ADER’S MUSINGS – NO NEED TO WAIT FOR CURVE INVERSIONS

June 22, 2018                                                       

* Oh, how the mighty fall, GE kicked out of Dow, last 19th century holdout. * And, oh, how the S&P 500 has become a more aggressive index over the last 20 years. -- poses a heightened scare to index investors in next downturn, -- dividend yield will thus stay low. * Treasury yields hitting ‘fair value’ zone relative to equity dividends * More yields curves flatten, pointing to a common cause. -- Curve inversions in the future? They’re already here. * Was separating children from parents a ‘jumping the shark’ moment? -- Outcry overwhelming. Will markets start paying more heed to political tone, turmoil, dissensions?

An FT piece by John Authers made note that the defensive strategy of dividend investing isn’t working so well as yields have lifted. I’ll show you a chart of what I’m looking at in a moment, but his piece has interesting insights that are worth your attention.  One is of the change in the composition of the S&P 500 in the context of index investing. Dividend-plays tend to go with stocks that are lower quality within the S&P 500, and lower momentum as well, so are not in an economic sweet spot.  Further, and importantly, the dividend yield has edged below the 10-year creating a compelling competitive force.

But here’s thing that really struck me which he based on observations of Jim Paulsen of Leuthold. He said that there’s been a secular decline in the ‘defensiveness’ of the S&P 500 over the last 30-yrs concomitant with the rise in ETFs. In other words, the S&P 500 is more vulnerable to a market downturn as its lost a share of so-called defensive stocks, yet investors favoring index investing are getting in a sense a less diversified bundle. Today the defensive sectors -- utilities, telecoms, pharma and consumer staples -- represent a lower proportion of the S&P 500 than they did at the height of the dotcom bubble 18 years ago.

The cautionary note is, of course, that in the event of an S&P bear market the reduced influence of presumably outperforming or mitigating defensive stocks will result in ‘outsized’ weakness compared to historical exposures.

This brings up the concept of ‘value’, something I discussed at a recent presentation to a hedge fund group of my readers. Where is value in the Treasury market? There never was a more imprecise science making the effort to come up with an approach, let alone a level, a rather open-ended argument. And thank goodness because it makes whatever I come up with as credible as the next guy’s.

At the risk of repeating a theme, I’ll state again that the past several years have encouraged investors who normally would be inclined to seek income via the bond market to be overly weighted in stocks, especially dividend payers. That’s made a lot of sense given low rates and low volatility.  But now, and in the near term, rates are becoming a lot more interesting. Consider that with the S&P dividend yield at 1.88%, 10s yield 95 bp more and 2s over 50 bp more. The mean spread between 10s and the S&P dividend has been 89 bp since 2006 which is another way of saying 10s look ‘fair’ to that singular measures. And if you believe 10s are headed to, say, 3.25-3.50%, then that spread moves closer to 160 bp, or near the highs of the last 10 years.

If the Fed Funds rise by, say, 100 bp in the next year, and 2s move to near 3.25% then that spread moves close to 135 bp, the widest it’s been since late 2007. This is all to say that the bond market is looking a lot more compelling as a competitive investment to dividend-oriented equity investors.

I mentioned that bit about how the S&P index has changed to have much less exposure to defensive stocks than it once had. As you look at the chart below, specifically focus on the dividend yields. It’s hardly a leap to suggest that the sort of dividend yields that were around in the 90s and before, 2.85% from 1984-2000, won’t be returning anytime soon given how the index has lightened up on the weighting of dividend payers.

CHARTS AND THEMATICS:  It’s time to talk more about the yield curve. A good deal of attention is being paid to its flattening trajectory and the implications of, say, another 100 bp of hiking by next summer and possible more beyond then, the idea being we’ll get an inverted yield curve and all that implies. Take a look at my Bloomberg Prophets piece on the topic -- paste NSN PADKMA6JIJUP then hit <go> or ask me for a copy.

I have little to add to the topic in terms of what it predicts. An inverted 2s/10s curve has preceded each of the last five recessions since the 1970s and the 1s/10s curve has inverted 10 times in advance of the last nine recessions. (In the chart illustrating all this, I included Federal Debt as a % of GDP to illustrate the problem we’ll face in the next recession in terms of fiscal stimulus, or lack thereof, to help bail us out.)  With 2s/10s at 37 bp, it’s not unreasonable to expect that another 100 bp of Fed hikes in the coming 12 months will take that spread to inversion. And as the saying goes, the past is prologue.

There are other curves out there that are inverting already and enhance the narrative. One is an oddball in that it looks at sentiment vs. rates but I think fits the story. This one looks at the spread between U Michigan’s 5-year Inflation Outlook vs Next year’s, an effective 5-yr minus 1-yr inflation call. It’s at -30 bp which is simply saying that longer-run inflations expectations are running below the near-term ones. It plays well with the expectation for more aggressive Fed hikes sooner and a pause later. U Michigan’s survey is one of those “Market Measures of Inflation Expectations” the Fed talks about (https://goo.gl/bU5BCH). 

To be sure, it’s been negative for a while, but the negative spread has been widening, i.e. near-term expectations are rising relative to long-term expectations, which would seem to support the story and curve angle. Note I’ve included Inflation as one of the things the NFIB measures as a “most important problem” for the small businesses. In the realm of the 10 problems they ask about, inflation is one up from the bottom or a ‘least important’ problem. The bottom honor is held by ‘Financial and Interest Rates.’

And then there’s one that’s making the rounds of the arcane, but interesting, inversion that raises my eyebrows but there you go. Recently JPM put out a piece alerting us to a global yield curve inverting. Using the GBI Broad Bond Indexes in their 1-3 yr and 7-10 yr cohorts you can see this readily. Thing is, I can’t find that reflected in the any of the actual G7 curves. A Zero Hedge piece that alerted me to this phenomenon explains it’s due to how the index weights US duration in the various buckets, i.e. it overweights the short duration one vs. the longer one since there is more short-term US debt in the world relative to longer-term debt.

At the same time, the average duration of foreign debt has expanded sharply, outpacing the gain in the comparable measure of US debt. Thus, we have more non-US debt in the longer duration buckets and in a world of so much ‘negative’ rate issuance, those overweighted foreign bonds have a lower (considerably lower) yield than does our comparable-term bucket. In any event, by such astute manipulation they come up with an inverted curve which, notably and affirmingly, closely follows what the good old US 2s/10s does.

Now that I understand how they got there, the correlation with 2s/10s is very compelling. They also cite the 1-month US OIS 2-yr vs. 3-yr forward spread. I’ll use their chart to show you what’s up. So, in this space of Overnight Index Swaps we have an inversion (and had one earlier in the year as well). The upshot is that there are a lot of curves out there cautioning us about the future from different perspectives.

Note that I could not replicate the inversion using Bloomberg data (and happy to share the chart with you if you want it. Just ask.) Still, this curve is basically flat so their point remains valid.

IN OTHER NEWS:  Did the Administration just hit a “jump the shark” moment? There is, of course, a massive upheaval over the immigration “zero tolerance” policy that separates children from their parents. It has reach such an extent that former First Ladies from both parties have voiced their strong opposition, the UN Human Rights chief calls it “unconscionable’ and the divergent ‘blame’ between House and Senate GOP leaders, i.e. Trump can fix it immediately, and the Administration, i.e. it’s all the Democrat’s fault, underscores something obnoxious. Forgetting the broader issue of immigration, specifically illegal immigration, separating young kids from parents is heartless. 

Kirstjen Nielsen, who runs Homeland Security, is under pressure from some to resign which is ironic given just a few weeks ago she supposedly drafted a resignation letter after she was berated by Trump in a Cabinet meeting. Now, she emphasizes the zero-tolerance policy which has become a euphemism for that parent/child separation issue. Meanwhile, on Fox News, they’ve called the facilities that house the separated children “essentially summer camps.” Laura Bush calls them, “eerily reminiscent of . . . internment camps” and former CIA director Hayden compared them to Auschwitz. Conservative commentator Ann Coulter said of the children, “These child actors weeping and crying on all the other networks 24/7 right now; do not fall for it, Mr. President.” Wah, wah, Corey Lewandowski? People, grow up. Seriously.

Meanwhile, Microsoft employees protested about their company’s work with ICE, while other firms have upped their support for nonprofits helping immigrants. The NYT relays that there’s anger from the Fox’s entertainment division creators. The American Medical Association is against the policy, too. Then there’s the departure of GOP strategist Steve Schmidt, a McCain advisor during his Presidential bid, from his party calling the leadership a lot of “feckless cowards.” Heavy criticism also came from U.S. Chamber of Commerce and Business Roundtable, two organizations that usually would be very supportive of a pro-business President. "This is not who we are, and it must end now," Tom Donohue, the longtime president of the chamber, wrote in a blog post.

Yes, Trump issued an executive order reversing the policy of separating kids after saying he couldn’t do it and even then some 2,300 of the already separated kids will stay separated.

Do I mention this to wave some left-leaning political flag in the midst of my market musings as if I’m taking advantage of my stature to voice such an opinion? Give me a break; stature? NO, I’m bringing this up because of the evidently growing angst and anger in the country, in the GOP too, which has MARKET CONSEQUENCES.

Something viscerally perceptible is up with our politics or, rather, our reaction to politics. My sense is the market has reflected a lot of shock at the tone of Trump and his various cabinet members, and the GOP’s acquiescence on, for instance, the deficit explosion by paralysis. Maybe it’s a wait and see approach. Maybe it’s the ‘clarity’ of what lower taxes can do and the generic state of the economy. I will point out that the Unemployment Rate did slip to 4.5% as Obama left office from well over 9% when he was elected, which is to say Trump gets a lot of applause when the trend was well in place.

With the approach of mid-term elections, I can only see this sort of public miasma over a GOP policy backfiring on GOP candidates OR, as we are starting to see to some degree of potential restraint over the trade policies, increasing umbrage being taken by the GOP Congressional members. This adds greatly to a near-term, say through November, degree of uncertainty that will certainly add to risk volatility and, I think, risk-off price action. Maybe the fear, or the result, is the Democrats taking one or both houses in Congress. In the event of that, we can assume that many of Trump’s policies will be staunched, at least new initiatives, and so we need to consider the consequences of such an outcome.

Trade is under the executive branch, but certain restraints -- considered by the GOP, by the way -- are possible if not likely. New fiscal spending will face a challenge. I have thought for a long while now that the market’s ‘tolerance’ to complacency over the antics in Washington were bizarre and dangerous. By dangerous I mean in terms of weighing too heavily on the deficit-boosting tax cuts and use of such funds for fueling buybacks vs. investment.  The S&P 500 remains a bit below the euphoric levels post the tax plan; perhaps this is a hint of discomfort with the emboldened Administration. I think it is.

Of course, adding to such angst is the empirical evidence to suggest that 1) the stock market is rich to GDP and 2), certain stocks, a very concentrated bunch, have had outsized gains compared to the bulk of the market. I again bring up a piece by the FT’s Robin Wigglesworth which makes me squirm; since 2012, Apple alone has returned some $210 bn to shareholders which more than the market value of all but 20 of largest listed firms in the US. In May, Apple said it would buy back another $100 bn in shares.

NEAR-TERM MARKET THOUGHTS: The last week was dominated by sideways consolidation in Treasuries of the gains posted after the FOMC, weak Chinese data and the ongoing tariff threats.   Consolidation is just that; trading around an obtained set of levels but neither making progress against that or a rejection. In what was a relatively light week for data this make some sense. More importantly I don’t think you can take away a directional impetus from consolidation of the relatively small gains after 10s probed once again that 3% mark. I guess that’s my way of saying we continue to chop about, though with some supply coming down the curve (2s, 5s and 7s) I probably would err on the side of some concession which would tend to flatten the curve a bit. It’s largely a technical play.

A couple of things came up that I think could be the start of something bigger. I refer to the impact of the tariff ‘war’ on sentiment, behavior and Fed thinking. Don’t make more of that than just a ‘hmmm,’ at least for now. But Powell did say before the ECB forum, “Changes in trade policy could cause us to have to question the outlook… For the first time, we’re hearing about decisions to postpone investment, postpone hiring.”

Further he said, “If you ask, is it in the forecast yet or the outlook? The answer is no. You don’t see it in the performance of the economy and we don’t have any way to know how to put it into the outlook just yet.”

This sword cuts both ways. At once, it’s on the radar and could temper the pace of hiking. On the other, he’s not sounding overly concerned. He reiterated that he still sees monetary policy as accommodative and sees fiscal policy as an additive for a few years yet. I suppose this a case of ‘watch this space.’

I did think his recent words explaining why they removed forward guidance is interesting and maybe creates a better market for trading the curve and Fed Fund futures as we parse nuances between the raw data and what that means for monetary policy amidst less Fed guidance on the topic. That’s an afterthought.

Less of an afterthought, is the performance of small cap stocks and the notion that such companies will do better in a trade war as they are more domestically focused. Too, we see the Philadelphia Fed survey showing a softer tone with its sharp decline in New Orders which may be related to businesses starting to be cautious. See Powell’s comment above.  A Business Roundtable survey last month had 95% of CEOs calling trade wars a risk of varying proportions and 90% saying the result would be higher input costs. Oh, and to be sure, these higher input costs will likely be passed on to US consumers but would not have a positive impact on real wages.

Below is a histogram, i.e. Market Profile, of 10-year yield where I combined activity from June 10-14 to show a high-volume level of 2.95+%.  This is near-term support.  Below is a single print low coinciding with the June 19 high-volume area near 2.88% and so resistance.  A narrow range I know, but there you go. Next is 2s/10s on a daily chart which looks a bit too flat with momentum measures rounding UP.  The 21-day MA at 41 bp is my near-term target as we slog through the coming week into July 4 (early exits?).  I think 2s holds 2.50% as resistance.  I’m especially interested in the sentiment/confidence and survey data coming out; Markit PMIs, Conference Board, U Mich and Chicago PMI to be specific.

David Ader, Chief Macro Strategist for Informa Financial Intelligence

Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor’s annual survey.

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