“What gets measured gets managed.” That statement is a large part of how I look at individual companies, especially as it relates to metrics like executive compensation. If the CEO gets paid primarily on sales and earnings growth, for example, you need to watch asset efficiency. And if a company changes management but not compensation structure, you can bet not much will change except for the group picture in the annual report.
In asset management, the most commonly used measurement is quarterly performance. It is an imperfect tool, to say the least. There’s plenty of academic literature that shows real money management skill (versus luck) is hard to spot in even a 5-year track record. But “we dance with who we brung”, and quarterly performance is our date to the prom.
The recent narrative shift in global capital markets could therefore not have come at a worse time. January was a stellar month, with the S&P 500 up 5.6%, EAFE equities +5.0%, Emerging Markets up 8.3%, and US large cap Tech +7.0%. Then the story changed from “Higher interest rates don’t matter” to “higher interest rates are the only thing that matter”. The volatility shock from VIX-linked products last week only cemented the notion that second-order effects lurk menacingly inside this new story markets now embrace.
Since we are now almost exactly half way through the first quarter of 2018, investors tethered to quarterly performance have a tough call to make: what narrative will dominate the second half of Q1? Here are the choices, simplified for brevity:
Scenario #1: Equity investors will soon shift their focus from the ill effects of higher interest rates to the bullish developments in corporate profit growth, since Q1 earnings season should print eye-catching +17% bottom line comps to last year. In this environment:
- The S&P rallies 3-4% from current levels, which still wouldn’t make for new highs but would be a welcomed reprieve for equity holders. Volatility would diminish, but the days of a sub-10 CBOE VIX Index are gone.
- The US 10 Year Treasury drifts to just under 3.0%, but also exhibits less volatility than recent norms. The momentum here feels too strong to deny.
- Financials and Technology lead the way, as they are both expected to post 20% earnings growth in Q1.
- Emerging markets equities outperform EAFE stocks due their much higher weighting of Technology stocks, which should piggyback on the move in US listed Tech.
Scenario #2: Markets struggle with rising interest rates, but declining equity market volatility (and hopes for Q1 earnings) provide a counterweight. In this environment:
- Equities end the quarter flat on the year at, essentially, today’s close.
- 10 Year Treasury yields rise to just over 3.0% on the back of slightly hotter inflation, wage and employment data. Tomorrow’s CPI report, Jay Powell’s testimony to Congress on February 28th, and the February Jobs Report break no new ground on inflation expectations. The late March Fed meeting is probably too late in the quarter to shift expectations in Q1.
- Investors view Tech stocks as a safe haven due to its relative strength in the first half of the quarter and the group rallies 2-3% in a flat tape. And, not to stereotype, but tech investors care less about valuations than most. EM outperforms EAFE for the same reason as Scenario #1.
Scenario #3: The second half of Q1 2018 closely resembles the first two weeks of February. Here:
- US equities go back to their 5-year average valuations of 16x forward earnings (S&P 500 at 2512, or 5.6% lower for the year).
- 10 Year yields move quickly past 3.0%.
- Correlations (which we covered yesterday) reconverge and there really is no safe haven. Volatility remains at current levels or ticks higher.
Now, the important question to ask is not “Which scenario do I think is most likely?” but “which scenario do I think other market participants will settle on in the coming 4 weeks?”
Scenario #3 (notable downside for equities and bonds) feels the most likely, but only because it closely resembles the very near past. And that’s where it runs into some trouble. To keep this narrative in the lead position, inflation expectations have to continue to get worse at an accelerating rate. Possible, but a tall ask given where we are today. And asset price volatility is no longer dormant, so the chance of a “Vol shock” such as last week is mathematically lower.
Scenario #1 (relief rally) would be a welcomed change, but seems even more unlikely than #3. It is hard to believe that investors will abandon the inflation/higher rate narrative very quickly. They have seen the cost of complacently ignoring it and are now “Once bitten, twice shy”.
That leaves us with Scenario #2 (muddle along) as the default winner, if only by a hair. In this case, equities play tug of war with interest rates, but neither side makes much progress. First quarter 2018 goes in the books as the first round of the fight between rising interest rates and stock valuations, but with no clear winner (and certainly no knock-out).
In the end, however, the central message of this note is to encourage you to see the next 6 weeks not just through your own investment lens. Market narratives are shifting right now and remain muddy in comparison to the last 5 years. While quarterly performance may be the measurement by which we are judged, the real stories that drive outsized moves in asset prices always take longer to develop.