“Climate is what we expect, weather is what we get”
-Andrew John Herbertson, British geographer
If you’re not an aspiring arborist (or from California), xeriscaping refers to a type of landscaping that reduces or totally eliminates the need for supplemental irrigation (i.e. you don’t really need to water it).
The term entered popular lexicon in late 2014 and peaked on google trends in early 2015 at the tail-end end of the driest 4-year period in the history of California.
As drought conditions ravaged CA from 2011-2017 and broad water use restrictions were implemented, people increasingly traded their grass lawns and lush garden greenery for water conserving and drought tolerant gardens.
Of course, in large part, “drought tolerant garden” was just a euphemism for rocks and cactuses.
It wasn’t aesthetically preferable but it was effective …. A kind of environment adaptive version of one of our recurrent macro mantra’s: “play the game you’re in, not the one you wish you were playing”.
Back to the Global Macro Grind…
Let’s craft ourselves a little climatology-inspired common sense logic chain this morning.
We’ll call it the macro xeriscape portfolio - a kind of low-intensity, sleep easy portfolio for acute, 2nd derivative droughts in growth.
Starting with the larger macro ecosystem … which has transitioned from the lush green and warm temperate glow of harmonized acceleration of 2017 to the diversified microclimates of #GlobalDivergences in 1H18 to the impending shift to the arid exsiccation of synchronized slowdown into 2019:
- GDP: 2.8% Y/Y in 2Q18 = record 8 straight quarters of accelerating Y/Y growth = the cycle peak
- Earnings season = S&P sales and earnings growth in 2Q accelerated to +9.8% Y/Y and +25.5% Y/Y, respectively. The tax-reform related juicing of margins and corporate profitability (& repo announcements) now has 2 quarters of runway left before we annualize the impact and run into an uncompable base effect stiff-arm
- Valuation: Forward PE on the S&P 500 is currently 17.5X, representing a full 2.5 turns below the 2017 cycle peak and almost a full turn versus the latest 2Y average.
Here’s one interpretation of those factor dynamics: Domestic growth is now past peak, earnings are again strong but are benefitting from a transient tax reform related juicing and investor’s are discounting that transience and the prospects of slowing growth/earnings by refusing to retrace to peak multiples. Slowing Growth + Slowing Earnings (with corporate margins at peak) shouldn’t get a premium valuation.
An alternate and opposing interpretation would be that: Domestic growth is still good and policy uncertainty is constraining equity multiples globally and if we can hurdle that uncertainty, multiple expansion can drive prices higher despite any pending moderation in growth expectation.
Perhaps.
What else is going on:
- REITS/UTES = outperforming by 147 bps and 131bps, respectively, month-to-date.
- Style Factors = Low Beta, High Yield, Large Cap, Slower Growth are all now outperforming over the past 1M and 3M
It’s a fledgling deviation but the current complexion of sector and style factor outperformance is a discrete shift from that characterizing relative performance over the previous 2 years.
Now, let’s quickly aerate the data drudgery soil with some audience participation. Any guesses on the following number trifecta?:
- 2.03%
- 2.31%
- 2.58%
Those are the yields on the 3M T-Bill, 3M LIBOR and 2Y Treasury Bill, respectively. In other words, the effective risk-free return on cash is running at ~250bps …. in dollars that are appreciating.
All of this, of course, just represents a simplified, alternate contextualization of our expectation for “Less Good” to remain the apt descriptor of high frequency macro conditions as Growth and Inflation, both domestically and globally, decelerate as we move through the balance of 2H.
It’s been a great 2Y run …. and with cash yields at decade highs, growth set to slow, corporate margins at peak, the profit cycle cresting and the market beginning to price in those realities, tactically xeriscaping your portfolio with some selective Quad 4 allocation rotation should be accompanied by a cathartic sense of accomplishment not a sense of reluctant attrition.
Lastly, let’s just get the macro-political news of the day yesterday out of the way.
Trump was ostensibly trial ballooning his best Erodogan impression in the Hamptons on Friday and then again to Reuters on Monday in an apparent attempt to see if exerting (dovish) pressure in the Fed’s direction could find some broader support.
Just to be clear …. and this is neither a political point nor a particularly controversial or unique conceptual insight … it’s the administration’s policy that’s adding to any incremental hawkish out of the Fed.
Unprecedented late-cycle fiscal stimulus and protectionist policy are really only uni-directional in their prospective impact. That is, they can only really serve as an inflationary impetus nearer-term.
By extension, the flow through implication to policy is similarly uni-directional nearer-term, causing Powell et al to tilt incrementally more hawkish, either proactively and tangibly or via rhetorical posturing.
Moreover, to the extent those same policies drive market expectations for EM/EU growth lower (amplifying their already negative slope), it only perpetuates the policy & growth divergences themes we’ve been detailing for 8-months and further supports the dollar.
And while accusing China and Europe of currency manipulation may not be completely off-base (dabbling in that dark art is the implicit dictate of every central bank), to the extent recent Fx weakness has been a function of the market attempting to discount prospective policy impacts, that’s called price discovery, not manipulation (at least not exclusively).
That fact that evolving market dynamics (stronger dollar) directly undermine the goal the trade policy initiated was designed to serve doesn’t make it the manipulative work of some clandestine conspirateur. Doubling down on protectionism as retribution for any perceived manipulation only reinforces the dollar and (policy) divergence dynamic.
Chirping Powell, meanwhile, only casts an intractable shadow of politicization over policy decisions, adding noise to the already complicated task of disentangling the motivations behind the policy decision calculus.
Inclusive of it all: Official forecasts are what they expect, the data is what we get … and effectively front-running and arb’ing the spread between the two remains macro alpha’s playground.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.80-2.97% (bearish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 7 (bullish)
Utilities (XLU) 52.97-54.85 (bullish)
REITS (VNQ) 82.00-84.49 (bullish)
Industrials (XLI) 74.29-76.99 (bearish)
Nikkei 215 (bearish)
DAX 12031-12581 (bearish)
VIX 10.55-15.56 (neutral)
USD 95.03-97.24 (bullish)
Oil (WTI) 64.30-68.21 (bearish)
Gold 1170-1218 (bearish)
Copper 2.54-2.81 (bearish)
Keep moving,
Christian B. Drake
U.S. Macro analyst
