Download Breaking Up Is Hard to Do: Three Market Odd Couples That Won`t

June 2017
Breaking Up Is Hard to Do:
Three Market Odd Couples That Won’t Last Forever
by Michael Arone, CFA,
Chief Investment Strategist,
US SPDR Business
Lies don’t end relationships, usually the truth does.
— Nishan Panwar
Relationships are messy. And, sometimes couples just don’t
seem to naturally fit together. C’mon, you know what I’m talking
about. One is too tall or too short for the other. One of them is
way too good-looking to be with the other, or too smart or too
ambitious. Their personalities or politics just don’t gel. We all
have that odd couple as friends, the couple you and your other
friends thought would never last. We’re so fascinated with
seemingly inexplicable relationships that fiction is full of
romantic mismatches. Catherine and Heathcliff. Benjamin and
Mrs. Robinson. Ron and Hermione.
And today, the New Abnormal environment offers an
interesting breeding ground for puzzling dalliances and
potentially fatal attractions. Meet our capital market
odd couples:
1. Stock investors and bond investors
2. US economic policy and the US dollar
3. Tight labor market and stagnant wage growth
Giddily in the honeymoon stages of their relationships, these
couples remain oblivious to the oddness of the attraction that
binds them together. Lost in their current love affairs are the
underlying contradictions of their affection. However, as
temperatures rise this summer, so too may tempers flare
regarding all those pesky little things that add up and bother
us in any complex relationship.
Figure 1: Rising Equities and a Flattening Yield Curve Belie
Two Opposing Outlooks
S&P Index Level
10Y–2Y Yield Spread
2450
1.3
2425
1.2
2375
1.1
2325
1.0
2275
0.9
2225
Jan
2017
— S&P 500 Index
Feb
2017
Apr
2017
Jun
2017
0.8
— US 10Y-2Y Treasury Yield Spread
Source: Bloomberg Finance LP as of 06/13/2017. Past performance is not a guarantee
of future results.
Let’s explore whether our capital market odd couples are built
to last like James Carville and Mary Matalin or if they are just
another summer fling like Danny Zuko and Sandy Olsson.
Stocks and Bonds: Trouble in Paradise When
Polar Opposites Attract
Stocks and bonds are like that couple that’s always fighting —
Mr. & Mrs. Bickerson. They never seem to be on the same page,
yet they have an inseparable connection. Stocks have bountiful
optimism and want to grow and increase their earnings power.
They want to be free from the burden of rules and costs from
taxes. On the other hand, bonds are pessimistic and grumpy.
They are cynical and question everything. Instead of dreaming
big, bonds want cold hard facts. Better yet, they want solid cash
flows to make them feel secure. They may not like the rules any
more than stocks do, but they welcome strong covenants to
ensure they are protected if the relationship turns sour — kind
of like a prenup. Lower taxes suit bonds just fine, too, because
that means more cash flow for them.
Breaking Up Is Hard to Do: Three Market Odd Couples That Won’t Last Forever
Old habits die hard, and stocks and bonds are confident in
their very different perspectives. Stocks are excited about the
potential for better economic growth, improving earnings,
lower taxes, less regulation, still low rates and very little
inflation. This is the perfect love potion and stocks have become
smitten with this story. As a result, US stock indexes are at or
near all-time highs. Stock investors are head-over-heels in love!
Not surprisingly, the outlook for the more skeptical half of the
Bickerson couple is a little less rosy, informed by expectations
for sluggish growth and very little inflation. Bond yields are
influenced by three factors — growth expectations, inflation
expectations and term premium. In regard to growth, the yield
curve has been flattening for most of the first half of the year.
This signals that bond investors don’t believe growth will be as
strong as their optimistic stock partners expect. After a post-US
election inflation scare that saw 10-year Treasury yields
touch 2.6 percent, inflation expectations have been rolling
over alongside diminishing global growth expectations and
falling commodity prices. Amid rising global policy uncertainty,
Washington DC scandals and growing geopolitical tensions in
North Korea and the Middle East, bond investors seeking the
security of US Treasuries are demanding less yields (term
premium) for the safety of their capital. As a result, bond yields
have been falling, which means bond prices have been rising.
So, how long before there is trouble in paradise? Can stock and
bond investors both be right? Perhaps in the short-term sluggish
growth, low rates and benign inflation may keep the peace in the
stock and bond household. At some point, however, the natural
tension between stocks and bonds will likely flare up and need
to be resolved. After all, US monetary policy is gradually
tightening, with the Fed raising rates another quarter
percentage point on June 14, but fiscal policy is still absent.
Unless something changes in this dynamic soon, I’m fearful
bond investors will win this couple’s dispute and stock investors
may find themselves sleeping on the couch. And, like all
couple dust-ups, the hardest part may be admitting that
you were wrong.
US Economic Policy and the US Dollar:
The Ultimate Power Couple
When the high school “It Couple” is crowned Prom King and
Queen, their power surges. In the same way, sound fiscal policy
that complements good monetary policy should result in greater
growth and demand for a nation’s currency. In the aftermath of
the US election, investors certainly expected a seamless transfer
of economic support from accommodative monetary policy to
increased fiscal policy spending. Higher expected US economic
growth and already greater interest rate differentials compared
State Street Global Advisors
Figure 2: Stalled Legislation Leads to Dollar Declines
DXY Index
US 5 Year Breakeven
104
2.10
100
1.80
96
1.50
92
May
2016
— DXY Index
July
2016
Sept
2016
Nov
2016
Jan
2017
Mar
2017
May
2017
1.20
— US 5 Year Breakeven
Source: Bloomberg Finance LP as of 06/13/2017. Past performance is not a guarantee
of future results.
to the rest of the developed world (especially German bunds and
Japanese government bonds) were expected to further bolster
US dollar strength. In fact, the US Dollar Index responded by
hitting multi-year highs in early January.
However, as so often happens after the last dance ends and the
fancy gowns are hung in closets and the powder blue tuxedos
are returned to the shop, some of the magic dies. Greater US
economic growth and higher interest rate differentials
combined with tighter monetary policy should woo US dollar
fondness, but the US dollar has continued to play hard to get
in 2017 — so much so that the investor crush on the US dollar
has faded. In fact, the US Dollar Index has fallen about 5
percent this year. The baton handoff from monetary policy to
fiscal policy has been fumbled. US monetary policy is gradually
tightening and fiscal policy is stalled. Economic growth in
Europe outpaced US growth in the first quarter, a feat not
achieved in some time. Investor demand for euros has
climbed as a result. Investor skittishness about the current
environment has also boosted demand for the perceived
safety of Japanese yen.
How can the power couple rekindle their flame? Higher relative
interest rates supported by gradual monetary policy tightening,
increased fiscal spending and better economic growth should
result in greater demand for US dollars. Should the dollar
rebound, investors should consider value and cyclical sectors
of the market. If policy fails and growth disappoints, defensive
and growth sectors which have led the way thus far in 2017 are
likely to continue their momentum.
2
Breaking Up Is Hard to Do: Three Market Odd Couples That Won’t Last Forever
Figure 3: Unemployment Recovers but Wage Pressures
Have Yet to Materialize
Unemployment Rate (%)
Avg Hourly Earnings Yearly Change (%)
10
3.75
3.25
8
2.75
2.25
6
1.75
4
Dec
2008
Sep
2011
Jul
2014
May
2017
1.25
foreign workers have entered the workforce. Lastly, the pent-up
potential for productivity gains has allowed companies to
adjust their operations rather than increase pay for their staff.
Meanwhile, today’s workers are left imploring their
employers, “Show me the money!” and wondering just how
much lower unemployment can go without a commensurate
pick-up in wages. This odd couple relationship should begin
to demonstrate some changes soon. After years of falling
unemployment during the long business expansion, layoffs
could be on the horizon, especially if growth and fiscal policy
do not materialize as expected while monetary policy tightens
its grip on the economy. Otherwise, I would expect labor to take
a greater share of capital through increased wages. Either way,
this relationship is headed for Splitsville.
— US Unemployment Rate (%)
— US Avg. Hourly Earnings All Employees (% Change YoY)
Source: Bloomberg Finance LP as of 06/13/2017.
Tight Labor Market and Stagnant Wages:
It’s All About the Money, Honey!
Any couple’s finances are a touchy subject. For many, the bills
pile up while the money never seems to stretch as far as it used
to. Today, that stress is prevalent across the nation as jobs
appear bountiful but pay raises are scarce. The good news is
that the US economy is at or near full employment as evidenced
by the current 4.3 percent unemployment rate, down from
almost 10 percent in 2009.1 The strength of the labor market is
a big reason the Fed is gradually raising rates. However, wages
have been stuck in neutral, barely growing above inflation.
Remarkably, even with the unemployment rate continuing
to decline, the change in average hourly earnings recently
fell to 2.5 percent.2
Many theories have been put forward to explain the odd
dynamics of full employment with little wage acceleration.
Aging demographics has resulted in a declining supply of
workers rather than a rapid growth in jobs. Companies and
small businesses are reluctant to raise wages in a low
inflation environment for fear higher wages will eat into
already challenged profit margins. The reduction of
manufacturing as a percentage of the economy has displaced
many factory workers over the last 30 years. This has resulted
in a mismatch between the skills employers want and the skills
potential employees have. The structural force of labor mobility
has put downward pressure on wages as more women and
State Street Global Advisors
The New Abnormal’s Strange Bedfellows
Stocks and bonds, economic policy and the dollar, the labor
market and wage growth. We’ve certainly gotten used to seeing
them together. Yet, even as we’ve become comfortable with
the mismatches, we suspect something has to give over the
long term. Sooner or later the Bickersons must reconcile their
opposite outlooks or their performance must diverge. As for the
power couple of sound economic policy and US dollar strength,
they must commit to working together to avoid less than perfect
policy and anemic economic growth. Finally, still falling
unemployment must be accompanied by an increase in
wages to dodge a reversal in the labor market trends that
could spark an increase in unemployment.
How soon before these relationships hit the rocks? For my part,
I expect the Bickersons to live in peace and harmony for a little
while longer. Modest growth, better earnings, low rates and low
inflation may result in both stock and bond investors celebrating
positive returns at year end. If there’s a trigger for change, some
revelation or event to hasten a breakup, it will be progress on
the fiscal agenda combined with gradual tightening of monetary
policy. In that case, look for bonds and bond proxies to fall
some while value and cyclical sectors outperform. Under this
scenario, the US dollar would rise modestly from current levels
and labor would incrementally capture more of the capital pie.
That would mean more summer sizzle and less of those
awkward “It’s not you, it’s me” conversations. But it’s always
difficult to tell with matters of the heart.
1
2
Bloomberg Finance LP as of 06/13/2017.
Bloomberg Finance LP as of 06/13/2017.
3
Breaking Up Is Hard to Do: Three Market Odd Couples That Won’t Last Forever
Glossary
5-year Break-even Rate The break-even rate is applied to bonds and refers to the
difference between the yield on a nominal fixed-rate bond and the real yield on an
inflation-linked bond (such as a Treasury inflation-protected security, or Tips) of
similar maturity and credit quality. If inflation averages more than the break-even
rate, the inflation-linked investment will outperform the fixed-rate bond. If inflation
averages below the break-even rate, the fixed-rate bond will outperform the
inflation-linked bond.
S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500
companies from leading industries and captures approximately 80% coverage of
available market capitalization.
US Dollar Index, or DXY A benchmark that measures the performance of the US
Dollar against a basket of currencies: the euro (EUR), the Japanese yen (JPY), the British
pound sterling (GBP), the Canadian dollar (CAD), the Swiss Franc (CHF) and the Swedish
krona (SEK). For reference, the US Dollar Index is structured as follows: 57.6% EUR,
13.6% JPY, 11.9% GBP, 9.1% CAD, 4.2% SEK and 3.6% CHF.
Yield The income produced by an investment, typically calculated as the interest
received annually divided by the price of the investment. Yield comes from interestbearing securities, such as bonds and dividend-paying stocks.
Yield Spread The difference between yields on differing debt instruments of varying
maturities, credit ratings and risk, calculated by deducting the yield of one instrument
from another.
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