Weekly Market Flash Archives - MV Financial
 

MV Weekly Market Flash: The Cost of Easy Money

MV Weekly Market Flash: Earnings May Matter in 2H19

MV Weekly Market Flash: Greenbacks in Wonderland

MV Weekly Market Flash: The Insurance Cut and the Melt-Up

MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

MV Weekly Market Flash: The Problem of Non-Quantifiable Risk

MV Weekly Market Flash: Strange Curves

MV Weekly Market Flash: Volatility, The Good and The Bad

MV Weekly Market Flash: Seven and Ten In China

MV Weekly Market Flash: The Performance Art of Trade Talks

MV Weekly Market Flash: The Cost of Easy Money

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According to the teachings of traditional financial theory, investors make rational choices when deciding which assets to include in their portfolios, based on their particular return objectives and tolerance for risk. “Choice” implies evaluating the relative merits of the cash flow prospects for Company ABC versus Company XYZ, or the stability of securities backed by the full faith and credit of the United States government versus those issued by sovereign entities in volatile frontier markets, and assigning valuations accordingly. The safer the asset, the less return an investor should demand for holding it. Which is why it might have raised...

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MV Weekly Market Flash: Earnings May Matter in 2H19

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Second half already? As the third quarter of Year 2019 gets underway, pundits great and small will no doubt be pondering what surprises the remaining months will have in store for us. We kick off the back half of the year with tidings of great perseverance, as our economy now is officially the longest on record. Three cheers, or something. The august mavens at the Business Cycle Dating Committee (yes, really) of the National Bureau of Economic Research, the semi-official proclaimers of growth cycles and recessions, figure that the current upswing began in June 2009, making this the 121st month...

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MV Weekly Market Flash: Greenbacks in Wonderland

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Sweden, France and Germany are all in the news this week, and not just because they all have teams competing in the quarterfinals of the Women’s World Cup (we are hoping that by the time this article comes to press one of those three – France – will be en route to exiting the tournament at the hands of our own awesome US women’s soccer team). No, the other noteworthy news is that all three countries are now card-carrying members of Club Wonderland, the ever-expanding coterie of nations with benchmark 10-year interest rates trading in negative territory. Investors, it would...

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MV Weekly Market Flash: The Insurance Cut and the Melt-Up

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Here’s a quote from a mainstream media fixture. How recent is it? “Financial markets have soared during the last month on expectations of a cut in rates. The Federal Reserve’s top officials…may have grown increasingly reluctant in the last several weeks to risk causing turmoil on Wall Street by leaving rates unchanged, analysts said.” That little blurb from a New York Times article certainly sounds like it could have been written sometime within the past, oh, forty-eight hours. In fact, that article came out on July 7, 1995, two days after the Alan Greenspan Fed cut interest rates for the...

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MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

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Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to...

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MV Weekly Market Flash: The Problem of Non-Quantifiable Risk

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Consider the following: at some point between now and the end of July there will in almost all likelihood be a new prime minister in the United Kingdom, as current PM Theresa May has stated her intention to resign within that time frame. Now consider this: the next prime minister of a nation of 66 million citizens will be chosen by…approximately 124 thousand of them. These enfranchised citizens constitute the registered, card-carrying members of the Conservative Party and they alone will receive the ballots asking for their preference between two Conservative Members of Parliament (whose identities have not yet been...

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MV Weekly Market Flash: Strange Curves

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Well, we’re 22 trading days into the pullback that started after the last S&P 500 record high set on April 30. That’s 123 fewer than the 145 trading days it took for the last pullback to regain its previous high, from September 2018 to April 2019. Which, by the by, was exactly the same number of market-open days – 145 – that it took the January 2018 correction to regain its former altitude. Interesting for those who like to read meaning into randomness, perhaps…But we digress! Because, yes, the S&P 500’s retreat of more than five percent from that April...

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MV Weekly Market Flash: Volatility, The Good and The Bad

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In our annual market outlook back in January (wait, is it already Memorial Day weekend?!) we had two principal things to say about volatility. First, that we expected to see a higher level of volatility as one of the key defining characteristics of risk asset markets in 2019; second, that volatility is not always associated with downward trends in asset prices (meaning that higher volatility could be present in both up markets and down markets). How has that prognostication played out so far this year? As we head into the summer season it seems a good time to revisit our...

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MV Weekly Market Flash: Seven and Ten In China

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This week’s financial news cycle has been all about China, and a wacky week it has been. On Monday major global equity indexes experienced their biggest pullback since January as trade tensions continued to fill up the Twitter feeds of the investor class and their trader bots. Not that it was all that much of a pullback: the S&P 500 was off a bit more than two percent, the Nasdaq a bit more than that. Predictably, of course, the mainstream news outlets chose to ignore the relatively minor percentage point drop and put up instead the screaming headline “Dow Plunges...

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MV Weekly Market Flash: The Performance Art of Trade Talks

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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...

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MV Weekly Market Flash: The Cost of Easy Money

According to the teachings of traditional financial theory, investors make rational choices when deciding which assets to include in their portfolios, based on their particular return objectives and tolerance for risk. “Choice” implies evaluating the relative merits of the cash flow prospects for Company ABC versus Company XYZ, or the stability of securities backed by the full faith and credit of the United States government versus those issued by sovereign entities in volatile frontier markets, and assigning valuations accordingly. The safer the asset, the less return an investor should demand for holding it. Which is why it might have raised a few eyebrows earlier this week when the yield on 10-year government bonds issued by Greece – yes, that Greece – briefly fell below the yield on comparable US Treasury securities.

The Lagarde Put

If you have been following the goings-on in the capital marketplace for some years now, you may remember that back in 2012 Greece was on the verge of failing out of the single-currency Eurozone, and its government bonds were fetching yields of nearly 35 percent. But 2012 was also the year of the three most famous words pronounced on the European continent since “veni, vidi, vici” – “whatever it takes” per European Central Bank chief Mario Draghi. Draghi’s term will end this coming October, and the ECB torch will most likely pass to Christine Lagarde, current head of the International Monetary Fund. Lagarde will ascend to the commanding heights of a world where those dog-eared pages of traditional finance textbooks are as good as worthless. Euro-denominated bonds issued by the Czech Republic trade at negative yields, while Japanese insurance companies, thirsting for positive yields, scour the likes of Kazakhstan and even Turkey for inclusions to their portfolios. “How low is too low?” will likely be one of the persistent questions to be faced by the new ECB chief. The first 10-year benchmark to come with a coupon of minus one percent may not be too far down the road.

It’s the Fed’s World, We Just Live In It

Back on this side of the Atlantic, “Fed funds cut in July” appears to have joined death and taxes as the only certainties in life. Equity markets were briefly unsettled earlier in the week by the better than expected jobs numbers that came out last Friday. Good news (e.g. jobs, wages, consumer confidence), after all, might throw a wrench into those rate cut expectations. Not to worry, though, as Fed Chair Powell made it perfectly clear that, come what may, the rate cut is in the post.

Now, from the standpoint of prolonging the economic growth cycle it may be entirely reasonable to produce a couple “insurance” rate cuts – a topic we discussed here a couple weeks back. The problem is that in the current market environment, these are not just one-off measures but rather part and parcel of a seemingly endless program of easy money all around the world. What this accomplishes in economic terms is up for debate; what is not debatable is that it has a distorting effect on asset prices. Not just in the form of negative interest rates and Greek bonds trading at par with Treasuries, but in the valuation of equities as well.

Back in the days when those old finance textbooks were relevant, there was a methodology for calculating the value of a company’s equity by computing the net present value of a future stream of cash flows. The net present value figure was arrived at by assuming an appropriate cost of capital and then discounting future cash flows back to the present at that cost of capital. All else being equal, a decline in interest rates will increase the value of those cash flows being discounted to the present (that’s one big reason why stock prices reflexively rise on the news of interest rate cuts). When rates go to zero or turn negative, though, it can render meaningless that discount rate calculation. Market prices are distorted accordingly, and the ability of investors to make rational choices between assets of varying creditworthiness is likewise impaired.

The current bull market is in its eleventh year, the second-longest on record since the end of the Second World War. This longevity is almost entirely due to the presence of easy money. The market’s inability to live without the Fed, ECB et al was made perfectly clear last fall, when fears about monetary tightening took equities just nanometers away from a bear market. A willingness to trade rational price discovery for the security of government intervention is the bargain investors have accepted. It’s the TINA market – There Is No Alternative. What nobody wants to do is imagine what might come after TINA.

MV Weekly Market Flash: Earnings May Matter in 2H19

Second half already? As the third quarter of Year 2019 gets underway, pundits great and small will no doubt be pondering what surprises the remaining months will have in store for us. We kick off the back half of the year with tidings of great perseverance, as our economy now is officially the longest on record. Three cheers, or something. The august mavens at the Business Cycle Dating Committee (yes, really) of the National Bureau of Economic Research, the semi-official proclaimers of growth cycles and recessions, figure that the current upswing began in June 2009, making this the 121st month of the cycle. Take that, economy of the 1990s with your paltry 120 months of good times!

Earnings Ahead, Earnings Behind

One subject that did not get much attention in the first half of the year was corporate earnings. Arguably, earnings are the most important thing to pay attention to when analyzing stock prices, since (in theory, anyway) a stock price is nothing more and nothing less than a net present value assumption of the future earning potential of a company’s assets in place. But the year’s first two earnings seasons played second fiddle to the much more obsessed-over Fed pivot on monetary policy and the constant ebbs and flows of the trade war. They might start to matter again. In the chart below we show the earnings per share (EPS) trend – a largely positive trend – for the S&P 500 over the past five years.

Okay, so what’s going on with this graph? The dotted green line represents next twelve months’ (NTM) earnings; in other words, what earnings are likely to be twelve months from now according to the analysts who cover these companies for securities firms. For example, we note that on July 2, 2018 the consensus estimate of these analysts was that, one year hence, the actual earnings per share of the S&P 500 would be $167.67.

However, one of the fixtures of life in analyst world is that projections rarely match up with reality. In that same chart above we can see that on July 2 of this year (i.e., yesterday) the actual last twelve months’ (LTM, the dotted red line) S&P 500 earnings amounted to just $152.50. Why the discrepancy? The gap between projected and actual earnings is an accumulation of years and years of misfires by the analysts due to anything from calculation errors to unexpected events to occasional efforts to game the system.

In any event, the combined intelligence from both the forward-looking and backward-looking EPS numbers tells us that earnings have slowed since the end of last year, and also that analysts expect the growth rate in the months ahead to be modest. The consensus analyst growth estimate used by FactSet, a market research company, currently stands at 2.95 percent for the full year 2019. As recently as December of last year, the same analysts were predicting EPS growth of 6.57 percent for the same period.

Recession No, Compression Maybe

Where that dotted red line of LTM earnings goes from here will no doubt be related to what happens to the economy at large in the near term. The prospect of an economic slowdown has taken root in investors’ minds, and has been the principal factor driving the Fed’s abrupt dovish pivot on monetary policy. The market loves a dovish Fed like little else, but weak earnings can throw a wet blanket on the best laid plans of the FOMC. Earnings, after all, are the denominator of the price-earnings (PE) ratio, arguably the most widely used valuation metric for stock prices. The chart below shows the PE ratio trend (for both NTM and LTM earnings per share) for the past five years.

One might interpret this chart as suggesting that there is not much to worry about valuation-wise. Both the LTM (red) and NTM (green) PE ratios are not too far away from their five year averages of 18.9x and 16.7 times respectively. That is comfortably below where they were for most of 2017 and 2018 up to the major stock market pullback last fall. But they still are not particularly cheap by historical comparison. According to a related measure, the Cyclically Adjusted Price Earnings (CAPE) ratio published by economist (and Nobel Prize winner) Robert Shiller, the market today is still more expensive than it was at the peak of any growth market except for those of 1929 and 2000.

What that means is that there may not be much room for the numerator of the PE ratio – stock prices – to run too hot without a concurrently brisk pace of earnings growth. The PE ratio can expand (i.e. stock price growth outpaces earnings growth) if investors believe the earnings will eventually catch up. This often happens in the early months of a recovery cycle. Alternatively, the ratio may compress (i.e. outsize downward pressure on prices relative to earnings) if expectations are for a winter season for earnings. This is frequently a feature of late-cycle behavior, when sentiment about growth prospects wanes. We may not be there yet – again, there are no compelling signs of an imminent recession – but sentiment has a habit of running ahead of the facts on the ground. We will be paying close attention as companies gear up for the start of this next earnings season after the holiday.

MV Weekly Market Flash: Greenbacks in Wonderland

Sweden, France and Germany are all in the news this week, and not just because they all have teams competing in the quarterfinals of the Women’s World Cup (we are hoping that by the time this article comes to press one of those three – France – will be en route to exiting the tournament at the hands of our own awesome US women’s soccer team). No, the other noteworthy news is that all three countries are now card-carrying members of Club Wonderland, the ever-expanding coterie of nations with benchmark 10-year interest rates trading in negative territory. Investors, it would seem, cannot get enough of the opportunity to pay for the “privilege” of lending to sovereign nations. And the looking glass world gets weirder still: in Denmark (which, by the by, does not have a team contending in the World Cup) there are stories of financial institutions offering mortgages to homebuyers with negative interest rates. You heard that right – buy a home in Copenhagen and get paid by the lender at the same time. Pretty sweet, however insane-sounding to anyone schooled in the quaint old ways of traditional financial theory.

Meanwhile, In Not-Yet-Wonderland

Back here at home we remain, for the present time at least, on the real-world side of the looking glass. Interest rates are low, with the 10-year Treasury yield just barely holding ground at two percent, its lowest level since November 2016 (the benchmark has come full circle since launching itself on that absurd “infrastructure-reflation trade” that was all the rage in the aftermath of the US elections that month). Two percent isn’t much – it’s basically zero purchasing power on an inflation-adjusted basis. But the logic of holding the world’s safest fixed income security and still getting paid interest seems pretty solid compared with the alternative of investing in Eurozone Wonderland bonds. Right? And that would seem to at least partially explain why the US dollar has remained strong even while US interest rates have plummeted in recent months. The chart below shows the greenback’s current trend versus interest rates.

The dollar-euro exchange rate would seem to be a useful point of analysis for considering interest rate trends in Real World USA and Wonderland Europe. As the Fed steadily executed its dovish U-turn over the course of the first half of 2019, the dollar remained firm – the rationale being, of course, that non-US investors still preferred to hold US assets (thus supporting the value of the dollar) rather than play the loser’s game of negative interest rates. So far so good. What has taken some currency traders by surprise, though, is a fairly pronounced trend reversal for the dollar that started in late May and intensified after the most recent FOMC policy meeting last week. Could the dollar be in for a longer period of weakness?

Market Ahead of Its Skis

What would a bear case for the dollar look like? Here it’s more a question of relative, rather than absolute, price movements. The European Central Bank remains dovish – nobody expects any kind of coordinated interest rate hike policy over there any time in the foreseeable future. But there’s not a whole lot more downside for rates either – unless we completely jump through a 4-D hyperplane and into a parallel universe where negative interest rates in the low-mid single digits are the norm. In the US, on the other hand, there are nine downward steps (of 25 basis points each) if the Fed wants to take us back to the zero lower bound where the Fed funds rate resided through most of the first half of this decade. And the consensus for a dramatic series of imminent cuts is remarkably strong right now. Three by year-end and maybe as much as a full 50 basis point move in July is the odds-on wager in the Fed funds futures market.

So it would be the relative magnitude of the Fed’s dovish turn, versus the more limited tools available to the ECB, that could spark a more sustained downward move in the dollar. In so doing it would give an immediate boost to the non-US asset holdings in domestic investors’ portfolios. If – and we still think this is a big if – those rate cuts go ahead to the extent the market believes.

But there is also a reasonable case to make that the market has gotten ahead of its skis on this rate cut consensus. Remember – there is still no hard evidence that a somewhat slower pace of growth in the US will lead to a recession in the near term. In a matter of days – come July – this current economic growth cycle will become the longest on record in the US. The trade war – everyone’s go-to excuse for why the Fed would take drastic action on rates – ebbs and flows with a daily barrage of superficial headlines from sources lacking in credibility. Meanwhile, safe-harbor assets like US Treasuries seem rather unlikely to lose much of their luster in a market environment with risk-off inclinations. Long story short: taking an overly bearish position on the US dollar could prove painful in the weeks and months ahead.

MV Weekly Market Flash: The Insurance Cut and the Melt-Up

Here’s a quote from a mainstream media fixture. How recent is it? “Financial markets have soared during the last month on expectations of a cut in rates. The Federal Reserve’s top officials…may have grown increasingly reluctant in the last several weeks to risk causing turmoil on Wall Street by leaving rates unchanged, analysts said.”

That little blurb from a New York Times article certainly sounds like it could have been written sometime within the past, oh, forty-eight hours. In fact, that article came out on July 7, 1995, two days after the Alan Greenspan Fed cut interest rates for the first time since 1992 (the article’s subtitle “Stocks and Bonds Soar” of course would be no less appropriate for anything written during the week ending June 21, 2019). The 1995 event was a particular flavor of monetary policy action called an “insurance cut,” and it has some instructive value for what might be going through the minds of the Powell Fed today.

Anatomy of an Insurance Cut

In the chart below we illustrate the context in which the 1995 rate (and two subsequent cuts ending in February 1996) took place. What we think of today as the “Roaring ‘90s” had not yet gotten into gear (in fact it was just about to start with the initial public offering of Netscape, the Internet browser, just one month after the Fed’s rate cut). In July 1995 the Fed had just capped off a series of seven rate hikes that had begun in 1994 and that had taken the stock market by surprise. Core inflation had crept back up above three percent, and a handful of economic indicators warned of a potential slowdown.

Despite the upturn in inflation, many observers at the time – on Wall Street, in corporate executive suites and in the Clinton White House alike – complained that the Fed’s rate hike program in 1994-95 had gone too far, too fast. Politics were certainly part of this mix, summer 1995 being a bit over a year away from the next presidential election (stop us if you’ve heard this one before). While the headline numbers didn’t suggest that a recession was imminent, there were indications that business investment had slowed with a build-up in inventories. The index of leading indicators, often used as a predictive signal for a downturn, had come in negative for four consecutive months. In announcing the rate cut, the Greenspan Fed emphasized that this move was more about getting out in front of any potential downturn, and less about the looming imminence of such a reversal.

Again, any of this sound familiar?

It’s a Different World

Equity investors, of course, would dearly love to imagine that a Fed insurance cut policy will always lead to the kind of outcome seen in the latter years of that chart above; namely, the stock market melt-up that roared through the late ‘90s and into the first couple months of the new millennium. Such an outcome is certainly possible. But before putting on one’s “party like it’s 1999” hat, it would be advisable to consider the differences between then and now.

The most glaring difference, in looking at the above charts, is the vast amount of blank space between the Fed funds rate and inflation. Yes, there was positive purchasing power for fixed income investors back in those days. Moreover, the US economy was able to grow, and grow quite nicely, with nominal interest rates in the mid/upper-single digits. This was real, organic economic growth. Yes – it’s easy to conflate the economic growth cycle of the late 1990s with the Internet bubble. But that bubble didn’t really take off until the very last part of the cycle – and in actual economic terms, Internet-related commerce was not a major contributor to total gross domestic product. This was a solid growth cycle.

The Greenspan insurance cuts, then, were undertaken with a fairly high degree of confidence in the economy’s underlying resilience. Today’s message is starkly different. What the market and the Fed apparently both conclude is that the present economic growth cycle cannot withstand the pressure of interest rates much or at all higher than the 2.5 percent upper bound where the Fed funds rate currently resides (and forget about positive purchasing power for anyone invested in high-grade fixed income securities). It’s a signal that, if the economy does turn negative, then central banks are going to have to get even more creative than they did back in the wake of the 2008 recession, because a rate cut policy from today’s already anemic levels won’t carry much firepower.

For the moment, the mentality among investors is optimistic that a best-of-all-possible-worlds result will come out of this. Dreams of a late-90s style melt-up are no doubt dancing in the heads of investors as they shovel $14.4 billion into global equity funds this week – the biggest inflow in 15 months. But no two bull markets are alike, and that goes for insurance-style rate cuts as well

MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to imagine “risk-on” as the dominant sentiment in global markets. A healthy allocation to core equities and higher-risk satellite classes like small cap and non-US emerging markets would be a plausible strategy, while perhaps reducing core fixed income weights to the lower end of your approved range.

No Reward for Risk
Of course, being in possession of just that one snippet of information about the future means that you wouldn’t have known that stocks came within a whisper of ending their decade-long bull market in December 2018, or that the Fed would make a sudden and radical U-turn in January towards a more dovish policy stance. Even so, one of the noteworthy things about the 2019 incarnation of the equity bull is how confined it is to US large caps, while riskier asset classes have sputtered. The chart below illustrates this divergence between bonds and large cap stocks on the one hand and everything else on the other.

From that point in time one year ago both US small caps and non-US emerging markets are down around 10 percent – still in or close to a technical correction. Non-US developed markets haven’t fared much better, in part due to the translation effect of a strong dollar on foreign currency assets. So a broad-based risk-on mindset has never really set in. The star asset class for this period, particularly when looked at on a risk-adjusted basis, is fixed income. The US Aggregate Bond index is up low-mid single digits for this period, performing a little better than large cap value equities and just a bit behind large cap growth stocks but with much less volatility, as clearly seen in the chart.

Divergence Ahead?
Bonds are in favor largely because the market has talked itself into believing that a forthcoming economic downturn will necessitate aggressive action by the Fed and other central banks (the presumed downturn being global in nature and in fact catalyzed more by flagging economies outside the US than here at home, at least for now). But there is a twist here within the friendly confines of the fixed income space. If economic conditions really are set to turn down, then a logical assumption would be that credit risk spreads start to widen. But that has not happened. Investment grade corporates and high yield issues alike are holding up just fine. The iShares iBoxx High Yield Corporate Bond ETF is up around 6.4 percent in total return for the year to date.

So here’s the picture: while the market is definitely not in a “risk-on” mindset, as evidenced by the poor performance of many higher-risk asset classes, neither is it completely “risk-off” as shown by those healthy returns for large cap stocks and the absence of credit risk spread widening. It’s as if there is some arbitrary line, on the one side of which are assets thought to be protected by a dovish Fed, with the other side being for assets vulnerable to the full-on effects of a worsening economy.

In recent commentaries we have argued that this odd arrangement is not sustainable. At some point either we realize that the economy actually is stronger than expected – in which case asset classes should revert to a more traditional risk frontier (higher return for higher risk) – or that a global recession is indeed imminent, in which case the market goes full risk-off, credit spreads widen and large cap equities get their comeuppance.

But there is an alternative view, which appears to be the one embodied by today’s conventional wisdom. This view holds that the magic of central banks will continue to work well enough to keep the worst of a downturn at bay. In this world, holding a handful of traditionally higher-risk assets like large cap US equities and low investment grade / high yield bonds makes sense, but taking on additional risk from other asset classes doesn’t pay (since the source of market return is permissive monetary policy, not organic economic growth). To be perfectly honest we think this is a risky view with the potential for serious mispricing of certain asset types. But it’s 2019, folks, and strange is the new normal.

MV Weekly Market Flash: The Problem of Non-Quantifiable Risk

Consider the following: at some point between now and the end of July there will in almost all likelihood be a new prime minister in the United Kingdom, as current PM Theresa May has stated her intention to resign within that time frame. Now consider this: the next prime minister of a nation of 66 million citizens will be chosen by…approximately 124 thousand of them. These enfranchised citizens constitute the registered, card-carrying members of the Conservative Party and they alone will receive the ballots asking for their preference between two Conservative Members of Parliament (whose identities have not yet been decided). Whoever wins the larger percentage of those ballots will, given the make-up of the core Conservative Party membership, very likely be in the camp of “hard Brexit” and thus anathema to as much as 53 percent of the total UK electorate. For various reasons both constitutional and procedural, there is an entirely plausible case to make that this next Tory government could drive the UK over a no-deal Brexit cliff before or upon the current decision deadline of October 31.

Quantify This!
We bring up this particular issue not for the sake of political analysis, but to illustrate a particularly challenging issue in the current capital market environment: how to price in risks that are, for all intents and purposes, unquantifiable. Brexit is of course not the only issue whose multiple moving parts and lack of historical precedents befuddle conventional risk analysts. The health of global trade and of the very system of unfettered flows of capital, goods and services across borders that has served as the default backdrop for more than three decades of valuing assets is uncertain. The system’s most important player, the United States, has embarked on a program of weaponizing the tools of this system for perceived national gain. Elsewhere, the traditional center-right and center-left political parties that have dominated the political scene throughout the entire postwar period are in radical decline.

How does one price any of this into the valuation of this or that asset? Sure, it’s easy enough to throw together a conventional model, assigning probabilities to various outcomes and then matching each outcome with a guesstimate as to the price impact on stocks, crude oil or high yield bonds. But those guesses amount to no more than throwing a dart at the wall while blindfolded. Would a hard Brexit, or a hot trade war, or a sharp turn towards authoritarian populism in more of the developed and developing world be good or bad for Brent crude or the US tech sector or the euro? Who knows? There is literally no hard empirical data to suggest the correctness of one guess – one throw of the dart – versus another.

In Powell They Trust
In the absence of the ability to rationally price the various organic risks afoot in the global marketplace, all the eggs find themselves in one basket: the willingness of central banks, principally the US Fed, to do anything it takes to keep risk asset markets from falling. Last fall we saw what happens when that faith is shaken. For a period of weeks between late September and late December 2018 it became clear that there was a less than certain chance the Fed would step in to backstop falling markets. Had the Fed not radically reversed course in early January with a major policy U-turn, it is entirely plausible that the near-bear market reached on December 24 would have turned into a real bear market. But the Fed lived up to its reputation as the redeemer and comforter for the investor class, and all was well again.

The Fed put, in effect, has become the substitute for organic risk analysis in a world of profound macro uncertainties. This explains why the dominant characteristic of markets in 2019 to date is that bonds and equities are joined at the hip – the prices of both rising under the expectation that central banks will continue to – and continue to be able to – underwrite whatever disruptions actually come about as a result of a hard Brexit or a tsunami of tariffs or whatever else comes along.

We’ll have another chance to see, very shortly, whether this undiluted faith in the Fed is justified. The market is currently pricing in about a 70 percent chance that the Fed will cut rates three times in the next year. Some comments this week by Chair Powell provided succor to this view – equity markets surged on Tuesday on the interpretation that any negative outcomes from an aggressive US tariff policy will be offset by a flood of Fed dollars. On June 19 we will see just what combination of words and/or action support that view when the FOMC concludes its June meeting.

And therein lies the ultimate exercise in non-quantifiable risk. Either the Fed and other central banks can prop up asset markets indefinitely, come what may, or they can’t. Assign a probability to each outcome, put on a blindfold and throw the dart.

MV Weekly Market Flash: Strange Curves

Well, we’re 22 trading days into the pullback that started after the last S&P 500 record high set on April 30. That’s 123 fewer than the 145 trading days it took for the last pullback to regain its previous high, from September 2018 to April 2019. Which, by the by, was exactly the same number of market-open days – 145 – that it took the January 2018 correction to regain its former altitude. Interesting for those who like to read meaning into randomness, perhaps…But we digress! Because, yes, the S&P 500’s retreat of more than five percent from that April 30 high has the usual red lights flashing all across the CNBC screen and Dow point drops (always point drops, always the Dow, so much more dramatic than the more mundane percentage creeps) juxtaposed next to the head of a speechifying Robert Mueller. But the real story this week is in the bond market, and specifically the strange shape of the Treasury yield curve.

The Yield Scythe
The chart below shows the evolution of the Treasury yield curve’s shape over the past month and compares it to what a more normal curve looked like one year ago. The blue line represents the most recent configuration of the curve, which looks like nothing more than a scythe ready to attack a field of wheat. Or a Marxist sickle missing its hammer, perhaps.

We’ve talked about the yield curve in these pages before, of course. The shape of the curve is important because an inverted curve – which is what is currently happening between short and intermediate term maturities – has historically been an extremely reliable predictor of recession. Every recession in the past sixty years has been ushered in by an inverted yield curve (though the timing between a curve inversion and the onset of a recession is subject to high levels of variance).

Do the Math
The relationship between the yield curve and the economy is not complicated, as bond math is entirely straightforward. Yields drop when prices rise, and prices on low-risk securities like US Treasuries rise when investors seek safe havens from riskier assets like stocks. When intermediate yields drop, it can signal the assumption by investors that central bankers will be pushing down short term rates.

Right now the Fed funds rate – the overnight lending rate between banks that the Fed effectively controls through its open market policy operations – is within a target range of 2.25 – 2.5 percent. You can see that short term Treasuries, which tend to move more or less in sync with the Fed funds rate, are all bunched around the middle of that target range, while the intermediate maturities of two to ten years all trade below the floor of the Fed funds range. In many ways, this is just a visual confirmation of what we already know to be true from other data sources like the Fed funds futures market. Bond investors expect at least one, maybe two, rate cuts before the end of the year. In other words, they look into the future and see a Fed funds target range with a floor as low as 1.75 percent – and where the Fed funds rate goes, those short-term Treasuries will follow. Then the yield curve would revert to something more like a less-steep version of that yellow line on the above chart.

But Where Is the Evidence?
The one missing piece in this puzzle is…well, actual evidence. Recall that we have just posted the lowest unemployment rate – 3.6 percent – since 1969. Real GDP growth remains positive, if not necessarily going gangbusters, and while corporate earnings have decelerated from the tax cut-fueled high of 2018, businesses’ top line sales continue to grow at a healthy pace – over five percent for Q1 of this year with almost all S&P 500 companies having reported. Low inflation continues to perplex the Fed. But the core personal consumption expenditure (PCE) index, the Fed’s preferred inflation gauge, also stayed below two percent for most of the second half of the 1990s, one of the strongest economic growth cycles in US history. A PCE of 1.6 percent – where it is today – shouldn’t set off alarm bells.

All this aside, it is generally not a good idea to blithely ignore whatever message the bond market may be sending. No recession appears to be looming on the horizon, and the case for immediate Fed rate cuts is not as glaringly obvious to us as the conventional bond investor wisdom seems to have it. But the yield curve in its strange, scythe-like form doesn’t appear to be going anywhere either, and we must continue to give it due attention.

MV Weekly Market Flash: Volatility, The Good and The Bad

In our annual market outlook back in January (wait, is it already Memorial Day weekend?!) we had two principal things to say about volatility. First, that we expected to see a higher level of volatility as one of the key defining characteristics of risk asset markets in 2019; second, that volatility is not always associated with downward trends in asset prices (meaning that higher volatility could be present in both up markets and down markets). How has that prognostication played out so far this year? As we head into the summer season it seems a good time to revisit our January musings.

Peaks, Valleys and Mesas
Those of you familiar with how we have described volatility in the past will have encountered our topological renditions of the VIX index of market volatility, commonly known as the market’s “fear gauge.” Briefly, we have intermittent peaks when risk levels suddenly spike into the heavens like so many Gothic spires, and we have calm undulating valleys when investor attitudes are serene. And then we have mesas – extended periods where volatility is elevated but not as dramatic as those short spikes. The chart below provides a full rendering of this VIX topography over the market cycle of the past three years. In this chart the VIX is represented by the dotted green trendline, while the solid blue line shows the price trend movement for the S&P 500.

The peaks are pretty straightforward: they tend to happen when equity prices go into a tailspin. The most prominent risk spikes over the past three years, unsurprisingly, coincided with the sudden correction in stock prices in February 2018 and again in fall-winter of the same year. Those earlier, smaller spikes you see in 2016 coincided with the Brexit vote and the run-up to the US presidential election in the same year. Of course, in the aftermath of that election and throughout most of the following year investor sentiment was for the most part calm, and we experienced a long volatility valley that wound up setting successive new lows for the VIX throughout the summer and fall of 2017.

The mesas – that third topological element – figures into the interim period between the market correction spikes of February and October-December 2018, and again in the period since. Here we circle back to those comments about volatility we made in our January annual outlook. Higher volatility has indeed been a characteristic of asset markets this year, even though the overall price trend for most asset classes has been resoundingly positive. You can see that the VIX mesa between January and May 2019 is somewhat more elevated than that of April – September 2018, with more time spent above the long term average of 14.22 for this entire three year period. We think this is consistent with the contextual themes we discussed in our outlook: expectations for slower growth and a tougher set of comps for corporate earnings and margins, along with continued uncertainty about global trade. The mesa probably would have been higher still had not the Fed turned abruptly on its monetary policy towards a more dovish stance, with no more rate hikes in the foreseeable future.

Wider Intraday Spreads
The VIX, of course, is not the only way to look at risk and at times it can be misleading. VIX contracts are traded, bought and sold like any other asset, and as such what the index may be telling you on any given day can have more to do with flighty investor sentiment than with the underlying risk properties of the assets themselves. One such risk property is the intraday spread – the magnitude of difference between a stock’s intraday high and low price, expressed as a percentage of the closing price. In the chart below we show the intraday trend for the S&P 500 between August 2017 and the present.

Here’s how to interpret this chart: it shows the number of trading days each month for which the day’s intraday high-low variance (HLV) was greater than the average HLV for the entire period. For the entire period measured, the average HLV was 0.89 percent, meaning that the price difference between the high and the low was 0.89 percent of the closing price. So for any given day, if the HLV was higher than 0.89 percent that day was counted in that month’s tally. For example, in each of the months of September, October and November 2017, there was only one day in which the high-low variance was higher than the period average. By contrast, in both October and December 2018 the daily HLV was higher than average for nineteen days (in other words, for practically the entire month).

How does this chart help us understand the current risk environment? Well, the average number of higher HLV days for the first five months of this year (through the 5/23 close) is 8.2, including double-digit HLV days in both January and May. Again we want to make the point that volatility can be elevated even when the market is going up – January 2019 saw one of the strongest monthly price gains on record for the S&P 500, but there was higher than average intraday volatility for fourteen out of twenty-one total trading days. Conversely, the twelve HLV days recorded thus far for May coincide with a more risk-off mentality for investors as they pulled back in the wake of new record highs in April.

We believe there continues to be good reason to expect higher volatility in the weeks ahead. Remember – that may be good volatility or bad volatility. Given the way stocks trade in the present day, driven largely by reactive short-term quantitative models, any directional price trends are largely at the mercy of the daily headlines. The collective wisdom of the market may determine that trade war fears are overblown and the Fed has its back. Or, the consensus may be that the Fed’s toolbox is already pretty low on new surprises and global developments are unnerving. Either way, we will be looking at the elevation patterns in those mesas to gauge how much more volatility may lie ahead

MV Weekly Market Flash: Seven and Ten In China

This week’s financial news cycle has been all about China, and a wacky week it has been. On Monday major global equity indexes experienced their biggest pullback since January as trade tensions continued to fill up the Twitter feeds of the investor class and their trader bots. Not that it was all that much of a pullback: the S&P 500 was off a bit more than two percent, the Nasdaq a bit more than that. Predictably, of course, the mainstream news outlets chose to ignore the relatively minor percentage point drop and put up instead the screaming headline “Dow Plunges 600 Points!” “Six hundred” is sort of a big number, unlike “two percent” and so it had to be thus to maintain the focus of their audience for a few more minutes before they all went back to whatever this year’s Candy Crush diversion happens to be. Anyway, stock markets recovered as the week wore on though in a somewhat jittery state. But a potentially more consequential development was playing out a bit behind the scenes in the bond and currency markets. In numerological terms those developments played around the numbers seven and ten.

Unlucky Number Seven
The seven in question refers to the amount of Chinese renminbi that one US dollar buys. Right now the RMB/USD exchange rate is hovering above that threshold, at about 6.9 renminbi to the dollar. That’s not the lowest level for the Chinese currency since Beijing implemented a managed float system to replace the old fixed rate back at the turn of the decade, but it is close. The chart below shows the currency’s price trend over this period.

In the past, China has been accused of purposely undervaluing its currency in order to make its products more attractive to export markets. If that were the case, one would expect Beijing’s monetary authorities to be perfectly happy to let the renminbi fall below seven. The reality, though, is that currency manipulation of this sort has been out of favor for many years. Since the middle of the present decade China’s currency policy has consisted of two main aims: first, to open up the currency to a more prominent role in global financial flows in a manner more befitting of the world’s second largest economy; and second, to prevent massive capital outflows by domestic owners of renminbi-denominated assets. This second point, remember, was a major concern back in August 2015 and again in January 2016 when economic concerns sparked a wave of outflows. At that time Beijing commenced a sustained program of reducing their substantial holdings of foreign exchange reserves in an effort to bolster the currency – in effect, to keep the currency from falling below that threshold of seven to the dollar.

The Tenacious Ten
Which, in turn, brings us to the number ten, as in “10-year Treasury.” Because when talk turns to China’s store of foreign exchange reserves, the dominant asset in question is US Treasuries, the 10-year benchmark prominent among the spectrum of maturities therein. How important is it for China to support its currency above that seven threshold? Important enough to accelerate the pace of Treasury sales – perhaps goaded on by the parallel role such a move could play as a salvo in the trade disputes?

The good news is that a massive sale of Treasuries is probably not in the cards, at least not given the current state of things where China’s economic health remains relatively robust and the trade war is still more about posturing than actual infliction of damage. For one thing, it’s hard to think of a useful asset China could find to replace US government paper for its FX reserves. Japanese government bonds or German bunds? Those are similar in risk profile, but they also carry negative interest rates all the way out to the ten year maturity band. Nein, danke.

Nor is it even certain that substantial Treasury sales by the asset’s largest foreign holder would have a deep impact. The Treasury bond market is around $16 trillion in total size, of which China holds a bit more than $1 trillion in its FX portfolio. There is vanishingly little evidence of any widespread distaste for Treasuries among investors, many of whom expect Fed rate cuts in the next couple years and a general flight to quality sentiment as the global economy slows. That sentiment would likely attract plenty of buyers to any fire sale operation mounted by Beijing.

So that’s the good news. But it is also pretty clear that Beijing will try and do whatever it takes to prevent the kind of financial instability experienced in 2015-16, and a stable currency is a big part of that equation. The headlines may all be about bellicose trade war tweets (and they will no doubt continue to push and pull short term stock price movements), but there is much more going on with China that could play out in uncertain ways in the weeks and months ahead.

MV Weekly Market Flash: The Performance Art of Trade Talks

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.

Wait, What?

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.