Last Week Today: Saudi Arabia pledged to eliminate any oil shortage from Iranian sanctions by pushing up production from 10.7 million to 11 million barrels per day. | MBS, Saudi’s crown prince called Khashoggi’s murder “heinous”; two days later, Saudi Arabia admitted the murder was premeditated – and the worst cover-up in history continued to unravel. | The European Central Bank reiterated the end to bond purchases in December. | The Fed’s “Beige Book” showed sustained strength in labor markets and rising prices across almost all Fed districts, suggesting that absent a severe deterioration in capital markets, the Fed will raise interest rates in December.
Concluding a tumultuous week, the S&P 500 briefly dipped into correction territory, before bouncing midday Friday. For the week, the S&P 500 fell -3.9% and is –9.3% from its all-time high (-10% is considered a “correction” and -20% a “bear market”). The tech-infused Nasdaq Index was not as fortunate and is officially in a correction after falling -3.8% last week to -11.6% from its August 29th high mark. The rise in equity market volatility and building losses (the S&P 500 has shed $2.1 trillion in market capitalization this month) is intensifying criticism of the Fed’s monetary policy (from President Trump to CNBC-pundit Jim Cramer). Irrespective of the criticism, the Fed is unlikely to change course in the near-term absent a much lower level on the S&P 500 (e.g., another -10% drop) or the weakness spreads to credit markets (high yield bonds have had only a muted reaction relative to equities, thus far).
International developed market equities did not fare much better last week as the EAFE Index fell -3.5% and Emerging Markets lost another -3.3% (-17% YTD). Chinese equities bucked the global trend, rising +1.9% for the week, though ’tis a drop in the bucket compared to the -19.5% YTD decline.
For detailed weekly, month-to-date and year-to-date asset class performance, please click here.
Q3 GDP Review. The first estimate of third-quarter economic output was released on Friday. Below is a quick summary of the report:
- Q3 real (inflation-adjusted) annualized GDP growth was 3.5% – higher than the consensus estimate of 3.3%, but well off the 4.2% pace of Q2.
- Equipment investment rose by only 0.4%, in spite of the corporate tax cut and more generous depreciation allowances.
- Residential investment contracted by 4.0%, the third consecutive quarterly decline.
- Inflation (as measured by the Core Personal Consumption Expenditure deflator) rose only 1.6% annualized in the third quarter (vs. the consensus estimate of 1.8%) and is moving away from the Fed’s target of 2.0%.
Takeaway: No real surprises relative to our house view. We expect that the boost from fiscal stimulus (so evident in Q2’s economic activity) will continue to fade and GDP growth will track back towards 2% in 2019. Slowing economic growth in the absence of inflationary pressures will call into question the Fed’s forecast of four rate hikes between now and the end of 2019.
Pessimists. Worries contributing to the equity market decline:
- Impact of the trade war (highlighted by companies like 3M during its earnings call last week)
- The Fed’s interest rate increases
- Italy’s standoff with the European Union over its budget
- Slowing profit growth
- China’s economic growth
The question for investors is how much of these known concerns are already priced into the market. There are also several reasons to think we are not in the midst of a significant pullback, two of which are described below.
Optimists I. The forward Price to Earnings (P/E) multiple for the S&P 500 has tumbled to 15.6x, from 18.8x at the end of January. Globally, the MSCI All-Country World Index P/E multiple has fallen to 13.8x from 16.7x.
Optimists II. 48% of S&P 500 companies are now out of their blackout windows and can resume share buybacks. With the recent pullback, most companies will be able to buy their shares at a discount compared to the prices before the Q4 earnings blackout period began which may buoy the market.
Hedgies. Hedge funds are typically engaged in diversifying portfolios from the inherent risks in traditional asset classes (i.e., fixed income and equities). It sounds good on paper, but it is complicated to execute in practice. With thousands of available funds, most investors gravitate to strategies that are easily explainable, such as long/short equity. In long/short equity strategy, a portfolio manager purchases a basket of stocks she believes will move higher in value and she shorts (i.e., sells) a basket of stocks she thinks will go down in value. The problem with that approach is that while the volatility may be lower than an S&P 500 investment, the average long/short equity fund maintains significant net exposure to the stock market. For example, it is common for long/short funds to have greater than 70% net long equity exposure. The bias toward net long exposure means that the average hedge fund will move in sync with the stock market, which feels good when the market is rising (as it had relentlessly before this year) but fails to offer diversification when the market is declining. Indeed, through last Thursday, the S&P 500 was down -7.06% month-to-date, and Goldman Sachs’ measure of long/short hedge fund performance was off by -7.75%.
Not all hedge fund strategies are created equal, and there are a variety of strategies that reliably diversify portfolios in the long-run. But long-biased equity long/short strategies are not one of them and typically represent a very expensive means of doubling down on equity exposure. By contrast, Covenant does not employ traditional long/short strategies in our hedge fund allocations. Instead, we focus on strategies with positive expected returns and low to no correlation to equity investments. Through last week our recommended basket was down -1.2% MTD – while performance is slightly negative in the short-run, the strategy has provided real diversification and protected capital during a very tumultuous month. The message here is that strategy selection is incredibly important when investing in alternative investment strategies.
Last Week Today: The U.S. budget deficit jumped from $665.8 billion in 2017 to $779.0 billion in 2018 (3.9% of GDP) as spending increased by 3.2%, but tax receipts only rose by 0.4%. | The Job Opening and Labor Turnover (JOLT) survey for August revealed a record 7.1 million job openings – there are only about 6 million people who are considered unemployed. | China’s Q3 GDP growth rate was 6.5%, the lowest in ten years, but only 0.1% below consensus estimates. | President Trump pulled out of a 144-year old postal treaty, raising China’s shipping costs into the U.S. And, Treasury Secretary Steve Mnuchin is considering changes to how the U.S. defines currency manipulation, potentially giving President Trump a chance to label China a foreign-exchange manipulator. Both actions serve to tighten the screws on China as President Trump is seeking maximum leverage to redefine trade terms between the world’s largest economies.
Financial markets are realizing the higher volatility levels that October is known for. Although Tuesday saw a global equity rally in which the S&P 500 jumped +2.2%, it was an otherwise difficult week as the S&P 500 declined the other four days to close the week flat. International equities fared slightly better, with Developed International stocks (i.e., the EAFE Index) eking out a +0.1%. Among relevant market indexes, Japan’s Nikkei Index was the top performer, gaining 1.2% – however, all major regional indexes are down -5% to -8% MTD. In fixed-income land, yields on US Treasuries rose a handful of basis points, with the yield on the 10-year bond closing the week at 3.19%. Although off its recent high of 3.23%, the yield has remained above 3% for five weeks, something that hasn’t happened since 2011.
Q3 GDP will be released this week. Current estimates show a deceleration from Q2’s 4.2% growth rate, to about 3.2% – 3.5%. This growth level would be consistent with our view that Q2 was likely the peak growth rate for the cycle and that economic growth will trend back towards its potential growth rate of 2% in the coming year
For detailed weekly, month-to-date and year-to-date asset class performance, please click here.
Corporate Earnings Update: earnings season is in full swing. Through last Friday, 17% of S&P 500 companies had reported Q3 financial results, and earnings growth is tracking +19.4% YOY. Approximately 160 companies will join the earnings catwalk this week. Strong Q3 earnings are expected and priced into markets – what’s not priced into markets is the outlook for the next year and analysts are carefully parsing management teams’ forecasts for signs of margin deterioration from labor costs and tariffs.
Fed Update: Minutes from the September Federal Open Market Committee (FOMC) meeting were released Wednesday. Overall, it was a reasonably balanced report, though traders focused on a comment reporting that a few participants had discussed moving policy into restrictive territory.
Participants offered their views about how much additional policy firming would likely be required for the Committee to sustainably achieve its objectives of maximum employment and 2 percent inflation. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances.
In Fed speak, “restrictive” means that the Fed funds rate is higher than the real neutral interest rate (aka, R-star rate) that neither stimulates nor restricts the economy. The thing about the neutral interest rate is that it cannot be measured in real time, only estimated. For what it’s worth, this unobservable metric is currently estimated to be about 1%. With inflation running at approximately 2%, this implies the Fed Funds rate would become restrictive when it moves from the current level of 2.25% to 3% (or in three more 0.25% rate hikes).
Takeaway: Though monetary policy is not predetermined, it will take a significant shock for the Fed to abandon its quarterly rate hike trajectory. Given the uncertainty regarding R-star, it is entirely possible that the Fed unintentionally becomes too restrictive and joins a long line of Federal Reserve governing bodies by “murdering” the economic expansion. On the plus side, Fed Chair Powell has more financial market experience that he does formal economic training, and he is wary of relying on unobservable metrics to make monetary policy decisions. Indeed, within the FOMC Powell is advocating a new “risk-management approach” to monetary policy that acknowledges the lagged effect of changes in interest rates. Adhering to this strategy is becoming increasingly important to the Fed’s objective of engineering a soft-landing for the economy as the real Fed Funds rate gets closer to the theoretical R-star rate.
What Trade War? While tariffs are impacting farmers and businesses that trade internationally, they have had little lasting impact on the equity markets. As the chart below highlights, headlines about the trade war have a relatively short half-life when it comes to U.S. stocks with equities returning to their pre-event peak level within two business days in more than 50% of trade news events.
Oxford Economics analyzed 70 trade ware news events over the past two years and found:
- A clear decline in the impact of negative news on global equities
- Rapid reversals of equity losses that do arise
- A stark contrast between the reaction of U.S. and Chinese markets (where negative news has a more lasting impact on the latter)
- Minimal effects on bonds
Indeed, as so often happens, domestic markets have become desensitized to the rhetoric. Of course, if the rhetoric transitions into an all-out trade war, resulting in an unwind of established, cost-effective supply chains, global growth will slow, and financial markets will react the world over. Below is one firm’s estimate of the worldwide growth drag from a full-blown trade war.
Air Bags. If you do not find any of the information above helpful, perhaps this will be of greater utility for the next time you go grocery shopping. Assuming your palate is not averse to Chili Cheese Fritos, they represent the best bang for your buck regarding product vs. air. Cheetos are the worst offender, with the bags consisting of 59% air and only 41% product. It’s good to see that one of my favorites, Pringles, are only 28% air owing to their finely engineered stackable shape.
Last Week Today: Q3 Earnings season kicked off last week, with 47 companies posting results. Overall, the earnings reports were OK, but macroeconomic concerns swamped earnings reports, driving markets down. Earnings season really gets rolling this week, with nearly 200 companies scheduled to report. After a smattering of negative preannouncements, investors are keen to learn both about the quarter behind, but even more importantly what management teams expect in Q4 and in 2019. | The International Monetary Fund reduced its 2018/2019 global GDP growth forecast from 3.9% to 3.7%, mainly on restrictive trade policy concerns. | New home sales in NYC declined 39% in Q3, with a median price decline of 9%. | President Trump criticized the Fed’s monetary policy as “crazy” tight but said he would not fire new Fed Chair Jay Powell.
Although markets staged a counter-rally on Friday, it was a poor week for risk assets. Developed markets (domestic and international) equities declined by about -4%, but in a change of pace emerging markets outperformed “only” falling by -2.0%. At the mid-point of the month, most broad equity market indices are down more than -5%. US Treasuries rallied on the week as the yield on the 10-year declined by -0.07% to 3.16% amidst a modest steepening of the yield curve. Precious metals were mixed (gold +1.1%, silver -0.4%), copper gained +1.4%, and WTI Crude fell -4.0% to $71.34 a barrel. Market losses caused the VIX Index (a measure of S&P 500 volatility) to jump +43.8% to 21.31, slightly above the long-term historical average. For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Economic Data Update: Below is a summary of Q3 economic data and our current outlook.
- The labor force expanded, but at 0.5% it grew at the lower end of its recent range of 0.5% to 1.0%. Note: If the labor force were growing at 1%, the unemployment rate would remain stable with 150,000 jobs added each month. Instead, the six-month average job growth has been slightly above 200,000 explaining why the headline (U-3) unemployment rate has declined from 4.1% at the end of Q1 to 3.7% in September.
- Tight labor market conditions are giving rise to accelerating wage growth – while year-over-year wage growth was 2.8%, the three-month average is 3.2% for production and hourly employees.
- The Small Business survey labor scarcity index is at an all-time high, indicating skilled labor is in extremely short supply.
- Bottom Line: The demand for labor is outstripping the supply of labor leading to a declining unemployment rate and, after a long delay, rising wage pressure. The Fed is well aware of this dynamic, and it is one of the key reasons the Fed is forecasting another rate hike in December and three more in 2019.
- Aggregate year-over-year (YOY) income (= total people working x total hours worked x wages) increased by approximately 4.8% on a nominal basis, or 2% on an inflation-adjusted basis.
- The savings rate is in the mid-6% range, which is close to the historical average, implying consumers have dry powder in the event of leaner times.
- Real, inflation-adjusted disposable income per capita grew at 2.2% YOY.
- Actual wage growth is catching-up to survey data from several months ago that suggested wages would increase.
- Core retail sales spending rose 9.4% YOY, or by approximately 6.7% on an inflation-adjusted basis. It’s worth noting that data over the last couple of months indicate a modest weakening in this data series.
- Bottom Line: The strong demand for labor, associated rising real wages, and a decent savings rate is giving rise to elevated consumer confidence. These conditions augur for continued spending, a key ingredient for a stable economy in which approximately 70% of GDP is comprised of consumption.
NOT AS GOOD
- Two consecutive quarters of negative growth for residential and non-residential structures – Q3 is likely to show a further contraction.
- Single-family home permits are flat YOY; multifamily permit growth is negative YOY.
- Existing home sales trending downward from 4.9 million last year to 4.75 million currently.
- Bottom Line: Private residential and non-residential sectors are in a mild recession. A contributing factor is affordability as the rise in housing prices has outstripped wage growth for a long time now, a situation exacerbated in high tax states through the removal of the State and Local Tax deduction in the recently passed tax reform package.
- ISM Manufacturing and Services surveys indicate strong pricing pressure.
- Wage pressures are now evident and unlikely to abate absent stronger labor market growth – the NFIB Small Business survey’s actual and forecast compensation levels are high by historical standards.
- Large corporations (i.e., 3M, Home Depot, and Costco) are reporting heightened margin and price pressures.
- Core PPI (less volatile trade services) is up 3% YOY, and intermediate services were up 3.3% YOY – in other words, inflation is present in the manufacturing and services pipeline.
- Bottom Line: After an extended period, inflation is no longer missing in this economic recovery. However, it remains to be seen if businesses will be able to raise prices (in which case inflation will rise at the consumer level, i.e., a rising CPI Index) or if companies will have to eat it (lower profit margins). The latter scenario will be particularly troublesome for the stock market, which has already priced-in double-digit profit growth. One of the two scenarios will come to pass unless increasing productivity comes to the rescue to stave off both consumer inflation and margin deterioration.
Bottom-Bottom Line: The economy remains on solid footing, and the Federal Reserve holds the keys to the future trajectory of economic growth. The Fed’s job is being made more difficult by the late-cycle, pro-growth tax reform and fiscal policies of the government, forcing their hand to raise rates to a level they believe will forestall meaningful inflation, while remaining nimble enough to reduce rates once those effects pass to avoid a hard landing (i.e., a recession). Engineering a soft-landing has only been accomplished once in the post-war era (in the late 90’s). In the meantime, the economy will continue to expand at an above-trend rate for at least the next couple of quarters, but it is unlikely to achieve the 4.2% annualized rate witnessed in Q2.
Last Week Today: Italy’s anti-establishment government announced a budget with a deficit of 2.4%, pushing back against the European Union’s warnings for Italy to shore up its finances. | Fed Chair Jerome Powell remarked “The US is experiencing a remarkably positive set of economic circumstances…We’re a long way from neutral Fed Funds at this point, probably… We may lift rates past neutral.” Powell’s Fed is trying to engineer a “soft landing” for the economy, a task made more difficult by a balance sheet bloated through QE combined with unprecedented late cycle stimulus. | All eyes were on the August payroll report, even though Hurricane Florence likely distorted the data. A below-consensus estimate of 134k jobs were added in September, but revisions to July and August data more than made up for the shortfall, adding 87k jobs. The headline unemployment rate (U-3), fell to 3.7%, the lowest since December 1969 (the same month Vince Lombardi coached his final football game). Average hourly earnings rose 0.29%, but the rise was likely inflated by the absence of lower-paid workers evacuating from Hurricane Florence. Regardless of “Flo’s” impact, it was a solid labor report that stoked concern the Fed may be behind the inflation curve.
Strong economic data and messaging from the Fed led to a sharp rise in interest rates and a drop in equities late last week. Rates rose across the yield curve, but more so at the long-end resulting in a steeper curve. While generally a welcome change from recent flattening, the speed with which rates have risen thus far is more important to equity investors than the absolute level of rates which remain low by historical standards. Based on last week’s moves, the current yield curve looks like this:
- 2-year +0.07% to 2.89%, a ten-year high
- 10-year +0.17% to 3.23%, a seven-year high
- 30-year +0.20% to 3.4%, a four-year high
Equities declined globally. Emerging markets bore the brunt of the pain, falling -4.5% (-11.6% YTD), developed markets ex-US stocks declined by -1.6% (-2.6% YTD), and the S&P 500 fell -0.9% (+9.5% YTD). The technology-focused Nasdaq Index was the worst performing domestic index, selling off by -3.2% (+13.8% YTD). Volatility increased, as is typical during market sell-offs, with the VIX Index rising 22.3% for the week, though at 14.82 volatility remains 4-5 points below its long run, historical average. WTI Crude oil rose +1.5% (+23.0% YTD) to $74.34 per barrel. The national average price for a gallon of gasoline reached $2.91, a 16% year-over-year rise. For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
What if a trade deal is not the objective…for the U.S. or China? Many celebrated the trade agreement with Mexico and Canada (the “USMCA”) as the first step in a broader strategy to further isolate China in global trade, thereby increasing pressure on Chinese President Xi Jinping to come to the negotiating table. However, what if the NAFTA revamp instead merely opens the door to a prolonged battle with China? This is the thesis of Arthur Kroeber, an analyst for the well-regarded macroeconomic research firm Gavekal. Kroeber posits that a fairer trade agreement for the U.S. with China is not what’s at stake. Instead, the stakes are much higher and focus on China’s existential threat to continued U.S. global dominance.
Politics was a primary source of motivation for President Trump to complete the USMCA deal because more than half of U.S. states count Mexico or Canada as their largest export market. Absent an agreement, the Republican party would have invited increased political vulnerability in the mid-term elections. Moreover, neither Mexico nor Canada present a threat to U.S. geopolitical power. However, with China the situation is decidedly different:
- China is the top export market for only five states, reducing political fallout from a trade stalemate.
- China presents a clear-and-present danger to US influence in Asia (i.e., China’s “Belt and Road” project designed to secure trade links with Central Asia, Europe, and Africa).
- China represents a strategic threat as they have openly stated their intent to surpass the U.S. to become a leading producer of cutting-edge technology, such as artificial intelligence.
Fundamental to the last two points, a subset of President Trump’s advisors consists of trade warriors and national security hawks who now see an opportunity to reverse China’s growing global influence. In sum, the political limitations are looser and the long-term implications far higher in the dispute with China as compared to Canada and Mexico.
If Kroeber is correct, the objective of U.S. policy is to break or, at least, severely reduce the reliance of US companies to manufacture goods in China. Evidence of success would be US companies moving manufacturing operations to other countries, removing a critical source of intellectual property and business investment from an obvious strategic rival. For example, last week Bloomberg reported that the Chinese military had embedded microchips in servers used by at least 30 US companies (including Apple and Amazon), as well as the Department of Defense and Department of Justice, to gather intellectual property along with trade and government secrets. It’s notable, relative to Kroeber’s thesis, that this act of espionage was first discovered in 2015 but is just now being made public. This revelation alone is likely to reduce U.S. management team’s enthusiasm for investing in China and will assist the U.S. government in its efforts to break the China-US manufacturing supply chain.
On the other side of the world, and the geopolitical chess match, China may not be all that interested in rushing to strike a trade deal with the United States. If China’s long-term strategy is to compete with the U.S. for global leadership, it will need to consolidate regional power, de-link its currency from the US Dollar, and take steps to be viewed as a safe harbor for countries to invest excess currency reserves, according to Gavekal’s Founding Partner, Charles Gave.
As it turns out, China has been moving in this direction for several years now. For example, the “Belt and Road” venture is a massive infrastructure project that will increase China’s financial and commercial cooperation with more than 70 neighboring countries across the Eurasian land mass and beyond.
Concerning further de-linking the Chinese Renminbi (RMB) from the US Dollar, earlier this year China took a significant step forward by launching an RMB-denominated oil futures contract. Importantly, the launch of the futures contract strategically lines up with the near completion of hydrocarbon pipelines between Russia and China. The ability to hedge oil prices in the local currency via the RMB-oil futures contract makes RMB a more attractive medium of exchange and reduces the need for China to pay Russia in US Dollars for imported Russian oil.
Finally, to provide a repository for countries’ excess currency reserves, in early 2017 the Chinese government opened its bond market to foreign investors via the “bond connect” program to serve as the Asian equivalent of a risk-free asset. The government did so after several years of ensuring that Chinese bonds outperformed traditional safe-haven assets, like the German Bund and US Treasuries, to attract investors. Indeed, since the beginning of 2013, Chinese bonds have outperformed both US and German equivalents, and foreign holdings of Chinese bonds are now 1.5+ trillion RMB, an increase of more than 60% from a year ago (source: Bloomberg). If the bonds continue to perform and the RMB remains stable, at least relative to other Asian currencies, Chinese sovereign bonds will allow governments in the region to invest excess capital within Asia.
These articles illuminate the deeper strategic objectives of the two most powerful countries in the world. Most observers still believe the U.S. and China will eventually reach a trade deal as it seems to be in both countries best immediate interests. That may still be the case. However, if Gavekal’s theses prove accurate, trade is merely a pawn in each country’s longer-term strategy.
Early warning signals that Kroeber is correct include the U.S. levying higher tariffs, limits on visas for Chinese tech workers and students, and sanctions on Chinese companies with a record of cyber-espionage. If Gave’s thesis is accurate, China will delay substantive trade negotiations choosing instead to use this time to more firmly entrench itself as a regional hegemon. As the famous Chinese military strategist, Sun Tzu wrote: “He who knows when he needs to fight, and when he doesn’t, will be victorious.“
Kroeber and Gave are fundamentally speaking about two sides of the same geopolitical coin. The reasons the U.S. may not be interested in a trade deal with China reflect the Chinese government’s actions to compete head-to-head with the U.S. for global supremacy. What’s interesting about Krober and Gave’s theses, unlike most macroeconomic discourse, is that they are not mutually exclusive and both may be correct.
Last Week Today: China pushed back from the negotiating table, snubbing additional trade talks with the U.S. (at least for now). | Key OPEC members Russia and Saudi Arabia dismissed U.S. requests for output increases to combat rising oil prices. | The Fed raised interest rates for the eighth time this cycle, to 2.25% and for the first time in more than ten years, the Fed Funds rate is now higher than the Core CPI inflation rate. | On Thursday, the S.E.C. filed a lawsuit against Tesla and Elon Musk over his Tweet claiming “funding secured” to privatize Tesla. The suit was settled two days later with Musk agreeing to pay a $20 million fine and relinquishing his role as Chairman of the company for three years; importantly for Tesla’s investors, Musk will retain the CEO role. | Late last night, NAFTA was replaced by the U.S.-Mexico-Canada Agreement (USMCA) as the three countries, which exchange more than $1 trillion annually in goods and services, came to a trade agreement.
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Fed Policy Update: The Fed’s updated interest rate forecast (aka, the “Dot Plot”) was released on Wednesday. The updated Dot Plot extends the interest rate forecast period out to 2021 and the median expectation for the committee is to raise rates five more times: once more in 2018, three times in 2019, and once in 2020. The Fed currently believes the terminal rate (i.e., the highest Fed Funds rate of this cycle) will be 3.50%. The unchanged terminal rate in this forecast was interpreted as dovish by a market concerned the Fed might suggest another hike or two in 2021. Instead, the Fed expects to cut rates by 0.5% sometime beyond 2021, as their long-term view is that 3% is the correct Fed Funds interest rate for the economy and inflation to stabilize at a sustainable pace. Chairman Powell has stressed that the Fed’s policy is data dependent, so like any forecast, this is subject to change.
Passive Influence – As has been well documented, the steady rise in domestic equity market prices since the Great Financial Crisis has proven to be a challenging market environment for active equity managers. One reason is that stocks have been highly correlated for much of this period, leaving little room to add value through security selection. In other words, because stocks have moved together in a rather undifferentiated pattern, individual stock selection has been less effective, sowing the seeds for passive investment strategies to gain in popularity. Indeed, the proportion of assets under management in passive strategies has doubled from about 20% of total assets in 2009 to 42% today (Source: BofA Merrill Lynch). Vanguard, the vaunted low-cost passive investment strategy provider, is a clear beneficiary of the “passive movement” as the percentage of S&P 500 market capitalization held by Vanguard funds has more than doubled over this timeframe.
At a more granular level, Vanguard has emerged as a significant investor in nearly every company in the S&P 500 Index. To wit, Vanguard funds owned 5% or more of the outstanding shares in only 23% of S&P 500 stocks in 2010, but today that number is just shy of 100%!!!
Passive investing’s considerable market share contributes to a positive feedback loop in which additional flows into index funds creates demand for the same positions already held in those funds, pushing those stock prices higher. However, that same positive feedback loop exists in weaker markets in which investors pull money from passive index funds. S&P 500 stocks with sizeable passive ownership evidence this capital flow phenomenon. According to research from BofA Merrill Lynch, these stocks exhibit volatility that is approximately 20% higher relative to those with lower passive ownership (as measured by 3-month annualized daily volatility).
The message here is that the extra 20% volatility that adds to a portfolio’s returns on the way up is reflexive, and will work against investors in a choppy, or declining market (in fact, from a mathematical perspective, downside volatility has a disproportionately negative impact on a portfolio’s value due to negative compounding). From a portfolio management perspective, if one is uncomfortable with this state of affairs, the best solution is not necessarily to abandon passive investing, but to allocate a portion of their equity exposure to active managers with high tracking error. These types of strategies – which include portfolios that are differentiated from the S&P 500, either through the names they hold, the weights of the names (relative to the index), or a combination of the two – can complement core passive equity holdings through the back end of the business cycle.
Consumer Sentiment Up, Up, and Away – Bloomberg’s Consumer Sentiment Index is comprised of weekly survey data that extends back to 1985, and measures consumer current perceptions on three variables: the state of the economy, personal finances, and whether it’s a good time to buy needed goods or services. Last week, this index reached its highest level since 2000, bolstered by accelerating wages and the strongest personal income growth in at least three years. Consumer sentiment is relevant, because a healthy consumer is essential to GDP growth since consumption accounts for approximately 70% of the domestic economy.
In an interesting side note, the divergence between the comfort levels of self-identified Republicans and Democrats is striking. Whereas Democratic consumer sentiment (represented by the blue line) is virtually unchanged since President Trump’s election, Republican sentiment (the red line) has nearly doubled.
Regardless of the political divide, in the aggregate, consumer sentiment is signaling continued economic growth ahead and last week the Fed upgraded their forecast for 2018 GDP from 2.8% to 3.1%. Its worth noting that the Fed does not believe this level of growth is sustainable (nor do we, unless productivity rises), forecasting annual inflation-adjusted growth to slow over the next two years to an average 2.5% in 2019 and 2% in 2020. Although it includes slower growth, the forecast is not too shabby for an economy that, by that time, will have been expanding for more than a decade.