Jackson Hole is, by all accounts, a lovely redoubt, high up in the Rocky Mountains of Wyoming. As has been the case every August since 1978, the monetary mandarins who set the agenda for the world’s central banks will dutifully traipse up to this hiking and skiing paradise next week for their annual economic symposium. The attention span of the global investment community will briefly train its attention on Jackson Hole, and not on account of the riveting topics on tap for keynote speeches and panel confabs. This year’s symposium title is “Fostering a Dynamic Global Economy,” an anodyne and, in this contentious day and age, somewhat wistful formulation. If nothing else, though, it at least rolls off the tongue more easily than last year’s unfortunate word salad of a lead line: “Designing Resilient Monetary Policy Frameworks for the Future.” Central banker says what?
Euron a Roll
No, investors’ interest in the proceedings will be strictly limited to whatever policy utterances may spring forth from the lips of bankers, none more so than European Central Bank chief Mario Draghi. A frisson of anticipation rippled in late June from Draghi’s musings about the stronger than expected pace of recovery in the Eurozone. These musings, not unlike Ben Bernanke’s “taper” kerfuffle of May 2013, sent bond markets and the euro into a tizzy as investors imagined the beginning of the end of Eurozone QE. The euro in particular went on a tear, as the chart below illustrates:
So much did the currency respond to fears of a more aggressive QE taper by the ECB that a strong euro has replaced a strong Eurozone as the central bank’s chief concern, as revealed by the most recent ECB minutes published this week. The euro’s strength puts regional companies at a competitive disadvantage for their exports, and complicates the ECB’s elusive target of 2 percent inflation. The characteristically cautious and incremental Draghi is thus likely to be on his guard to avoid any comments that could be interpreted by the market as hawkish policy leanings. Those tuning into the Jackson Hole proceedings may well come away with little more than the bland sentences peppered with bursts of arcane math that make up the majority of central bank speeches. More likely, investors will have to wait until the ECB’s next policy meetings in September and October for guidance on the timing of QE tapering.
The Smell of Fear
Concerns about the euro come at the same time as a smattering of long-dormant volatility comes back into risk asset markets. The CBOE VIX index has found a new home above 15 in recent days – still below the commonly accepted fear threshold of 20, but well above the sub-10 all-time lows it has plumbed for much of the past several months. Global stock indexes have experienced some attendant turbulence in the form of 1 percent-plus intraday pullbacks – fairly tame by historical norms but enough to re-ignite the chatter about the duration of this bull market, expensive valuations and all the rest.
It’s been awhile since shaky asset markets have tested central bankers’ nerves. Nor is there any clear indication that this late summer volatility will develop into anything more than a brief passing thunderstorm or two. But we have sufficient evidence from recent history that the policymakers do react to asset prices. They will likely be wary of pushing too hard for normalization policies (tapering on the part of the ECB, balance sheet reduction and further rate hikes for the Fed) if they sense that such moves will feed into already jittery capital markets.
Chances are that the only “hikes” on the agenda at Jackson Hole will be the kind involving nature’s beauty, not interest rates. We don’t expect much from Wyoming to be moving markets next week. But the central bankers still face a dilemma: how to proceed with the normalization they so want to accomplish when (a) market reactions could be troublesome, and (b) the urgency from a macroeconomic perspective is not clear and present. This will be one of the key contextual themes, we believe, heading into the fall.
Should you be concerned about the somewhat bumpy ride US stocks have encountered in the past couple days? Or is this a welcome chance to get in some long overdue bargain hunting before the S&P 500 resumes its lazy upward drift to a series of new highs?
The answer would depend, we imagine, on whether you see the unrest on the Korean peninsula – arguably the best go-to explanation for yesterday’s 1.45 percent pullback in the US benchmark index – as something genuinely serious and potentially destabilizing, or as little more than a spate of made-for-Twitter taunts that will, as these things generally do, settle down. As you contemplate this, bear in mind that most of the intense geopolitical flashpoints in history (notably including the 1962 Cuban Missile Crisis) have had relatively negligible impacts on asset returns in the months following the event. We have noted before that disaster doesn’t strike far more often than it does strike.
Caveat Bargain Hunter
That being said – and our instinctive proclivity towards bargain-hunting notwithstanding – there are some reasons entirely unrelated to geopolitics that merit some thought before doubling down on your equity market exposure. This comes back to a theme we have discussed extensively with clients in recent weeks, namely, the rather listless, leaderless nature of the market’s upward drift this summer. Consider the chart below, which shows the relative performance of the main S&P 500 industry sectors against the benchmark index for the year to date.
In this chart we draw particular attention to three sectors: technology, financials and energy. These are the three sectors that were the key drivers of profit growth in the just-concluded second quarter earnings season. Energy led the way with a triple-digit earnings rebound from the depths of the sector’s miserable 2016. Technology and financials both enjoyed double-digit earnings growth and the tech sector’s top line was strong as well, helped along by the benign tailwind of a weaker dollar against major trading partners.
With the exception of tech, though, these earnings haven’t translated into share price performance. Energy continues to be the market’s problem child, seemingly unable to convince investors that the current trough recovery in earnings is sustainable. Financials, of course, were the darling of the post-election reflation trade before that ill-conceived flight of fancy crashed and burned in this year’s first quarter. Banks and their ilk have trailed the benchmark since then. And tech, even though it maintains a solid performance lead this year, has shown itself to be vulnerable on several occasions, most notably with that big pullback in early June.
The apparent lack of attention paid to earnings extends to the level of individual stocks as well. A Financial Times article earlier this week reported on the market’s apparent failure to reward companies beating their Q2 earnings estimates, noting that “there has been little or no reward for companies reporting better than expected earnings per share and sales.” This observation fits in squarely with our contention that, while the market drifts higher in the absence of a compelling negative headwind, it lacks a sustaining theme. And without such a sustaining theme the market is, we believe, more vulnerable to the types of external shocks we have seen this week.
Labor Day Looms
As we write this before Friday’s market open, we have no crystal ball to tell us whether yesterday’s pullback will extend for a few more days (S&P 500 futures are about flat with 20 minutes to go before the open). We haven’t seen a multi-day pullback for more than a year and a half, but they do happen with some regularity. We think it more likely than not that the Korea kerfuffle will subside in due time, playground taunts from both heads of state kept in check by cooler heads. But the listless market will still be exposed to these kinds of periodic shocks, and they may come into sharper focus as the traditional back to school season approaches. Yesterday the VIX, the market’s “fear gauge”, shot up above 17 after weeks of historically low dormancy. Until we have another compelling, sustainable positive trend narrative, we should not be surprised to see more of these periodic, brief solar flares.
There’s not much interesting going on in the stock market these days, even less so than in the August “dog days” of years past. Oh sure, the Dow breaks 22,000 and local news stations go into one of their predictable round-number happy dances (as if the Dow Jones Industrial Average were anything other than a quaint relic from the 19th century). The S&P 500 (a more useful proxy for the “stock market”) lazily drifts along, sporadically setting new highs on the gentle currents of decent corporate earnings and low, but fairly stable, macroeconomic growth. Volatility, that once-fearsome stalker of equity portfolios, seems to be on the cup of fossilizing into amber or the permafrost.
On the other hand, bonds – wow! Everyone’s talking about bonds, normally the portfolio slice over which investors don’t lose sleep. More specifically, everyone’s talking about what could happen to bond prices if central banks follow through on a combination of raising rates and reducing balance sheets. Safe to say that “Raise and Reduce” focuses Wall Street’s attention in the same crystal-clear way that “Repeal and Replace” engaged the gimlet eyes of health care activists in recent weeks. For much of 2017 to date, yields on longer-dated bonds like Treasuries and investment grade corporates have remained relatively subdued while rates at the short end of the yield curve have climbed in expectations of further rate hikes. But ever since Mario Draghi mused about the pace of recovery in the Eurozone in late July, intermediate bonds (in particular Bunds and other European issues) have been channeling much of that volatility that the stock market has lost. Investors reasonably want to know if their bond portfolios are safe.
History Compared to What?
The issue at hand is whether central banks will go ahead with all these “Raise and Reduce” plans. If they were to do so, and if intermediate and long term rates were to suddenly spike as a result, then all those supposedly safe bond portfolios would be in the crosshairs. The “bond bubble” you may have heard about if you tune into the financial news channels and their bespoke pundits contemplates this scenario. At some point, the argument will wind its way back to the phrase “historically low rates” to describe how, after plumbing the lowest levels in the history of the American republic a scant twelve months ago, there is nowhere for rates to go but up, and possibly up a lot.
But what exactly are these historical averages, we would ask, and how relevant are they to the current environment? Bond yields don’t exist in a vacuum; they generally are related to the rate of growth and, particularly, the rate of inflation in an economy. In this context, historical averages are misleading. The average rate of core inflation (consumer prices excluding the volatile sectors of energy and food) from 1960 to the present was 3.8 percent, and the corresponding average rate of real GDP growth was 3.0 percent. Over the same time period, average yields on the 10-year Treasury bond were 6.2 percent, clearly far above where they have trended for most of this decade.
Past Performance Indicative of Nothing in Particular
But this 57 year “history” is hardly homogeneous. The first half of the 1960s enjoyed the tailwind of a very unusual confluence of productivity growth and growing labor participation that began after the Second World War. Those trends had petered out by the early 1970s, replaced by lackluster growth and soaring inflation – the “stagflation” era that still gives central bankers nightmares and clouds their policy thinking. Growth resumed in the 1980s with the help of both household and corporate debt, then experienced a very brief spike in productivity in the late 1990s. An uneven pace of growth in the mid-2000s collapsed with the 2007-09 recession, leading us to the current era of slow growth, tepid wages and moderate consumer prices.
The chart below shows the GDP and inflation trends over this time period. If bond yields are supposed to reflect what the collective wisdom considers a reasonable reward for deferring consumption today for return tomorrow, then what does this past history tell us about where rates might reasonably be in the weeks and months ahead?
As we have argued numerous times in these pages, the case for long-term growth much above the current trend of around 2 percent is weak: none of the catalysts – population, labor force participation or productivity – are working in the right direction. What would drive sharply higher inflation, then? And in the absence of a genuine inflation threat, what would prompt central bankers – well aware of their status as practically the only relevant economic policymakers in the world today – to take draconian action to battle imaginary dragons?
One can never rule out the potential for human error, and central bankers of course are still only human. But we do not think that a collapse in bond prices arising out of intensely hawkish central bank maneuvers is a high or even moderate probability scenario as we chart out the final leg of 2017 market trends.
Over the past few months, we’ve had a number of conversations with clients that go something like this:
Client: Wow, these are crazy times, huh? Politics! Never seen anything like this!
Us: Yep, they sure are crazy times.
Client: So, why does the stock market keep going up? When should I be worried?
In today’s commentary we will address this concern, and explain why we believe that, whatever one thinks of the political dynamics playing out here at home or abroad, it probably is not a good idea to transpose these sentiments onto a view of portfolio allocation. Political risk is a real thing. But history has shown there to be very little causal relationship between momentous political events and movements in risk asset markets. Any market environment, whether bull or bear, is affected by tens of thousands of variables every day, many of which have little correlation with each other, and very few of which are easy to pinpoint and ascribe to prime mover status. We offer up a case study in support of this claim: the US stock market in the early 1970s that encompassed the Nixon Watergate scandal.
That Dreary Seventies Market
President Nixon resigned from office in August, 1974, shortly after it became clear that Congress was preparing to commence impeachment proceedings in the wake of the revelations about the Watergate crimes and attempted cover-up by the administration. As the chart below shows, the S&P 500 fell quite a bit during the month of August 1974, as well as before and after the Nixon resignation. But the chart also shows that there was a lot else going on at the same time.
The Nixon resignation remains to date the most consequential political scandal in modern American history. It had an earth-shaking effect on the political culture in Washington, leading to far-reaching attempts by lawmakers to restore the integrity of the systems and institutions the scandal had tarnished. As far as markets were concerned, though, Watergate was far down the list of events giving investors headaches. Following a historically unprecedented period of economic growth and rise in living standards over the prior two decades, the first five years of the 1970s witnessed two wrenchingly painful recessions, spiraling inflation and a gut-punch to household budgets in the form of OPEC’s 1973 oil embargo. The freefall in stocks that took place in 1973 and 1974, if it is to be tied to any specific catalyst, flows from the real dollars-and-cents impact of the embargo and the recession. Watergate, as important as it was as a political event, was little more than a blip on a radar screen already filled with bad news.
Tweets Come and Go, Markets Carry On
Which brings us back to today’s daily carnival of the bizarre from the banks of the Potomac Drainage Basin. While the tweets fly and the heads of the high priests of conventional wisdom explode, the economy…well, just chugs along at more or less the same pace it has for the past several years. Today’s initial Q2 GDP reading (2.6 percent, slightly below expectations) sets us up for another year of growth averaging somewhere around 2 percent. The labor market is healthy, there is neither hyperinflation nor deflation, and corporate earnings growth is trending close to double digits. No major world economy appears in imminent danger of a lurch to negative growth.
Yes, stock prices are expensive by most reasonable valuation measures. And yes, there is not much in the way of sector leadership momentum. But until and unless we see compelling signs of a shift away from this uncannily stable macro context, we see little evidence that Washington shenanigans will have much of an impact on stocks. At some point, those tens of thousands of global variables at play will deliver up a different set of considerations and necessitate new strategic thinking. Trying to time the precise market impact, as always, is a fool’s errand.
Investors with broad-based commodity exposure haven’t had much to cheer about in the year to date. The Bloomberg Commodity Index, for example, was down more than five percent at the end of the year’s first half. The main culprit? Crude oil prices, and the tendency for commodity indexes to be heavily weighted towards the oozy black stuff. That is for good reason: for more than a century, oil has been the world’s most important commodity, the magical elixir powering the modes of transport that arose from the invention of the internal combustion engine. George Bissell, a New York lawyer, in the 1850s succeeded in his obsessive quest to extract the flammable “rock oil” known to reside under the craggy outcrops of western Pennsylvania. Had he not, the world today would know Saudi Arabia merely as a nondescript, likely poor desert kingdom. Nobody would have ever cared about who shot J.R.
While oil continues to struggle with both demand and supply headwinds – the slow pace of global growth on the one hand and the growing importance of non-conventional drillers in supplying the marginal barrel to the market on the other – other commodities in indexes like the Bloomberg are doing just fine, thank you. Precious metals have registered decent single-digit gains, likewise industrial metals like copper and aluminum, and also agricultural staples such as corn and wheat. Of all these, though, there is an interesting larger story about one: copper. It’s not a story for today, as in “what’s hot for my portfolio in 2017?” – but there is a potentially growing narrative around longer term demand trends based on something that is being much talked about this year: the rise of the electronic vehicle.
Copper for EV-er
Electronic vehicles, or EVs, have been in the news recently with chatter around the planned forthcoming roll-out of the Tesla Model 3, the attempt to bring this company’s offerings out of the stratosphere and into the affordability range for the masses. Meanwhile, Volvo has announced its intention to produce only battery-powered or hybrid vehicle by 2019. Scarcely an auto producer in existence has not joined the chorus of paeans to an EV-imagined future.
How soon – and at what cadence – this becomes a reality has major implications for copper. This industrial metal figures into several key parts of the EV manufacturing process including, importantly, the lithium-ion batteries that power the vehicles. Various demand projections for lithium-ion batteries over the coming 10-15 years, assuming certain levels of consumer adoption, show eye-popping ramp-ups that, if remotely accurate, would strain the total volume of commercially mined copper available from current sources. Many of the world’s existing facilities are many decades old, so the race is on for those with wildcatter tendencies to locate new sources in politically stable regions of the world to cope with the potential demand explosion.
Devil Is In the Details
Of course, much of the speculation about the potential role of copper in the brave new world of EVs is just that – speculation. There is no consensus on exactly how much of the metal would be required once the production processes become standardized and cost-efficient along the lines of how automobile factories evolved in the first half of the 20th century. Nor is it at all clear that electronic cars and other vehicles will see the same type of rapid, widespread consumer adoption patterns that we have seen from other technology offerings in recent years.
That being said, one of the important things to always remember about investing is that, over time, the tectonic plates do shift. The past is not prologue to the future – and the storied past hundred years of oil may be a poor predictor of the future for “Texas tea.” It’s worth keeping an eye -- and perhaps a small ante at the table – on copper’s future fortunes.