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