Last week global equity markets rose in what many consider the final trading week of the year. While the markets are open this week, wedged between the Christmas and New Year’s holidays, most trading desks will operated by skeleton crews whose main responsibility is to call their bosses if a global event shocks the financial markets. Last week’s rally (which included gains of +1.5% to +3% in broad indices) was a nice bounce, but insufficient to push equity markets into positive territory for the month.
In response to the general risk-on sentiment last week, precious metals, industrial metals and energy assets rallied (Natural Gas rose 15.6%, though at $2/MMBTU it remains more than 80% below its 2008 high of nearly $14/MMBTU). With assets flowing toward risky assets, naturally fixed income instruments declined (the 10-year UST is now yielding 2.2%, while the 30-year UST remains below 3% @ 2.96%). The VIX Index, a measure of stock market volatility, also fell -24%, closing the week at a rather sanguine level of 15.6.
Additional asset class performance detail can be found here.
Looking Forward: The end of each calendar year always brings a flurry of market forecasts for the upcoming year. It also brings personal forecasts about how one will change her/his behavior, aka “New Year’s Resolutions”. The majority of both types of forecasts usually end up being wrong. Rather than add to the numerous lists of predictions for what may or may not happen in 2016, below is a summary of a recent conversation that, at least for me, was a great reminder of why the United States (despite many, many problems) is the greatest country in the world.
This conversation took place on a flight to the East Coast where I was headed for business meetings with a lot of work to complete. A young couple with an infant sat next to me, and like most people in my situation I thought selfishly “Ugghhh….this is going to be a long flight”. After struggling midflight to mix baby formula for his four-month, the young man (who I will call Bradley) struck up a conversation by asking if I was working on a business plan. Thus began an unexpected dialogue that ranged from politics to foreign policy to parenting.
Bradley, as I learned during the conversation, is a seasoned Army Ranger. Following several deployments to Iraq and Afghanistan, he is currently training to become a commander. Bradley’s goal is to return to the Middle East to lead high-value missions and “bring the fight to terrorists, as opposed to having them come to America”. He did not make this remark in a cheesy, naïvely patriotic manner that you would hear in a movie, rather it was stated in a reserved, yet determined way that comes from an experienced warrior. One that has been engaged not only in the idea of battling an amorphous, non-state sponsored terrorist movement, but in live firefights with ISIS’s human manifestations.
“With a new child aren’t you afraid of what might happen to you when you go back?” His reply was straightforward – “Our training, our equipment and our resolve give us the advantage. I’ve trained Iraqi army soldiers, and they really don’t give a sh*t about protecting anything besides Baghdad. They lack discipline and the dedication to training that is required to be a great soldier. I’ve also fought alongside coalition soldiers, and while better than the Iraqis, they don’t train as hard as U.S. soldiers. They lack the same level of extreme motivation that powers U.S. forces. It is a cultural thing. That is the difference with America – we take pride in our work, our craft. This is why America is the one remaining superpower – we take everything more seriously than other people in the world. I hope we as a nation don’t lose that”. Though a relatively simple assessment of the world order, it resonated with me.
“We need to instill a strong work ethic in the young people of our nation and rally against an increasingly common sense of entitlement. The United States became a world power through hard work and maintaining that status will require the same. Countries don’t remain super powers without hard work and innovation – complacency is the enemy few people talk about.”
Thank the good Lord that there are people like Bradley in our country. People who voluntarily risk their lives in faraway places to preserve our liberties and to allow us to pursue our own interests.
There will be no update next week due to the New Year’s holiday, but I’ll be back on January 11, 2016. In the meantime, I hope that 2016 brings health, happiness and success for you and your loved ones.
Wherefore art thou Santa? After an initially positive reaction to the Fed’s decision to raise interest rates and the rather dovish language that accompanied the announcement, global risk assets sold off in the back half of the week pushing equity markets further into negative territory for the month. Many had hoped that the Fed’s decision to finally move away from ZIRP (Zero Interest Rate Policy) would instill investors with confidence that the economy is gaining strength and catalyze a market rally into year end. So far those Christmas wishes are nothing more than “visions of sugar-plums dancing” in investors heads. Though there is time yet for a year-end rally, over the long-term fundamentals matter and future equity market gains will more likely come from rising profits than P/E multiple expansion…. yet, evidence of the former is scant at this time.
Additional asset class performance detail can be found here.
First Time? The Fed’s move marks the first interest rate increase in more than ten years. As a result of the timing between now and the last interest rate hike, there is a generation of traders that have not experienced a rate tightening cycle. The absence of a declining rate tailwind will test both the newbies and the veterans, providing an opportunity for the truly talented traders to separate themselves from the pack.
Scary Movie. Last week Bloomberg ran a piece highlighting potential market risk scenarios based on a survey of more than 100 economists. This survey identified the top three risks as:
1. The price of oil spiking to over $100 per barrel in reaction to Islamic State attacks.
2. The U.K. exiting the European Union
3. A cyber-attack taking down the financial system
I will suggest another risk that is on my radar: Operating in unchartered territory, a major central bank (US, ECB, BOJ, or PBOC) commits a monetary policy error that plunges the global economy into another deep recession.
This is frightful stuff no doubt. But is it any scarier than other periods in history, such as the Cold War between the U.S. and Russia? Markets are always facing risks (known and unknown). Sometimes these risks come to the fore as an “event” resulting in large market dislocations, such as the 9/11 terrorist attacks (2001) and wars with Iraq parts I (2003) & II (2007). However, more often than not the risks are thankfully unrealized. I’m not suggesting that the risks cited by Bloomberg should be ignored, rather I’m positing that investors need to take these risks into consideration and refrain from concentrating portfolios in a single asset class (even if that asset class has performed well recently – strike that, especially if that asset class has performed well recently). Spreading portfolio risk allows investors to participate in market appreciation during good times, manage downside risk during bad times, and rebalance to sell high and buy low. Long story short (and in a not-so-subtle nod to Dos Equis beer’s “Most Interesting Man in the World”), I urge you to stay diversified my friends.
Economic Data Release Summary. Annual Inflation, as measured by the Consumer Price Index, climbed to 0.5% (from 0.2%) in November in spite of a 2.4% month-over-month (m/m) decline in gasoline prices. Core inflation (excluding food and energy) rose to an 18-month high of 2%. On a shorter-term basis, three-month annualized core inflation is running at 2.4%. In spite of the higher inflation rates, we don’t believe we are in the beginning phase of runaway inflation. For one, the uptick in inflation was aided by weak year-over-year comps and negative inflation rates rolling out of the calculations. Moreover, with credit growth slowing on a global basis we just don’t see evidence of widespread inflationary pressures globally or in the U.S. Of course, if the data changes, we’ll change our view accordingly, we just don’t see evidence to do so at this time. Industrial Production in November declined 0.6% m/m vs. expectations of -0.1% as utilities (warmer weather) and mining output fell more than anticipated. If there was a bright spot in the report it is that manufacturing output was stable in November vs. consensus expectations of 0.1% decline.
In other news, the House of Representatives passed a spending bill on Friday that will fund the government through Sept 2016. Perhaps more importantly, the bill lifted the 40-year old ban on exporting oil from the U.S. (too bad the politicians didn’t make this decision when oil was priced above $100 per barrel).
Equity markets suffered their worst weekly decline since the August correction as prices of key commodities (metals and fuels) fell to new cyclical lows. Developed market equities slumped between 2% and 4%, while emerging market stocks declined nearly 5% on the week. Last week’s drop pushed the S&P 500 into negative territory on a year-to-date basis. This is not a prediction, but if stocks do not recover from here 2015 will be the first year since the Financial Crisis in 2008 that the benchmark index has produced a negative total return.
What caused the sell-off last week? The cheeky response is that there were more sellers than buyers. While that is factually accurate the truth is no one knows precisely, but price action in the commodities markets is likely one of the more important explanatory factors. Energy-related commodities experienced an even worse week than equities with Brent and WTI crude prices plunging more than 10%, while front-end futures contracts for natural gas fell 9%. Notably, the price for WTI Crude ended the week at $35.62 per barrel, the lowest closing price since the commodity bottomed at $35.40 during the Financial Crisis in January 2009 (note: WTI crude is trading below $35 this morning). Another noteworthy event during the week in commodity-land was Kinder Morgan’s decision to cut its dividend by 75%, the first major MLP to do so.
The energy complex carnage impacted high yield spreads, which blew out to multi-year highs (relative to comparable maturity US treasury yields). For example, the Barclays Corporate High Yield bond index (CSI BARC INDEX) closed the week yielding 6.18% over 10-year US Treasuries. Conversely, U.S. Treasuries provided their traditional safe haven role in periods of stress as the yields compressed across the curve with the 30-year bond yield declining below 3% again closing the week at 2.87%. I would note that the decline in UST yields appeared rather modest given the overall financial market stress and may be a result of expectations that the Fed will raise interest rates during their final FOMC meeting of the year this week. Trivia: Which occurred more recently, an increase in the Federal Funds rate or the release of the first iPhone? (The answer is included at the end of this note).
Additional market detail can be found here.
Caveat Emptor. While hedge funds are often criticized for being illiquid during periods of extreme stress, Third Avenue proved last week that highly regulated, daily liquid mutual funds are capable of locking-up client capital as well. Third Avenue’s Focused Credit fund (TFCVX) halted redemptions from its high yield strategy to allow for an orderly wind down, meaning that investors who thought they held a daily liquid publicly traded instrument, in fact do not. While nearly unprecedented to put into effect, most (if not all) mutual fund prospectuses include an often overlooked provision that allows the manager to prevent investor redemptions. Traditionally mutual funds limited their trading to traditional, highly liquid equities and developed market sovereign debt instruments, which made this provision largely unnecessary. However as the profit seeking machine known as “Wall Street” seeks to expand its footprint with retail investors, product innovation has pushed mutual fund strategies into less liquid instruments such as high-yield corporate debt and as a result meeting daily liquidity demands can become problematic. TFCVX offers yet another lesson for investors to use common sense when purchasing securities, keeping in mind the liquidity of the underlying instruments held by the mutual funds they purchase.
Economic Data Release Summary. The headline November US Retail sales figure increased by a rather modest 0.2% m/m, however this was dragged down by a 0.8% decline from lower gasoline prices (a net positive for the consumer). Importantly, control group sales (which exclude gas, autos and building materials) rose by a more encouraging 0.6% m/m. The University of Michigan consumer confidence index rose to 91.8, a four-month high indicating fourth quarter consumption levels should be relatively healthy. Notably, while the current conditions index increased to 107.0 (from 104.3), the expectations index declined to 82 (from 82.9) signifying that consumers are becoming more anxious about the future (at least on the margin).
Trivia Answer: The first iPhone was released on June 29, 2007; the last time the Fed raised the Federal Funds Rate was July 11, 2006. It is hard to believe that the most recent interest rate increase occurred before the introduction of the now ubiquitous iPhone.
Equities wobbled on Wednesday afternoon when Fed Chairman Yellen gave the market further evidence the Fed will raise interest rates at their next meeting on December 15/16th The wobble turned into a stagger on Thursday when European Central Bank President Mario “Do-Whatever-It-Takes” Draghi failed to meet market expectations (and/or hopes) in the form of additional ECB stimulus. On Friday, much of the market pain was reversed when Draghi and his team, obviously shocked at the market’s reaction to his latest stimulus plan, stated emphatically: “We have the power to act. We have the determination to act. We have the commitment to act.” Asset prices reacted powerfully, undoing much of the damage that had been inflicted the day before.
Market Recap. In spite of elevated daily volatility levels, weekly performance of stocks was muted. Large cap US stocks continued their run of outperformance (+0.1%), while small cap US (-1.6%) European (-3.3%) and emerging market (-1.7%) equity indices lagged. On a YTD basis, performance of regional equity indices ranks differently, led by Japan (+13.6%) Europe. (+10.6%) and China (+5.7%). Meanwhile, the S&P 500 was up +3.6% through last Friday, while Emerging Markets are down -13.0% YTD.
Volatility was also pronounced in global interest rates during the week, though again on a weekly basis yields rose only modestly. The UST 10-year bond yield rose +0.05% to 2.27% (the 10-year UST has been trading in a range of 2.0% – 2.4% over the last six months). High yield bond spreads compressed slightly.This is worth monitoring as the spreads have been on a widening trend since June of this year, implying lower credit quality (higher risk) corporations are having a more difficult time financing their businesses, which can serve as an early indicator of a recession (though that is not our baseline forecast).
Precious metals staged one of their best weekly rallies on the year, though gold, silver and copper prices are negative on a YTD basis. Crude oil had a tough week, with the price of WTI declining more than -4% to end the week at $39.97 per barrel. Surprisingly, in spite of the divergent monetary policy paths of the U.S. and most of the developed world, the USD declined -1.7% last week. The fall in the USD likely resulted from a short-squeeze, as the long USD trade is one of the most crowded trades on the planet right now. The USD may continue to rise against global currencies, but my guess is that a lot of that has already been priced into the marketplace.
Additional market detail can be found here.
Why didn’t Super Mario deliver? I think there are three potential reasons Draghi’s latest stimulus plan fell short of market expectations:
1. Growth in the Eurozone, though slow, is progressing and the ECB would like to see this play out further before taking more forceful monetary policy actions.
2. The ever-austere Germans are pressuring the ECB to take less, rather than more, monetary policy action. Germany has a long and strong history of financial conservatism. In fact, the country recently voted against making a bid for the 2024 Olympics citing concerns about the costs of hosting the world games. Keep in mind that Germany is the largest and strongest economy in the Eurozone, so they could certainly afford to host the Olympics.
3. In an interconnected global marketplace, it is logical to assume that Draghi and Yellen are in communication with one another choreographing, at least to some degree, their respective monetary policy actions. Draghi still has plenty of dry powder to apply to the market, but doing so directly in advance of a likely Fed rate hike may be less effective than waiting until after the event.
In reality, Draghi’s decision likely contained elements of all three reasons offered above. Leaving the reasoning for his recent policy decision aside, we are witnessing a changing of the guard in the ongoing narrative of central bank influence on the markets. In fact, Bloomberg recently called Draghi the “global economy’s chief protector” supplanting the Fed in that role. As such, we can expect global markets to pay increasing attention to Draghi with last week’s actions serving as an example of what is to come.
Economic Data Release Summary. The ISM manufacturing index declined to a six-year low of 48.6 in November (vs. 50.1 in October) as dollar strength continues to weigh on the manufacturing sector. The ISM non-manufacturing index declined from a near decade high of 59.1 to 55.9 in November. In spite of the decline, the reading above 50 indicates the service sector remains solidly in expansion territory (note that the services sector is a much larger component of the domestic economy than manufacturing). Non-farm Payrolls increased by a healthy 211,000 in November. The headline unemployment rate remained at 5% as more people entered he labor force. The Fed is on track to raise rates at their December 15/16th meeting.