August was a quiet month for markets, with U.S. and international developed stocks rising slightly. Emerging market equities continued to perform very well, with returns getting a boost from the continued decline in the dollar. The dollar fell 0.91% against a basket of currencies, pushed lower as traders’ expectations of Fed rate hikes continued to move in a dovish direction. At present, Fed Funds futures contracts are pricing in just 2% chance of a rate hike in September and November, and a 42% chance of a rate hike in December. This in spite of the Fed itself saying it will hike rates one more time this year, based on their internal projections issued after the July meeting. Bond yields fell during the month on increasingly dovish outlook, with the 10 Year Treasury yield closing August at 2.14%.
As we head out of the low volume months of summer and into the fall, it is helpful to play a little scenario analysis and think about what might spur a correction in the market. It is our view that a shift in Fed policy, which catches the markets offsides, could be the most likely culprit for increased volatility. We noted in the opening paragraph the drop in the dollar in August. YTD, the greenback is down around 9.5% and hedge fund positioning has grown increasingly bearish.
In effect, the dollar is pricing in tepid economic growth, the absence of any fiscal stimulus, and a continued dovish stance from the Fed in the coming months. A reversal in the dollar trade could bring some volatility back to markets, but it would require at least one of the aforementioned factors to surprise investors.
Wall Street seems to think that fiscal action is dead in the water, and it may be, though Republican leadership in the House has clearly not thrown in the towel despite unending dysfunction in the White House. Discussions regarding the tax plan are ongoing and include efforts to make all overseas cash deemed as repatriated rather than offering an option to repatriate. This would in essence automatically subject any overseas cash to the tax, but allow the tax to be paid over a multi-year period. It would also pave the way towards eliminating the incentive to tax shelter abroad, as companies continued to do so after the Bush repatriation holiday, assuming that another would come down the pipe at some future venture. As has been the case with prior tax negotiations, the wild card is deficit hawks in the GOP, who do not have the Obamacare repeal feather in their cap to offset tax revenue losses. However, investors would be wise not to sleep on the potential for a bill to get pushed through as Republicans, and Trump, are hungry for any victory in the first year of their majority.
What is more likely in our view is for the Fed to turn more hawkish than the market anticipates. Note that this is not an assumption they will shift towards 6 rate hikes a year. Rather, it is a guess that given tight labor markets and improving global economic growth, which should lead to firmer inflation, they have more flexibility to hit their target rate range of 2.00 to 2.25% at the end of 2018. Consider the following chart showing Citi’s Global GDP growth revisions. From 2013 to 2016, GDP estimates were consistently revised lower as the year went along. However, 2017 and 2018 forecasts have been consistently revised higher, reflecting improving growth in ex-US developed markets and emerging markets.
Yet in spite of full employment and improving global growth expectations, the CME futures market for August of 2018 is projecting a very dovish outlook. For instance, futures are pricing in 35% probability the Fed does not hike rates at all between now and August of next year, just 45% probability that they hike once, and basically no chance that they hit their target range of 2.0 to 2.25%.
It is also important to note that in addition to the two official Fed mandates – full employment and keeping inflation in check – likely allowing them to raise rates more than the market anticipates, the “unofficial” mandates are also allowing them to hike rates at their desired pace. We often joke the Fed’s “third mandate” is to keep the VIX below 20, which they have had no trouble adhering to given the absence of volatility over the last year. The dollar has also been incredibly weak, and given that various Fed presidents have made a point to mention the negative effects of strong dollar in past commentaries when they discussed keeping policy accommodative, it would not be surprising to see them mention the weak dollar when considering firming policy further. Again, the point here is not that the economy cannot handle 2.0% interest rates from the Fed but rather that we should think about what might increase volatility in the market. From our perspective, given the sharp decline in the dollar and the complacent views about future Fed policy, any increase in hawkish talk from Fed officials may prompt a correction in U.S. equities.
One area of the market that has not benefitted from the weak dollar and the rebound in global growth is the energy sector. Crude oil prices have been plagued by oversupply, a direct effect of each E&P operator in the Permian pumping oil as fast as possible to hit their CEO’s bonus targets. Drilling efficiency in the Permian and other areas has improved significantly, allowing production to ramp back up.
As a result of supply imbalances, WTI oil has fallen 12% this year while the S&P 500 energy sector has fallen 14.3%.
Master Limited Partnerships, as measured by the Alerian MLP Index, have fallen 6.43%, YTD. Though MLPs have weathered the downturn in crude better than other energy sectors, the performance has been disappointing given the hopes of deregulation, tax reform, and infrastructure support that accompanied the space at the end of 2016.
In spite of weak performance this year, MLPs present an intriguing value opportunity going forward at a point in time when very few U.S. equity sectors offer compelling discounts. For instance, the Alerian currently yields 7.9% vs. a historical average of 6.9%. This equals a spread to the 10 Year Treasury of 683 bps vs. a historical average of 366 bps. Though some operators have cut distributions, the majority of pipeline companies have maintained or grown their distributions in the most recent quarter.
Even though an infrastructure bill sees extremely slim chances of passing, there are six major pipeline projects waiting approval from the Federal Energy Regulatory Commission this fall. Institutional interest in the space has also picked up in recent months. In August, Blackstone acquired Harvest Fund Advisors, a specialty MLP asset manager, in order to take advantage of low valuations in the space. This year, they have also purchased pipeline operator EagleClaw Midstream Ventures LLC and put a $1.6 billion stake in Energy Transfer Partners’ Rover gas pipeline. Blackstone’s increasing presence in MLPs coincides with increased institutional ownership. Whereas retail investors made up nearly 75% of MLP ownership base a decade ago, they have steadily declined to around 50% as of the end of last year.
The increase in institutional and foreign ownership stands to bring about steadier hands to the asset class and should help with stabilizing the space after the heightened volatility of the last two years. Also, increased production, which has depressed crude prices in the short-term, is a longer-term positive for MLPs as it means increased volume flowing through the pipes. Though value has been out of favor compared to growth, and energy has been the worst performing S&P sector YTD, MLPs present an attractive long-term investment opportunity due to favorable yields, increasing distributions, steadier ownership base, and improving transportation volumes.
Lastly, on emerging markets, which are one of the strongest performing asset classes this year with the MSCI EM index returning 28.29% YTD, fund flows have picked up YTD but net flows since 2014 are still sharply negative.
Though some worry about the effects of further Fed rate hikes (if they move faster than expectations, as we suggested at the beginning of this note), emerging market equities have been resilient in the face of previous rate hikes. Ping Jiang, CIO of PING Capital, a prominent global macro hedge fund, notes EM equities rallied 135% in the face of the Fed raising rates from 1% to 5.25% in the early 2000’s. Economic growth estimates in emerging markets have also been revised higher over the last year, with the IMF boosting its forecast for Chinese economic growth to 6.4% from 6.0% for the next four years.
On China’s recent credit boom, which has helped fuel their rebound in economic growth, Oppenheimer Funds notes that total credit to GDP has increased to 202% of GDP.
They believe that while the jump in debt levels will lead to a growing array of non-performing loans, there is not a crisis is looming. “For a big crisis to occur, there would need to be a funding crisis at the banks. But savings rates are high and money can’t readily leave the economy – two factors that make a funding crisis very unlikely.” The FT recently highlighted that in mainland Chinese households, the household debt to GDP ratio is 28%, compared to 90% for the UK.
The combination of higher household savings rates, lower dependence upon foreign flows, and a managed currency give China greater flexibility going forward than Japan or Korea had in the 1990’s when they faced debt crises.
Looking forward, emerging markets are poised to offer higher economic growth than developed markets due to better demographics and greater spending power across a growing middle class. Valuation levels also continue to be very compelling relative to developed markets, with a broad EM CAPE ratio coming in at 15.6 vs. 23.4 for global developed markets, a discount of 50%.
Though a discount has always been present in emerging market equities vs. developed equities, due to greater presence of cyclical firms, this gap could decrease as tech and service oriented firms, with higher margins and less cyclical sensitivity, become a greater presence in the asset class.
Though regional instability in North Korea may create pockets of short-term volatility, as may any rebound in the dollar if the Fed turns more hawkish, we anticipate that emerging markets will provide continued outperformance vs. U.S. and developed markets over the long-term.
U.S. equities took a bit of a breather in August, with the S&P trending slightly lower for most of the month before closing higher by 0.29%. YTD, the S&P has returned 11.85%. Emerging market equities continue to perform very well, with a 2.35% return in August and a YTD return of 28.65%. Small cap value is one of the worst performing areas in the market, with the Russell 2000 Value index falling 2.47% during the month and moving into negative territory, YTD, with a return of minus 1.35% for 2017. Fixed income securities of nearly all stripes continue to benefit from a flattening yield curve, with the Barclays Agg returning 3.71%, YTD.
Looking forward, we are cautious on a potential rebound in the U.S. dollar, which could come as a result of a more hawkish Fed, higher inflation expectations, or improving growth. Positioning within the dollar has turned sharply negative and expectations for future Fed policy are incredibly dovish. Though we doubt the Fed will take an aggressive stance towards hiking rates, it is entirely possible that any shift that is more aggressive than the market’s current dovish expectations catches dollar bears offsides.
With respect to asset class positioning, we continue to have favorable views on MLPs as one of the few attractive sectors in the U.S. equity market from a valuation and growth standpoint. We also believe the recent run in emerging markets, though it may experience some volatility if the dollar turns higher, is the beginning of a longer-term trend of outperformance vs. U.S. equities.
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, including YTD data, is as of 9/1/2017 unless otherwise noted.