Divergent – the breakdown of stock market correlations, temp or perm?

Divergent – the breakdown of stock market correlations, temp or perm?

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Macro Letter – No 101 – 31-08-2018

Divergent – the breakdown of stock market correlations, temp or perm?

  • Emerging market stocks have stabilised, helped by the strength of US equities
  • Rising emerging market bond yields are beginning to attract investor attention
  • US tariffs and domestic tax cuts support US economic growth
  • US$ strength is dampening US inflation, doing the work of the Federal Reserve

To begin delving into the recent out-performance of the US stock market relative to its international peers, we need to reflect on the global fiscal and monetary response to the last crisis. After the great financial recession of 2008/2009, the main driver of stock market performance was the combined reduction of interest rates by the world’s largest central banks. When rate cuts failed to stimulate sufficient economic growth – and conscious of the failure of monetary largesse to stimulate the Japanese economy – the Federal Reserve embarked on successive rounds of ‘experimental’ quantitative easing. The US government also played its part, introducing the Troubled Asset Relief Program – TARP. Despite these substantial interventions, the velocity of circulation of money supply plummeted: and, although it had met elements of its dual-mandate (stable prices and full employment), the Fed remained concerned that whilst unemployment declined, average earnings stubbornly refused to rise.

Eventually the US economy began to grow and, after almost a decade, the Federal Reserve, cautiously attempted to reverse the temporary, emergency measures it had been forced to adopt. It was helped by the election of a new president who, during his election campaign, had pledged to cut taxes and impose tariffs on imported goods which he believed were being dumped on the US market.

Europe and Japan, meanwhile, struggled to gain economic traction, the overhang of debt more than offsetting the even lower level of interest rates in these markets. Emerging markets, which had recovered from the crisis of 1998 but adopted fiscal rectitude in the process, now resorted to debt in order to maintain growth. They had room to manoeuvre, having deleveraged for more than a decade, but the spectre of a trade war with the US has made them vulnerable to any strengthening of the reserve currency. They need to raise interest rates, by more than is required to control domestic inflation, in order to defend against capital flight.

In light of these developments, the recent divergence between developed and emerging markets – and especially the outperformance of US stocks – is understandable. US rates are rising, elsewhere in developed markets they are generally not; added to which, US tariffs are biting, especially in mercantilist economies which have relied, for so many years, on exporting to the ‘buyer of last resort’ – namely the US. Nonetheless, the chart below shows that divergence has occurred quite frequently over the past 15 years, this phenomenon is likely to be temporary: –

MSCI Developed vs MSCI EM 24-8-2018 Yardeni Research

Source: MSCI, Yardeni Research

Another factor is at work, which benefits US stocks, the outperformance of the technology sector. As finance costs have fallen, to levels never witnessed in recorded history, it has become easier for zombie companies to survive, crowding out more favourable investment opportunities, but it has also allowed, technology companies, with no expectation of near-term positive earnings, to continue raising capital and servicing their debts for far longer than during the tech-bubble of the 1990’s; added to which, the most successful technology companies, which evolved in the aftermath of the bursting of the tech bubble, have come to dominate their niches, often, globally. Cheap capital has helped prolong their market dominance.

Finally, capital flows have played a significant part. As emerging market stocks came under pressure, international asset managers were quick to redeem. These assets, repatriated most often to the US, need to be reallocated: US stocks have been an obvious destination, supported by a business-friendly administration, tax cuts and tariff barriers to international competition. These factors may be short-term but so is the stock holding period of the average investment manager.

Among the most important questions to consider looking ahead over the next five years are these: –

  1. Will US tariffs start to have a negative impact on US inflation, economic growth and employment?
  2. Will the US$ continue to rise? And, if so, will commodity prices suffer, forcing the Federal Reserve to reverse its tightening as import price inflation collapses?
  3. Will the collapse in the value of the Turkish Lira and the Argentine Peso prompt further competitive devaluation of other emerging market currencies?

In answer to the first question, I believe it will take a considerable amount of time for employment and economic growth to be affected, provided that consumer and business confidence remains strong. Inflation will rise unless the US$ rises faster.

Which brings us to the second question. With higher interest rates and broad-based economic growth, primed by a tax cut and tariffs barriers, I expect the US$ to be well supported. Unemployment maybe at a record low, but the quality of employment remains poor. The Gig economy offers workers flexibility, but at the cost of earning potential. Inflation in raw materials will continued to be tempered by a lack of purchasing power among the vastly expanded ranks of the temporarily and cheaply employed.

Switching to the question of contagion. I believe the ramifications of the recent collapse in the value of the Turkish Lira will spread, but only to vulnerable countries; trade deficit countries will be the beneficiaries as import prices fall (see the table at the end of this letter for a recent snapshot of the impact since mid-July).

At a recent symposium hosted by Aberdeen Standard Asset Management – Emerging Markets: increasing or decreasing risks? they polled delegates about the prospects for emerging markets, these were their findings: –

83% believe risks in EMs are increasing; 17% believe they are decreasing

46% consider rising U.S. interest rates/rising U.S. dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat

50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latin America to have the greatest potential

64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.

The increase in EM bond yields may be encouraging investors back into fixed income, but as I wrote recently in Macro Letter – No 99 – 22-06-2018 – Where in the world? Hunting for value in the bond market there are a limited number of markets where the 10yr yield offers more than 2% above the base rate and the real-yield is greater than 1.5%. That Turkey has now joined there ranks, with a base rate of 17.75%, inflation at 15.85% and a 10yr government bond yield of 21.03%, should not be regarded as a recommendation to invest. Here is a table looking at the way yields have evolved over the past two months, for a selection of emerging markets, sorted by largest increase in real-yield (for the purposes of this table I’ve ignored the shape of the yield curve): –

EM Real Yield change June to August 2018

Source: Investing.com

Turkish bonds may begin to look good value from a real-yield perspective, but their new government’s approach to the imposition of US tariffs has not been constructive for financial markets: now, sanctions have ensued. With more than half of all Turkish borrowing denominated in foreign currencies, the fortunes of the Lira are unlikely to rebound, bond yields may well rise further too, but Argentina, with inflation at 31% and 10yr (actually it’s a 9yr benchmark bond) yielding 18% there may be cause for hope.

Emerging market currencies have been mixed since July. The Turkish Lira is down another 28%, the Argentinian Peso by 12%, Brazilian Real shed 6.3% and the South African Rand is 5.7% weaker, however the Indonesian Rupiah has declined by just 1.6%. The table below is updated from Macro Letter 100 – 13-07-2018 – Canary in the coal-mine – Emerging market contagion. It shows the performance of currencies and stocks in the period January to mid-July and from mid-July to the 28th August, the countries are arranged by size of economy, largest to smallest: –

EM FX and stocks Jan-Jul and Jul-Aug 2018

Source: Investing.com

It is not unusual to see an emerging stock market rise in response to a collapse in its domestic currency, especially where the country runs a trade surplus with developed countries, but, as the US closes its doors to imports and growth in Europe and Japan stalls, fear could spread. Capital flight may hasten a ‘sudden stop’ sending some of the most vulnerable emerging markets into a sharp and painful recession.

Conclusions and Investment Opportunities

My prediction of six weeks ago was that Turkey would be the market to watch. Contagion has been evident in the wake of the decline of the Lira and the rise in bond yields, but it has not been widespread. Those countries with twin deficits remain vulnerable. In terms of stock markets Indonesia looks remarkably expensive by many measures, India is not far behind. Russia – and to a lesser extent Turkey – continues to appear cheap… ‘The markets can remain irrational longer than I can remain solvent,’ as Keynes once said.

Emerging market bonds may recover if the Federal Reserve tightening cycle is truncated. This will only occur if the pace of US economic growth slows in 2019 and 2020. Another possibility is that the Trump administration manage to achieve their goal, of fairer trading arrangements with China, Europe and beyond, then the impact of tariffs on emerging market economies may be relatively short-lived. The price action in global stock markets have been divergent recently, but the worst of the contagion may be past. Mexico and the US have made progress on replacing NAFTA. Other countries may acquiesce to the new Trumpian compact.

The bull market in US stocks is now the longest ever recorded, it would be incautious to recommend stocks except for the very long-run at this stage in the cycle. In the near-term emerging market volatility should diminish and over-sold markets are likely to rebound. Medium-term, those countries hardest hit by the recent crisis will languish until the inflationary effects of currency depreciations have fed through. In the Long Run, a number of emerging markets, Turkey included, offer value: they have demographics on their side.

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Stocks for the Long Run but not the short

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Macro Letter – No 93 – 23-03-2018

Stocks for the Long Run but not the short

  • In the long run stocks outperform bonds
  • For a decade stocks, bonds and real estate have risen in tandem
  • The risk of a substantial correction is high
  • Value-based equity investment is unfashionably enticing

The first part of the title of this Macro Letter is borrowed from an excellent book originally written in 1994. Among several observations made by the author, Jeremy Siegel, was the idea that stocks would at least keep pace with GDP growth or even exceed it at the national level. The data, which went back to the 19th Century, showed that stocks also outperformed bonds in the long-run. The price one has to pay for that outperformance is higher volatility than for bonds and occasional, possibly protracted, periods of under-performance or, if your portfolio is concentrated, the risk of default. This is not to say that bonds are exempt from default risk, notwithstanding the term ‘risk free rate’ which we associate with many government obligations. A diversified portfolio of stocks (and bonds) has been seen as the ideal investment approach ever since Markowitz promulgated the concept of modern portfolio theory.

Today, passive index tracking funds have swallowed a massive percentage of all the investment which flows into the stock market. Why? Because robust empirical data shows that it is almost impossible for active portfolio managers to consistently outperform their benchmark index in the long run once their higher fees have been factored in.

An interesting way of showing how indexation has propelled the stock market higher recently, regardless of valuation, is shown in this chart from Ben Hunt at Epsilon Theory – Three Body Problem. He uses it to show how the factor which is QE has trumped everything in its wake. I’ll allow Ben to explain:-

Here’s the impact of all that gravity on the Quality-of-Companies derivative investment strategy.

The green line below is the S&P 500 index. The white line below is a Quality Index sponsored by Deutsche Bank. They look at 1,000 global large cap companies and evaluate them for return on equity, return on invested capital, and accounting accruals … quantifiable proxies for the most common ways that investors think about quality. Because the goal is to isolate the Quality factor, the index is long in equal amounts the top 20% of measured  companies and short the bottom 20% (so market neutral), and has equal amounts invested long and short in the component sectors of the market (so sector neutral). The chart begins on March 9, 2009, when the Fed launched its first QE program.

epsilon-theory-the-three-body-problem-december-21-2017-quality-index-graph

Source: Bloomberg, Deutsche Bank

Over the past eight and a half years, Quality has been absolutely useless as an investment derivative. You’ve made a grand total of not quite 3% on your investment, while the S&P 500 is up almost 300%.

Long term there are two strategies which have been shown to consistently improve risk adjusted return from the stock market, momentum (by which I mean trend following) and value (I refer you to Graham and Dodd). Last month the Managed Futures community, consisting primarily of momentum based strategies, had its worst month for 17 years. Value, as the chart above declares, has been out of favour since the great recession at the very least. Indiscriminate Momentum has been the star performer over the same period. The chart below uses a log scale and is adjusted for inflation:-

S&P 1870 to 2018

Source: Advisor Perspectives

At the current level we are certainly sucking on ether in terms of the variance from trend. If the driver has been QE and QQE then the experiment have been unprecedented; a policy mistake is almost inevitable, as Central Banks endeavour to unwind their egregious largesse.

My good friend, and a former head of bond trading at Bankers Trust, wrote a recent essay on the subject of Federal Reserve policy in the new monetary era. He has kindly consented to allow me to quote some of his poignant observations, he starts by zooming out – the emphasis is mine:-

Recent debates regarding future monetary policy seem to focus on a degree of micro-economic precision no longer reliably available from the monthly data.  Arguments about minor changes in the yield curve or how many tightening moves will occur this year risk ignoring the dramatic adjustments in all major economic policies of the United States, not to mention the plausible array of international responses…

for the first time since the demise of Bear Stearns, et al; global sovereign bond markets will have to seek out a new assemblage of price-sensitive buyers…

Given that QE was a systematic purchase programme devoid of any judgement about relative or absolute value, the return of the price-sensitive buyer, is an important distinction. The author goes on to question how one can hope to model the current policy mix.

 …There is no confident means of modeling the interaction of residual QE, tax reform, fiscal pump-priming, and now aggressive tariffs. This Mnuchin concoction is designed to generate growth exceeding 3%.  If successful, the Fed’s inflation goal will finally be breached in a meaningful way…

…Classical economists will argue that higher global tariffs are contractionary; threatening the recession that boosts adrenaline levels among the passionate yield curve flattening crowd.  But they are also inflationary as they reduce global productivity and bolster input prices…

Contractionary and inflationary, in other words stagflationary. I wonder whether the current bevvy of dovish central bankers will ever switch their focus to price stability at the risk of destroying growth – and the inevitable collapsed in employment that would signify?

Hot on the heels of Wednesday’s rate hike, the author (who wrote the essay last week) goes on to discuss the market fixation with 25bp rate increases – an adage from my early days in the market was, ‘Rates go up by the lift and down by the stairs,’ there is no reason why the Fed shouldn’t be more pre-emptive, except for the damage it might do to their reputation if catastrophe (read recession) ensues. A glance at the 30yr T-Bond chart shows 3.25% as a level of critical support. Pointing to the dwindling of foreign currency reserves of other central banks as the effect of tariffs reduces their trade surplus with the US, not to mention the deficit funding needs of the current administration, Allan concludes:-

…Powell will hopefully resort to his own roots as a pragmatic investment banker rather than try to retool Yellenism.  He will have to be very creative to avoid abrupt shifts in liquidity preference.  I strongly advise a very open mind on Powell monetary policy.  From current levels, a substantial steepening of the yield curve is far more likely than material flattening, as all fiscal indicators point toward market-led higher bond yields.

What we witnessed in the stock market during February was a wake-up call. QE is being reversed in the US and what went up – stocks, bonds and real estate – is bound to come back down. Over the next decade it is unlikely that stocks can deliver the capital appreciation we have witnessed during the previous 10 years.

Whilst global stock market correlations have declined of late they remain high (see the chart below) the value based approach – which, as the Deutsche Bank index shows, has underwhelmed consistently for the past decade – may now offer a defensive alternative to exiting the stock market completely. This does not have to be Long/Short or Equity Market Neutral. One can still find good stocks even when overall market sentiment is dire.

Stock Mkt correlations July 2017

Source: Charles Schwab, Factset

For momentum investors the first problem with stocks is their relatively high correlation. A momentum based strategy may help if there is a dramatic sell-off, but if the markets move sideways, these strategies are liable to haemorrhage via a steady sequence of false signals, selling at the nadir of the trading range and buying at the zenith, as the overall market moves listlessly sideways. Value strategies generally fare better in this environment by purchasing the undervalued and selling the overvalued.

The table below from Star Capital assesses stock indices using a range of metrics, it is sorted by the 10yr CAPE ratio:-

CAPE etc Star Capital 28-2-2018

Source: Star Capital

Of course there are weaknesses in using these methodologies even at the index level. The valuation methods applied by Obermatt in the table below may be of greater benefit to the value oriented investor. These are there Top 10 stocks from the S&P500 index by value, they also assess each stock on the basis of growth and safety, creating a composite ‘combined’ evaluation:-

TOP 10 VALUE SandP500 - Obermatt

Source: Obermatt

Conclusion

I was asked this week, why I am still not bearish on the stock market? The simple answer is because the market has yet to turn. ‘The market can remain irrational longer than I can remain solvent,’ is one of Keynes more enduring observations. Fundamental valuations suggest that stocks will underperform over the next decade because they are expensive today. This implies that a bear market may be nigh, but it does not guarantee it. Using a very long-term moving average one might not have exited the stock market since the 1980’s, every bear-market since then has been a mere corrective wave.

The amount of political capital tied up in the stock market is unparalleled. In a world or QE, fiat currencies, budget deficits and big government, it seems foolhardy to bite the hand which feeds. Stocks may well suffer from a sharp and substantial correction. Even if they don’t plummet like a stone they are likely to deliver underwhelming returns over the next decade, but I still believe they offer the best value in the long run. A tactical reduction in exposure may be warranted but be prepared to wait for a protracted period gaining little or nothing from your cash. Diversify into other asset classes but remember the degree to which the level of interest rates and liquidity may influence their prices. Unfashionable value investing remains a tempting alternative.