Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years. After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread.
Meet the New Spread, Same As the Old Spread
There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.
But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.
Welcome to the Jungle
Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.
As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.
What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.
Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.
The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.
If you have paid any attention to the daily dose of financial media chatter over the past month or so (and we are of the firm opinion that there are many, many more productive ways to spend one’s time) you have no doubt come into contact with the phrase “flat yield curve.” If the phrase piqued your interest and you listened on, you would have learned that flat yield curves sometimes become inverted yield curves and that these are consistently accurate signals of imminent recession, going back at least to the beginning of the 1980s.
This topic is of particular interest today because the yield curve happens to be relatively flat. As we write this the spread (difference) between the 10-year Treasury yield and the 2-year Treasury yield – a common proxy for the yield curve – is just 0.25 percent. That is much tighter than usual. In fact the last time the yield curve was this flat was in August 2007 – and any financial pundit worth his or her salt will not hesitate to remind you what happened after that. The chart below diagrams the longer-term relationship between 10-year and 2-year Treasury yields going back to 1995.
Before the Fall
In the above chart we focus attention on two previous market cycle turns where a flat or inverted curve was followed by a recession and bear market environment: 2000-02, and 2007-09. It is true that in both these instances a recession followed the flattening of the curve (the red-shaded columns indicate the duration of the equity market drawdown). But it’s also important to pay attention to what happened before things turned south.
Both of these bear market environments were preceded by an extended period of growth during which the yield curve was also relatively flat. These “growth plus flat curve” periods are indicated by the green-shaded columns in the chart. As you can see the late 1990s – from about mid-late 1997 through the 2000 stock market peak – were characterized by very little daylight between the 2- and 10-year yields. The same is true from late 2005 through summer of 2007 (the S&P 500 peaked in October 2007 before starting its long day’s journey into night).
You Can Go Your Own Way
In both of those prior cases, in other words, a flattening yield curve wasn’t a signal of very much at all, and investors who took the cue to jump ship as soon as the spread went horizontal missed out on a considerable amount of equity market growth. In fact, the dynamic of “flat curve plus growth,” far from being unusual, is not unexpected. It has to do with what the respective movements of short term and long term yields tend to tell us about what’s going on in the world.
Short term rates are a much more accurate gauge of monetary policy than yields with more distant maturities. If bond investors anticipate an upcoming round of monetary tightening by the Fed, they will tend to move out of short-term fixed rate securities, sending yields on those securities higher. When does monetary policy normally turn tighter? When growth is heating up, of course – so it should be no surprise that short term rates will start trending up well before the growth cycle actually peaks.
Longer term yields, on the other hand, are much less predictable and tend to go their own way based on a variety of factors. For example, in that 2005-07 period when short term rates were trending up, the 10-year yield stayed relatively flat. Why? Because this period coincided with the height of China’s “supercycle” during which Beijing routinely bought gobs of Treasury bonds with its export earnings, building a massive war chest of dollar-denominated foreign exchange reserves.
To Every Cycle Its Own Story
At the same time, many other central banks were building up their FX reserves so as to not repeat the problems they experienced in the various currency crises of the late 1990s. Yes – the late 1990s, when economies from southeast Asia to the former Soviet Union to Latin America ran into liquidity difficulties and injected a massive amount of volatility into world markets. Global investors responded to the volatility by seeking out safe haven assets like – surprise! – longer-dated US Treasury bonds. Which partly explains why the yield curve was so flat from ’97 through the 2000 market peak.
So yes – at some point it is likelier than not that we will see another flat-to-inverted yield curve lead into another recession. Meanwhile, the dynamics driving longer-term bond issues today are not the same as the ones at play in the mid 2000s or the late 1990s. Maybe spreads will widen if a stronger than expected inflationary trend takes root. Maybe the 10-year yield will fall further if US assets are perceived to be the safest port in a global trade war storm. The important point for today, in our opinion, is that there is a resounding absence of data suggesting that this next recession is right around the corner. We believe there is a better chance than not for some more green shading on that chart between now and the next sustained downturn.
The financial news headlines on this, the first Friday of the second half of 2018, seem fitting. Appropriately contradictory, one might say, providing a taste for what may lie ahead in these next six months. First, we have news that Donald Trump’s splendid little trade war is happening, for real now! Tariffs have been slapped on the first $34 billion worth of products imported from China. On the other side of the ledger, an American ship full of soya beans was steaming full-on to reach the Chinese port of Dalian in time to offload its supply before facing the retaliatory tariffs mandated from Beijing. Too bad, so sad, missed the deadline. Apparently the fate of the ship, the Peak Pegasus, was all the rage on Chinese social media. The trade war will be Twitterized.
The second headline today, of course, was another month of bang-up jobs numbers led by 213K worth of payroll gains (and upward revisions for prior months). Even the labor force participation rate, a more structural reading of labor market health, ticked up (more people coming back into the jobs pool is also why the headline unemployment rate nudged up a tad from 3.8 to 4.0 percent). Hourly wages, a closely followed metric as a sign of potential inflation, recorded another modest year-on-year gain of 2.7 percent.
So there it is: the economy continues to carry on in good health, much as before, but the trade war has moved from the theoretical periphery to the actual center. How is this going to play out in asset markets?
Manufacturers Feel the Pain
The products covered by this first round of $34 billion in tariffs are not the ones that tend to show up in Wal-Mart or Best Buy – so the practical impact of the trade war will not yet be fully felt on the US consumer. The products on this first list include mostly manufacturing components like industrial lathes, heating equipment, oil and gas drilling platform parts and harvester-thresher combines. If you look at that list and think “Hmm, I wonder how that affects companies like Caterpillar, John Deere and Boeing” – well, you can see for yourself by looking at the troubled performance of these companies’ shares in the stock market. As of today those components will cost US manufacturers 25 percent more than they did yesterday. That’s a lot of pressure on profit margins, not to mention the added expense of time and money in trying to figure out how to reconfigure supply chains and locate alternative vendor sources.
Consumers Up Next
The question – and probably one of the keys to whether this trade war inflicts real damage on risk asset portfolios – is whether the next slates of tariffs move from theoretical to actual. These are the lists that will affect you and me as consumers. In total, the US has drawn up lists amounting to $500 billion in tariffs for Chinese imports. In 2017 the US imported $505 billion from China – we’re basically talking about the sum total of everything with a “Made in China” label on it. Consumers will feel the pain.
If it comes to pass. The collective wisdom of investors today has not yet bought into the inevitability of an all-out trade war. US stocks are on track to notch decent gains for this first week of the second half. The job numbers seem to be holding the upper hand in terms of investor sentiment. Sell-side equity analysts have not made meaningful downward revisions to their sunny outlook for corporate sales and earnings. Sales for S&P 500 companies are expected to grow at a rate of 7.3 percent this year. That reflects an improved assessment from the 6.5 percent those same analysts were projecting three months ago – before the trade war heated up. The good times, apparently, can continue to roll.
Since we haven’t had a global trade war since the 1920s, we can’t model out just how these tariffs, in part or in full, will impact the global economy. Maybe the positive headline macro numbers, along with healthy corporate sales and profits, can power through this. Perhaps the trade war will turn out to be little more than a tempest in a teapot. We may be about to find out.
It’s been one of those weeks where a virtual hailstorm of headlines overwhelms the normal mechanics of cognitive functioning. So much so, that one could easily turn one’s attention away from China for a brief second and turn it back to find that the currency has plummeted in a manner eerily similar to that of August 2015. The chart below shows the path of the renminbi over this time period, along with the concurrent trend of the Shanghai Composite stock index.
Remembrance of Shocks Past
In the chart above we highlight the two “China shocks” that rippled out into global markets in 2015 and 2016. The first was a sudden devaluation of the renminbi in August ’15, a move that caught global investors by surprise. The domestic China stock market was already in freefall then, but the currency move heightened broader fears of an economic slowdown and eventually pushed the US stock market into correction territory.
The second China shock happened just months later, when a raft of negative macro headlines greeted investors at the very start of the new year. Another global risk asset correction ensued, though the drawdown was relatively brief.
Considering those past shocks, though, investors are reasonably concerned about the implications of this week’s moves in both the renminbi and Chinese equities – which briefly entered bear market territory earlier this week. Pouring fuel on the flames, of course, is the addition of an X-factor that wasn’t present for the previous shocks – the looming presence of a potential trade war. Coupled with renewed concerns about China’s growth prospects – with or without a trade war – there is a strong sense in some camps that a third China shock may reverberate out into the global markets.
Less Is More
We understand the concerns, particularly as they are far from the only news items creating a general sense of uncertainty in the world. But our sense is that China’s growth troubles are actually good – good for the country and ultimately good for the global economy. What has slowed down in China this year – well, ever since last autumn’s Communist Party Congress, in fact – has been leveraged fixed asset investment. This is where state-owned enterprises raise copious amounts of debt and invest in infrastructure and property development projects for the primary (seemingly) purpose of beefing up the headline GDP number.
Beijing’s economic authorities have been trying to rebalance the economy away from these repeated trips to the borrow-and-build trough since 2014, but the turbulent domestic financial market conditions of 2015-16 weakened their resolve. The deleveraging commitment got a new breath of life with President Xi Jinping’s consolidation of power after last October’s party congress. With little to worry about politically, Xi and the party formalized the model of “quality over quantity” in the growth equation. So while fixed asset investment and borrowing have slowed considerably, consumer spending has increased. The service economy is growing as a percentage of overall GDP. In the long term, this is a more sustainable model for the world’s second largest economy than unwise lending for the construction of bridges to nowhere.
The Trade Factor
Yes, but what about the trade war? Well, it’s true that uncertainty about the future of trade in general is a clear and present factor in the state of world markets. The unnerving headlines seem unlikely to go away any time soon – the latest today being Trump’s apparent intention to take the US out of the World Trade Organization (without really understanding what that organization is or how, legally, the US would untangle itself from the organization that is the successor to the General Agreement on Tariffs and Trade framework the US itself architected at the Bretton Woods meetings of 1944).
We haven’t had a global trade war since the 1920s, though, so while it is certainly possible to model alternative scenarios, there’s not much in the way of actual data to support persuasive analysis of potential winners and losers. In the meantime, as regards China, the recent patterns in the stock and currency markets merit some concern, but the underlying story is not as negative as some of the present day commentary would suggest.
Did you hear the news this week? General Electric, one of the world’s oldest going concerns, was dropped from its august perch in the Dow Jones Industrial Average. That index of 30 companies will no longer include the only company still in business today that was a constituent member of the Dow Twelve – the companies Charles Dow fashioned into a market index back in 1896. GE will be replaced by Walgreens, which is probably not a bad idea since retail pharmacy is currently under-represented in the index (Wal-Mart being the only company in the heretofore 30 where you can get a prescription filled).
As with just about anything Dow-related, though, the news about GE and Walgreens matters more for stock market historians and storytellers than it does for actual investors.
A Quaint Relic
To the mind of the typical retail investor, “the Dow” is interchangeable with “the market.” Round number days on this index – when it, say, breaks 20,000 for the first time – are feted like national holidays in the financial media. When the stock market experienced a technical correction earlier this year, commentators were breathless with the report that the Dow had fallen by more points (1,179 to be exact) than ever before in its history.
None of which matters for any reason other than idle water cooler gossip. In fact, the media’s fixation on the Dow’s points loss on February 5 was not only pointless, but potentially harmful if it induced anyone to actually sell out in a panic. The percentage loss corresponding to that decline of 1,179 points was nowhere close to the all-time record loss of 22 percent, on October 19 1987.
Yes, it’s fun to study the Dow to gain a perspective on how the US economy has evolved over the last 122 years. It’s nice to arrive at cocktail parties armed with trivia like Distilling & Cattle Feeding or Standard Rope & Twine (two of the original twelve companies that didn’t have quite the staying power of GE). But that’s where the usefulness ends. Consider the fact that of today’s market-moving FAANG companies (Facebook, Amazon, Apple, Netflix and Google) only one – Apple – is represented in the Dow. Technology stocks make up about 25 percent of the total market capitalization of the S&P 500 (and an even greater percentage of the NASDAQ Composite). The tech names represented on the Dow – Apple, IBM, Cisco Systems, Microsoft and Visa – are not exactly unimportant, but they are less representative of the full spectrum of what is arguably the most influential sector of the US economy in 2018.
Price of Everything, Value of Nothing
The other major problem with the Dow, in addition to the somewhat arbitrary and backward-looking nature of the 30 constituent names, is the way the index’s performance is calculated. Whereas the S&P 500, NASDAQ and most other broad market indexes calculate performance based on market capitalization (number of shares outstanding times share price), the Dow is a price-based index. This means adding up all the share prices of the 30 stocks and dividing them by a divisor (which changes over time to reflect share splits, share dividends and the like).
The basic flaw in the price methodology is that it gives stocks with a higher price more impact on returns than stocks with a lower price. If Company A has a stock price of $100 and Company B has a stock price of $10, then Company A’s share price movements have a bigger impact on the index than those of Company B. But those raw share prices tell you absolutely nothing about the economics of either company. If Company A has 1,000 shares of stock outstanding and Company B has 10,000 shares of stock outstanding then both companies have the same market capitalization -- $100,000. In a market cap-weighted index like the S&P 500 their share price movements would have the same impact, not the skewed outcomes they produce on a price index like the Dow.
Here Today, Here Tomorrow
Of course, we do realize that all our carping about the Dow Jones Industrial Average will not stop it from being “the market” in the popular lexicon. Humans gonna be humans, after all. And that’s fine, as long as you make sure that your actual portfolio pays more attention to today’s economy than to the colorful past chapters of US stock market history. Now, there are times, of course, when the Dow will outperform the broader benchmarks, and there are times when it will underperform. As the chart below shows, right now is one of those times when it is underperforming – actually in negative territory for the year to date while both the S&P 500 and the NASDAQ Composite are in the black.
It’s a nice bit of history, but there’s no reason to have it in your portfolio. Exposure to large cap US stocks is best achieved through a broad market cap index like the S&P 500 or the Russell 1000. Adding other distinct asset classes like small caps, developed and emerging international equities can help achieve long term risk-adjusted return goals. That’s prudent diversification, to which the Dow is just a frivolous sideshow. A fun sideshow (hello, Nash Motors, inductee of 1932!), but a sideshow all the same.