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 Rest of the Americas: Reprise

We are continuing our review of what has happened since we laid out our expectations in our Perspectives at the beginning of the year. We had a view that one could find all manner of investment opportunities, long and short, without moving beyond the continents of the Americas. Given the volatility of the markets and the currency and commodity movements since then it is time to take a fresh look—particularly at the rest of the Americas. Below is a reprise of our expectations and our update of how the expectations have changed. Commodity and Currency movements as well as specific governance issues may cause a greater dispersion in results for the rest of the year.

 

CIO PERSPECTIVES RECAP: JAN 2016

The Rest of the Americas: Still some Economic Issues but an Improving Picture as One Moves from North to South 

Canada, in many ways, is a large natural resource company. Until the energy picture improves, there remain issues as a new and different government starts to grapple with the current environment. In addition, while the Canadian banks avoided much of the turbulence experienced in the US from the mortgage fiascos, their housing market has gotten somewhat extended from growth that occurred under the umbrella of high energy prices in the early part of this decade.

On the other hand, we see elements of reform and a better competitive environment globally in Mexico. Lower energy prices have slowed development and reform in this sector, but other sectors continue to move forward. This remains a good story of growth, reform and development.

Moving further south, if the project stays on schedule, by mid-year the expanded Panama Canal should be in operation with the ability to receive the Post-Panamax cargo ships that carry two to three times the previous loads that could make it through the canal. This will change patterns of traffic to the east and west coast ports of the US from East Asia, reduce transportation costs, and, most likely, produce a shift of traffic via the Suez Canal back to Panama. It could likely result in some increased infrastructure spending for some of the US ports as well as the supporting rail and truck traffic from these new patterns of shipping. An under-the-radar change that could have some unintended consequences positive and negative.

With the Argentina election leading to major change combined with elections in Venezuela and pressure on Brazil to change, the center of gravity on reform and a better investment environment in South America may be moving in the right direction. There is no question that the overall economic situation in South America is quite dependent on exports of hard and soft commodities. Until the commodity supply/demand picture improves, it may be difficult for the overall investment environment to improve significantly. We may be entering an environment where some prices are falling below operating breakeven. Let’s keep in mind, though, that energy is a big part of the cost of extraction and refining for most hard commodities. Miners and refiners will keep producing if there is a dollar contribution toward fixed costs. With the metals priced in dollars for the most part, the currency weakness many of these countries have seen is a further reduction in costs. It is possible as we get later into the year modest increases in demand combined with reductions in supply may shift the patterns. At the same time, it is highly unlikely that we will see major improvements in governance and economic results early in the year in these three countries mentioned. However, the tone has shifted. This is an opportunity for the US to affect the rate and quality of change in these three important South American countries with an impact on the whole continent.

While the change in our relations with Cuba gets media attention, a similar reaching out by the current administration to change relationships with the three countries is a real possibility. One will be able to find all of the varieties of investment opportunities within the Americas with similar risk characteristics as exist throughout the rest of the world. This is a slight overstatement, of course, but just saying…

One does have to be careful of what is going on with capital flows. The countries in South America are dependent on export growth primarily tied to commodities. While Argentina may be coming out the other side of its ability to access the capital markets, it is not clear that other countries can make it through this period without some degree of financial stress. But, the Americas represent an unusual somewhat isolated set of investment opportunities across the equity, fixed income, and fixed asset markets, both public and private.


 

TODAY: MAY 2016

Commodity Movements push much of the Americas to Unsustainable Levels—too Fast, too Soon

 Below are three bar charts showing returns in local currency and dollar-based YTD for most of the capital markets worldwide as well as a specific focus on the Americas and commodities.

 

Fig1_2016-Equity-Market-Americas_051616

Fig2_2016-Equity-Market_perf_051616

Fig3_2016-HardSoftCommodities_051616

In part, the commodity run has to do with the weakness of the dollar against many currencies. Gold and possibly other precious metals are primarily moving because of the dollar, but also because they can act as sources of real returns against an expectation of rising inflation, low interest rates, and, maybe low equity returns. Our expectation had been a likely shift occurring on the commodity front as we moved into the second half of the year. In part, this was based on a step-up by China on the fiscal side which would increase demand and prices for a variety of commodities as infrastructure and support of inventory building took place. It would appear that China has already started that process. Unfortunately, I think this could lead to some disappointment later as China backs away from this fiscal push, much as they did after the 2008-2009 debacle. China did keep things going with prices peaking in 2011. There has been some slowdown on the supply front, with much uncertainty about OPEC and Saudi Arabia, specifically regarding oil, but other supply slowdowns elsewhere including the fires that rage in the Canadian oil sands region. Of course, the rise in prices could reflect concern about the Cushing Fault—one of our cocktail conversation expectations. Even 60 Minutes is now talking about earthquakes in Oklahoma.

That aside, as we pointed out in our Perspectives piece, China is the biggest source of supply and demand in the hard commodities, and effectively, controls the markets. Higher prices may lead to bad economic decisions regarding maintaining or even increasing production in response to the prices. These increases will likely end when China stops supporting the price and/or the dollar begins strengthening as it becomes clearer that a recession is unlikely—slow growth, but growth, wage increases and hiring pushing up consumption but not necessarily profits. Last month, for example, total compensation for all those employed was actually up 0.7% March to April. That’s a pretty healthy annual rate.

So what does one do now? The Americas look a bit ahead of themselves. While we are seeing change in Latin America, there will be some major hurdles for the major countries on governance and fiscal budgets. Commodity prices could continue to provide a lift if what is going on in China continues. I think we will start seeing more dispersion in the results in Latin America as the year unfolds.

We have already indicated that we expect the slower growth of the global economy to produce dispersion among country and company results. Below are two tables that show what has happened in the US specifically by industry with the energy industry as a poster child.

 

Fig4_Blog_S&P-Dispersion-by-Sector_051716

Fig5_Blog_S&P-Dispersion-by-Sector_EnergyBreakout_051716

This does require a broader and more specific look across more asset classes and more managers to take advantage of the dispersion and the spread we could likely see between the liquid markets and those with an ability to buy into less liquid sectors. The opportunity set is getting broader and requiring a real understanding of risk and a real understanding of liquidity requirements.

Lastly, so much of what I discussed depends on what happens here in the US as well. As my colleague, Lara Magnusen, recently pointed out in Bloomberg, any positive economic data out of the US may convince investors that the Fed will indeed raise rates at their next meeting. The knock on effect here is that you could see some real strength in the dollar, and thus reversals in commodity markets generally.[1] The rest of the Americas are thus dependent on a highly correlated set of variables affecting commodity markets, and, ultimately, the broader economic landscape.

[1] Bloomberg.com, May 1, 2016, Gold Keeps Shining as Funds Miss Out on the Best Rally in Two Months

A Look at the Year Ahead

Providing some answers to the questions on the media’s minds (and maybe the investors’).

This is the time of year when we get a lot of questions regarding our outlook for next year including a call for point estimates on the usual indices and other variables. It is somewhat pointless to provide point estimates, but we did some of that below. We are in an unusual environment, with many variables that can certainly see some volatility throughout the year with, in my view, greater dispersion in results, similar to this past year. We are working on our annual Altegris Perpectives piece, “What to Expect in 2016 (and Beyond).” I must say, it is a harder year for developing definitive expectations than I have seen in a long time. That says something about the markets and increases the desire to spend time with the micro folks as opposed to the macro types. Historically, when this has been the case, that has paid off.  Paying Attention is still the advice, but I would add the words of my friend and former co-worker many years back, Art Cashin, “…Stay Nimble.”  As many of you who on occasion read the Altegris Blogs, you have seen me write that Past Performance is Not Indicative of Future Results. Given some of the dispersion we did see in 2015, this may be a time when last year’s performance may be more indicative of this coming year’s results.

Below are some of the consistent questions that have come up from those looking for answers.

 

Taking into consideration the rollercoaster some equity investors found themselves on this past year, particularly in August, what are the biggest risks facing investors in the stock market in 2016?

There’s a long list of factors impacting the stock market as we begin the New Year. The global slowdown, a strong dollar and the Federal Reserve’s late-in-the-game rate change, to name a few, all add a degree of uncertainty for investors. I would also stress two other factors that will play into investor returns: another year of profit disappointment driven by wage increases and the end of the oil dividend for many corporations.

 

What will be the biggest surprise for investors over the next 12 to 18 months?

Inflation could pick up a lot faster than widely anticipated. I would encourage investors to keep an eye on wage growth.

 

How are you advising clients looking to allocate assets and potentially reinvigorate their returns entering into the New Year?

We’ll be publishing an in-depth outlook with a few wild cards shortly, but I can provide a quick preview of what we’re seeing in the markets.

To the extent an investor doesn’t need liquidity, the opportunities in the less liquid parts of the markets will likely benefit from a growing illiquidity premium. Just don’t buy a daily liquidity fund that has been buying illiquid securities to juice returns.

Investors experienced no to low equity returns in 2015. We’re predicting more of the same for equities next year. It may prove to be a good year for true equity hedge fund managers. In terms of fixed income, we’re anticipating some credit accidents, but on balance, no major credit meltdowns. The recent moves in the high yield markets may have provided some opportunities if one does very specific credit analysis security by security.  Activist and event-driven managers are likely to experience favorable returns as M&A activity continues to be strong going into 2016. As we have seen this past year, sometimes an activist approach doesn’t work, but I think over time it does. This recent action does open up opportunities for those who have a longer time horizon and are dealing in the less liquid parts of the markets. I recently made a point (which I stole from one of our own, Greg Brucher) “…investors buy and hope, activists buy and influence, and private equity firms buy and fix.”  There will be a lot of situations open for fixing over the next few years.

 

Given Donald Trump’s campaign has been getting a lot of media attention, with speculation that he could actually have a shot at the Republican nomination, what would the election of Donald Trump mean for equities?

Trump’s nomination would most likely be a negative for equities since it would represent some element of disarray in the Republican Party. If he is elected, however, we think it could potentially be positive for the markets. Most of the programs he is calling for would raise debt levels more than any previous administration’s policies. The upside for the economy would be a lot of fiscal stimulus. The downside is that it would inevitably increase rates. This would also bode well for defense stocks. Whoever is elected, I think the odds of more fiscal action is higher than it has been over the last 8 years, even amidst ongoing dysfunction at the Congressional level.

Historically, the President only affects stocks on the margin. But as we’ve seen with Trump’s campaign for the nomination, a Trump presidency would no doubt be a different animal.

 

Who would be the best presidential candidate for the stock market? 

I’m more interested in picking the best candidate for the country. While one could say what’s good for the stock market is good for the country, I tend to think it’s the other way around. Historically, markets have done better under Democratic presidents, but it’s a close call.

 

Looking forward to the next 12 months, on which sectors are you taking a bullish or bearish stance?

We’re bullish on defense stocks, technology and healthcare. In terms of technology, we’re actually favoring old tech over new tech, particularly companies involved with the cloud, cybersecurity and have been spending on R&D.  Moore’s Law continues to be operative.

Consumer staples and most fast food companies are where we’re currently bearish. While staples tend to be a more defensive sector that does relatively well in slow growth environments, changing eating and drinking habits among Americans are going to make it tough for these companies to keep up and generate meaningful returns. Once again, it is company by company, but they won’t all be making the adjustments to new habits in a timely fashion.

 

If you had to give 2016 year-end targets for a handful of major market indicators and indices, what would they be?

Take the point estimates with a grain of salt because on any given day those numbers can and will change. But overall the market may keep pace with nominal GDP results next year in spite of the profit picture looking quite weak.

S&P 500: 2,120 (but with big dispersion)

Dow: 18,100

10-year Treasury yield: 2.65%

Gold: $1150

Crude oil (WTI): $52 (this was my target before this latest downdraft and I’m sticking with it—at the moment)

Fed Funds Rate: 0.75%