SEPTEMBER 2018

Five Debates That Will Likely Drive Markets Through Year-End

Category: Portfolio Management

By Doug Cohen, Managing Director, Portfolio Management

It has been 55 years since Nat King Cole’s “Those Lazy-Hazy-Crazy Days of Summer” topped the charts. With the days of this summer winding down (having surely delivered on at least the last of Cole’s three adjectives), I thought it would be helpful to frame the five key questions that are likely to drive markets over the final third of the year.

1) Can the second longest US economic expansion on record remain on track despite some potentially formidable headwinds?

To be sure, the correlation between risk assets (equities in particular) and GDP is anything but 1.0. However, at a very basic level, recessions are the true game changers. Avoid a recession and the bull market likely stays intact, despite occasional corrections akin to the one in late January/early February of this year. The vast majority of traditional recession warning signs related to credit spreads, real interest rates, earnings revisions, and energy prices are at relatively benign levels. The shape of the yield curve is a notable cautionary outlier though. An inverted yield curve (2-year Treasuries yielding more than their 10-year counterparts) has historically been a reliable recession indicator—albeit with the recession usually coming 10-18 months later. An inversion typically signals that credit is tightening in the banking system and that the market has become convinced that trouble is on the horizon. As usual, there is a “it’s different this time” argument to be made in the sense that the unprecedented global quantitative easing has distorted traditional yield dynamics, but the current 20 or so basis point spread between the 2-year and the 10-year does not leave a lot of wiggle room. In our opinion, one additional concern relates to the fact that, unlike prior periods, the majority of daily equity trading is now dominated by algorithms. To the extent past inversions have signaled trouble, will the new algorithms collectively begin to move into “sell mode” if/when an inversion occurs?

The other key threat to the US economy is the global economy. The stronger dollar, a potentially significant slowdown in the Chinese economy, currency angst in assorted emerging markets (Turkey is, of course, currently in the maelstrom), a continued spike in European populism, and rising trade tensions all could derail the strong business and consumer confidence that have made the US a positive global economic outlier over the past 12-18 months. We could spend a lot more time here on just the trade tensions alone—fortunately, Athena Research has done just that with its recent landscape review on “Evaluating Potential China Trade Tariffs.”

2) To the extent quantitative easing was the dominant catalyst for the post-financial crisis market boom, will a transition to quantitative tightening result in a corresponding bust?

First, we should be clear that there is no clear precedent to answer this question. History may not repeat, but in this case it doesn’t even rhyme. That is, there has never been a global monetary stimulus that rivals the one that to this day still has approximately $8 trillion dollars (more specifically Swiss Francs, Yen, and Euros) trading with negative yields. Given that we are still in largely uncharted territory, we believe that global central bankers will continue to err on the side of caution. They realize that the recovery of the global financial system is still tenuous. As such, future tightening moves are likely to be gradual and well-telegraphed. After several false starts (recall the “taper tantrum” and the aborted efforts to end QE1, QE2, etc.), the US appears to be well on the road to monetary normalization. We think Chairman Powell has managed to maintain much of the credibility and goodwill that his predecessor enjoyed. We do not expect his Federal Reserve to cave easily to potential political pressures.

The outlook for Europe is murkier in that the recent economic deceleration and rising populism (including an uncertain Brexit) may prevent the European Central Bank from ending quantitative easing in the second half of 2018, as it had hoped. The silver lining there is that, as we have seen in the US, equity and bond markets may well take such a delay in stride as it implies more “easy money” for longer.

3) Will markets continue to largely ignore one of the most unorthodox presidencies in US history?

Some Trump supporters might take umbrage at the phrasing of this question as US equities have surged by over 35% since the 2016 election. The economy has seemingly found a new gear amidst the 2017 tax cuts and broad deregulation. Importantly, the stock market has begun to reward companies that re-invest in their businesses via research and development and capital expenditure more than those that have emphasized financial engineering (primarily stock buybacks). The capital markets have generally taken potential overhangs such as trade uncertainty, the Mueller investigation, and a broad array of geopolitical tensions (North Korea, Russia, Iran, Turkey, etc.) in stride.

The question relates more to the market’s seemed disinterest in most of the Trump-related issues that have kept tabloid headline writers and Op-Ed columnists working overtime. There’s ample room for debate regarding the short- and long-term impacts of President Trump, but our view is that the market’s resilience speaks first and foremost to the checks and balances in place in the United States. Over the years, we have talked to many Fortune 500 CEO’s about the best places to do business around the world and we’re hard pressed to think of more than a handful that did not list the US as their clear top choice. Home country bias aside, we think that speaks to a business landscape and rule of law that transcends the presidency.

In the market’s view, policy has mattered far more than politics. That said, we believe that the November mid-term elections will surely register on investor radar screens. At present, neither party should feel overly confident about having control of either chamber come January. Most experts believe that the Republicans are likely to retain a slim majority in the Senate. However, the House looks increasingly likely to revert to Democratic control. There will certainly be several twists and turns along the way, but our best guess is that markets would be copasetic with such an outcome.

4) Will a strong US dollar begin to cause more significant dislocations?

America’s outsized economic growth relative to most of the world (and the Federal Reserve’s corresponding rate hikes) fueled a 5.7% surge in the greenback in the second quarter of 2018—the largest quarterly gain since third quarter of 2011. While a strong dollar has some important attributes, such as cheaper imports (less inflationary pressure at the margin) and the bolstering of its status as the world’s reserve currency at a time when China and others have questioned that role, there are some significant drawbacks as well. The stronger greenback has contributed to weakness in various emerging market economies and made the case for synchronous global growth less compelling. Moreover, given that over 40% of S&P 500 earnings are generated overseas, a stronger dollar can weigh heavily on the earnings of multinational corporations. Indeed, companies that reported earnings in the second quarter of 2018 cited the strength of the dollar as the most challenging headwind, exacerbated by an increasingly uncertain trade environment. This is an area where President Trump could play a meaningful role as he has long favored a weaker dollar in his public remarks; as such, more jawboning from the president in favor of a weaker dollar and an end to Federal Reserve tightening seems likely.

To be clear, the trade weighted dollar is only up about 4% this year and is still just below the near 15-year high set in early 2017. As with interest rates, markets tend to take gradual currency moves in stride. However, sustained sharp moves often cause distress—as per the recent volatility in Turkey, South Africa, and Argentina. Given the prevailing economic trends fueled by an aggressive fiscal stimulus that continues to favor US growth relative to the rest of the world, we are hard-pressed to see the dollar losing much ground in the second half of 2018.

5) What’s in the price?

With the caveat that valuation assessments are largely more art than science, we believe that equity and fixed income valuations are generally still rich, but somewhat more favorable today than they were at the beginning the year. For equities, there are many valuation metrics to analyze, ranging from conventional one-year forward-looking price to earnings (P/E) ratios, such as the Shiller PE Ratio, to ten-year backward-looking inflation-adjusted ratios, such as Market Cap to GDP. The combination of 23% earnings growth and a more modest 10% year-to-date gain in the S&P 500 have taken the US one-year forward-looking P/E ratio from nearly 18x earlier this year to about 16.5x at present. Accounting for still-low prevailing interest rates, a 16.5x P/E ratio is very close to the average for the past 50 years. By definition, the Shiller P/E Ratio tends to move more slowly; however, the impact of the 2008-2009 financial crisis will soon roll off. As such, all else equal, the current reading of about 32 (near historical peaks) is likely to decline to a still very high 28 or so over the next year. The Buffett indicator is currently at approximately 145%, near its 1999/2000 peak. Suffice it to say, it is flashing a red warning signal—as it has for the past two-plus years.

On the bond side, we typically look at three broad measures: spreads versus history, yields versus history, and Z-scores based on spreads on a five-year basis. In broad stokes, spreads remain quite tight versus history. Yields have become somewhat less tight, as have the Z-scores. On the last measure, high yield muni’s look unusually rich whereas Treasuries have begun to look somewhat inexpensive on a yield basis.

Valuations tend to mean little in the short-term but do frame the longer-term risk/reward tradeoff well, in our view.  Suffice it to say that on balance, current valuations for risk assets remain fair to rich by historical standards. Both equities and bonds certainly could edge higher over the last third of the year but it would likely be in the face of prevailing valuations, not because of them.

 

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