Turkey, Nice, the Brexit, China’s debt, Italian banks, and a severely divided US political and civil front, among others…the headlines are heavy with human losses, discontent and questions. One could surmise that the concept of government globally, which includes foreign policy, domestic focuses, and fiscal plans, could all do with some reflection. Something’s not working.
And then, there’s monetary policy – working in overdrive due to the lack of its fiscal counterpart (not just my opinion, but also per hints by Draghi, Yellen, and others). It has driven investors in the elusive quest for some – any – returns, by continuing to bid up whatever has yield across asset classes. In what is possibly the strangest post-recession statistic to date, the S&P 500 was making all-time highs last week just as the 10-year Treasury yield made all-time lows; alongside, Germany and Switzerland set records in issuing negative-yielding long-term debt. And, as the BOE’s Mark Carney signaled rates would remain low due to the Brexit, stocks worldwide recovered all their Brexit losses and emerging markets continued to get capital inflows – again, for the yield. Concerns including Zika, heavy debt loads, and persistently low oil prices aside, the best performers YTD in fixed income have been emerging market debt, both local and dollar denominated, up over 10%, and the same on the equity front, with emerging markets up nearly 6%.
It’s scary to think how quickly things might reverse when rates rise.
Given the mounting importance of global risks for the Fed, it got me thinking: as investors, it’s becoming imperative to weigh geopolitical risks more than ever before, given its significance these days. Sure – through finance theory, one could find this in the country risk premium in CAPM models, using government yields. However, today, in a world where Treasuries and sovereign bond yields are in completely strange, never-before-seen territory, does that concept still hold? After all, if there’s one thing economists agree on these days, it’s that finance textbooks all need a rethink in this low rate era.
Perhaps gold would be a better reflection of risk…it is up 26% YTD, after all – with the only outperformers being other thinly traded commodities, excluding oil. However, a percentage of gold’s rise is likely reflecting inflation expectations – and that contribution is dicey to dissect. How about the VIX? Interestingly enough, that’s nearly 70% below its long-term average – despite all the turbulence. The bottom-line: market participants seem to love equities – and while rates stay low, it seems they will, also, stay undeterred. 2016 will perhaps be sent to the books as another year of Wall Street speculating on monetary policy projections. Whatever happened to the concept of capital flowing to ideas that genuinely deserve it, staying there with patience, and dynamic companies and innovative breakthroughs making the headlines? It’s still happening, of course – but amid all the other information, investors may be missing it, and perhaps investing for a myriad of different reasons. Here are some other thoughts to ponder on 2016’s market state:
Cash, cash, and less cash…much has been said about buybacks and their impact on creating a floor for the markets. That definitely has some truth to it: In 2012, quarterly buybacks averaged $90 billion and have steadily risen since; in Q1 this year, they set a post-recession record of $161 billion for the S&P 500, per S&P data. The source of the funding, however, remains concerning. While the large caps reflect nearly $1.5 trillion in cash on their balance sheets, per Yahoo Finance, as of Q2’s end, operating cash flow was flat YoY. However, the growth rate for cash was 5.7%; debt, meanwhile, grew nearly 10%. Low rates were intended to stimulate investment – capex, however, has fallen nearly 8% YoY…and buybacks have soared. So, there’s clearly some misalignment, in that the average firm doesn’t seem to be seeing investment opportunities – choosing to return more and more cash instead. This is likely to come to an end once tightening occurs; investors should note that Q3’2007’s buybacks, at approximately $170 billion, were slightly higher than Q1’2016. The year after was pretty rough.
IPOs are back…Q2 showed a good rebound, which is a heartening sign; per Renaissance Capital data, 34 IPOs raised $5.5 billion, compared to the barely $1 billion raised in Q1. The returns were pretty solid on average, but Twilio took the cake, up over 100%. In my opinion, the success was partly due to it being one of the few ways public investors could also make a play on Uber, which uses Twilio for alerts to riders. In any case, the state seems healthy. Healthcare, meanwhile, continued to top the charts with nearly half of the IPOs; next up was financials, followed by technology. That sector IPO trend has been pretty solid over several quarters, and the reason it is important is one can extrapolate where the VC world and entrepreneurial mind is headed: the elusive, fascinating goal of increasing life expectancy, a revamp of the banking intermediary for more direct-to-consumer interaction, and the overall use of technology to make pretty much everything we do more efficient – right from asset utilization, data analytics, faster communication and productivity. Some data points on this? Approximately 21 million WhatsApp messages, 2.4 million Google searches, and 350,000 tweets are sent each minute, per Excelacome’s statistics. Talk about connectivity and information transfer. Note the renaissance of Nintendo with Pokemon GO, which could heavily speed up the incorporation of augmented reality in our daily lives in the coming months. Importantly, most of these activities – and sectors – are heavily shielded from geopolitical turbulence, which gives them a much clearer runway for growth. The trailblazers remain at it – Amazon’s Prime Day set retail and e-commerce records, and with R&D spending at the top tech firms also running at a faster pace than ever, amid all the risks and concerns in the world, one should remain confident that the long term looks extremely bright for investors, firms, and consumers, including society as a whole. If one needed convincing that innovation or the markets matter, the simple statistic that global poverty is on track to fall below 12% this year, from over 37% in 1990 (that’s about when Eastern Europe, India and China joined the global market party), per the World Bank, provides some solace.
What it means for you: That’s the long run. Now, back to today. The S&P 500 finds itself at roughly 17x forward earnings, slightly more expensive than its 14.5x 20-year average. At the beginning of the year, my belief was that a P/E multiple contraction would lead to headwinds for stocks in 2016. Over the past week, the US economy provided numerous data points that signaled that economic growth, while slow, was alive and well stateside, with rising inflation expectations. That, again, brings back the Fed. If it tightens, will capital move out of emerging markets too rapidly for their foreign exchange reserves and currencies to handle? Will the Italian banking conundrum, with absolutely no painless solution per The Economist, unravel European banking, which is already suffering tremendously? And, will investors be able to swallow the numerous geopolitical events (‘Amid Terrorism, Stocks Rise’ was a pretty discomforting Barron’s headline) that keep cropping up, for the sake of yield? Equities are primed for an impact if sentiment takes a downturn. The rest of the year is likely to be very uneasy, given the distinct question that waits to be answered: how many more straws will it take to break the camel’s back on Wall Street in 2016? My concern is that it’s not too many.
