Remember the “Seinfeld” television series?
There is an episode called, “The Opposite,” in which George Costanza decides that every decision he has ever made has been wrong. Jerry Seinfeld tells him that that then means that if he does the opposite of his instinct, then every decision will have to be right.
George applies that advice and has amazing success—including landing a job with the New York Yankees.
If George ran the Fed…
We’d bet there are a few global central bankers who are tempted to try this strategy.
U.S. Federal Reserve Chairman Janet Yellen raised the fed funds target rate in December 2015 after almost ten years with no increases. Her plan was to begin movement toward a more normal interest rate structure.
Most people expected at least some increase in rates across the entire U.S. Treasury yield curve. The 10-year U.S. Treasury Note ended 2015 with a yield of 2.27%. On March 31, 2016, the 10-year ended the quarter with a yield of 1.77%. Interestingly, a welcome outcome from this unexpected drop was a sharp decline in the U.S. dollar—exactly the opposite of market expectations at the beginning of the year.
The Bank of Japan moved its headline target lending rate into negative territory on Jan. 29, 2016, in an effort to battle its persistent deflation. One of its objectives was to weaken the yen, which would inject some inflationary pressures into Japan’s economy. Well, not so much. The yen strengthened on the news. Meanwhile, February industrial production in Japan slumped 6.2% for the sharpest drop since the 2011 tsunami.
Mario Draghi, the president of the European Central Bank (ECB), announced a massive increase to its Quantitative Easing program in March. The plan includes monthly purchases of 80 billion euros ($91 billion) of corporate bonds and government securities for at least another year.
This plan was much more grandiose than expected, and part of its shock value was to boost the expectation of inflation. When inflation is expected, it often shows up in the data very quickly.
Instead, European headline inflation remains mired in negative territory. Core inflation is close to 1%, which is one-half of Draghi’s target. Furthermore, euro-zone economic confidence dropped in March for the third consecutive month. (And this survey occurred before the tragic Brussels terrorist attack.)
There is a Fed official who tried his own version of the “opposite” strategy. James Bullard, president of the Federal Reserve Bank of St. Louis and a member of the Federal Open Market Committee in 2016, spoke about not raising the fed funds target rate back in mid-February.
This is exactly when sentiment was increasingly negative and some headlines even mentioned the possibility of recession. Then, just five weeks later, Bullard adopted the opposite strategy and suggested the Fed might raise its target rate as soon as the April Federal Open Market Committee meeting. (In the event, the committee chose to maintain its target range.)
Less than a week after that opposite, there was the central bank version of a “smack down.” Janet Yellen gave a speech to the Economic Club of New York. Not only did she make it very clear there would be no April increase (as it indeed turned out), she even mused about the possibility of reversing the December rate increase.
Her comments were noteworthy and point to “low for longer” once again. There was only passing reference to U.S. employment and inflation targets, which comprise the Fed’s mandate in total.
On an opposite note, Janet Yellen frequently referred to global weakness and uncertainty. She sounded apprehensive. Apprehensive central bankers typically do not raise rates. After her comments, fed funds futures were trading at levels indicating only a 62% expectation of any Fed rate hike in 2016.
The 2016 investment environment has been dominated by sluggish global economic growth and dramatic responses from an increasingly desperate community of central bankers. Global stock markets fell 11.3% in the first six weeks of the year and rose 13.2% in the second six weeks of the year.
Volatility in the U.S. stock market is reflected by the VIX index, which is also known as the “fear gauge.” The index rose 51% early in 2016 before settling down and ending the quarter with a 53% decline from its peak. Gold, often considered a safe-haven for investors, rose over 16% in the quarter.
Throughout this topsy-turvy environment, the U.S. stock market overcame its shaky start to the new year with a splendid seven-week, late-quarter rally. From its Feb. 11 low, the S&P 500 stock market index moved up 13.2%. It gained 1.8% in the last week of March alone on Yellen’s smack down. Investors were uplifted by the idea of a continued low interest rate environment, even though the reasons for that environment were steeped in economic weakness. For the first quarter, the S&P 500 had a 1.41% gain.
Better outlook at home
While Chairman Yellen ruminates over the global growth environment, the U.S. economic environment is looking OK, which equity investors have recognized.
Fourth-quarter 2015 annualized Gross Domestic Product (GDP) growth was just revised upward from 1.0% to 1.4%. GDP growth estimates for 2016 are positive, but they have fallen from about 2.6% to 2.0%. Our less-than-robust economic environment continues.
Fortunately, U.S. employment numbers are rock-solid, with a March increase in nonfarm payroll employment of 215,000. The average quarterly gain was 209,000, which compares favorably to the first-quarter 2015 average gain of 190,000.
Over 98% of the net new jobs in March were full-time, and the employment-to-population ratio hit a seven-year high. Wage gains remain contained with year-over-year growth of 2.3%, which is an improvement from recent lows but still not exactly celebratory.
We take extra encouragement from the forward-looking, behavior-based JOLTS (Job Openings and Labor Turnover Survey), which indicates a rise in the willingness of employees to quit their jobs.
Our favorite economist, David Rosenberg, of Gluskin Sheff & Associates, Inc., calls this the “take this job and shove it” index.
JOLTS jumped from 9.7% in February to 10.5% in March and stands at its highest level since 2008. Furthermore, the survey shows job openings at their third-highest level on record going back to 2000.
The U.S. employment situation has been the foundation of our optimism for some time now. We admit, however, to a nagging worry about the U.S. industrial complex. Manufacturers have been hit hard by the strong U.S. dollar, which makes their exported products expensive to foreign purchasers. Additionally, of course, the falling price of oil has hit the U.S. energy producers and suppliers. Fortunately, new reports indicate a bit of light on the horizon, albeit a few clouds as well.
The main cloud was still evident in the recent employment report. Although there was a net increase in overall jobs, the manufacturing segment lost a net 29,000 jobs. The manufacturing workweek also shrank to a three-month low.
Bright note on purchasing front
The light on the horizon, however, comes from the Institute for Supply Management (ISM). Its Purchasing Manager Index for manufacturers showed an increase from 49.5% to 51.8% in March and then 50.8% in April.
Numbers above 50 indicate more companies are growing than shrinking. The March figure was the first reading above 50 in six months. In April, 11 of the 18 industries (61%) included in the survey reported growth. This compares to only 51.5% last year. Although the new-orders sub-index retreated somewhat from its recent high, the diffusion index is still above 50 and, therefore, indicates expansion. Export orders showed their largest one-month increase in almost five years. This happened on the heels of the U.S. dollar’s steepest decline in five years, which in our opinion is no coincidence.
Considering the Costanza Strategy
Although “The Opposite” strategy worked for George Costanza, it contributes to a challenging environment for investors.
We have a Federal Reserve that wants inflation. It appears willing to focus less on its official mandate of stable U.S. pricing and full U.S. employment, which by most accounts we have achieved, and more on global economic conditions.
Extremely low interest rates will remain with us longer than most anyone anticipated, despite the U.S. at full employment, with even a few whiffs of inflation.
Beautiful, boring bonds
With rate increases practically off the table for now, Wall Street is only too happy to offer desperate investors a new instrument that miraculously provides high yield and no risk.
A recent article in The Wall Street Journal article highlighted the return of sub-prime mortgage-backed securities packaged for the individual investor.
Our advice: Don’t!
Do the opposite.
In bond land right now, boring is beautiful. This may not be what investors want to hear, but there it is. If you need a reminder of our advice, check out the movie, “The Big Short.”
The one area of bond spice that investors may consider is the high yield, i.e., junk bond, market.
We have gingerly mentioned this market segment in the past. It was hit hard over the last several months because about 10% of the issuers in this arena are in the energy sector. Now that oil prices have moved up over 50% from their lows, the high-yield market has recovered somewhat. Yield spreads (the difference in yield between a junk bond and an investment-grade bond) have narrowed, but they remain wider than normal.
There are risks in this market. The best ways to mitigate those risks include a small portfolio allocation as well as use of a diversified fund that emphasizes the least junky junk.
Peer through uncertainty with stocks
Investor behavior is affected by many developments, including global politics, terrorism, local politics, weather, etc. Right now especially, there is no shortage of uncertainty. The beauty of the investment profession, however, is the opportunity to look through some of that uncertainty and participate in the future success of businesses through the purchase of stocks.
The best environment for stocks is one that includes steady or falling interest rates and rising earnings. Plenty of extraneous developments may muddy the waters, but a focus on those two elements provides clarity. Additional focus on the price paid for a business determines overall investment success.
We have low interest rates, which are generally good for stocks. What concerns us over the short term is the combination of sluggish earnings and high valuations. The recent Bureau of Economic Analysis report showed corporate earnings fell at an annualized 7.8% rate in the fourth quarter of 2015. Four of the past six quarters registered a decline in profit growth.
Analysts expect an almost 7% year-over-year decline in earnings from S&P 500 companies in the first quarter of 2016. Almost 20% of companies in the index have issued negative pre-announcements, which is close to the record-high.
Aggregate U.S. corporate profits are lower today than they were in the fourth quarter of 2011. In 2011, the market’s price/earnings ratio was 13. Today, it is 19. It may not feel like it because of all of the volatility in the first quarter, but the U.S. stock market is trading just shy of its record high. Productivity continues to slump, which leads to compressed profit margins, yet valuations are stretched.
Most investment newsletters urge caution and the expectation of continued volatility. Good advice.
“Costanzaism” and the stock market
Let us expand on that advice. We are more constructive toward U.S. equities than many of our peers. For one thing, while the U.S. political scene continues to contribute to uncertainty now, there is good news on the horizon. After early November, that uncertainty will be over!
Furthermore, we expect the latter half of the year to show improvement in economic growth and productivity and, therefore, earnings growth.
It will be a bumpy ride. There will be times when investors will want to crawl under a rock. We suggest the opposite.
Looking out a bit, we see a U.S. dollar that is no longer strengthening. The dollar’s strength did a number on U.S. corporate earnings over the last several quarters. We will be moving away from difficult earnings comparisons to easier comparisons on that basis.
Meanwhile, financing costs remain low thanks to low interest rates. Given continued in-fighting within OPEC (Organization of the Petroleum Exporting Countries), we believe energy costs will stay low, which offers further support to earnings.
Then, consider this. The U.S. has seen an amazing number of net payroll additions. The majority of these additions are permanent as opposed to temporary. So, today’s CEOs are hiring in an environment of less-than-robust GDP growth.
These are not snap decisions. CEOs remain heavily incented to keep costs low. Why are they willing to hire?
In our opinion, one reason is because they see improvement in the latter half of the year. And, an increasingly employed population will drive demand growth, contributing to a rather virtuous cycle for earnings.
Not perfect, but pretty good.
Optimistic about the long view
So right now, earnings visibility is cloudy, yet equity valuations are very high. This is the work of our old friend, TINA. TINA (There Is No Alternative) is sticking around because of our low-interest-rate environment. These high valuations keep us cautious, and we have no problem taking advantage of the current stock market rally by reducing any over-exposure to stocks.
But, TINA’s tenacity and a second-half view of improving economic and earnings growth keep us constructive on stocks for the long haul. The immediate path is full of potholes just like our end-of-winter streets. Drivers, maintaining a cautious approach and looking ahead, will do fine. The same is true for investors.
This article is updated and adapted with permission from the April 2016 edition of Associated Bank’s Economic & Investment Environment Review.
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