Q3 2016 Market Update and Outlook: A Golden Summer

At the end of Q2 2016, uncertainty was on the rise, the geopolitical environment was fragile and financial markets appeared highly susceptible to exogenous shocks. Global stock indices wobbled, safe haven trades such as long Japanese yen and long US treasuries gained steam, all while gold rallied in tandem with investor uncertainty. We expected much of the same for the summer months of Q3 2016 as the US election cycle unfolded. Yet, the resilience of financial markets has truly been phenomenal. The US stock market, as represented by the S&P 500 TR index is up over 8% for the year. The NASDAQ composite hit another all-time high in September. Truly, this resilience may not be an anomaly after all. Excluding 2008, the US stock market has been up every year since 2003, many of these years it’s been up double digits, though past performance is no guarantee of future results. For those of us who value fundamentals and see the current economic landscape as a highly intricate house of cards, the continued rally, and subsequent drop in equity market volatility, is perplexing. Chairwoman Janet Yellen punted on increasing interest rates this quarter. Although the yield on the 10-year treasury was ultimately up in the third quarter, it also hit an all-time low in July of 1.36% in the post Brexit flight to quality. Ongoing massive global central bank stimulus (bond buying) led to an even larger supply of negative yielding bonds globally, making our US 10-year treasury look like a high yielding security relative to our foreign brethren. Can this continue forever? Surely, at some point in the not too distant future, negative interest rates will be viewed as some kind of insane experiment where we all should have known better. Yet, we feel that the financial markets seem as complacent as ever, comfortable and warm in a central bank security blanket.

We firmly believe the Fed should raise interest rates this year; yet, this assertion is materially dependent on the strength of economic data as we move into Q4. At the same time, the US is not an economic island. We could see economic data continue to improve; but if Europe continues to struggle, growth in China slows further, or other global forces take hold, the potential for a Fed rate hike could disappear. As we sit here today, the yield curve continues to flatten; which has been an economic harbinger. What’s nearly for certain in our minds is that global central banks will intervene with appropriate liquidity to prevent any political crisis from turning into a financial crisis. But, with zero to negative interest rates globally, central banks are already constrained and have limited tools to stabilize markets.

Accordingly, we believe investors should look to diversify portfolio risks away from long-only holdings in stocks and fixed income, dependent of course, on the individual’s goals and risk tolerances, among other factors. The traditional 60/40 portfolio has been a winning asset allocation since the depths of the financial crisis but in our opinion has overstayed its welcome. We are in no way predicting a crisis; rather, we view this as a market in which preemptive thinking is paramount.

The Times They Are A-Changin’

As we approach the end of summer, here’s my perspective on economic issues worth watching.

Employment
The big new noise is the July employment report. Job growth surged, according to the Department of Labor. The US economy added 255,000 positions, according to the Department of Labor, far more than the 180,000 increase that economists had been predicting. Average hourly wages rose 0.3 percent, also higher than expected. The unemployment rate remained unchanged at 4.9 percent.

I am going a bit out on a limb here, but I go back to what appears to be some changes in the pattern of hiring and layoffs as the US has shifted from an industrial to a service economy. Ordinarily July is a big layoff month as factories historically shut down for a good part of that month to install new, more productive equipment. In addition, some service entities, including educational facilities, also have reductions in force around that time. But the times they are a-changin’. School facilities are altering their schedules, and factories don’t necessarily have to close for upgrading. Typically, close to one million people leave the work force in July. That gets seasonally-adjusted to a positive number about which we all talk. As I have said, I have never met a seasonally-adjusted person. It will be interesting to see what happens this year with the labor market relatively tight and the patterns changing. This affected the numbers in May and June with May being understated while June more than made up for that understatement. The pattern YTD is about 100,000 short between the seasonally-adjusted numbers and the unadjusted numbers. Let’s see how the job numbers play out in coming months—revised numbers will be released in September. Meanwhile, I think we should pay more attention to the wage numbers, which are rising. Over the year, average hourly earnings have risen by 2.6 percent. Higher wages are a big component of the Fed’s inflation gauge. Both the July employment numbers and higher wages could affect the Fed’s thinking in September.

Brexit
In the meantime Brexit continues to be newsworthy. Bank of England Governor Mark Carney has taken precautions to ease the potential downside for Britain. In response, instead of punishing the UK, the EU has an opportunity to move toward a more United Europe. It has to take a harder look at what has to be done throughout Europe on the fiscal side and with regard to the debt and negative rates. The question is, will it? I think it has to. Raw democracy may get in the way.

What else?
As I have previously observed, I think the emerging markets with some volatility are where the growth is. India has to fall in that camp. The reform steps are a start. One has to remember that India is the world’s largest democracy. Whether Indian Prime Minister Narendra Modi can navigate his way through this is another question. I think he can, but it will be a volatile road.

As I have said before I find the Americas the most interesting set of markets. They have had quite a run in anticipation of change from Cape Columbia to Tierra del Fuego. Just think if our focus was to make America great in the broadest sense of the definition. We still have long-term issues of growth globally. It will be a slower pace overall, but the opportunities may prove to be broader. Maybe a measure of stability in real assets and some understanding of the value of illiquidity premiums become a focus. So, pay attention to the Americas, all of them.

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/

The End of the Beginning or Beginning of the End (Redux): Written Commentary

For those of you who did not have the time to watch the video on this topic, below is a more complete text of what I had to say:

  1. Tragedies in Orlando and in England by themselves are difficult to comprehend and clearly represent elements of extremism that indicate some “permission” to behave at the raw end of emotions. This has on the margin an impact on the US elections and the Brexit vote. The next few days may tell us what direction this pushes voters’ thought process.
  2. This adds to the near-term elements of uncertainty. But, what happens if the first event, the Brexit vote, is REMAIN as opposed to EXIT? This removes an element of uncertainty against a backdrop of central banks already having provided liquidity to deal with a negative vote. This reminds me a little bit of Y2K. If the vote is EXIT we may already be set up for that. If it is REMAIN we have a lot of “excess liquidity” in the system.
  3. In the meantime, while economic data, as always, is mixed globally—in the US, with the exception of some of the employment numbers which we can’t ignore, other numbers could be said to support Fed action: Core CPI is up 2.2%, year-over-year unemployment claims remain low, wages and housing seems to be fixed, GDP may surprise, and wages are up not just in the US but elsewhere, up 10% in China, about 2% in Europe, and even up in Japan.

All this would support rate increases by the Fed, but as I said in a recent video, it may wait for the July employment report which isn’t available until first week in August. Why July? We are seeing major shifts in hiring, firing and exit patterns in the employment rolls. If nothing else, this makes it very difficult to “seasonally-adjust” (SA) any reported numbers. We had a reported seasonally-adjusted number for May of +38,000. As one can see in the tables below, 651,000 not-seasonally-adjusted (NSA) persons actually joined the payroll, which is well below the 900,000 number for May, 2015. YTD, the total employment numbers SA and NSA are 748,000 and 476,000 respectively. This compares to final numbers for 2015 for the same period of 1,033,000 and 881,000.

There will be further adjustments when the BLS adds the pluses and minuses from the data on another 20% of its 650,000 establishments as it completes the May survey over the next two months. Given the first seasonal-adjustment to 38,000, which is less than 6% of the NSA number, it wouldn’t take much to move the month into a negative number. The last time May was a negative number was in 2009 (-303,000 SA) when the NSA additions to the payroll that month were only +384,000. On the other hand, July could be an upside surprise. As one can see from the table for 2015, July is a big month for reduction in real payrolls. This is a result of reductions in the educational field and changing patterns in retailing. And, it is typically a big shutdown month for manufacturing entities to make changes to processes. Given that the industrial sector has become a smaller part of the makeup of the work force while more in-line changes are taking place, this number could surprise. How this gets translated into a seasonally-adjusted number is difficult to judge. It continues to amaze me that so much weight is put on this seasonally-adjusted number. Seasonal adjustments are difficult enough in a stable environment. When patterns of hiring, firing and exits from job participation are changing and the mix of services versus industrial continues to favor services, any single number has to be viewed with some circumspection, but has to be recognized. There are other numbers that give a better view of what is going on in the labor market as the Fed ponders.

TBL_Blog_OTM Change_Jan11-May16_032816

However, markets may anticipate and the excess liquidity will be put to work in a risk-on mode if the Brexit vote is Remain.

We will be paying attention to employment to determine if this is the end of the beginning or the beginning of the end—an expression I stole from Anatole Kaletsky at Gavekal. I think we are at the end of the beginning of what has been a strange cycle. There is more to come. In the meantime, my comfort level with fundamental analysis is low, while the more sophisticated trend followers are seeing movements that to me support a continuation of the cycle. These uncorrelated sets of strategies deserve some attention as well as less liquid strategies of those who can handle the illiquidity and take advantage of the time arbitrage that exists for those managers who do not have to deal with the needs of investors who fall into the liquidity trap—something I just wrote about in Think Advisor.

Grexit and investing in a Sartre world

On Friday, June 26th, I was on Bloomberg Market Makers with Olivia Sterns and Pimm Fox to spend a few minutes talking about the news of the day and the markets.  In a short period of time one tries to respond to some of the issues that may not have been covered or where the on-air personalities are looking for a little more color on previously discussed issues. As usual, the day before, the producers ask for a few thoughts on some topics that could be covered during the session. The questions for the day were Grexit—will it happen and what if it does; Brexit—lots of talk from Britain about leaving the Eurozone—could it happen; China and its tech stocks—is this market a bubble; and the US Markets—are we at the end. As you can see from the video, as is always the case, there isn’t enough time to go into all the topics, certainly not in depth. Below are the notes sent over on Thursday of last week on the various questions. This gives you some sense of the making of the sausage in preparation for the brief appearances on the screen. I admire the amount of work that goes into the creation of these brief segments, and the maintenance of coherence and continuity achieved by the folks in front of the camera for the full two hours. (I also appreciate the opportunity to wear the makeup all day). Appearances do matter (in a different sense of that expression), because they force one to crystallize immediate thoughts affecting the markets, much as our managers have to do every day. Some trends being reestablished and volatility can lead to opportunity.

Please read the notes on Grexit written for the moment of appearance, but I have some further thoughts, subsequent to Tsipras’ decision to put the idea to a referendum:

Depending on how the referendum is positioned, odds could favor a majority vote from the closet Eurozonistas to accept a form of what is proposed, stay inside the Zone and within the Euro. This can give Tsipras cover to cut a deal grudgingly acceptable to the various players including Germany. An unusual approach to reaching this goal, and it carries huge risks. For Tsipras to be pushing for a “No” vote really makes it a vote on his continuation in office. A “Yes” vote would likely lead to the forming of a new government. This next week, particularly with the banks closed, won’t come close to representing the end of the drama. Sartre must have had a vision of the Eurozone when he wrote “No Exit” in 1943. Garcin may be Greece. The door is open. Hell is other members of the Eurozone. We are somewhere near the end of this existential one-act play. And, we are all in it… Make sure you know your lines. Pay Attention to the cues. This is moving in various directions every moment. 

 

The Friday Notes

Grexit: It is not to Germany’s benefit to have the Euro structure collapse. This has been a boon for the country in terms of employment and trade balances combined with cheap credit. So the most likely outcome is some extension of the problem with the first steps toward reform and some manner of debt forgiveness, either through major extensions of maturities or some defined workout period. Tsipras is popular within Greece and has fought the good fight, which politically puts him in a better place. If he’s smart he has already written his speech to the Greek populace about what he has achieved and where he has had to compromise to produce what is best for the majority of the people. On that path, I don’t think this will lead to political turmoil. The biggest risk is a continued run on the banks. If you had money in the banks why would you leave it there under any circumstance? To me the ultimate “solution” is a creation of a Northern and Southern Euro. This will have a negative impact on trade for the Northern countries as the NEuro would be stronger while the SEuro (or maybe the Franc) would be significantly weaker. This would take time, but the path would likely result in a weaker single currency until the two Euros are established. It would be interesting if we start to see trading in a when-issued SEuro and NEuro.  I know this sounds far-fetched, but the situation we find ourselves in is a bit far-fetched as well.

Britain and the talk of exiting the EU, I don’t have any knowledge or thoughts on that. Just seems like talk.

China and technology, I have written a chapter in a new book on China edited and produced by John Mauldin and Worth Wray, “A Great Leap Forward?” My chapter is on Invention, Innovation and Implementation in China and its impact on the pace of technological change globally as well as in country. China is great on Invention. They have work to do on Innovation, and lots to do on Implementation. But we are seeing continuing signs of success. China is already filing more patents than either Japan or the US and soon they will be issuing more. They have created a legal system (heaven forbid!) for the defense of intellectual property. What’s interesting is only 15% of the patent lawsuits being filed are against non-Chinese companies. 85% are Chinese companies against Chinese companies. My view has always been that once a country has intellectual property to defend the pace of creation accelerates. China has almost 5 times our population.  They most likely have an IQ distribution that is not different from the rest of the world. That means they actually have a population of very smart people—their top quartile—equal to more than the total population of the United States.  We better watch out. Regarding their stock prices, particularly technology stocks, there are some specific factors that have led to very significant elements of speculation. I believe one should leave this market to the professionals. At the same time, they do have a domestic market for their technology significantly larger than anyone else’s, and a growing global market. I do see some shades of the dotcom boom with some differences. I actually ran a venture capital portfolio during that period and managed others doing the same. It was fun and amazing. And, at the end, if the valuations put on the companies accurately represented the present value of a future stream of revenues and profits, a small number of companies would have equaled the total GDP of the US in a measurable period. But, recognize that today we are dealing with technologies where processing speeds are more than 2000 times faster than they were at the end of the dotcom boom and the networking effect is similar. This is a revolution involving user bases multiples larger than that period: 413mm internet users in 2000 and 3,150mm today growing at 8 users per second. 214 Billion emails sent every day. 4 ¼ Billion Google searches every day. Are multiples really high for the ultimate winners? Maybe not, but one just has to figure out which are the winners, from which countries and deal with the fact that new disruptors are disrupting the old disruptors as we speak.

The US markets. Given the lower pace of top line growth, peak profit margins, the likelihood that credit will become more expensive, and the current multiples it is hard to optimistically put a growth on the stock market of more than 5-7% per annum, sort of in line with nominal GDP growth. If inflation stays low, 5-7% may prove to be high. 4-5% may be more like it. That means, on balance the equity markets will slowly grind their way up over the next decade and we will be talking about new highs. Yes, accidents can cause significant corrections, but probably not a bear market for awhile, unless we get way overvalued–which I don’t expect.  In fixed income it’s another story. I don’t see the credit risk—yet–that Carl Icahn may see, but I do see rates rising, at least in North America.  I think traditional fixed income is not necessarily the risk mitigator and return generator it has been for the last thirty years.

A further note: It doesn’t appear that the beta play on the stock market or a traditional weighting to the bond market are the ways to generate returns necessary for meeting one’s retirement or other family goals. One may have to look for active management, unconventional strategies and maybe some form of illiquidity premium to achieve those long-term goals. It is not clear that history is rhyming, much less repeating itself. Past performance is not indicative of future results. We continue to Pay Attention to the clues and cues as we work toward creating an Act II of this play. Where is Sartre when we need him?