Market in a nutshell
The first quarter of 2018 kicked off with a bang, as the market "melt up" from the sugar high of tax reform and an extraordinary Q4 earnings season pushed stock prices to all-time highs, and global economic conditions justified a really optimistic environment for risk assets. Early February saw the launch of market distress behind inflation fears that pushed interest rates higher that then caused panic attack in the stock market. Things stabilized, markets settled, then rallied, and the bulk of the sell-off was made up for in a matter of two weeks. And then the Trump administration started a tariff tantrum, and markets have zigged and zagged around fears of a global trade war ever since. We sell off on days that it is clear the trade posturing will continue; we rally on days that it is clear that much of it is just muscle flexing. But nonetheless, good fundamentals are up against uncertainty in trade policy and monetary policy.
Some Trade War Warning Shots
The market suffered its worst week in over two years last week, led by a 700+ point drop Thursday and another 400+ point drop on Friday (the cumulative toll being a stunning $1.4 trillion of market cap in the S&P 500).It was hard to take seriously the idea that China would not retaliate from $60 billion of tariffs the Trump administration had announced against them. And indeed, China quickly announced a 15% tariff on wine, dried fruit and nuts, fresh fruit, steel pipes, ginseng, and modified ethanol, and a 25% tariff of recycled aluminum goods and pork. China’s retaliation was absolutely the reason for the Thursday and Friday sell-off last week. But thus far, their announced tariffs only affect $3 billion of the $172 billion that China imports from the U.S. each year (meaning, the market was likely far more concerned about what lies ahead than even the first shot itself).
The big rally on Monday this week was based on the indications over the weekend that, yes, the rhetoric we are seeing now is primarily posturing and flexing. Do we believe this resurgence of protectionist conversation will prove to be more bark than bite? Sure, but don’t expect markets to “shrug off” and de-volatize in the midst of this action.
Some China Clarity
At the end of the day, the source of the volatility is the Trump administration dealing with this very challenging reality: There is very little they can do to punish China for various violations and undesirable trade practices that will not punish America more than they punish China.
China and Trade are boring. Let's talk fun stuff: The FED
When the Fed raised rates a quarter point last week (as the entire market knew was coming), and laid out their expectations and criteria for the path ahead, market actors got to do what we all do worst - attempt to interpret what simply cannot be accurately interpreted. "What does he really mean when he says [this or that]?" "What would they do it [this or that] happened?" Etc. As we have said for many years - the Fed has to be analyzed by what they do, and never what they say. "We anticipate tightening monetary policy as such, unless we do not tighten monetary policy as such" - is not actionable guidance. "We will go where the data takes us" is the same as saying "we do not know what we will do at this time." The Fed wants to have monetary policy more normalized than it presently is. The Fed is hyper-sensitive to monetary policy decisions that disrupt capital markets (as they have been for 20 years now). The Fed is limited in what they can do when it comes to actual employment, and actual inflation. And the Fed has become very unwilling to surprise markets. So we follow what they do, and ignore trying to parse out what the use of a certain adverb in a press release may really mean, etc.
Bottom line - they are normalizing, and they are doing it slowly.The short term rate the Fed can control will go higher, slowly. For now.
How big was Monday? Also - Math.
The +677 point move in the Dow on Monday was the 3rd biggest point move up in history. And in percentage terms, it was the 349th biggest day in history. Oh the realities of a large market price denominator! =)
Some Advice on Asset Allocation
The "inflation vs. deflation" fight has been the key fight of the last ten years, and will be for some time to come. Lacking "normal" or "level" monetary policy, the various convulsions that take place around inflation expectations or disinflationary shocks (etc.) have a big market impact because they force counter-acting measures from the Fed, as opposed to functioning in a more healthy equilibrium. But for those who believe that "it is obvious rates are going higher," and then conclude from that "obvious" premise that "it is obvious bonds are going down," be careful. Likewise, the narrative of any premise being obvious is only 50% likely on a good day, and the odds that your conclusion from that premise will be accurate has an ever lower chance of playing out. I speak here to the specifics of inflation and disinflation, and actionable conclusions from both. I have never, ever, ever seen an area in which premises have proven more wrong, or in which conclusions from premises have proven more wrong, than what I have seen both novices and experts say about inflation and deflation over the years. Keep that in mind in formulating an asset allocation. We sure do.
Digesting the Fed
When we look at the Fed announcement last week for clues about what lies in store for markets, we are reminded that looking at what they say is not as helpful as looking at what they do. The ten-year bond yield did not budge, staying at 2.85% (where in fact, it basically was at the very beginning of February).
Do you see my point? With a few head fakes here and there, and a little dip (really little) along the way, the longer term bond rate has actually just stayed completely flat for essentially two months, as market prognosticators have worked themselves into a tizzy about rates moving higher, etc. What we see is a Fed that only has control over the short rate, and that will prove incapable of controlling long term rates as this process continues. They can (and do) control the short term rate, but when we listen to the new Fed speak, we do not hear anything that suggests they have been able to change the rules of the game. There remains a lot of leverage in the economy, which controls how much they can do with rate policy without creating significant disruption (which is something they have consistently shown they don't want to do).
Where interest rates matter and where they do not
One of the very legitimate and simple arguments made for how important what the Fed does is to the health of the stock market is that low interest rates facilitate borrowing and activity that adds to the bottom line which is driving stock prices. Put differently, higher interest rates cut into margins, and profits are the mother's milk of stock investing. It is all true enough, but a couple observations need to be made. First, the slightly higher short term rates right now still represent a very low absolute rate for corporate borrowers, and in fact, with spreads tightening, have not created a much higher yield for corporate borrowers at all. Yet.
The only two stocks in the Dow that are up since the market top of late January? Intel (INTC) and Cisco (CSCO).
Did someone say bond market?
I am old enough to remember February of 2018 when rising bond yields meant the end of the equity bull market. Fast forward all of five weeks or so, and we see bond yields having dropped quite a bit, and markets still in volatile times. Why? The bond market is not buying the inflationary thesis, and if tariffs do become a real problem (vs. a political/volatility problem), it would suppress nominal growth, which pushes yields lower, and bond prices higher. I cannot say enough how important it is that one avoid the pedestrian assumption that "rates are going higher" so "all bonds should be avoided." The first premise is not clear. And the conclusion is a classic non-sequitur. Asset allocation, friends. Disciplined asset allocation.
Brexit Truth Serum
From the Wall Street Journal last weekend (1):
"New orders from manufacturers in Britain are at their highest level in a generation; the national happiness index is at an all-time peak; demand is so high for labor that there is inadequate supply to fill it; equity prices, stock prices, and foreign investment are all at new highs; unemployment is at a 43-year low; GDP has risen by 1.4% (vs. the predictions of significant GDP decline)."
The fact of the matter is that the doom-and-gloom Brexit predictions were politically motivated, not economically derived, and rooted in a complete misunderstanding of how markets actually work. There remains key variables in how things play out, including the nature of future trade agreements. But we believe the self-interested Brexit-skeptics are not the best source of how to forecast the future of British prosperity, let alone investment prospects.
More on MLP's
It is interesting to note that in the week the FERC announced their ruling taking away a certain tax loophole some MLP's have enjoyed on some projects, MLP's were actually down that week less than the market was. The day of the announcement, by the way, was merely the 36th worst day of all time for the MLP sector (h/t www.mlpguy.com). In other words, it sure seems that sentiment may have bottomed (though how long it "stays bottomed" is a different matter altogether).
I do want to unpack the ruling itself more. A few clients reached out wondering if this ruling enhanced the attractiveness of corporate pipeline companies vs. MLP structures (a reasonable hypothesis). And yet, certain c-corp pipeline companies were down just as much as the rest of the space (overall, that was not the case). However, regardless of the complicated reasons for that, the fact of the matter is that there has been a significant migration of MLP companies pursuing a c-corp structure anyways, and we have to imagine this ruling will only advance that migration.
Living on the edge
This chart fascinated me today. There is a credit rating ("BBB-") that is NOT considered "junk," but is considered the "lowest possible rating that is not junk." The total volume of BBB- bonds out there is now more than double the entire junk bond universe. So while the size of high yield credit market does not appear to have grown much since the financial crisis, the "almost high yield" market has grown, big time.
Oh, did we mention this?
Trade war. Tighter monetary policy. Political risk. So much "stormy" stuff out there. But did we mention this?
In the first month after corporate tax reform took effect, non-defense capital goods orders surged 1.8% month-over-month.
Chart of the Week
The movement of bond yields matters, but investors probably care about the volatility of it all even more!
Quote of the Week
"Those who talk should do, and only those who do should talk."
-- Sextus Empiricus