Greetings from New York City where we have been inundated with market perspective and outlook all day, every day, and are in the midst of an annual reflection period that coincides perfectly with a period of extreme curiosity in capital markets. I want to use this week's Dividend Café to really delve into that "market curiosity," and will use next week's Dividend Café to better capture many of this week's conclusions around equity markets, fixed income landscape, and asset allocation positioning. In the meantime, let's get into it ...
Are rising interest rates to blame for market volatility?
I address in greater detail below what I think was specifically behind the market events of last week, but there is a larger, more under-arching narrative that has formed which essentially centers around rising rates as the culprit for our distress. I have written before of the short-sightedness in people invested in risk assets believing that permanently low (and going lower) rates were for the best. But apart from that, allow me to offer an objective look at the impact of rising rates thus far:
- I am certain it is beginning to effect housing prices and new housing starts (see the section on this below), but I am equally certain that cannot be called a negative on the economy. Permanently advancing housing prices above and beyond rational affordability metrics are a negative for the economy, not a positive.
- Returns on Invested Capital for American businesses remain comfortably higher than borrowing costs, and I can think of no metric I care about more than this.
- Credit supply is certainly not impacted yet by the higher rates. So what these last two points mean is that companies have plenty of ability to borrow, and they have plenty of ability to do so profitably.
Looking for a crack
One consistent theme I am seeing from macro analysts trying to handicap the possibility of a better overall environment for risk assets is the search for some sign that the Fed is getting wobbly in their quest for monetary normalization. At this time, Fed governors have given no such sign that their resolve is weakening. A drain on liquidity worldwide is a macro headwind for markets that were not previously anticipated. To be clearer than perhaps many market prognosticators are being - the pressure in markets is not, as we see it, as much related to the actual inflation levels and such that the Fed is supposedly concerned about, but rather, is related to the actions they are taking in response to such. Oh, the irony.
Unpacking what really happened in last week's meltdown
I spent a significant portion of the last 48 hours looking deeper into the nature of the market sell-off we experienced Wednesday and Thursday of this week. Friday’s rebound notwithstanding, it was a particularly destabilizing week, made more so by the lack of real explanation or catalyst. By Thursday I was finding the explanation that investors were merely prepping for a new round of inflation expectations (and therefore higher interest rates) wholly unsatisfactory. For one thing, that expectation of meaningfully higher inflation is balderdash (not the word I wanted to use). Secondly, I see no evidence anyone really believes it, and as fate would have it, the money was flowing from risk assets like equities to Treasury bonds (pushing yields down, not up). In other words, it was a classic risk-off decline, not a new paradigm of higher inflation/interest rates driving this. Allow me to unpack all this more …
I believe more and more it was a story of the dollar's rise specifically against the Yuan. Note, I did not say "the dollar's rise" as a sort of general global currency appreciation, because in fact, it declined last week against the Euro and many other currencies. I am specifically talking about the Yuan.
- The Yuan has not been over 7 to the dollar in over ten years. The currency depreciation taking place in China (partially if not largely to fend off the impact of the trade tariffs) is not, in and of itself, economically destabilizing. However, it most certainly can become so and can indicate/point to economic instability, if it is followed by large capital outflows. This happened in August of 2015 and January of 2016 and global markets absolutely threw up until things stabilized.
- A huge part of me believes that the talk of China being labeled a currency manipulator is creating an undertone of market instability, in so much as it could weaken global growth to some degree at a time when global growth is not in any mood for complication. [SEE POLITICS & MONEY BELOW FOR UPDATE]
- And I would not ignore the Italian debt fiasco, either. The spread over bunds blew back out over 3%, meaning things are hardly well across the pond.
- The huge part of the market driven by momentum factors flipped to the short side, or at least to the sell side, and an extraordinary unwinding of leveraged trades began. The report I read indicates that it was not merely quantitative hedge funds and CTA's selling, but directional hedge funds as well (who certainly had leverage on their positions).
- All of this leads me to believe that there is fear of global conditions hitting U.S. markets and that if the fears around China and Europe prove warranted, it may paradoxically end up with more money coming into U.S. markets.
- So is it the ten-year yield we have to watch to guess where the market is going next? Hardly. A rising bond yield offers this kind of predictive value: Click here to view the chart.
- I have several colleagues that are quick to point out that right as this sell-off was cascading, about 90% of the S&P 500 was in a "blackout" period from buying back their own stock, as they are within the window of their own earnings announcements. The chart here (click here to view) verifies this is true, but I have to say, if this was a real contributing factor, that cannot be taken as a positive (that the market would now be so dependent on company buybacks).
- The violence of the sell-off was likely accelerated by "technical" factors like leveraged trade unwinds, ETF order books, and CTA/risk parity trades. But the directional sell-off cannot be blamed on such.
- Buyers to offset the selling pressure may have been limited by the lack of company treasurers in the marketplace buying back their own stock, but that cannot be considered a primary factor, and if it were, we have an unhealthy market that relies so heavily on such.
- International/global conditions may very well be what breaks the Fed's resolve in their 2018 hawkishness, but we do not know that.
- We are happy with our present asset allocations, grateful for our alternative investment performance, and convinced that our defensive bias in equity portfolios has been and will continue to be the right thing for our clients.
- China's capital controls are worth watching. Again, the key is what capital flows indicate about their economy, not what they do to their economy.
- This immediate period of extreme market swings is stupid. It doesn't point to reality. Good investment policy is never found in extreme activity.
- Finally, FUNDAMENTALS WIN IN THE END. Unfortunately, I have yet to devise or find an investment strategy where I can divorce all investments of fundamental strength from peripheral noise that ought not be having such an effect.
How bad was last week's sell-off?
- Half of the Russell 2000 (small-cap index) is now down 20% or more from their highs (a bear market)
- $175 billion of market cap was lost in the FANG stocks in ONE DAY. Just on Wednesday, the combined value of Facebook, Amazon, Netflix, and Google was down $175 billion in one day.
Housing market weakness
I have never, ever believed in the utterly absurd belief that permanent and uninterrupted housing market price appreciation is a sign, let alone the sign, of a healthy economy. Indeed, I believe an economy can be unhealthy even when housing prices are rising, and I believe an economy can be quite healthy even when housing prices are declining. In fact, sometimes the healthiest thing for the economy is for housing prices to adjust. There are both economic and moral fallacies that have created wrong assumptions about this issue, but I will resist the diversion.
That said, it is perfectly compatible to note that housing prices are weakening, even as the economy is strengthening. Housing starts were down 5.3% last month and are barely up on the year. Mortgage applications were down 5.9% last week. It is reasonable to assume that lower prices (not severely lower, at all), longer time on the market, and general shifts in buyer sentiment are largely tied to rising interest rates.
The fact of the matter is loan delinquencies are very low, home equity line withdrawals are not increasing, and there is little sign of a "bubble." What there is plenty of support for, however, is that housing is a highly interest rate sensitive sector, and we entered a rising rate environment already over-priced in terms of housing affordability.
What should we be watching?
I do believe the idea of a resolution with the U.S. and China on trade disputes being as easy as Europe, Canada, and Mexico proved to be remains a problematic view for markets. The 10-year bond yield being 3.25% in the United States (or whatever) does not concern me nearly as much as potential for unforced errors in trade policy detracting from economic growth, or even adding to China's economic stability in a way that rattles global markets. China is not a place we want much direct investment in, but it is a place that we are certain has a profound contagion effect on our own markets.
In this week's contrarian indicator ...
Where will the dollar go from here?
The first red circle below represents the last time hedge fund bets on the dollar going higher were this high. The chart shows how the dollar did after that. The red circle on the far right represents the new high in bets on the dollar, set over the last week.
Politics & Money: Beltway Bulls and Bears
- I argued last weekend that much of the recent market distress was China-fear-related, and I stand by that hypothesis. I also added anecdotally that the possibility of the U.S. labeling China a currency manipulator was adding to the volatility fray. The President has frequently chimed in on this issue, and recently Secretary Mnuchin has jawboned as well (though as of press time has not given into Presidential pressure to actually label China a manipulator). The fact of the matter is, while politically inconvenient, China's interventions lately have been to strengthen its currency (or soften its weakening), not the opposite.
- Senate Majority Leader, Mitch McConnell, confirmed this week that the re-done NAFTA agreement the Trump administration has submitted will be voted on by the next Congress, post-midterm. This was expected.
- The Treasury Department decided NOT to label China a currency-manipulator this week
- On Wednesday this week the White House released results of deregulatory agenda since the President took office, claiming $33 billion of savings across federal agencies. In contrast, there was $245 billion of added costs the first 21 months of the Obama administration. Because the estimate for negative impact to the economy from the trade war is roughly $30 billion, it appears that just deregulation is more than offsetting that negative impact in a macro sense, let alone the stimulus of tax reform.
Quote of the Week
"The dissenter is every human being at those moments of his life when he resigns momentarily from the herd and thinks for himself."
-- Archibald MacLeish