The Four Horsemen (Plus One)
“When the people of Iceland are forced to grow their own pineapples, we know we have a problem.” – Dan Roberts, MacKay Shields
The long bull market in equities ran into stiff resistance on several fronts as we pushed through the first quarter of the new year. We list the following among the most consequential challenges to market pricing today:
S&P 500 Index (October 2017 – April 2018)
Source: Thomson Reuters DataStream 4/4/18. Past performance is not indicative of future results. An investment cannot be made in an index. The views expressed herein are that of the Strategic Asset Allocation and Solutions and are for illustrative purposes only.
Trouble began in late January with the release of estimated average hourly earnings, which showed unexpectedly large growth, year over year. Conventional wisdom has long held that wages will rise in response to a tightening labor market, as employers are forced to bid more aggressively in their efforts to attract talent. That relationship had, thus far, failed to materialize in the current cycle with compensation growth remaining subdued, even as unemployment fell toward 4%. Evidence that the traditional relationship might finally be reappearing sent shockwaves through the market. Higher wages can chew into corporate profit margins, drive upwards the cost of debt capital, and erode the present value of future earnings (and hence put downward pressure on equity price multiples).
Forced Unwind of Esoteric Trading Strategies
The initial sell-off spawned by inflation fears created a pop in both real and implied volatility. That, in turn, led to algorithm-driven sell orders from risk parity, managed volatility, and short VIX strategies, extending the price drop into correction territory. This chain of events was in some ways reminiscent of the implosion of “portfolio insurance” strategies on Black Monday way back in the fall of ’87. Wall Street’s financial engineers have struck again…
Tightening Monetary Policy
The change in leadership at the Federal Reserve from Janet Yellen to Jerome Powell brought no discernable policy modification. The Fed continues on its path of gradual hikes to target overnight lending rates and incrementally stepping up the pace at which it allows its balance sheet to roll off. Additionally, members of the committee as a group expressed expectations of modestly higher rates down the road than were previously estimated.
Actual financial conditions tightened further, as spreads on private lending (commercial paper, LIBOR) have widened significantly in recent months. This appears to be driven by technical supply/demand considerations rather than concern over credit quality, but regardless of the reason, debt capital is being rationed to a degree we haven’t seen in many years.
Big Tech Regulatory Risk
Abuse of Facebook user data during the Presidential election again raises the specter of more aggressive regulatory oversight. For years, technology companies have led the market higher, while operating in an environment of benign neglect. That may now be coming to an end, as both privacy issues and monopolistic practices draw scrutiny. Litigation and compliance costs are likely to rise, gnawing away at investor sentiment toward the sector.
The Trump administration has repeatedly attacked the liberal economic order, upping the ferocity with each additional move. It began with tariffs on imports of solar panels and washing machines. Next up were duties imposed on steel and aluminum. Trump’s economic advisor, Gary Cohn, found this sufficiently reprehensible enough to tender his resignation over the matter (to be replaced by a protectionist, Peter Navarro). And then, in late March, came a set of heavy tariffs on roughly $50B in Chinese goods, along with the promise that this is to be “the first of many” such policy maneuvers. While these actions unto themselves are still relatively immaterial to aggregate economic activity, there has been a clear tone change out of Washington. The steady march toward more open trade that has guided policy for the past several decades is under assault. Financial markets are responding by discounting the possibility these policy actions may be only the initial skirmishes in the ugly trade war to come.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
LIBOR is a benchmark rate, which some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.
VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge.”
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