Hurricane Harvey only grazed San Antonio, but other areas of the state are dealing with massive flooding and the ancillary problems it creates. Our thoughts and prayers are with those impacted by Harvey and the first responders who are trying to help them.
Equity markets bobbed and weaved, but ended the week looking more like undefeated boxing champion Floyd Mayweather than his over-matched opponent Connor McGregor. Jabbed by rumors that Gary Cohn (White House Economic Council Director and the presumptive next Fed Chair) would resign and President Trump’s threat to shut down the government if Congress doesn’t approve funding for The Wall, investors countered on hopes that a tax reform package will be completed before the end of the year and that the debt ceiling will be raised in September. Domestic large cap equities gained 0.8% on the week, though they remain underwater on the month down about 1%. Small cap stocks posted a 1.5% gain on the week, but are still down 3.3% in August. International equities also posted gains for the week, though Emerging and Frontier Market indexes led the way rising 2.2% and 1.3% respectively vs. 0.2% for Developed ex-US stocks. The yields on U.S. Treasuries declined as Fed Chair Yellen offered no new information regarding monetary policy in her speech at Jackson Hole (the USD also declined, described further below). Precious metals rose 0.6% and gold is now up 12.5% YTD. WTI Crude slid 1.3% to $47.87 per barrel.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Yellen’s Swan Song? – Last week global central bankers gathered in Jackson Hole for the annual Economic Symposium. The event began in 1978 as a forum for the world’s monetary policy makers to gather and discuss important issues they are facing behind closed doors and away from the political spotlight of their everyday workings. However, the event has evolved and now serves as an important platform for major bankers to signal future policy intentions. Encouraging the dissemination of information, reporters comprise an increasing proportion of the attendees, swelling from 6% in the early years to more than 12% at this invite-only event. Probably the most memorable policy announcement from Jackson Hole came in 2010 as the negative effects of the Financial Crisis were reverberating around the world. At that event, Fed Chairman Ben Bernanke gave a speech in which he said “Should further action prove necessary, (Fed) policy options are available to provide additional stimulus.” This speech served as the preamble to Quantitative Easing II.
This year’s official topic “Fostering a Dynamic Global Economy” was designed to help attendees focus on the sluggish economic growth many countries have experienced since the financial crash of 2008. Investors anticipated that Fed Chair Yellen may drop some hawkish policy hints, but her speech sounded more like someone who knows her time in the role is fleeting. She used her stretch at the podium to recap the Financial Crisis and defend the Fed’s monetary response. Chair Yellen closed on an optimistic note, suggesting the Fed can use these same monetary tools to prevent another financial calamity. The next headline speaker, ECB President Mario Draghi, also kept his cards close to the vest. Many were hoping he would provide details about the next steps for monetary policy in the Euro Zone, but the closest he got was to remark that making adjustments to monetary policy are “never easy”.
As the chart below highlights, the USD moved sharply lower following each of the speeches by Yellen and Draghi, reinforcing a trend that began at the start of 2017.
Sources: Bloomberg and Covenant Investment Research
Thus far this year, the U.S. dollar has declined 9.5% against a basket of trading partner currencies and more than 11% vs. the Euro specifically. A weaker U.S. dollar is not all bad as it makes U.S. exports more competitive and can help boost sales for companies like those in the S&P 500 that collectively derive more than 40% of their revenue from overseas sources.
In sum, Jackson Hole was a bit of a snooze fest and the U.S. dollar declined as a result. Hopefully, the bankers made progress with their ideas for how to boost global economic growth in their meetings behind closed doors.
The Big 2 – As members of Congress finish up their summer vacations and prepare to return to Washington, September 29th is likely circled with a big red marker on their calendars. On this date two important deadlines are converging:
- Debt Ceiling: The Treasury needs Congress to approve raising the debt ceiling so the Treasury can borrow money and continue to fund programs and services such as social security, Medicare, Medicaid, and the military.
- 2018 Budget Approval: The government’s fiscal year begins on October 1st. The budget is necessary as it authorizes levels of government spending and where the dollars are directed.
Most remember the last government shutdown, when Congressional infighting prevented a budget agreement in 2013. As the deadline approached and ultimately was breached, stock market volatility increased and the S&P 500 ultimately sold off by 4% over a two-week period. Congress eventually came to their senses to pass a budget and some have suggested that the falling equity market played a role. Even as political strife has increased since 2013, odds are that deals will get done this year (the political ramifications of a government shutdown would be very costly). But the twists and turns leading to their resolution will cause stock market volatility to rise if we get close to September 29th without a resolution on these two fronts. Then again, equity volatility may be a necessary catalyst for the deeply entrenched politicians in Congress to act.
It was an eventful week, but not a week of good events. From political strife at home to terrorist acts abroad, the media channels had a lot to talk about. Financial markets were impacted by these events and prices changed swiftly as investors reacted to rumors, facts and updates to the same rumors and facts. When the dust settled on the week, domestic equity markets declined modestly, while international developed (except for Japan) and emerging market equity indices moved higher. European stocks took an outsized hit on Thursday and Friday following the tragic terrorist event in Spain. A somber reminder that while our country has a number of internal issues that must be dealt with, there is a global organization of radicalized Muslims that wishes to do harm to those that do not share their beliefs.
For the most part, while equity market volatility has increased over the last two weeks, the markets have largely been stuck in the mud. Most broad indices (e.g. S&P 500, Nasdaq, MSCI All Country World Index) are at similar price levels to where they were at the end of May. In other words, while equity indices have zigged and zagged, they have made little-to-no progress in 2.5 months. This is not unusual market behavior, especially for this time of the year (hence the old Wall Street adage “Sell in May and Go Away”), but the additional volatility has caught many off-guard. Again, it seems that investors have become conditioned to low volatility. Reportedly, the Dow has only dropped by > 1% in three days this year vs. 34 times in 2015, and 24 times in 2016.
Yields on US Treasuries ended the week marginally higher at the front and middle of the curve (bonds maturing in 2 years through 10 years) and marginally lower on the long-end of the curve at 30-year maturity. Currently, the yield on the 10-year UST is 2.19% and the yield on the 30-year bond is 2.78% (low, but levels consistent with a slowly expanding economy accompanied by low inflation expectations). Precious metals and crude declined on the week, but here again, losses were mild at less than 1%. The US Dollar ticked higher by 0.4%, but remains down 8.6% year-to-date (a weaker USD is a positive for US exporters, especially manufacturers, who can provide more competitive international bids in a weak USD environment). For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
When Doves Coo – Minutes from the July Federal Open Market Committee (“FOMC”) meeting were released last week. As usual, it makes for rather dry reading. Yet, a couple of topics are worth highlighting. First, the FOMC staff is concerned about elevated asset prices.
Vulnerabilities with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets.
Apparently, the relentless rise in asset prices has ratcheted up risk of a pullback from “notable” to “elevated” among members of the FOMC. It’s also worth noting that the accompanying historically low volatility levels of prices was not lost on the FOMC (keep in mind, this meeting took place prior to the showdown with North Korea and the events of last week).
Second, the FOMC may be once again shifting how it sets monetary policy.
Most observed that the Committee could afford to be patient under current circumstances in deciding when to increase the federal funds rate further and argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist and that inflation was more clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term.
This is a big deal, so let’s unpack the statement. Translating into non-Fed speak (and dissecting a rather long sentence) it appears that the Fed is pivoting from setting monetary policy based on forecasts to actual observed data. This is notable because as recently as December 2016, the Fed had signaled they would set monetary policy based on the output of their forecasts (which have been flat out inaccurate). Employing a wait-and-see approach to inflation and interest rates implies a slower pace of hiking than previously believed if inflationary pressures fail to materialize.
It’s also worth noting that in the second part of that sentence, the FOMC specifically noted a “symmetric 2 percent objective” for the inflation level. This implies that the FOMC will not overreact should inflation rise toward their 2% target, a concern highlighted in last week’s synopsis in the “Inflation Stagnation” commentary.
In sum, although the FOMC is concerned about elevated asset prices, they are unlikely to raise rates simply to address perceived valuation imbalances. It is neither politically expedient nor is it consistent with their dual mandate of price stability (i.e. stable inflation) and maximum employment. On balance, the FOMC meeting minutes tip in favor of the doves. Thus, if inflationary data remains subdued we should expect a slow pace of rate increases allowing the economic expansion to continue at a measured pace.
Teslas and Trees – It’s difficult not to appreciate the sleek styling, impressive technology and flat out quickness of Tesla vehicles. Aside from Tesla’s endemic “cool” factor, another common reason people cite for buying is that the vehicles are 100% electric. That is, they generate no pollution, including zero carbon dioxide emissions. Carbon dioxide is one of the primary “Greenhouse Gases” and, according to abundant research, is contributing to global climate change. Hence, the common belief is that replacing one’s traditional internal combustion engine with an electric vehicle will reduce his/her carbon footprint (i.e. the amount of carbon dioxide generated by that individual). What I’ve always wondered is, when giving consideration to how the electricity that powers these vehicles is produced, are Tesla vehicles as environmentally friendly as commonly believed? The answer came in a report from Morgan Stanley that found “the carbon emissions generated by the electricity required for electric vehicles are greater than those saved by cutting out direct vehicle emissions”. In other words, electric vehicles reduce direct carbon dioxide emissions, but these are not perpetual motion machines and they require electricity to charge their batteries. The vehicle’s greenhouse emissions are essentially pushed up the productivity chain and are generated in the form of electricity power plant greenhouse emissions. So unless one is recharging their Tesla’s lithium batteries with electricity generated from wind or solar energy, enjoy the vehicle but go ahead and plant some trees to offset your carbon footprint.
For all of the “fire and fury” rhetoric between Kim Jong-un, the leader of the Democratic People’s Republic of Korea* and President Trump, domestic equity markets fell all of 1.4% last week. Based on the breathless coverage by media pundits, you would have thought the market was in an unequivocal freefall. Perhaps, after nine years of a bull market, that as of late has also been characterized by historically low volatility, a large swath of the investing public has grown “soft”. That is, market action out of sync with investors recent experience (though mild by historical standards) causes a disproportionate level of alarm. While risky assets declined in response to the geopolitical tensions, safe haven assets received a bid as the yield on 10-year Treasury bond retreated to 2.19% and gold jumped 2.4% for the week. The price of crude seemed more in tune with fundamental production and storage levels than politics, falling 1.5% to $48.82 per barrel. The VIX Index jumped 54.6% for the week, which seems like a lot, but it currently stands at 15.5, several points below its long-term average level. The substantial increase in the VIX Index (relative to the small move in equity markets) likely resulted from investor positioning well-ahead of this week’s geopolitical fireworks and is discussed further in the “Short Volatility” section at the end of this piece.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Inflation Stagnation – Recent metrics are running counter to the Fed’s message that weak inflation is transitory and additional interest rate hikes are warranted. Intelligent people can disagree on the length of time specified by the term “transitory”. The dictionary definition is “not permanent”. By that definition everything is transitory with the exception of God and the passage of time. Unfortunately, members of the Fed (and mere mortals like the rest of us) don’t have the luxury of operating within an open-ended timeframe in which transitory could mean one month or 100 years. The Fed’s timeline is closer to the former as they attempt to normalize interest rates without pushing a slow-growth economy into recession. As such, the meaning of transitory takes on greater significance.
On that note, Producer Price Index (PPI) and Consumer Price Index (CPI) data for July revealed a continued absence of inflationary pressures. As such, the duration of weak inflation data is beginning to stretch the logical, if not practical, bounds of what transitory means (or should mean) to the Fed.
In July, PPI declined by 0.1%. PPI measures prices at the wholesale or producer level (i.e. the cost of goods and services further up the value chain from the consumer). This reading was consistent for both the headline PPI and Core PPI, which were expected to rise 0.1% and 0.2%, respectively. On a year-over-year basis, PPI peaked at 2.5% in April, but has now declined to 1.9% – its lowest level since January. PPI is often viewed as a leading indicator for CPI as higher prices at the producer level often get pushed down to consumers as businesses attempt to maintain profit margins.
Similar to PPI, June readings for CPI were also below expectations of economists (and some members of the Fed) that continue to believe a pick-up inflation is imminent. To be fair, the headline CPI increased by 0.1% to 1.7% on a year-over-year basis (vs. expectations of a 0.2% bump), however Core CPI (ex-food and energy) remained at 1.7% year-over-year (note: if not for rounding to one decimal place, Core CPI actually decreased slightly year-over-year).
The chart below shows the respective levels of PPI (blue shading) and Core CPI (gray line) since 2011.
Sources: Bloomberg and Covenant Investment Research
The good news is inflation isn’t dead, it’s dormant and a sustained trend of slowly rising inflation will emerge if the economy continues to expand. Even at 2%-2.5% annualized growth, inflation will eventually reach the Fed’s target of 2%.
However even slowly rising inflation could be in jeopardy if the Fed tries to fine-tune monetary policy such that inflation lands perfectly at 2%. In fact, they will almost assuredly fail to reach their target. In other words, should the Fed treat the 2% target as a ceiling rather than an average level around which inflation can fluctuate (below and above) by continuing to raise interest rates in the face of data that suggests otherwise, the economy is likely to slow further and inflation to fall short of their target. As FTN’s Chief Economist, Chris Low, quipped “The Fed should be wise to follow the advice of its young maverick Kashkari [Federal Reserve Bank of Minneapolis President]: Be patient and acknowledge what is in the data. It is the path to ultimate credibility.”
Dallas Fed President Rob Kaplan seems to be lining up behind Kashkari as well, stating last Friday that the Fed should be patient for further evidence that inflation will rise before tightening policy again. Keep in mind that the Fed’s current plan for interest rates (i.e. their “dot plot”) includes raising rates one more time this year and three times in 2018. At the same time the Fed intends to reverse Quantitative Easing later this year which is also a form of monetary policy tightening. The combination may prove to be too much tightening for an economy expanding at a sub-3% annual growth rate, causing the Fed to reassess planned rate hikes for 2018.
Short Volatility – One area generating legitimate concern amongst sophisticated investors, but has received little media coverage, is the growth of short volatility (aka “short vol” investment products. Over the last several years Wall Street has sought to capitalize on the prevalence of low volatility by promoting short vol ETFs and ETNs (exchange traded notes) also known as “inverse VIX” products (e.g. XIV, SVXY, ZIV, etc.) and other strategies that incorporate the sale of volatility such as covered call writing and “return enhancement overlays”. These products sell volatility to the market and are consistently profitable so long as volatility remains at current levels or moves lower. Vol selling strategies are analogous to an insurance company that sells earthquake insurance – it is a very profitable line of business, until a large earthquake strikes and the insurance company is obligated to make good on the policies they sold. The performance of naïve vol selling strategies typically look something like this – long periods of small, but consistent gains, followed by large losses.
In early August, the number of short VIX futures positions hit an all-time high as investors gravitated to the gold rush of easy money. In turn, last Thursday’s selloff resulted in record trading of VIX options and futures (the underlying instruments for VIX-related products) with the highest ever-single day volume in VIX options and the 3rd largest VIX futures rebalance (Source: Macro Risk Advisors). Keep in mind this occurred after only a 1.4% selloff in the S&P 500. The bigger concern is that a larger selloff sparks a positive feedback mechanism in which selling feeds on itself generating outsized losses for the holders of short-volatility products and equity markets in general.
*The Democratic People’s Republic of Korea was formed in 1948 and has had exactly three leaders: Kim Il-sung, his son Kim Jong-il, and his grandson (and current leader) Kim Jong-un. I looked, but could not find a definition of “democratic” that includes a political system comprised of a lineage of ruthless dictators.
Good to be back. Although I took some time away from writing each week, I remained engaged with the markets and investors, both professionals and non-professionals. Truth be told, not much has changed in the last four weeks relative to perceptions of the markets, not that I expected it to. Four weeks is a blink of an eye in investment terms…especially in the midst of a nine-year Bull Market. The market may very well continue to run higher, but counter to most previous cycles, the Bulls reasoning seems to be that slow economic growth will keep a lid on inflation, which in turn will allow central banks to maintain low interest rates.
…it is hard to overstate the extraordinary nature of today’s landscape. All previous periods of extreme asset valuation required investors to imagine…a wildly optimistic future…. But today they expect the opposite. Due to unfavorable demographics and over-indebtedness, investors expect…perpetually low interest rates, which they then use to justify extreme valuations across other asset classes in an endogenous loop that is increasingly disconnected from the real economy. This is the dominant pricing model for global assets today.
– Eric Peters, CIO OneRiver Asset Management
Low interest rates are the “mother’s milk” of discounted cash flow models used to justify historically high valuations of bonds, equity and real estate assets as a recent chart from The Economist highlights. Note, a discounted cash flow model is a valuation method that uses projections of future free cash flows and discounts them to arrive at a present value estimate. All else being equal, a lower discount rate (i.e. the prevailing interest rate adjusted for various risk factors) results in a higher estimate of present value.
But earnings have been strong, right? Yes, and no. Earnings per share have been beating analysts’ expectations, but actual earnings (that is, total corporate profits) as of Q1 were more than $150 billion lower than their recent peak in Q4 2014 (Source: U.S. Bureau of Economic Analysis). In the chart below, the corporate buying of stocks represents stock repurchases, which have reduced the number of shares outstanding. In reducing the denominator (i.e. the number of outstanding shares) in the earnings per share calculation, lower aggregate profits are disguised in higher earnings per share metrics.
When will it end? What will cause it to end? Nobody knows the answer to either question. But, outside of a geopolitical event or natural disaster, the most likely cause of the next market decline will be a monetary policy error by a major central bank. The mistake may not even be committed domestically, given the interconnectedness of the global economy. For example, China’s government could tighten monetary policy too much, causing a major slowdown in the world’s primary growth engine. The point is trying to pick a top is a fool’s errand, yet at the same time there will be a top…we just don’t know where or when.
Which brings to mind an excerpt from legendary value investor Seth Klarman’s book Margin of Safety. I’ve modified the numbers, but the math remains the same.
An investor [Investor 1] who earns 6% annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor [Investor 2] who earns 10% a year for nine years and then loses 25% the tenth year. There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90% of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance is not the primary focus of most institutional investors.
Stocks have lost an average of 33% from top to bottom in recessions going back to 1929 (Source: Credit Suisse). Due to compounding, a 33% loss in Year 10 would wipe out 5.5 years of paper profits. God forbid markets experience a loss similar to the Dot.com bust or the Great Recession, which would not only eviscerate 9 years of gains, but generate real capital losses (i.e. an initial $100 investment would be worth only $80 after ten years). The following graph illustrates Klarman’s point about the outcome for the two investors under various scenarios.
Source: Covenant Investment Research
The message here is a simple one: we live in extraordinary times, but not unprecedented times as it relates to market valuations.
Investing in risky assets has been rewarded for an extended period, but these conditions will not exist in perpetuity (though they may persist for longer than many people believe). While the next market downturn may be difficult to imagine given the performance of equities over the last nine years, it is inevitable. And when it does occur, the key to succeeding through the downturn (just as it has been with all of the previous drawdowns), is to ensure your portfolio is not levered to a single risk factor in advance of the pullback. Importantly, this doesn’t imply that one should avoid equity exposure altogether – equities are an important component to portfolio appreciation, but equities should not be the only source of return (and risk) in a portfolio. Diversification may seem costly in the early and middle portions of a business cycle as Seth Klarman points out. Yet, it is the disciplined investor who pushes back against the siren song of “This Time Is Different” that will be able to mitigate losses and generate the greatest wealth in the market.