March Newsletter Pt 1: The Return of the Gorilla

Posted by Alex Frey (@alexhfrey )

Writing a newsletter that takes the “rational” approach to investing has its tough moments. Alarmist financial news sells for a reason – it’s novel, it provokes an emotional response, it plays to the cascading waves of fear and greed that all human brains are susceptible too. “Taking a long-term view” – while right – is not always as interesting. Nonetheless, we try to stay out of the mud here, and for the most part that means ignoring the day to day fluctuations of the markets. 

But this is an investing newsletter, and sometimes it’s impossible to ignore the 800 lb guerilla in the room, especially when it comes with a name. 

As you all know, the gorilla has returned to the stock market since we last wrote here. The gorilla’s name: volatility. So this month, we have a special two-part series. In the first part, we’ll look at how and why volatility has returned, and whether it portends the start of an economic recession. In the next part (which will go live at the end of the month), we will take a rational look at the underlying valuation of the stock market.

Prognosticators are always talking about a “spike” in this or that. If you want to see what a true “spike” looks like, check out Figure 1. The plot shows the S&P 500 index and the VIX index for the past year. For those of you who aren’t familiar with the VIX, it uses option prices to determine how much volatility investors are expecting in the coming month. A high value means that investors are expecting a lot of volatility. For the past year, until very recently, the S&P500 was having a smooth ride up, and the VIX was slowly declining. Now, out of nowhere, volatility is back, the S&P 500 has dropped (and regained much of the drop), and the VIX has taken a big jump up. 

As a somewhat amusing aside, there was an ETF (stock symbol XIV) that was structured to follow the inverse of the VIX (to rise when the VIX falls and vice versa). Figure 2 shows how this ETF fared over the last five years. After steadily rising for most of the past year, it quickly fell to near zero on February 6 and was disbanded on February 16. Perhaps this is a lesson to stay away from exotic investment products.

Img1Figure 1: The performance of the S&P 500 and the VIX index for the past year.

Img2Figure 2: XIV share price for the past 5 years. Steady uptrend since early 2016, then…. Oops.

So why has volatility returned? 

Many pundits suggested that recent data on wage growth and the consumer price index (CPI) stirred the markets. The Bureau of Labor Statistics reported that the consumer price index grew 2.1% over the past year (December to December), and the average hourly wage (not inflation adjusted) grew 2.9% (January to January). These data could indicate that a revival of inflation is imminent. In response to these data (and in response to the increase in federal funds rate, which is set by the Federal Reserve), the interest rate on 10-year treasury bonds has risen from 2.42% a year ago to 2.89% as we are writing this. Rising interest rates decrease the value of stocks, which you can see in two ways: 1) As bonds yield higher returns, they become more attractive investments vis a vis equities, 2) To value you a stock, you must discount the future value of the companies cash-flows to equity at a discount rate, as interest rates rise so does that discount rate, lowering current values.
Of course, it’s a bit fruitless to try to pin down the direct cause of any market move. The simple fact is: volatility has, for at least the moment, returned. To gauge how scared we shall be, let’s take a look at the fundamentals. 

The thing that concerns most investors is the prospect of either another recession or, worse a 2008-style financial crisis. But before looking at the economic fundamentals, it’s worth pondering – is that even the right thing to focus on? Intuition says there should be a strong correlation between the performance of the economy and the performance of the stock market. The level of the gross national product (GDP) controls corporate revenues. Profit margins may vary (they are currently very high by historical standards), but competition should provide some limits as to how much they can vary. High profit margins should attract new competitors, and low profit margins should discourage new competitors and cause some old competitors to drop out. So, in the long run, corporate profits should be correlated with GDP, and market prices should be correlated with profits. 

Data supports this view, although the correlation is certainly not perfect. Figure 3 shows how the annual total return on the S&P 500 compares with the annual variation in GDP for the last 20 years. We have multiplied the changes in GDP by 5 to make the comparison easier. The correlation between the two is quite good. Figure 4 shows the same comparison for the years from 1968 to 1998. In this case one can see cases where the market was out of sync with the economy, but the correlation is still fairly good. So, we accept the intuitive conclusion that a strong economy is good for stocks and a weak economy is bad for stocks.

Figure 3: Comparison between the real growth rate of GDP and the real return on the S&P 500 for the past 20 years. The GDP growth rate has been multiplied by 5 to make comparison easier. S&P 500 data is from Robert Shiller’s online data base. GDP data is from the Federal Reserve Economic Data (FRED).

Img4Figure 4: Comparison between the real growth rate of GDP and the real return on the S&P 500 for the years from 1968 to1998. The GDP growth rate has been multiplied by 5 to make comparison easier.

So, what are the economic prospects in the U.S. now? We were sympathetic with a recent headline in the Economist magazine that mentioned “America’s extraordinary economic gamble”. They were referring to the recent tax cut and the effect that it will have on the economy. The U.S. already has a significant budget deficit, and that deficit was predicted to increase, for demographic reasons, even before the tax cut. Most economists think that the tax cut will increase the deficit. In addition, Congress recently approved significant spending increases for the next two years. The Economist magazine estimates that the U.S. annual deficit will reach $1 trillion (about 5% of GDP) in 2019. Deficit spending can stimulate an economy (it’s called a fiscal stimulus). When unemployment is high, and the economy has surplus capacity, conventional economic theory says that deficits can stimulate economic growth without causing inflation. But the U.S. economy has been growing for nine years, and the unemployment rate has fallen to the lower end of the range that the Federal Reserve considers to be full employment. In this situation, conventional economic theory says that fiscal stimulus is likely to cause inflation and higher interest rates that negate the positive effect on growth. In fact, by crowding out private investment, the deficits may reduce the rate of growth.   

Of course, those who support the tax cuts have some arguments on their side. 

First, the U.S. may not be as close to full employment as the headline figures indicate. The labor force participation rate (the percentage of the population that is employed or looking for work) peaked around 2000. The trends for potential workers between 25 and 54 years of age are shown in Figure 5. Although there has been a recent increase, the current participation rate is well below the 2000 peak. Presumably, many of the missing workers left the labor force because they were discouraged, and perhaps they could be drawn back into the labor force by a robust economy. If so, the potential supply of labor might be greater than most people think. 

Second, productivity growth in the U.S. has been quite low recently as compared to historical growth rates. Figure 6 shows the historical trends in productivity. The recently enacted tax cuts were concentrated on corporations, and the tax cuts might induce corporations to begin making productivity increasing investments. A tightening labor supply could provide more impetus to such investments, and improvements in robotic technology and artificial intelligence (AI) create many possibilities for significant gains in productivity. If this happens, the combination of faster than expected labor force growth and faster than expected productivity growth could allow the economy to grow much more rapidly than most economists expect. If productivity growth returned to its post WWII average of about 2.2% per year, that alone could make a significant difference. And of course, more rapid economic growth would increase tax revenues and decrease the deficit. 

So, the outcome of the great experiment will be determined by whether productivity and the labor force can grow fast enough to overcome the increase in debt. Frankly, we doubt that it can, but we would like to be proved wrong.

Figure 5: Civilian labor participation rate for ages 25 to 54 years.

Img6Figure 6: Non-farm labor productivity. The data is from the Federal Reserve Economic Data (FRED) and is presented as a four-year trailing average (annualized). 

Another way to look at the debt issue, is to look at the combined government and private debt. Many economists believe that the total debt gives a better picture of how the debt may affect economic performance. Figure 7 shows the government, private, and total debt for the United States. The government debt includes state and local government but excludes debts that the government owes to itself. The private debt includes only non-financial entities, i.e. it excludes banks and financial intermediaries. The total debt as a percentage of GDP is close to the peak that it reached at the end of WWII (not shown in the figure), but it has been stable for the past few years. The tax cuts and the spending increases that we recently passed could change this picture, and we could soon begin to see debt increasing as a percentage of GDP. The potential problem here is that servicing this debt could become a significant problem if interest rates continue to rise.

Figure 7: Government, private and total debt for the United States. Debt the government owes itself has be excluded from the government debt. Data is from FRED. 

So far, we have only discussed the U.S. economy, but IvyVest investors invest internationally and international trends are equally important. Here there is good news. In 2017, for the first time in years, all major sections of the world were growing, although growth in South American was very slow. GDP growth rates in 2017 for various areas were as follows; U.S, 2.3%; the Euro area, 2.5%; China, 6.9%; Japan, 1.6%; India, 6.3%, all of Asia and the pacific region, 5.5% (estimated). When all areas are growing, there are synergistic effects that help everybody, and U.S. and international stock markets should benefit. 

Of course, debt can be a concern to international economies. Figures 8, 9, 10, and 11 depict the debt situation in the Euro area (the countries that use the Euro), emerging market countries, China (China is also included as one of the emerging market countries), and all advanced countries (the Euro area and the U.S. are also included among the advanced countries). In the Euro area debt as a percent of GDP seems to have stabilized in the past few years and may even be very slightly declining. As a percent of GDP, debt in the Euro area is slightly greater than in the U.S. Looking at all of the advanced economies, total debt seems to have stabilized, albeit at a rather high level. In the Emerging Market countries, debt is increasing at a worrisome rate, but total debt as a percent of GDP is well below that in the U.S. and the Euro area. China is a dominant contributor in the Emerging Market sector, so it is interesting to look a China by itself. Debt in China has been increasing rapidly. Most of the debt is in the private sector, but the total debt in China is very similar to that in the U.S. and Europe, and the trend is a concern. China creates demand for products from many countries, and a slow down in China could affect many countries. 

Our summary of all of this is that the revival of volatility was not driven by a fundamental deterioration in the world economy. Instead, the world economy is currently functioning very well. The main risks are high levels of total debt (public + private) and a pickup in inflation. Rising bond yields may have already priced some of this in, and this might have been part of the cause of the stock market slump. But it’s too early to say whether this is the long-awaited end of the thirty year bond bull market or not. Elevated levels of debt have been a feature of the economy for some time and it's difficult to predict when they will hit a tipping point and "break" (i.e. cause another financial crisis). 

The gorilla is back -- but it's too early too suggest he portends a complete economic meltdown. Does that mean that equity markets will be spared? It's too early to say that as well. In the next installment of this month's letter we'll look at the other fundamental backdrop to this all -- valuations. If markets are truly in a bubble territory than even a single gorilla might be able to wreck a lot of havoc. 


Figure 8: Debt as percentage of GDP for the Euro area countries. Data is from the Bank for International Settlements.

Img9Figure 9: Debt as percentage of GDP for the Emerging Market countries. Data is from the Bank for International Settlements.


Figure 10: Debt as percentage of GDP for China. Data is from the Bank for International Settlements.

Figure 11: Debt as percentage of GDP for all advanced countries. Data is from the Bank for International Settlements.

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By Alex Frey