Mission Accomplished (Updated 2018) - Q1 2018 Market Commentary

by: Benjamin Lavine, CFA

The beginning of the quarter saw a euphoric start for global equities as investors celebrated the passage of the Republican tax plan that lowered the tax burden for U.S. corporations.

However, the market regime abruptly shifted following the January employment release at month-end.  Investors were spooked over the rising wages component that sparked initial inflation fears.

At the end of January, we argued that investors had front-loaded about half their annual performance but that assumed no change to the underlying risk regime which abruptly shifted.

In March, more signs of market stress emerged as a key corporate funding signal (LIBOR-OIS spread) rose to levels not seen since 2009.

The removal of the Fed Put along with an elevated interest rate environment and uncertainty arising over fiscal and trade deficits have produced a new risk regime resulting in higher risk premiums being demanded by investors.

Data Source: Bloomberg

Source: istockphoto.com

It is not often (and, in fact, extremely rare) that our writings concerning market inflection points happen to coincide with the actual inflection points. An old southern saying states that even a blind squirrel finds an acorn every now and then, and this 'blind squirrel' has had the fortune of finding several acorns over the past two years.

The first acorn we found occurred in February 2016, when we wrote that at an 800+ basis point spread above risk-free Treasuries, high yield bonds presented a compelling buying opportunity, since such extreme spread levels have generally produced positive forward returns. Sure enough (actually, we were a little unsure at the time as oil prices had plummeted to the mid-$20/barrel range), the market bottomed right around the time we published that piece, and the high yield market has rallied with the Bloomberg/Barclays High Yield spread dropping to as low as 2.9% in late October of last year before rising to 3.45% at the end of 1Q2018 (Figure 1). Since we published that piece, the Bloomberg/Barclays High Yield Index has returned a cumulative 30.1% through 3/31/2018.

Figure 1 - It's Been a Nice Ride for High Yield Investors from the Panic-Stricken 800+ Spread Levels Reached in early 2016 (High Yield Spreads Through 3/31/2018)

A more recent acorn we stumbled upon occurred in our March 10, 2018 blog post celebrating the anniversary of the current bull market (hopefully, this continues as an annual exercise). In the piece, we sounded a cautionary note that investors appeared to be overcrowded in U.S. large cap technology, justified by strong cycle-high profitability, but whose valuations also surpassed prior levels, especially when viewed against small cap value, an 'undercrowded' trade to say the least. For now, it appears that 'technology', as proxied by the Nasdaq 100, is succumbing to some self-inflected wounds (the practice of selling user data to aggregators has called into question the business models of social media giants such as Facebook and Twitter; earnings warnings from key semiconductors and Tencent; a marquee emerging market tech holding, headline risk over self-autonomous car crashes and moratoriums from future tests). Technology stocks are also succumbing to political headwinds such as the Trump Administration's restriction of Chinese investments in U.S. technology over national security concerns and what impact a potential trade war erupting between the U.S. and China will have on overseas revenue. The European Union is also threatening more restrictions such as requiring social media users to opt-in to privately share their data.

So far, the Nasdaq 100 Index appears to have peaked on March 12 (trading at a cycle high of 5.85x price/book), a couple of days after we published that blog piece. The valuation spread between Nasdaq 100 and S&P Small Cap Value has narrowed since we published the piece (Figure 2) with Nasdaq 100 valued at 5.40x price/book versus 1.67x for S&P Small Cap Value.

Figure 2 - The Valuation and Profitability Gaps Between Large Cap Technology (Proxied by Nasdaq 100 Index) versus S&P Small Cap Value (through 3/31/2018)

Have we seen a peak in investor enthusiasm for technology? We argued that much of the widening valuation gap between the Nasdaq 100 and Small Cap Value could be rationally explained by the diverging gap in relative profitability (as proxied by forward expected return on equity). Now, technology investors must assess whether profitability is as good as it gets (25% expected ROE over the next year) with the Nasdaq 100 trading at cycle high valuations. Small Cap Value historically trades at a discount due to its less attractive profitability and growth attributes, but improvement in the latter needs only to happen at the margin for the valuation gap with large cap technology to narrow. What remains less certain is what consumer backlash many of the tech highflyers will face, as well as, the impact from increased regulatory scrutiny and restrictions on the sharing of private data. Finally, investors are starting to realize that, although highly profitable, technology revenue is still subject to business cyclicality.

Mission Accomplished - The Third Acorn

A third acorn we believe we've stumbled upon concerns the outlook on Fed policy as we've written on multiple occasions such as our three Mission Accomplished pieces (here, here and here) as well as the 'New Neutral'. In these pieces written after the UK Brexit vote, we've argued that the Federal Reserve has sought to normalize monetary policy from the emergency measures that were implemented following the 2008 Great Financial Crisis. However, as with other strategists calling for cyclical reflation, we believed that inflationary forces would emerge in the form of higher wages. This has yet to transpire except for a notable uptick in wages contained in the January U.S. employment release, which caused interest rates to spike and drove a short-term meltdown in volatility trades.

Given that inflationary forces do not seem to be gathering steam, despite the threat of a global trade war, we pivoted on our Mission Accomplished thesis to suggest that the Fed's real aim is to tighten financial conditions (and that the 2% inflation target has turned into the Fed's MacGuffin), whether to offset hyper-stimulative fiscal policy from tax cuts and federal spending, or, as we've now come to appreciate, the removal of the ' Fed Put' which started as the Greenspan Put during Alan Greenspan's tenure as Fed Chair in the 1990s and early 2000 period.

There has been no explicit policy stance taken by the Fed in reference to said Put. But it can be implied based on the Fed's signal, following the March meeting that resulted in a 0.25% rate hike, that it could "pick up the pace of interest rate increases". In other words, the Fed appears to be willing to raise rates above their theoretical neutral levels (i.e. the level that is high enough to support sustainable economic growth without sparking inflation) in order to preempt any excessive growth down the road. Fed Funds futures had been pricing in a low probability of four rate hikes this year, but this changed in February as the probability for a 2.25-2.50% Fed rate rose to a not-insignificant level (Figure 3).

Figure 3: Rising Expectations of Four Federal Reserve Rate Hikes in 2018

Source: Bloomberg

Removal of the Fed Put means that the Fed won't necessarily step in to sooth volatile markets unless that volatility reflects a real systematic threat facing the U.S. economy. The low levels of volatility that investors had gotten used to in 2017 (before those who were short volatility via inverse VIX futures exchange-traded portfolios got wiped out in early February of this year) are a thing of the past under this new risk regime of fiscal uncertainty (widening fiscal and trade deficits) and a Federal Reserve bent on normalizing monetary policy, including the withdrawal of implied support when markets turn volatile.

So, 'Mission Accomplished' has evolved from normalizing short-term interest rates to normalizing the Fed's reaction function when it comes to implied market support. Whether the Fed reaches Mission Accomplished nirvana before a global recession arrives remains to be seen, but success could take the form of capital market valuations coming in to reflect the removal of the Fed Put without crashing and putting economic growth at risk. A tightwire act indeed, but one the Fed is willing to walk in order to accomplish its mission.

Tighter Financial Conditions Abound as Risk Gets Re-Priced

Why would the stock market care about tighter financial conditions when S&P 500 earnings are expected to grow 18.5% in 2018 on top of 6.7% revenue growth? Will a large market correction combined with a blow-out in corporate credit spreads drive the Fed to backslide from this commitment to achieve Mission Accomplished? These are all important questions that need answers, but investors need to be aware of a more fundamental shift in market pricing of risk under a market regime absent of Fed Puts.

As the Fed has effectively raised the bar for when it chooses to intervene, whether with explicit (slowing the pace of rate hikes) or implicit (public comments suggesting a slowing pace) support, investors should appreciate that market risk premiums are going up. That means implied volatility priced into equity options (i.e. the VIX) should trade at higher levels. Forward equity valuations should come down and credit spreads should widen from their historically high/low levels. And a combination of higher credit spreads on top of elevated interest rates should further drive up the equity risk premium.

Prior to the April 2nd sell-off, the forward equity multiple of the S&P 500 had dropped to ~16x next 12-months expected earnings at quarter-end. The forward multiple peaked in mid-January at 18.5x (Figure 4). The good news is that much of the repricing in equity risk had already occurred throughout the first quarter, and even with the markets down on the first trading day of the second quarter (S&P 500 down ~3% as we write this), the risk premium adjustments are starting to take place, allowing for more attractive entry points for risk-seeking investors assuming the macro environment holds up. Although underappreciated today, the macro environment from 2012-2015 didn't look attractive which resulted in investors rotating into low volatility, defensive segments of the market. One could argue that the macro environment looks more attractive today versus the earlier period, barring a systemic blowup out of China (see below).

Figure 4 - S&P 500 Forward P/E Has Dropped from Its Cycle-High Levels As Risk Gets Re-Priced

In the meantime, financial conditions have certainly tightened (Figure 5) as a result of higher interest rates, although they have tightened from very loose levels. This is the intent of Fed Rate hikes; to 'tap' the brakes on marginal lending but no so much that it causes a screeching halt to the economy.

Figure 5 - Financial Conditions Have Tightened but from Very Loose Levels

On the corporate lending side, financial conditions have gotten noticeably tighter as many investors have raised concerns over the widening spread between short-term LIBOR rates versus overnight lending (widening spreads could indicate heightened demand for U.S. dollar liquidity by banks). But based on the linked article, a doubling of the LIBOR-OIS spread from 2009 levels could reflect the new normal of lower corporate demand to park overseas cash into short-term credit (as a result of the Republican tax plan). Even if a widening LIBOR-OIS spread can be explained by this new demand dynamic (as opposed to a sudden need for liquid U.S. funding from banks), it still reflects tightening conditions that have spread to BBB-rated credit spreads (Figure 6).

Figure 6 - Lower Investment Grade Borrowing Has Gotten More Expensive Following the Republican Tax Plan

The rest of the world has not experienced as much volatility as the U.S. Non-U.S. developed and emerging-markets outperformed the S&P 500 in March. Much of this was due to U.S. dollar weakness versus major currencies [the Dollar Spot Index (DXY) is down 10.3% on a year-over-year basis]. One recent macro concern that has emerged is whether we've seen a peak in global business sentiment as indicated by Purchasing Manager Index Surveys (PMIs) (Figure 7).

Figure 7 - Global and Emerging Market PMIs Remain Strong Despite Peaking in Late 2017

Finally, credit goes to Grant's Interest Rate Observer for highlighting the risk posed by the large presence of Chinese commercial banks. Using similar data from Bloomberg, we recreated this chart (Figure 8) displaying total Chinese commercial bank assets as a percent of World GDP compared with the U.S. and Japan (all in $US terms). At nearly 50% of World GDP, the Chinese banking system (estimated at $38-40 trillion at year-end compared to $17.4 trillion for the U.S.) is much more highly geared towards world economic growth versus the other major industrialized countries and certainly geared towards the health of the Chinese economy ($13.1 trillion GDP).

Figure 8 - China's Banking Assets Have Mushroomed Over the Past Five Years

Much of China's incremental economic growth comes from credit creation through its banking system, so 15% credit growth off of a $40 trillion bank asset base would amount to $6 trillion. Even if we were to assume that world economic growth does not falter in the near future, how does one effectively deploy $6 trillion of new credit, and what happens if even 10% of this new credit growth tries to make its way out of the country (keep in mind that China's trade surplus was estimated at $420 billion at year-end)? Apart from widening its trade surplus (difficult in a period of heightened trade war rhetoric), how would the Peoples Bank of China (PBoC) even raise the necessary reserves to support this incremental credit growth?

China's gearing does pose a systemic threat to the global economy and financial markets, a risk we raised in our 2017 year-end market commentary. However, we believe this risk comes with a long fuse, but that fuse grows shorter by the day.

Finally, in our January 2018 Market Commentary following the strong 6% return in global equity markets, we suggested that investors had effectively 'clipped half their coupon' in the form of how much total return they could expect via earnings growth. But this was written in the context of no change to the risk regime. Now that we're seeing a change to the risk regime, investors can expect more volatility and higher risk premiums. For those with a long-term time horizon, higher risk premiums will help establish better long-term entry points to achieve higher expected returns. But investors used to a 2017 risk environment may need to re-calibrate their expectations.

1st Quarter 2018 Recap - It Was Large Cap Growth Up Until Trump Chimed In

Despite the volatility experienced throughout the quarter that saw S&P VIX rise from the low 9s at the beginning of January to 20 at quarter-end (having peaked at 37 in early February during the short VIX trade massacre), investors expressed a clear preference for large cap growth and momentum style of investing (see 1Q2018 Performance Charts at the end of this commentary). This preference abruptly shifted toward defensive, low-volatility assets following Trump's trade war rhetoric and restrictions on Chinese investments in U.S. tech companies as well as the industry-specific woes listed at the beginning of this article.

U.S. large growth still outperformed value for the quarter but that outperformance narrowed towards the end of March. Small cap outperformed large cap after having lagged for much of the quarter. Technology and consumer discretionary sectors were the only positive sector performers for the quarter, but they gave back some of their gains in March. Financials held up for the quarter but then gave back their gains over concerns on rising funding costs (LIBOR/OIS spread) and a flattening U.S. Treasury Yield curve that makes long-term lending less attractive versus short-term borrowing.

International markets turned in mixed returns with Emerging Markets and Japan leading all major regions while broader Asia and Europe lagged. Investors are growing increasingly nervous about Japan Prime Minister Shinzo Abe's alleged involvement in a scandal over the sale of public land to a private school closely connected to the Abe family. Should Abe be forced to resign over the scandal, a leadership crisis could ensue, possibly derailing the economic improvement under Abenomics.

Finally, 5-year/5-year forward inflation expectations and the flattening of the 2-10 year U.S. Treasury term structure suggest fixed income investors are not expecting an upsurge in long-term inflation and imply that there is a lid to Federal Reserve Rate hikes. If the markets were concerned about the economy sliding into a deflationary recession, then we would likely see those concerns being priced into long-term inflation expectations dropping well below 2% and the term structure inverting with short-term rates exceeding long-term rates.

1Q2018 Performance Charts


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