Last week’s Economic Insights (August is a Wicked Month) described how most equity markets were struggling, Gold was drooping, crypto and many fiat currencies were on the floor while US equities and the dollar powered on. Siren voices every year tell US investors to ‘sell in May and go away’ even though the phrase is an old City of London saw. Sometimes it works and sometimes it doesn’t. So far this summer even UK equity markets are slightly up on their April close while in the US the Dow, S & P 500, Nasdaq Composite and Russell 2000 (Small caps) are respectively 6.6%, 8.2%, 11.7% and 11.7% higher. The US equity bandwagon has been rolling now for (take your pick) the last 4 months, 3 years, 5 years or 9 years. Quite a few stocks have dropped off along the way and in 2018 it has often seemed that only the FAAMNGs and their Chinese cousin BATs were still left on board, all of which are genuine growth companies but their share prices have reached levels that, to varying degrees, can no longer be justified by fundamental factors. It is almost as if investors have kept betting on the bandwagon because they cannot afford it to stop. A cynical view might be that investing in the FAAMNGs has become an insurance policy providing protection for fund managers’ careers (everyone is exposed) rather than for absolute portfolio performance. Since April, far from going away, there have been even more investment flows into the dollar that has led to loop-backs in US asset prices’ pushing equity indices yet higher. However, from as recently as mid-July there have been signs that some investors believe that some US stocks are just too ‘valuable’ and at current prices do not represent ‘good value’, leading to increasing talk of rotation into ‘undervalued’ stocks.
Of course, the bandwagon may well keep rolling for a while yet as the US economy drives on and US companies keep reporting strong quarterly results. On the other hand, there are plenty of things to worry about. In this edition of Economic Insights, I have assembled several excellent thought-provoking charts to balance the argument and kept my own observations to the minimum. Lest it be said that I am sitting on the fence, I should say that I expect stock rotation to become increasingly widespread and accompanied by quite sharp outbreaks of volatility that end in corrections rather a single major crash. I suspect this will be determined by market dynamics rather than by external macroeconomic developments, although in the age of Trump political shocks cannot be ruled out. Those who believe in monthly patterns in equity markets should note that September has on average had the worst monthly record for big caps while small caps notoriously languish between July and October. The planets could well be aligning for a major rotation between stocks and/or a new correction and one could do worse than keep an eye on the trades of companies’ directors and officers..
Figure 1: Boom time: Year on year growth in Sales of S & P 500 companies March 2001-August 2018
Strong top-line growth in Q2 again fed through to corporate profits and earnings per share. A heady combination of Labour Market (Employment, Unemployment, job vacancies) numbers, and tax cuts boosting Personal Incomes and Spending feeding through to Retail Sales means that Consumption should hold up for the rest of 2018 and into 2019.
Chart 2: Animal spirits aroused: Near record highs in National Federation of Independent Business Optimism Index
Whether or not they voted for President Trump, small business owners are amongst the most vocal beneficiaries of his tax cuts. Many of them, unlike major public corporations, are not able to pass on the benefits to shareholders via share buy-back programmes or dividends pay-outs and instead are hiring and investing in expansion. This should maintain Business Investment at current levels for a good while yet and support the Labour market. However, the ISM and Markit PMI surveys of larger companies are starting to wobble after a strong run.
Chart 3: Money market rates vs. Fed forecasts: the market still does not believe FOMC members’ forecasts of their own decisions!
Figure 3 shows the famous dot plot of FOMC members’ forecasts of future Fed Funds rates (effectively overnight inter-bank rates used to maintain reserves at the Fed) vs. futures prices for the Overnight Swap Rate (which tracks 3-month LIBOR). Although it seems very technical, Figure 3 simply shows that the market does not believe that the FOMC will be able to hike as much as it wants. After years of easing monetary policy the FOMC is aiming to ‘normalise’ both interest rates and the size of its balance sheet. There is very considerable scope for debate as to what constitutes ‘normal’ and, inevitably, President Trump is weighing in, effectively challenging the long-established independence of the Fed. He is concerned about the impact on both the economy and the stock market. Ironically, the more he challenges the Fed the less investors like it and the dollar is already showing signs of stress but that brings a further irony in that a lower dollar would be good for both US and international markets. Perhaps that is one of Mr Trump’s purposes but creating such uncertainty seems unhelpful. In the meantime, the Fed is likely to maintain a dignified silence while closely monitoring the effects of reduced liquidity.
Chart 4: Exposed: US dollar-denominated debt securities issued by Emerging Market companies ($bn)
Source: Bank of international settlements
Turkey is currently making the headlines amidst fears of contagion and, despite not all Emerging Markets’ being similarly exposed, a prolonged crisis could well have global adverse macroeconomic consequences and end up hitting financial markets in developed economies. Liquidity is the problem and, as Mohamed El-Erian puts it, Turkey needs to break the circuit and ensure access to dollars for Turkish corporate borrowers. Unfortunately, this requires President Erdogan to bend the knee and seek help from the IMF (and, even worse, from the Fed in the form of a swap line) while hiking lira interest rates and imposing austerity. Mr Trump is probably relishing the pressure he is putting on yet another ‘strong man’. Other countries such as Argentina and Brazil may need help sooner than it will take Mr Erdogan to blink. Meanwhile, a softer dollar would help all round.
Chart 5: A new sub-prime? Student loans drive US Consumer Debt ever higher
An increasing source of concern has been the unequal spread of both income and wealth in Developed Economies, especially in the US. Higher interest rates will certainly affect everyone with a car loan and credit card but a more immediate crisis appears to be brewing for both borrowers and lenders of Student Loans and yes they have been securitised. Mortgage rates in the US are typically fixed for longer periods but higher money market rates will affect poorer families wanting to buy a home (over 60% of houses in the US are owner-occupied) and all those wanting to move house. At best, normalising interest rates will affect disposable income and overall Consumption, which is why Mr Trump is trying to lean on the Fed.
Chart 6: Tax cuts and GDP: post-Midterm elections will Trump be able to push through another round?
Source: Scotiabank via WSJ Daily Shot
In their eagerness to deliver tax cuts President Trump and the GOP leadership in Congress entered into a Faustian bargain with the Democrats, who were eager to avoid a federal government shut-down as well as protect their own favourite spending programmes. The hitherto fiscally virtuous Republican Party has become a promoter of huge federal budget deficits even if higher economic growth does generate larger tax receipts. The benefits are concentrated in 2018 and to a lesser extent in 2019 with the moment of truth in 2020 just at the point that the wider economic cycle is likely to be reaching maturity. It is hard to see an easy political, fiscal or economic resolution.
Figure 7: Trump on trade: a clear and consistent strategy?
Source: Peterson Institute
President Trump likes winning and it has to be said that he has given each of Strongmen Putin, Xi and Erdogan a bloody nose over the last few weeks. Having said that, despite the flexing of US economic muscles it is far from clear what are his goals and whether he is achieving them. A possible common thread is impressing those who voted for him in 2016 to turn out in the Midterm Elections in November and conserve the GOP majority in both the Senate and the House of Representatives. Mr Xi is reportedly confused as to what Mr Trump wants: promote jobs in the US via protectionist tariffs or make it easier or US companies to invest in China while discouraging Chinese investment in US companies. Mr Putin must also be puzzled why Mr Trump is so keen to escalate sanctions at the same time as proclaiming a new climate for Russo-American relations. Mr Erdogan must wonder why Mr Trump is so keen to humiliate him when the US needs Turkey’s support in Syria. It may be that Mr Trump sees higher tariffs as a new source of revenue but he does not seem in a hurry to impose them on a large scale. It is too early to judge whether more jobs are being created in the US than lost but the likelihood is that corporations will pass on to their customers any tariff costs and any resulting inflation is likely to strengthen the Fed’s intention to hike interest rates. Such are the consequences of political and economic iconoclasm!
Figure 8: US in favour and nearly everybody else out
Source: BoA Merill Lynch
Every month Bank of America Merrill Lynch canvasses over 2000 global investors and over the years the results have proved a useful leading indicator of changes in market sentiment. Figure 8 shows US assets to remain very much in favour but cash has become much more important while Tech and the US dollar have slipped in August. It is worth noting that both UK and Emerging Markets are still being shunned.
Chart 9: Most crowded trades: FAAMNGs and BATs on top for how long?
Source: BoA Merill Lynch
Figure 9 is another chart from the August BAML global survey and shows what respondents consider the ‘most crowded trades’. it is significant that the connected (but not exactly interchangeable) Long FAANG-BAT, Long Nasdaq and Long USD trades have ‘ruled the roost’ since December 2016, apart from ephemeral Bitcoin flurries in 2017. Continuing the punning, the moment is surely drawing near when investors have to decide how much more blood they want to suck out from ‘vampire trade’ of FAANGs and BATs!
Chart 10: Biggest corporations by market cap 1985-2018: Sic transit gloria mundi
Figure 10 in tracing the changes in market caps must make sobering viewing to the captains of US Industry. IBM had the largest market cap in the 1980s until giving way to Exxon and GE in the early 1990s. GE then came the leader only to be unseated by Microsoft and CISCO in the Tech flurry but struck back in the 2000 crash. Exxon took over in the 2008-9 crash but was brushed aside by Apple in 2011 while Microsoft’s surge took longer. Missing from the chart are Amazon and Alphabet but both are already bigger than Microsoft and their time may yet come.
Chart 11: Biggest corporations by market cap 1985-2018: Sic transit gloria mundi
Yesterday marked the occasion of the ‘official’ longest bull-market in US history, provided one treats the plunges in 2016 and Q1 of 2018 as merely nasty corrections. The question now arises as to what will cause it to stop. As discussed above, absent a political shock, it may be that investors will settle for corrections and rotations rather old-fashioned crashes. We may not find out soon, however.
Chart 12: Legal Insiders’ trading over last 12 months: more sales than purchases
Figure 12 charts purchases and sales of directors and officers in their own corporation’s shares over the last 12 months and it must be emphasised that these transactions have been properly conducted and publicly disclosed. Purchases have typically been even with the only spike in November, which was a month of strong gains in the US equity indices. Sales have been more erratic with spikes occurring both in months with strong gains (November, January, May and July) and losses (February and March). Some of the sales in the Tech sector are known to be related to the expiry of restrictions on dealing. It is too early to read much significance into August’s spike but it if it goes much higher and/or lasts longer then we may see an accelerated rotation between stocks and/or another market correction. Worth watching!