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.”