Sirens of the Golden Punchbowl
To the Sirens first shalt thou come, who beguile all men whosoever comes to them …. But do thou row past them, and anoint the ears of thy comrades with beeswax, lest any of the rest may hear. Homer, Odyssey
There is something about financial markets that promote willful delusion. Remember the “Taper Tantrum” in 2013? For months, then-Fed Chairman Ben Bernanke primed the markets for a gradual rollback of the bank’s easy-money fix. But when he finally announced a reduction of debt purchases, investors fled for the exits, so deeply had they been lulled into complacency by the bond-binge muse.
A half-decade later, and Wall Street remains in thrall to the golden punchbowl. Consider the warning signs that preceded February’s market correction and its lingering volatility. It is clear that December’s earnings peak, the topping out of Bitcoin and the launching of the Trump tax plan was in fact ground zero for the tremors that followed. Perhaps a more significant auger was the spike in interest rates and foreign exchange volume in early January, which came on the heels of “breakout” rates of inflation building since last September.
Hovering about these cyclical factors of course was the secular reality of the Fed’s policy normalization, now well under way and soon to be followed by its European and Japanese counterparts. Still, it took hard evidence of US wage inflation – despite years of healthy job creation – together with a muscular January CPI report to remind investors what end-of-cycle growth looks like.
The consequence of this delayed response was one of the sharpest pull-backs since the financial crisis – mass hysteria being a cousin of delusion – accelerated by program trading, a convenient scapegoat for all manner of market mayhem until someone programs them to sue for defamation.
Where does this leave us? Not far from where we began, actually. If the triggers for the sell-off were hiding in plain sight and, at least in respect, easily located on the economic cycle, we have only to acknowledge that once again we sold ourselves a bill of goods – namely the conceit that this bull run was materially different than the ones that came before it. However we may delude ourselves to the contrary, wages rise in a crowded labor market, which chases consumer prices higher and compels central bankers to raise interest rates lest the economy overheats. We also know that bond investors demand higher rates of return as borrowing costs rise, particularly when one essential market player is shrinking its balance sheet while another is dramatically increasing debt issues to finance extraordinary items like massive tax relief.
While some may find this something of a letdown, I for one am heartened to know that the old rubrics still apply.
And in fact, Anfield believes that equity markets – however mortal – can look forward to another good year. Two of the factors that propelled stock prices deep into record terrain – healthy corporate profits and a strong global economy – continue to surge ahead. FactSet Research reported last month that the forward 12-month P/E ratio for the S&P 500 is 16.9, which is above the 5-year and 10-year averages at 16.0 and 14.3 respectively. And it forecasts that nearly 75% of S&P 500 companies have reported positive EPS surprises for Q4 2017. Meanwhile, the International Monetary Fund in January boosted its forecast for global GDP growth to 3.7% in 2017 and 3.9% for 2018 in part on the strength of the Trump tax cuts, an adjustment that followed similar upward revisions announced by The World Bank and the OECD.
The third catalyst for growth – stable interest rates – was in fact the fuel that powered the first two. For now, financial conditions remain accommodating. Despite talk of multiple interest-rate hikes this year, credit is still loose and yields remain at historic lows.
Indeed, last month Morgan Stanley announced that the Treasuries rout – which cool heads recognized for what it was months before it went ballistic in January – has all but fizzled. Compare that to earlier comments by the redoubtable Bill Gross that fixed-income markets had gone bearish after the yield on the 10-year Treasury bill reached 2.5%.
FYI, when I entered this business in the early 1990’s the 10-year was paying out between 8% and 9%. Somehow, we survived and this too shall pass.
But it’s important to remember that bond markets have been walking a tightrope for some time – going at least as far back to the Taper Tantrum. Looking forward, returns will be lower and volatility will get higher. Credit spreads will widen as investors demand a premium for potential illiquidity.
In a thoughtful note, Scott Minerd, Guggenheim’s Global Chief Financial Officer, wrote recently that “bull markets don’t die of old age. As they grow older they become more vulnerable to shocks as companies and households get overextended. Monetary policy tightens … and so ends the business cycle. This cycle should prove no exception as the Fed will have to tighten to offset the late-cycle fiscal easing in the pipeline.”
Minerd allowed that his team has studied the late-cycle conduct of several key economic and market indicators and concluded that a recession is due as early as 2019.
That may not be our prognosis, but we’ll be packing beeswax just in case.