Reaching The Macro Inflection Point: 2Q2017 Market Commentary

by: Benjamin Lavine, CFA


Ex-U.S. markets led the U.S. market as global macro conditions continue to improve despite efforts by China to crackdown on ‘systematic risk’ within its financial system.

Global fixed income had been benefiting from flattening yield curves and lower volatility before being surprised by hawkish comments from the European and Canadian central banks.

The 10-Year U.S. Treasury yield had dropped to 2.14% before spiking to 2.30% at quarter-end. The 10-Year German Bund yield rose to 0.47% from a low of 0.25%.

U.S. NYMEX spot oil dropped to $43/barrel from $50/barrel at the beginning of the quarter before recovering to $46/barrel at quarter-end. Energy investors were surprised by the surge in U.S. production as U.S. producers took advantage of the recovery in prices from earlier in the year.

The conflicting signals seen in equity, bond, and volatility markets imply that we are reaching an inflection point on the macro development front. All seem to point to a slowdown but in varying degrees as very few see an inflationary-led cyclical growth spurt.

Data Source: Bloomberg

Reaching the Macro Inflection Point


There are moments when conditions make it more challenging to write a market commentary, especially when the narrative keeps shifting. Prior to the last week of the quarter, it appeared the narrative had settled into a calm, defensive market characterized by low volatility and low rates. But then the final week saw the U.S. dollar weaken and global bond yields rise over hawkish central bank comments. And just when the political focus began to shift away from the Trump administration to Congress debating health care reform, the U.S. president decided to engage in a wrestling match with the media.

The global bond market sell-off began with hawkish comments from European Central Bank president Mario Draghi who mentioned in a speech that the ECB is preparing to reduce its monetary stimulus later in the year. The comments surprised investors as the euro rapidly rose against major currencies and global bond yields rose (Chart 1) as fixed income investors interpreted Draghi's comments as a sign that global economic conditions have improved to warrant removing emergency monetary measures such as quantitative easing.

Chart 1 - U.S. and European Bond Yields Rise Following Hawkish ECB Comments

The U.S. dollar continued its year-to-date weakness (Chart 2) against major currencies as the world starts to catch up to the normalized rate path communicated by the U.S. Federal Reserve from last year. The U.S. dollar is now trading at similar levels prior to the November election. The U.S. dollar is down 3.45% for the quarter and -6.44% for 2017, which helps explain a good portion of the outperformance of ex-U.S. equity markets versus the U.S. (Chart 3).

Chart 2 - U.S. Dollar Weakens and the Euro Strengthens as the World Starts to Catch Up to the U.S.

Chart 3 - Ex-U.S. Markets Outperform the U.S.

The conflicting signals seen in equity, bond, and volatility markets imply that we are reaching an inflection point on the macro development front. All seem to point to a slowdown but in varying degrees as very few see an inflationary-led cyclical growth spurt. Despite the peripatetic shift in forward growth expectations, U.S. consensus for 2017 GDP growth has remained 2.2-2.3% over the last two years. The Federal Reserve of Atlanta's GDPNow model is forecasting 2.7% annualized growth for 2Q (as of 6/30/17) which has steadily declined from the beginning of April.

If we are not sliding towards another recession, then the markets are at least signaling an environment of low but scarce growth characterized by a search for yield while avoiding anything remotely cyclical (i.e. commodities). The late quarter sell-off in precious metals also seems to confirm this outlook.

For now, the Federal Reserve appears to be committed towards one more rate hike this year (a total of three for 2017) despite the flattening of U.S. yield curve and lower inflation expectations priced into TIPs (Chart 4). One could argue that since Fed Reserve Chair Janet Yellen and ECB President Mario Draghi are approaching the end of their terms, the tradition for central bank leadership transition is to ensure that the successor is handed a more normalized policy regime from their predecessors. In addition, the lack of wage growth has enabled the Federal Reserve to pursue 'data dependent' policies that will help ensure they remain behind the curve should inflation eventually pick up.

Chart 4 - Bond Market Sees a Lower Inflationary Environment

Sentiment Shift Towards Low Volatility Just Getting Started

Despite the quarter-end spike in global yields and volatility, inflationary trends remain subdued (Chart 5) and buyers should step in to take advantage of oversold conditions.

Chart 5 - Core Inflation (PCE Core Deflator) Loses Steam

With the dramatic drop in the 10-year Treasury Yield and this quarter's outperformance of defensive sectors over cyclical sectors, we find ourselves debating whether the so-called 'low volatility' trade looks overcrowded. Although 'momentum' strategies have turned in strong performance this quarter (Chart 6), the rally in 'low volatility' stocks could just now be picking up steam.

Chart 6 - U.S. Momentum Runs Ahead of All Other Factor Strategies

Chart 7 displays the PowerShares Low Volatility ETF (SPLV) sensitivity to 'value' and 'momentum' risk factors as defined by Bloomberg's 1-year forward risk model versus the S&P 500 Index (as proxied by SPY). The most recent SPLV basket does not exhibit as high relative exposure to momentum (versus the S&P 500) as it did a year ago prior to the Brexit vote, although its relative exposure to momentum has risen more recently, while its relative exposure to value remains flat. In other words, low volatility does not appear to be extended, and in this period of uncertainty around inflation (or lack thereof) and cyclical growth, we would not be surprised to see even more sentiment shift towards low volatility.

Chart 7 - U.S. Low Volatility: Relative Sentiment Not as Extended Versus Prior Year

Source: Bloomberg PORT as of 6/30/2017

Of course, an upward move in inflation would arrest this shift towards low volatility (as well as long duration fixed income risk), but, mobile data plans aside, it is difficult to pinpoint inflationary pressures given this year's drop in commodity prices. Market expectations for long-term inflation now remain comfortably below 2% despite an economy near full employment. A flattening yield curve also suggests that investors doubt Federal Reserve officials' forecasts on renewed inflationary pressures.

We have seen this picture play out multiple times since the 2008 financial crisis - a secular disinflationary psychology that is difficult to shake (and rational if one believes in the New Normal of muted growth). Interest rates peak out ahead of economic disappointments, the curve flattens, commodity prices drop, inflation expectations drop, and equity investors shift from cyclical value to defensive growth. What can potentially break this cycle is some meaningful progress on pushing through fiscal and tax reforms and some renewed momentum in overseas growth, especially in Asia.

Yet, inflation continues to play hide-and-seek in a period of full employment, as there could be larger productivity forces at play, such as technology in retail (Amazon), ride-sharing (Uber/Lyft), and North American oil/gas production (fracking), which are putting a downward shift on prices. And the main beneficiary of this technology is the consumer, so that the next upward move in the cycle could come from an acceleration in consumer spending rather than from business investment.

Echoes of 1989 Nikkei Peak?

Towards the end of the quarter, the China Banking Regulatory Commission announced a review to determine whether the " systemic risk of some large enterprises" poses a hazard to the country's banks and overall health of the economy. Shares of companies involved in large overseas acquisitions such as HNA Group, Fosun International, and Wanda Film Holdings plunged on the news. In addition, privately-held Anbang Insurance Group (owner of the Waldorf) came under scrutiny following "a series of critical articles about its finances, and after its head, Wu Xiaohui, [had] been detained by authorities for several weeks."

China continues to experience the fallout of running a large capital account surplus where its enterprises and populace face challenges deploying their excess savings. One can't help draw similarities between China's experience today versus that of Japan at its market peak in 1989 before the Nikkei dropped 38% in 1990 and producing a bear market that is entering its third decade. Both countries experienced significant asset bubbles in equities and real estate fueled by excess financial leverage. Transnational companies from both countries also embarked on a an overseas spending spree to deploy excess capital. One can draw symbolic parallels such as trophy properties (Mitsubishi - Rockefeller Towers and Anbang - Waldorf) and movie production (Sony - Columbia Pictures and Wanda Group - Legendary Entertainment).

This latest crackdown by Chinese regulatory authorities to stem the risk of excess financial leverage recalls similar efforts by Japan's central bank to rein in speculation by tightening monetary policy. Japan's stock market peaked at around the time of the fifth tightening. Typically, once the dust settles following an asset price collapse, the market suffers from the aftermath of non-performing assets when such assets were deemed 'money good' as long as markets had stayed euphoric.

Chinese authorities are hoping to "tamp down credit excesses before they produce a bust like the U.S. subprime crisis..." Will China experience a similar fate to that of Japan as it seeks to "rein in a heady credit boom fueled by so-called wealth management products" tied to stocks and real estate? A larger question concerns which government system is better equipped to tackle excess credit boom-and-bust cycles. The 1989 Nikkei peak and the 2008 subprime mortgage collapse suggest that neither a central-and-control nor a western-style-market regime were better equipped to handle the aftermath. Market collapses from excess credit accumulation result in major short-term pain or a drawn-out malaise due to a zombie financial system weighed down by non-performing assets. Perhaps, China's experience will be different this time around.

Another key question is whether China's efforts to tamp down excess credit will have knock-on effects across the global markets or whether such efforts will be 'contained.' Given how many financial assets are priced with narrow risk premiums, there is little room for error should China decide to tighten its credit markets.

Oil Sell-Off

Oil prices accelerated a sell-off that began in the first quarter with NYMEX spot prices dropping from a 2017 peak of $54.45/barrel to a low of $43/barrel before recovering to $46/barrel at quarter-end. In their 2017Q2 MLP Insights, Global X Funds notes how global oil production has actually fallen this year (Chart 8), with the U.S. being the only region to show positive production versus the rest of the world. Nonetheless, energy investors were surprised to see how quick U.S. production came back online as breakeven costs continue to drop (according to Global X, breakeven now estimated at $35-40/barrel - a 55% drop from 2013 levels).

Chart 8 - The World Awash in Oil? Global Production is Actually Down for the Year

What are the main contributors to the drop in break-even prices that have caught investors by surprise? Global X lists three likely catalysts:

Technological advances (big data, 3-D imaging techniques, advanced materials in drilling and pumps) Renegotiated oilfield services costs High-grading, or employing the most efficient existing wells, rather than drilling for new ones.

For now, North American shale producers are the new price setters and limit the effectiveness of OPEC's curtailing of production to support prices.

Needless to say, energy demand is not falling off a cliff but continues to grow year-over-year. The major oil price collapse from 3Q2014 to 1Q2016 occurred in a backdrop where China's energy demand had actually declined during the first half of 2014 (according to the International Energy Agency). Chinese's apparent oil demand has risen this year according to S&P Platts suggesting that the backdrop for energy, although slower in prior cycles, is not decelerating to a degree that suggests a major supply/demand imbalance is developing like the one seen in 2014-2015 (Chart 9). Credit spreads widened (Chart 10) a bit during the sell-off but still remain narrow suggesting little financial pressure on oil producers.

Chart 9 - Global Supply/Demand Gap Ticks Up but Demand Continues to Increase

Chart 10 - Credit Spreads Remain Narrow Despite Commodity Price Volatility

Outlook for Remainder of the Year

With GDP expected to moderately grow this year and global central banks pursuing normalization of monetary policies, the second half of this year could see more of the same from the first half, namely low volatility (and lowered expectations). According to Factset Earnings Insight (ending 6/30/2017), 2Q earnings are expected to grow 6.6% which is down from the 8.7% growth forecasted at the beginning of the year, but the downward revision has been driven by the energy sector. For all of 2017, analysts expect earnings growth of 9.8% on top of revenue growth of 5.1%.

Short of a global disruption (i.e. China systemic risk), global financial assets should continue to be priced at a premium, whether equities (high P/E multiples) or credit (low credit spreads). If energy prices stabilize at current levels and some progress is made in D.C. concerning health care and tax reform, then the focus should shift towards how earnings will track for the remainder of the year.


At the time of this writing, 3D Asset Management held positions in SPLV and SPY. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as July 3, 2017 and are subject to change as influencing factors change.

Disclosure: I am/we are long SPLV, SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.