Global equities pushed higher last week with Japan’s Nikkei Index leading the way gaining 4.3% (-7.0% YTD). European stocks increased by 1.5%, while China declined by 3%. In the U.S., the S&P 500 appreciated by 0.5%, but investors favored Value stocks (+1.6%) over Growth stocks (-0.4%) by a wide margin, as some of the stocks darlings from last year missed Q1 earnings estimates. Examples include Google/Alphabet (-5.4% on Friday, after rising 47% in 2015) and Microsoft (down 7% on Friday, but up 23% in 2015). Elsewhere, high yield bond prices continued to exhibit a strong correlation to the price of oil. Since reaching a high yield of 8.4% (as measured by the CSI Barclays Index) in February (when oil prices bottomed at $26 per barrel), high yield bonds have rallied in concert with oil and now yield “only” 5.7%. On that note, WTI Crude gained 8.3% last week and now trades at $43.73 per barrel.
Detailed asset class return data is available here.
Treading Water: The S&P 500 has been trading in a wide range for the last 18 months, marked by about 2130 on the high end and 1800 on the low end. Over this time frame the lows and the highs of this 15% range have been tested multiple times, but it has yet to breakout in either direction. Last week’s performance pushed the S&P 500 over 2100 for the first time this year, but the question remains can the market reach ever higher levels? The short-term answer will come from the first quarter corporate earnings results which are being reported over the next couple of weeks. With management teams having guided expectations lower over the last several months, earnings are likely to “beat” sell-side analysts’ estimates in the aggregate – if they don’t, we could be revisiting the bottom-end of the trading range soon.
Sources: Bloomberg and Covenant Investment Research
In the intermediate term however, the market direction will be determined by actual and expected monetary policy actions by central banks. For better or for worse, this is the world we live in now – one large central bank trade. Central bankers have engineered an impressive rally since 2009 that absent some noise in 2011, was largely uninterrupted until 2014 as markets responded positively to wave after wave of ever-inventive policies designed to push liquidity into their respective economies. Yet, since the end of 2014 investors’ reactions to policy actions have been less predictable and global equity markets have lost their momentum. Are we at the end of the era of Central Banker Omnipotence? No one can answer that question ex-ante, but the stakes are high for investors. Diversification amongst asset classes, geographies, and investment strategies (including hedging strategies) remains investors’ most effective weapon against highly uncertain outcomes.
Circular Logic: The Flash Manufacturing PMI (preliminary results of manufacturing activity, including output, new orders and prices) for Japan dropped further in April. Now at 48, the PMI indicates that Japan’s manufacturing sector is contracting (a reading above 50 signifies expansion, below 50 contraction). The PMI reading was dragged down by a decline in exports, which have suffered as a result of a surge in Japan’s currency (the Yen) in the last few months making Japanese-produced goods comparatively more expensive. Already, there are calls for the Bank of Japan (BOJ) to cut interest rates further when they meet this week in an effort to devalue the Yen and make Japanese goods more competitive. But here’s the thing… the recent rise in the Yen coincided with the BOJ adopting a negative interest rate policy in January. Will pushing rates further into negative territory have the desired impact on the Yen, or will it backfire once again?
Be well and godspeed,
The past week was a good one for risk assets with global equities appreciating more than 2.5%. Japan led the way with a gain of 7% (+0.5% MTD), Europe rose by 3.5% (+1.7% MTD) and though U.S. Equities lagged their international counterparts, they increased by a respectable 1.6% (+1.1% MTD). In spite of the general risk-on sentiment, the price of U.S. Treasuries barely budged as weak inflation data from March will put less pressure on the Fed to raise rates when the meet later this month (April 26 & 27). Gold gave back some of its recent gains, declining by 0.5%, whereas Silver jumped 5.6%. The price of WTI Crude continued its upward momentum, gaining 1.8% for the week (+5.5% MTD). The VIX Index (sometimes called the “Fear Index”) declined by 11% during the week to 13.7, indicating that investors anticipate further gains in risky assets. Detailed asset class return data is attached here.
Law of Diminishing Returns I: During the 45 years leading up to the turn of the century, it took about $1.70 of nonfinancial debt to generate $1.00 of GDP. Since 2000, it has taken on average $3.30 of nonfinancial debt to generate $1.00 of GDP Non-financial debt includes household, business, federal, state and local government debt.
Law of Diminishing Returns II: In 2015, Nominal GDP (the broadest indicator of economic performance) rose by $549 billion, while nonfinancial debt increased by a staggering $1.9 trillion, I.e 3.5x faster than GDP last year. The diminishing returns on debt indicate one of two things, or perhaps both:
- The debt is not being used for productive purposes (e.g. Corporations issuing loans to increase stock buybacks may be good for the price of the stock, but it is not an economically productive use of capital);
- Excessive debt levels in an economy constrain growth, rather than enhance it. Total debt is now 370% of GDP, well above the critical level of 250% – 300% cited by academic studies as the threshold at which debt begins to slow economic activity.
The U.S. Is better off than other developed economies considering that the Eurozone’s total-debt-to-GDP ratio is 457% and Japan’s is 615%. The indebtedness race is not one that we want to win – witness Japan’s anemic growth rate over the last 20 years. All is not lost as the U.S. economy is not predestined to follow Japan. However,, the longer we delay making the difficult decisions to reduce debt the more intractable the problem becomes. (Data provided by Hoisington Investment Management).
Be well and godspeed,
After a furious six-week rally, equity markets opened the second quarter in the red. Large cap domestic equities are faring better on the margin (down 0.5% MTD) than global equities (down 1% MTD). Market volatility remains elevated as evidenced by the S&P 500 which saw three consecutive days of moves in excess of 1% last week (one up and two down). Japanese equities bare special mention as the Nikkei index fell 5.6% MTD (down 16.2% YTD). The Yen has gained more than 4% thus far in April despite Japan’s negative interest rate policy (which was designed to depreciate the value of the Yen – oops). Elsewhere, the price of US Treasury bonds rose (i.e. the yield fell) as would be expected in an equity market decline. More surprising, and perhaps a good sign that markets are beginning to decouple from the price of oil, is that WTI rose 8% last week and is now up 7.2% YTD at $39.72 per barrel. Detailed asset class performance is available here.
Funny and True: Last week Bernie Sanders claimed that General Electric is “destroying the moral fabric” of America. GE’s CEO Jeffrey Immelt responded “We create wealth and jobs, instead of just calling for them in speeches”. Isn’t that the truth! That is not a comment about any specific Presidential hopeful, but rather about politicians in general. Take the current U.S. Congress. While they all talk about wanting a better economy and better opportunities for their constituents, very few of them are willing to make the tough decisions that are necessary for our economy to function better in the years ahead. Instead they regularly grandstand in Congressional hearings, grilling Fed Chairman Janet Yellen about why her monetary policy is failing to generate the level of economic growth they expect. What they don’t realize (or willingly ignore) is that absent fiscal reform, robust growth will be extremely difficult to achieve. Monetary policy cannot do it alone. Having gotten that off my chest, I’ll step down from my soapbox now.
The Theory of Negativity: Negativity is spreading across the globe and I’m not referring to bullish vs. bearish views on equity markets (though that seems to be changing on a daily basis given stock market action). Originally used by central banks in Sweden and Switzerland, the adoption of negative interest rate policies by the European Central Bank and Bank of Japan have accelerated the growth of negative yielding government bonds (i.e. investors pay the government for the privilege of lending them money). As a result, 29% of global government bond issuance now sports negative yields. Moreover, a massive 66% of global government bonds yield less than 1% (see chart). By comparison, the US-10 year bond is yielding 1.71%. Who thinks interest rates in the U.S. will rise significantly in the near-term given both the yield differential and the backdrop of slow economic growth globally? While anything is possible, not everything is probable.
Source: JP Morgan
Economic Wrap-up: The ISM Non-Manufacturing index for March rose to a stronger than expected level of 54.5. However, the recovery represents only a small reversal from the downward trend that began last July when the index peaked at 60.3 and declined to 53.4 in February of this year. Further gains in this index will be necessary to overcome what has recently been a slowing pace of expansion in the services sector. To this end, the new orders sub-index in this report showed healthy gains, which portends future growth. The Job Opening and Labor Turnover Survey (JOLTS) report for February seems to confirm our thesis that the labor cycle has likely peaked for this business cycle, at least as it relates to job openings which have plateaued recently (at a good, relatively high level). Job openings are a leading indicator of future hiring activity. If indeed the labor cycle has peaked, it does not imply that it is about to contract – rather it could be characterized as a maturing process where we would not expect to see hiring at the same pace as has been witnessed in the last couple of years. Minutes from the most recent Federal Open Market Committee (FOMC aka “The Fed”) meeting confirmed what Fed Chairman Yellen had already conveyed via the media. Namely that the Fed is concerned about the effect that international developments might have on the U.S. Economy and is likely to proceed slowly with the rate normalization process.
March ended the first quarter of 2016 on a positive note with equity markets staging an impressive rally, yet the 7-year old bull market remains in a tenuous position. Although developed market equities rallied around 7%, the S&P 500 is barely positive year-to-date and developed markets outside of the U.S. are under water. Emerging markets have been the best performing geography thus far this year, rallying 13% in March and are up more than 5% year-to-date.
The chart below highlights just how choppy the quarter was. Most broad indices traded in a 10% range, only to end the quarter roughly flat. Detailed asset class performance is available here.
Sources: Bloomberg and Covenant Investment Research
Once again the rise in equity prices was less about dramatically improving economic fundamentals (see Show Me the Money below) than it was central bank actions. For example, in March the European Central Bank launched another round of QE (that included pushing interest rates further into negative territory), the Bank of England held interest rate levels static, and the Fed (in addition to not raising interest rates) crafted a very dovish message that reduced the number of expected interest rate increases in 2016 from 4 to 2. Clearly no central banker is ready to remove the punch bowl just yet.
And why would they? Both Japan and the European Union economies are on the cusp of outright deflation. While growth in the U.S. economy is well below average, it is the envy of developed markets the world over. Moreover, with such a low growth rate, the U.S. economy is uncomfortably susceptible to global dynamics. A point that Fed Chair Janet Yellen acknowledged in her recent remarks. So….. it looks like the extraordinarily accommodative monetary policies will be with us for the foreseeable future.
Show Me the Money: Historically, corporate profits have been a very good leading indicator of economic activity and stock prices. Unfortunately, profit data over the last 21 months are signaling a warning sign as they have been in a downward trend since the mid-point of 2014. Moreover, retained earnings are declining at a faster pace than profits as management teams direct idle cash to stock buybacks and dividends that, while economically unproductive, serve to support their company’s stock price.
Source: FTN Financial
Corporate profits are not a perfect indicator of future economic growth nor the direction of stock prices. Yet, as the chart above illustrates, there is a strong relationship between them. As such, some caution is warranted until corporate profits reverse their current trajectory.
Economic Data Summary: Consumption growth continued to expand (+0.2% month-over-month (m/m)) in February, albeit it at a slower pace than in Q4 ’15. This was not a big surprise, given the downward revisions to Retail Sales a couple of weeks ago. The Conference Board’s measure of U.S. Consumer Confidence rebounded from February’s reading of 94 to 96.2 in March. More importantly, the forward-looking expectations sub-index jumped to 84.7 (from 79.9), which may portend a pick-up in consumption as consumers generally feel good about the future. Some of that confidence is likely stemming from the solid labor market, which added another 215,000 jobs in March. The manufacturing sector showed signs of life in March as the ISM Manufacturing Index rose to 51.8 after languishing for five months below 50 (a reading below 50 indicates a contraction).