As the third quarter earnings season draws to a close, approximately 90 percent of U.S. and European companies have now reported. Overall, earnings were largely in line or exceeded analysts’ estimates for the quarter. Yet, it appears some of the bloom may be coming off the “profits rose” as consensus estimates are no longer being raised for next year. “While they look good overall, the strong momentum apparent since Q1 is now fading” according to European banking behemoth Societe Generale. In other words, corporate earnings are healthy, but analysts are not seeing a catalyst for improvement. Perhaps, successful passage of the tax reform plan will serve as that catalyst.
It was a choppy week for equities in which the streak of consecutive days without a decline of 0.5% or more ended at 50 days (the longest since 1965) on Wednesday when the S&P 500 declined by 0.55%. Global equity markets largely followed the U.S. and Thursday’s rally of 0.8% created two-way daily-volatility that ultimately yielded flattish performance on the week for broad equity indices: S&P 500 (-0.1%) and MSCI All Country World Index (+0.1%). Within fixed income, concerns about high yield debt drove investors to sell the instruments. Yields pushed higher by 0.07% in a continuation of a trend that seen high-yield spreads widen by 0.43% month-to-date. The trend towards a flatter yield curve for US Treasuries also remains intact, as 2-year bond yields rose by 0.07% on the week, while 30-year bond yields declined by 0.1%. A large number of economists and investors watch the shape of the yield curve, as an inverted curve has been associated with the last seven recessions. The good news is that while the yield curve appears to be headed toward inversion, it is still 100 basis points away from being inverted and the trend could reverse at any time.
Precious metals gained on the week (gold +1.4%, silver +2.5%). Finally, OPEC issued a forecast for increased crude oil demand in 2018, which conflicted with the International Energy Agency’s forecast for slightly lower demand levels. Crude prices moved modestly lower on the week, though the decline was more prevalent in the international markets (-1.2% for Brent Crude) than here at home, where WTI Crude fell only 0.3%.
For more detail on weekly, month-to-date and year-to-date asset class performance please click here.
Inflation Shocks – Last week rampant inflation reared its head. Not in the broad Consumer Price Index, the widely-cited inflation metric tallied by the U.S. government’s Bureau of Economic Analysis. Rather, the inflation referenced here was surfaced by Christie’s Auction House and the vanguard in electric automobile development, Tesla. On Wednesday, Christie’s auctioned da Vinci’s 500 year-old “Salvator Mundi” for $400mm. Christie’s earned a $50mm commission, bringing the total transaction value for the portrait of Jesus Christ to $450mm. In 2005, this painting was acquired at an estate sale for $10,000 equating to price appreciation of 4,000,000% in a little more than 10 years. Setting aside the controversy surrounding the authenticity of the painting, the princely sum that was paid is yet another example of excess in the markets complementing historically high valuations in nearly every asset class, from equities to real estate to high-yield debt.
The second bout of inflation last week was promoted by Elon Musk on Thursday when he revealed Tesla’s new 18-wheeler, with a 1,000,000 mile warranty. Compared to today’s long-haul truck warranty plans of 300,000 miles, Tesla just created warranty inflation of 333%. Yet, this inflation is fundamentally different than price inflation. It represents improved efficiency, which leads to increased productivity and higher economic output.
We’ll take all the productivity inflation we can get, but the remarkable price paid for a single painting (which exceeded the total estimated $422mm cost of the new Whitney Museum of American Art in New York City) is yet another signal that asset valuations are pushing to worrisome levels.
Ivy Outlook – In a wide-ranging interview last week, David Swensen (the celebrated Chief Investment Officer for Yale University’s endowment) touched on his team’s outlook and portfolio positioning. Yale’s endowment is known for being an early adopter of “alternative” investments and is typically one of the top performing university endowments.
The endowment is incredibly important to Yale’s operating budget, providing 60-65% of the annual funding for Yale College, the graduate school and the professional schools. For the last 32 years, the assumed rate of return for the Yale Endowment has been 8.25% annually. However, in the interview, Swensen noted that based on the currently elevated level of global asset valuations, Yale’s forward expectations are closer to 5% – a 40% decline in expected returns that, if proven accurate, will directly impact Yale’s operating budget. Swensen’s team is also currently targeting a 32.5% allocation to assets with low correlation to equities, which includes short-term government bonds, cash and absolute return strategies (i.e. hedge funds). This is up from 15% at the lows of the Financial Crisis. Swensen joins a growing list of renowned investors forecasting tougher sledding ahead.
There will not be a Synopsis next week as I plan to take a week off from writing to enjoy the holiday with my family. Be well and Happy Thanksgiving to you and yours.
Jp.
Domestic equity indices closed the week lower, but the damage was minimal with declines of less than 0.5%. Developed international markets followed their U.S. cousins, while emerging markets posted gains of 0.7% (pushing year-to-date performance above 34%). Interest rates moved modestly higher across the curve, with the yield on the 10-year UST closing the week at 2.4% (at the top end of the 2.1% – 2.4% range it’s inhabited for the last seven months). At the beginning of the week Saudi Arabia’s Prince Salman ordered the arrests of more than 200 people to purge corrupt factions within the country (or to consolidate his power, or both). Prince Salman’s actions caught the market by surprise, helping push the price of oil higher. WTI Crude jumped 2% to $56.74 per barrel, the highest price level since early January.
For more detail on weekly, month-to-date and year-to-date asset class performance please click here.
Calm Seas – For the first time in 9 weeks, the S&P 500 posted a decline. But it was of trivial magnitude, falling only 0.1% (inclusive of dividends). Underscoring the low volatility that has characterized this phase of the bull market, Friday marked a big day for market geeks as it was reportedly the first 12-month period in the history of the S&P 500 without a 3% drawdown. And they aren’t talking about a daily decline of 3%…they mean a market peak to market trough of -3% (which could occur over the course of several days or weeks). By this measure, in 95 years of data, there has never been a calmer time in the market than we have just experienced.
This Time is Different? The Bank of England recently published research on its “Underground Blog” highlighting trends in more than 700 years of interest rates. An impressive historical data set built from the risk-free rate of the dominant asset in each period since 1311. In case you are wondering, the data begins with interest rates in Italian city states and then moves from Spain, to the Province of Holland, the U.K., Germany and the U.S. as the balance of global power shifted through history.
While the 700-year average is 4.78%, the more recent 200-year average is closer to 2.6%. Even measured against the lower 200-year average level, today’s real rates are “severely depressed” according to the author of the research, Harvard University’s Paul Schmelzing. Indeed, the current downward trend is one of the longest in the data set, second only to the “Long Depression” that begin in the 1880s. Anecdotally, the “Long Depression” was characterized by low productivity growth, deflationary price dynamics and rising global populism/protectionism. Sound familiar?
Over this 700-year data set, there have been nine interest rate “depressions” – prolonged periods of declining interest rates. The cautionary tale from the data is that reversals from the depressions tend to be relatively swift. Historically, within two years after reaching their lows, interest rates gained on average 3.15%. And there were two occasions when rates jumped by more than 6% in 24 months. The moral of the 700-year story is that unless this time is different, history is signaling higher rates in the near future. A countervailing force to higher rates, and why this time may truly be different, is that never in history has there been such a massive overhang of global debt.
Be well,
Jp.
The two big news events last week with regards to the economy had little immediate impact on financial markets: House Republicans introduced their tax bill and Jerome “Jay” Powell was nominated as the next Fed Chair. Neither event moved markets significantly, with the exception of a decline in the prices of homebuilder stocks who are expected to see lower demand for expensive properties as a result of limits on mortgage interest deductions for loans in excess of $500,000. Now is when the real fun begins as lobbyists, who were previously kept in the dark about the contents of the bill (along with the rest of us), will descend upon D.C. to try to convince lawmakers to protect their special interests. Since the Senate still has to approve the bill, it is safe to say that the contents of the bill are subject to change and the final version will likely look very different than what was revealed on Thursday.
The Big 3 stock indices (Dow Jones, S&P 500 and Nasdaq) closed the week at record levels. Having charged through the historically perilous months of September and October, the mighty bull has worked up a lather and is poised for a strong finish in the more seasonally friendly holiday months. Speaking of which, domestic equities got off to a quick start in the first three days of November, recording gains of 0.5%. Developed markets ex-US moved higher by about the same, though Japan stood out with a jump of 2.4%. Yields on US government bonds declined, as the yield curve continues to flatten. The disparity between equity gains (implying stronger growth ahead) and a flattening yield curve (implying weaker growth in the future) is a conundrum of which much has been written. I would suggest that a contributing factor is demographics, as aging Boomers seek to protect their retirement nest eggs in the safety of bonds (supporting this thesis, the amount of cash flowing into fixed income vs. equity mutual funds/ETFs is roughly 2:1 on a YTD basis). Crude gained a little better than 2%, closing the week at $55.54 a barrel (the highest level since June 2015).
For more detail on weekly, month-to-date and year-to-date asset class performance please click here.
Winning – October marked the twelfth month of consecutive gains for the S&P 500 (inclusive of dividends). An unlikely, but impressive run in which the index has generated a total return of 23.6%. How have other major market indexes performed over this timeframe? Pretty darn well as historically low interest rates combined with a globally synchronized improvement in economic growth have created a goldilocks environment for stock appreciation.
Changing Labor Market – The Great Recession destroyed between 7 million and 9 million jobs. Though estimates vary by data source, the fact is an astounding number of jobs were lost impacting families nationwide, some of whom are still feeling the pains of unemployment or underemployment. However, the Great Recession did not destroy jobs homogenously, rather it was those jobs requiring the least amount of education that bore the brunt of the pain. Although unemployment is at historic lows, the job recovery has been extremely uneven. A recent report by business consulting firm Accenture and Harvard Business School lays bare the gritty details of how the Great Recession has transformed the job market and gutted available jobs for those with a high school diploma or less education. As the chart below shows, there was actually net positive job growth through the Great Recession for the more educated populace (Bachelor’s degree or higher).
As the Great Recession transitioned into the Great Recovery, job growth in this educated sector accelerated generating more than 8.4 million new jobs through 2016. By contrast, the less educated cohort lost 5.6 million jobs and have only gained 80,000 in the recovery – essentially the opportunities that existed for this cohort have vanished, replaced by automation or filled by better educated workers. Those in between a high school diploma and a college degree are somewhere in the middle, but have at least experienced net positive job growth of roughly 1.3 million.
The employment disparity helps explain a few notable trends:
- Continued high unemployment in the former manufacturing regions of the country.
- Income disparity between the educated and uneducated contributing to the rise of populism.
- The increasing levels of student debt as would-be workers recognize they need more education to be hired. Unfortunately, these tend to be the laborers that can least afford an advanced degree, but are forced to incur debt to compete for jobs.
Perhaps this situation will change if the unemployment rate continues to drop, further tightening the labor market and forcing managers to be less choosy about who they hire. On the other hand, technological advances in robotics and Artificial Intelligence augur for continued destruction of low-skill jobs. If not addressed, this portion of the labor pool will be a drag on economic growth and society, requiring a social safety net to provide assistance with food and shelter. A potential solution is for companies to offer employees apprenticeships in which workers are paid to learn specific, necessary skills without incurring debt. The benefit to companies would be a highly productive employee base available at a relatively low cost. It’s just a thought.
Be well,
Jp.