Posts tagged Us Equity Market
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.
And the band plays on. Some random convergence of factors could conceivably interrupt and reverse today’s upward push in the S&P 500 before the benchmark index ends with its seventh straight record close…but those would likely be bad odds to take. Yesterday was the 30 year anniversary of 1987’s Black Monday, when stocks tanked by more than 20 percent in a single day. Financial pundits, with not much better to do, spent much of the day in college dorm-style bull sessions with each other, speculating about whether 10/19/87 could ever happen again. It certainly didn’t happen yesterday, even though lower overnight futures injected a frisson of excitement into the morning chatter that dissipated as the afternoon yielded a predictable recovery and small gain for share prices.
We feel for those journalists – it’s tough being a financial commentator these days! Nothing ever happens except for the market shrugging off any potentially disruptive event, while displaying brief spasms of ecstasy whenever the subject of tax cuts percolates to the top of the daily news feed. Now the chatter is homing in on what may well be the only remaining story of any note (from the market’s perspective) before the end of the year: the identity of the new Fed chair when Janet Yellen’s term ends next January. A decision is supposedly forthcoming in the next couple weeks (the incumbent administration suggests it will be before November 3). Our sense is that, regardless of who among the short-listed candidates is tapped, the impact on markets will likely be negligible.
If It Ain’t Broke…
There are two issues at stake here: first, who the winning candidate will be, and second, how that candidate would actually govern once ensconced in the Eccles Building. There are currently five names under consideration. On a spectrum from dove to hawk they read as follows: current Fed governor Jerome (Jay) Powell, current Fed chair Janet Yellen, former Fed governor Kevin Warsh, Stanford University economist John Taylor, and current Trump advisor Gary Cohn. Let’s say right off the top that we see next to no chance that Cohn will draw the winning ticket; among insiders close to the decision process, his name appears to still be in the mix for cosmetic reasons only.
That leaves four. Two, Powell and Yellen herself, reliably fall into the camp of “stay the course” – their votes on FOMC policy decisions, after all, are publicly documented and widely known. Speculation this week has Powell as the overall front-runner with considerable support both from the administration’s inner circle and among both Republican and Democratic senators who will be involved in the confirmation process. There would be a rational logic for Trump to ultimately thumbs-up Powell: in so doing, he would be making the safest choice for business as usual, while still getting to theatrically crow to his base that he dumped the Obama-era Fed head.
…Don’t Fix It
Just because Powell’s star seems ascendant this week, though, does not mean that the two more hawkish choices of Warsh or Taylor are out of the picture. This is not an administration known for predictably rational decision making. So what happens then? Speculation is particularly focused on John Taylor, the Stanford professor whose “Taylor rule” – a mathematical formulation of the responsiveness of interest rates to inflation and other economic inputs – suggests that rates should currently be higher than they are. Would a Taylor Fed necessarily mean a dramatic acceleration of rate hikes and attendant balance sheet normalization?
Perhaps not. It’s worth remembering that a Taylor Fed would be looking at the same data as the Yellen Fed, and that data include inflation readings, the danger-zone indicators of which are conspicuously absent. The Taylor rule is not immune to the inflation conundrum with which the Fed’s other analytical models have struggled. It’s also worth remembering that the Fed chair still has to take into account the positions of the other FOMC voting members. Whoever the new chair is, he or she will not be any less interested in building consensus towards unanimous decisions than past chairs. That’s how stable monetary policy is conducted.
The global economy is largely in sync with low to moderate growth, decently functioning labor markets and modest levels of inflation. That’s the real context in which stock prices can keep drifting up with no sizable upside headwinds. We think it is unlikely that, come 2018, a new Fed will be tempted to push their luck with policies that could choke off the growth before its time. For these reasons we think it unlikely that the identity of the new Fed chair will stand in the way of a business-as-usual mood in the market that, barring something currently unforeseen, could carry into and through the upcoming holiday season.
Another week, another string of record highs for U.S. equities. But this wasn’t just your normal “upward drift for no particular reason” set of days. It was an “upward drift for no particular reason AND a 20 year record smashed!” sequence of new highs. Yes, the last time the S&P 500 recorded six consecutive all-time records was in June 1997, back when the Spice Girls were telling us what we want, what we really, really want. And while prices continued their inexorable ascent, volatility continued to plumb new lows. The CBOE VIX index, the market’s so-called “fear gauge”, suggests that times have never been safer for equity investors: the index has closed below 10 more times in 2017 than in any other year since the VIX first launched in 1990.
The Great Risk Conundrum
This presents a conundrum: while the S&P 500 is more expensive than any other time in the past hundred years (the heights before the market crashes of 1929 and 2000 being the exceptions), it is also serenely placid. Contrast today’s environment with the stretch of market history leading up to the 2000 dot-com crash. The chart below shows the VIX index price trend from 1998 to the present.
The contrast between today and the late 1990s is noteworthy. The S&P 500 reached a then-all time high of 1527 in March 2000. As the above chart shows, though, the final two years of that bull market came with exceedingly high volatility. A VIX price of 20 or higher is considered to be a high risk environment; the index remained above that level for much of the final stretch of that raging bull market. In the mid-2000s the situation was different, but the VIX still was consistently trading at elevated levels well in advance of the 2008 crash.
See No Evil, Hear No Evil
During both of those earlier periods (i.e. 1998-2000 and 2006-2007) markets were jittery for a variety of reasons. Periodic pullbacks in the stock market reflected these concerns – in particular, the Russian debt default of 1998 that led to the collapse of hedge fund Long Term Capital Management, and then, in early 2007, the failure of two Bear Stearns mortgage-backed funds that turned out to be the canary in the coal mine for the broader financial system meltdown. In both cases, investors would eventually buy the dip and keep the damage contained, but markets would remain in an elevated state of nervousness until the bottom finally fell out.
The message the market sends today is entirely different; namely, that there is literally nothing out there in the big bad world that could have an adverse impact on risk asset markets. Arguably, the one single issue able to move investors to action (in a positive direction) for the past twelve months has been tax reform. This trend, which we highlighted in last week’s column, continues with a vengeance despite a lack of hard evidence that any kind of truly meaningful, broad-base reform will emerge out of the current Congress and White House. Apart from taxes, though, the market seems content to channel its inner Metallica and proclaim that “nothing else matters.”
Even if the “reflation trade” that springs from tax reform hopes dies out again – like it did back in February – we think it more likely than not that the market would simply revert to form and drift ever so gently upwards. Why wouldn’t it? The global economy, if not particularly inspiring, is at least in relative harmony with growth occurring in most major regions encompassing both developed and emerging markets. Not a single piece of headline macro data suggests that the current recovery cycle has peaked. Quite the opposite: when economies peak they tend to overheat, in the form of escalating prices and wages. This simply has not happened. As long as it doesn’t happen, the Fed and other central banks will have a great deal of latitude in guiding their balance sheets and policy actions back towards some semblance of normal.
Thus the “sunny skies” portion of today’s column title. The “swan songs” bit refers to the black swans – the unexpected events that can suddenly emerge from the murky sea of risk factors and knock Ms. Market off her game. We know from observing market behavior this year that the bar is high indeed for the kind of black swan that could have an impact. But the very definition of a black swan is something you can’t name because you have never seen it before – so you have no way of quantifying what it is before it happens. Presumably there will be such swans in our not too distant future. One or two such events could even be of such import as to keep market volatility elevated for longer, akin to that stretch of bull market between 1998 and 2000. Then – and perhaps only then – do investors’ thoughts turn seriously to questions of more defense in their allocation strategies.
Gentle reader, please indulge us our seeming obsession with the subject of inflation. Yes, we know that other macro metrics matter as well, but inflation is both the big mystery – as we discussed in last week’s column – and arguably the heavy hand pushing and pulling the market to and fro. Today we focus more on this “actionable” aspect of inflation. Or, to perhaps be more precise, we focus on the curious case of a market with the stars of an imagined reflationary surge sparkling in its eyes – in the very same week when yet another month’s reading informs us that a pick-up in inflation is nowhere to be seen in the real world.
Not Dead Yet
It really doesn’t take much, even after all this time. The so-called “reflation-infrastructure trade,” which financial pundits necessarily rebranded as the “Trump trade,” died an unofficial death back in the first couple months of the year. That’s about the time when the US dollar swooned at the feet of a soaring euro and Aussie dollar, and value stocks in sectors like financials and energy ceded the high ground to their growth counterparts in tech.
But 2017 is, if nothing else, the year of endless lives, whether it be multiple attempts to repeal and replace healthcare policy or the renewed insistence that hypergrowth-fueled inflation is just around the corner. “The Trump Trade Is Back!” screamed Bloomberg News on Wednesday, joined by a chorus of like headlines from Yahoo! Finance, Business Insider and others. Once again financial institutions and resource companies were the market darlings. Bond yields perked up. Even the beleaguered dollar took a victory lap or two. Mr. Market was ready to party like it’s late 2016.
A Framework of an Outline of a Plan
The catalyst for this week’s effervescence, of course, was the release on Wednesday of a tax reform framework. It wasn’t really a plan, because plans generally contain details about specific sources of revenues and costs over a defined time frame, grounded in plausible assumptions. The major assumption made by the authors of this framework is that it will somehow deliver anywhere from 3 to 6 percent (depending on whom in the administration you care to believe) in long-term sustainable growth.
Now, given that we have not experienced real GDP growth of that caliber for many decades, it would be reasonable to believe that a boost of that magnitude would beget more inflation, hence higher interest rates, hence the improved fortunes of banks and oil drillers and the like. Unfortunately for the credibility of the proposal’s framers, the plausibility of sustained growth at those levels is vanishingly low. The Fed’s median estimate of US long-term growth potential is 1.8 percent. Earlier this year the Congressional Budget Office estimated that if all the fiscal stimulus measures proposed at one time or another by the new administration (tax reform, infrastructure spend and all the rest) were successfully implemented, it could add one tenth of one percent to long term growth. So the Fed’s 1.8 percent would become 1.9 percent, hardly reason to break out the Veuve Cliquot.
Back in the Real World
Meanwhile Friday morning delivered yet another Debbie Downer data point to the market’s Pollyanna. The personal consumption expenditure (PCE) index, the Fed’s preferred inflation measure, came in for the month of August below consensus expectations at 0.1 percent. That translates to a 1.3 percent year-on-year gain, matching its lowest level for the past five years and well below the Fed’s elusive 2 percent target. We imagine this reality will likely show up again soon enough in the bond and currency markets (which also were the first to ditch the Trump trade back in February). But the stock market is a different animal. Is there enough wishful thinking to keep the reflation trade alive long enough to get through the tricky month of October and into the usually festive holiday trade mindset? Perhaps there is – money has to go somewhere, after all. At some point, though, reality bites back.