Legislative Gridlock, Corrections, and Buying When There’s Blood in the Streets

Last week, the Democratic Party regained control of the House in the midterm elections.  An as-expected outcome to US midterms has allowed stocks and other risky markets (excluding oil) to continue retracing their October losses, since underlying US earnings remain impressive (+28% Y/Y EPS growth and +8% surprise vs. consensus).  A split Congress is likely to result in a return of legislative gridlock, reducing the possibility of further fiscal stimulus and increasing the possibility that US growth will decelerate over time.

Looking back at the past three decades, it is clear that a divided Congress rarely delivers substantive legislative change.  Exceptions were Reagan’s tax reform in the mid-1980s and Clinton’s tax/deregulatory reforms in the late 1990s.  While there is agreement between the two political parties on the need for infrastructure spending, the parties remain divided on the amount and how it should be financed.  Democrats generally think it should be large (~$1 trillion) and federally-financed, while Republicans think it should be smaller (~$200 billion) and co-financed with states and/or the private sector.  Absent an increase in urgency stemming from a growth downturn, it’s difficult to see the two sides reaching agreement.

On the other hand, a possible truce in the US-China trade war is the more interesting potential deal.  This is because the responsibility for trade policy largely remains in President Trump’s hands and because the opportunity comes in just a couple weeks when Trump and Xi meet at the G20.  It’s highly unlikely that there will be an agreement to rollback tariffs; however, there could still be a constructive outcome, such as a US agreement to restart negotiations that have been absent for months, and to not impose further tariffs.  This clarity could drive a substantial rally in trade-sensitive assets (i.e. domestic and emerging market equity indices, along with specific sectors such as autos and semiconductors).  That said, it’s tough to expect any short-term deal on goods trade to reduce long-term tensions between the two countries in the areas of national security, intellectual property rights, and forced technology transfer.

October’s 9.8% peak-to-trough drop was just shy of being the second correction this year.  10%+ corrections have occurred 1x per year on average since 1928, but the last time we saw more than one correction in a single year was in 2008, in which we saw three.  Today’s concerns include slowing growth, rising interest rates (i.e. rising cost of capital), data rolling over (i.e. housing, lackluster consumer spending, etc.), worsening trade tensions with China, weak global fundamentals (i.e. Europe, Turkey, China, Brazil, Argentina, etc.), and an increasingly hawkish Fed.  However, I think draining liquidity (the Fed’s QT program and now the ECB and BOJ tapering their QE purchases) was the primary catalyst for the October correction.  The good news is that global asset prices now reflect this risk.  The bad news is that the growth in global central bank balance sheets is set to decelerate and go negative by January.  I think markets will remain choppy for the foreseeable future and will be very tough to trade. However, the S&P 500 trades at 15.2x 2019 earnings (6.7% earnings yield), which seems pretty attractive relative to the 3.2% yield on 10-Year US Treasuries.  If I had to pick one of these places to put my money for the next 10 years, I would without a doubt pick the S&P 500.

“The time to buy is when there’s blood in the streets,” as the famous Rothschild saying goes.  Most investors are bearish on emerging market equities, even though EM valuations are now significantly lower than at the worst point in the 2015-2016 episode.  Consensus is bullish USD even though US growth could start to converge with the rest of the world.  Most people think the Fed will keep hiking “until something breaks,” and many more think the trade backdrop can only get worse.  I don’t have a crystal ball, but I think sentiment on all of these topics can improve in the coming months.  Historically, stocks have rallied after midterm elections, and retracing recent declines seems like the most likely scenario to me.  But, even if they don’t, at least you’re buying them cheap and when expectations are low.

Top 10 Reads of the Week

  1. Barron’s: Howard Marks on Surviving Market Storms 
  2. Bloomberg: Three Reasons to Fear Another ‘Great War’ Today
  3. The Economist: Gene Drives Promise Great Gains and Great Dangers
  4. Wired: 12 Things You Learn Over Two Decades of Lunches With Stan Lee
  5. WSJ:  Ten Takeaways from the 2018 Midterm Elections
  6. WSJ: US Oil Enters Bear Market on Rising inventories, Worries of Oversupply
  7. Bloomberg: China Has More Distressed Corporate Debt Than All Other EMs
  8. Politico: 2020 Presidential Candidates Who Could Take on Trump
  9. The Economist: Germany’s Chancellor Announces her Resignation as Party Leader
  10. The New York Post: The World’s Stinkiest Fruit Causes Flight Delay

Financial Markets and the Adverse Effects of Stability

The most important development this week was the Trump Administration announcing on Monday that it will impose tariffs on $200bn of imports from China.  Tariffs will initially take effect at 10% on those products but are scheduled to increase to 25% in January 2019 if there’s no resolution.  Stocks dipped a bit on Monday, but they have since recovered with both the S&P 500 and Dow Jones Industrial Average closing at their all-time highs on Friday.  This week exemplifies what seems to be a developing trend in which investors have become desensitized to these negative headlines.  Whether it be emerging market weakness (i.e. Argentina, Turkey, Brazil, Russia) or trade war escalation—all investors who have decreased exposure to US risk assets on these headlines over the past few months have drastically underperformed and have thus seem to have been almost conditioned to mostly ignore these headlines.  Many managers are now chasing performance and need to stay invested, and this has lead to a “buy the dip” mentality.  “Bears sound smart but bulls make money” is a phrase I’ve heard a lot in the past few months.

Overall, the effects of these tariff measures on both real GDP growth and inflation are expected to be pretty moderate, but there is still risk of further escalation from here.  The White House statement (https://www.whitehouse.gov/briefings-statements/statement-from-the-president-4/) indicates that “if China takes retaliatory action” against farmers or other industries, the US “will immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”  However, it does look like China is retaliating—on Tuesday, they put tariffs on $60bn of US exports.  It seems like escalation to some sort of “phase three” tariffs that cover all Chinese imports is slowly becoming more and more likely.  It’s probably not the official market view yet, but the Trump Administration has set up this conflict in a way that makes it nearly impossible for this issue to be resolved over the next few months.  The demands that are being made of China are simply too existential for the Chinese to capitulate on anytime soon.  It’s very difficult to tell where the market expects these sanctions to go and what’s already “priced in.”  Some economic analysis suggests that tariffs on all Chinese goods would only reduce US real GDP growth by ~0.5%, but this is imprecise work because it only takes into account income effects.  There are a bunch of other indirect costs, such as confidence and financial conditions, that can’t be easily modeled.  In addition to these risks stemming from trade war escalation, there is also contagion risk stemming from several country-specific situations.

Turkey is currently in the midst of a currency crisis with the Turkish Lira down ~40% YTD. However, this could morph into a banking crisis or a private or sovereign default.  Further FX weakness could pave the way for debt repayment difficulties due to dampened future income in FX terms, which would in turn lead to a rise in non-performing loans in the banking system.  Rising non-performing loans in the banking system could in turn negatively influence their capital adequacy ratio and profitability.  This presents significant counterparty/contagion risk—especially in Europe, which is the most exposed to the region in terms of direct exposure to Turkish banks and corporates.  Argentina is also in the midst of a currency crisis.  The government has gone a long way in reducing the twin deficit problem (from last year to next year, the current account deficit will go from -5% to -1% and the budget deficit will go from -4.2% to flat).  The government has also been successful with monetary tightening and could still tighten further.  Argentina will also be isolated from market volatility in terms of financing through 2019, thanks to the IMF program.  However, the problem remains that for Argentinian Peso inflation to converge to a single-digit number by 2021 (the current goal of the IMF), they will have to tackle the issue of indexation of prices and salary backward-looking weight increases.  This will require congressional support, and it will be very unpopular.  Thus, it is very likely that Argentina will have to continue living with a double-digit inflation rate for the foreseeable future.  In the past, the FX market has been a precursor to runs on deposits in the banking system.  It could also engender the sustainability of the adjustment program, and it could erode popular support for the government and cause political turmoil.  The political cycle will further elevate uncertainty: elections 12 months away, and the odds of Macri getting reelected are continuing to drop.

There is no doubt that the Fed is tracking these global developments very carefully and factoring it into their outlook for the US economy.  However, the Fed’s mandate is domestic and these developments are not yet at the stage where they’re going to affect policy (even to the point of changing their language in an upcoming statement).  With growth strong and inflation hitting the Fed’s mandate, the Fed is probably going to raise two more times this year and at least three times next year.  Life will probably get more difficult for emerging markets from here.  Even as it gets more serious, it’s still difficult to imagine the Fed altering its policy.  The Fed’s job is to get things right in the US, and the rest of the world will benefit if they achieve that.  If they pause due to pain in EM and allow for inflation to take off more than desired, there will be a lot more pain later down the road.  The following chart depicts the divergence in EM stocks vs US stocks:

So why exactly are US stocks at all-time highs?  Well these issues haven’t materialized in U.S. data yet.  The U.S. economy is expected to grow at 5-6% in nominal terms in both 2018 and 2019.  U.S. company earnings have been very strong and S&P 500 earnings are projected to grow at ~15% and ~10% in 2018 and 2019, respectively.  Inflation remains muted with 2018 and 2019 CPI forecasts at 2.5% and 2.3%, respectively.  The Fed has also been hiking at a very gradual and non-threatening pace, as depicted in the graph below.

Lastly—and perhaps most importantly—stocks aren’t too expensive when compared to bonds.  The S&P 500 trades at ~18x forward earnings, or a 5.5% earnings yield.  When you take into account the fact that these earnings are growing nicely over the course of this year and next, it makes for a relatively attractive investment as opposed to a 10-Year US Treasury that only yields 3.06%.  Although it definitely seems like rates are rising, they appear to be somewhat capped by the German 10Y.  A good rule of thumb is that the interest rate on the US 10-Year Treasury should roughly equal the nominal GDP growth rate.  If this rule is true, why aren’t 10Y yields at 5% or 6%?  The answer is that they would be if the US economy was completely isolated from the rest of the world.  However, it isn’t.  In an interconnected global economy money can flow from other countries to the US.  Thus, with German 10Y Bunds yielding ~47bps and Japan Government 10 Year bonds at ~0%, a 3% US 10Y yield looks pretty attractive.  As you can see in the graph below, US 10Y yields have almost directly followed the average of nominal GDP growth and the yield on the German 10Y.  With some quick math, we can average the current 5.4% nominal growth as of 2Q18 with the 47bps German 10Y yield to get 2.94%… not to far off from the current 3.06% yield.

Thus, until the aforementioned economic environment changes, US stocks can still go higher.  However, when the data does change things could end up being pretty bad.  In August, the current bull market in US stocks became the longest one in history.  Volatility has been relatively subdued and massive quantitative easing programs have created a tremendously stable bull market run.  I think this long period of stability could result in a very harsh movement in asset prices when the economic environment changes.

It may be somewhat counterintuitive, but stability is not always good for the economy.  Firms, countries and other economic systems become very weak during long periods of steady prosperity devoid of setbacks.  This is because hidden vulnerabilities accumulate silently under the surface (remember the 2008 Financial Crisis?).  To borrow from Nassim Nicholas Taleb in his book Antifragile, variations act as purges.  Small forest fires periodically cleanse the system of the most flammable material—hindering the opportunity to accumulate.  Systematically preventing forest fires from taking place “to be safe” makes the big ones much worse.

In markets, fixing prices, or, equivalently, eliminating speculators (and the moderate volatility that they bring) provides an illusion of stability, with periods of calm punctuated with large jumps.  Because players are unused to volatility, the slightest price variation will then be attributed to insider information, or to changes in the state of the system, and will cause panics—January of 2018 is a great example.  When things don’t vary, a very slight move makes people believe that the world is ending.  Injecting some confusion stabilizes the system.

Many old trading veterans use a simple heuristic: when a market reaches a “new low” (i.e. drops to a level not seen in a long time), there is “a lot of blood” to come, with people rushing to the exit.  Some people unused to losing money will be experiencing a large loss and will incur distress.  Tellingly, they call it a “cleanup,” getting the “weak hands” out of the way.  When many such weak hands rush to the door, they collectively cause crashes.  A volatile market doesn’t let people go such a long time without a “cleanup” of risks, thereby preventing such market collapses.

In sum, the current desensitization to headlines and a “buy the dip” mentality could continue to send stocks to new heights, but when things change—as they always do—things could get pretty ugly.

Top 10 Reads of the Week

  1. Ray Dalio: A Path to War? 
  2. Siegel vs. Shiller: Is the Stock Market Overvalued?
  3. Flirting with Models: The Misleading Lessons of History
  4. WSJ: Wall Street’s Marijuana Madness: ‘It’s like the Internet in 1997’
  5. WSJ: China Retaliates with Tariffs on $60 Billion of U.S. Goods
  6. Financial Times: Iran Accuses US of ‘Starting a War’ in Fight Over Sanctions
  7. Financial Times: Fed Funds Rate Set to Rise Past Inflation for First Time Since 2008
  8. Financial Times: Why Investors Should Worry About Rising Wages
  9. The Economist: Jair Bolsonaro, Latin America’s Latest Menace
  10. The Economist: Why Russia and China’s Joint Military Exercises Should Worry the West

A Drier Forest

It seems like every time the market tries to rally on the back of great fundamentals, some exogenous shock pulls it right back down.  First it was VIX and vol-selling, then LIBOR-OIS, then Argentina and Turkey, and now Italy and trade wars.  Are these events just “noise” or is there a pattern here?

These patterns of weakness are most likely a direct consequence of reduced central bank buying. The artificial, large, and sustained buying presence of Quantitative Easing flooded financial markets with liquidity and dramatically suppressed volatility.   As QE evaporates, markets have to adjust and rediscover how to price risk.  And while they’re adjusting to these new realities, there will be volatility.

While the individual shocks may be unpredictable, I think investors have to take into account the vulnerabilities of any complex system.  Global markets are incredibly complex systems, and it’s impossible to calculate all of the ways shocks can reverberate across them.  Rather than trying to anticipate a spark, I think investors should be paying attention to the dryness of the forest more broadly.  I don’t think the economic recovery is over by any means, but the “forest” (global markets) is vastly “drier” (riskier) without the support of QE than it was with it.   While growth and corporate fundamentals are strong, volatility spikes with these events for a reason, and this noise should not be looked through.

We should be hedging our bets when insurance is cheap rather than trying to predict the next shock.  If you have a some sort of predictive framework that allowed you to predict the demise of XIV and Argentina/Turkey/Italy turmoil, you probably should be raising billions of dollars and starting your own hedge fund ASAP.

The main threats to risk assets are systemic in nature, and chances of an exogenous shock sparking a global recession are higher than they were a year ago.  The most commonly accepted risk is that the fed hikes too quickly (most likely stemming from an inflation overshoot).  It doesn’t end there, though.  Anti-establishment 5SM and League parties reached an 11th-hour government deal, but the end of the Italian political crisis doesn’t mean the end of uncertainties (the focus will now be on fiscal policy and the size of the likely increase in public debt).  Further, trade war escalation could lead to higher inflation and lower growth.

In summary, there’s no shortage of risks for today’s investors.  Additionally, these risks are often unpredictable given how complex and interconnected global financial markets are.  The “forest” is a lot drier than it was when central banks were flooding financial markets with liquidity. Growth and fundamentals remain strong, so it’s ok to be in equities, but if you are, consider buying protection when it’s cheap and markets are optimistic (i.e. buying S&P puts when stocks are up and the VIX is down).

Top 10 Reads of the Week

  1. Naval: How to Get Rich (without getting lucky)
  2. 13D Research: Liquidity is the New Leverage
  3. WSJ: Why Italy is Flirting with Euro Exit and Spain Isn’t
  4. Wired: As Rental Cars Fade Away, Avis Will Try Anything to Survive
  5. MIT Technology Review: It’s Fiction, but America Just Got Wiped Out by a Man-Made Terror Germ
  6. The Economist: Does China’s Digital Police State Have Echoes in the West?
  7. The Economist: Italy Needs to Be Handled with Care
  8. Wired: How One Apple Programmer Got Apps Talking to Each Other
  9. A16Z: Decrypticng Crypto, From Bitcoing and Blockchain to ICOs
  10. CryptoEconomics: The Blockchain Economy: A Beginner’s Guide to Institutional Cryptoeconomics

Financial Repression and The Most Important Prices in Capitalism

In just a quick recap of the week, both stocks and bonds traded with a weaker tone despite the decline in Treasury yields and strong 1Q earnings.  It appears that investor sentiment has been adversely affected by a combination of ongoing rate concerns, continued elevated volatility, and a stronger dollar.  However corporate fundamentals and the global economy remain solid.  Trade negotiations will be a key focus in the coming weeks.

I’ve wanted to write a note on the subject of interest rates for a while, but I’ve had a tough time figuring out exactly what I wanted to say.  Stanley Druckenmiller’s op-ed (#1 in top 10 reads) provides a good base to build on.  Let’s start with the fact that interest rates are the most important prices in capitalism.  The intrinsic value of almost every asset (Bitcoin being an obvious exception) is the present value of its future cash flows.  Every capital budgeting decision is made on the basis of—or should be made on the basis of—a project’s net present value.  The key common factor in these calculations is the discount rate, which is just the risk-free interest rate (3 Month T-Bill yields for practical purposes) plus some type of risk premium for duration, credit, equity, and many other types of risks.  What are interest rates exactly? An interest rate is simply the price of money. When anybody needs cash, the interest rate is the price they pay each year to borrow that money.  When the demand for money is greater than the supply of it, interest rates go up, and vice versa.  The key point is that they are prices, and like any prices, they are better discovered than administered.

The disconnect between price and value in the global bond market is immense.  Never in 5,000 years have interest rates been below zero—today, more than $3.5 trillion of bonds worldwide trade with negative yields.  It is evidence of the most radical, improvisational, and reckless monetary tinkering ever seen.    Bond selection is a negative art.  It’s a process of rejection.  The most you can get back is par with interest.  When you look at a bond, you’re supposed to be inherently defensive.  However, the current environment is what you get when Mario Draghi is bidding against you.

While it’s hard to understand negative interest rates, it shouldn’t be too hard to understand the differing incentives of market participants.  The central bank decision makers have a completely different set of incentives and goals than other market participants.  On the surface, these policies are put in place to combat weak economies, spur economic growth, and reduce unemployment—oh and of course to hit a 2.0% inflation target.  However, it can be argued that other reasons are playing a larger role.  Right now US total public debt as a percentage of GDP sits at 104% and is increasing ever year.  The federal government’s annual deficit is expected to exceed $1 trillion in 2020, and national debt of $21 trillion will soar to more than $33 trillion by 2028, according to the CBO.  Countries such as Japan (253%) and Italy (132%) have higher debt-to-GDP ratios and are in even worse shape.  This is unsustainable, and you might be able to guess why central banks would want to engage in financially repressive policies.

A subtle type of debt restructuring takes the form of “financial repression.” Financial repression refers to a set of government policies that create an environment of low or negative real interest rates, with the unstated intention of generating cheap funding for government spending.  However, this has been taken to the extreme in the current regime of central bank policy to the point of debt liquidation.  To steal from Carmen Reinhart (a professor of international economics at Harvard), “Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.”  So basically, when nominal rates exceed inflation—as they currently do in Europe and Japan—total debt is actually being reduced in real terms.  For example, Europe’s CPI is running at 1.7% vs. a 1.1% yield on the average European Union 10Y note (an annual debt reduction of 60bps in real terms).  Japan—the most indebted country in the world—has a CPI running at ~1% today vs. a nearly 0% (not a typo) 10Y JGB nominal yield (an annual real debt reduction of 1%).   The Fed has been less aggressive, but Janet Yellen has previously guided to more QE in the event of another recession.  How this will all playout, I have no idea.  Nothing has snapped yet, but we are in uncharted territory.

I wonder if people will look back on the negative yields of today and ask, “what were they thinking?”  There is an overarching complacency on the concept of credit and the path of interest rates going forward.  Central banks are literally creating money with a few clicks of the keyboard, and it forces you to ask “what is money?”  Too many people think: “if the Fed doesn’t want higher rates, we won’t get them.”  Let’s say stocks tank 25%+ and Powell enacts “QE n”.  You have to ask yourself what happens to faith in the US currency in that scenario.  We have to look back to the 1970s when the market lost confidence in fiat currencies and the institutions that managed them (will look into this in more detail next week).

Interest rates tend to trend in generation-like cycles.  Very few people have been around to see a bond bear market.  It is very possible that interest rates could be going up for the rest of our careers.  The bond bull market started in September 1981 and may have ended in July 2016.  I’m not making a call for the world to end or some type of severe inflection in rates or hyperinflation.  These same concerns could’ve been raised every year for almost a decade.  I’m just saying that this is a crucial topic that all investors need to pay attention to and monitor closely.

Top 10 Reads of the Week

  1. WSJ: Where’s the Invisible Hand When You Need it
  2. WSJ: A Limit to China’s economic Rise: Not Enough Babies
  3. MIT Technology Review: Let’s Destroy Bitcoin
  4. WSJ: Trump’s Aggressive Trade Agenda Brings Heightened Tensions
  5. ZeroHedge: “Musk Meltdown”: Tesla Tumbles After Elon Cuts Off Conference Call Question
  6. Bloomberg: US Factories Are Showing Signs of Buckling From Demand Surge
  7. Barron’s: Exxon Mobil is a Bet on the Future of Oil
  8. Barron’s: John Doerr on Leadership, Education, Google, and AI
  9. The Economist: Trade Talks Expose a Chasm Between China and America
  10. Wired: CGI ‘Influencers’ on Instagram?  They’re Only the Beginning

Tweets, Tech, and Tariffs

This was a volatile week.  On Monday, the S&P 500 fell over 2% and dropped through its 200-day moving average early in the day as Tech resumed its selloff in the wake of another Trump tweet attacking Amazon over USPS finances and taxes.  Stocks shrugged off the FAANG selloff to close higher on Tuesday, but that night, the Office of the US Trade Representative unveiled a list of proposed tariffs on $50bn of Chinese imports, on which an additional tariff of 25% will be imposed.  China reacted immediately the following morning with counter-measures of the same scale and intensity, proposing a retaliatory tariff of 25% on $50bn of US imports including soybeans, autos, and aircraft.  DOW Futures were down 500+ points premarket but surprisingly closed up ~230 points on Wednesday.  Equities were positive again on Thursday as investors chalked up the impact of the announced trade policies as minor.  Then on Thursday night, President Trump suggested that the US should consider sanctioning an additional $100bn of Chinese imports.  Stocks were down a lot all day Friday, and the DOW closed down 572 pts.  On the week, The S&P 500 and Dow Jones Industrial Average finished down -1.35% and -0.67%, respectively.  Credit markets sold off as well, but to a lesser extent, driven in part by a lower weighting of the tech sector.  The graph below shows the swings of the S&P 500 throughout the week.

Right now, all investors are assessing the probability and potential severity of a trade war.  My view is that this is mostly posturing by the US Administration going into negotiations (similar to NAFTA).  It’s important to remember that these tariffs are proposals, not policy.  The actual policies are likely to be negotiated down.  Even then, full implementation would reduce US and Chinese growth trivially.  A 25% tariff on $50bn of imports is equivalent to only 0.1% of China GDP and 0.06% of US GDP.  Retaliatory trade restrictions are also limited by the fact that the US only exports ~$150bn of goods to China but imports more than $500bn.  However, China can retaliate in other ways (i.e. by reducing US Treasury bond holdings or restricting services trade and market access for US companies).  Nonetheless, I think this recent $100bn suggestion/threat is just a negotiating tactic to get China to meet US demands.  The demand list from the US will likely ask China to further reduce auto import tariffs, speed up the opening of the financial sector, and increase imports of semiconductors from the US.  I’m sure there’ll be a number of “shocking” headlines that come out as negotiations unfold, but unless something drastically changes, I think a lot of it is just noise.

A few weeks ago, I thought the risk/reward relationship of US equities was skewed to the downside with the S&P 500 at 2,752 and harsh trade rhetoric coming out of the White House.  I think the risk/reward is much better today as tech has come down a good bit and markets are pricing in a much higher probability of a trade war.  The S&P 500 presently sits at 2,604, or 16.7x forward earnings.  16.7x isn’t too cheap from a historical standpoint, but fiscal stimulus and a strong global economic growth cycle are expected to grow earnings another 10% in 2019, from $156 to $172.  Furthermore, I think there is a lot of near-term upside as investors shift their focus from trade frictions and tech regulatory risks to a 1Q earnings season that begins at the end of next week (April 13th).  Consensus forecasts 1Q18 EPS growth of 17% y/y (10% organic when excluding tax cuts).  Of course, the downside risk for 1Q sales and EPS misses is substantial.  Furthermore, Friday’s payroll report suggests that the economy is not on the cusp of overheating and that the Fed is not behind the curve (Nonfarm payrolls rose 103k vs. 185k consensus and the previous two months’ prints were revised down by 50k). Although I try not to read too much into single data points, the report does ease concerns of upside surprises to inflation and/or a too hawkish fed.  Rates are by far my number-one concern for risk assets this year, and the 10-Year Treasury yield closed at a relatively benign 2.77% on Friday.  Overall, the risk/reward of US equities seems balanced.  Fixed income, not so much, but that’s a topic for another post.

My Top 10 Reads of the Week:

On Monday, Jeff Gundlach, who is right a lot, tweeted: “I learned Dow Theory (and many other things) from the late great Richard Russell, probably the best investment newsletter writer of all time”.  Perhaps somewhat embarrassingly, I hadn’t heard of Richard Russell and decided to check it out.  This explains the disproportionate number of Dow Theory articles.  Here’s a link to Richard Russell’s book Dow Theory Today  if interested.

  1. Wikipedia: Dow Theory
  2. Dow Theory Letters: The History of the Dow Theory
  3. Dow Theory Letters: Rich Man, Poor Man
  4. The Grumpy Economist: Unraveling
  5. Barron’s: AI: Coming to a Portfolio Near You
  6. Dow Theory Letters: Acting
  7. Dow Theory Letters: Hope
  8. Dow Theory Letters: Time
  9. The Economist: A Trade War Between American and China Takes Shape
  10. WSJ: In the Oil Patch, Bigger is No Longer Better

 

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

How Bad Are Rising Rates For Stocks?

Despite a week devoid of inflation catalysts, markets are still struggling to determine whether or not the newer narrative (inflation and Fed policy) will derail the older one (above-trend growth and earnings).   Inflation worries and rising rates were among several factors that jolted equity markets out of complacency earlier this month.  Yet equities have largely looked through the upside surprise in core CPI two weeks ago, which increased at the fastest pace in 12 years.  Furthermore, if this rebound in inflation continues, it will continue alongside quarterly Fed hikes.  A key question going forward is how risk assets will digest these developments over the coming months.

In theory, higher rates should negatively impact equity profits and valuation multiples for three main reasons: 1) rising interest expense hurts corporate profits (S&P 500 total debt ex financials stands at ~$5 trillion); 2) a higher discount rate reduces the net present value of future earnings (from a DCF perspective); and 3) declining relative valuation support (income investors rotate as bond yields compete with dividend yield).  However this is a gradual process and periods of rising interest rates have actually coincided with positive stock returns close to 90% of the time.  In fact, the best year was 2013, during which the S&P 500 returned 32% despite the 126bp rise in the yield on the 10Y Treasury (see graph below).

That being said, we may be getting closer to exiting the “sweet spot.”  Historically, the probability of loss for the S&P 500 increases when the 10-year Treasury yield rises above 3%, with the best S&P 500 returns occurring when the 10-yr Treasury yield has ranged from 2%-3%, particularly when yields have been rising.

While rising long-term rates will ultimately become a negative for profits and multiples, current levels probably don’t warrant de-risking and selling equities.  Fundamentals remain strong, expansionary fiscal policy should provide a further boost, and global central banks remain supportive.  However, if inflation rises more quickly than expected, concerns over Fed policy would probably dominate markets, even if activity and earnings data continue to evidence above-trend growth.  The reason is that faster inflation accelerates endgame thinking around the business cycle, and investors are not positioned for a possible 2019 end to the expansion if Fed policy has to turn restrictive next year (Fed  funds futures are only pricing in four hikes between now and the end of 2019).

My Top 10 Reads of the Week:

  1. MIT Technology Review: 10 Breakthrough Technologies 2018
  2. MIT Technology Review: A Smarter Smart City
  3. WSJ: How Jeffrey Immelt’s ‘Success Theater’ Masked the Rot at GE
  4. Wired: Crispr Gene Editing Will Transform How We Eradicate Invasive Species
  5. MIT Technology Review: The “Black Mirror” Scenarios That Are Leading Some Experts to Call for More Secrecy on AI
  6. WSJ: The Risk Pension Funds Can’t Escape
  7. MIT Technology Review: The Carbon-Capture Era May Finally Be Starting
  8. The Economist: License to Kill Competition
  9. The Economist: How Does Chinese Tech Stack Up Against American Tech?
  10. WSJ: Dollar-Rate Breakdown Exposes Foreign-Exchange Mystery

Well That Was Quick… And Confusing

Well that was quick—volatility has retraced two-thirds of its early-February spike and stocks have retaken half of their 10% peak-to-trough decline.  After two weeks of heightened fears about rising inflation and higher rates, investors seemed largely to ignore the much-anticipated CPI release on Wednesday.  The inflation data were ahead of expectations, at 2.1%, driven by an unexpected strength in core goods.  Despite the strong print, risk markets unexpectedly rallied even though rates (believed to be the catalyst for the recent rout), continued to sell off.  Some believe this reaction was due to worse-than-expected retail sales, which brought the economy’s strength into question.  While one would expect this to be negative, it seemed to ease fears that the Fed might be more aggressive with monetary policy.  Others believe the steep drop in the USD provided the most relief for US equities.  Others cite a reflation trade.  Nonetheless, it is certainly confusing how, within less than two weeks, investors can go from calling for the onset of a bear market to equities rallying back to within 6% of all-time highs.

Leading up to this point, there have been many technical vs. fundamental debates to explain the multi-sigma market downturn two weeks ago.  Many of the technical arguments largely blame the turbulence on the VIX shock (following the surprise in wages), interest rate volatility and risk parity/trend-following strategies.  One fundamentals-based explanation suggests that there has been a repricing that reflects a progressive shift from a ‘strong growth and earnings upgrade’ narrative to one in which inflation risks are interrupting the conversation.  The first, subtle inflation warning came in mid-January when US core CPI surprised minimally (1.8% actual vs. 1.7% expected).  The second came three Fridays ago (Feb 2nd) when wages delivered a chunkier overshoot (2.9% vs. 2.6%).  The third is coming via Congress, which is easing fiscal policy for the second time in three months by lifting spending caps.  If higher inflation is a precondition for restrictive Fed policy in 2019, then it seems responsible for markets to price a risk premium for overheating due to a possible policy mistake.  As a result, the S&P 500 fell by 10% for the first time in 500 days.  However, if this is the case, then why did stocks quickly rally to within 6% of their all-time highs after even stronger CPI and PPI numbers this week?  A plethora of reasons have surfaced to explain this rebound, including: weak retail sales, a weaker USD, investor positioning/FOMO, etc.  I’m not really sure to be honest.  Good explanations are rarely binary because multiple forces conspire.

The explanation that makes the most sense to me is centered on a sort of reflation trade—buying stocks and selling bonds in response to rising inflation and strong growth.  We are in a strong global growth environment, and US inflation has printed stronger than expected on almost every measure over the past month (average earnings, CPI, and PPI).  Even though the market has been expecting labor costs and broader price gauges to firm this year as slack diminished further and transitory factors faded, it did not expect so many beats so soon.  This is why the ongoing bond bear market is delivering more volatility across rates, equities and currencies than is typical for a rising rate environment, and consequently why stocks are rising and credit spreads tightening less than they typically do when Treasuries sell off.  However, there will always be skeptics of any price upturn given structural disinflationary forces (i.e. Amazon effect and globalization).   So one might take this as a clear green light to buy equities and short bonds, right?  I personally would be more cautious.

A point made by investor Adam Robinson seems applicable to these severe responses to recent data points.   Many investors have been conditioned to believe that the better they understand the world, the better their investment results will be.  This makes sense—the more information we accumulate, the better informed we become and the better our decisions.  However, in the counterintuitive world of investing, too much information can actually hurt results.

In 1973, acclaimed psychologist, Paul Slovic, decided to evaluate the effect of information on decision-making.  He gathered eight professional horserace handicappers for a test that would consist of predicting 40 horse races in four consecutive rounds.  In the first round, each gambler would be given the five pieces of information he wanted on each horse, which would vary from handicapper to handicapper.  One handicapper might want the jockey’s years of experience as one of his top five variables, while another might want the fastest speed any given horse had achieved in the past year.  Then, Slovic asked each handicapper to state his level of confidence in his prediction.  As it turns out, there was an average of ten horses in each race, so we would expect that by random guessing, each handicapper would be right 10% of the time, and that their confidence in their blind guess would be 10%.

So in round one, with just five pieces of information, the handicappers were 17% accurate, which is pretty good (70% better than the 10% chance they started with when given zero pieces of information).  And interestingly, their confidence was 19%–almost exactly as confident as they should’ve been.  In round two, they were given ten pieces of information.  In round three, 20 pieces of information.  And in the fourth and final round 40 pieces of information.  Surprisingly, their accuracy had flatlined at 17% in each round as they were no more accurate with the additional 35 pieces of information.  Unfortunately, their average confidence level nearly doubled—to 34%!  So the additional information made them no more accurate but a whole lot more confident, which presumably would have led them to increase the size of their bets.

Beyond a certain minimum amount, additional information only feeds—leaving aside the considerable cost of and delay occasioned in acquiring it—what psychologists call “confirmation bias.”  The information we gain that conflicts with our original assessment or conclusion, we conveniently ignore or dismiss, while the information that confirms our original decision makes us increasingly certain that our conclusion was correct.

So, to return to investing, the problem with trying to understand the world is that it is simply far too complex to grasp, and the more dogged our attempts to understand the world, the more we earnestly want to “explain” events and trends in it, the more we become attached to our resulting beliefs—which are always more or less mistaken—blinding us to the financial trends that are actually unfolding.  Worse, we think we understand the world, giving us as investors a false sense of confidence, when in fact we always more or less misunderstand it.  You hear it all the time from even the most seasoned investors and financial “experts” that this trend or that “doesn’t make sense.” “It doesn’t make sense that the dollar keeps going lower” or “it makes no sense that stocks keep going higher.”  But what’s really going on when investors say that something makes no sense is that they have a dozen reasons why the trend should be moving in the opposite direction… yet it keeps moving in the current direction.  So, they believe the trend makes no sense.  But what makes no sense is their model of the world.  The world always makes sense.

So, looking forward to next week and beyond—yes global and US growth are good; yes stocks should outperform bonds in periods of inflation; yes investors need income; and yes the return on cash is zero.  However, I would argue for caution as there’s no shortage of risks in today’s investing landscape.  First of all, rates have risen really fast.  The yield on the 10-year Treasury has risen from 2.40% at the end of 2017 to 2.87% this Friday.  Further, global yields are rising much faster than U.S. yields.  The back up in Treasury yields is nothing compared to Bund yields which have more than doubled in two months, rising from 0.31% on December 14th to 0.71% on Friday.

Historically, copper divided by gold has been the single best predictor of interest rates bar none.  Copper is durable, highly conductive, and resistant to bacteria growth, which gives it a long list of industrial uses (i.e. wires, motors, plumbing, etc.).  Gold has a handful of industrial applications, but its relative rarity makes it useful chiefly as jewelry and money—bricks, ingots, and coins meant to store value.  Copper’s rise tends to mean economic activity is improving, or that investors expect it to.  Gold can be more idiosyncratic, but it sometimes rises when investors fear turmoil.  A surge in the copper/gold ratio, then bodes well for growth, which can nudge inflation and lead central bankers to raise interest rates, which tends to damp bond prices and boost yields.  Right now, copper vs. gold is near 4-month lows (albeit way higher than the lows of 2016).  This means that metals traders are positioning for slightly lower interest rates from here.  However, even if that ends up being the case, it’s difficult to be sure that valuations have already digested these higher rates (rising rates are bad for all long-duration asset classes).

Another point to keep in mind, is that when you go back and look at declines that were roughly the same size as the one we experience two weeks ago into Thursday’s low of ~7% below the highs (2015, 2011, 2008, 2002, 2001, 1998, and 1987), each time, equities retested those lows sometime 5-8 weeks after the initial decline.  I’m not predicting that equities will retest the lows of two Thursdays ago, but it’s important to keep in mind that every time we’ve been right here in the last 50 years, we have retested the lows.

Central bank communications will also be in focus next week with the January FOMC meeting minutes on Wednesday and accounts of the ECB meeting on Thursday.  For the ECB, focus will be on their degree of comfort with increased expectations for rate hikes in 2019, timeline for reviewing forward guidance, and the extent of their concerns around the impact of Euro appreciation on the inflation outlook. The January FOMC minutes will likely suggest that the Fed continues to expect a gradual pace of rate hikes remains appropriate as confidence in their inflation outlook improves.  What will likely matter more for the FOMC outlook is the unprecedented late-cycle fiscal stimulus.  Fiscal easing ($1 trillion+ federal deficit or 5.2% of GDP in 2019) at full employment runs the risk of significantly overheating the economy, which would force the Fed to tighten more aggressively.  The rising risk of a hard landing should probably be the key focus going forward as signs of overheating in the growth and labor market data likely pose more risk than a few inflation beats.  Also, propped up global growth (via trade) as a byproduct of US stimulus may be indirect support for initial steps by the ECB and BoJ to begin policy normalization later this year.

Lastly, I’d also be cautious with respect to the potential effects of wage growth and inflation on US corporate profits.  If wages rise, corporations’ costs will increase, but will they be able to pass along price increases to the US consumer in a hyper-competitive, Amazon-dominated world?  I’m not sure.

Overall, I’m positive on equities going forward and negative on bonds.  Stock valuations aren’t super high at 17.5x forward earnings (they aren’t necessarily cheap either!), and global growth looks good.  However, I’d skew more to the cautious-side as we get later in the cycle and wouldn’t be aggressively long stocks with a ~70% stocks and ~30% cash portfolio seeming about fine for me, personally.

My Top 10 Reads of the Week:

  1. The Economist: The Falcon Heavy’s Creator is Trying to Change More Worlds than One 
  2. WSJ: U.S. Consumer Prices Rose 0.5% in January, Up 2.1% On Year
  3. Ray Dalio: It’s All Classic: The Main Questions are About Timing and What the Next Downturn Will be Like
  4. The Economist: America’s Extraordinary Economic Gamble
  5. Bill and Melinda Gates: The 10 Toughest Questions We Get
  6. Wired: Scientists Know How You’ll Respond to Nuclear War – And They Have a Plan
  7. WSJ: Regulator Looks Into Alleged Manipulation of VIX, Wall Street’s ‘Fear Index’
  8. MIT Technology Review: 2017 Was the Year Consumer DNA Testing Blew Up
  9. Wired: Watch Boston Dynamics’ SpotMini Robot Open a Door
  10. Wired: Lab-Grown Meat is Coming Whether You Like It or Not