In a week where the 10-year bond yield breaching 3% made countless headlines, yields on bonds maturing in 10 years or more actually declined on a week-over-week basis. The decline was modest, but it appears there is demand for longer-dated bonds with a 3% yield (vs. a dividend yield of less than 2% for the S&P 500). Equities began the week on their back foot but largely recovered in the latter half of the week. The S&P 500 ended the week virtually unchanged, while small-cap and technology stocks recorded modest declines of 0.5% or less. Internationally, Japan’s Nikkei Index led the way, continuing a strong run of performance gaining 1.7% on the week and 4.7% month-to-date. European stocks are also having a good run with a gain of 0.8% on the week, pushing the BE500 Index to a monthly increase of 4.2%. Despite the disparate monthly geographic performances, most regional indices are close to flat for the year (inclusive of dividends), while China’s main stock index stands out with a -6.8% performance year-to-date.i
The Federal Open Market Committee meets this week on Tuesday and Wednesday, for the third of eight scheduled meetings this year. There will be no press conference following the meeting, and hence expectations of a rate hike are low. The Fed has fallen into a pattern in which rate changes are limited to meetings involving a press conference, and the next one of those meetings is June 12 – 13th. Although it is unlikely, if the Fed raises rates this week, it will catch the market offsides, and the reaction will be adverse for both fixed income and equity investments.
For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Q1 GDP – Although below the 3% annualized rate of the last three quarters, Q1 2018 GDP growth was solid. Against a consensus forecast of 2.0%, the first estimate of Q1 real, annualized growth was 2.3%. Key takeaways from the report include:
Consumption: Comprising approximately 70% of the domestic economy, consumption’s importance in economic growth is self-evident. On a quarter-over-quarter basis consumption in the first quarter declined from 4% to 1.1%, which initiated heartburn amongst some casual observers. However, the growth rate in Q1 was made to look weak only by the comparison to above-trend growth in Q4. Consumption in Q4 was juiced by reconstruction and replacement spending (estimated at $50 billion) as consumers recovered from the three hurricanes in August and September, setting a high bar for the quarter-over-quarter comparison. As the chart below shows, Q4 consumption growth was well above trend, and the slower growth in Q1 is a return to the longer-term trend.
Source: Bureau of Economic Analysis and FTN Financial
Inflation: The quarterly core Personal Consumption Expenditures (PCE) rose at an annualized rate of 2.5%, the highest level since 2011. Importantly, the Employment Cost Index (ECI), a measure of wages, rose 0.8% (vs. the consensus estimate of 0.7%) as companies are finally willing to offer more to attract workers in a tight labor market. Homing in specifically on “wages and salaries,” this component of the ECI rose 1.0%, which is the fastest pace since 2003.
The effects of higher wages and lower taxes are starting to show up in paychecks. The following chart includes aggregate payroll direct deposit data from Bank of America customer accounts. The sharp spike on the far right of the graph represents year-over-year after-tax wage increases of 5.2% in March and 7.5% in April.
Sources: Bank of America and The Wall Street Journal
With consumer confidence elevated, wages moving higher and the positive effects of tax reform beginning to filter into paychecks, consumption is set to bounce higher in Q2 and GDP growth along with it.
After months of escalating geopolitical tensions, last week brought good news on multiple fronts. North and South Korea are evidently negotiating an end to the Korean War – a war in which fighting ended in 1953, but did not include a formal peace treaty. It was announced that CIA Director Mike Pompeo traveled to North Korea to lay the groundwork for the upcoming Kim-Trump summit. And following last weekend’s air strikes on Syria, Russia refrained from responding militarily. Equity markets came into the week like a lion and left like a lamb, netting to modest gains of about 0.5% for broad developed market stock indices. Emerging and frontier market stocks fared worse, dropping a little more than 1%. On a year-to-date basis, most developed market stock indices have gained less than 1% (including dividends).
Interest rates moved higher last week, likely in response to a series of hawkish speeches (12 in all) by Fed officials. The yield on a 10-year US Treasury bond closed the week at 2.96%, a 0.13% rise over the prior week. It may not sound like much, but that it is a pretty big move in stodgy bond land. It’s also worth noting that while you can eek out an extra 0.5% annually (a tight spread by historical standards) investing in bonds that mature in 10-years instead of 2-year bonds, you only earn an additional 0.21% investing in 30-year bonds that mature 20 years later. Clearly, the “long-bond” crowd is not expecting that inflation will rise significantly over the intermediate term.
On Friday, the Bureau of Economic Analysis will release Q1 GDP data. The consensus estimate is for real, annualized growth of a little better than 2%. Most analysts believe that growth will pick-up to a level closer to 3% over the remainder of the year. The cause (or causes) for first quarter growth to be lower than subsequent quarters since the Financial Crisis are not well understood, but the pattern has been clear up to this point.
For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Two-Handed Economists – A frustrated President Harry Truman once said “Give me a one-handed economist. All my economists say ‘on the one hand‘… ‘but on the other hand’”. The latest Global Financial Stability Report from the International Monetary Fund (IMF) would not impress Truman. Below are a few examples:
- Emerging markets have generally improving fundamentals, but could be vulnerable to a sudden tightening of global financial conditions.
- Banks have strengthened their balance sheets since the crisis, but parts of the system face a structural US dollar liquidity mismatch that could be a vulnerability.
- Crypto assets have features that may improve market efficiency, but they could also pose risks if used with leverage or without appropriate safeguards.
There is a reason that economics is called the dismal science. Economies are extraordinarily complex systems subject to a myriad of variables that complicate forecasts. While the IMF hedged their bets on emerging markets, banks and crypto assets, the organization was clear in its warning about global debt levels.
Thanks to nearly ten years of accommodative monetary policies, public and private debt reached $164trillion in 2016, which equates to 225% of global GDP – 12 percentage points higher than the 2009 peak. The IMF report states that high debt levels have increased short-term risks to financial stability and medium-term risks remain elevated as higher inflation could force central banks to raise interest rates faster, tightening financial conditions and slowing growth. The annual report also cited stretched valuations of risk assets combined with leverage and liquidity mismatches as a potential risk for the financial system.
Labor Love? – Since tax reform was implemented on January 1st, it has become increasingly clear where companies intend to direct a significant portion of their tax savings, and it’s not on R&D, capital expenditures or pay raises for employees. Instead, acquisitions and stock buybacks appear to be the favored destinations for the tax savings windfall, familiar destinations for excess cash flow to anyone keeping track since the Financial Crisis. In the first quarter of this year, US acquisitions amounted to $473 billion, an increase of 66% over last year and the highest first-quarter total on record. And while the majority of publicly traded companies are currently in a blackout period for stock buybacks (due to pending Q1 earnings releases), Goldman Sachs buyback desk has already seen a 62% year-over-year increase in repurchases. Indeed, stock buyback authorizations for S&P 500 companies totaled $205 billion thus far this year, a 48% increase over the same point in 2017. Looking at this from a slightly different perspective, the results are largely the same. The non-profit organization Just Capital has analyzed 120 large U.S. corporations and found that the majority of the tax savings are going to shareholders.
The skinny 6% “Workers” slice of the pie in the chart above represents wage increases, one-time bonuses, expanded worker benefits, spending on training and other services. The official unemployment rate is the lowest since 2000, yet, as has been the case since the Financial Crisis, labor is still not reaping the rewards of the economic recovery as the majority of profits are being distributed to the equity holders widening the highly publicized wealth inequality gap. To be sure, wages have increased since the Financial Crisis, but real wage pressure remains absent, implying the labor market is not as tight as the official unemployment rate suggests.
Laffer Logic – Over the weekend, Barron’s published an interview with Arthur Laffer, the economist known for the Laffer Curve. The Laffer Curve theory posits that raising tax rates beyond a certain point is counter-productive for raising further tax revenue. Yet, a corollary to the the Laffer Curve has dire implications for the advancement of societies and continual improvement of our lives through innovation. Namely, taxes are a strong disincentive to behavior that benefits society such as ingenuity and, at its most base level, work.
By redistributing income [via taxation], you take from someone who has a little more, and you give to someone who has a little bit less. By taking from someone who has a little bit more, you reduce their incentive, and they produce a little bit less; by giving to someone who has a little less, they suddenly have an alternative source of income, and they, too, will produce a little bit less. The more you redistribute, the greater will be the total loss in income. The limit function here, which is really interesting, is if you were to redistribute income totally, if everyone who made above the average income, you tax them 100% of the excess, and everyone who made below the average, you subsidize them up to the average income—you follow me? Everyone would have the same income. If you actually did that… everyone will end up equal, at zero. At zero, no one will work.
Mr. Laffer is, of course, presenting the extreme example to make his case. And even he would concede that some taxation is required to maintain essential social services such as fire, police, military, etc. Incentives are a powerful motivator…as are disincentives, and that is the crux of Laffer’s logic.
The week in review: positive developments in the trade spat with China, U.S. sanctions Russia, the FBI raids the office (hotel room, safety-deposit box, phones and home) of President Trump’s lawyer, House Speaker Paul Ryan announces he won’t run for re-election, Facebook’s CEO testifies to Congress about personal data security of its users, tweets about imminent strikes on Syria with “new and smart missiles” followed by delivery of such missiles, and the Congressional Budget Office updated their forecast that U.S. debt will reach 100% of annual GDP by 2027 – a level last seen during World War II. It’s doubtful that the last news item moved markets, but it is probably the most important event from last week. The year 2027 is a way off, but history has shown that countries with debt levels at or above 100% of GDP are subject to slower economic growth. Slower economic growth translates into slower profit growth, which translates into lower investment returns across all asset classes. Someday investors will care the U.S. has a debt problem… just not today.
For the week, equity markets rallied with domestic stocks (S&P 500 +2.0%) outperforming international stock indices (EAFE +1.2%, China +0.5%, Emerging Markets +0.7%). Amongst domestic stocks, small cap (Russell 2000 +2.4%) and technology (Nasdaq +2.8%) were the best performers. Last week’s rally pushed the S&P 500 to essentially breakeven on a year-to-date performance basis. Yields on the short end of the credit curve jumped last week, with a noticeable flattening as longer-dated bonds barely budged. The yield spread between 2-year notes and 10-year bonds ended the week at 46.6 bps, as the curve creeps closer to inverting. The threat of attacking Syria proved a boon for precious metals (gold +1.0%, silver +1.7%) and the energy complex as the price of WTI Crude jumped +8.6% to $67.39 per barrel – its highest level since November 2014.
For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Volatility Cyclicality – Following historically low volatility in 2017, the daily (and sometimes hourly) swings in equity markets prices are drawing a lot of attention. Markets have always been subject to idiosyncratic “headline risk” – unexpected news causing investors to reassess the future value of their portfolio holdings. And the news is flying fast and furious this year from the potential for a trade war with China to regulatory scrutiny of significant technology companies to developments around the President’s alleged misdeeds. It’s not as if the last several years were devoid of news events, but these idiosyncratic market risks were overwhelmed by an ultra-accommodative monetary policy which, by design, inflated the value of risky assets. Global quantitative easing and historically low-interest rates largely immunized markets from headline risk and volatility.
However, the structural underpinnings of the low volatility environment are now giving way as the Federal Reserve removes accommodation in response to decent economic growth. From a historical perspective, rising volatility should not be surprising late in the business cycle, which is where we find ourselves today.
Indeed, equity market volatility follows a reasonably predictable pattern that correlates with the business cycle and the shape of the yield curve. In the early stages of a cycle (i.e., when the economy is emerging from a recession), volatility tends to be low due to improving business conditions, cheap and available credit, and low inflation – conditions that allow the Federal Reserve to remain on the sidelines keeping monetary policy accommodative. Conversely, late in the cycle these conditions reverse as the Fed raises interest rates to cool the economy and prevent inflation from exceeding its long-run target of 2%. The Fed’s actions directly impact the short-end of the yield curve (bonds that mature within two years) pushing yields higher, while longer-dated bond yields tend to be less reactive. This combination results in a narrowing of the spread (also known as yield curve flattening) between the 10-year bond yield and shorter-term yields such as the Fed Funds Rate.
A tightening of monetary policy increases the risk of recession as the Fed Funds Rate is a blunt tool whose impact on the economy is lagged. Indeed, most recessions have been caused by an overly aggressive Fed whose actions squelch economic growth as rising interest rates curtail corporate profitability. Lower profitability results in reduced hiring, creating a positive feedback loop in the economy: lower profitability à less hiring à reduced consumption à lower sales à lower profitability à less hiring, and so on.
The spread between the Fed Funds Rate and the 10-year US Treasury provides a good indication of the state of monetary policy. When monetary policy is easy, the spread is wide, and when monetary policy is tighter, the spread narrows. As the chart below indicates, periods of tighter monetary policy (represented by a low yield spread on the left-hand axis) are associated with higher volatility as captured by the level of the VIX Index. Keep in mind when viewing this chart that the right-hand axis showing the level of the VIX Index is inverted (higher VIX levels are represented lower in the diagram).
Source: Merrill Lynch
Using history as a guide, we are at a point in the business cycle where volatility will be structurally higher. News headlines will still impact the day-to-day movements, but the absence of headlines is unlikely to cause volatility to meaningfully subside as the Fed continues to tighten monetary policy.
Speaking of Tightening – Although Federal Reserve Chair Jerome Powell has stressed that the Fed is not on a pre-ordained path to higher rates and that each rate decision is “data dependent,” the Fed is apparently concerned about future inflation. In fact, analyzing speeches from the Fed governors shows that the Fed is more concerned about inflation now than at any point since the Great Recession.
Absent a meaningfully economic shock (which is different from an isolated stock market shock), those that doubt the Fed will continue to raise rates may want to reconsider their position.
Tariff tough-talk once again roiled financial markets last week, as uncertainty provoked volatility. The 5-day trading week included two daily declines of more than 2% in the S&P 500 and two days of 1%+ gains, netting to a weekly decrease of 1.4%. The Nasdaq Index did worse, down 2.1% as the treasured FANG (Facebook, Amazon, Netflix, Google/Alphabet) stocks no longer look unassailable. International stocks fared better for the most part, with regional indices in Europe and Japan recording gains of around 1%. Frontier markets also posted gains on the week, while emerging market equities fell modestly, dragged down by a -0.8% decline in China’s primary equity index. Fixed income investments did not prove to be a foil for equity declines, as interest rates rose on the week with a modest yield curve steepening bias. Precious metals offered some protection (Gold +0.6%, Silver +0.1%), but the energy commodity complex suffered with WTI Crude declining 4.4% to $62.06 per barrel.
Razor’s Edge: Stocks are in a critical, if not precarious, position. The daily 1%+ moves both up and down this year (there have been 27 of them in 66 total trading days thus far this year) have resulted in the market traveling a great distance, yet not making any real progress in either direction. Currently, the S&P 500 Index is down 9.3% from its all-time high, on the cusp of a technical “correction” (defined as a 10% decline from its high) and testing its 200-day moving average for the fourth time already this month. Trade conflict with China is responsible for many of the recent large moves, but something equally as important looms soon – Q1 earnings season. Kicking off on April 13th, analysts’ consensus forecasts for the S&P 500 include a 17% jump in year-over-year earnings per share and a 10% increase in revenue (if realized, both would be the fastest growth since 2011). Much of this has been priced into the market so investors will be keen to see if their favorite corporates can deliver and support a bullish outlook for the rest of the year. In a period of high growth expectations, frayed nerves concerning trade, and a technically vulnerable stock market, the Q1 earnings season and associated forward guidance will set the stage for whether stocks end the year in the black or the red.
Change and Uncertainty: President Trump campaigned as an outsider that would “drain the swamp” and bring real change to America. While the question of whether he drained the swamp is debatable, the President is effecting change. The administration has cut taxes and reduced regulation. Some people like it, some people don’t, but it is change. And if one is to use the stock market, consumer confidence and business optimism as indicators, it has thus far been effective change. Currently, President Trump is trying to undo decades of trade pacts which he believes are disadvantageous to the U.S., and he is laser-focused on China. Of all his endeavors thus far, with the possible exception of his dealings with North Korea, the current situation with China is creating the most significant uncertainty. Stock markets don’t like uncertainty….and have reacted accordingly.
Change is messy. By its very nature change introduces uncertainty. Harkening back to North Korea, Trump’s approach was different than any President in recent memory. But with the help of China (ironically), Kim Jong-un has agreed to discuss the denuclearization of North Korea. Is President Trump’s current dealings with China regarding trade just another chapter in The Art of the Deal? It’s a high stakes game, and his approach is unorthodox until you recognize it for what it likely is… positioning for negotiation. Trump’s latest move to threaten trade tariffs on an additional $100B of Chinese imports is akin to a poker player forcing another with a smaller stack of chips to decide if he trusts his cards enough to go “all-in.” China has the “short stack” in this scenario because they don’t import enough products from the U.S. to be able to match the breadth of the total tariffs proposed on Chinese goods imported to the U.S.
Source: The Daily Shot.
Sure, there are other levers the Chinese can pull (e.g., refusing to purchase U.S. Treasuries), but President Trump is trying to read China’s eyes about their confidence to go all in.
Engaging in a full-on trade war would be an irresponsible outcome for both U.S. and Chinese leaders. It would be disingenuous not to at least give them the benefit of the doubt that they know both countries are better together than apart on trade. Indeed, even as they increase their trade rhetoric, both sides are talking, and the timeline of the proposed U.S. tariffs invites negotiation:
- May 15th – U.S. business interests will be allowed to air concerns publicly at the International Trade Commission.
- May 22nd – Deadline for companies to object to proposed tariffs.
- 180 days – Following the May 22nd deadline, the U.S. still has 180 days to decide if they will implement the tariffs.
Although the administration will hear companies’ opinions on tariffs, it doesn’t mean the administration will listen. It is doubtful the Trump Administration cares what lobbyists have to say about the tariffs. Rather, this extended comment period creates an intentional window for negotiation. And that’s already been taking place. According to the Wall Street Journal, Chinese economic envoy Liu He has recently been in dialogue with both U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin about a further opening of the Chinese market.
As the author of The Art of the Deal faces off against students of Sun Tzu’s The Art of War one would expect that, hard tactics aside, compromise is available and in the best interests of all involved. If not, the synchronous global expansion, already fraying at the edges, will unravel quickly. High stakes poker, indeed.