Posts tagged Risk
Animal spirits are running high in the month of March to date. A whole dealer’s choice of assets ranging from global stocks to crude oil to the South African rand and Turkish new lira are all climbing out of the depths of despair in which they had been mired for most of the first two months of the year. For the time being, anyway, it appears to be a moment for the long-suffering to shine. While emerging markets and energy & production stocks have their day in the sun, the so-called “Nifty Nine” and other darlings of 2015 languish. The MSCI Emerging Markets index is up 5.4 percent since the month began, and more than thirteen percent above the six and a half year low point reached back on January 21. Bargain hunters quite naturally sniff a deal: is it one worth taking?
The Rally in Context
Thirteen percent is nothing to sneeze at, but it remains a long way even from relatively recent high water marks. The chart below illustrates the price performance of the MSCI Emerging Markets index over the past ten years. The dotted horizontal lines represent, respectively, the pre-recession all-time high (2007), post-recession high (2011) and last two years’ high (2014).
Investors viewing emerging markets from a tactical standpoint would probably look with most interest at that last two years’ number: even after the recent rally, the index is still more than 28 percent away from the L2Y high point reached in September of 2014. That’s a lot of ground, which arguably means that tactical investors could take comfort in not having missed the boat. Double-digit annual gains would not necessarily be out of the question with the right combination of EM-friendly tailwinds.
Not Much New Under the Sun
Chief among those tailwinds would likely be a continued run-up in energy and industrial metals prices, a strengthening of local currencies against the US dollar, and a general absence of bad-news surprises principally from China, but also from other suffering EM locales including Brazil and Russia. A glance at the headlines in the month to date, though, suggests that not much has really changed in the fundamental landscape of the global economy. The recent rally in crude prices, arguably (if unusually) the principal catalyst in equity strength, is based less on a real improvement in the global supply-demand balance than on atmospherics about what oil ministers will say to each other when they (supposedly) meet later this month. China’s recent headline numbers have been less than impressive, including capital outflows, weak industrial production and sagging imports and exports. Brazil’s recession is turning deeper than expected, while the ongoing Petrobras political scandal has now ensnared the country’s former president, Luiz Inácio Lula da Silva. Perhaps the brightest recent news tidbit from emerging markets comes from the unlikely source of Argentina. That longstanding pariah appears ready to return to the capital markets after the new government of Mauricio Macri settled a longstanding debt dispute with major creditors earlier this week.
In our commentary last week we suggested not getting too comfortable even while enjoying the fruits of the recent global equities rally. We would extend that cautionary note even more emphatically to emerging markets. While the above chart shows enticing new ground to break on the upside, there is plenty of potential downside as well. In a market environment driven largely by whichever lurking X-factors pop into or out of existence like so much antimatter, the next big move could be either way.
Amid the volatility and daily event fetishes that have driven asset markets hither and yon this year, the US economy continues to steadily plod along. The data points are a mixed bag: missed GDP and productivity numbers here, consumer confidence and retail gains there. But the overall picture is relatively healthy. Importantly, there are some bright spots in the long-elusive area of wage and price gains. Hourly wage growth was, in fact, the one positive takeaway in an otherwise unimpressive jobs report at the beginning of this month. Now this morning’s January inflation report shows prices growing slightly ahead of consensus. Core inflation (excluding food and energy) is up 2.2 percent on a non-seasonally adjusted year-on-year basis, its highest level in four years.
The oil price collapse has kept the all-inclusive headline inflation number well below core inflation for the past year and a half. That may be changing. The energy index component of today’s CPI report was negative 6.5 percent – the lowest decline since November 2014. Year-on-year headline CPI for January was twice the December level: 1.4 percent up from 0.7 percent. The chart below illustrates the recent trend in prices. If oil prices manage to stabilize, we can expect to see the headline number converge ever closer to core CPI.
Stay, Raise or Cut?
It is somewhat ironic that the next FOMC meeting concludes on March 16, the very same day on which the BLS will release the February CPI data. It is not totally implausible to imagine that headline CPI will be close to or even at that magic 2 percent threshold when FOMC members peruse the 8:30 am BLS release that day. They will already have digested new information on personal consumption expenditure (PCE – 2/26) and hourly wages (3/4) by then. Recent data on retail sales, industrial production, capacity utilization and consumer confidence indicate the potential for an upside surprise in those PCE and wage numbers.
On balance the news is net-positive for the economy, but that may not translate to a much-desired adrenaline boost for the stock market. The Fed is not sitting on the “horns of a dilemma”, as the fella said, but on the shaky tripod of a trilemma. Should they stand pat with rates where they are now? Push ahead with another 25 basis point hike as a sign of confidence in the economy’s continued recovery? Or – and this is highly unlikely but at least in the realm of possibility given global developments – contemplate a reversal? Interest rate policy divergence among leading economies has not gone down well with markets since the Fed’s last move in December. The global stampede towards the Pleasure Island of negative interest rates makes the Fed’s decision all the more tricky, irrespective of the conclusions they would normally draw from domestic data.
El Niño and Mr. Market
Lurking behind this policy trilemma is a capital market environment that perhaps resembles nothing more than US East Coast weather patterns this winter. We’ve had heat waves along with record levels of snowfall here in the nation’s capital, and temperatures that fluctuate from frigid to tropical seemingly overnight (we woke up in the teens today and are preparing for upper sixties tomorrow). That’s intraday volatility worthy of the S&P 500 – which registered three consecutive days of gains over one percent earlier this week after falling by more than one percent in three of the previous five days. Now, to be sure, we have not yet seen the displays of outright panic that so often accompany pullback environments. In the first eleven trading days of August 2011 the market gained or lost more than four percent five times. And the maximum peak-trough drawdown to date remains far short of the minus 19 percent low point of the 2011 event. So far.
But the threat of a deeper downturn lurks behind every X-factor that pops into and out of existence each day. The FOMC explicitly called out their concerns in January’s post-meeting communiqué, referring to the “global economic and financial developments” keeping them up at night. It is a pretty good bet that these “developments” are not going away between now and March 15-16. If more US economic data surprise on the upside between now and then, it is going to be a very difficult call for Chairwoman Yellen & Co.
Well, that happened. The technical correction we have all talked about for the past four years finally showed up and sent pretty much any asset class with a risk component into a tailspin. The magnitude of the correction (thus far) is nothing particularly out of the ordinary as these things go: the S&P 500 was down 12.4 percent from its May 21 high when the markets closed on Tuesday (it recovered about half of that in the subsequent two days). But this action-packed sequence of six negative trading days produced some curious artifacts and served notice that, while history is more likely to record this event as a bull market correction than a bear market onset, we should be prepared for more twists and turns down the road. Here are five things we observed from this week’s craziness.
#1: ETFs – The Scream Heard ‘Round the World
Call it a delayed coming-out party for an asset that came into this world some twenty two years ago. ETFs promised cheap, efficient access to the market via index proxies, and by and large they have delivered on that promise. More recently, though, ETFs have become the asset of choice for a wide range of active and quasi-active strategies, employed by a spectrum of participants from seasoned investment pros to couch potato day traders. Their presence during the more insane moments of the pullback was unmistakable.
Consider the S&P 500 – the very living, breathing embodiment of a broad market benchmark. Two ETFs widely used as proxies for the S&P 500 are SPY, the SPDR product present at the ETF creation in 1993, and IVV, the BlackRock iShares offering. SPY has a market value of over $163 billion, while IVV clocks in around $67 billion. Pretty liquid, no? But something went seriously wrong with IVV on Monday morning. From a Friday close of $198, IVV shares briefly plunged to a low of $147 shortly after the Monday open. That’s a loss of almost 26 percent - far more than the index itself. Far more, in fact, than SPY, which in the same time period lost about 7.6 percent from its Friday close, more in line with what the market itself was doing. Now, the discrepancy didn’t last long, and both ETFs finished the day closely tracking the index. But that will be small comfort to those whose IVV orders were filled at peak divergence. Small comfort, as well, to the rest of us who care about fair and orderly markets.
#2: Rear-Window Vision Is Alive and Well
Pullbacks – as opposed to actual bear markets – are like sandstorms in the desert. You know they’re going to happen, but you’re still surprised every time the sand blows up into your face. As always, it didn’t take long for pundits of various stripes to start filling pages with their “I saw this coming” narrative. Did we learn anything new about the world last Friday? Sure, Shanghai and Shenzhen took another pasting. Yes, sagging commodities prices are probably a better measure of China’s economic slowdown than the official statistics. But A shares started tanking back in June, and China’s more modest pace of activity has been an ongoing story for the last year.
So why now? It’s a variation on the butterfly wings of chaos theory – a conflux of random events around the world creates the conditions for the storm. Same as it was last October, when the Ebola scare, a mysterious drop in bond yields and falling oil prices were ascribed to that month’s 7.5 percent pullback. Now, are there investors out there on the right side of the trade when these events happen? Of course – statistically it would be nearly impossible for there not to be. But getting the timing right for these brief flare-ups is much more about luck than skill.
#3: Noise 1, Signals 0
While the size of the reversal was not out of line with past correction environments, certain metrics seemed way out of line. Front and center among those is volatility. On Monday, August 17 the CBOE VIX closed at a gentle 13, not far from where it had traded throughout a mostly calm summer. One week later it was reaching intraday levels last seen during the 2008 meltdown and closed at 41 – roughly the same as where it closed on the first post-9/11 trading session back in 2001. Very likely, the unusually high vol spike is not unrelated to our observation #1 above – the amplification of price swings provided by ETF-heavy short term trading strategies.
The so-called Copenhagen Interpretation theory of quantum mechanics posits that the act of observing an event at the subatomic level influences its outcome. Increasingly we seem to have a Copenhagen Interpretation of the capital markets: the aggregate behavior of the tens of thousands of algorithms programmed to go this way or that when triggered by a signal wind up altering the signal – arguably making that signal less useful as a predictive metric going forward. Traders using traditional volatility signals would probably be well-served to revisit their algorithms once the dust from this flare-up has settled.
#4: It’s 1998 Again!
Not really, of course. But there are some interesting parallels. In the middle of 1998 we were well into a bull market, valuations were stretched (to say the least) and various unsettling things were going on in the world. All of which was enough to send the S&P 500 into a 19 percent reversal from its July high to early October. As usual, it was easy for commentators to conjure up world-is-ending talking points: Russia defaults! LTCM goes bust! Clinton impeachment! We were both there – the times were indeed unsettling. But investors who bailed out in a September panic missed out on another year and a half of a stampeding bull. Again – we do not mean to be facetious and suggest that history will repeat itself. Sooner or later the bear will likely emerge from its lair. But we think it more likely that the bear will reveal its hand with a few more corrections – with at least one giddy “melt-up” along the way – before we write the coda on this bull.
#5: The Song Remains the Same
Every so often we go back to the Annual Outlook we published back in January to see where our views have changed and where they haven’t changed. It is noteworthy as to how much of this year’s story remains the same. Continued modest but steady growth in the US? Check – amid this week’s mayhem we had strong readings on consumer confidence, durable goods and the 2Q GDP revision. Europe managing to stay a few feet away from the deflation abyss? Check. Emerging markets struggling to regain their long-lost tag of “growth engine” while China struggles to maintain momentum? These are the fundamentals as we see them. They are in our opinion not inconsistent with the type of correction we saw this week, but also not the likely ingredients for a global recession that would drag down global asset markets for a long spell.
We expect to see more volatility ahead, with an eventful September just around the corner and the tricks and treats of October lurking beyond. For the time being, though, we think these are conditions to play through, and not panic over.
“Every unhappy family is unhappy in its own way.” The opening sentiment in Tolstoy’s great novel Anna Karenina works just as well for commodities markets in the summer of 2015 as it did for Russian aristocratic clans in the 19th century. Every major commodities “family” – from precious metals to energy and industrial metals – is unhappy. And the reasons are quite specific to each. Oil suffers from a supply glut. Copper and nickel feel the brunt of contracting production in China. Gold has lost its luster as a safe haven – nobody went piling into gold during the recent turmoil in Greece, for example.
Oh, sure, there are exceptions to the rule out there in the byways and back roads of the commodities world. Traders put a “squeeze” on robusta coffee futures last month and bid September contracts up to a ridiculous spread versus July delivery. But by and large, it has been a long and hard summer for the global economy’s major physical inputs. The chart below illustrates the shared pain.
As dismal a picture as this chart paints, it does not even tell the full story. From its last six years’ high point in April 2011, Brent crude oil has tumbled 61 percent. Copper has fallen by nearly 50 percent over the same period, and gold’s retreat has topped 40 percent. Imagine what the conversation would be if major equity indexes had spent the past six years falling on an order of this magnitude. When the S&P 500 gives ground in the high double digits, retirement nest eggs look fragile and the prospect of recession looms large. When oil prices plummet – well, we just pay less at the pump. Good news, right? Not necessarily. Commodities price trends give us important information about the world economy. Right now the news is decidedly mixed.
Awash in Supply
Oil bulls got sideswiped by a steady drip-drip of supply news in July, with accelerating OPEC production dominating the headlines. Saudi Arabia remained firm to its commitment articulated last November to gain share rather than support prices through restricted output. Production in Iraq reached record levels. And the prospect of Iran – holder of the world’s fourth-largest proven reserves – reentering the market after years of sanctions added a further depressive element. Meanwhile, US shale producers still appear mostly determined to power through the downturn and find ways to further reduce their cost structures rather than let up on output.
The China Malaise
The unhappy story told by industrial metals is set in China, which is by far the world’s largest importer of copper, aluminum, nickel and other key metals. Forget about all the eye-popping gyrations on the Shanghai and Shenzhen stock bourses. The really important story in China is the slowdown in growth, punctuated by a sharper than expected manufacturing contraction in both June and July and coming on the heels of forty straight months of declines in the domestic producer price index. Whereas the oil story is mostly (not entirely) about supply, the plight of industrial metals has more to do with demand. And weaker demand from China has hit the export accounts of other emerging markets. It should come as little surprise that the MSCI Emerging Markets index is off by more than 12 percent from its June highs.
All That (Doesn’t) Glitter
Then there is gold. It would be fair to say that the gold bugs who went running for the hills in 2009, worried about the inflationary tinderbox the Fed was supposedly opening with its quantitative easing programs, have not been rewarded for their excessive caution. But at least gold was a part of the “risk off” trade back in 2011 when we had our last really big pullback in equities. Fast forward to July 2015, with Greece once again on the front pages and consensus forming around the idea that a breakup of the Eurozone is a matter of when, not if. Over the course of this month, with Greek banks shutting down and Chinese stocks plunging into bear territory, the price of gold actually fell by six percent. This is perhaps a useful reminder of something we have said from time to time on the pages of these weekly commentaries. There is nothing magical or mythical about gold. It is a commodity, with a price that goes up and down like any other commodity. Lately, the movement has been mostly down.
Trouble Ahead, Trouble Behind
Unfortunately for gold bugs, oil bulls and any other species looking for commodities gains to ring out the year, the road ahead does not look much more promising than the road behind. First of all, neither the oversupply of oil nor the slowing of growth in China look set to end any time soon. Those headwinds are likely to continue. Secondly, those headwinds are likely to compound further still if the Fed goes ahead with its rate program, as expected sometime between September and December. Higher interest rates impose a natural cost on holding commodities – after all, investors do not get any interest or dividend income from storing bars of gold or barrels of oil. Now, if a rising Fed funds rate signals a faster tempo to global real economic growth, we would expect that growth to translate into higher commodities prices at some point. From where we stand now, though, that “some point” still seems to be some distance away.
There were not too many headline macroeconomic numbers out this week, a week in which a large dose of volatility returned to global equity and commodity markets. One data point that did stand out was a 14 year record low number of claims for unemployment benefits. The seasonally adjusted number of jobless claims stood at 264,000, the lowest since April 2000. This, along with another report of growth in the manufacturing sector, added more data to a long string of upbeat numbers for the U.S. economy. Yet concerns abound that growth is too slow, too uneven and too dependent on monetary stimulus to sustain itself. This week’s pullback - 7.4% in the S&P 500 following double-digit falls in riskier assets – has brought the growth debate back to the center of discussion.
When Doves Cry
The market volatility has, predictably, elicited dovish cooing from some corners of the Fed (though not from Chairwoman Yellen herself). Talk is on the table of extending the current round of bond purchases past the planned sell-by date of October 29, and even potentially a new easing program if conditions warrant. We would be surprised to see either of those outcomes from the next Fed meeting, and still expect the first rate cut to take place sometime in 2015. But the Fed has a dilemma. On the one hand, it is aware of the risks that come with too much easy money, including the risk that there may not be much more that monetary stimulus can do to boost wages or get inflation closer to its 2% target level. On the other hand, the Fed is clearly sensitive to how markets react to its policy decisions. If the 7.4% hiccup in the S&P 500 were to spill into larger losses (even if for no clear reasons, as can happen from time to time) then the likelihood of some kind of QE4(ever?) would increase.
Weaning the Patient
The first bout of QE in 2009 was necessary to restore liquidity to financial markets that had been devastated by the 2008 crash. The second and third rounds, in 2010 and 2012, were arguably less urgently necessary but, we believe, were the right thing to do in support of economic growth and in the absence of effective policymaking anywhere else in the government. And there is a good case to make that growth even in the U.S. has not quite reached escape velocity. But the longer the patient stays on morphine, the harder it becomes to wean the patient off the drug. The economy should be able to handle continued growth without more Fed bond buying and with overnight rates 0.25-0.5% higher than where they are today. Unless falling asset prices are a clearer manifestation of a real, imminent crisis than we see today, they should not be the prime motivating factor in further monetary easing.
Where We Go From Here
Investors will be reading the smoke signals from the October 28-29 FOMC meeting with extra scrutiny. In the meantime we may see some continuing volatility in the markets. A testing of the recent lows is not out of the question. But wherever the growth debate eventually takes us, we see few compelling reasons in the here and now to change the fundamental picture we have seen for a while, with steady U.S. growth at the center and mostly manageable problems where they do exist. That picture could change. If it doesn’t, though, we would expect further price damage to be limited.