Market Perspective

Reality Bites – “Snap back to reality, oh there goes gravity” *

We think the above hip-hop lyric succinctly sums up the first quarter of 2018. The market’s ode to the genre is timely as Kendrick Lamar just wrapped up the first Pulitzer Prize in music ever won by a hip-hop artist. The first quarter of 2018 was a battle. With the hype of tax cuts, stashed offshore dollars coming home and all other things Trumpian, equity market participants chose their sides, suited up, and entered the ring.

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Early January was a bull market continuation until the Bears started throwing haymakers. With U.S. led global monetary tightening trends and mounting political and geo-political risk in their corner, the Bears took charge and pummeled the market with large flurries of volatility. Bulls played defense and counterpunched with soon-to-be announced solid Q1 earnings potentials and bags of money that should line shareholder pockets over the coming 12 months.

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Who won? Let’s call it a stalemate for now as the S&P 500 return was only slightly negative for the quarter.

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However, we believe that gravity has taken hold. Q1 will likely represent the cycle top for equity markets, with the S&P 500 rising to just below 2900 index points. It would take a Herculean effort to pierce this ceiling during the remainder of the year and any attempt to breach those January highs that falls short is certainly a double top indicator and a selling opportunity.

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The first quarter might not have been the epic Ali vs Frasier type of bout, but certainly a more pedestrian Holyfield vs Tyson fight seems like a reasonable comparison.

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For the past few years, the equity market mantra has been “buy the dips”. The theory has been that economic fundamentals, easy money and new fiscal stimulus provide significant tailwinds for equity valuations in the absence of being able to find returns in other asset classes. Previous downturns were quickly met with large buying programs and stock buybacks, working to reverse losses within weeks. Additionally, price volatility fell to historically low levels.

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That dynamic changed in the first quarter. As Bulls and Bears exchanged body blows, the path forward for equity markets became less certain. The underlying belief in higher prices waned and for the first time since early 2016, we saw two-way risk being priced in the marketplace as volatility violently spiked higher.

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While consensus has not fully moved to “sell the bounce mode” yet (likely waiting for another attempt to sell closer to the January peak), “buy the dip” has become a more onerous proposition. This simple, yet subtle shift in sentiment has significant market implications and is one of the factors behind our belief that equities have seen a top.

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In our opinion, the return of two-way risk in equity markets has been long overdue and is certainly a welcome and healthy development. Suppressed volatility over intermediate periods of time shows complacency, which is both unhealthy and sets the table for future shocks. It also contradicts the need for inflated valuations, driven by years of experimental quantitative easing, to reverse course as the tide of easy money goes out with shifting central bank policies.

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Moreover, these evolving equity market dynamics have left interest rates caught in the crossfire. Bond markets are dealing with their own conundrum of positive and negative influences. On the positive side of the equation is shrinking corporate supply due to offshore profit repatriation and the potential for corporate balance sheet improvement. Additionally, the massive yield differentials versus other sovereign debt remains a positive for U.S. rates. On the negative side is ever increasing U.S. Treasury supply in the face of reduced Fed purchases and tax cuts that will balloon the deficit fairly soon. Oh yes, the Fed is hiking interest rates and commodities have been grinding higher too!

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Interestingly, while rates are higher over the past nine months and bond prices have fallen, there is a point at which enough equity market selling causes the bond market to retake its safe-haven status from time to time.

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Investors will retreat to their corners during the first half of the second quarter with eyes glued to corporate earnings and economic data, like in the good old days. However, it would not be surprising to see the boxing ring lights fire up again mid-quarter or earlier. If earnings do not meet expectations and the beneficiaries of repatriated cash ends up in the hands of bondholders through corporate balance sheet cleanup and not with shareholders via more dividends and new buy back announcements, then the Bears will come out swinging again.

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In any event, the challenge for all investors is to stay focused and not get distracted by the daily presidential tweet storms and look out to the horizon. Maybe the #deletefacebook movement could morph into #deletetwitter and the noise would fall ever so slightly.

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Looking at the next nine months, there are still a few reasons to be optimistic. The current economic expansion will not end this year as key economic indicators remain constructive, favoring the muddling-along characteristics that have defined this elongated cycle. Some early indications from Q1 earnings have been positive. And perhaps Q2 earnings will be even more telling since earnings are backwards looking. Additionally, looming mid-term elections may be supportive. Grid lock has to be better than what we have seen over the past year. 2019, however, is looking more ominous. Be wary of following the dip buying mentality and carry a heavy dose of skepticism.

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* “Lose Yourself” (Eminem, 2002)

Volatility Makes An Appearance

In our 2018 outlook, we discussed the complacency within financial markets and the lack of volatility in almost every asset class. As a result, we thought that prices could be susceptible to an abrupt reversal without notice. Well, early February was a wake-up call. The February selloff was sudden and sharp with the S&P 500 giving up over 12% at the lows. Intraday trading ranges, which had been less than 1% for a considerable amount of time, suddenly blew out to 3% – 4%. Some investors booked profits while the hoard of new equity dollars from January pulled out and those sellers licked their wounds. Quant funds and momentum players applied additional pressure by putting on fresh shorts when the markets quickly sold through stop losses. The biggest damage, however, was reserved for strategies that were short market volatility.

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The sudden and sharp spike in volatility caused a mini unwind of the trade that has worked so well during an era of Central Bank asset purchases and zero interest rates. Namely: buy stocks, buy bonds, short market volatility, and forget about it.

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During the volatility-drenched trading days of early February, the pundits conducted a feverish search for the catalyst. Who or what was to blame for the startling shift in market sentiment? Maybe 10 year U.S. Treasury yields trending toward 3% with rising wage inflation sparked the market rout? Perhaps greedy Wall Street firms creating problem child Exchange Traded Notes & ETFs were to blame? Somehow, individually these explanations seemed to miss the point. More likely, the sense that everyone is walking on eggshells meant that when the first sign of smoke appeared, everyone raced for the same exit door. Sell first and ask questions later, is a pretty standard response to these types of moves. Interestingly to us, there are some differences in market structure today versus the past.

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The rise of technology used to run trading programs has advanced significantly over the past decade. Instead of humans trading everything, now humans program algorithms that execute trades autonomously. Many programs are built with momentum indicators which tend to exaggerate moves in either direction if stop loss triggers are hit. Quick and aggressive down trades now come with equally sharp reversals – like the early part of this month. There have been a number of these moves over the past five years. People used to call them flash crashes, but let’s assume for now it is more normal. If one looks at trading patterns around the Brexit referendum and U.S. Presidential election, they are similar to what we have seen over the past few weeks.

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So instead of looking for the catalyst like a needle in the haystack it is just better to remember that in many cases, price action is the real story.

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Even though the equity markets rebounded swiftly last week, the move should not be swept under the rug and forgotten. Instead, place it in a broader context. From a fundamental perspective, not much has truly changed. The probability of a near term recession remains fairly low. The Federal Reserve is in tightening mode while inflation is trending higher. Additionally, the markets have been looking for fiscal stimulus from Trump for over a year and finally got a taste of it via tax cuts. But that was two months ago and the associated deficits will increase government bond issuance.

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In a world of artificially low interest rates, the decade long search for return has been aggressive and unwavering. These dynamics not only incented weaker hands (who tend to sell at inopportune times) to dip their toes into unchartered territory, but also encouraged the development and adoption of new products and trading strategies. The rise of black box and high frequency trading strategies, coupled with Central Bank inflated appetite for return, has made markets more prone to the type of moves we witnessed in early February.

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As this business cycle wears on, we are focused on two things. First is dry powder and liquidity. That is making sure we have the ability to add exposure when volatility creates opportunities. Second is our investment time horizon. When faced with seemingly random and violent market fluctuations, the only way to avoid getting whipsawed is to take a step back and view the short term volatility in broader context of long-term investment objectives. That’s why now more than ever being able to see through near-term volatility and identifying long-run value is paramount.

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Lastly, this spike in volatility should not be met with fear and insecurity. Instead, it should be greeted with bright eyes and excitement. It is exactly these types of market environments that provide the opportunity for active managers to add value for their clients. That leaves us in a much better environment than practically all of 2017.

The Year In Review. The Year Ahead. And Bitcoin, Why Not?

As we move through the first few days of 2018, we would like to take a moment to reflect on the year gone by and provide some thoughts on the 12 months ahead. We hope 2017 was a good one for you and yours, and we wish you a happy, healthy, and successful 2018.

The Year In Review

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2017 was a year of synchronized global growth coupled with continued accommodative global monetary policy. With a backdrop of dismissed political/geo-political uncertainty and diminishing volatility, asset returns across the board were impressive. Equity markets marched higher and high yield bonds posted solid returns. The yield on the benchmark 10-year U.S. Treasury remained largely unchanged for the year, as the yield curve flattened in dramatic fashion. Investor complacency took over as volatility in all asset classes collapsed. Meanwhile, the Federal Reserve stayed true to their message from a year ago delivering three interest rate hikes along with starting the process of reducing the size of their balance sheet (quantitative tightening) by decreasing the amount of principal reinvested each month.

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On the fiscal side, the Trump administration managed to deliver on one of the cornerstones of his election promises – getting a tax bill done. In the short-run, we expect that the tax cuts will provide a modest boost to economic growth, but at the expense of an already dismal outlook for the U.S. deficit. The cuts are driven by a significant increase in deficit financing, so if substantially higher growth rates do not materialize as estimated (less than likely), then difficult political discussions will surely follow. Additionally, with wealth disparity continuing to swell and the increasing polarization of red/blue states due to the new limit on state tax deductions, this tax bill ensures that these conversations have little chance to turn towards moderation. Lastly, from a growth perspective, we are puzzled by the timing of this tax bill. Traditionally, these types of fiscal moves are saved for times of economic hardship instead of during periods of economic expansion. With the unemployment rate at 17-year lows and solid underlying momentum in the economy, it begs the question: what is the rationale for spending fiscal bullets now as opposed to saving them for a time when the economy is truly in need of fiscal stimulus?

The Year Ahead

Monetary Policy

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We expect an uneventful leadership transition at the Federal Reserve. New FOMC Chairman Jerome Powell is a noted consensus builder who has never voted against the majority during his tenure on the Federal Reserve Board of Governors. We expect him to continue the FOMC’s message of gradual rate hikes in 2018 while allowing for flexibility (should incoming data warrant a change in policy stance). With that said, Chair Powell’s job will not be easy as turnover within the Committee brings new faces and new egos to deliberations. The deeper into the current hiking cycle, the higher the stakes and costs associated with any potential policy miscommunication will be.

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Despite the Fed’s best efforts (three rate hikes and quantitative tightening), financial conditions continued easing in 2017. Equity markets and home prices increased, and corporate credit spreads tightened. Yields, aside from short maturities, have barely moved as term premium appears to be a thing of the past. Said differently, the tightening of monetary policy in 2017 has been more about removing accommodation rather than tightening financial conditions. This dynamic can’t, and won’t, last forever.

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The Fed forecasts three more interest rate hikes in 2018, while the markets are priced for less. At this point, our tendency is to take the Fed at its word, understanding that a significant drop in economic activity or a large increase in inflation will cause the Fed to shift its course. However, we are less concerned about the absolute number of rates hikes and more focused on the point at which rate hikes switch from being a removal of accommodation to actual tightening. Once there is more clarity on the latter, we would expect to see a dramatically different reaction in financial markets than seen thus far in the current hiking cycle.

Fiscal Policy

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President Trump campaigned on a pro-growth platform promising tax cuts, infrastructure spending, and the rollback of Obamacare and overly burdensome regulations. While executive orders rolling back regulations seemed to flow pretty frequently from President Trump’s desk over the past year, there were no large legislative gains until the fourth quarter. Just days before Christmas, the new administration got its first victory, passing the Tax Cuts and Jobs Act. The bill was marketed as a tax cut for the middle class, but seems to provide the most benefits to companies and those that can take advantage of pass-through entities. Starting in 2018, most American families will see the government taking less out of each paycheck, but those cuts are temporary, and a subtle change to the inflation measure buried within the tax code will slowly erode individual gains before the cuts eventually sunset at the end of 2025. There will continue to be arguments over the scenarios in which middle class families pay less; however, there is no arguing that the spoils of this bill will go to the wealthy and corporations.

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While the tax cuts look to be a short-term tailwind for the U.S. economy, the potential longer-run growth implications are less friendly. Most importantly, the bill increases the federal deficit by an estimated $1.5 trillion over 10-years. Legislators’ use of “Dynamic Scoring” to prove the bill’s worth is a red flag for potential suffocation of future long-term expansion. Using potential increased velocity of economic growth to pay for an outsized increase in deficits is pretty much a non-starter in most rational circles.

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Secondarily, we are not convinced that companies will suddenly increase wages and hiring while engaging in new capital expenditure plans – a key component that the tax cut proponents hark upon. Frankly, if U.S. corporations had projects and investments that would materially and positively affect their bottom lines, a tax cut is not the propellant – they would have acted already!

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Finally, the trillions of dollars held by U.S. companies in overseas subsidiaries only pertains to a relatively small number of firms and the technology sector represents the lion’s share. We are not convinced that big tech companies with newly repatriated cash is a stimulant for sustained, higher long-run growth.

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What having more cash – either via a tax cut or repatriation – does allow companies to do is continue with their shareholder friendly activity. Firms like Apple that issued large bond deals to finance higher dividends and buybacks can now retire some of that debt early and tighten up their balance sheets. With that said, deleveraging in response to policy changes usually takes place over long periods of time and any changes will likely be on the margin and depend heavily on corporate expectations for Trump’s re-election.

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With the tax bill passed, the administration will likely turn its attention to infrastructure spending and trade deals. We suspect that any movement on the infrastructure front will be difficult given current and expected future deficit levels. There is no arguing that American infrastructure is in need of attention, but given U.S. debt dynamics and the fact that brinkmanship remains the default political strategy in D.C., we are not placing high odds on the passage of a large infrastructure package for 2018. On the trade front, the administration has a clearer ability to more easily influence trade deals. We’ll be following the handling of NAFTA re-negotiations as a blue print for the new ‘America First’ stance on trade.

Economic Activity

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In our view, the probability of a recession in the next 12 months remains low. This is the 9th year of the current expansion (long in the tooth by any historical comparison), yet global growth looks robust and synchronized. All of the world’s top 45 economies grew in 2017 and are expected to do the same this year according the Organization for Economic Cooperation and Development (OECD). For much of the current expansion, the story has been one of the U.S. economy leading the global pack. That narrative has now shifted to one of global strength, which should help to prolong the current U.S. expansion.

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Looking at leading economic indicators, the U.S. economy is on solid footing. Manufacturing and non-manufacturing surveys remain elevated and measures of both consumer and business confidence are at, or near, cycle highs. The labor market, our preferred gauge of underlying economic trends, remains solid with steady month-over-month job creation. The unemployment rate sits at 17-year lows and new unemployment claims are historically low. The only piece missing is growth in wages as the average worker continues to see their purchasing power erode year after year. It is worth noting that some of the year-over-year wage measures are being skewed somewhat lower as a result of structural changes.

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Our long standing, accordion-like business cycle thesis remains intact. The unprecedented amount of monetary accommodation arising from the 2008 financial crisis stretched the typical business cycle from 4-6 years to an elongated 8-12. While the tax cuts are shrouded with uncertainty and only time will reveal the true unintended consequences, there are a few scenarios that we believe to be highly likely. The tax bill will help corporations the most, providing them the latitude for another round of financial engineering. This could propel stock markets even higher as their earnings ratios suddenly end up looking more attractive – even without top line growth. Secondly, the tax cuts should be a short-term consumption booster over the next year, maybe two. Lastly, the tax bill will spark a further polarization in U.S. politics as income inequality gaps grow wider, and Republicans use blunt swords to punish states that typically vote blue. None of these outcomes are beneficial to long-term growth and stability. In short, once this economic cycle ends, there is a probability of a deeper trough due to the end of year 2017 legislation than before.

Risks To The Outlook

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We continue to be amazed by the lack of volatility across all asset classes. The market seems willing to shrug off any negative geopolitical news. Whether it is the threat of nuclear war with North Korea, mass shootings or terrorist bombings, the markets hardly react negatively anymore. When they do, it’s short-lived as both Brexit and Trump’s election inspired initial selloffs only to spur a rebound to fresh highs. The complacency that has penetrated all corners of the market leaves asset prices susceptible to an abrupt reversal. However, unlike in 2007 and 2008, there is no big leveraged housing-type bubble hanging precariously over investors’ heads. Sure, an event that had previously been shrugged off by market participants may spark the beginning of the down-trade, but most likely it is something no one anticipates, save for a few “seers” who will live off that call for the next decade.

Ahh, But Isn’t Bitcoin A Bubble?

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Before diving into the weeds, let us be clear about how we view Bitcoin from an asset allocation perspective. We would never consider allocating any client capital to crypto currencies such as Bitcoin or funds that invest in the like. Digital currencies have yet to show fundamental value as an accepted medium of exchange for legitimate goods and services. With that said, just because we would never consider allocation capital to Bitcoin or other crypto currencies doesn’t mean the story isn’t interesting.

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Bitcoin is an open sourced digital currency powered completely by its users. Transactions are anonymous and irreversible, helping to create a level of perceived security that has increased the popularity of the cryptocurrency. While the unregulated and decentralized characteristics of Bitcoin have contributed to its success, these have also become some of Bitcoin’s (and others) biggest weaknesses. For Bitcoin, the cost of energy and computing power to mine an additional coin is now close to $6,000/coin and must rise in accordance with the algorithm. The number of available Bitcoins is only 21 million. Together, these problems characterize Bitcoin as more similar to Beenie Babies than Benjamins. If that is not enough, the increasing number of hacks (not unlike bank robberies) have highlighted the lack of ability to act as a store value. There are no authorities to either protect against or assist in reclaiming stolen Bitcoins. Additionally, there is almost no chance of reversing fraudulent transactions to recover stolen coins. So much for deposit insurance.

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Bitcoin and its brethren remain extremely risky, and bubble-like behavior should be enough to cause pause for any potential investor. Whether it was the South Sea Company, Dutch Tulip Mania, the Dot Coms, or the U.S. housing market last decade, Bitcoin’s chart looks pretty similar.

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Digital currencies are in their infancy and platforms like Venmo, PayPal, and others have infinitely more penetration with consumers. We expect subsequent iterations to address some of the shortcomings which could increase the probability of digital currency acceptance. While the future of Bitcoin is unknown, the Blockchain technology behind the digital currency appears to have broader implications. While its notoriety came from the rise of Bitcoin, Blockchain is not a currency-only problem solver. At its core, Blockchain is a public ledger containing every transaction ever processed for the asset in question. This verifies the validity of every transaction. Although originally designed for Bitcoin, Blockchain technology has greater uses elsewhere, far beyond the murky, uncertain world of Bitcoin.

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Within the financial markets, trades and settlements could become almost simultaneous through Blockchain, eliminating the need for intermediaries. Errors would be eliminated and security would be strengthened by using encryption technology rather than a standard username/password process. Smart contracts and stronger identity management are also potential applications. Blockchain can be programmed to automatically execute once certain conditions are met without a third party involved. Client verification can cross multiple markets and institutions, potentially reducing the duplication of customers’ due diligence requirements from increased regulations.

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All of this is to say that while get-rich stories associated with Bitcoin dominate today’s headlines, the more interesting story to us is the potential long-run implications of the technology across industries.