WhartonHill Investment Advisors’ Under the Hood series is a more technical commentary than our Viewpoints series, designed for both clients and peers in the investment industry.
Stocks continued their unimpeded march higher while volatility continued to plumb new lows, with the S&P 500 finishing July up 1.40% and the MSCI ACWI Ex US index returning 2.73%. Emerging market equities performed very well, with the MSCI EM index returning 4.84%. The CBOE VIX index continued to crater, falling to a decade low level of 9.36 during the month. Bond yields held fairly steady during the month, with the 10 Year Treasury Yield closing July at 2.29%, in line with the prior month close of 2.30%. High yield bonds posted favorable returns, with the iShares iBoxx High Yield ETF (HYG) gaining 1.07% during the month. HYG is now up 5.41% in 2017 as spreads have tightened to multi-year lows.
The current low volatility regime has dominated headlines and has led to a narrative that quiet market conditions can only last so long, before a volatility spike will knock investors from their complacency. However, low volatility in of itself does not beget high volatility in the future. BlackRock puts the dynamic as follows: “the history of volatility is one of long stretches of calm punctuated by brief moments of crisis.”
They go on to note that markets are typically either in a low or high volatility state, with high volatility regimes rarely occurring without an economic expansion coming to an end. Though the expansion is certainly in the later stages, we have not seen warning signs that it is likely to come to a halt any time soon.
What warning signs would we look for? First and foremost, we look to the labor market for indications on the economy’s health. Labor market data provides a real time, frequently updated look at the wellbeing of the economy that provides insight into both business and consumer spending. Two of the key labor market data points we monitor are weekly jobless claims and the trend within the benchmark unemployment rate. At present, the weekly reading of initial claims stands at 244,000 vs. a historical average reading of 357,000 and a current expansion average of 351,000.
Jobless claims have continued to trend lower and as of the most recent reading (end of July) are down 8%, year over year. Until the trend begins to move higher or consistently reads above 300,000 a week, we are not concerned regarding initial jobless claims data.
The other key reading in the labor market is that of the unemployment rate, also known as U-3. Though high unemployment rates are often coincident with a recession, and thus the absolute level is not a good predictor of whether the economy is starting to soften, the trend in unemployment is a helpful gauge for economic health. One way to read the trend in unemployment is to view the current level of U-3 relative to its twelve month moving average. When U-3 moves higher than its average over the last year, it is a reliable indicator that the economy is beginning to slow down. For 10 of the last 11 recessions, U-3 has started to move above its twelve month moving average ahead of the start of the recession. Though it has not been a perfect timing indicator for U.S. equity markets, the return patterns in the S&P 500 after unemployment trends higher have shown notable weakness compared to all other time periods.
For instance, in all time periods, the S&P 500 has generated an average one year price return of 8.8% and a positive return in 73% of all observations. After U-3 breaks above its twelve month moving average, the average one year return was minus 0.5% and the frequency of positive returns falls to 50%. Again, it is not a perfect indicator (nothing is) but it is fairly reliable for anticipating economic and market weakness.
Looking abroad, we continue to be encouraged by the improving economic picture in Europe. Business sentiment in Germany has hit multi-year highs and points to improving GDP growth.
PMI gauges in the Eurozone have continued to trend higher while UK, US, and Japanese PMI data has turned lower. Other areas such as loan growth, which contracted for 3 straight years during the Greek debt crisis, has finally sustained positive momentum.
Credit creation in the Eurozone has significant room for improvement, which should benefit the financial sector as well as broad European indices. We have noted in prior commentary that one of the major detractors in European equities is the heavier allocation to the financial sector vs. the tech sector in the U.S. For example, in the iShares Eurozone ETF (EZU), financials are 21% of the allocation while tech is just 7.85%. By comparison, the S&P 500 has a 23% weighting to tech and a 15% weighting to financials. Improvements in credit growth, less regulatory impediments with Basel 3 in the rearview, and a sense that euro implosion is not the given many pegged it for a few years ago are all factors that should continue to help improve European equity returns going forward.
Looking at emerging markets, which have performed spectacularly this year as the dollar has weakened and Chinese government spending has buoyed their economy, there remains room for future equity outperformance in our minds. Emerging market earnings cycles often move over extended periods of time, as do shifts in performance relative to developed market equities. KKR notes that the current EM downturn has lasted nearly 7 years (81 months), in line with the 7-year length of the last EM bear market.
Following the last bear market, EM stocks outperformed DM stocks for 12 years (108 months). KKR notes in their mid-year outlook that the technology sector now has overtaken financials as the leading sector in MSCI EM market capitalization. In their opinion, “this baton hand-off points to not only an important maturing of emerging market economies but also that public investors are now able to own securities and indexes that are more directly levered to EM’s rising GDP per capita stories. In the past, this was clearly not the case, as many EM indexes were heavily tilted towards just commodity and financial companies.” Increasing share of technology representation in emerging market equity indices should also help close the valuation gap between emerging markets and developed markets, a gap which has been persistent to the greater representation of financials and commodity sensitive companies in EM indices.
Looking towards U.S. fixed income markets, the long end of the curve remains stubbornly flat, with the Ten Year closing the month at 2.29%. High yield bonds have loved the docile trading in Treasury yields this year, with spreads on the BAML US HY Master Index moving from 422 bps at the start of the year to 360 bps as of the end of July. Spreads are slightly above all-time tights of 240 (reached in 2007), but are well below historical averages of 575 bps. Given the outlook for the economy and the Fed – relative tame inflation, lackluster growth, and a slow push higher from the Fed – high yield could still deliver modestly positive returns in the near-term, as spreads can stay tight for multiple years. However, the push into high yield instruments has embedded the asset class with more duration than is desirable and little in the way of valuation protection should a risk event occur. Loans on the other hand are still trading at fair to attractive levels relative to historic medians and have no duration to boot.
The majority of leveraged loans have also hit their LIBOR floor rates of 1.00% and now offer income upside should the Fed continue to raise rates going forward. Given that some of the more attractive opportunities in the loan space exist in the riskier parts of the credit spectrum, using an active manager to take advantage of these gives the best opportunity for alpha.
Lastly, to touch on the politics briefly (as we cannot devote more than just a passing comment to it in good faith), an interesting dynamic that we have seen is the market’s acceptance that political volatility is here to stay in the U.S. and it should be shrugged off by equity traders. In general, we believe that political tension should not be taken too seriously as long-term compounded returns tend to be generated from trends that are not affected by the day to day posturing in Washington. However, we would just caution that complacency has set in regarding the potential for political fallout to affect the business investment climate. At the outset, we noted that a low level on the VIX is not a precursor towards a move higher in the VIX. However, when you combine weak seasonality heading into August and the lack of even a 5% move lower in over a year, we think some caution is warranted with respect to the potential for a minor correction in the next few months., It also doesn’t help the situation that the Wall Street Journal ran an article about retail investors in Boca Raton making a killing by betting against the VIX.
International and emerging markets continue to lead the charge higher, now putting in YTD returns over 20%. U.S. equities also continue to perform very well, with the S&P 500 up nearly 12%, YTD. Volatility remains close to all-time lows and while a low absolute level on the VIX is not a guaranteed precursor towards a spike in volatility, investors would be well served to not get overly complacent heading into the closing month of summer given seasonality plus the continuation of political volatility.
We are encouraged by the continuation in economic momentum abroad, with European economies finally enjoying the combination of tailwinds in the financial space and the removal of persistent regulatory and political headwinds. Emerging markets have also benefited from a supportive Chinese government as well as improving sectoral dynamics. We are of the view that EM outperformance vs. DM could be a prolonged trend over the next few years as investors look kindly upon equity valuations, demographics, and improving currency levels.
Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. Wharton Hill and IFP are separate entities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All index and market data is via Morningstar, unless otherwise noted. Trailing returns is as of 8/31/2017 unless otherwise noted.