By: Neel Kulkarni May 30th, 2016
Wall Street finds itself in strange waters. We’re in the seventh year of the second longest bull market ever – and while equities are up over 230% since March 2009 – that sounds normal – 10-year Treasury yields, instead, have moved from 2.8% to 1.8% during the same span. Usual late expansion characteristics such as high inflation, commodity spikes or overheating credit are nowhere to be found, and amid a massively polarized opinion base, a possible 25 basis point rate hike has created a frenzy such that the media only seems focused on will-they-or-wont-they debates with any strategists gracing the stage. Move over, Drake – monetary policy’s topping the charts, and it’s likely to continue doing so until the June 15th Fed press conference.
And why not? Multiple asset classes are certainly moving to the Fed’s rhythm. Notice that with the higher rate talk in recent weeks, the dollar has gained over 3% in May per the WSJ Dollar Index, the DJIA has backtracked on its YTD gains and is now up only 2%, financials have gained over 11% in the past three months, and short-term yields have jumped, noting investors are taking this stuff seriously.
What else could have caused these moves? Labor markets remain pretty much as tight as they were seven months ago, the S&P 500 remains fair-to-expensive, at 16.7x forward earnings (FactSet data), and 10-year yields, usually showing inflation and real growth projections, are at the same levels they were in early 2015. In fact, the S&P 500 is virtually unchanged since late 2014 – which is when tapering began in the United States. May’s moves definitely reflected changing rate expectations.
Moving ahead, Wall Street is likely to keep in mind that Canada, Israel, South Korea, and even the ECB had to reverse course around the 2011-span when they hiked earlier than their economies were able to handle; it was followed, in some cases, with quantitative easing – the opposite extreme action. Also, the pain of January’s collapse after one rate hike in December remains fresh. And, beyond the United States, can emerging markets handle currency moves favoring the dollar? It isn’t unreasonable to think that rate hike conversations are dominating East Hampton’s grilling scene this weekend.
With monetary policy reigning the headlines, the confusion may make you find yourself in Frasier’s shoes, where you don’t know what to do with those tossed salads and scrambled eggs. Here are four points investors should keep in mind, while acknowledging that this summer may be a rough one for equities:
- Macro Trades Have Been Driven by Currencies: 2016’s favorite international trades have fallen flat YTD; Europe is down 5%, Japan is down 12%, and India is barely scraping positive. Meanwhile, the much-ignored markets of Russia, South Africa, Turkey, Argentina, and Brazil have had solid years (in local currencies). So, crowded trades can hurt. 2016’s moves seem highly noise-driven – it’s not like some of these countries are doing something revolutionary to spur economic growth – it could just be easing and currency fluctuation. Both the euro and yen have gained against the dollar YTD; the negative correlation with local market returns is distinct. Emerging markets have done great, but mainly because the dollar stopped weakening and the danger of capital flight reduced, and also because of oil’s meteoric 100% rise in two months. The 2nd half may pan out extremely differently if rate hikes occur, and if oil’s run ends via supply coming back – not something fiscal policies can necessarily dictate. Country fundamentals will take a backseat this summer; if you’ve invested for the long run, buckle up.
- New Money Shows Reason For Optimism: Now, let’s look at the IPO scene. The US Renaissance IPO index is down 2.7% YTD. The firm’s data shows a 55% drop in IPOs from last year, and a 57% reduction in capital raised. However, five IPOs raised cash last week – the busiest week of the year so far. Tie this together with VC data: in Q1, per NVCA data for the United States, $12 billion in funds were raised by VCs (the highest amount in 10 years), even though actual investments were only $14.8 billion compared to $18.2 billion in Q1’15. So, the focus on startups, brave ideas and alternative venture investment remains steadfast, despite volatile markets and passive migration. Important to note: software, healthcare services, and biotechnology remain among the top four sectors for deals. Tech has rebounded over the past 3 months, and it’s barely trading at 16x forward earnings compared to its 20-year average of 20x in the S&P 500. If that sector continues to rise and the IPO market continues to strengthen, VCs can cash out and fund more ideas; the cycle will continue. It seems realistic, given on the public side, firms including Salesforce (CRM), Facebook (FB), Amazon (AMZN), and Nvidia (NVDA) are significantly outperforming the NASDAQ YTD; investors, thankfully, have not lost their taste in fine companies amid monetary churn.
- The S&P 500 Needs A New Leader: And then, while the S&P 500 may be up 2% YTD (a massive rebound from February), the sectors leading the index are utilities, energy, and telecommunication services – up 12%, 11% and 10% respectively. All are pretty expensive on a forward multiple ratio, and if rates rise, it’s fair game that these get hit given the reason investors have gone to them is for substituting non-existent coupons with great dividend yields and stability. In that case, which sector will step in to provide a floor to the S&P 500? Consumer discretionary stocks? Technology? Both have historically been poor in the late-cycle span, per Fidelity Business Cycle data; this case may be different for tech, though, as it may be simply undervalued. Industrials? Difficult to think, given their heavy international revenue streams coupled with a strengthening dollar. The financial sector strength would be key – especially considering they have been, by far, the worst-performing sector over the past ten years – the same span as record low interest rates have existed. Therefore, investors should watch financials and technology to see if a successful baton transfer occurs.
- The 10-year Must Rise…Or Should It? Finally, the yield curve. 2-year Treasury yields have jumped significantly, from 0.7% to 0.9% through the beginning of May to date, but 10-year yields have remained flat over the same span, yielding 1.8%. That yield suggests that long-term inflation expectations or real growth – or both – are weak in projection. However, sovereign buying or selling overseas by Saudi Arabia, China, and other emerging markets to shore up currencies, raise cash, control rates, etc. may be distorting that historical logic. Whatever the case, the curve has definitely flattened – and the previous three recessions were preceded by inverted curves. Therefore, this is a data point worth watching.
What it means for you: Due to the weight of monetary policy on investors’ minds, asset classes all over are likely to significantly adjust following June’s Fed meeting; the BOJ actually follows the day after. The second point above, however, is what investor should remember – there’s plenty of capital out there, and it’s going to be invested sooner or later. Companies that define trends and revolutionize industries will almost always prosper in the long run, and that’s an investment you can control. Investing in Nike or Microsoft in the 1980s would have returned over 35,000% by now; selling midway because of some minor policy change and panicking with the herd would have killed it. This applies more than ever today. The coming summer is likely to be historic, and may provide significant churn for the world’s markets. That’s fine, because volatility is driven by new information, and it’s natural for prices to take some time to adjust when there’s a whole lot of it. Let investors sort themselves out; scoop up bargains as they appear. And if you don’t know what to do with those tossed salads and scrambled eggs…don’t worry, you’re not alone. Wall Street is, in that way, distinctly different from Frasier’s profession: doing nothing can actually be a good approach!
