In the interests of timeliness and recognizing the upcoming holiday weekend, we are providing an abridged Market Update to address the immediate market movements.
June 24th almost looked like it would be the day of reckoning that the market bears have been waiting for. Markets had been relatively calm for the entire quarter, with domestic equity prices creeping slowly toward all-time highs. Combined with minimal volatility, there was a steady information flow with few surprises. That all came to an abrupt halt last week when the U.K. voted to leave the E.U. While polls started to show Leave gaining favor in the preceding week, the vote still took the markets by surprise. Despite polling, money managers, infamously accurate betting houses and Leave voters themselves all expected undecided voters to veer towards the status quo and avoid the catastrophic ramifications of an exit from the E.U.
If you dig into the voting patterns, you see a story that is deeply troubling for the U.K. Scotland voted overwhelmingly to stay, as did Northern Ireland by a smaller margin. Both regions are now weighing their options to leave the U.K. Within England and Wales, voting diverged across age demographics. Over 80% of those over 55 voted and most did so in favor of leaving. Meanwhile, 64% of the 18-24 age group did NOT vote, despite having the most to lose from an exit.
Since the vote, the leadership has been thrust into chaos as Prime Minister David Cameron announced his resignation and the Leave campaign unable to assemble to carry out the transition they initiated. Combine the deep divisions across British society with a rudderless political structure and you have a recipe for a decade of economic stagnation and social upheaval. Meanwhile, the E.U. still faces income inequality, immigration, and an aging population. If it were ever a time to look elsewhere for a engine of global economic growth, now is that time.
Figures for the U.S. are encouraging – employment figures continue to improve ever so slightly, there is nominal GDP growth and housing prices progress upward. However, we still have not seen a clear path to further economic expansion that would counterbalance the issues in Europe. The movement up in U.S. equities reflect sentiment that the U.S. will continue to decouple from global issues, a belief that we do not hold. U.S. companies are closely intertwined with international markets and will never be fully insulated from volatility in China or political changes in Europe.
This can be seen in the bond market, which has had a remarkable year. Annualized returns in the various bond sectors are all in the double digits (or roughly 5-9% gains for year-to-date). Some of these gains are misleading, as the energy fixed income sector is simply recovering from a beating late last year. Still, the U.S. dollar is the safe haven currency and U.S. debt is the “safe” risk asset for now. The Fed has supported this notion by keeping rates low. With just one rate hike this year, and no more expected for 2016, we will continue to have a regimen of cheap money.
None of this should be viewed without looking into the social and political dysfunctions we face here in the U.S. The factors around the Brexit vote have stunning similarities to those of the U.S. presidential race. You have a deeply divided conservative party, an immigration debate exuding racial hatred, and a discourse full of factual liberties and lies. In a possible foreshadowing, since the morning after the vote, Leave campaigners have retracted promises, seen European leaders publicly reject their characterization of post-Brexit relations, and scrambled over who will become the next prime minister. And in the meantime, the pound fell to a 31-year low and has not recovered.
While there are many commonalities across trade, subsidies and immigration, the core issue here is vast income inequality that is either ignored or institutionalized. Until there is a solid dialog and commitment from politicians to meaningfully address this problem, it will only get worse in the coming years. We have seen many insightful and thoughtful analyses of this issue, and will start to share some of these on the Vodia blog.
While we did not foresee the Brexit result, we have been defensive in our portfolio construction for the year. It is grounded in a fundamental view that drivers of growth are limited while drivers of volatility are abundant. Equities are about two-thirds of their long-term target levels, or lower in some instances, with a continued mix of healthcare, industrials, technology and pure dividend stocks. The corollary is that we have a heavier balance towards fixed income – both corporate ladders and actively traded structured notes – which continue to beat their respective benchmarks and provide stable portfolio growth. We are also holding a high cash and cash equivalents position – 15% on average. This enables us to buy on excessive market volatility.
This mix has worked well for the year, but we recognize that there will be continued volatility in the markets until there is more clarity on the U.S. election and global economic conditions. Below are the charts that are most relevant to this discussion, while the Live Market Update will provide clients with a deeper analysis of the markets.
All the best for an enjoyable and stress-free summer.
“The world is a dangerous place to live; not because of the people who are evil, but because of the people who don’t do anything about it.”
— Albert Einstein
It is difficult to ignore the language of hate, violence, and prejudice that has become the focal point of our political discourse, taking the place of democratic values, civil liberties, and American idealism. This rapid devolution has its roots in many sources, but perhaps most importantly, it is the byproduct of a financial dynamic taking place in our economy.
The economic fundamentals of the past decade have created stark inequalities. Nine million jobs were lost during the sub-prime blow-up and the subsequent recession. Trillions were swiped from retirement accounts and lifetime savings, but the bankers who caused the debacle walked away with bonuses intact. Only one person went to jail for a fraud that spanned years and billions in ill-gotten gains [see footnote 1]. This is all reported alongside stories of Asian wealth invading our real estate market and the unimaginable opulence of the top 0.01%. These stories linger even as our memories of the crises have faded.
Many of the people who lost their stability as a result of these crises now find themselves supporting a candidate who calls core democratic values into question. The current state of anger among many social conservatives is exacerbated by fear-mongering in the media and amongst political candidates. The Republican party is now scrambling to convince their electorate that they should vote “responsibly,” but the damage of their rhetoric for the past twenty years may be irreversible.
These undercurrents show themselves in myriad ways. The economic recovery since the great recession has been asymmetrical — markets regained their value while wages remained stagnant. As the “labor force” has regained full employment, a wide swath of the population has remained shut out from the labor force. And this is a pattern that has repeated itself on multiple occasions – the financial markets create havoc on middle class savings while those with significant wealth can avoid any real impact to their quality of life.
Unfortunately this dynamic is building again. The past five years have seen a dramatic recovery in equity values at the expense of reliable, predictable investment income (witness CD rates below 1%). That recovery is now on tenuous footing, with significant holes in the global economy. As we examine the first quarter of the year, the stresses again are building towards that next cycle of financial distress.
The start of 2016 was a challenge. The year opened with a massive purge in the equity markets that was the worst start to a year in a century. In the first six weeks, the S&P fell -10.3%, but then regained all of its losses in just a few weeks — no news, and little change in the economic fundamentals.
While we focus on fundamental analysis in our investment strategies, a brief dip into technical trading is helpful here. Technical trading aims to use statistical analysis to tap into the psychology of the market and identify trading patterns, rather than looking at the fundamentals of the asset. The charts on the S&P 500 shows a very concerning technical pattern: lower lows and lower highs. Put another way, if market movement is broken into blocks of several days or weeks, then each block is actually trading flat or lower and has been since May 2015. That trend – a “roll over” in the market – points to further volatility ahead, and volatility always leads to lower market prices.
The causes of this equity behavior are multifaceted. In our January 2016 Market Update, we discussed one such factor: the correlation between the market growth since 2008 and the three Quantitative Easing programs by the Fed. Another factor has been stock buy-backs and dividend increases, largely funded by debt issued at historically low rates. This flow of money from both governments and corporations was necessary to offset the net outflows of equity mutual funds. The charts below document this trend: each year since 2009, fund managers have pulled money from equities, and yet the S&P went through a prolonged period of growth due to QE and burgeoning stock buybacks. It is not a perfect correlation — trading by US fund managers doesn’t make up the entire story of the S&P, but the underlying dynamic is powerful.
It is not clear how much longer this dynamic will continue since QE has officially ended and rates have remained stubbornly low. The corollary to this trend has been the bond market, which roared ahead during this period. A large portion of the new debt issued during this period went to companies in the energy sector, from oil exploration to pipelines and coal. Yet with energy prices going through a massive collapse, those firms are struggling to turn a profit, much less service their debt. As a result, a wave of defaults are about to hit this summer and fall. Already the first two situations have surfaced: Chesapeake Energy just pledged all of their assets to keep an existing credit line open, and Peabody Energy declared Chapter 11 bankruptcy. Both firms will continue to operate, but this is going to be a harsh wake-up call for bond investors.
In summary, the financial markets are in a period of transition, and the downside for both stocks and bonds is more concerning than the upside. A simple fundamental measure is price-to-earnings ratio on the overall stock market. Currently, the S&P 500 companies are expected to have combined earnings per share of $125. Using a historical multiplier on that figure for stable market conditions of 15x, that gives us an SPX level of 1,875. As of this writing, the SPX is over 2,000. To go higher, corporate earnings need to grow beyond expectations, or markets need to accept higher multiples. Neither of those events will happen without some form of basic change to the economic story.
The dashboard below gives a good overall summary of what we are seeing at play in the economy today. Keep in mind that there are hundreds of factors to track in the economy, and the importance of any one factor is heavily dependent on the underlying economic model.
While we have seen some nominal improvement in a couple of economic indicators, overall the conditions are mixed, with continued erosion on certain social factors. The housing market is going to be critical for the U.S. economy to move forward with any conviction, and while those numbers are still trending well, we are at levels that are well below the peak a decade ago. GDP growth also continues to give us mixed messages, with continued expansion in the U.S., but at a level that cannot withstand a shock (2% annual GDP growth). Meanwhile, China’s slowing growth takes away a large piece of anticipated future demand.
The part of the picture that is most instructive is the labor market. With all the hype around the low unemployment rate, we continue to remind folks that their are still segments of the population that have yet to return to the labor force. Although we sustained a 63% employment ratio through the last economic expansion, we have only been able to attain 59.8% as a maximum since then. That level is on par with the 1970s, when most families were single wage earners and women were discouraged from participating in the workforce.
The second leg of this labor issue is the rise of the “Gig economy” – alternative work arrangements that lack basic employee benefits and can be terminated as needed. Based on a recent study by Katz and Krueger, the Gig economy has gone from less than 10% of the labor force to nearly 16% over a twenty-year span [see footnote 2]. The inferences are significant. First, the vast majority of our workforce net gains are in temporary labor arrangements pointing to the eroding circumstances of the labor force. Second, this is a trend that started before the Great Recession, indicating a longer term downwards trend in jobs stability.
The trend can also be seen in average wage rates, as the middle-class worker has barely seen a wage increase in almost 20 years. This paralysis erodes quality of life, as core living costs continue to rise dramatically, namely education and healthcare. With the middle class largely unable to afford college, student debt loads have rocketed to $1.3 trillion, and many families face bankruptcy or inability to access treatment given healthcare costs.
The underlying economic fundamentals in the U.S. are deeply skewed. There is no doubt that the top wage earners continue to do well, and those with investment assets continue to see their wealth increase. Yet those factors benefit just a limited percent of the population. The remaining picture is one of job uncertainty and financial instability. The bigger problem, however, is that backlash is being funneled into highly destructive political notions that threaten to tear at the fabric of our country. Without a clear way to address these fundamental issues, the economic situation will continue to get worse.
Globally, the picture continues to bring uncertainty and the commodity picture is going to continue to cloud the markets for the next few quarters. Instead of helping the economy by boosting consumer spending, low oil prices are driving firms out of business, causing the supply to shrink in the U.S. and overseas. Even Norway is having a difficult time justifying the capital expenditures to keep their national output at current levels in the near future. With the U.S. production shrinking by nearly 1 million barrels per day by the end of this year, oil prices will quickly self-correct. Meanwhile, the politics of oil continue to play out in the Middle East as Saudi Arabia and Iran engage in their power struggle. (I took out that last sentence because it sounded like a prediction that could be wrong)
Considering limited global resources, climate change and broader social issues exacerbated by the financial markets, there is a distinct need to re-configure the global economy. Today, the economy is based on consumption — U.S. consumption levels peaked at 75% of GDP, and China has explicitly used the U.S. model as a way to grow their economy and global power. This is not sustainable as the numbers get into the tens of trillions of dollars and the political structures start to favor the few at the top of the consumer chain.
Until those matters are addressed, however, we will continue to see wild gyrations and emerging asset bubbles. Those gyrations are expressed today in equity volatility, and will migrate to other assets classes. Our approach at Vodia continues to be one of holding onto fewer stocks and more bonds that are insensitive to changes in interest rates. A larger cash position allows for us to maneuver around that volatility.
The remainder of this year will see this dynamic continue to play out. There will be periods of calm, but market volatility will surely blossom again. Once the capitulation is complete, a haze of relief will drive prices back to prior values to again start the cycle.
We will continue to view the core strength of our portfolios as being the bond structures we have developed along with alternative strategies that we can deploy as appropriate. Any heavy reliance on equities for growth in the coming year (or years) is fraught with the risks outlined and limited upside. And until the presidential race is resolved in the U.S., markets will be highly anxious.
So while it is imperative that we focus on social challenges through the lens of economic and environmental instabilities, we will continue to observe and plan our move to a more aggressive positioning in the portfolios.
All the best for a beautiful spring.
David B. Matias
 The banker was Kareem Serageldin, who was sentenced to 30 months in jail for the concealment of hundreds of million in losses in mortgage-backed securities at Credit Suisse.
 See Lawrence F. Katz and Alan B. Krueger, “The Rise and Nature of Alternative Work Arrangements in the US, 1995-2015.”
I usually like to use the Market Update to offer you reflections on events of the past quarter and observations of underlying trends looking forward. Unfortunately, the disappointment of 2015 and the disastrous start to 2016 defy most sound analyses. Namely, the first two weeks of 2016 gave us the worst opening to a year since 1929, and it is a fact that will cloud every analysis that you read, including this one.
The phrase that perhaps best describes the past year is “paradigm shift.” While the years 2010-2014 were characterized by massive monetary stimulus (an unprecedented $4.5 trillion of new money in the form of quantitative easing, augmented by a zero-interest rate policy), the removal of that stimulus has left us with a volatile, rocky market that is dealing with some unanticipated side effects. Recall that the Fed has purchased tens of billions of dollars of various debt instruments from banks over the past seven years, creating new money in the financial system in the form of Fed credits to these institutions. From the end of Quantitative Easing 3 (QE3) in October of 2014, volatility has spiked and U.S. equity returns have been flat or down. The global markets have fared far worse, as you’ll see from the charts that follow.
Financially, economically, and socially, we have never seen conditions such as these. Keep in mind that the Great Recession of 2008 exposed gaping holes in our economic foundation, bringing the global economy, as well as the financial markets as we knew them, to a halt. Certain things we held sacred — the safety of U.S. Government debt, the security of money market funds, the fundamental solvency of the banking system — were all destroyed. The U.S. Federal Reserve stepped into this void and, for seven years, pumped trillions into the economy to keep it growing. Now that the pump has been closed, we are in a new period of transition and the economy is struggling to find its footing.
The negative trend that began in the third quarter of 2015 continued through the end of the year and into the first weeks of this year. Domestic equities showed little progress: major indices were down, and dividend yields pushed them slightly positive. International equities were a veritable disaster: developed markets showed small losses while emerging markets blew through all sorts of support levels. The poster child for this was China, which witnessed a mercurial rise followed by a full collapse, followed by a second collapse this past week.
Bonds didn’t do much better. U.S. Treasuries, usually the safest bet, were able to generate a small gain of 1.3%, but didn’t manage to beat inflation. Any bond with some sort of risk associated with it, even small, showed some losses for the year. The biggest story in the bond market was the non-investment grade or ‘junk’ sector. After years of steady gains based on interest income and tightening corporate spreads, the decline in oil and other commodities caused a dramatic reversal. Company defaults for energy firms will rise in 2016 – it remains to be seen how far that will spread to other bond sectors.
In contrast, the tech and healthcare sectors performed above the norm. Amazon, Netflix, Google and Facebook showed growing profits despite significant skepticism from prior quarters. The big name in tech — Apple — wasn’t so fortunate. As one of the largest companies in the world, it is simply impossible to sustain the level of growth it has shown over the past few years. Despite their record-breaking profitability, this dampening of expected growth is beginning to impact its stock price.
The interesting movements mostly happened in healthcare. With the cost of debt virtually zero, and with slowing growth of top-line revenues, there were some amazing mergers that drove strong market returns. An interesting anecdote is Allergan; it announced in July of 2015 that it would sell its generics business to Teva, then later in the year, announced a “merger” with Pfizer with serious expected synergies and tax benefits. If you were an investor in Allergan, you would have seen swings of 25% during the year, with impressive gains along the way if you timed it correctly.
The biggest disruption in the markets continues to be China, where signs of trouble cause serious reverberations through the S&P 500 and the energy markets. The logic driving this is deceptively simple: if China slows down, we lose the growth equivalent of the European Union (as discussed in the October Market Update). But the reality is far less straightforward. China’s total market capitalization is $5.57 trillion, and volatility is driven almost exclusively by failed regulation and the dominance of domestic retail investors.
The link between these factors and U.S. equity markets is most likely a familiar theme: financialization, which drives short-term market dynamics away from fundamental values. We have seen it with gold, oil, the Swiss Franc, and a host of other assets that have been whipsawed by trading momentum. Once an asset or company gets into the trading spotlight, there is a pile-on effect that wildly drives the price, usually down.
Timing will continue to be important given these factors, particularly until there is greater clarity about the direction of the economy and the Fed. While we prefer to focus on fundamentals and long-term holds, our style of active trading is the only one that generated notable gains in the past year, and it is likely the same for this one.
The Fed rate increase has been a dominant news item for the entire year. The year started with the expectation that the Fed would increase rates pretty early on, which was followed by delays and ultimately doubts over whether it would happen at all. While the impact of the actual rate increase of 0.25% is negligible, the information communicated has a huge impact on the perception of the economy.
In theory, the Fed assembles the country’s smartest minds to analyze the most timely and complete data on the economy available. If they see that we need a tighter policy, it implies strong economic expansion ahead. If they lower rates, it implies weak growth. How the market interprets Fed announcements has become a bit of a sport, with players and spectators wringing meaning from every move of the Fed.
Currently, the Fed’s plans to continue policy firming signals expectations of steady growth in the coming years. The dot-chart below shows the range of expectations of Fed participants on direction and pace. Unfortunately, the market has a different view. And as one trader recently joked with me, “[T]he Fed has accurately predicted eleven of the past zero economic recoveries.” The timing of its predictions have been consistently wrong, and we have yet to see success following a low inflation, low growth mode.
This leads us to share in the concern that the Fed could have it wrong again. Given the market action of the past few weeks and legitimate concerns over global growth, any moderate Fed tightening could risk pushing the economy into a recession. With no room to lower rates, we would be looking instead at somewhat draconian measures to stimulate the economy. Fiscal stimulus, for example, has been conspicuously absent in this recovery. Given current government debt levels and the political environment, increasing deficit spending is largely untenable. So in sum, a recovery is far from certain and there are few options to rely on in the case of another slowdown.
While concerns focus mainly overseas, the domestic figures we track — housing and employment — remain pretty stable. Jobs continue to grow at a steady clip: nearly 300,000 new jobs in December. It is important to note, however, that the overall employment ratio remains at historic lows. Most who lost their jobs in 2008/9 have yet to be re-hired into comparable positions. Millennials, on the other hand, have yet to achieve full-time employment at typical levels and are inhibited by $11 trillion in student debt, which has grown at 12% a year for the past 10 years. Given these nuances, job gains are far from enough to further economic expansion.
The housing picture is similar. Although there is relative stability and some growth, a large impediment here will be mortgages. With rates increasing, banks unwilling to lend in less-than-perfect situations, and regulation shooting up, further increases in the housing market will have to come from fundamental demand as opposed to increased leverage. Growth in the sector is critical to pushing forward the U.S. economy, with labor and raw materials heavily dependent on this dynamic.
So while the recovery is uncertain, there is enough strength in key sectors to believe we will avoid recession. There are dangers that continue — the strong dollar is a headwind for exports and the housing market might stall out — but the fundamentals are still sound. The major exception is the dynamic in the energy market, a major employer in this country and consumer of capital expenditures.
The factors that lead to sub-$30/barrel crude are myriad, but the most salient pieces of information are the lack of reliable data and complex political dynamics. As we have seen across asset classes since 2008, an asset can be destroyed by traders the second that cracks form, irrespective of fundamentals. A good example is gold, which rocketed up in 2011 to later collapse in 2013 over just a two-day trading period, and it has not recovered since.
We have seen a similar action on oil since mid-2014 when OPEC ceased defending the price just at the time that U.S. shale producers were ramping up to historic highs. Political dynamics play an enormous role in oil: from Libya to Venezuela, there are a range of governments — some more dysfunctional than others — that rely almost entirely on oil revenues, without which the leaders would struggle for legitimacy. The result is an irrational supply dynamic with each actor producing as much as possible to make up for lower prices, driving the oil to nearly worthless values.
A second storyline has emerged that places the focus on the hostility between the Saudis and Iran. Consider the fact that the price of oil is this low at exactly the moment that the Iranians plan to start new exports. While the two countries are partners in OPEC, they are regional enemies representing the competing Muslim sects and fighting their wars through proxies. Iran supports various terrorist organizations and Saudi Arabia unapologetically represses Shia rights and existence internally. It is possible that the oil market has become the Saudi’s latest proxy in ‘containing’ Iran’s influence in the region, despite its impact across the rest of oil producers and their own economy.
At this point, most every major oil producer is producing at or near maximum capacity. The only exception is Iran, which intends to increase exports starting this month but is unlikely to get to pre-sanction levels for years given the nature of their oil fields and their decline in productivity with disuse. Iran has already announced a need for $30 billion in capital expenditures by foreign corporations to restart their fields. In hard numbers, OPEC currently produces 32.6 million barrels per day (mmbd). While the U.S. production peaked at 9.3 mmbd in Q2 of 2015, that figure is starting to decline and has already lost 0.2 mmbd since then. Given the shutdown of two-thirds of the drilling rigs in the U.S. in 2015, that decline will continue for many quarters, even with the relative ease of drilling for shale.
On the demand side, cheap oil and gasoline does only one thing: increase usage. Cornerstone estimates that global demand moved up by 5.0 mmbd since 2014, to 97.0 mmbd, and shows signs of steady increases on an annualized basis. Even demand from China, with their supposed slow-down, increased 2.7% through 2015. With the supply figures stagnant at best, and demand increasing, we will soon flip to net shortages. The problem is that most oil statistics are generated by econometric models, rather than actual measurements. As a result, the data is subject to changing market conditions, taking months and sometimes years to get accurate measures.
We will also see changes in inventories, which reached historic highs in 2015 and are now seeing slow but accelerating declines. The challenge going forward is not low oil, but the shock that is building as all these dynamics develop into unmovable trends. About forty companies in North America have gone into bankruptcy protection because of the fall in prices, and investment by the survivors has come to a virtual halt. It takes years to develop new reserves, far slower than what will be needed to meet the expanding demand for oil. While there are many steps between here and an energy-induced recession, the price becomes disconnected from the fundamentals when one barrel of oil is traded 26 times in one day, as it is now. In short, we are “priming the pump” for a nasty whiplash in oil prices that could create an entirely new set of dynamics in the years ahead.
COP21 and the Climate Agreement
Ironically, the major highlight to 2015 is the complete antithesis to the oil situation. While oil producers have created a situation in which oil consumption will reach historic highs, 195 nations agreed to find ways to reduce carbon emissions to avoid global warming beyond 1.5ºC. While this limit is unlikely to be enough to prevent dramatic change to the environment, it is projected to be enough to allow the planet to be habitable beyond the next century.
The dynamics here are complex and difficult. It took over 20 years to reach this consensus, during which time most of the damage is already done and not reversible. Getting all the countries to agree was a herculean effort, but the compromise is that this is not binding and not funded. It is also unclear what each country needs to do to get there.
But despite the shortfalls, the ramifications will impact the economy and the markets for decades. The changes today are nascent: solar and wind companies have started to grow in market cap and are investable sectors, but they have yet to generate the sorts of returns one would expect from disruptive technologies. Energy has dominated the equity and debt markets for decades, as one of the core growth drivers and income producers. Going forward, as we shift away from a carbon-based energy infrastructure, those market fundamentals will have to find a new home, presenting significant challenges to asset managers. At the same time, the opportunities that open up will be enormous.
Despite the bottoming out of oil, coal and natural gas, renewables saw more money invested and capacity added in 2015 then ever before. And of all champions of renewables to emerge, China spent a record $111 billion on clean energy infrastructure in 2015. But an unintended consequence of this investment is that it has wiped out profitability. Take the solar industry as an example: back in 2008, First Solar soared in value to $300/share on the prospect of panels on every home and building. But after the Chinese entered the market in the way that a rhino enters a swimming pool, the profitability of that industry disappeared. With the help of extensive government subsidies, Chinese manufacturers reached massive scale driving down global prices on panels. Now First Solar trades at $60/share.
How this all impacts the investing community is still unclear. But given the burst of new capacity, it is global agreements such as COP21 that will foster increases in demand necessary to restore profitability. In time, investment opportunities will become clearer, whether it is direct manufacture of alternative energy components, delivery systems or enabling technology to improve existing systems. All companies need to adopt sustainable business models that balance the needs of environmental stability with those of society. Without that balance, revenues will be challenged and profits will diminish. Businesses able to strike the balance will not just survive, but thrive, in the next economy.
We are in the most difficult period since 2008, and it is not clear when the next recession will hit this country, or if we are insulated from the next global slowdown. But despite the emotional anxiety of the markets, the fundamentals in the U.S. are still strong. What we haven’t experienced in a long time is a domestic market devoid of government stimulus.
Adding to the anxiety and uncertainty is this backwards dynamic of plummeting energy prices at a time when the global community acknowledges that our energy infrastructure needs to be radically different in the future. With this layered on top of a growing global population, it is no wonder that the markets are unclear. The world is changing dramatically, and that can be frightening.
We will continue to invest in this market with some risk assets (such as equities), but will continue to be very selective about these areas. The balance needs lean towards predictable, stable investments, which are plentiful yet only marginally better than cash in some instances. The resulting mix emphasizes that returns will be muted in this period of transition, until there is greater clarity on the sources and sustainability of economic growth.
We are staying patient, and expect many interesting opportunities to emerge. In the mean time, the volatility and uncertainty will continue to spook the markets and investors. A steady perspective, and a keen eye on identifying value in the rubble of market volatility will continue to be the basis of our management of the situation.
David B. Matias
The past three months have been a troubling time in the markets. If you were to listen only to the financial media, you might believe that China is falling apart at the seams, the U.S. economy is tipping into a recession and El Nino is about to push California into the Pacific. However, the reality is very different from this perception. There are many issues to raise alarm in the current market environment, but the fundamental core of the economy continues to show signs of strength. The volatility of the markets, however, has been severe and worrisome.
As I write this update, the market just completed a late summer gyration of down -10% and then up +8% to get back to its starting point for the year. While zero growth in the stock market may sound benign as compared to mounting losses, the volatility has been unlike any we’ve seen since 2008 and the source of much of this public concern. More important, many sectors of the market have seen near collapse this year, as we will discuss, and the large funds are suffering. We will not see the final fund returns until the end of the year, but interim reports show many large funds posting excessive losses for 2015 triggering further selling.
With conflicting or incomplete data, the factors causing this disruption in the market have been elusive to both the experts, and me, though there are some likely explanations. One of these centers on the impact of hedge funds and electronic trading on the markets and the volatility it can create. I will also discuss the Exchange Traded Fund (ETF) market and the tensions created by its rapid growth in so many directions at once. Meanwhile, asset allocation strategies are also facing an impending shift. The end of Fed stimulus programs last year, the expected rise in interest rates, and a slower-growth China are all factors that will contribute to a change in the investment landscape and an important shift in money management allocations that follows.
The summer and early fall brought news about the slowdown in China and fears of its impact on the global economy. Their central bankers acknowledged these issues when they devalued the currency in August, triggering the first spate of market volatility. While China has grown to become the third largest economic region (behind the U.S. and the European Union), the pace of its growth makes it the largest single contributor to incremental demand. The chart below shows the relative size of the major economies, and the impact that Chinese growth has on global consumption.
With consumption representing roughly half of all economic activity, global growth is highly sensitive to this dynamic in China. The economy needs to maintain some growth in order keep the existing job base, and also to expand that base as the working population grows. Those incomes lead to spending, generating both demand and wealth. Trends such as the growing middle class (and indirectly, increasingly stable political environments) are directly rooted in this process. As an example of this process, look at sales of iPhones in China, and Apple’s marketing plans there. China is going to be the largest iPhone market for Apple this quarter. If China isn’t buying as many phones, Apple doesn’t hit their growth targets on which investor expectations are built. It is far from the end of Apple if his happens, but with a market on edge, there is no room for such a miss with Apple.
The world’s production and supply of everything from raw materials to iPhones is based on projections for demand. With China growing at 7%, you need “X.” With China growing at only 5%, you need significantly less than “X.” That is the problem right now: China is still growing, it is just that the forecasting done two years ago was overly ambitious, and the world’s supply chain was built for more.
Over the past twelve months, the oversupply in raw materials has resulted in precipitous drops in prices. Whether the price action matches the true oversupply or reflects the exacerbating impact of financialization is a dynamic that will play out in the coming months. Financialization continues to expand as derivatives products of all kinds expand access to each of these markets. For instance, each barrel of oil that is generated each day is bought and sold 26-times by the end of that day. Minuscule manipulations in the price of that barrel and every other barrel can have an enormous impact on the market for oil.
The oil price drops have had devastating impacts on energy companies, ripping out their capital expenditure budgets and causing growth to slow in related sectors. The clearest example of this is the contraction in the industrial sector as oil companies have less and less incremental spending – and we are sure to see this anemic growth continue. Take, for instance, Caterpillar (CAT), which supplies mining equipment to mines and combines to wheat growers. Facing lower prices across the board, the first measure producers take is to cut capital spending and delay replacing old equipment. CAT took a beating earlier in the year because of this dynamic. In late September, they took another beating when they announced the immediate implications in terms of employee cuts. One could argue that this is an opportunity for the company to cut excess and to be much more profitable when demand resumes, but that is lost on the market in a trading environment that is hostile to deviations from expectations.
The reality test is to look at economic indicators, and how those indicators have been trending. China’s data is not always accurate, which creates uncertainty, and the market abhors uncertainty. The U.S. has the opposite problem. From our massive government infrastructure for reporting data to private drones mapping growing activity, we are flooded with information. The following charts are the ones that we like to look at most closely, and the trends are consistent with a year ago.
What is troubling is the turbulence of the recent market correction. The chart below shows the VIX – a measure of expectations of future volatility – since 2008. Namely, after China devalued their currency, the VIX moved to levels that we haven’t seen since October of 2008, when things truly were a disaster in the world and the economy was falling apart. While the economy was vastly different in August then it was in 2008, it takes far less to drive volatility to those levels.
Since 2007, we have seen a number of events, pretty much on an annual basis, in which volatility spikes to levels that are typical of once-in-a-decade events. The volatility swings of 2008 were the first; the Flash Crash of 2010 was another, Black Monday 2011, gold in 2012, the Swiss Franc in 2014, and now the S&P 500 with commodities this past summer. The underlying situation is typically the same – the market moves in a manner that has no bearing on the economic fundamentals.
The way trading technology has evolved lockstep with financial engineering is one of the more cogent of possible explanations for the dislocation. High frequency trading allows thousands of trades to be executed in nanoseconds to capture minuscule profits at massive scale. Financialization compounds the problem. But Exchange Traded Funds (ETFs) are starting to take center stage, as a growing and significant portion of the daily trading is related to these funds. While there is no definitive evidence on the topic, it appears that ETFs were at the center of the Flash Crash and the gold collapse.
Monday morning, August 24, is a good example of this dysfunction and the impact of ETFs. On the prior Friday, the market had lost 3%. Monday morning, it looked like the market was going to lose another 3-5%. The ETF market, where a massive amount of retail money is invested, was frozen. Quite literally, over 1,000 individual ETF issues could not trade. And when they did trade, the execution was up to 30% away from the underlying securities. For reference, ETF’s rarely trade more than 0.1% away from the underlying index value.
We have three factors that have weighed heavily on the long-view investment managers who control the bulk of long-term public investments. First, as you might recall, the quantitative easing program by the U.S. central bankers ended with its final block of buying in October 2014. The Fed has effectively stopped printing money, removing the ‘methadone’ for the market. While the Fed has yet to remove this liquidity from the market, it is still a significant change of flows.
Next, we have the imminent increase in Fed borrowing rates that will take place either this fall or into 2016. It was over nine years ago, in June 2006, when we last saw these rates rising. That is a dramatic change for an industry that is heavily populated with young traders and managers. The Wall Street Journal reported that Minneapolis-based U.S. Bank estimates that 70% of employees in impacted positions haven’t experienced a rate hike – a phenomenon exacerbated by layoffs that followed the financial crisis.
The final factor in the sea change is China. While they are still growing and will likely do so for a long time, the tapering of that growth has dramatic implications for commodities, and subsequently industries that support commodities producers. Factor all this together, and you have an environment in which long-term asset managers are using new allocation strategies that will take months to deploy. The first step in that reallocation it to sell existing positions. Later comes the buying, that lag driven by the perception of current market volatility.
Given the absence of key growth drivers, we expect to continue to see a stable but slow growth domestic economy, without inflation, and a Europe that will benefit from a weaker currency and their own central banking stimulus programs. The jobs data continues to show a low level of unemployment claims with modest jobs growth. Corporate earnings have not come far short of expectations, but are not creating too many surprises to the upside either. In essence, the fundamentals are pretty solid and not yet giving anyone reason to turn instead to risky assets.
The strong dollar and the related increase in the cost of our exports doesn’t help matters, but with the Fed rate policy is such limbo, the dollar may start to lose some value this winter, helping that sector of our economy. We also see significant upside in the price of oil given the irregularities in reported demand by the IEA. Any prolonged spike in oil prices combined with a weakening dollar would be a tremendous boost to both the energy and industrial sectors in the U.S.
The use of individual equities in this volatile market environment is key to generating strong returns. Companies that possess strong growth potential or are beaten down simply because of the systemic fears in the market or in their particular sector – rather than individual fundamentals – are our focus. The carnage in the healthcare sector this month was a good example of all companies getting punished despite any resilience individual companies may possess in their respective markets.
Furthermore, a continued focus on non-equity assets classes will help to stabilize portfolios through the uncertainly. Held-to-maturity bonds continue to be a strong income driver, while alternative investment strategies around private pooled funds continue to perform well irrespective of market volatility. In essence, the basics of investment for value and long-term horizons become far more important in this environment than any short-term play on market volatility.
In the mean time, all the best for an early start to this winter and a spectacular fall foliage season.
David B. Matias