The Days Ahead: Markets closed Monday. Not a big news week but, hey, early days.
Stocks rose every day this week. At the worst point this year (February 8th) we were down 11% from the S&P 500’s all-time high. It's now less than 5%. We'd like to see stocks take a breath for a while. Some of the action is short-covering and profit taking. We get that. But how do you manage around a company like Netflix, which is up 45% this year, fell 13% and rose 11%? And what can one make of Berkshire buying even more of Apple and Teva? Is that a confidence vote in tech and pharma? Or lack of M&A opportunities for Berkshire?
Either way, we’re in a period of rapid descents and recoveries. Meanwhile, bonds were flat, which was better than people expected.
1. Why volatility had to come back. Markets become accustomed to events very quickly. For a number of years, portfolio managers had very decent returns from stocks and bonds without the normal downside risk. “This is the new normal” they thought. “How can we make money from that [think, think...] aha, we will put more volatility into our portfolios and earn even more.”
And if you're a Harvard alum or government employee in Hawaii, that’s what you got and that’s why Harvard’s endowment returned a total of 11.9% from 2015 to 2017, while a standard 60/40 mix of U.S. equities and bonds returned 21%. Now, it's fun to laugh at Harvard but the real point was that a 60/40 portfolio had extraordinary gains over the last three years and even beyond that…
Over the 20 years, a 60/40 portfolio (the black line) returned 97% of a full equity portfolio (blue line) with a worst drawdown of 29% against 57% for the S&P 500. In 2017, the 60/40 did not have a single month of negative returns and captured 70% of the market’s 20% return. In the words of our friends at Goldman Sachs, a 60/40 portfolio had “…one of the strongest risk-adjusted returns since the 1960s as bonds and equities went up together, with very low volatility.” And they would know.
Why? Put it down to a generous mix of growth expectations, low rates, low inflation and predictable central bank policy. That has now changed. In less than six weeks, the budget put a very large hole in the deficits. Here’s OMB director, Mulvaney:
“And yeah, you’re going to see a spike in the deficit over what we had originally expected this year because we — tax revenues are going down (sic). ”
To which one might reasonably ask, “And you're okay with trillion-dollar deficits?” and he would reply,
“There is a way out of this. By the way, we do all of this, okay, without changing Medicare — or at least the benefits that people get with Medicare. We’ve always talked about the drug stuff…(again, sic).”
At which point, one might reasonably face plant and conclude they're making this stuff up as they go along.
Now last year, the budget deficit was $665bn or 4% of GDP. Interest payments were around $503bn but net interest was $360bn (because the Fed remits interest earned on its Treasury holdings back to the Treasury). The new tax bill adds $1.5 trillion to the deficit, over 10 years, and then the new budget deal (the one that increased defense spending from $630bn to $686bn) adds another $320bn, over two years. It all doesn't look good and some pretty sober people think that $665bn could be $1 trillion next year. Buy, hey, we've always got that drug thing.
Of course, a lot can happen in one year and 10 years so it’s no good playing the doomsday machine yet. But you can see just how much uncertainty the market now has to price in. And uncertainty means more volatility. Expect that black line to get a little more choppy in coming months. We'd remind clients that’s why we’re long international and emerging markets. The dollar is likely to continue to be a casualty.
2. The markets puts on its beagle nose: As regular readers know, we’ve been very sanguine about inflation for a number of reasons mostly because deflationary forces are large, secular and demographic. But there is a whiff of higher inflation in the air and for the first time in a quite a few years, we had a CPI report that the market actually cared about. The headline looked like this:
These are all year-on-year numbers and there’s really nothing to see. Core inflation was unchanged at 1.8%, headline also unchanged at 2.1% and the biggest (24% of the index) component of the CPI, owner’s rent, was also unchanged. Yay, on lower cell phone charges.
But closing in on some of the details, such as apparel and gas (because of tax increases) and there are some pointers that the core inflation may edge up to around 2.5% which is consistent with the Fed’s PCE target of 2.0%. We would stress that this will all happen very slowly. But the market is a bit more wary these days and that's one reason interest sensitive stocks like Real Estate had a bad day (and year).
3. The stock market is not the economy (Part Many). As stocks hit more turbulence, you will now hear politicians complain the market ignores positive fundamentals. That's true because the market is a predictive machine. If it was a coincident indicator it would offer rather dismal returns. But here's a reminder:
Stocks on top. The economy below. Stand-out years are i) the 1980s where the economy had great back-to-back years but the market had two big corrections and ii) the post 2010 period where very slow growth was matched with outsized stock gains.
There are many reasons, of course, starting with the simple fact that S&P 500 companies only employ around 11% of the U.S. workforce (and some of those are overseas employees….not all companies break them out)…the S&P 500 is more export dependent than the U.S…stock market earnings can be changed with share buybacks and so on.
Last week, we saw weak retail sales, industrial production and so-so consumer confidence numbers and housing starts. We think the market is slowly adapting to, yes, higher growth, but with a lot more long-tail risk. Throw in an untested Fed and tensions rise. But, all together now, the stock market is not the economy.
Bottom Line: The FOMO (Fear of Missing Out) trade is now the FOBL (Fear of being long). That's not an original point…I stole it from somewhere. We're still in a market finding its feet in a new world where deficits matter. There’ll be more surprises to come and, again, that's the reason we like Treasuries.
Here's the link to the Mulvaney (OMB Director) interview. For some reason the WH chose not to update it. https://www.whitehouse.gov/briefings-statements/press-briefing-omb-director-mick-mulvaney-president-trumps-fy2018-budget/
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