How to Potentially Enhance Equity Performance in a Climate of Uncertainty

As challenging as the investment landscape has been, we expect it to be even more so going forward. Global growth is slow, and the returns we have seen in recent years have been pulled forward by quantitative easing and the low interest-rate environment. Over the next ten years, returns are likely to be lower across all asset classes than they were during the past ten years.

In that context, we offer three themes investors can potentially utilize to enhance the returns of their equity portfolios. These themes underscore the reasons we believe private equity can be a useful component of investor portfolios in this kind of climate.

To view the article in its entirety, click here.

REITs vs. Your Home

Many people don’t have an investment allocation to real estate investment trusts (“REITs”) because they believe they already have “enough” exposure to “real estate” through ownership of their home. REITs and your home are very different asset classes with very different characteristics. REITs invest primarily in commercial real estate, which is any non-residential property used for commercial profit-making purposes. Your home is an investment in residential real estate, which is a type of property, containing either a single-family or multifamily structure, which is available for occupation and non-business purposes.

Performance

Over the past 20 years publicly-traded REITs have returned an annualized 11.23% total return and homes have returned 3.47%, or just a little more than inflation. Over these 20 years, REITs returned more than 7x (740%) while homes didn’t quite double (98%). Publicly-traded REITs have been one of the top performing asset classes and homes have been one of the worst over the past 20 years.

Fig1_REITs_vs_Homes_08-2016

There are many differences between REITs and your home that contribute to this notable difference in performance. The largest contributor is that commercial real estate can generate positive cash flows but the residential home you live in cannot. By living in your home, you are effectively consuming the market rate rent that your home might have procured. If you forgo rent, as you do by living in your home, the return profile changes to be basically little more than an inflation hedge.  Performance of real estate follows the following formula: Total Return = price change + rent collected

Fig2_TBL-REITvsHome_080116

Diversification

With your home, 100% of the asset is in one property type and in one geographic market – this is concentration in its purist form, the opposite of diversification. On the other hand, with publicly-traded REITs, investors can choose from dozens of property types (including, but not limited to, specialized real estate sectors such as data centers, cell phone towers, casinos, medical research labs, infrastructure, prisons, ski areas, etc.) across any market in the U.S. and most major markets in the world. The opportunity for diversification in publicly-traded REITs vastly exceeds that of a single home.

Liquidity

Homes are relatively illiquid compared to public REITs that can be traded every day the stock market is open and settle to cash virtually immediately. This is in stark contrast to the home market, which may be illiquid for months, seasons, or even years, and can take months to settle to cash.

Transaction Costs

Transacting a home is much more costly than transacting in publicly-traded REITs. When you sell a home, the typical transaction cost is more than 6% of the home’s sale price (for perspective, based on data from the last 20 years as shown in the Total Return chart above, this is equal to about five years’ worth of your home’s price appreciation after inflation). In contrast, it costs little more than pocket change to trade shares of a public REIT ($7.95 per trade at Fidelity[1] and $4.95 per trade at Scottrade[2]).

Flexibility

Home ownership is not flexible. The entry price for a home is typically six-figures and you can’t really buy or sell a percentage of a home – it is binary: either you are in all the way or you are completely out. With publicly-traded REITs you can buy almost any amount you wish in single share increments (typically $20-$50/share) on the stock market. With public REITs you can trim, add or change a position in almost any amount on almost any day.

Supply & Demand

Perhaps the single most impactful factor that undermines home price appreciation is the ability of developers to add new product to the market. In our opinion, homes are the type of real estate most likely to be oversupplied because we believe they are the cheapest, smallest, quickest and least complicated real estate product type to build. AACA also believes that whenever the cost to build new homes is below the current market value of existing homes, builders will build new homes, which could create a price ceiling on the appreciation of your home. Additionally, in recessions, construction costs (materials and labor costs) decrease, which makes building new homes less expensive and creates additional new supply. This combination of factors could dampen your home’s price rebound out of a recession relative to public REITs, as shown in the historical graph below.

Volatility

Let’s look at volatility of publicly-traded REITs and homes. Below is a graph of the past 10 years, which includes the financial crisis. Since public REITs trade on the stock market, the share price of these REITs are subject to fluctuation in the stock market and as such experience volatility. However, we would argue the underlying physical real estate owned by the REITs can’t be much different in volatility than your physical home. The difference is that your home isn’t bought and sold every day and marked to that market price. That being said, in the graph below we see that homes sold off -32.81% and public REITs sold off -58.89% in the financial crisis. However, looking at a longer period of time, homes captured 56% of the downside and 8% of the upside of public REITs over the past 10 years – homes have been asymmetrical to the downside. And public REITs have since gone on to return 105.17% over the past 10 years while homes have returned 8.56% in that same time period.

Fig3_REITs_vs_Homes_08-2016

Final Thoughts

We believe you should think of your home first and foremost as the place you and your family live and second as an inflation hedge for your invested principal – nothing more than that. You should not think of your home as an investment in real estate (as history shows there has been almost no meaningful return after inflation). Publicly-traded REITs and your home are very different asset classes with very different characteristics.

But what if I rent my home out?

But what if I buy a home and rent it out? That would be good, right? Sure, you will grab the warranted rent (assuming you can find a good renter), but you may also be the one grabbing a plunger to fix the toilet on Christmas Eve when your renter calls. Also, you still need a place to live so you will presumably either be buying or renting a home to live in. Additionally, it is probably unlikely that you can rent one house as efficiently as a public REIT that has professional leasing, revenue optimization software, economies of scale, expert experience, market knowledge and real-time industry data. Lastly, if you want to buy a home and rent it out, there are several publicly-traded REITs that do that.

[1] https://www.fidelity.com/trading/commissions-and-margin-rates?s_tnt=76947:8:0

[2] http://welcome.tradeking.com/scottrade-comparison/?engine=google&campaign=ckws+-+scottrade+-+phrase&adgroup=scottrade+-+phrase&network=g&device=c&model=&keyword=scottrade&matchtype=p&position=1t2&adid=112556498471&ADTRK=sgo+ckws+-+scottrade+-+phrase+-+scottrade+-+phrase&gclid=CjwKEAjw5cG8BRDQj_CNh9nwxTUSJAAHdX3fPoZt6xE0DtdNphAY9XH6vkU3v3Kz-Yvhl8TO8_aeGRoCNW_w_wcB

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.

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.

 

 

Employment, China and Other Fed Funds Factors—Redux

September or October or next year

Employment Numbers below Consensus, but…

 The first seasonally-adjusted employment number for August was well below consensus at 173,000, and well below where we would expect the revised numbers to end up for the month. On the positive side, the unemployment rate declined to 5.1%. Hourly wages are up 2.2% versus a year ago and rose 0.3% month-over-month. Average weekly earnings are up 2.49% from a year ago. The mixed news in the weekly earnings numbers was a rise of only 1.89% year-over-year for non-supervisory and production workers. Backing into the number for supervisory and more skilled labor, the weekly earnings increase appears to be closer to 5.5% year-over-year. That would indicate the pressure for more highly skilled workers may be pushing wages up faster among that segment of the labor force—wage inequality at work.

Employment numbers for June and July were revised up as shown in our “geek table”
below of the seasonally-adjusted and not-seasonally-adjusted numbers for this year
and last.

TBL_Blog_OTM Change_Jan14-Aug15_090915

We would expect to see further revisions up for the July and August numbers, but that will come after the September Fed meeting. I do have some concern that the not-seasonally-adjusted number for August is starting out lower than last year, while the seasonally-adjusted number is higher. As I have said before, I have yet to be able to understand the seasonal adjustment factors. That’s one reason why I refer to this as the “geek table.”

The Overall Employment Picture could Support a Rate Move, but…

The employment picture by itself could support a Fed funds rate move in September or certainly October. However, market turmoil, China, the dollar, and the lack of inflation provide an excuse to delay a rate rise. It is our view that if there is no rate rise in September or October, we will likely not see a rate rise until early 2016. While the futures number and pundits put higher odds on a December increase, let’s remember that December is a month of significant rebalancing of cash positions among financial institutions and corporations. The last thing the market needs is another variable such as a change in the Fed funds rate target thrown into the mix. A change in the target rate this month or next would allow some time for the markets to adjust and for the Fed to continue testing its reverse repurchase (RRP) facility as a control mechanism for the effective Fed funds rate. I also think an increase in the fall would be an indication from the Fed that they have confidence the US economy is actually on a decent path of growth. While this would be a disappointment for those looking for support of financial assets away from the fundamentals, in my view it would be the start of a positive path to “normality.” The volatility in the financial markets would likely continue, but against a backdrop of the US, at least, coming out of the abnormalities of the QE period which produced a rising tide for most financial assets. As this tide dissipates, we will begin to see who is actually wearing a bathing suit. We have entered into a period of active management of corporate and financial assets. Accidents will happen on what will still be an accommodative path to “normality,” but this will open up opportunities for those actually paying attention to fundamentals. It will be a slower growth path over the next several years than we have historically seen, with a premium likely for management talent within companies and asset managers—a different mix compared to the last six years or more.

China and Emerging Markets in the News, but…

The wild card in all this would still appear to emanate from what is going on in China; although the emerging markets, Europe, Russia, and the Middle East bear watching. I am pretty solidly in the camp of those who don’t believe there will be a hard landing for China. I think the growth rate is slowing and actually wrote last December that I thought China growth would fall to 5%. I could be low (or not). It is true that the industrial and fixed capital investment side of China is in a major slump. This is the source of the lower demand and oversupply for a variety of the hard commodities as well as oil. That, in part, is caused by the slower growth in the rest of the world, which will continue. China over built and it will take many years for the country to grow into the capacity it has created. Unfortunately, the capacity will likely be less efficient than newer factories and transportation systems available at that time. In the near-term, this has a major impact on a number of China’s emerging markets suppliers who have historically been big exporters to China. However, it continues to look like the services sector—a big employer—in the Chinese economy is continuing to grow. Depending on the source, it appears that at least 50% of the population is employed in the services sector now, up from 35% 10 years ago, with the shift coming from the agricultural sector. China still has 29% of its population employed in agriculture. That compares with 1.2% in the US and similar numbers in other developed economies (the US had 29% of its population employed in the agricultural sector in 1915, 100 years ago). Services accounted for 46% of the Chinese GDP in 2013—it’s probably closer to 50% this year, because it is growing at a fast rate as industry is falling. Industry was 44% in 2013 with agriculture at 10%. By the way, construction, which seems to be a big topic, was only 7% of GDP (a part of the industry number).

TBL_Blog_ChinaSectorBreakdown_YTD083115_091515

 

As indicated, while China itself can weather this shift, the impact on a variety of the emerging markets can be severe—both for those countries exporting raw materials as well as intermediate goods. There will be credit issues, particularly for countries that have taken on USD-denominated debt. Away from the emerging markets, we will see credit issues as well, which open up some interesting opportunities in the illiquid space and the liquid markets. We have seen major dislocations in currencies and relative market performance. The tables below give some sense of year-to-date moves as well as the increased volatility:

TBL_Blog_USDvsFgnCurr+EquityIndexPerf_YTD083115_090915

Volatility and Dispersion to Continue…but…

We expect the volatility and dispersion in performance by markets, sectors, and individual securities to continue against a backdrop of slower global growth. This is regardless of whether the Fed moves this fall. There are significant opportunities being created on the positive and negative side. It requires making some judgments regarding relative risk that may have less to do with recent history and more to do with some decisions about how the financial markets may operate differently in a more disparate idiosyncratic world. We are paying attention to what we believe are the best active, less-correlated managers across the investment spectrum.

Note: Some of what we have discussed can get a bit technical, and, by the time these thoughts are published, the world has moved on. We try to condense our thoughts in regular short videos, and, fortunately, do get an occasional chance to express our views on various media. Viewing or listening to these thoughts is a good shorthand way to get slightly more current views. Here’s an exampleYou can also click on “Updated Video Commentary” for 2- to 3-minute videos of our views.

Our survey shows the role of alternatives in portfolios is likely to increase—But the language needs to change.

We asked Prosek Partners to conduct a survey of a random selection of attendees at our SIC15 held in May. The topic, of course, was the Role of Alternatives in Future Portfolios. 124 of the 649 attendees were asked a series of questions regarding their use of alternatives and some of the issues affecting their decision processes. One has to say that even though this was a random sample of attendees, almost all the attendees were relatively sophisticated institutional and individual investors and advisors, who were there to listen to a variety of observers and analysts of the global markets, economies, and geopolitics. We have commented on some of the observations at the conference, and you will be seeing videos on the Altegris site beginning June 24. These were not novices when it comes to alternative investments. Every attendee interviewed had some participation in alternatives, with different reasons for their use from complements to traditional strategies, substitutes for traditional equity or bond allocations to hedges against volatility.

70% of the advisors, 69% of the private investors and 63% of the institutions expect to have a net increase in their alternative holdings in the second half of 2015. This may reflect the tone of uncertainties expressed by the speakers at the conference regarding where expected market returns may come from and the possible volatility associated with them.  Highest on the list for advisors and private investors are Managed Futures/Global Macro (33%) while institutions put Private Equity (36%) at the top of the list.  Private Equity (25%) and Long/Short Equity (21%) are also high for advisors and private investors while the institutions put Managed futures/Macro (20%) and Long/Short Equity (20%) next on their list. Interestingly, there were also some expected decreases in all categories: Private Equity, Long/Short Equity, Managed Futures/Macro and Alternative Fixed Income with some investors increasing and decreasing the same strategies. I would read into this a fairly active approach to using alternatives in the portfolios with some concerns about the markets in general—in particular, the fixed income markets. This was certainly the anecdotal tone among attendees away from the hard numbers in the survey.

The survey participants were also asked what percent of a portfolio should be in alternatives. 10-25% was the most common range (59%). Interestingly, 15% indicated 25-50% as the range, while 3% indicated the allocation should be above 50%. We have seen certain institutions, endowments in particular, move toward having alternatives as a core of their allocations with more tactical allocations for long only active managers and straight beta plays using ETFs. It is interesting to see suggestions of higher allocations to alternatives coming from advisors and private investors.

Of particular interest to us were a series of questions regarding attributes of importance and concerns in making investments in alternatives. Clarity Regarding Investment Philosophy and Strategy ranked highest (60%) among attributes and second among concerns (24%) with Lack of Education on the Product Offerings (10%) being the third most significant concern. Among concerns, fees (53%, but 80% among Advisors), was the highest. This has been a high concern for the whole time I have been in the industry. And, with some democratization as well as Moore’s Law at work, the universe of strategies that do justify the fees on a net return basis continues to shrink.

Clearly the industry has some work to do explaining the strategies and positioning them appropriately in portfolios. The term “alternatives” may be part of the problem. This is hard for me to say given that it is an integral part of our name. It has come to represent a multitude of strategies within the investment universe and carries with it a tinge of the exotic. Merriam-Webster describes an alternative as: “different from the usual or conventional. Existing or functioning outside the established cultural, social, or economic system.” That makes it a little scary for some—or maybe for most. In truth, most of these alternative strategies are simply investment approaches that carry different degrees of risk, correlation and sometimes, liquidity, within the classic 60/40 stock/bond allocations. Others, such as true managed futures and absolute return strategies, provide uncorrelated return and risk streams to these classic allocations.  The decisions one makes on including such “alternatives” are not too different from deciding how much to allocate between a small-cap growth strategy or large-cap value in equities, or between high yield and investment grade in the bond world. I can remember when a deviation from the center of the classic style boxes was viewed as exotic and “alternative.”  Every strategy carries with it a different risk and return profile, and allocations should adjust according to the specific needs of the investor.  Given an investor’s goals and desired outcomes, it could be that various “alternative” strategies might offer better ways of achieving them. We have a responsibility to add investment clarity to make this a more complete picture as opposed to an exotic one.   The survey provided some surprises, even for us, with some very positive messages given our focus. It also pointed out, even among a sophisticated group of investors, there is work to do. We are Paying Attention.

Employment Numbers Surprise Almost No One; Alter No Fed Expectations, But…

Are we entering a longer growth, but lower return environment?

The Numbers

April employment numbers of 223,000 jobs added dropped the unemployment rate to 5.4%. March numbers were revised lower to 85,000 jobs vs. the 126,000 previously reported. Wages rose quite modestly month-over-month. This report provided a sigh of relief for the bulls on both the stock and the bond markets, reinforcing a view that the Federal Reserve will be in no hurry to raise rates. But, there are some nuances to the report, which we will discuss in the geek session below, that continue to suggest that the labor market is tight, wages will likely rise, and we will see the Funds rate rising this year. The pace will likely be slow. We still need more data.

 

What We are Watching—The Usual Plus China

As we have said before we are watching the employment numbers, wages and commodity prices with a further eye on China. As we indicated in our Perspectives “What to Expect…” pieces we believe the China numbers will prove disappointing as the country continues its transition to a more consumption-driven economy. We received some reinforcement on this view from Michael Pettis at our Altegris Mauldin Economics Strategic Investment Conference (SIC 2015) a week ago Michael believes that China will ultimately see its growth rate fall substantially—possibly to 4% or less as investment as a percent of GDP declines while consumption rises. Whether that number ultimately occurs, the direction and the mix of growth would indicate commodity prices could stay low as this important incremental buyer adds to industrial and infrastructure capacity at a slower rate. I spent some time at the Milken Conference before our SIC 2015 began, focusing on the China presentations to get some other views on the outlook. I heard little suggesting that China would take actions to maintain its growth at the reported 7% level. Instead, China is taking a very strategic long-term view both domestically and internationally. Infrastructure (e.g., Silk Road initiatives) is geared toward the strategic; internal policy initiatives (e.g., corruption, intellectual property, environment, technology, property) are geared toward the strategic. Currency is geared toward the strategic. China will take steps to avoid problems with the banking system—and those are significant–, but the message was China believes it can maintain political stability during a period of declining growth rates. I specifically asked someone (who will remain nameless) if there was any number from China that would change his view on what could happen next. The response: there was no number; low numbers are expected. News that could change his view would relate to political instability, not economic instability, suggesting disagreement between those currently in power pushing change and those who want the status quo. He dismissed that possibility but did bring it up, so it is worth watching. One has to watch through opaque lenses. In addition, to quote Gary Shilling at our SIC, “growth can cover a multitude of sins.” Gary was making that point with Lacy Hunt of Hoisington Investment Management, who was forecasting very slow global growth for decades to come stemming from the debt load the world’s economies are carrying. It certainly applies to China, as the slower growth may expose “sins” of which we are currently unaware.

 

Where Does that Leave Us?

In the short-term, the markets are reacting to every data point that indicates when the Fed may be tightening and at what pace. I believe that the data as we move through the quarter will support a view that the US economy is growing and the labor market is continuing to tighten. The Fed will wait for the data on the quarter, but the markets may not. We do need more data.

I agree with the general tone of the SIC that we are in for an extended period of low growth in the US and globally. The macro risks would appear to be more geopolitical than economic. The ultimate effect is on corporate profitability. With slower top-line growth, a more competitive battle for market share is likely. Specific company results will be more management dependent with a different mix of sectors performing well vs. the QE world we have been living in.

If the market comes to believe that the economic cycle will be slower but extended, multiples could rise above what are now some pretty full levels. If multiples do rise, discounting an apparently more certain future with lower rates, surprisingly, volatility could rise with it. Markets will react more violently in both directions to any news that pushes the longer-term view one way or the other. That volatility will most likely come from the interactions of the US economy with the rest of the world, the impact of that on currency and the ultimate rebalancing of supply and demand in the commodity sector. Although, Peter Diamandis at SIC presented a view of a world of “Abundance” (his book) that was hard to ignore, forecasting a world of oversupply in all factors of production. His presentation also reinforced a focus on technology as a driver of variable returns throughout many industries, including the technology and social media industries themselves. As Moore’s Law continues to march along, or even accelerate, we may see new disruptors disrupting the “old” disruptors. It is possible that includes some of the “old technology” companies surprisingly re-emerging as the “Internet of Things” and “Big Data” become even more important.

Rates will likely rise in the US, but the pace and magnitude may be consistent with a low growth environment with the real rate of interest being close to zero. In that environment one would have to look away from simply investing in the indexes to achieve returns. Active management, risk management, and a true look at the need for immediate liquidity versus long-term capital building should become a more significant part of the search for solutions in a low-return environment.

 

Specific Observations from the Strategic Investment Conference

Thoughts from the SIC that relate to employment and the Fed, included a view from Dave Rosenberg, echoed by others with some variations, that we were in for a very long but low growth cycle with a recession several years away.

Jim Bianco expressed the view that the Fed is most interested in financial market stability and is unlikely to raise rates until the Fed dots (the governors’ forecasts of the Funds rate) and the financial futures were closer together. The financial markets clearly are reflecting a slower pace for Funds rates rising than the dots from the Fed governors. On the other hand, former Fed governor Larry Meyer, who should know, said to Pay Attention to the governors’ forecasts of timing and degree. The markets will have to react. Chairperson Yellen’s recent comments about the markets would tend to support that observation. Jeff Gundlach said he would expect the Fed to allow the two key variables, employment and inflation, to run “hot,” above the targets for some time before raising rates. A view he has expressed in other fora subsequently.

The above comments specifically related to employment, the US economy and the Fed. There were many more observations from the various speakers at the SIC on a variety of global topics. You will be seeing those in videos we will be posting from many of the presenters as well as additional blog posts.

 

And Now for the Geek View on Employment

The actual employment rate fell from 5.4650% to 5.4427%. Rounding gets one from 5.5% to 5.4%. 14,000 more unemployed would have kept the number at 5.5%. One modest revision could get us there. To get to 5.3% from where we are would take a significantly larger change in the numbers. It might take us several months to see that. We may find ourselves “stuck” at 5.4% for some time even if the employment rolls increase by 200,000 or more for the next several months. The pundits will have a field day.

However, there are some strange things going on. I have commented previously that we are dealing with seasonally adjusted numbers. As the table below shows, we actually employed 1,178,000 more individuals in April. That ended up being 223,000 seasonally adjusted persons. Last year the actual employment increase of 1,152,000 people on the first go-round was seasonally adjusted to 288,000. The seasonal adjustment factors for 2015 have changed and could produce surprising numbers to the upside as we move through the year.

TBL_Blog_OTM-Change_Jan14-Apr15_050814v2

The unemployment rates (RU) broken down by demographics do say something about tightness in the labor markets. For example, the RU for those 25 and older is at 4.5%. Those with less than a high school education in that age group are at 8.6% while those with a college degree or more are at 2.7%. 16-19 yr. olds have a 17.1% RU. The black community is at 9.6% vs. whites at 4.7%. As I have said before, using Fed policy to deal with issues around education and training is not the most efficient and economically sensible approach to these structural and social problems.

I pay more attention to wages as an indication of the degree of tightness in the labor markets. The wage gains, while modest, are rising. Hourly earnings are up 1.85% from a year ago, and the index of weekly payrolls is up 4.7%. This is in spite of the declines related to the extraction (logging and mining) industries.  For logging and mining, hourly earnings are down about 1% from a year ago to $26.26 per hour (third highest vs. utilities at $34.01 and Information Services at 28.69). Weekly earnings are down 2.9% to $1213/week vs. a $704 average overall. Logging and mining still has the highest weekly hours worked: 46.2/week vs. 33.7/week overall. These results do support our view that the labor markets, away from energy, are tightening enough to produce an increase in wage growth, which ultimately works its way into the profit picture—particularly in a slow growth environment.

The real message, though, is take all these numbers with several grains of salt. There is always more to dissect in the labor market. I can’t wait for the next JOLTS report…