Bull markets don’t die of old age
Old Wall Street Expression
May you stay forever young
Despite much turmoil, volatility, and unsettling headlines, the US markets were modestly positive for the first half of the year. Through June 30, most indices were still below their late January peaks, but had recovered much of the ground lost in the steep declines of the first part of February. Outside of the US, markets are mainly negative for the year, and look worse in US Dollars than in their local currencies as a result of the strength of the US Dollar, especially since late March. Fixed income has struggled this year with the rise of interest rates, which mainly occurred during the first quarter. Returns in the high yield market were also flat, reflecting the tight credit spreads coming into the year, as well as the absolute low level of yields in that market.
In many ways, the US equity market results so far this year reflect a continuation of several key trends that have been developing over the past several years; most notably the performance gap between growth and value stocks. Historically, stocks classified as value stocks have outperformed growth stocks over long time periods (Source: Value Walk), while growth has done meaningfully better over the past 10-15 years. Page 3 of attached Month-End Asset Return Analysis – June 2018 shows annualized total returns for the S&P Growth Index and the S&P Value Index over past time periods up to 20 years. As you can see, Growth has beaten Value in each of the measurement periods, and the gap is growing. This is also true for the MSCI World Index (GIC Slide 2).
One of the key investment ideas behind value investing is that companies facing challenges will often be able to right the ship, and in doing so, will experience significant stock market appreciation, because the starting point is a low earnings multiple. In today’s world of disruptive change, this is happening less and less. It appears that far fewer companies are able to engineer turnarounds or to thrive against new competitors who have redefined and upended their markets. Not only are companies facing new, agile competitors, but consumers are changing their purchasing and consumption habits, including spending a smaller share of their money on older, traditional goods, and much more on newer, intangible products (Source: Deloitte). Our kids are spending more on electronic games, online services, movies and videos, and less on clothes and jewelry, and they are buying everything in different ways than we did 30 or 50 years ago. All of these trends are creating serious headwinds for many older companies, and we can see it across numerous parts of the economy. These forces undermine some of the key tenets of value investing. So, while the tremendous outperformance of growth is likely to revert somewhat, value’s days of long-term outperformance or equal performance may be over. Successful value investors are evolving by expanding their definitions of what constitutes value, and by seeking to avoid companies that they believe are imperiled by disruptive change.
Along with challenges for many companies and industries, the changes in the US and global economies have also created a greater distribution of individual winners and losers in the US economy, leading to widening gaps in income, education, marriage rates, substance abuse, and many other measures of well-being or its opposite (Source: Bloomberg). As a candidate, Donald Trump successfully tapped into this, building a base of voters who have generally fared poorly over the past 20 years or more. Trump’s base – and especially those who had switched parties in the past one or two national elections – are generally rural, lower-income, less-educated voters from the industrial heartland. He identified two main arguments that resonated with this population – the idea that illegal immigrants have been driving down wages and taking jobs from Americans, and the idea that the US has been a victim of bad trade deals and unfair trading practices by many of our trading partners, thereby chasing US jobs offshore.
Trade is a tremendously complex arena. The media and politicians generally talk about the trade deficit in goods, but there are other relevant metrics and figures, including the balance of payments, which includes the trade account, the services account, other current account items such as investment income, and the capital account (flows of capital), as well as the relationship of these items to the budget deficit and to currency exchange rates. Our trade deficits have generally arisen because American companies have decided to locate their own manufacturing abroad, or to source raw materials, component parts, or finished goods from other American or foreign companies operating abroad, in all cases to take advantage of lower prices or costs, or to use an economics term, other countries’ competitive advantages. And who are the beneficiaries of these lower prices? American companies and consumers. Thus, our generally open trade borders have helped keep the US and its private sector more competitive by driving prices lower, and have benefitted US consumers by continually improving living standards. The overall deficits in trade and services are offset by capital flows into our country, as investors around the world want to own US government debt, as well as US equities, private investments, and other direct investments such as foreign companies investing to build factories, stores, etc. These capital flows are highly beneficial to the country, allowing our governments to finance themselves at lower rates, providing capital for the private sector, and building businesses that employ American workers. In the aggregate, foreign governments, companies and individuals own $11.3 trillion of US government and corporate debt, $7.2 trillion of US equities (Source: Bloomberg), and $46 trillion of direct foreign investment (Source: Trading Economics) in businesses employing nearly 7 million workers (Source: Pew Research).
While most discussion about trade focuses on the trade in goods, services are an important and growing component of our trade flows. As our consumption patterns shift to services, and as more and more of our economy is based on services, focusing only on goods ignores the largest and fastest growing part of the US economy, where most of our highly-valued companies and high-paying jobs are. In fact, over the past 12 years, our trade deficit has remained fairly constant (it was $807 billion in 2017), while our services surplus has more than tripled (to $255 billion last year). With only 8% of all US jobs in the manufacturing sector, it is odd to focus only on goods (Source: U.S. Census).
It is also not clear that a trade deficit, in isolation, is a bad thing. The US has run a trade deficit in goods every single year since 1976, and the deficit has grown fastest when our economy was doing best; the time of the greatest growth of our trade deficit in goods was the period from 1995 to 2000, when the economy enjoyed its strongest period of the past 50+ years, while the trade deficit ballooned from $159 billion in 1995 to $436 billion in 2000. Since 2000, the trade deficit has grown less than the growth in GDP, and has been flat in nominal dollars since 2006, as mentioned. Going back to 1976, the only times the trade deficit has gone down are during recessions (Source: U.S. Census).
One of the basic arguments put forth by economists is that competitive advantages are the main drivers of trade flows, and that any attempt to manage trade balances is bound to fail because lowering imports (through tariffs) will create a surplus of dollars in the international currency markets and drive up the value of the dollar against the currencies of our trading partners, thereby hurting exports and helping imports, offsetting the impact of the tariffs. In the months after the election, when there was talk in DC of a “border adjustment” tax on all products made outside of the US, this argument appeared regularly in the financial media. Theoretically, the US could couple tariffs with restrictions on the flow of capital into the US, in order to stop the US dollar from appreciating. That would put us in a similar situation to a number of closed, emerging economies, and it is hard to imagine would be advantageous long-term. In general, closing markets – to trade or to capital - causes companies and countries to become less competitive over time, raising costs, lowering productivity, and eroding living standards. With the rare and complicated recent exception of China, less open economies have not been great successes. One can argue that our relatively open trade borders are at least in part responsible for the fact that US companies are among the global leaders in virtually every new and strategically important industry.
However, getting back to Trump’s base, there is no question that millions of working class Americans, many of them white, blue collar workers in the industrial heartland, have lost ground (at least on a relative basis) over the past 20 years. The number of manufacturing jobs today is roughly 12.7 million (Source: Bureau of Labor Statistics), down from 17.2 million in 2000, and roughly flat with the 2008 number of 12.8 million. Furthermore, wages in the manufacturing sector have lagged other parts of the economy (Source: Reuters). There is also no question that many of our trading partners have higher tariffs and other barriers to US imports than we do for their imports (Source: Reuters). Chinese companies have a well-earned reputation for stealing intellectual property from their joint venture partners (Source: Market Watch) and China even has put forth and published an industrial policy called Made in China 2025, whose goal is to provide significant state resources and backing to domestic Chinese companies to achieve dominance in 10 key strategic industries by 2025. Thus, even though the prospects for actually bringing manufacturing jobs back to the US, or reducing our trade deficit in goods appear to be slim, the President has a strong argument that our trade deals can be improved. This is what we are predicting – that there will be some renegotiations that will be heralded as great deals, but it will take several years to see that the impact on the trade deficit will be negligible.
This leads to a bigger question of what the markets are reflecting in terms of the Administration. Many observers, and especially those who are not Trump fans, have spent the past 18 months waiting for economy or the markets to crash, or for some geopolitical disaster to happen. Early last year, as the President took office, fears were high that chaos would ensue, and that between repealing Obamacare, cancelling NAFTA, pursuing a trade war with China, and various other campaign promises, something bad was likely to happen. I confess to having harbored some of these concerns at that time. Meanwhile, as 2017 unfolded, none of the bad scenarios happened, and the December Tax Bill was the only major piece of legislation passed. The market melted up on accelerating US and global growth, amidst record low volatility. This year, Trump seems to be more aggressively pursuing his original agenda. As partially reflected in the first half returns, the Administration is generating some fear in the rest of the world, but the US markets have mainly taken it in stride.
US investors seem to be adopting the view that Trump’s willingness to throw around America’s weight in terms of economic and military power might actually achieve some tangible results, whether it is a better trading relationship with China and other major trading partners, higher defense spending by our NATO partners, a potential denuclearization of North Korea, and other important global issues. It is interesting to note that that there is not much of a domestic agenda now, but with the economy doing well and the job market strong, that is not necessarily a bad thing.
In our January email, we expressed the view that we were seeing elevating valuations, some evidence of investor euphoria, and a general melting away of cautious behavior. In retrospect, there were bubbles in cryptocurrencies and in bets against volatility, both of which have popped. The two strategies have been hammered this year, and between that, the general sideways direction of the US market, and losses in most fixed income and international strategies, investors are in a more cautious mood these days. We also had identified wage growth and inflation as important economic metrics to watch, and although both have continued to tick up at a modest pace, neither are showing reasons for panic.
In general, although we are more than nine years into a recovery – making this the second longest expansion in US history (Source: National Bureau of Economic Research) – most of the classic signs of the end of the economic cycle have not materialized. Wages continue to tick up slowly, with June’s Average Hourly Earnings (“AHEs”) +2.7% year to year (Slide 3). One economic analysis we recently read pointed out that during the expansions of the 1980’s, 1990’s and 2000’s, once AHE growth turned up, AHEs accelerated from roughly +2% to +4% in an average 2 ½ year period. In this decade, AHEs have been slowly accelerating for more than 5 years, and the annual growth rate has moved up less than one percentage point during that period. If 4% is the peak again this cycle, it could take several more years to get there. Inflation, which tends to track AHE, is also on a slow trend upwards, reaching 2.8% nominal CPI growth for June (Slide 4).
Other economic indicators are also suggesting a benign outlook. Consumer confidence, and various indices of leading economic indicators are all solid, leading Morgan Stanley’s Recession Risk Model to register a very low risk today of a near-term recession (Slides 5, 6 and 7). Outside the US, most of the large economies are growing, giving us a global synchronized expansion (Slide 8).
We have not seen the extent of speculative activity as in prior cycles. Equity market valuations, while above long-term averages, appear to be approximately one standard deviation overvalued, lower than the past three market peaks (Slide 9). This year, we have seen a significant contraction of market multiples across the world, most notably in the US in part due to lower corporate taxes (Slide 10). One could argue that the buoyant markets of last year anticipated this year’s strong earnings growth, but even so, such a multiple contraction is unusual for market peaks. In fact, the market multiple today is no higher than five years ago, which is also highly unusual. This year, we have even seen a pullback in the flow of new dollars into equity ETFs (Source: Reuters). Morgan Stanley’s proprietary Equity Risk Indicator model is also showing a reduced level of market risk today (Slide 11). In terms of the credit markets, it is a mixed bag. Leverage in the household sector has significantly improved, (Source: Federal Reserve Bank of St. Louis), and delinquency rates are stable or falling (Source: WSJ), while corporate leverage is at all-time highs (Source: CNN). Much of the leverage has been provided by the capital markets, while bank lending has seen moderate growth (Source: NY Times).
Our Morgan Stanley strategists have been more cautious this year, and have recently upped their level of concern. Mike Wilson, our Chief Investment Officer, came into the year with a mixed message, predicting a strengthening global economy, rising interest rates and tightening financial conditions, cyclicals outperforming growth and international markets outperforming the US (Slide 12). He saw earnings growth peaking in 2018, and volatility heating up. He updated his views in June, downgrading cyclicals, and moving more into defensive sectors like REITs and utilities (Slide 13). He also has been expressing concerns about tech stocks and small caps, two areas that are trading at or near all-time highs (Slides 14 and 15). Wilson continues to see financial conditions tightening, repeating a process that played out in 2015 and early 2016, and that had led to significant carnage in energy prices, in industrial and financial stocks, and in emerging market equities. As conditions tighten over the next year, he expects more carnage (Slide 16 and 17).
Ellen Zentner, the firm’s Chief US Economist, published a piece in the New York Times expressing her view that the derivative and secondary effects of a trade war have not been properly assessed by investors, who have focused just on the dollar amount of goods subject to tariffs, and the small share of US GDP that those goods represent. She believes that other effects could include continued appreciation of the US dollar, which depresses US earnings (as more than 40% of S&P sales are generated outside the US) (Source: S&P Dow Jones Indices), exacerbates our trade deficits and hurts EM governments and companies, many of which have borrowed in dollars to obtain lower interest rates; risks that China or other countries will make it more difficult for US companies to operate there, and consumer backlash in those countries against US brands. We have attached some other recent GIC publications discussing concerns about trade and inflation.
Everyone seems to be speaking about the potential of an inverted yield curve in the next 6-12 months, and the ill omen it would represent. In these discussions people are generally referring to the spread between the US Treasury 10-year yield and the US Treasury 2-year yield; when the 2-year yield exceeds the 10-year yield, the spread is negative, and the yield curve is inverted. Slide 18 shows the history of the 10-year to 2-year yield curve spread for the past 40+ years. What all the commentators are saying, and what the slide clearly illustrates, is that each time the curve has inverted, it has proceeded or coincided with a recession. It also shows that the yield curve has been flattening since the beginning of 2014, and that it is now down to roughly 0.25%. Doing a little math on two to three more Fed Funds tightenings in the next year, it appears that we may be heading for an inverted yield curve in 2019, unless rates move up at the longer end of the curve, or the Fed stops tightening.
One of our economic newsletters directed us to a somewhat wonkish, recent paper on the Fed Notes section of the Federal Reserve’s website, which makes the argument that a better recession predictor than the 10-year to 2-year spread has been what the authors define as the near-term forward spread. This is calculated as the difference between the current implied forward rate on Treasury bills six quarters from now, and the current yield on three-month Treasury bills. Besides being a better predictor of recessions, this spread has the added advantage of making more intuitive sense than the 10-2 spread because it hones in on the market’s prediction of what the Fed will actually do in the next 18 months. It also helps avoid arguments that the 10-year yields have been distorted by quantitative easing and other unprecedented monetary experiments around the globe. Interestingly, the near-term forward spread has been moving up this year, and is not predicting or even moving in the direction of predicting a recession in the next 12 months.
The attached Morgan Stanley Research piece A Spotter’s Guide to Bull Corrections and Bear Markets analyzes how various sectors and asset classes have performed before, during and after past bull market corrections and bear markets, in an attempt to identify the signs for each one, and presumably be in a position to mitigate losses in the next bear market. Their conclusion is that certain asset classes, including US equities, global discretionary and materials equities, Japanese and British government bonds, and copper are all showing signs of being within 12 months of a peak, while other important asset classes such as Emerging Market and European equities, global staples equities, credit spreads and US Treasury yields are not. Thus, the conclusion of the piece is that we are likely not within 12 months of the end of the bull market.
So, while many strategists and economists are looking out a year or two and predicting that current trends will likely lead to rising inflation and wages, higher interest rates and ultimately the end of the economic cycle, the data we are seeing is not supporting that view yet. Of course, each cycle is different, and we will never get a perfect checklist of conditions before the market cycle turns. We will keep watching closely, recognizing the risk that by the time the data is more obvious, it might be late to act. In the meantime, it seems to us that it pays to be more cautious than we have been in the past seven years, as we are certainly closer to the end of the cycle than we have been.
Below are some links to other recent pieces from our Global Investment Committee.
On the Markets - July
GIC Weekly - 7/16/18
As always, we welcome your questions, comments and feedback.
Richard and Team