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.