Macro, Markets, and Malarkey

Stocks and Bonds
It feels like forever ago, but back in February, the S&P 500 hit its lowest level since 2014 as global growth fears spooked investors, leading to liquidations and deleveraging—most notably for sovereign wealth funds.

Fast forward to now…as of the end of July 2016, the S&P 500 closed at 2,173.60—up 7.5% from the beginning of the year. And, 10-year treasury yields started the year at 2.24%; as of the end of July 2016, rates were at 1.46%—a 35% decline in yield from the beginning of the year. These are big movements in both domestic stock and bond markets which investors shouldn’t take lightly.

Fig1_S&P+10yrTreasury

Also, more than $11 trillion in negative yielding bonds are outstanding, largely in Europe and Japan. The Financial Times wrote a great piece recently highlighting the post-Brexit surge in investor bond purchases.[1]

Fig2_GlobalNegYieldSovDebt

This means that if an investor holds one of these bonds until maturity, they actually lose money. They are also paying the issuer for the right to own these bonds, versus receiving some sort of payment in return—as Finance 101 teaches us should be the case. Governments with massive stimulus policies (ECB, Bank of Japan, and now the Bank of England) are buying up bonds, bidding up the price of these bonds and thus sending yields negative. Accelerating the decline in yields is the fact that the supply of such bonds is not ample enough to meet this demand. Negative yields are supposed to entice investors to invest in other assets, since they clearly lose money by investing in such bonds. This hasn’t happened. And yes, this is completely backwards and deflationary.

Currencies and Commodities
Currency markets have not been immune to this storyline; as Europe and Japan use monetary policy to help grow their economies, foreign investments flow to the US for its higher yields. Since May, foreign buying coupled with more hawkish Fed speak has strengthened the US dollar versus other currencies.

Fig3_USDollarIndex

If the US dollar continues to strengthen or simply stays strong on a relative basis, this has the potential effect of placing a lid on US inflation. The stronger the US economy gets versus its global counterparts, the stronger the dollar looks versus other currencies.

A strong dollar is usually a negative for commodities. And in fact, the strong dollar has kept commodity markets mostly in check since early May, as we wrote about in Commodities at a Crossroads. Of note, crude oil fell to under $30 a barrel earlier this year, sliding alongside the S&P 500, touching its lowest levels since May of 2002. It then spiked to above $50, and now hovers just north of $40 due to dollar related price pressure—nearly 20% below its peak in June of $50.11.

The US Economy and Election
That’s not all. We’ve barely discussed the domestic economy. Here at home, despite anemic GDP growth of 1.2% for Q2, economic growth is indeed expanding as evidenced by the latest payroll and hiring figures. Non-farm payrolls increased by 255,000 in July on a seasonally-adjusted basis, with the unemployment rate at a very healthy 4.9%. Wage growth and labor market improvements here in the US makes a strong case for the Fed to raise rates. Our view is they should raise rates in September, ahead of the election. Whether they will or not remains another question.

Lastly, and as an homage to Vice President Biden’s favorite saying, “malarkey,” rhetoric around the US election has truly captured the American public, including ourselves. We are seeing raw democracy at work here and elsewhere. People are voting against the establishment; it’s a small segment of the human race, but it affects us all. In the meantime, it may become clearer that at extremes, when enough of the populace is truly feeling disadvantaged, capitalism has to make some changes. Otherwise capitalism and democracy are not going to work when the rule of law favors a few as opposed to the many. While this line of thinking may be too philosophical for a financial markets blog, it merits consideration because it does affect one’s view on investing.

Thus far financial markets have not reacted to the election news melee, but investors should pay attention. Should the Republicans lose their majority in the House and Senate, and Hillary Clinton is elected, this could have a dramatic impact on GDP as government spending will very likely increase…then again, it will also increase if Trump builds his wall.

What Should Investors Do?
Stocks can be at record highs throughout the year. The reality is that it doesn’t take much of a move to set a new record high when you have just made one. Odds are we will see low growth for the rest of the year, maybe the rest of the decade. One should expect dispersion by country and company with thoughtful, well analyzed decisions to make on what to own. This is going to take real professionals who are either doing real fundamental analysis or machine learning or can take advantage of the volatility and the anomalies. It’s going to be a different market. We all know that global and country growth comes from demographics and technology (of which productivity is a subset if you can measure it). But, there is a payback when the easy money goes away, causing slower growth than the demographics and technology would suggest.

In light of this, our view is that investors should have two areas of their portfolio well covered. First, there are downside risks to the market right now. Ignoring this fact would potentially leave one’s portfolio without a buffer, and we believe every portfolio needs uncorrelated assets. While it is self-serving to advocate for managed futures, Altegris has a focus on managed futures because time and time again they have performed during some of the worst periods for traditional equity markets.
Fig4_PR_ManagedFuturesPerfDuringEquityMarketStress_1288-NLD-882016

Equity markets could continue to push for new highs, but we believe they are also susceptible to periods of steep losses. Managed futures performance has historically been uncorrelated to the performance of the broad stock market, and we strongly believe all investors with risk capital should consider this diversifying return stream, given the current macro picture.

The second bookend to investors’ portfolios, given the market environment, is private equity. Private equity was one of the few areas that didn’t sell off when investors panicked earlier this year, and whose returns can be orthogonal to the returns of traditional markets. Now, private equity is not a liquid investment option, so investors must be thoughtful in terms of just how much they allocate. But it is the forgoing of frequent liquidity that makes private equity attractive in our opinion. This is what is commonly referred to as the illiquidity premium, which is essentially the potential reward of enhanced returns—over time. This potential for enhanced returns may be particularly attractive for investors given the uncertainty in traditional equities at present.

The bottom line is that investors should aim to diversify portfolios. Look for ways to grow and preserve capital in your portfolio and seek returns in areas where investment managers have a real edge and understanding of the underlying investments. Pay attention, and invest for the future of your portfolios.

 

Data sourced from Bloomberg unless otherwise specified.

[1] Financial Times, June 29, 2016: http://www.ft.com/fastft/2016/06/29/negative-yielding-sovereign-debt-rises-to-11-7tn-globally/

Beginning the Look Back at What We Expected for 2016 (and Beyond)

At the beginning of the year we wrote a Perspective on “What to Expect in 2016 (and Beyond).” There were several expectations of which many were not likely to play out until later in the year. For example, our views on commodities staying flat were based on dollar strength and China not beginning its full-fledged fiscal response to its growth until later this year. Dollar weakness and the steps China has taken already have pushed the timing up with gold being the poster child for this change along with the major industrial commodities. Stay tuned on this one. This could be temporary.

It is our plan to comment in “Outside the Boxes” on various of these expectations as differences unfold along with a complete review at mid-year. Below, is the first of these reviews.

This update, having to do with the Presidential race, was in our “…cocktail conversations…” section along with an earthquake prediction and a view on dietary habits and their impact on historically defensive stocks. While this would ordinarily be a part of cocktail hour, it is my view that what is happening in our electorate as witnessed by the Trump phenomenon, could reinforce elements of volatility and dispersion in the investment markets, particularly in a slow growth environment. The thoughts reference the markets, but also raise some questions about the 230-year experiment this country has been having with democracy.

The blog starts with a reprise of what we said at the beginning of the year followed by the “update.”
Worth paying attention.

 

The January 2016 Reprise

Screenshot of What to Expect in 2016 for 5-5-16 blog

 

The May 2016 Update

 

“I’m sentimental, if you know what I mean,
I love the country, but I can’t stand the scene.
And I’m neither left or right,
I’m just staying home tonight,
Getting lost in that hopeless little screen.
…I’m still holding up,
This little wild bouquet,
Democracy is coming to the USA.”

—Leonard Cohen  

Democracy lyrics © Sony/ATV Music Publishing LLC

 

The Winning Ticket 

It certainly looks like it will be Trump and somebody on the Republican ticket. It is still critical for the ticket to have the highest odds of winning Ohio and Florida. One would think that a reconciliation with Kasich would have been the answer. Hillary Clinton, the presumptive Democratic candidate, has to consider a similar logic. While history suggests that Vice Presidential candidates are selected more for their contribution subsequent to the election, this year could be different. It has certainly been a different primary season.

 

Democracy: Head, Heart or Gut

I started this update with the lines from one of Leonard Cohen’s many great songs, “Democracy.”
These thoughts express my sentiments pretty precisely. This may be one of the most democratic elections we have had in a long time. The constituencies have been motivated by non-establishment candidates on both sides to vote as they feel in terms of their innate fears and beliefs coming from the gut and the heart. This is in contrast to the more “enlightened” fears that would come from the head, calling for preservation of the system. This is what, historically, has been presented by the “Establishment.”

There have always been differences in the views between the two major parties of what really is important in the system, but the outcomes have been conventional and, ultimately, supportive of global commerce, finance, and an expanding role of government. In this election, the anti-establishment elements may end up determining what will appear to be a different path. Although, I would expect that the ultimate differences will not be long-lasting.

The historical evidence suggests this uncontrolled versus enlightened democracy was not envisioned by the forefathers of this 230 year experiment. Democracy in its raw form is coming to the USA.

 

Pay Attention

Nevertheless, the uncertainty that may come out of the conventions and then, the election outcome, combined with what will be a slow growth period globally will likely lead to continued volatility and wider dispersion in financial and investment results. This does require a fresh look at allocations and investment strategies for the near-term as well as the next several years.

A Flat Market Year-to-date

If one was fortunate enough to avoid the noise of the first three months of the year, one could point to a flat equity market for the year-to-date (YTD) with the 10-year treasury yield declining from 2.24% to 1.91% as the yield curve flattened. Most were not fortunate enough to avoid the noise and the liquidity trap that led to some selling at the wrong time and not much buying. The poor macro guys were making all kinds of bets, while the hedge funds tried to make the most of the dispersion amongst individual securities.

We have written about greater volatility and greater dispersion as a characteristic of a slow growth economy, which produces increased differentiation of earnings performance and a generally slower growth in overall equity performance. We believe this condition will be with us for some time to come as the global economy works its way through industrial overcapacity and the recession produced in the global industrial sector. In the meantime, service sectors around the world and disruptive information technology have been the primary source of jobs. Ultimately, IT will change the mix of talent needed. That is already showing up in the JOLTS reports with quits and job openings at high levels. While one can see the dispersion in individual stocks, we also see dispersion in the pace and the drivers of economic growth in both developed and developing markets. It is worth looking at the dispersion by industry within the US, and we have included a table showing what has happened YTD in the energy sector featuring the 10 best and worst performers year-to-date.

Fig1_TBL_Blog_S&P-Dispersion-by-Sector+EnergyDetail_032916

The US is, in our view, rightfully, on a path back toward normality led by Fed action without much fiscal help. Odds are if the economy continues to produce job growth and, ultimately, wage increases, we will see additional increases in the Fed funds rate this year (See Altegris Perspectives, “What to Expect in 2016 (And Beyond)” for some specific forecasts made as the year began on Fed rate hikes, oil prices, the markets, and a few other variables).

There are two variables at work, which would appear to be affecting the timing and magnitude of the Fed funds rate increases. One of them is bogus in my view, but the other one is a bit more troubling. The bogus element is the excuse of what is happening outside the US as a reason to both delay and reduce the likely Fed funds rate increases for this year. The second variable, which has not been made explicit, but, in my view, is a driver of the move away from being data-driven, has to do with the elections in November. The noise coming from both major parties—to the extent we still have two major parties—has, as a part of their message, been looking to what has really gone on at the Fed with finger-pointing blame for the rate of growth perceived to be lower than it should have been; and making sure that the next president makes it “right.”

There has always been a political consideration that the Fed has been required to acknowledge, even in Paul Volcker’s day. However, with the rhetoric coming from the candidates, I believe the Fed is taking a very cautious approach with a willingness to err on the side of not doing anything that could, in hindsight, be viewed as disrupting the growth path we are on. This likely means fewer increases than were originally anticipated this year and later in the year, unless the employment data forces the Fed’s hand. Our expectation as expressed in our Perspectives piece was for two increases this year. That is now appearing to be the general view (which likely means it’s wrong). If the general view proves to be wrong, I would think we would see more than two increases as opposed to a reduction. As I said in the Perspectives piece, the second half of the year may be very different from the first half—and that’s without the Cushing quake.

As long as we are dealing with unspoken strategies, one could take this even further into the world of strategic interlinkage of actions with an unexpected outcome: The lack of a Fed funds rate increase has had a negative impact on the dollar, and, along with some elements on the supply/demand front, has been a factor in pushing the WTI (Cushing) oil price up from a low of $26.68/barrel on January 20 to around $40/bbl now, while the spread has narrowed with Brent, which hit a low of $28.58/bbl on January 13, and is at the same price as WTI now. The $11/bbl increase in Brent is a huge benefit to Russia, which is pumping out a recent high of over 10.3 million barrels of oil a day. At the same time, the ruble has declined over the last two years relative to the dollar by 50% making every dollar received worth twice as much to the economy and reserves than it might otherwise. The sudden withdrawal of the Russian military’s support of the Syrian government, “mission accomplished” combined with noises about reaching some type of settlement desired by many of the significant Middle East oil producers seems coincident with the interesting move of oil prices off their lows. We will see how long these prices hold, but every day is a huge benefit to Mr. Putin, and some belief or hinted commitment that oil prices may stay a bit higher is reason enough to move toward being a part of a cease-fire and potential settlement. This is not a benefit to the US economy away from the oil and gas industry. It simply reinforces our view that growth will be slow and profit dispersion will be significant, and things happen in this world that are more complex than the pundits think. It continues to require a relook at allocations and a realistic view of what kind of returns one can expect from the traditional liquid markets overall for some time to come.

The dispersion will lead to moments in time when the value proposition is overwhelmingly positive. Those are the most difficult times to make the buy decisions as opposed to selling at the bottom. We have written and “webinared” before about the illiquidity premium that is available and may be necessary to achieve one’s financial goals, as well as the increasing value of pattern recognition as Moore’s Law continues to increase the ability of those who know how to use the technology to the benefit of their clients. We will continue to see these unusual volatile moves as we work our way through this long low return environment. It is a different investing environment.

In the short term, I still believe we need to PAY ATTENTION to the employment reports as a major factor for the Fed, the economy, and, most likely, the elections. We will be getting the March report this coming Friday.

As one can see from the table of historical seasonally-adjusted and not seasonally-adjusted employment numbers, February, March and April typically make up for the actual declines in the employment rolls in January. However, this January’s decline—larger than many of the previous Januaries—along with the numbers of late last year, seem to indicate a changing pattern that is not necessarily being picked up in the seasonally-adjusted numbers. If the make-up actually occurs in February through April, the seasonally-adjusted numbers could be explosive.

Fig2_TBL_Blog_OTM Change_Jan11-Feb16_032816

This will make for interesting media responses. Of more importance will be what is actually happening to wage and weekly payroll increases and what that means for total wages, including additions to the payrolls. This does get pretty technical, and the changing pattern could lead to just the opposite of what I am describing. The wage numbers will be of more importance to the Fed and will likely become the topic that could drive the Fed’s decisions on timing and magnitude of funds rate increases against the backdrop of an adversarial political environment. The confusion that comes with these seasonally-adjusted numbers will add to the volatility and uncertainty about what the Fed will actually do.

To some extent it is noise; to another extent it is a signal, reinforcing the view that we are in a different, slow growth environment that will call for some real decisions on asset allocations and the choices of strategies to meet one’s goals. We can help with some of those solutions. They are not blanket solutions that apply to all investors, but instead do require some real understanding of what an investor or her advisor is trying to achieve over a specific time frame.