Via ConvergEx's Nick Colas,
Today we offer up five market counterfactuals – “What ifs” – to both illustrate why large cap U.S. equities just closed near their highest levels of 2016 and consider the conventional wisdom about whether the current rally is sustainable.
Our home base: where asset prices and other trends started the year.
For example, global interest rates began 2016 at much higher levels: the U.S. 10 year at 2.24% (now 1.80%), German Bunds at 0.64% (now 0.11%) and Japanese government bonds at 0.27% (now -0.28%). Where would U.S. equities be if global yields were unchanged this year? (Spoiler alert: lower.) Or consider crude oil prices, up from $37/barrel to $49/barrel, lifting large cap energy stocks by 11% and responsible for 25% of the S&P 500’s gains YTD. Then there is the recent worry over global smartphone sales and what that means for mega-cap Apple (still 3% of the S&P 500), which has clipped market returns by 0.21% (7% of total). The dollar – down 3% in 2016 – is another item on the “what if” list, but the elephant in the room is “What if Donald Trump were not the Republican nominee?” Markets seem to have ignored him for now, but can that continue into the general election season?
What if President John Kennedy had rolled out of Dealey Plaza unharmed? Would he have avoided a larger military entanglement in Vietnam? Or more quickly embraced the civil rights movement than his successor? Would it have been John Jr running for President in 2008, or now? And would Marilyn Monroe ever have become first lady, as she reportedly told Jackie was her goal?
The term for that kind of scenario analysis is “Counterfactual thinking” – considering possible alternative events to those that actually occurred. What if you had majored in Classics instead of Business, or married someone besides your current spouse? How would your life be different? Would you be happier? Poorer, but happier? (Yes, that’s a thing.)
Today we’ll unpack the current U.S. market through the lens of 5 counterfactuals, all anchored in a prior reality: where the world was 155 days ago, at the end of 2015. Our goal is to highlight what has taken the S&P 500 to its highest point in 2016 and assess the sustainability of current valuations and market dynamics.
#1: What if global interest rates were the same as 12/31/2016?
Since the start of the year, global long term interest rates have fallen dramatically:
· US 10 year Treasuries went from a 2.24% yield to 1.80% today.
· German 10 year Bunds yield just 11 basis points now, down from 64% bp on New Year’s.
· Japanese 10 year government bonds now sport a negative 11 basis point yield, down from 27 basis points at the start of 2016.
The reasons for these declines are largely due to punk economic growth in Europe and Japan combined with central bank bond buying in those regions. This has pulled U.S. rates lower in their wake, even though domestic economic growth is grinding modestly higher. Lower rates make equities look more attractive (at 2.1% the S&P 500 yields more than a 10 year Treasury) and, voila, you have a rally in U.S. stocks.
Our Answer: U.S. Equities would likely be down on the year if interest rates were unchanged. The tipping point here relates to economic and corporate earnings growth balanced against nominal interest rates. The central narrative surrounding capital markets is that global growth is very slow for a variety of fundamental reasons. Therefore if global yields were unchanged even with current central bank bond buying, it would be due to an increasing fear of inflation. Good for policymakers and their goals, but likely bad for stocks.
#2 – What if crude oil prices were unchanged in 2016?
The year began with spot West Texas Intermediate trading at $37/barrel and now trades for $49/barrel, up 32% YTD. The move higher has both lifted large cap energy stocks by 10.8% and reassured capital markets that we are not at the brink of global recession. Many investors look at oil prices as the blood pressure reading of the world economy – you don’t want it too high (inflationary hypertension) or too low (deflationary coma).
Our Answer: higher oil prices have been very helpful in reestablishing investor confidence in everything from U.S. economic growth (we are still by far the largest oil consumer country in the world) to Chinese economic expansion (they are #2) to the relative stability of many oil-producing countries. The most easily quantifiable benefit: at 7% of the S&P 500, the energy sector’s 10.8% YTD rally means that oil’s rise is responsible for some 25% of the entire rally this year in large cap U.S. stocks.
#3 – What if the dollar hadn’t weakened by 3% this year, but was instead unchanged?
Based on the DXY Dollar Index, the U.S. greenback has been on a bit of a wild ride this year, starting at 98.75, dropping to 92, and then bouncing to a close today of 95.6. Put another way – the dollar has been almost as volatile as stocks. At its current level, it suits U.S. monetary policymakers to a “T” – just weak enough to help the earnings of large multinational companies (who might expand and hire due to better earnings) but strong enough of late to confirm that the Fed’s message of a potential rate increase is getting through.
Our Answer: this one might not matter much to the current level of U.S. equities. The net change year-to-date, just 3%, still leaves the dollar below where it has traded for much of the time since early 2015. Any dramatic strengthening would likely hurt equities, unless it came with a healthy dose economic growth.
#4 – What if tech investors still thought smartphones were a global growth category?
Apple may be just one company, but it is still has the largest single weighting in the S&P 500, at 2.97%. Microsoft holds the #2 spot, at 2.28% and the dual classes of Alphabet combine to 2.39%. That means that Apple’s key market – global smartphones – is important to the equity market as whole.
Our Answer: As with the dollar, Apple’s move (down 7% for the year) doesn’t overly change general market returns. If Apple were flat on the year, the S&P would only be 0.21% higher.
#5 – What if Donald Trump were not the Republican nominee for President?
I think if you had asked market participants a year ago “Where would you guess the S&P 500 was trading if I told you that in one year’s time Donald Trump were the Republican Party candidate for President”, the answers would have ranged from 1,000 to 1,500. Surely that kind of unexpected turn of events must have tied to a market meltdown, large geopolitical shock, or both. And yet here we are. The only way to square the circle is to assume that investors think the chance of a Donald Trump presidency is essentially zero, because here we are at 2016 highs.
Our Answer: Stocks would likely be exactly where they are now if Mr. Trump were not the nominee. The more important observation is actually “Why are capital markets ignoring the social message that his success (and to a similar degree Senator Sanders’ rise) seems to be delivering to Wall Street’s front door?” Yes, the Electoral College and demographic decks seem stacked against Donald Trump, but that doesn’t negate the reason he got as far as he did. Remember when Jeb Bush was the seeming favorite? It wasn’t that long ago.
Our bottom line here is that two of our counterfactuals neatly illuminate why U.S. stocks are working: lower interest rates and stable-to-rising oil prices. The former underpins market valuations, the latter sends soothing signals about global economic growth and supports hopes for an earnings rebound in the energy sector. As for when – or even if – markets get around to pondering what a Trump campaign signals about broader social issues, I doubt we’ll need counterfactuals to illuminate those messages once they come along.
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