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.

Markets are Macro Right Now, but the Details Don’t Support Those Bets

Just a few observations:

Volatility

I was waiting for the numbers this morning. As one can see, the US consumer seems to be doing just fine. They are actually buying real goods and services, taking advantage of increased income, transportation costs are down, and there is a generally okay outlook.

I think we are seeing some major macro bets being made and pressed, which is pushing up volatility. The big macro bet seems to be that we are heading toward a global recession. I just don’t see it at this stage. We are clearly in a global industrial recession already with oversupply relative to demand and an inability or unwillingness of countries to spend on infrastructure as an offset to the lack of corporate expansion. But this is in a global economy that is more and more services oriented of which the US is a poster child and China is on an accelerating path in that direction. China may also be one of the few countries that has a major infrastructure initiative around the Silk Road.

In addition, as I have said before, given the low prices of oil and other commodities, I believe we are seeing liquidations of sovereign wealth portfolios from those countries dependent on revenues from these commodities, in order to meet fiscal budgets. Oil prices at these levels are not a company problem away from the oil patch, but they are a country problem, which will add to volatility globally.  The volatility is actually opening up some very interesting investment opportunities for those investment managers who actually look at individual companies on both the credit side and the equity side. When we get into these slow growth, but volatile periods, we begin seeing real dispersion. Look at last year: 250 of the S&P 500 stocks up on average 18% and 254 down on average 17%. I suspect we will see the same this year and for many years to come as we work our way out of the overcapacity on the industrial side and the heavy debt burden that has been accrued during this low interest rate environment. WE have started off this year with less dispersion. Anytime you see the market move up or down in double digits you do get less dispersion, although it doesn’t totally disappear. There are close to 100 stocks up this year—even 25% of the energy stocks.  It’s a different environment and we are somewhat captive to a very heavy bet being made that the world is collapsing. I don’t think that is the case.

 

China

This is a very thin market and therefore, should show greater volatility than broader markets. The Chinese have tried to manage the market similar to the Limit Up/Limit Down rules that we have on our markets, but theirs is much smaller and can expect to see high volatility given the lack of transparency. I think the Chinese stock market is a side show; what is actually going on in their economy is not. China is on a path to slower growth. The mechanics are complex, but the objective is achieving a high enough level of employment against a decline in the savings rate, which by itself, should be a stimulant for growth. The rest of the world, which has been dependent on this high rate of growth, will have to adjust. That is what we are going through now globally. This is complex and my level of knowledge (frankly, most people’s level of knowledge) is very superficial. It is an important driver for the global economy, but folks cannot count on it being the super driver and it is not the only one.

 

A Side Comment

I don’t quite get Janet Yellen’s remarks regarding the “surprise” low oil prices and how low negative rates have gotten in Europe. I also do not understand her giving any weight to the possibility of the US moving to negative rates. This is not good for the markets. We are in a slow growth environment that could go on for a long time, and without much fiscal help, the Fed has managed to get the employment numbers back up to a decent level. We need to get into the spring to really see how the numbers look given the bizarre seasonal adjustments that take place in December and January. I am looking forward to the spring. It might take a little longer for us to understand exactly where we are, but I don’t see us in a bad spot. I think the second half of the year could be very different from the first half if we can get the macro bets under control. We just have to Pay Attention.

 

 

Not Quite Impotent, but a World Away from Omnipotent

In this blog, Bob says let’s not blame all today’s problems on the US Fed (although some find that tempting). We are in a complex, idiosyncratic, interlinked world. This supports Bob’s view that we have to look at the pieces. Of course, China is a big one.—Jack Rivkin

 

Not Quite Impotent, but a World Away from Omnipotent by Bob Barbera

Suppose the world’s economic policy makers ceded authority to a central entity, in recognition of the fact that national economic prospects, increasingly, are largely influenced by global developments. What would a Keynesian benevolent despot do, if she had control of all nations’ economic policy levers?

She would embrace the notion that the world suffered from an insufficiency of demand. She would acknowledge that three striking imbalances are in place, one international, one financial and one within most nations. She would impose policy changes meant to resuscitate global demand and unwind global imbalances.

She would acknowledge the obvious and point out that in the aftermath of the Great Recession, global recovery has been strikingly sluggish. Only China and the United States registered meaningful recoveries. China embarked upon a state government financed real estate boom, which temporarily lifted its economy and other emerging economies. When this stimulus ended, so did recovery for China and the rest of the developing world. The USA embraced fiscal stimulus, early on, but reversed course soon. Aggressive monetary policy stimulus, did deliver modest expansion through 2015. Europe has failed to deliver any meaningful recovery.

Equally obvious, she would note, China and Germany run large and destabilizing trade surpluses. The USA and Europe are saddled with large and still deteriorating trade deficits. So, too, is it obvious that monetary policy, alone has limited ability to right the global ship, in a world where the most common short term interest rate is ZERO. Financial system excesses are a genuine risk, when central banks are forced to deliver ever more liquidity into asset markets, in their attempts to lift real economic activity.

Finally, she would lament the violent shift toward income inequality, noting that the super-wealthy spend very little of their income, worsening demand deficiency, even if one ignores any notion of equitable outcomes.

She would declare, therefore, that policies would need to do the following:

  1. Jump start global demand.
  2. Reduce global trade imbalances.
  3. Relieve pressures on central banks.
  4. Reverse income inequality pressures.

She would declare China and Germany as the new places to look for demand stimulus. Major tax cuts would be enacted in both nations. Tax cuts would be super progressive.

Large tax adjustments would be made globally, so as to shift after tax incomes toward low and middle income earners. She would slowly remove developed world monetary policy stimulus. This would occur, however, only after clear evidence of strong global growth and a return to inflation rates above 2% in developed world economies.

Alas, our savior is a fiction. Nations have no intention of ceding control of their policy levers. Any one nation, therefore, pursues a policy that is focused solely on its nation, while accounting for global influences on its nation, arriving in part a consequence of policy moves taken by other nations.

Worse still, policy makers in many nations are likely operating with many self-imposed constraints. Fiscal stimulus? Tax changes to modify income inequality? In most nations the only game in town is monetary policy. That is, of course, excluding European nations. European nations don’t even have an empowered central bank that they can alone control.

It is in this spirit that one has to feel genuine empathy for Janet Yellen. Monetary policy in the USA has delivered modest recovery. And after over seven years of zero interest rates, USA central bankers, recalling the financial bubbles that precipitated the last several recessions, decided they might try to slowly wean markets away from full throttle liquidity provision. But increasingly it appears that China’s efforts to create a new growth engine have failed and the rest of the developing world is contracting as a consequence. In Europe, Germany steadfastly refuses to pursue any sort of pro-growth policies. As a consequence, the U.S. dollar has resumed its ascent. Thus the USA faces both faltering rest-of-world demand and rising dollar rising [sic]. As a consequence the mismatch between USA spending gains and output gains is destined to worsen. Likewise, despite low U.S. unemployment, inflation looks set to fall in the quarters ahead, not rise.

Should Yellen reverse course, end the plans to tighten and hint at a potential reversal for short rates? That may be in cards. But is it the issue of the hour? More to the point, did a 25 basis point move up for short rates in the USA doom China’s economy? Did a promise of perhaps four tightening moves in the USA over the next year shut down European growth? In sum, is the Fed the precipitator of emerging evidence of a global reversal of fortunes? If Chair Yellen were our global Keynesian benevolent despot, and global barometers were heading south, we could confidently say yes. Given her complete inability to adjust the many policy levers around the globe that are wrongly positioned, how can you lay today’s madness at her feet?