The “Reach For Yield Is Spreading” by Worth Wray – STA Wealth Management
INSIDE THIS EDITION:
The “Reach for Yield is Spreading”
For What It’s Worth
Weekly Technical Comment
Features Articles & Interviews
We will be hosting an Open House event entitled “Portfolio Construction for a Stormy Market” on Wednesday, September 7, 2016 from 6:00-8:00 o’clock in the evening and we will be honored to have you attend. Here we will discuss not only current market conditions and how they will affect you but more importantly how to prepare and plan financially in spite of them.
Please take advantage of this opportunity and confirm your attendance to the Open House and REGISTER HERE. Seating WILL be limited.
We look forward to seeing you!
Economic Growth Slows and the Fed Talks of Raising
Written by: Luke Patterson
CEO & Chief Investment Officer
Overall economic growth has been tepid since late last year, with GDP advancing at a modest pace of 0.9% in the fourth quarter of 2015, 0.8% in the first quarter of 2016, and 1.1% in the second quarter.
Friday’s revised report showed slightly weaker second-quarter GDP growth compared with the government’s initial estimate last month of 1.2%.
Also, last week the Fed governors met in Jackson Hole, Wyoming, and the market took notice of the Fed Chair’s commentary.
Janet Yellen’s main sermon was about the tools the Fed could utilize in the future when easing will be required, and what made headlines and caught the market’s attention was this:
“Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months”
Investor’s clearly took notice with bond yields rising to two-month highs and the equity market suffering from its worst week since the Brexit referendum (Dow -0.8%, the S&P 500 -0.7%, and the NASDAQ -0.4%).
Tightening into a one percent growth economy and a six-quarter long profits recession is a risky game to play. But this is the same Fed that pulled the trigger last December under similar macro conditions.
No doubt the Fed has made the threats before. Whether you look at the “taper tantrum” of three years ago or the pledged four hikes at the start of 2016, we have been here before.
The general investing public buys the least at the bottom and the most at the peak. Global bond funds posted a $6.6 billion net inflow last week and the intake during this QE era is approaching the $1 trillion mark. Investors continue to chase returns here, returns that can only occur if yields become even more microscopic or, in some cases, more negative.
Take note – all “crowded” trades that worked well on the Fed-on-the-sidelines view could be on the receiving end of a serious test in coming weeks and months. Friday’s response to the Jackson Hole commentary by the Fed should be used as a template of what to expect if the Fed isn’t bluffing again.
The “Reach for Yield is Spreading”
In last week’s report we featured a piece entitled “Quest for Yield”. Well… the quest continues as investors seek income and the increase in portfolio risk is the result of desperate maneuvers to fill the shortfall in state pensions.
According to The Pew Charitable Trusts state pension funds are looking at a $1 trillion shortfall in what they owe workers in benefits. While many states have cut benefits to new workers and frozen plans for current staff, they cannot cut benefits that have already been earned by public employees. That means they have to find money to make up the shortfall by cutting other programs, raising taxes, generating higher returns or some combination.
Pew reported that states were to make up $35 billion of their unfunded liabilities in fiscal 2014, leaving a shortfall of $934 billion. That’s because of stronger returns in 2014, but returns fell again sharply in 2015, to just 3 percent. Those lower returns mean states with badly underfunded liabilities will have to come up with more money to fill the shortfall.
States with the biggest funding gaps include Illinois and Kentucky, the two worst-funded systems, with just 41 percent of what’s needed to pay the benefits promised to public employees. New Jersey has set aside just 42 percent. Only three states have set aside enough money to fully pay retirement benefits owed to current and future retirees: South Dakota, Oregon and Wisconsin. For those of us in Texas, the Lone Star State has just over 80 percent of what is needed.
With few options and time running out to fill these pension shortfalls. The “reach for yield” is spreading to U.S. pension funds. They are now employing option strategies in an attempt to increase the yields on their portfolios. What could possibly go wrong?
In this case, they are selling put options on the S&P 500 which produces income but they in turn bear the risk if stock prices fall. This process is sometimes called selling portfolio insurance because others will buy these options to protect their account from declines. The Wall Street Journal reports pension funds in Hawaii and South Carolina are now doing this with the thought this income will protect against declines in the U.S. stock market. In reality, they are essentially increasing their exposure to losses if the market falls quickly.
Typically, as long as the stock market remains unchanged or higher, the pension funds will keep the premium they receive for selling this insurance. If the stock market declines, they will have to pay those who purchased protection from them in an amount equal to the losses incurred. Generally, the bigger the stock market decline the more they would pay out.
Even more troubling, the pension funds are misunderstanding the likely effect on their portfolios. The pension funds believe this strategy will reduce risk. However, past returns show this will likely increase portfolio risk and the correlation to the stock market. Not likely the desired outcome that is needed.
For What It’s Worth…
R* You Ready for a Global Shock?
Written by: Worth Wray
Chief Economist & Global Macro Strategist
- 2016 has been a year of desperate central bank intervention to contain the US dollar, support a global reflation, and buy time for major governments to build on this fragile peace in the currency war.
- This “Shanghai Accord” has held the world together for six exceptionally strange months, but time is running out as political pressures in fragile economies change the incentives for central banks to put global stability ahead of their domestic mandates.
- Japan is getting desperate. The Euro area is slowly tearing apart. Oversupplied commodity markets aren’t seeing the demand growth most analysts expected going into this year. And China’s incentives to cooperate with the Western world are quickly fading away as a number of key dates (the G-20 meeting on September 4-5, the RMB’s inclusion in the SDR on October 1, and the US Presidential election on November 8) come and go.
- Needless to say, the Fed is in a tough spot. That may explain why Janet Yellen and her closest colleagues (Fischer & Williams) are simultaneously laying out the groundwork for a radical rethink in the Fed’s policy framework while they talk up the data-driven need for another rate hike in the near future. It may signal that – just as the Fed is preparing the hike interest rates – it’s also preparing to respond to the shock(s) that may follow.
- Contrary to Fed attitudes in recent years, this change of heart may be the result of long, hard contemplation about the impact of weak productivity growth and aging societies on economic performance, or it could be an intentionally timed attempt to get out in front of a major shock before it happens.
- With all that in mind, my colleagues and I on the STA investment committee continue to take a conservative posture in our client portfolios with an underweight allocation to equities, an overweight to high-grade fixed income and yield-generating real assets, and a healthy allocation to defensive assets like gold and managed futures.
- The prospect for a global FX shock may seem unsettling, but we believe it’s exactly what global markets need to bring good assets back to reasonable prices.
Is the Shanghai Accord Set to Expire?
As longtime FWIW readers know, 2016 has been a year of desperate central bank intervention to contain the US dollar, support a global reflation, and buy time for major governments to build on this fragile peace in the currency war (“Did Central Banks Just Save the World” & “An Offer They Can’t Refuse”).
Even in the wake of Brexit, even with European banks melting down, and even with Japan falling back into deflation, this “Shanghai Accord” – so named for the G20 meeting this past February where policy elites from the US, EU, Japan, & China struck a secret deal to stave off a global crisis – has now remained in effect for six exceptionally strange months.
By temporarily putting global stability ahead of their domestic mandates, they’ve bought time for governments to swing into action. The trouble is, lynchpin governments like the United States and Germany continue to drag their feet on debt-driven fiscal stimulus and unpopular structural reforms.
Like I’ve written for most of the year, stability only lasts as long as the trade-weighted US dollar stays range-bound. If it breaks higher, we can expect a fall in commodity prices, a pick-up in Chinese capital outflows, and a sharp fall in emerging market currencies; but if it breaks lower, we can expect major crises in Europe and Japan as local currency strength throws the world’s largest debtor-states back into deflation.
From that perspective, time is finally running out as political pressures in fragile economies change the incentives for central banks to keep working together in good faith.
Japan is getting desperate. The Euro area is slowly tearing apart. Oversupplied commodity markets aren’t seeing the demand growth most analysts expected going into this year. And China’s incentives to cooperate with the Western world are quickly fading away as a number of key dates (the G-20 meeting on September 4-5, the RMB’s inclusion in the SDR on October 1, and the US Presidential election on November 8) come and go.
Needless to say, the Fed is in a tough spot & that’s where I want to focus this week as market expectations for another rate hike storm back ahead of next week’s G20 meeting.
“Fed Imperils G20 Calm”
Just look at this stunning headline from Bloomberg’s Justina Lee:
By throwing massive fiscal and credit stimulus at the Chinese economy throughout 2016 and publicly insisting on a stable RMB “at all costs,” Beijing has completely flipped the Western media narrative over the last six months.
When the yuan gradually falls against a trade weighted FX basket, it’s seen as an encouraging move toward a more market-oriented currency. And when it slides against the US dollar, Beijing now looks more like a victim rather than an aggressor.
It’s a HUGE win for Chinese policymakers who – as I wrote a couple weeks ago (“Yuan Year Later”) – are quickly running out of options.
Contrary to popular belief, Beijing is no longer the master of its own destiny when it comes to the RMB. Massive stimulus has failed to reinvigorate the economy as credit growth loses its effectiveness. Chinese residents are voting with their feet. And the State Administration of Foreign Exchange (also known as “SAFE”) has failed to stem the tide of ongoing capital flight, which only moderated this Spring as a result of broad US dollar weakness.
Though the market still believes that China’s $3.2 trillion in foreign exchange reserves give Beijing the ability to defy market forces indefinitely, the truth is that this “war chest” pales in comparison to the country’s massive and constantly growing $22 trillion M2 money supply.
As I told Bloomberg’s Sid Verma in a recent interview (“Why We Still Need to Worry About China’s FX Reserves”), that leaves Beijing with an FX reserve/M2 ratio of just 14% if we ignore the fact that roughly a third of these funds are illiquid… not much in the event that a firming US dollar leads to accelerating outflows.
Fortunately for China, the RMB’s inclusion in the IMF’s Special Drawing Rights (SDR) reserve currency basket on October 1 comes with a few requirements – namely, that China will continue to open its capital account (i.e. to let money flow more freely into and out of the country) and that it will allow the RMB to become more freely useable over the relatively short-term.
That gives Beijing the cover it needs to float the RMB under a narrative of bold, IMF-endorsed reform as opposed to competitive devaluation. And, unless major and/or central banks agree on an orderly process for China’s next big exchange rate announcement, it can happen literally any day.
In my mind – and in the Fed’s – it’s one of the biggest macro risks in the world today, but as my friend and Segra Capital CIO Adam Rodman points out, it also may be one the most unavoidable.
“It is my opinion that, given where China currently sits in their economic and credit cycle, a weakening currency is simply one of the many natural economic adjustments that should take place as part of rebalancing. We’ve witnessed several examples of currency devaluations in other economies without the same level of stigmatization (it has most often been applauded). I think it’s unfair that China should be held to an exceptional, and separate standard. Domestic liquidity conditions, net balance of payments, relative growth and inflation, should be the objective metrics by which the market judges fair value for any currency, including the renminbi.”
So why, then, is the Fed suddenly so eager to hike interest rates with the risk of a Chinese currency adjustment steadily rising?
Why has everyone from Fed Chair Yellen and Vice Chair Fischer to NY Fed President Dudley and St Louis Fed President Bullard come out in favor of a September and/or December hike when doing so could force China to float the RMB and send an epic shockwave through global markets?
Some Fed watchers will speculate that the Fed is trying to set China up for a contentious and/or embarrassing G-20 meeting, or that the Fed is threatening Beijing with rate hikes the same way Beijing has periodically threatened the Fed with a weaker RMB over the last year.
But I think there’s a simpler explanation.
While Yellen plays a key role in whatever deal the US, EU, Japan, & China struck back in February, it’s almost certainly above the rest of the FOMC’s pay grade. I’m sure they’ve all heard the rumors by now, but plausible deniability is an invaluable thing when a central bank is reaching beyond its domestic mandate in an election year.
That’s why San Francisco Fed President John Williams can stand up in front of a crowd and laugh off the idea that something happened in Shanghai, while A-list financial historian & elite global macro consultant Niall Ferguson calls it “the most interesting question of the year.”
As far as the rest of the FOMC is concerned, the volatility in the financial markets and weakness in the incoming economic data earlier this year warranted a distinctly dovish downshift from its previous guidance for four rate hikes in 2016. While the Fed had what it needed to hike rates in June, they had to be careful in the run-up to the UK’s In/Out referendum. And with the ultimate fall-out from Brexit still up in the air, they could not come to a strong enough consensus to hike in July.
Again, the Shanghai Accord has bought more time than I imagined back in March, but here we are – six months later – and the Fed is a lot closer to achieving its dual mandate.
As you can see in the chart below, the labor market continues to post solid gains…
… while mainstream economists continue to forecast a meaningful increase in both headline and core PCE (the Fed’s preferred inflation measure).
In other words, “the case for an increase in the federal funds rate has strengthened in recent months” – as Ms. Yellen noted just last week – and the votes appear to be there as policy doves like Bullard, Dudley, and Rosengren get behind the push for a 2016 rate hike (as long as the incoming economic data continues to justify a move).
Rather than putting global stability ahead of its domestic mandate, the Fed is now in a position where it’s breaking away from the rest of the world at a critical moment.
To be perfectly clear, I don’t see a huge risk in the Fed singlehandedly driving the dollar to dangerous heights since every FOMC voter – including the hawkish Kansas City Fed President Esther George – obsessively emphasizes that future rate increases should be slow and gradual (assuming the data continues to warrant additional hikes at all).
Still, even a modest rise in US rate expectations can have a firming effect on the dollar so that foreign central banks and/or foreign shocks – like another “shock & awe” easing announcement in Japan, a sudden RMB float, or a Brexit-like result in Italy’s upcoming constitutional referendum (which could require a big increase in ECB easing measures) – can drive the trade weighted basket to problem levels for the world economy.
At minimum, the Fed’s latest communication blitz could lead to a period of risk aversion in global markets as it remains stuck in a self-reinforcing feedback loop.
Then again, it could end the cycle and bring on a recession either as a function of pushing the already weak US economy over the edge or by triggering spillback from the outside world.
I’ve been writing about these risks incessantly for the last four months, so I know I may sound like a broken record. But it’s all coming together exactly as I feared. And, oddly enough, it’s happening almost exactly on the timeline that former Fed insider and Jeffries’ Chief Market Strategist David Zervos outlined back in April.
Risks are clearly on the rise – this time maybe to a crescendo – but what’s even more interesting is how this story is evolving.
R* You Ready for a Global Shock?
At the same time that Fed Chair Janet Yellen, Fed Vice Chair Stanley Fischer, and San Francisco Fed President John Williams are pushing for another rate hike in the coming months, they’re also laying the groundwork for a radical “rethink” in the Fed’s policy framework.
Technically speaking, their argument focuses on the natural rate of interest (also known as R* in economic circles). Without getting too deep into the details, just imagine that this is the ideal interest rate that leads to full employment without too much inflation.
If the Fed keeps rates too low for too long, you get asset bubbles and inflation as the economy overheats. If it keeps rates too high, you get higher unemployment as the economy runs below potential and/or falls into recession. So the theoretical goal at this stage in the cycle is to set interest rates as close to that ideal level as possible to avoid distortions and/or disruptions in the broader economy.
Of course, this model-driven framework ignores the fact that we are living in a highly leveraged, highly interconnected, and incredibly complex global system that’s extremely vulnerable to international ripple effects.
Like the OECD’s William White told me last summer, “If we have a problem anywhere in the global economy, it is going to translate into a problem everywhere.”
But assuming the Fed’s academic approach actually works, the tricky part is figuring out how the natural rate evolves over time depending on the vitality of the overall economy. On that note, Ms. Yellen made an important comment at the June FOMC press conference that her colleagues have continued to build on in recent weeks.
In addition to pointing out that “persistent factors” like slow productivity growth and aging demographics may be “holding down the longer-run level of neutral rates,” she went on to say “all of us are involved in a process of constantly reevaluating where the natural rate is going, and I think what you see is a downward shift in that assessment over time… that maybe more of what’s causing this neutral rate to be low are factors that are not going to be rapidly disappearing but will be part of the new normal.”
Translation: Structural headwinds in the US economy may call for interest rates to stay lower for longer and, since that means interest rates may not rise back to levels that provide a buffer against the next recession, the Fed needs to rethink its entire policy framework.
That’s right in line with Williams’ August 15 paper (“Monetary Policy in a Low R-star World”), more or less consistent with Fischer’s August 21 speech at the Aspen institute, and it’s exactly what Ms. Yellen articulated in her August 26 speech in Jackson Hole.
All this may seem a bit dry and technical, so allow me to connect the dots for you.
Just as the Fed is preparing to hike interest rates, it’s also preparing to respond to the global shock that may follow (or may transpire regardless of a Fed hike).
That’s why she offered this chart last week to highlight the uncertain of path of the fed funds rate, which could supposedly range between 0.25% and 4.75% by the end of 2018.
“The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted,” she explained. “When shocks occur and the economic outlook changes, monetary policy needs to adjust.”
Did you get that?
Rather than sticking with a strong and optimistic narrative, Ms. Yellen has finally realized just how vulnerable the US economy is to a game-changing shock from abroad… almost as if she expects one in the coming months.
She’s carefully laying out her bag of tricks for all the world to see, including forward guidance, large scale asset purchases across a broader range of assets, raising the 2% inflation target, or even explicitly targeting a level for nominal GDP.
This change of heart – coming just ahead of the G20 leader’s summit as the dollar begins to firm and the RMB starts to slide on greater 2016 Fed hike expectations – could be the result of a sudden epiphany about the impact of weak productivity growth and aging societies on economic performance (in the case of Williams’ argument), or it could be a carefully planned attempt to get out in front of a major shock before it happens (in the case of Yellen’s and/or Fischer’s argument).
I’m not saying that the Fed can prevent a global shakeout if the Shanghai Accord breaks down the currency war returns with a vengeance. But they’re clearly worried with limited room to maneuver until some kind of foreign event justifies a radical shift in policy.
At that point, we can expect the Fed to act aggressively to support the US economy – but namely to reign in the dollar.
As I’m putting the finishing touches to this letter at 8:26 on a Texas Tuesday morning, here are the headlines rolling across my computer screen.
Bloomberg: “The Yuan’s Recent Stability May Be Coming to An End”
MarketWatch: “Dollar Moves Higher as Investors Watch for More Fed Talk”
Now, I don’t suggest investing purely on headlines. But it’s interesting to see the ideas we’ve been discussing for months at STA work their way into the popular narrative. Of course, most investors still aren’t putting the pieces together… which tells me there’s still a lot of untapped opportunity.
While hedge fund legends like Mark Hart, Kyle Bass, and John Burbank can exploit these events directly by shorting the Chinese currency or making other asymmetric bets (big upside with a small & defined downside), you probably can’t afford to put these trades on if you have less than $25 or $30 million.
But you can absolutely play defense as we wait for a major correction to bring great assets back in line with reasonable prices.
Are you ready for a global shock? It sure seems like Ms. Yellen is as ready as she’ll ever be.
-Worth Wray, Chief Economist & Global Macro Strategist
Weekly Technical Comment
Written by: Luke Patterson
CEO & Chief Investment Officer
S&P 500: Long-Term Indicators Overbought…
The market has been reaching recent new highs and as a result, there is a tendency to focus on the shorter-term picture. People know that much of the market is manipulated by global central bank policy and even high frequency trading activities. With this in mind, I thought it would be a good idea to look at a trio of long-term indicators that tend to escape our immediate attention. The first is the 1% EMA of the Advance-Decline Ratio. Exponential Moving Average (EMA) is a moving average that gives greater weight to more recent data in an attempt to reduce the lag of (or “smooth”) the moving average.
Without going more into the indicator, let me just say that it is actually a 200 EMA of the Advance-Decline Ratio. That is the light brown index on the chart. Even with such a long-term EMA, it tends to be somewhat erratic. A 50 EMA (the overlaying black line) of it would be more useful. Zero line crossovers of the 50EMA generate long-term buy and sell signals, but I think that the more useful information is to identify overbought and oversold conditions when the 50EMA reaches extremes in the normal range. Currently, the indicator is very overbought.
The next indicator is the Percent of S&P 500 Stocks Above Their 200 EMA. At 77% it is also overbought, though not to the extreme it was in 2014.
Finally, we have the PBI (Percent Buy Index) for the S&P 500, which expresses the percentage of stocks on Price Momentum Model (PMM) BUY signals. At 82.8% it is also in the overbought part of its normal range.
While all three indicators are overbought, there is another critical piece of information that needs to be considered before reaching any conclusions: the SPY 50EMA is above the SPY 200EMA. By my definition that means that SPY is in a bull market, and should be considered in portfolio analysis and construction.
In a bull market, overbought conditions are less likely to result in serious corrections. From 2012 we can observe numerous corrections/pullbacks within the larger up trend, demonstrating the constant upward bias exerted by the bull market. The only time that was in doubt was during the sideways consolidation from August 2015 to February 2016.
CONCLUSION: Long-term indicators are quite overbought and they warn that a pullback or correction is likely, but that warning is mitigated by the fact that we are in a bull trend. Under these conditions it is probably not a good time to be opening new long positions, but it is also not a good time to go short. Caveat: This is my view in an intermediate-term context, not a recommendation.
Sector Relative Rotation Model
The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.
The chart below (updated through August 30, 2016) indicates relative strength (relative to the S&P 500 Index). Healthcare, Technology and Small Cap stocks are leading relative to the S&P 500. Consumer Staples and Consumer Discretion stocks have lagged. Materials, Industrials, Utilities, REITS and Energy indicate weakening, and Financials indicates improvement in the model. Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline.
Note: There are four quadrants on the chart:
- Leading (Green) – strong relative strength and strong momentum
- Weakening (Yellow) – strong relative strength but weakening momentum
- Lagging (Red) – weak relative strength and weak momentum
- Improving (Blue) –weak relative strength but improving moment
Featured Articles & Interviews
- Monday, August 29, 2016 – Mary Beth Franklin
Scott Bishop, Director of Financial Planning at STA Wealth hosted a special edition of the STA Money Hour with Guest Mary Beth Franklin, CFP®. If you are planning for your retirement, you should know that significant and long-term financial gains can be achieved by maximizing your Social Security benefits.
- Monday, August 15, 2016 – Michael Smith
Michael Smith and Matt Patrick Discuss U.S. Household Debt. 1 in 7 U.S. Households Have a Negative Net Worth.
- Thursday, July 21st, Grant Williams
Michael Smith and Worth Wray Interviewed Grant Williams. Worth, Mike and Grant spoke about the current Global Economic Environment, US Stocks, Monetary Policy and Gold. Grant is the author of the popular investment letter Things That Make You Go Hmmm… and co-founder of Real Vision Television. He has 30 years of experience in finance on the Asian, Australian, European and US markets and has held senior positions at several international investment houses. Grant is also a senior advisor to Vulpes Investment Management in Singapore.
If you have any questions, please feel free to email me at [email protected].
STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Worth Wray, Chief Economist & Global Macro Strategist
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.