Much like a cliffhanger episode of your favorite television show, the market gave us a cliffhanger at the end of Q1. The roller coaster, up and down ride of the S&P 500 in Q1 ended the quarter on the downbeat and at key support levels. Would markets hold? Tune in next time. Well, now we know that those levels held and Q2 produced a slow but steady walk higher in markets. The second quarter saw the S&P 500 Index up just shy of 3% which got the S&P 500 back on the positive side for 2018, albeit, just barely. While a decent quarter was had by equity holders, it still appears that the market remains stuck in a consolidation range. The same range that we have predicted it would be stuck in for months and that it cannot quite break out. Why are markets stuck? The economy is doing so well. We have seen tax cuts and the repatriation of money from overseas. Shouldn't that have markets rocketing higher?
Markets discount news in advance. Investors have anticipated peak profits. The tax cut, fiscal stimulus and repatriation of overseas funds were all widely anticipated. All of these maneuvers have helped profits tremendously, but they are also all things that cannot be repeated over and over again as part of the business cycle. These are one-time turbo boosts to the economy. Great earnings were widely expected and were priced in months ago.
The second and most important reason that stocks are treading water is that the Federal Reserve has begun pulling back on liquidity and are now draining money from markets. This is done by the reduction of the holdings on the balance sheet of the Federal Reserve and steadily raising interest rates. While the Federal Reserve has only just begun their plan to withdraw liquidity from historical extremes, markets have already begun to sputter.
It appears that markets are now waiting for the next catalyst. As you know, we are proponents of the central bank thesis. This is the thesis that we, and others, subscribe to, that proffers that central banks are responsible for the rise in asset prices as a direct correlation to loose monetary policy and the existence of historically large balance sheets at central banks around the globe. Those large balance sheets and low interest rates have helped generate a fourfold rise in the S&P from the nadir of the financial crisis.
The Federal Reserve is just getting started removing excess stimulus and yet the ancillary effects of the removal of easy money are already rippling around the globe. Raising rates and draining the balance sheet have the effect of making dollars more scarce and more valuable. The draining of the balance sheet will lead to the draining of asset markets as there are fewer dollars to go around. This could quite possibly engineer a crisis in emerging markets.
Why emerging markets? Emerging countries have borrowed large amounts of money. Part of the broader problem is that they borrowed it in US Dollar denominated terms. Think about that for a second. Say you are Brazil. You borrow US Dollars and turn it into the Brazilian Real. Your currency drops in value by 14% due to rising US interest rates which make the Dollar more expensive. You now need to pay back your debt in US Dollars. That's a problem. The country's economy begins to grind to a halt. Then, authorities from around the world beg the US to stop raising interest rates. This is all happening while the Federal Reserve asset removal from their balance sheet has really been just a drop in the proverbial bucket. Almost akin to losing a deck chair off of the RMS Titanic and yet central bankers around the world are begging the Fed to stop raising rates. Central banks from Europe to Japan have indicated that October of 2018 could see further tightening from central banks around the globe. That could be the next catalyst.
The first half of 2018 has seen that there is a new game in town. The high wire act known as the Federal Reserve has made its impact on markets around the globe. The current tightening policies of the FOMC have led to a rise in the US dollar. That rise has had an impact on emerging markets. In just the past 90 days, the Argentinean peso has fallen 30%. Other signs of distress have appeared in the Brazilian Real, the Turkish Lira and the South African Rand which are all down over 14% this quarter. We have seen Asian emerging markets fall 3-5% while China leads the way to the downside with a double-digit fall in its stock market for 2018. The change in policy by the Fed, by raising rates and shrinking its balance sheet has created a new dynamic. This new dynamic brings with it a flattening yield curve. A flattening yield curve makes it harder for banks to make money by lending and is seen as a harbinger of a slower economy.
In October, central banks (US, ECB, BOJ) are poised to jointly deliver a net monthly shrinkage for the first time in 10 years and then the pace of that shrinkage is scheduled to increase as the ECB and BOJ both taper. Will markets respond in kind? We suspect they will. Eventually, if markets move low enough and economies slow enough, it turns into a political issue. Will the Federal Reserve have the political will to continue shrinking policy as central bankers and politicians from around the world balk?
The Catch 22 for the Fed is firmly in place. As inflation begins to take hold in the US and in Germany, central bankers will be forced to tighten policy even more. Politicians will cry out in pain as economies slow or markets fall. If central bankers feel threatened by politicians, they may end up behind the curve on inflation. They will be faced with a choice. A choice between inflation in developed markets and currency chaos in emerging markets. Ironically, the next crisis will probably be caused by the central bankers' actions (or inactions) as they try to pare down their balance sheets and normalize interest rates.
Valuations - 1999
We have begun to have that old déjà vu feeling again. When you have been investing long enough, you see the same events over and over again. They just come in different forms and names. It's human nature. We have that feeling that we are seeing the same movie again and perhaps we have seen the ending before. The movie is the late 1990s.
Growth stocks again have taken a tremendous lead over value stocks and rumblings in emerging markets are growing steadily. Lately, what has piqued our interest is the tremendous disparity between large cap tech (i.e., Netflix (NASDAQ:NFLX)) and consumer staples (i.e., Kraft Heinz (NASDAQ:KHC)). 1999 was when tech overtook all reasonable valuations and left good quality companies in the dust. We currently see Netflix valued at 275x earnings with no dividend versus Kraft Heinz at 7x earnings and a 4.0% dividend. The change in sentiment may not be immediate, but it is important as investors that we are not blinded by the bright lights of the pundits and the headline du jour. At some point, value will become valuable again and growth will pay the dear price of not having any margin of safety in its valuation.
"Haven't we seen this movie before? Technology takes over the stock market late in a recovery cycle, seemingly making the bull ageless, pushing portfolios toward a more concentrated new-era exposure, stimulating investor greed bolstered daily by watching a chosen few (FANGs) rise to new heights, and convincing many that tech is really a defensive investment against late-cycle pressures which trouble other investments."- Leuthold Group's Jim Paulsen
While the hordes are chasing growth at any price (Amazon (NASDAQ:AMZN), Netflix, Microsoft (NASDAQ:MSFT)), we look to note what the smart money is doing. In our April 22, 2018 blog, we noted that Goldman Sachs (NYSE:GS) made an announcement that went widely missed. Goldman decided to halt the corporate buyback of Goldman stock. That gave us the sneaking suspicion that Goldman's leadership felt that their stock was not worth the price that it was currently trading. As we write, financial stocks have just finished a losing streak of 13 consecutive trading days - a new record. In April, when the announcement was made, Goldman Sachs was priced north of $260 a share. The stock is now down over 15% from those levels. Smart money indeed.
If you are a regular reader, you know that we follow certain investors as guides along this journey to try to parse out clues to the macro environment. Recently, Bridgewater Associates, the largest hedge fund in the world, offered this very direct warning about what comes next.
2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed's tightening will be peaking.
We are bearish on financial assets as the US economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop.
Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive - reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half. - Bridgewater's latest Daily Observations authored by co-CIO Greg Jensen
The Fed is pulling back on liquidity as it is the right thing to do for the United States. However, there are many outside the US that don't share that view. In particular, those include emerging markets that are beginning to submerge from Argentina to Turkey to Brazil. Those ripples across the pond from a rising US Dollar will form into waves that eventually hit our shores. This will put pressure on the Fed to slow its tightening cycle. As we always like to say, "There are no problems, only opportunities". We are loath to enter emerging markets as we see the Fed continuing to raise rates, but there are places to hide. Currently, small caps and mid caps have been the outperformers here in the US. The theory being that small and mid cap stocks will not suffer as much as their large caps brethren due to their lack of international sales.
Elsewhere, we see commodities as a place to generate return. We envision a scenario where the Fed will be handcuffed by political pressure. The Fed will be forced to slow rate hikes by Congress and by external international pressure. That should allow inflation to run unchecked for some time until the pain delivered by inflation becomes worth the cure and the cure is painful - much higher interest rates. We are already starting to see inflationary wage pressures in trucking and the oil patch. Commodities should continue to flourish under this scenario.
We are more bullish on the US than Europe. We are currently seeing Europe's economy slow down while the US speeds up. Why? The US and Europe both have QE and are buying assets in the real market. The difference is interest rates. The US is raising interest rates which is creating demand. Europe is not raising rates and therefore there is no impetus or motivation for people to spend. Jobs are getting more plentiful in the US. People can get raises, get better jobs, move, and spend money. Spending leads to more jobs with healthier pay which leads to people moving for better jobs which creates jobs and more spending. You get the picture.
QE is the kindling. Interest rates are the match. Europe just keeps pouring more gas on the fire without lighting the match. It took the US several tries before the market and economy gained confidence and believed that the Fed would continue to raise interest rates. Trump's fiscal and tax policies helped give the Fed cover and made its story more believable. Europe needs the same. Light the match. Having said this, the fire will only burn so long. What comes next? Commodity prices will rise along with inflation here in the US. The Fed will try to continue to raise rates, but the question remains will they end up behind the curve while feeding inflation? We think they will.
Markets are pricing in a Goldilocks scenario that is ever elusive and fleeting. Change is the only constant. The market can continue to chug along to higher prices, but that will become more difficult as we head into 2019 with less fiscal/tax stimulus and more QT around the world.
We have been expecting and investing for a 9-18 month period of consolidation after which we should see a rise in volatility as the market breaks out of its consolidation range. Our thesis about the market consolidating its gains around the 2,666 level on the S&P 500 for 9-18 months continues to hold. At the end of June, we will have seen month 7. Midterm election years in the United States have a poor record performance wise over history. We would expect more of the same in 2018. In fact, more specifically, July in midterm years has a particularly poor track record. That will have our focus as liquidity remains very light in the summer months and markets could be prone to shocks.
We continue to invest for low and rising inflation and anticipate stocks will continue to struggle within their current range. We have low duration with our bond portfolio and continue to add commodities to our asset allocation. Another focus is our cash and, for the first time in a decade, generating returns there. We continue to be the contingency planner. We are not predicting the direction of the market, but developing scenarios and having a plan no matter the outcome. It's not sexy. It's Investing 101. Do the basics right and the rest will take care of itself.