Grabbing a Seat Before the Music Stops

In July 2007, Citi’s Chuck Prince, infamously quipped when referring to the firm’s leveraged lending practices: “When the music stops, in terms of liquidity, things will be complicated.  But as long as the music is playing you’ve got to get up and dance.  We’re still dancing.”  That offhand comment has haunted the former Citigroup chief executive, and he has since tried to explain that he was referring to not wanting to lose top bankers who worked on private equity deals.  One of the consequences of “not dancing” was that Citi could lose private equity firms as clients and lose the bankers who have those relationships.  He compared running a firm like Citi to managing a baseball team where none of the players have contracts.  Just months after the dancing comment, Citi took a $1.5bn write-down tied to its leverage loan portfolio, and most of the bankers who did those deals are no longer employed by the firm.  Early into March of 2018, the music is still playing.  The economy is red-hot, but some investors are starting to get the sense that this might be as good as it gets.  Even though almost everyone insists a recession is at least 12-18 months away, it all could reverse at any moment.  A key advantage that individual investors have versus large institutions and hedge funds is that we don’t have to dance until the music stops–we’re not evaluated on the basis of the quarterly (sometimes monthly) performance of a benchmark, and we can take our chips off the table whenever we feel like it.

2017 was too easy.  The graph of the S&P 500 last year was pretty much just up and to the right, and everybody made an effortless 20%. Euphoria continued into January, but trees don’t grow to the sky, and I think that the days of easy money are over.  The S&P 500 peaked at 2,873 on January 26th—the day of President Trump’s Davos address.  Many expected the speech to be a clash of civilizations with an overall theme of “America first.” However, the speech was actually crafted for a kind of virtual togetherness, a merging of “America first” with everybody else as partners.  The key development was that President Trump’s radical anti-globalization and anti-free-trade rhetoric became real.  A key snippet: “We cannot have free and open trade if some countries exploit the system at the expense of others.  We support free trade, but it needs to be fair and reciprocal … The United States will no longer turn a blind eye to unfair economic practices, including massive intellectual property theft, industrial subsidies, and pervasive state-led economic planning … we will enforce our trade laws and restore integrity to the trading system.”  The following Monday, the S&P was down ~70 bps.  Not a huge move, and who knows, maybe it would’ve bounced back to reach new highs in the coming weeks.  However, President Trump emphasized the tough trade rhetoric again in his State of the Union Address on January 30th. The S&P closed at 2,822 (1.1% lower than the prior day and 1.8% below its peak).  The rotten February that ensued probably had more to do with interest rates, inflation, systematic outflows and low liquidity, but fears over belligerent trade policy have remained.

We have recovered from the 2,581 low of February 8th and now stand at 2,752 at Friday’s close.  Tamer US inflation was one precondition for risk to resume its uptrend.  It’s also crucial that both macro (global synchronized growth) and corporate fundamentals (tax reform and record earnings) remain intact.  Moreover, trade rhetoric was less belligerent this week.  There’s no reason that stocks can’t reach new highs and maybe even the common 3,000 S&P 500 price target.  In fact, (if I had to), I’d bet that they do move higher from here over the next month or two.  But fortunately I don’t have to.  There are few things I’d like to note as a significant number of investors remain overweight US Equities.

The current US expansion is almost the second-oldest of the post-war era, and asset class performance varies considerably over the business cycle.  Also, most equity and fixed income markets are expensive based on historical valuation metrics.  High valuations offer little protection or risk-premium for a possible slowdown as rates rise over the next two years—much less a more extreme outcome like a recession.  And now, President Trump is talking about imposing $60bn of intellectual property tariffs on Chinese goods (2.6% of total imports). Not only does this risk the possibility of tit-for-tat tariffs, but it (combined with a $10bn steel and aluminum tariff and a gas tax) would also cancel out a significant chunk of the $200bn tax cut ($80bn to corporations and $160bn to individuals) that is supposed to be a key driver economic growth over the next 1-2 years.  As mentioned previously, you also have interest rates that are being driven up by strong growth, a hiking fed, a large federal deficit, the reversing of global QE, and inflation (perhaps not on the most recent data point, but the trend is definitely upward).  Lastly, you have midterm elections this year.  On average, the S&P 500 has an 18% correction in a midterm election year.

So the question I’m asking myself right now is whether it’s worth it to try and ride the S&P 500 up another ~9% to 3,000 or take some chips off the table in case we get some sort of 10%+ correction.  First of all, I feel like everybody’s waiting for S&P 3,000, which probably means we won’t get there.  Nonetheless, I think it makes sense to reduce US stock exposure if you’re overweight—especially when the 1Y US Treasury is now offering a pretty attractive yield above 2%.  I love Warren Buffet’s famous mantra: “Rule No. 1: never lose money.  Rule No. 2: don’t forget rule No. 1.”  It highlights the power of compounding.  To use a very elementary example, let’s say you have $100 invested in the S&P 500.  If it falls 50%, the value of your investment drops to $50.  To get back to $100, you now have to make 100%, which can be a mountainous task.  This is obvious but it bears repeating.  Investing has to be thought of in terms of risk and reward.  The fact of the matter is nobody can predict the future.  The price of any asset should be a probability-weighted expected value.  If there’s a 50% chance of stock going to $100 and a 50% chance of it going to zero, that stock should be priced at $50.  When the odds are skewed against you, you’re supposed to take some chips off of the table.  When the odds are in your favor, you increase the size of your bet.  Nobody has a crystal ball and the sooner an investor acknowledges this, the better.  Right now, I think there’s more downside than upside in US equity and fixed income markets for the remainder of 2018.  The music may not have stopped yet, but fortunately, we don’t have to dance until it does.

My Top 10 Reads of the Week:

  1. Bloomberg: Not a Single Japanese 10-Year Bond Traded Tuesday
  2. WSJ: Who’s Afraid of Higher Wages?
  3. FT: Rex Tillerson: Tough Texan Who Failed to Connect with Washington
  4. Wired: Stephen Hawking, A Physicist Transcending Space and Time, Passes Away at 76
  5. MIT Technology Review: A Startup is Pitching a Mind-Uploading Service That is “100 Percent Fatal”
  6. WSJ: What’s the Biggest Trade on the New York Stock Exchange? The Last One
  7. HBR: Are Buybacks Really Shortchanging Investment?
  8. Wired: The Dangers of Big City Subsidies
  9. The Economist: The Battle for Digital Supremacy
  10. The Economist: Britain’s Poisoned Relationship with Russia

Struggling to be Productive

Risk assets rose last week, supported by the Trump administration’s decision to exempt Canada and Mexico from its steel and aluminum tariffs.  This moderate softening of the US’s stance on trade helped to ease trade war concerns.  US equities were particularly strong this week, rallying 1.74% on Friday, following a US employment report that reflected a surprisingly ‘Goldilocks’ outcome of strong jobs growth with few signs of labor costs overheating.  The February employment report showed a 313k increase in nonfarm payrolls (vs. 205k consensus), but only a 0.1% m/m gain in average hourly earnings (2.6% y/y).  The three-month average for total payrolls now stands at 242k, well above that needed to push the unemployment rate (currently at 4.1%) lower over time.

In past years, employment reports that included strong rates of hiring and modest wage growth were viewed as unambiguously positive for financial markets.  They signaled steady gains in household income, and, in turn, consumer spending (positive for corporate earnings), while subdued inflationary pressures meant little risk of abrupt monetary tightening.  However, at this stage of the business cycle, a lack of productivity growth (at levels near zero) warrants concern.

Going forward, robust rates of employment growth should be viewed as a negative for risk assets because it is a signal that additional output is being generated primarily through additional employment, instead of productivity growth.  This is a negative for because it would imply that the unemployment rate will remain on a downward path, Fed confidence in meeting their 2% inflation target will rise, and concerns about further policy normalization will increase.  On the other hand, a more positive scenario would be if employment growth slows while GDP growth remains robust.  This will likely be a signal of faster productivity growth.  Faster productivity growth would imply an increase in the economy’s potential growth rate, which would elongate the business cycle and support income and earnings, all while keeping inflation at bay.

The drop-off in productivity growth over the past few years was primarily caused by 1) lower capital investment, as corporations substituted away from higher-cost capital to labor (i.e. globalization); and 2) a disincentive for corporate managers to invest during the QE era.  The key to whether or not this ‘Goldilocks’ environment can continue will be determined by productivity growth.  An inflection in productivity would be positive for equity markets for two key reasons: 1) increased revenue and 2) the ability of increasingly productive firms to absorb rising compensation costs and preserve margins.  On the other hand, fixed income securities will likely face pressure due to higher real interest rates (there’s a general rule of thumb that the yield on the 10-Year Treasury should roughly equal nominal GDP, and as yields rise, bond prices fall).

On a positive note, incentives to invest are rising for corporate managers.  As the economy is closer to full employment, rising costs of labor relative to capital are incentivizing a shift back toward capital investment.  Companies are also further incentivized to increase investment following dramatic tax and policy reform.  Reducing corporate tax rates and accelerating depreciation, among other items such as deregulation, should lead to robust capital spending, faster rates of productivity growth, and stronger potential growth.  However, it is always tough to bet on an inflection.

In the near term, investors will be focused on inflation next week as CPI (Tuesday) and PPI (Wednesday) are on the data calendar, along with retail sales (also Wednesday).  Friday’s soft wage number cleared another hurdle for risk assets to recoup February losses, and a near-consensus US CPI would likely extend the recovery.  Upside surprises on the forthcoming inflation data would be a negative as it could prompt FOMC members to adjust their Fed Funds rate expectations at the March meeting.  Fed Funds futures rates are pricing in a nearly 100% probability of a hike at this March meeting, as data since the last FOMC meeting has been constructive.  Politics and trade will also be important topics this week as a trade war could break the positive feedback loop between growth and markets.  As discussed last week, the most important risk regarding trade (and consequently, global growth) would be sanctions against China for intellectual property violations.  The US ITC is supposed to conclude its Section 301 investigation by August, but judgement could come sooner.

My Top 10 1 Reads of the Week:

  1. Financial Times: This is Nuts, When Does Netflix Crash?

Protectionism or Posturing?

February closed as one of the worst months for both credit and equities since the beginning of 2016.  And then to kick off the first two days of March, President Trump’s embrace of protectionism in the form of threatened tariffs caused even more distress among investors.  Trump hinted that he intends to unveil new tariffs next week (about 25% on steel and 10% on aluminum).  Higher input costs and a margin squeeze are the first-order implications of tariffs.  There is also a chance that imposing tariffs on two critical global industries will elicit a response from our four largest trading partners (EU, China, Canada, and Mexico).  The question is how any of these trade partners might retaliate, what mechanisms make that possible under existing agreements (NAFTA, KORUS, etc.), and what the market will start to handicap as logical outcomes.

Market bulls will seek to downplay the potential effects while the bears will show the chaos that can unfold from retaliatory trade measures and how this action will poison NAFTA.  However, what’s going on with the equity market may actually be a very positive development on the tariff issue.  Apparently Trump’s thought-process on the tariffs is: “so what if people pay a little higher prices—we’re going to have a lot more jobs here.”   Despite Gary Cohn and the globalist wing’s repeated warnings that broad duties could ignite trade wars and ultimately harm US consumers, they made zero progress and Trump went ahead with his tariff announcement. The equity market reaction could be the external event needed to get the president’s attention that this may have some seriously negative consequences.  It’s not the steel and aluminum tariffs but the possibility of retaliation.

Hopefully this is all just posturing by President Trump. With Xi Jinping’s top economic advisor, Liu He, visiting the White House this week and the latest round of NAFTA talks wrapping up, this confrontational trade rhetoric could all end up seeming somewhat predictable in hindsight.

While the steel and aluminum tariffs would be bad, I think it makes sense to be more concerned with Section 301 (China and intellectual property stealing), because those tariffs can be in the hundreds of billions of dollars, and would represent a true macro risk—particularly if you own companies with a lot of exposure to China.  So that’s really the key issue to be watching.  Nonetheless, both issues and potential retaliation are super important and will be a key focus of next week.  Hopefully this is just posturing by President Trump, because if cooler heads do not prevail, everyone will lose.

My Top 10 Reads of the Week:

  1. WSJ: Gary Cohn’s Future Unclear After Setback on Tariffs
  2. The Economist: Vladimir Putin, the Meddler
  3. WSJ: How SoftBank, The World’s Biggest Tech Investor, Throws Around its Cash
  4. Ray Dalio: A US-China Trade War Would Be a Tragedy
  5. The Economist: The Right Way to do Brexit
  6. The Economist: Tackling Fannie and Freddie
  7. Wired: What Would A ‘Healthy’ Twitter Even Look Like?
  8. WSJ: US Will Be the World’s Largest Oil Producer by 2023, Says IEA
  9. TechCrunch: When Venture Capital Becomes Vanity Capital
  10. The Economist: How the West Got China Wrong