Posts tagged Risk
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.
There is a predictable visual theme that accompanies articles covering the quarterly release of China’s GDP growth statistics. Pictures of vast, creepily empty real estate development projects festoon the pages of analytical pieces by the likes of the Financial Times and the New York Times, introducing readers to little-known place names like Luoyang and Tianjin. The imagery helps underscore the central importance of the property sector to China (by some accounts 30 percent of its total economy), as well as the increasingly clear evidence that in this sector supply has vastly exceeded demand.
Feed the Beast
And that trend won’t be changing any time soon. In 2018 China’s growth started to slow noticeably. The stock market fell, fears of the effects of a trade war increased, and consumer activity flagged. As sure as night follows day, Beijing flooded the economy with stimulus, in the form of some $180 billion worth of local government bonds. The effects of that stimulus are evident in the chart below, showing the fixed investment trend over the past five years.
The dramatic uptick in the first three months of 2019 (the crimson trendline) is all about state-owned enterprises, through which that stimulus largesse was funneled. The vast majority of the largesse went right into infrastructure and property projects. There will be plenty more of those sprawling ghost cities for journalists to attach to their future reports.
The spree of property project-bound regional bonds was not the only form of stimulus; there was also a major tax cut aimed at small and midsized businesses to encourage them to invest in their markets. That seems to have had some effect on real economic activity (by which we mean things other than property projects in Nowheresville). Retail sales ticked up slightly in the first quarter after the pace of growth fell dramatically in 2018. This trend is shown in the chart below.
China’s economic authorities for years have been trying to rebalance the economy away from the old infrastructure/property schemata to a more consumer-oriented model. The problem is that every time growth starts to slow, the old playbook comes right back out. Notice in that earlier fixed investment chart the timing of the previous surge in state-owned investment spending: 2015 and 2016, when major parts of the economy seemed headed for a dramatic reversal of fortune. Each time this happens, it expands a credit bubble already of historic proportions. China’s debt to GDP ratio was 162 percent in 2008; it grew to 266 percent by last year. Waiting for the rebalancing is like waiting for Godot, while the debt piles up.
It Matters for Markets
The principal headline in this week’s data release was that the overall rate of GDP growth was somewhat better than expected, at 6.4 percent. The reaction among much of the world’s investor class appeared to take this at face value and chalk up one more reason to keep feeding funds into the great market melt-up of 2019. But those same analytical pieces featuring Luoyang’s empty towers point out that, as much of the economic stimulus was front-loaded in the first quarter, a double dip may well be in store. That may matter for markets at whatever time the equity rally takes a pause from its blistering year-to-date pace. Not everything matters for markets, but the performance of the world’s second largest economy is one of the more reliable attention-getters, at different times for better and for worse. The durability of the current stabilization will be something to watch heading into the year’s second half.
The bond market has been an active place of late. The Fed’s monetary policy pivot back in January (and an even more dovish position in March), a tempered outlook on global economic growth and related concerns have sparked a broad-based bond rally, with falling yields across most fixed income asset classes. We have been getting a number of questions from our clients about how these dynamics affect the returns they are seeing in the fixed income securities in their portfolios. So here are some key things to keep in mind when you are reviewing the bond portion of your portfolio.
It’s All In the Math
One question that comes up frequently is what drives relative performance between similar securities (e.g., governments or corporates) with different maturities. Consider, for example, the Treasury market. The chart below shows the relative yield trends of the 10-year Treasury note, a key benchmark for intermediate term bonds, and the 2-year note, a popular proxy for short term issues, so far this year.
Two things jump out in this chart. First, the spread between these two bonds is relatively tight. Currently just 18 basis points (0.18 percent) separate the 10-year and 2-year yields. The second thing is that the relative movement of each yield has been remarkably similar: when one goes up so does the other, and vice versa.
But when you look at the total return performance in your portfolio you will notice that they are not the same, or similar, at all. For example, the total return for the iShares 1-3 year Treasury ETF (SHY) for the year to date as of April 4 was 0.88 percent. The total return for the iShares 7-10 year Treasury ETF (IEF) was 2.15 percent. Big difference! What gives?
Fortunately, the answer is very simple: it’s all about the math. Bond pricing is entirely and completely driven by math. It’s all about the rate of interest and the magnitude & timing of a bond’s periodic interest and principal payments. The math works such that, for any incremental change in interest rates, the price of a longer-dated security will change by more than the price of a shorter-dated security. So, to use the example of the 2-year and the 10-year bonds in the above chart, the same decrease in the rate of interest will cause the longer-term price to appreciate by more than the shorter-term one. That’s why, all else being equal, bonds with longer maturities (or effective duration, which is a measure by which we compare the relative effect of interest rate changes) have outperformed ones with shorter durations this year.
A Bond’s Purpose
If you knew that interest rates were going to go down for a long time then, all else being equal, you would want to position your portfolio to capture the benefits of longer duration. Conversely, if your vision of the future is one of rising rates, then you are interested in shorter-dated securities as a way to reduce interest rate risk. Of course, nobody can ever know for certain which way rates are going to trend (think, for example, of the Fed’s complete U-turn between its December and January meetings). The answer – or our approach, in any case – is to maintain a range of short to intermediate duration exposures with an eye to mitigating the risk of a sudden jump in rates.
Ours is a fairly conservative approach for the simple reason that for our portfolios, the fixed income portion is where you go for safety, not for outperformance. Bonds are for stability (predictability of the size and timing of income streams) and for cushion against the risks to which other asset classes – primarily equities – are exposed. And it is those riskier asset classes – again, not bonds – where we actively seek growth through capital appreciation.
The total size of our fixed income allocation may change – higher or lower as a percentage of total portfolio assets depending on our overall market and economic outlook. But you won’t find us aggressively chasing returns through active duration management, because that is not why we have bonds in the first place.
It’s quite a world, this one we inhabit. Today is Brexit Day! Article 50 goes into effect at 11 pm Greenwich Mean Time…except, of course, that it doesn’t, because our esteemed and honourable Members of Parliament are still having an existential debate regarding what Brexit is all about (real time update: the debate is over, again, with no agreement, again). The Monty Python sketch about Silly Upper Class Twits comes to mind. But no matter! We have nothing more to say about Brexit other than commiserations for the 48 percent of the citizenry of the Isles who never wanted this farce in the first place. We are here to talk about one of the other surreal features of our present day Planet Earth. Negative interest rates are back, and they are back with a vengeance. Here’s a snapshot of the yield trend for the German 10-year Bund, the go-to safe haven asset for the European Union.
What Don’t We Know?
The German Bund’s fall back into negative rate Wonderland is, of course, just one part of a massive global rally in bonds. Last week we talked about the inversion of the US yield curve and what that may mean for fixed income and equity investors in the weeks and months ahead. Elsewhere in the world the same trend is playing out. Take, for example, New Zealand. The 10-year Kiwi, as the country’s government bonds are known, hit record low yields this week. Not “52 week low” or even “five year low” but actual record low. The Kiwi’s 10-year journey towards Wonderland (it has not yet gone through the looking glass to negative rates) is shown in the chart below.
The sharp rally in Kiwi prices (bond prices move inversely to their yields) has much to do with the effects of a China slowdown on economies in the Asia Pacific Region. It’s not the directional trend as much as the speed of this global bond rally that is surprising, however. After all, we have known for many months now that growth in China was slowing and that further potential negative risks lurked in the form of a worsening US-China trade environment. We knew this in September and December of last year, when the Fed pronounced a robust bill of health on the economy enabling future rate hikes. What was it, starting in January this year and snowballing through the first quarter, that caused first the Fed, then the ECB, and then pretty much everyone else to out-dove themselves? What do they know that we don’t?
Data Not There Yet
The right answer to that last question may well be…nothing. After all, the central banks aren’t directly responsible for the pace of this bond market rally. Traders are…and by traders we mean, of course, algorithm-driven bots primed to move whatever way the mass consciousness of the digital world seems to be going. Trading by Twitter. It is entirely possible that this rally is already overbought, with bond yields potentially set to return to less gloom-and-doom territory.
After all, the global economy is not in recession and the data still do not suggest it is heading towards one in the coming months. Here in the US we have one month of lousy job numbers and inflation still struggling to maintain a two percent range (the latest Core Personal Consumption Expenditure rate, released today, is 1.8 percent). Q1 GDP is expected to come in below two percent, but weak first quarters are not unusual. Not great, but not too bad. The IMF’s latest projection for real global GDP growth for 2019 is 3.5 percent – down from earlier projections but, again, still comfortably north of zero.
Postmodern Financial Theory
Yes, but what about the inverted yield curve we talked about last week? That hasn’t gone away, and it remains the most prescient harbinger of forthcoming recessions, based on past instances. Is there something different about fixed income markets now that possibly makes this indicator less useful than it once was? Well, yes actually. In no past recession, ever, was there the presence of unconventional monetary policy all around the world. No negative interest rates. These aren’t even supposed to exist according to the conventions of modern financial theory. A dollar today is worth more than a dollar tomorrow, and the rate of interest that expresses a future value in present value terms is positive – that’s why it is called the discount rate.
But we have negative interest rates today, in many parts of the world, and they have the effect of flattening curves in markets where rates are still positive (like the US). The real (inflation-adjusted) rate of return on a 10-year US Treasury note may be barely positive (as is the case today) but it is still a whole lot more attractive than actually paying the German government for the “privilege” of holding its 10-year debt in your portfolio. This is not normal – and it may well suggest that we should not be reading too many recessionary warnings into these tea leaves.
What to do, then? Well, this is Wonderland. Whatever emergent properties bubble out of the current soup of variables at play could go one way, and they could go the other way. Anyone who tells you they know which way that is, well, they probably also have a bridge to sell you. A little caution, without an undue reduction of exposure to growth, is how we have been positioning the portfolios under our discretion. That course of action still seems reasonable to us.