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Market commentary notes
Monthly call notes
Monday, May 2, 2016
Eric A. Stubbs
Senior Vice President –
Financial Advisor
Senior Portfolio Manager –
Portfolio Focus
1211 Avenue of the Americas
Suite 3300
New York, NY 10036
(212) 703-6165
[email protected]
Summary: Weak performance in April
Month and YTD market performance
In March, equity indexes saw something of a recovery returning YTD numbers
to flat for the major indexes. By mid-April we will start getting first quarter
earnings reports.
Here are the market numbers for the month and YTD for selected indexes:
Price Index
Apr %
YTD %
1 yr %
2015 est PE
S&P 500
0.39
1.74
1.21
19.1
S&P Mid Cap
1.20
4.89
-1.43
22.9
S&P Small Cap
1.15
3.72
-0.18
30.7
DJ All REIT
-1.61
4.18
7.24
Global xUS
2.63
2.25
-11.28
Emerg Mkt
0.54
6.29
-17.87
Source: Morningstar
Fixed Income and alternatives:
Total Return Index
Bar Agg Intermed
B of A Convertibles
S&P GSCI
CS High Yield
April %
YTD %
1 yr %
0.23
2.54
2.45
1.39
-1.69
-6.79
10.14
7.39
-29.26
3.87
7.10
-2.04
Source: Morningstar
In April, several of the equity indexes were positive but with muted returns relative
to March’s recovery. On a U.S. sector level Energy, Materials, Telecom and Utilities
have done well — rising YTD between 1% and 14% while Technology, Financials and
Healthcare have been slightly negative YTD.
Our Canada position continues to do well with the currency up mid-single digits and
the stock market up low single digits.
U.S. economy
The Advance estimate for 1Q2016 GDP just came out and was surprisingly weak
at +0.5%. We know that this is subject to revision — possibly quite substantially.
However, it is disturbing as a first take on a quarter that was supposed to herald
an improvement from the +1.4% in the previous quarter. By the way, it’s not far off
from the Atlanta Fed’s estimate a month ago of +0.7%, but well off the Blue Chip
consensus estimate of +2.0%. Drags on GDP included net trade — meaning exports
Page 2 of 3 Market commentary notes, continued
were weak compared to imports. Given the level or falling
dollar that suggests weakness in our export markets — which
is pretty much the rest of the world. Consumer spending
growth was also a little weaker at +1.9% versus a 4Q +2.4%,
and business investment declined 5.8%, while residential
investment surged at +14.9% following a strong 4Q (+10.1%).
Core inflation yoy was 2.1% (versus 1.7% a year ago) — so right
in line with Fed targets.
One thing to look out for, as has become customary, weak
early quarter results seem invariably to be followed by
declarations that the next two quarters are expected to be
strong. While mean reversion works over a couple or a few
years, I don’t think there’s any reason right now to expect the
rest of the year to be better than +2%, give or take.
However, despite weak overall real growth, employment
continues to do well. Initial jobless claims came in at 257K
following 248K in the previous week. Overall, the 4-week
average dropped to 256K. In my estimation, anything below
300K suggests a strong labor market and we are well below
that threshold. I wouldn’t worry about recession unless we
saw this figure making its way toward 350K.
Personal incomes also rose at a 3.4% nominal rate, which was
faster than spending. This raises the question: With incomes
up and employment up, why isn’t GDP growth better? The
answer seems to be in the savings rate which appears to have
risen to about 5.4%. In other words, people are paying down
debt instead of spending.
Let’s turn for a moment to the latest in corporate earnings
— one of the two drivers of the S&P’s direction; the other
being PE ratios. As of Friday, with three-quarters of the S&P
companies reporting (by market cap), we saw EPS on pace
to come in at -4.1% compared to a year ago, assuming the
current trends continue. Excluding energy, it was +1.0%.
This number was held down by disappointing reports from
some mega caps such as AAPL, GOOG and MSFT. If we
assume that was an anomaly, we will probably see EPS exEnergy finish the quarter around +2%. Also revenues look to
be about flat — with a small increase in domestic revenues
offset by weak exports.
Let me take a moment too, to refer to an article in the Sunday
New York Times by economist Robert Schiller. Prof. Schiller
asks in his article what sets off recessions and concludes,
I believe rightly, that it is NOT the things picked up by the
leading economic indicators. Meaning that declining stock
markets, rising unemployment, don’t start recessions. Instead
recessions begin when sentiment changes and people change
their spending patterns, pulling in their wallets and increasing
precautionary savings. This can be the result of a change
in views about spending — as was the case in the mid-70’s
and also in the Great Depression — or it can be the result of
changes in how the media reports conditions. But the point
is that without this change in our views of the future and our
reactions, we don’t get recessions even when some of the
objective measures like GDP growth or personal incomes are
weak. It’s this narrative regarding sentiment and conditions
that triggers the tipping point into recession.
From our standpoint as investors, this is both reassuring and
vexing. It’s reassuring in that it means weak growth, weak
spending doesn’t necessarily portend recession. On the other
hand, it’s frustrating in that we can’t predict these triggers and
changes in sentiment as easily as we might earnings changes
or GDP growth prospects. Suffice it to say that since 2008,
we’ve spent a good fraction of our time trying to predict these
sentiment switch points on the basis of a broad reading of the
media. The challenge comes when media and markets predict
a recession, as they did in mid-2011 with a 20% drop in the
stock market, and in mid-2014 and again at the beginning of
this year. In all three cases were heard stories of impending
recession here and abroad. In some cases, such as 2011 they
just evaporated. In others like 2012, 2014, we had actions by
the ECB that lead to a more positive narrative (whether or
not they could actually make good on their promises). As
investors, we have to not only watch fundamentals but also
try to gauge how other investors are processing the news.
International
In Europe, the major economies continue to grow at very
slow rates — although at +0.6%, Euro area growth surpassed
US growth by a small amount. The ECB launched a program
to buy corporate paper to try to boost lending by holding
down interest rates and freeing up bank capital. However,
it seems to me that interest rates aren’t their problem and
neither is the supply of loans. Rather it is a demand problem
— little demand for loans because of lack of confidence in
end consumer demand at home or abroad. In this kind of
environment, I’m not sure how the ECB’s strategy addresses
their objectives and given this lack of alignment, I’m not
prepared to expect success. However, if they are successful
in any measure, the impact is likely to be to put downward
pressure on our interest rates — which will add to bond
returns. Overall, we’ve been paring back on international
exposure especially in the U.S. dollar hedged form as we have
been raising cash in general.
Every month I look at global manufacturing PMIs to try to
discern how much growth we’re seeing and where. Our
global index, weighted by GDPs, came in at 50.8 – down an
insignificant 0.2 from the previous reading. Of the 16 major
economies that we track, none flipped across the 50 line in
either direction, but those that were above 50 were slightly
more above 50 this month. So we’re still at 12 above and 4
below. The Euro area was down 0.1 at 51.5. There were no
important changes among the oil producers either, with UAE
up 1.4 at 54.4, Russia down 0.3 at 48 and Brazil stuck at 46.
Page 3 of 3 Market commentary notes, continued
An observation of trade agreements
Thanks to the primary campaigns a lot more ink than is
typical has been spilled on pieces related to international
trade agreements. A little-known reality is that there’s a
trade agreement negotiation underway right now between
the US and the EC — called TTIP, “Transatlantic Trade and
Investment Partnership”. These negotiations have been onand-off since 2013 and there are many points of contention to
work through. However, much of the domestic conversation
has centered around the Transpacific Partnership (TPP) and
its impact on US jobs and the economy. I thought it was worth
taking a moment to offer some thoughts on the matter.
Conventional economic thought argues strongly that trade is
wealth-creating in both nations and agreements that remove
impediments and allow each country to focus on doing what
it is best at add to wealth creation. That’s the fundamental
argument for removing trade quotas, tariffs etc. — that free
trade benefits everyone.
However, more recently, people have begun to question the
theory with arguments that the negative impact on labor can
swamp the positive impact of facilitated trade. The argument is
basically that adjustments are costly. When industries contract
and others grow as a result of international competition, there
are enormous costs to workers and their families.
However, these arguments are usually presented with a lot of
hand-waving and aren’t very convincing because they aren’t
well detailed. I put together an example to illustrate
the argument.
Let’s imagine that the U.S. produces $1 Billion worth of
widgets for domestic sale. The cost structure breaks down
as follows:
Labor costs:
$400MM
Capital service:$100MM (representing $1 billion
in capital)
Materials and energy: $400MM
Profit:$100MM
Now imagine that Freedonia, another producer of widgets,
can produce them for $900MM.
There’s also $1B in stranded capital. Assuming generously,
a $400MM recovery, that’s a loss of $600MM in value. There’s
also a profit loss of $100MM per year. All of this together —
wages, profit, etc. might account for $80MM in tax revenues
lost.
So when you put all of this together, you have potential losses
of $1,080MM in the first year and $480MM in the next year,
declining over time. Total 5-year costs could be $2 billion.
Meanwhile, consumers save $100MM per year on widgets —
for a total gain of $500MM over 5 years. At the margin, the gain
may be a little more if widget demand is very price sensitive so
demand rises fast with the lower price.
The lesson from this example is that you can indeed have
significant costs to trade agreement adjustments. Those costs
will depend on how easily workers can find new jobs at similar
wages, how recoverable the capital is and how price sensitive
demand for the products is. This implies that agreements
facilitating services trade, technology products and
discretionary goods probably have a lower deadweight cost
than, say, energy products, agricultural goods and necessities.
Strategy
In GTAS we’ve been lightening up on equities as markets
have gone higher. In particular, we’ve been selling the
higher beta — more sensitive — types of equity. We’ve also
been lightening up on US dollar-hedged foreign equities in
preference to the international indexes with local currency
exposure. That’s because we believe that in an environment
wherein the Fed is moving slowly, the upward pressure on the
U.S. dollar may be reduced relative to previous expectations.
Put differently, Euro, Canadian dollar and emerging markets
currency appreciation is more likely that it had appeared.
In Yield-Gen we enjoyed a significant appreciation in energy
MLPs, high yield and business development corporations.
Since all three also have substantial yields, we’re expecting
a pretty good quarter. That said, these investments make the
underlying risk structure of Yield-Gen a little more equity-like.
We’ve been trying to balance that out with conventional short
and intermediate term investment grade corporate bonds to
avoid excessive equity-like movements in the accounts. It’s
a balancing act between wanting the higher yield and not
wanting too much stock-like exposure.
If production disappears in the U.S., it probably isn’t friction
free. For starters, the workers who earned $400MM now have
to look for other jobs and with reemployment might make
$300MM. That deadweight loss of $100MM has a multiplier
in our economy, that might conservatively be 2X. So the total
labor loss could be $300MM.
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