Posts tagged Us Equity Market
We will be publishing and distributing our Annual Outlook next week, a 24-page opus reflecting not only our analysis of the quotidian variables likely to be at play in the economy over the coming twelve months, but also a commentary on today’s world in a larger historical context. Meanwhile, we will use the opportunity of this week’s regular commentary to share with you the executive summary from the forthcoming Outlook, to give you an advance look of what you will read in further detail next week.
• “Moderate growth, low inflation, improving labor market”: this would have been a reasonable way to characterize US economic trends in 2013. And in 2014, 2015 and 2016. So it was not exactly an earth-shaking surprise when 2017 delivered…yes, moderate growth, low inflation and a still-improving labor market, if the latter slowed down just a bit in net new job creation. Tracking the macroeconomy has become something akin to watching daily episodes of Seinfeld. Not much of any consequence ever happens, and every now and then some amusing diversion appears to briefly engage one’s attention. Try as we might to unearth some new piece of information suggesting the approaching end of this placid state of affairs, we cannot. The data say what the data say. 2018, for the moment, looks set to deliver more of the same.
• The key difference between 2017 and earlier years in this recovery cycle was that the rest of the developed world came on board. Organic demand and consumer confidence perked up in the Eurozone, Britain managed to at least temporarily forestall a reckoning with the consequences of Brexit, Japan stayed positive while ex-Japan Asia Pacific countries did just fine. China, meanwhile, met its growth benchmarks by initially going back to the tried and true mix of debt-sourced spending on infrastructure and property. Beijing reversed course midyear, though, with a concerted program to reduce borrowing and recommit to economic rebalancing (this coincided with a further consolidation of power by President Xi Jinping). Elsewhere in emerging Asia and beyond, concerns about looming trade wars faded and domestic assets, including long-beleaguered currencies, perked up for a winner of a year. Again – while there are plenty of geopolitical variables that could form into tangible threats at any time – the basic macroeconomic variables appear stable. Markets ignored geopolitics last year, we expect them to do the same in the year ahead.
• Calendar-gazers are filling up the airwaves with the observation that the current recovery – from July 2009 to the present – is one of the longest on record. If we manage to avoid a recession between now and May, the current growth cycle will move ahead of that of 1961-70 as the second-longest, trailing only the ten years of good times from 1991 to 2001. To those nervously ticking off elapsed calendar days we offer two ripostes. First, markets and economies don’t pay attention to calendars, which are entirely a human construct. Second, there are potentially valid reasons why the current uptrend could go on for longer. From 2009 to 2014, arguably the main force behind continued growth was the Fed and its quantitative easing mechanics that flooded the world with money. Only more recently has the growth started to look more traditional – more like actual improvements in business and consumer sentiment begetting a virtuous cycle of increased supply feeding increased demand. If anything, the perky demand trends we see today more resemble those of an early than of a late stage in the cycle. The uniqueness of that multi-year experiment in unorthodox monetary policy may make comparisons with other growth periods less meaningful.
• So if the default assumption is that 2018 will be a year of very few changes to the presiding macroeconomic trends, what alternative scenarios could upend the base case? The key X-factor, we believe, is the one that nobody from Fed governors to that fellow holding court at the end of the bar completely understands; namely, the curious absence of inflation. The inflation rate has fallen short of the Fed’s explicit target of 2 percent throughout the entire recovery to date (when excluding the volatile categories of energy and foodstuffs). This despite the dramatic fall in the unemployment rate from 10 percent at its peak to just 4.1 percent today. The economic models built over the decades following the Second World War baked in the fundamental assumption of a trade-off between inflation and employment: be prepared to sacrifice one in pursuit of the other. That assumption has not held up at all in recent years. But before pronouncing last rites on the Phillips Curve, we again draw your attention to our observation in the previous bullet point: the kind of growth one normally sees early in a recovery cycle may only now be showing up. If so, then a sudden surge of higher than expected inflation would not be entirely implausible.
• The second alternative scenario that could disrupt the smooth sailing of most capital markets asset classes would be, perhaps, the other end of the spectrum from a growth-fueled resurgence of inflation. The Fed intends to raise rates again this year – three times if the stated expectations of the FOMC’s voting members are to be believed – and to begin winding down the balance sheet that grew to $4.5 trillion over the course of the QE years. These intentions reflect a confidence that the economy is fully ready to stand on its own two feet – which confidence, of course, proceeds from those same steady macro trends we described a few bullet points ago. But there is still a chance, and not necessarily a small one, that today’s bubbly sentiment is ephemeral and will dissipate once the crutch of monetary policy is finally and conclusively removed. Specifically, not one of the three structural drivers of long-term growth – population, labor force participation and productivity – are demonstrably stronger now than they were two years ago when we devoted some number of pages in our Annual Outlook to the concept of secular stagnation. There may be less to the current growth uptick than meets the eye. If so, a Fed misstep on the pace of unwinding easy money – too much, too soon – could be the trigger that boots the Goldilocks economy to the exit door.
• What both those alternative scenarios – an unexpected inflation surge and a Fed policy fumble – have in common is the potential to wreak havoc on credit markets. From an asset markets perspective, credit markets hold the key to how virtually any asset class – debt, equity or alternative – will perform. Here’s why. The risk-free rate – in general practice the yield on intermediate / long Treasury notes – is employed in just about every standard asset valuation model. All else being equal, an increase in interest rates has the effect of decreasing the present value of future cash flows. Asset managers will reprice their models if reality outstrips expectations about yields. A likely ripple effect resulting from a Treasury rate repricing would be widened risk spreads (affecting, for example, corporate investment grade and high yield bonds), a pullback in equity prices and a commensurate uptick in volatility. Whether the riskier conditions persist would be situation-specific, but there would very likely be at least some damage done.
• Again, we view these as alternative scenarios to be a more benign base case. Even if one of the other were to come to pass, though, it would not necessarily start the clock on a countdown to the end of this long bull market. For that to occur, we believe one of three events would have to emerge: a full-blown recession (which is different in nature from a periodic surge in inflation), a crisis such as the implosion of the financial system that led to the 2008 crash, or the outbreak of an actual hot war somewhere in the world that significantly involved the US and/or other large powers. The risk of any of these things happening in 2018 is not zero, but we would ascribe a probability of less than 25 percent to any of them.
• US equity valuations are stretched, particularly for the large cap growth segment of the total market that has consistently outperformed over the past several years. Relying on relative valuations alone would potentially lead investors to other areas, like Europe or emerging markets, that still have some catching up to do even after a strong performance in 2017. In the long run valuations matter – there is no coherent way to view a share price as anything other than the present value of a series of future cash flows. In the short run, valuations don’t always matter. Relative geographic performance in 2018 will be subject to other influences, not least of which will be the direction of the US dollar.
• The dollar was one of the big surprise stories of 2017. Long before equity shares in financial institutions or resource companies snapped out of their “reflation-infrastructure trade” myopia, the US currency had done a U-turn from its rapid post-election ascent. The dollar fell by nearly 10 percent against a basket of other major currencies last year, and that soft trend has continued thus far into 2018. Currency strength was a major force driving performance for developed and emerging market equities and debt last year. Whether a reprise of that trade is in store for the year ahead depends – again – on that tricky combination of alternative economic scenarios. If US interest rates rise substantially, with the ECB and the BoJ at the same time proceeding more cautiously, then a stronger dollar would be a rational expectation as investors pursue higher yields. That outcome is not set in stone, however. Major foreign investors – most notably China – may look to diversify their foreign exchange assets if their perception of US risk changes, which would, all else being equal, have a negative effect on the dollar.
• Commodities may stand on the other side of the dollar’s fortunes. A weaker dollar makes commodities more affordable in other currencies; that, along with the return of strong organic demand, may supply a tailwind to a range of energy and industrial commodities. But oil, which has recently surged to its highest levels in three years, remains vulnerable to the prospect of increased shale production in the US. As with currencies, there are many factors at play that could work either for or against key commodity classes.
• In conclusion, we could sum up the essence of our views thus: Things Don’t Change, Until They Do. The benign tailwinds of moderate, steady global growth will not last forever. Neither we nor anyone else can point with certainty to the date when the sea change happens. What we can do is pay close attention to the things that matter more. Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.
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.
Today is the first day of the last month of 2017, which means that predictions about asset markets in 2018 will be flying about fast and furious over the coming three weeks. As practitioners of the art and science of investment management ourselves, we know that quite a bit of work goes into the analysis that eventually finds expression in the “bonds will do X, stocks will do Y” type of formulations characteristic of these holiday season prognostications. A layperson might be excused, though, for concluding that all the market pros do is dust off last year’s report, or the year before, for that matter, and repackage it with the same observations. “Rates will rise because of the Fed, stocks will rise because of a stable economy and good earnings” worked for 2016 and it worked for 2017. Here’s visual proof: the price appreciation of the S&P 500 and the trend in the 2-year Treasury yield since December 2015:
It wasn’t linear, of course. There was the technical correction in early 2016 when both stocks and rates pulled back. Still, though, investors positioned for rising short term rates and steady gains in large cap domestic stock prices would have had little about which to complain over the past two years. Which, of course, brings us to the point of today’s commentary: is it Groundhog Day again, or does 2018 have something entirely different in store?
At the heart of this curious Groundhog Day phenomenon over the past couple years is the remarkable sameness in the broader macroeconomic environment. “Moderate GDP growth, with a healthy labor market and modest inflation” is a phrase you could have uttered on literally any given day over this period and been right. The only thing measurably different about 2017 was that this “Goldilocks” set of conditions was true not just of the US, but of almost any part of the developed (and much of the emerging as well) global economy. Adding the word “synchronized” to “moderate GDP growth” gives the phrase a distinct 2017 flavor. Thus, the good news for equities disseminated into non-US markets and finally gave investors some measure of reward for diversification.
There is almost nothing in the way of macro data points today suggesting a deviation from this “synchronized moderate growth” mantra. The major question mark, as we have discussed in other commentaries, is whether inflation will ever get in line with what the Fed’s models call for and rise above that elusive 2 percent target. Now, if inflation were to suddenly go pedal-to-the-metal, that could change assumptions about risk assets and blow up the Groundhog Day framework. In particular, an inflationary leap would likely send shockwaves into the middle and longer end of the bond yield curve, where rates have remained complacently low even while short term rates advanced. The 10-year yield is right around 2.4 percent today, almost exactly where it was at the beginning of the year and in fact not far from where it was at the beginning of 2016.
The sideways trajectory of the 10-year, in fact, supplies the explanation as to why stocks could rise so comfortably alongside the jump in short-term rates. While short term rates are closely correlated to the Fed’s monetary policy machinations, longer yields reflect a broader array of assumptions – including, importantly, assumptions about inflation. The flatness of intermediate rates suggests that bond investors expect economic growth to remain moderate, and inflation low. The bond market is not priced for a high inflation environment – which is reasonable, given the scant evidence that such an environment is imminent.
Can Stocks Keep Going?
So far, so good: the economic picture seems supportive of another Groundhog Day. What about stocks? There are still plenty of alternative paths for equities to travel in 2017 (and they are going kind of helter-skelter today on some breaking political news), but a solid double-digit performance would be a reasonable prognosis (the S&P 500 is up just under 20 percent on a total return basis for the year thus far). The current bull market is already the second longest historically, and valuations are stretched. Is there more room to run?
As we write this, the tax bill which has riveted the market’s attention for most of the past two weeks has not formally passed the Senate, nor been reconciled with the earlier House version to a final bill to send to the White House. But the odds of all that coming to pass are quite good. As we have noted before, the market’s obsession with taxes has little or nothing to do with fundamental economic growth. The non-partisan Joint Committee on Taxation said as much in the report it released late yesterday on the proposed bill’s likely economic impact: at best, contributing no more than about 0.1 percent to annual GDP growth over the next ten years.
But the market’s interest in the fate of the tax bill has little to do with long-term economics, and much to do with shareholder givebacks. To the extent that the bill results in tangible cash flow benefits for corporations in the next 1-2 years (and the quantification of such benefits remains quite variable), precedent informs us that the vast bulk of such gains would flow right back to shareholders in the form of buybacks and dividends. Buybacks and dividends don’t help the economy, but they most assuredly do help shareholders. That fact, alone, could supply enough of a tailwind to keep the bulls running long enough to grab the “longest duration” mantle.
Everything’s the Same, Until It Changes
So if you read a bunch of reports over the next couple weeks that sound incredibly similar to what you read a year ago, don’t rush to the judgment that its authors are lazily phoning it in. There remain very good reasons for the Groundhog Day framework for yet another year. Gains in stocks, an increase in short term rates alongside monetary policy moves, and longer term rates tempered by modest inflation are all plausible default-case scenarios.
But never forget that any scenario is just one out of many alternative outcomes. Market forces do not pay heed to the calendar year predilections of the human species. There is no shortage of factors out there that could upend the benign sameness of today’s conditions, and they will continue to demand our vigilance and readiness to adapt.
Every industry sector has its own received wisdom. In the energy sector, the two pillars of conventional wisdom for much of the past eighteen-odd months could read thus: (a) crude oil will trade within a range of $40 to $60, and (b) the fates of crude prices and shares in energy companies are joined at the hip. Recently, though, both of these articles of wisdom have come under fire. Energy stocks, as measured by the S&P 500 energy sector index, are up by a bit less than 14 percent from their year-to-date low set in late August. But the shares came late to the party: Brent spot crude oil reached its year-to-date low two months earlier, in late June, and has jumped a whopping 45 percent since. At the end of October the benchmark crude crashed through that $60 upper boundary and has kept going ever since. Are more good times in store, or is this yet another false dawn in the long-beleaguered energy sector?
Whither Thou Goest
That energy shares and oil prices are closely correlated is not particularly surprising, and the chart below illustrates just how much in lockstep this pair of assets normally moves. The divergence in late June, when crude started to rally while E&P shares stagnated and then fell further, caught off guard many pros who trade these spreads.
Given that close correlation, anyone with exposure to the energy sector must surely be focused on one question: is there justification for crude oil to sustain its move above the $60 resistance level, thus implying lots more upside for shares? A few weeks ago the answer, more likely than not, was “no.” Long-energy investors, then, should take some comfort in a recent prognostication by Bank of America Merrill Lynch opining that $75 might be a “reasonable” cyclical peak. If that level, plus or minus a few dollars, is a reasonable predictor – and if the historically tight correlation pattern between crude and shares still holds – then investors in energy sector equities could have a very merry holiday season.
The Upside Case
Perhaps the most convincing argument for the energy bulls is that much of the recent strength in crude prices is plausibly driven by organic demand. The global economy is in sync, with two quarters in a row of 3 percent US real GDP growth along with steady performances in China, India and other key global import markets. The continuity of global growth may finally be delivering a more durable tailwind to resource commodities. Meanwhile, on the supply side inventories wax and wane, but the supply glut that dominated sentiment a year ago seems to have waned. And US nonconventional explorers have also taken a pause: rig counts and other measures of activity in the Permian Basin and other key territories have stalled out now for a number of months. Add to this picture the ongoing effects of the OPEC production cuts and the recent political tensions in Saudi Arabia, and there would appear to be a reasonable amount of potential residual upside.
Caveats Still Apply
On the other hand, though, the structural reality remains in place that those US nonconventional producers are the key drivers of the marginal price of a barrel of crude. The recent downsizing of rig counts and active drilling projects may well be temporary as E&P firms look to shore up their beaten-down margins. Most shale drillers can now turn a profit at prices well below the current spot market. It is only a matter of time – and price level – before the activity will ramp up again. And we’re talking mostly about short-cycle projects that can turn off and on more nimbly than the traditional long-cycle, high capital expenditure projects of old.
Crude prices may well have another $10 or more of upside, but they come with plenty of caveats. For the next couple months though, at least, energy equities would seem to offer a reasonably robust performance opportunity.