Research & Insights

MV Weekly Market Flash: Inconsequential Tremors

May 19, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Anyone who has lived for some time in a city like Los Angeles or Tokyo knows what an inconsequential tremor is. You feel that shaking motion, perhaps hear some objects rattling on your desk. You momentarily catch your breath, and then it’s all over, usually within the span of less than ten seconds. Those inconsequential tremors happen frequently in any city with proximity to a major tectonic fault line. Only rarely – very, very rarely – do they develop into a serious earthquake capable of creating lasting damage.

Pullbacks by the Numbers

As with seismic tremors, so with financial markets. Our natural inclination is to not even categorize Wednesday’s 1.8 percent pullback in the S&P 500 as a tremor. Since it did briefly puncture the preternaturally serene calm prevailing in markets as of late, though – and come as it did amidst a new level of political volatility in Washington – we think this is a good time to dust off that pullback study – long unused – and remind our clients that tremors generally do not an earthquake make.

Our standard measure for a “pullback event” as it pertains to US large cap stocks is a retreat of five percent or more from a high water mark, followed by a subsequent recovery of five percent or more. There is no higher truth associated with the five percent threshold, but we think it is a useful benchmark. A five percent decline has impact – the TV talking heads take notice and investors feel those ephemeral goosebumps – but it falls short of a technical correction (10 percent off the high) or a bear market (20 percent retreat).

By this standard, there have been 190 pullback events on the S&P 500 since the end of the Second World War, or about 2.7 every year, on average, for the 71 years between then and now. And how many times did the pullbacks metastasize into full-fledged bear markets? Well, there was a very brief bear – about seven months in duration – from the end of 1961 to midsummer 1962. There was the dismal stretch from the record high of November 1968 to August 1982, which is how long it took for the S&P 500 to forever rise above that (nominal) ’68 high and bid it goodbye. And there were the two bear markets that bookended the first decade of the 21st century.

And that’s pretty much it for bear markets (Black Monday 1987, yeah, but that was basically a flash crash, not a bear proper). Mostly, those pullback events are just inconsequential tremors with no particular sustaining narrative. Revolutions, it is often noted by political historians, don’t happen far more often than they do happen.

Much Ado About Nothing

No two bear markets are alike, but the forces that propel them tend to arise organically from the thousands of disparate nodes of activity in the economy, and not from singular events in Washington DC. Whatever outcomes happen as a result of the current political and legal woes of the Trump administration – even the more far-fetched notions of some form of removal from office or a doubling-down of the crazy by the current residents of 1600 Pennsylvania – are highly unlikely to exert a meaningful impact on the economy at large. The slow-growth recovery continues at home and abroad. Quarterly earnings seem able to sustain at least mid-high single digit growth rates over a full fiscal year. These trends preceded Trump, and these trends seem likely to keep on keeping on.

We have no trouble imagining a near-term scenario that registers another five percent-plus pullback event in keeping with our definition above. We haven’t had one since February 2016, and that’s a long dry spell (remember that 2.7 events per year statistic we cited above). In the absence of any data implying a potential meaningful shift in the overall economic narrative, though, we are likely to consider any such event as yet another inconsequential tremor.

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MV Weekly Market Flash: The Fed and the Spread

May 12, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Three years ago, one could have driven a fleet of semitrailers through the open space between the 2 year and the 10 year US Treasury benchmark note yields. While there still is some distance between the two, it would be somewhat more amenable to a single row of Priuses (Prii?) passing through. As the chart below shows, the shorter term note, which is generally more directly responsive to Fed policy, remains very close to its five year high. The intermediate 10 year yield, by contrast, has meandered along a largely directionless trajectory. 

Untangling Policy, Demand and Expectations

The path of shorter term yields, for which the 2 year note is a useful proxy, is not hard to understand. The Fed began to make noises about tapering its QE policy in 2013 and then moved to a regime of reasonably explicit forward guidance on rates in 2015, resulting in the first increase at the end of that year. Despite falling sharply during the turmoil of early 2016, the 2 year resumed its upward path as conditions settled down and the case for a steady, if not spectacular, pace of economic recovery settled in as the default narrative. One should expect short term yields to continue tracking upwards in the absence of a reversal of the Fed’s stated intentions to keep raising rates.

For much of this time, the 10 year benchmark marched to a different drummer. Foreign demand was a key determinant of the consistently subdued yields experienced over this time – a trend that confounded no small number of bond pros. Rather than breaching 3 percent, as many expected, the 10 year actually set an all-time low – as in “since the founding of the American Republic all-time low” – in the immediate aftermath of Brexit.

The November election and the emergence of the so-called “reflation trade” brought about a shift in expectations, such that both intermediate and short yields moved largely in tandem. This was, as you will recall, when the prevailing mindset among investors imagined dramatic changes to the tax code and a sweeping new program of public spending on infrastructure. The spread between the 10 year and the 2 year in the weeks leading up to the election was mostly below 100 basis points, and it has not strayed very far from that level since.

Mind the Gap

The question now, of course, is whether there is still enough oomph in those reflationary expectations to send the 10 year into higher territory with a resulting steepening of the curve. This would be the putatively logical case to make for one who still believes there’s an infrastructure/tax reform pony out back with the capability to deliver the economic growth bump (however short-lived that might be) that is the administration’s central economic talking point. This view would consider the recent string of so-so hard data releases (including today’s six-of-one-half-dozen-of-the-other retail sales and inflation results) to be temporary and primed for near-term growth.

On the other hand, if the gap narrows still further – if the spread falls back into double digits as short term rates inch up while intermediates hold steady or fall again – investor brains could fall prey to the dark sentiments of an flat or inverted yield curve. That outcome would likely serve as a validation for those opining that bond yields represented the “smart view” while equity valuations soared on little more than a wing and a prayer.

The $4.5 Trillion Dollar Question

In the midst of all this is one very important and highly unpredictable variable: when and how the Fed plans to begin drawing down the $4.5 trillion balance sheet it racked up over the course of three quantitative easing programs. Observers will pay closer than usual attention to the forthcoming release of the FOMC’s minutes (scheduled for May 24) from its most recent policy meeting, scouring the language for clues about their intentions. The conventional wisdom is that the Fed believes there will eventually come a time when it needs to take rates back to zero and possibly launch another bout of QE. Having the dry powder to launch such a plan will necessitate a meaningful balance sheet reduction in the meantime. The tricky part, of course, will be to pull of this maneuver without roiling asset markets in so doing. Given the preternatural calm prevailing in risk asset markets currently, any hiccup could turn into a negative catalyst. Fed members will need to be practicing their triple-axel techniques to pull this off.

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MV Weekly Market Flash: Popular Data, Invisible Data

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It’s Jobs Friday, always a fun day for financial pundits as they craft ways to put a defining, click-friendly metaphor on the latest signal of health (or lack thereof) in the labor market. This month’s winning metaphor is that staple of kids’ birthday parties, the bouncy house. “US jobs growth bounces back” says the Financial Times. Adam Samson, the FT reporter whose byline is attached to that article, appears to be on the same cosmic wavelength as Patricia Cohen of the New York Times, whose lead headline today reads – wait for it – “U.S. Job Growth Bounces Back”. The style manuals of the FT and NYT – U.S. or US? Jobs plural or singular? Caps or no caps in the headline? – were on full display. Over at the Wall Street Journal they seem to have quietly retired the “Jobs Friday Live Blog” of times past, but the WSJ’s team of economists nonetheless has a massive “Everything You Need to Know” section on the April jobs report. Indeed, to the credit of those featured, that is one exhaustive parsing of the BLS release.

If Productivity Fell and Nobody Heard It, Did It Still Fall?

Not every macroeconomic headline gets the popular-kid treatment of the monthly BLS release, of course. Consider the financial headlines just yesterday, May the Fourth (insert nerdy Star Wars reference here). Yesterday was Productivity Thursday. Ha-ha, of course it wasn’t, because there was basically no coverage of the only economic data point that actually has the capability to deliver sustained growth. What did yesterday’s headlines focus on? Postmortem commentary on the FOMC’s meeting pointing to a June rate hike…the final pre-election debate between Macron and Le Pen over in France…the sausage makers on Capitol Hill hastily throwing together a gambit on the 18 percent of the US economy represented by health care. Important stories, all. Meanwhile, nonfarm labor productivity fell 0.6 percent for the first quarter, well below the consensus expectation of 0.1 percent and yet another lackluster contribution to a chronically underperforming long term trend.

Stop Us If You’ve Heard This One Before

Everyone talks about growth; the notion that the economy will be stronger in the future than it is today is literally the single animating notion behind the capitalist impulse to defer the benefits of a dollar today for the payoff of that dollar’s growth over a defined period of time. But talking about growth without focusing on productivity is like talking about why you just came down with a nasty cold without considering the fact that you recently went out for a walk in the snow barefoot, in shorts and a t-shirt. That is what makes the absence of Productivity Thursday so conspicuous, and why the obsessive focus on monthly payroll gains appears so misplaced.

If anything, the leading number of Jobs Friday should be the labor force participation rate. That nudged down to 62.9 percent from last month’s 63 percent. It remains far below the peak of more than 67 percent reached at the end of the 1990s. Why is this number important? All together now…long term growth is a function of three variables: overall population growth, growth in the number of people working as a percentage of total population, and productivity (how much gets produced for every hour of effort invested).

For most of human history the only variable that mattered was population growth. If that were still true, we would have to content ourselves with annual GDP growth around 0.7 percent, which happens to be the most recent annual rate of population growth. We have little reason to believe that labor force participation is going to improve anytime soon: both demographics and job-replacing technology will see to that. Which leaves productivity, and which is why Productivity Thursday deserves its rightful place at the cool table in the cafeteria of macroeconomic data. Yes, those payroll numbers are useful. But with the unemployment rate at 4.4 percent one might wonder why participation remains stagnant and wage growth is still relatively subdued. Productivity Thursday could help shed some light here.

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MV Weekly Market Flash: The Hard, the Soft and the Ugly

April 28, 2017

By Masood Vojdani & Katrina Lamb, CFA

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Another Friday, another “hard” piece of data that comes in shy of expectations. The Bureau of Economic Analysis released the first estimate of Q1 2017 real GDP growth, and the 0.7 percent quarter-on-quarter growth rate was a bit below economists’ consensus estimate of one percent. As a standalone data point this does not tell us very much. There will be two further revisions that could increase (or reduce) this first estimate. Q1 is notoriously subject to seasonal factors; for example, a warmer than average winter resulted in lower utility consumption by households, which in turn had a slowing effect on personal consumption expenditures. The first quarter of 2016 also produced sub-one percent growth, but that perked up to more robust levels as the year played out. As always, one data point doth not a trend make.

Sentimental Journey

That being said, today’s release will do little to shed light on the mysterious “hard versus soft” debate that has been a staple on the menu of financial gabfests this year. The GDP number comes on the heels of two other underwhelming “hard” macro releases of recent Fridays past: headline inflation below the Fed’s two percent target, and March payroll gains falling short of 100,000. By contrast, a number of “soft” numbers reflecting sentiment among consumers and small business owners have being going gangbusters; by some estimates consumer confidence is higher than it has been any time since the tech bubble peak in 2000. The upbeat sentiment has served for many in the commentariat as an easy go-to explanation for the stock market’s bubbly performance in the year to date (our own take on the market is a more mundane assessment of momentum feeding on itself, more or less impervious to outside catalysts).

Hard, Hard Road

The sentimental bullishness may yet converge into the subdued hard numbers, but it’s not a given. Take retail sales, which posted a modest gain in February and then fell in March. Now, with consumer sentiment being so jazzed up, shouldn’t some of that effervescence be showing up in the actual spending numbers? You can’t blame the weather for this one: those balmy February days should have been mall and DIY store magnets. In fact, the poor showing of retail sales throughout the first quarter was as good a sign as any that GDP might come up short. Seventy percent of growth in output is driven by consumer spending. If consumers aren’t walking the walk, then all the happy talk in the world isn’t going to move the growth needle.

And Now for the Ugly

Behind all these month-to-month metrics we use to measure the economy’s health is the grim reality that long-term growth remains challenged by three major headwinds: declining population growth, a smaller percentage of the population at work in the labor force, and anemic levels of total factor productivity. Of those three headwinds, the only one that can plausibly deliver growth as we know it is productivity. It was the unique convergence of productivity advances with baby boom demographics that delivered the amazing, historically unprecedented growth rates of the 1950s and 1960s. The demographics are no longer in our favor, so to have any growth at all we will need to see some material evidence that all the technology innovations of the last 10 to 15 years can deliver a new, sustained dose of productivity gains. Until that happens, we should not expect to see the kind of go-go growth being promised by some who should know better (ahem, Treasury Department tax plan crafters). At some point, sooner rather than later, this reality will likely make itself known in the soft data as much as the hard.

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MV Weekly Market Flash: Eurozone Is Priced for More of the Same

April 21, 2017

By Masood Vojdani & Katrina Lamb, CFA

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How much of an X-factor is European political risk in 2017? We got a partial answer (not much) from the outcome of the Dutch elections last month, which maintained the status quo even as the traditional center right and center left parties fared relatively poorly. We will get another drip-drip of insight this Sunday evening, as election officials tally up the results of the first round of voting in the French contest. There has been some nervous chatter among the pundits, mostly revolving around the scenario – unlikely but plausible – of a second round contest between Marine Le Pen and Jean Luc Mélenchon. Markets, however, appear unfazed. The euro is holding ground at around $1.07, and the spread on the French 10-year yield over the commensurate German Bund is 61 basis points, down from 78 in the wake of a flurry of Mélenchon-friendly polls last week. And, as the chart below shows, Eurozone equities are holding their outperformance gains versus the US S&P 500.

Macron-economics

The “what, me worry?” vibe boils down to a singular view that the ultimate winner of the election will be centrist Emmanuel Macron, a former economics minister and investment banker who cobbled together a new political movement to challenge the loathed traditional parties of the Socialists and Republicans. Macron’s platform is in line with the technocratic sensibilities of EU policy institutions and the IMF, focused on the integrity of the EU and the Eurozone with incremental rather than radical policies for dealing with the region’s ongoing difficulties.

Should Macron ultimately prevail, the market’s current positioning could augur for more outperformance ahead. Economic numbers continue to give cheer; the latest PMI readings show both manufacturing and services at a six year high. Growth, inflation and employment trends all continue to move in a positive, if still modestly so, direction. Other political risks lurk, notably in Italy, but the capacity to surprise will be greatly diminished if the French contest plays out as expected.

Zut alors, c’est le surpris!

What if Macron doesn’t win? If for no other reason, 2016 was instructive in explaining the pitfalls of polls and the many random factors that can lead to an outcome other than the highest-probability one. What will markets do on Monday morning if the two candidates left standing are Le Pen and Mélenchon? The short answer, given where markets are priced today, would probably be a pullback of somewhere between 5 – 10 percent for regional equity indexes and a move to haven assets like US Treasuries and German Bunds. That is what happened after the shock delivered by the Brexit vote last June. That pullback, though, as you will recall, was brief and contained. Within weeks of Brexit, equity markets had rebounded and the S&P 500 finally set its first record high in 14 months.

In the long run, we believe a Le Pen or Mélenchon victory would be of enormous consequence for the EU, more so than Britain’s exit. The market’s apparent ability to breezily whistle past every potential calamity would be tested perhaps more than in other recent political risk events. But if we have learned anything about Europe in the last seven years, starting with the wheels coming off the Greek economy, it is that European policymakers are masters of the craft when it comes to kicking the can down the road.

At some point – whether it be from disgruntled citizens voting centrists out of office, a round of financial institution failures or something else – the original flaws of the single currency design will likely deal a potentially deadly blow. But we have no reason to believe that reckoning is any time soon. Our advice to our clients should not surprise any regular reader of this column: resist the impulse to make any rash positioning plays either in advance of or following Sunday’s outcome, or that of the second round in early May.

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