to last year’s high mark of 2.63 percent. That’s also the 10-year’s peak yield since the crazy days of 2013’s “taper tantrum” – remember those good times? The chart below shows the 10-year yield trend over the past five years.
At the Mercy of Supply and Demand
Wednesday’s mini-panic dissipated soon enough; the 10-year yield fell back and remains, as we close out the week, around 5 to 8 basis points below that 2.63 percent threshold (a handful of bond pros out there believe markets will all go haywire if that threshold is breached, for reasons with which we don’t necessarily agree). The Chinese put out an anodyne denial of any intentions to scale back Treasury purchases. The S&P 500, which Wednesday morning futures indicated could suffer a meaningful pullback, briskly resumed its winning ways. And all the while volatility has remained in the fetal position which has been its custom for the last year.
But that hair-trigger reaction to the China rumor underscored just how antsy the bond market is right now, and how exposed it is to the basic laws of supply and demand. Bear in mind that intermediate and long term bond prices are subject to many variables, while short term bonds tend to much more closely track the Fed. One of the key drivers keeping yields in check for the past several years has been robust demand from overseas – robust enough to make up for the reduction in demand at home when the Fed ended its quantitative easing program. If international investors turn sour on US credit – for whatever reason, be it inflationary concerns, a bearish outlook on the dollar or even jitters over our chaotic politics – that has the potential to push yields well past the notional 2.63 percent ceiling. A subsequent move towards 3 percent would not be out of the question.
Visions of 1994 Dancing In Their Heads
The bond market angst has its own mantra: “Remember 1994!” That, of course, was the year the Greenspan Fed surprised the markets with an unexpectedly aggressive interest rate policy, starting with a rate hike nobody was anticipating in February of that year. Investors will remember 1994 as being a particularly roller-coaster one for stocks, as the surprise rate hikes caught an ebullient bull market off guard. The chart below illustrates the volatile peaks and valleys experienced by the S&P 500 that year.
Now, the conventional wisdom in 2018 is that the Fed will do its utmost to avoid the kind of surprises the Greenspan Fed engineered over the course of 1994 (which included a surprise 50 basis point hike in the middle of the year). But investors are also cognizant of the reality that there are new faces populating the Open Market Commission, which of course will feature a new chair in the person of Jerome Powell. All else being equal, the new Fed is likely to proceed cautiously and not risk unnerving markets with a policy surprise. But all else may not be equal, particularly if we get that inflationary surprise we’ve been discussing in a number of these weekly commentaries. Then, a new Fed trying to get its sea legs may face the urgency of making decisions amid a tempest not of its own making.
We’ve had some reasonably benign price numbers come out this week: core producer and consumer prices largely within expectations. Bond investors appear relieved – yields have been fairly muted yesterday and today even while equities keep up their frenetic go-go dance routine. But there is not much complacency behind the surface calm.
So, it’s that time of year again. Those endless “year in review” digests, the “10 best songs/books/episodes/tweets of 2017” listicles, the prognostications about what 2018 has in store. As if anyone actually knows. Yet, despite the fatuousness of the Old Year / New Year content factory, we absorb it all nonetheless, because we align the pace of our lives to the metronome of the calendar. The 365 days bookended by January 1 and December 31 are inherently no different than any other random sequential span of days. Yet we endow them with special meaning. How many investors know how their portfolios performed from, say, May 7 2015 to May 6, 2016? Some particularly assiduous types, perhaps, but not many! But how that mix of assets performed over the 12 months ended 31 December – well, to that particular performance metric attention must be paid.
683 Days and Who Cares
There’s nothing wrong, of course, with ordering our lives around the calendar. After all, that annual portfolio performance number does factor into something very real, namely the taxes on interest, dividends and capital gains to be paid by April 15. The problem with our calendar-centricness comes when we overplay the importance of these arbitrary dates in the context of asset market trends. 2017 was a good year for US equities. So was 2016 and for that matter so were 2013 and 2014 (2015 was so-so). There is a tendency to think, as one year ends and another begins, that some new dynamic must be at hand: some confluence of factors that will lend their distinct imprimatur to 2018. Nowhere do we see this tendency more pronounced – particularly this long into a bull run – than in people’s expectations about the arrival of the next reversal.
On February 11, 2016, the S&P 500 had retreated 14.2 percent from its previous all-time high reached on May 21, 2015 -- an elapsed time of 266 days. In between that high and low point, the blue chip index experienced another correction, falling by 12.4 percent from that May 21 high to October 25 (the market recovered again before falling in that subsequent Q1 2016 pullback). By popular convention, a “correction” represents a pullback of 10 percent or more from a previous high.
Here at MVF, we have our own metric of defining a meaningful pullback / recovery event: a retreat of more than 5 percent from a previous high, followed by a recovery of at least 5 percent from the low. We make note of this because it has been 683 days since the last 5 percent-plus pullback (corresponding to that 2/11/16 event). Now, 683 days is a long time. A very long time. Longer, in fact, than any other elapsed number of calendar days between two pullbacks of 5 percent or more in the S&P 500 since the end of the Second World War (the previous record being 593 days between December 18, 1957 and August 3, 1959). We came close – the S&P 500 fell about 4.8 percent from its previous high just before last year’s election. But close doesn’t count; the record stands. If we wake up on the morning of February 11, 2018 having not experienced a pullback of 5 percent or more from 2690 (the last high point on 12/18/17) then a full two years will have elapsed without a meaningful reversal in the market’s fortunes.
Pullbacks Don’t Need Reasons…
The question is, should anyone care that the current stretch of calm waters is the longest in postwar history? The answer is no, but the answer requires establishing the difference between a pullback (which can happen any time and often for no apparent reason at all) and a bear market (which tends to happen for specific reasons, is structural in nature and is also very infrequent). Perhaps the best illustration of this is the extremely brief, but nonetheless “meaningful,” pullback the market experienced in October 2014. The S&P 500 fell about 7.4 percent over a period of just less than a month from late September to early October (in reality, most of the carnage happened in a very brief few days leading up to the October 15 floor). And then it was over, and nobody quite knew what had happened. There was a brief “flash crash” in Treasury yields, there were some disconcerting headlines about the Ebola disease, and there was a freak-out of very short duration. And then it was over and back to business as usual.
…Bear Markets Do Need Reasons
That 2014 freak-out was largely due to chance – a random confluence of events that just happened, on that particular calendar week, to engender a brief market squall. It is also largely a matter of chance that the market didn’t pull back by more than 5 percent in late October 2016 (before the election), and it is largely a matter of chance that none of the various X-factors that bubbled up over the course of 2017 managed to form a vortex of disruption strong enough to pull down asset prices. In other words, that 683 day record from the last meaningful pullback event is due more to chance than to some unique set of circumstances. Another squall similar to the Ebola frenzy could also break out at any time, also largely due to chance.
Bear markets are different. The difference between the market crash of 2008 and that Ebola pullback wasn’t just a difference in magnitude, but in character. The 2008 event came along with an economic recession, which for its part came about on account of a systemic financial crisis that threatened to disrupt everything from bond markets to corporate payroll direct deposits. The textbook bear market, which ran from 1968 to 1982, came alongside the US economy’s running out of gas after its breakneck pace in the 1950s and 1960s. The high inflation, high interest rates and lackluster growth throughout much of the 1970s supplied plenty of reason for investors to avoid or dramatically reduce exposure to common stocks and bonds, in favor of real assets like precious metals and fossil fuels.
As this calendar year turns, we see very few signs of the kind of economic or financial unrest that could metastasize into a full-fledged bear market. That’s not to say that everything is rosy, and you can count on us to cast a cold eye over the particulars of the global landscape in our Annual Outlook next month. But the key features of that landscape – low inflation, moderate growth in output and stable labor markets – do not appear positioned for any kind of major sea change. Corporate earnings look set to continue to grow in the high single or low double digits, on average. We suggest keeping this in mind if you wake up one day and find your favorite stock market index pulling back by a few percent. Remember the Ebola freak-out. Remember that these things happen largely by chance. And remember that markets don’t march to the beat of the calendar.
Happy New Year to you and yours.
At least tulips were pretty to look at, on 17th century Amsterdam streets. Pets.com actually facilitated the sale of real products in its millennial heyday (at a steep loss, sure, but still). Was gold really 300 percent more glittery in January 1980 than it was in January 1979? Who knows, but, you, know, gold! Where there’s a bubble, there’s always something that at one time made sense, long before triple- or quadruple-digit annual returns turned the “thing” from obscure novelty to popular get-rich-quick sensation.
So what is the “thing” about so-called crypto-currencies and their most visible public face, bitcoin, which at the end of November was worth more than 1,700 percent of its value at the beginning of 2017? The crypto-currency phenomenon appears to be one of the only viable newsworthy events that can compete with Trump’s tweets for air time as this oddest of years finally approaches its end. It’s not our cup of tea, but as commentators on all things investment markets, we would be remiss by not giving the crypto-craze at least one column’s worth of consideration.
Bitcoin has been around for a scant nine years, presciently coming into the world around the same time that financial markets were falling apart in the great market crash of 2008. A mysterious figure going by the name of Satoshi Nakamoto (whose actual identity remains a mystery today) posted an arcane description of the protocols for a decentralized financial ledger technology onto an obscure mailing list for techies with a libertarian bent. The technology, called blockchain, is what bitcoin runs on much in the way that all websites run on the decentralized technology protocols that govern the Internet. Initially, bitcoins were an object of interest for only two groups of users: computer programmers, who earned rewards for solving complex programming issues (“mining” bitcoins), and shadowy denizens of the “dark web” of illegal drug traffickers and the like, who were attracted to the opaque features of blockchain through which they could trade and deal anonymously.
The Price of Everything…
Clearly, crypto-currencies’ days of nerdy and shady obscurity are long gone. They are now, for better or worse, in the process of transitioning to something resembling a mainstream asset class. This week, bitcoin futures began trading on the Chicago Board of Options Exchange (CBOE) and are due to launch on CBOE’s longstanding rival, the Chicago Mercantile Exchange (CME). A handful of large financial institutions are pushing the SEC for approval to launch bitcoin ETFs so that all the world can join in the fun. In a bit of sideline humor, the first ETF application earlier this year was submitted by none other than the Winklevoss twins, of Facebook notoriety. That application was denied. Fans hope that endowing the nascent crypto-currencies with the respectability of established platforms and institutions will facilitate efficient price discovery, expand the participant base and encourage liquidity.
…The Value of Nothing
Price efficiency and liquidity are noble aims, but they do not solve the fundamental question anyone planning to take a punt on crypto-currencies should ask: what exactly are they, and how should they be valued? Clearly, crypto-currencies do not bear the characteristics of either fixed income (legally binding claims to a known set of cash flows) or equities (residual nonbinding claims on company profits). They are more like commodities, perhaps, in having no intrinsic worth other than what people are willing to pay for them (bars of gold, barrels of oil and the like generate no cash flows and pay no dividends). But all commodities have specific uses in the real world, whether powering internal combustion engines or glittering from the necks of fashionable humans. Thus far, at least, there is no convincing use case for crypto-currencies outside of those obscure digital corners where they have resided to date.
Moreover, to call them currencies at all is to take very generous liberties with the meaning of “currency.” A reliable currency fulfills three specific use cases: a store of value, a medium of exchange and a unit of accounting measurement. An instrument capable of rising or falling by double digits on any given trading day falls woefully short of any of these three uses. Imagine, for a moment, that you live in a world where your home mortgage is denominated in bitcoin. How thrilled would you be to have no idea whether next month’s payment obligation would be a fraction of this month’s, or greater by a magnitude of ten or more? Until and unless these use case problems are solved, bitcoin and its ilk are no more currencies than are beads or clamshells.
Moreover, the claim made by some that bitcoin has the potential to be a new variation of the old gold standard is ludicrous. The argument here rests on the fact of bitcoin’s scarcity: baked into the computer code it runs on is a hard limit of 21 million bitcoins that can ever be issued. Like gold, goes this argument, the scarcity makes it a durable store of value. This argument fails for two reasons. First, bitcoin itself may be limited in maximum quantity, but there are now plenty of competing crypto-currencies out there and thus potentially no limits at all. Second, what made the gold standard work was not the inherent nature of the commodity itself but the fact that one ounce of gold was always exchangeable for a fixed amount of a national currency – the British pound sterling for most of the gold standard era – so there was never a doubt as to the relationship between a yellow rock mined from the ground and the cash that facilitated activity in the real economy. Sure, you could theoretically fix the value of a single bitcoin in US dollars or euros and call it a standard – but what would be the point?
When the Music’s Over
The most likely end to the crypto-currency craze, like those of bubbles past, will be pain for anyone left holding the bag when the music stops. But that does not mean there is no future for digital money. After all, the crash after the dot-com bubble did not arrest the rapid development of the Internet. In the case of the crypto-currencies it is the underlying technology – the blockchain distributed ledger system – that has real potential to revolutionize the world of financial payment systems. The technology is being widely studied by central banks – not as a way to decouple payment systems from national regulators, but as a way for the banks to provide better oversight to the rapidly growing marketplace for financial technology. Such oversight, of course, is radically opposite the original libertarian impulses of Satoshi Nakamoto’s protocols, which aimed instead to free money from its government monitors.
We will continue to study blockchain’s evolution, and will likely have more to say about it in future posts. As always, though, we caution our friends and clients to beware the lure of the free lunch…because it never is.