I’ve just updated my Keeping Score page for September, 3Q17 and year-to-date. IT continues its remarkable run. Utilities et al continue to falter.
Yesterday may have marked an inflection point in the US stock market. Today’s potential follow through, if it happens, will give us a better idea.
Domestically, Mr. Trump appears to be moving on from pressing his social program to tax reform–and, maybe, infrastructure spending, both of which are issues of potentially great positive economic significance. At the same time, results of the first round of the French presidential election (which pollsters got right, for once) seem to suggest the threat that France might leave the euro, thereby reducing the fabric of the EU to tatters, is diminishing.
yesterday’s S&P 500
How did Wall Street react to this news? The sector breakout of yesterday’s returns, according to Google Finance, are as follows:
S&P 500 +1.1%
Consumer discretionary +0.7%
Staples led the pack, presumably because this sector has the greatest exposure to Europe–and a rising euro. Financials advanced significantly also, on the idea that stronger economic growth will lead to rising interest rates, a situation that benefits banks.
Industrials and Materials perked up as well. Again, these are sectors that benefit from accelerating economic growth.
Energy marches to the beat of its own drummer. The rest are consistent with the story behind the winning sectors, either defensives or beneficiaries of moderate (that is, not rip-roaring) economic performance.
My guess is that this pattern may continue for a while yet. Personally, I’m most comfortable participating through Financials and IT.
As I’m writing this just after 8am est, the French stock market is up by about 5%, large-cap European issues are up 4%, the euro is up by 1%+ against the US$, and stock index futures show US stocks opening up about 1%.
This is all because yesterday’s first round of the French presidential election ended up pretty much as the polls had predicted. Candidates with 5%+ of the vote, in their order of finish, are:
Le Pen 21.4%
Fillon, an experienced politician and candidate of the center-left, had been the early favorite, but was undone by a scandal involving no-show government jobs for family members that paid, in total, more than €1 million. Fillon’s subsequent refusal to withdraw directly undermined the prospects for Macron, the centrist candidate, and gave life as well to Mélenchon, of the far left.
The market fear had been that, with the center/left vote split three ways, Marine Le Pen, the far right choice, might end up doing surprisingly well. That worry was intensified by the Brexit vote, the Trump victory and a terrorist incident in France last week.
The stakes in this election are very high. Le Pen’s key economic platform: leave the euro and repudiate French euro-denominated debt. The euro would be replaced by a new franc, which would be rapidly devalued–à la Abenomics in Japan–in order to give the economy a short-term boost. Repaying euro-denominated French government debt with francs would “solve” the problem of French national debt, but at the cost of destroying the country’s ability to borrow internationally in the future (think: Argentina). Were the Le Pen agenda to be implemented, it’s not clear to me how the EU could survive.
The consensus view now is that the Fillon and Mélenchon votes will gravitate to Macron, giving him a large victory in the second round of the election, between Macron and Le Pen, on May 7th (and earlier version of this post had the incorrect date). Let’s hope so.
We now have whole week until the potential US government shutdown over funding for the Trump-envisioned border wall with Mexico.
How good is the UK, the part of the EU most American investors know best, as a way to participate in potential economic strength in Europe over the coming 12 months?
Probably not good at all. Here’s why:
–since the Brexit vote last June, sterling has depreciated by 13+% against the US dollar and 8+% against the euro. While the loss of national wealth in Japan through depreciation dwarfs what has happened in the UK, the blow to holders of sterling-based assets is still immense.
Depreciation lowers the UK standard of living and reduces the purchasing power of residents by raising the cost of imported goods. While one might argue that the fall in sterling is in the past–and while the consumer will be in trouble benefits to export-oriented firms through lower costs are still to come–this may not be the case here. More in point #3.
–there’s some evidence that UK residents, realizing last June that prices would soon begin to rise, did a lot of extra consuming before/while firms were marking up their wares. If so, the UK economy could be in for a significant slowdown over the coming months, both because consumers are now poorer and because they’ve already used up a chunk of their budgets through anticipatory buying.
–much of the appeal of the UK as a destination for export-oriented manufacturing comes from its position as the large foreigner-friendly country in the EU, from which multinationals could reach into the rest of the union. That’s no longer the case. An article from yesterday’s Financial Times is titled ” Brussels starts to freeze Britain out of EU contracts.” Its basis is an EU government memo, which, as the FT reads it, advises staff to:
–avoid considering the UK for any new business dealings where contracts may extend beyond the two year deadline for Brexit
–cancel existing contracts with UK parties that extend beyond the Brexit deadline
–urge UK-based companies to relocate to continental Europe, presumably if they want favorable consideration for new business.
It seems to me that the EU leaked this memo to the FT to get the widest possible dissemination of its new not-so-friendly-to-the-UK policies. It implies that the post-Brexit business slowdown in the UK will start immediately, not in two years.
One set of potential winners: UK-based multinationals that do little or no business with the EU. These, like ARM Holdings, are also potential takeover targets–although it’s questionable if the UK will permit further acquisitions by foreigners.
We can divide the mature stock markets of the world into three groups: Japan, the US and Europe.
My long-held view is that Japan is a special situations market, where disastrous economic policy, hostility to foreign investors of all stripes a shrinking working population, make putting in the time to understand this intellectually fascinating culture not worth the effort for mainstream companies.
That leaves the US and UK/EU.
the case for Europe
Looking across the Atlantic, Europe appears to be a big mess. It has, so far, not really recovered from the recession of 2008-09. Grexit continues to be an issue, although relatively minor. But there’s also Brexit, with the additional possibility that Scotland will vote to secede from the UK. And there’s possibility that Marine Le Pen may become the next French president. She advocates Frexit + repudiation of France’s euro-denominated debt. In her stated social views, she’s the French version of Donald Trump. On top of all this, the population of the EU is older, and is growing more slowly, than that of the US. In a sense, the EU is the next Japan waiting for unfavorable demographics to take its toll.
What, then, could be the case for having exposure to Europe?
–the plus side of Donald Trump–tax reform, infrastructure, end to Congressional dysfunction–now appears to be at best a 2018 happening. In a relative sense, then, Europe looks better than it did a few months ago
–the EU began its economic rescue operations several years later than the US did. Because of this, one way of thinking about the EU is that it’s the US with, say, a three-year lag. If that’s correct, we should expect growth there to be perking up–and it is–and to remain at a somewhat better than normal level for a while.
–the mass of Middle Eastern refugees pouring into the EU has produced near-term political and social problems. However, many are young and well-educated. So as they are assimilated, they will provide a boost to the workforce–and therefore to GDP growth.
how to play Europe
Brexit will be bad for the UK economy, I think. Although much of the damage has already been done through depreciation of sterling, UK multinationals, especially those with exposure to the EU are, conceptually at least, the way to go. Even here, though, it’s not yet clear how access to these markets will be restricted as the UK leaves the European Union. So the UK probably isn’t the best way to participate.
Since we’re talking about local GDP being unusually good, multinationals are likely to be underperformers. EU-oriented firms will be the stars. Small will likely outperform large.
the US and China
About a quarter of the profits of the S&P 500 are sourced in Europe. So US-based, EU-oriented multinationals are also a way to play.
Another 10% or so of S&P earnings are China-related. Because China’s largest trading partner is the EU, some of the glow from the EU will rub off on export-oriented Chinese firms. Here I haven’t yet looked for names. But it may be possible to play the EU either through Chinese firms listed in the US or through US multinationals with China exposure. I’d put this group at the tail end of any list, however.
That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market. The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on …but reacts negatively on the third.
The third in this series of rate hikes will almost certainly come tomorrow.
The problem with this particular old saw is that there’s very little evidence from the past to support it. Yes, there may be an immediate knee-jerk reaction downward. But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise. Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.
Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth. As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option. On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices. In most cases, the two effects more or less offset one another. (Bonds are a different story. With the possible exception of junk bonds, all the pressure is downward.)
Of course, nothing having to do with economics is that simple. There are always other forces at work. Usually they don’t matter, however.
In this case, for example:
–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more. If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%. Let’s say 2.75%. Three-month T-bills yield 0.75% at present. To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.
I was stunned when an economist explained this to me when I was a starting out portfolio manager. I simply didn’t believe what she told me, until I went through the past data and verified what she said. Back then, I was the odd man out. Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.
–the bigger issue, I think, is Washington. I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending. The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done. If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan. That’s probably a negative for stocks …and a positive for bonds.
To a great degree, changes in interest rates and changes in currency substitute for each other in an overall macroeconomic sense. A rise in the world value of the US$ is equivalent to an increase in interest rates, in that both act to slow down overall US growth. A decline in rates or in the dollar acts as stimulus.
What is 2017 likely to bring?
Ignoring the mid-year lows, one-month T-bills began 2016 at a 0.17% yield and are now at 0.39%. The 10-year bond opened the year yielding 2.24% and is closing at 2.46%. Over the same period, the Federal Reserve has raised the overnight money rate by 0.25%.
My guess is that the Fed will raise the overnight lending rate by at least 0.50% and possibly by 0.75% in 2017. The latter would likely translate into a rise in the 10-year to something just below 3%, the former to a yield of 2.75% or so.
I think the chances of the larger rate rise are greater if the dollar remains around today’s level. As I’ve written recently, I think the US stock market is already trading as if long-dated Treasury bonds were yielding 4%–where I think the endpoint of restoring rates to normal will be. That’s something that probably won’t occur until 2018.
In addition, the US stock market has typically gone sideways during past times of Fed tightening. What would be unusual this time around would be if Congress follows through on a large, growth-stimulating, public works spending program. This would, I think, minimize any negative effect rising rates would have on stocks.
effects on the S&P 500
If the past is prologue, the main effect of rising rates and rising currency will be on the relative performance of sectors.
The more interest rates rise, the more attractive bonds will become vs.stocks whose main appeal is their stream of dividend income. So income stocks would be negatively affected.
The more the US$ rises, the weaker the US$ growth of foreign operations of US multinationals will be. Import-competing businesses would be hurt as well. Purely domestic firms would be relatively unaffected. My guess, however, is that the bulk of the dollar rise on a more functional national government has already occurred.