First Quarter 2017
The first quarter of 2017 saw a continuation of the post-election price trends. Equities were generally higher, rates were range bound, and spreads on investment grade and high yield bonds continued to tighten to historical lows. Digesting their large gains, bank stocks and small caps, while up, generally underperformed the broader market. In energy markets, Crude Oil was -5.81% lower, as larger increases in US production offset OPEC production cuts, and Natural Gas declined -14.24%, as mild winter weather led to increased stockpiles. Gold rose 8.3% in the quarter, helped by technical positioning (speculators had cut long positions after the election) and increasing geopolitical risk from North Korea and Syria.
In the US, rosy sentiment toward Trump’s economic and political agenda faded as partisan bickering picked up around the attempt to repeal the ACA healthcare law. Trump faced opposition from his own party, as some Republicans were not content with a partial repeal. This led many to question the ability of the Trump administration to push through the aggressive reforms the market expects, particularly corporate tax cuts. Generally, we think the broad idea of cutting corporate tax rates will have support on both sides of the aisle. However, the problems will come from accomplishing this in a revenue neutral way.
We are closely monitoring the debt ceiling debate that will no doubt pop up in the headlines soon. The US has roughly enough cash to last through late summer, at which point the debt ceiling will need to be raised. Our new Treasury Secretary, Steve Mnuchin, has asked House Speaker Paul Ryan to lift the debt ceiling post haste. However, we suspect, as the Republicans did with the Democrats, the Democrats will attempt to use the debt ceiling votes to extract concessions from the Republicans. No doubt, this needless drama could concern markets, as no one likes to see the US flirt with default as if it is a banana republic.
US economic news has been okay. Job growth continues, albeit modestly. US GDP for the 1st quarter is tracking near 0.5%, which is well below most economists’ expectations. The drop is led by very slow growth in consumer spending and equipment investments. In addition, the Federal Reserve is cautiously optimistic on the economy, but is very cautious in normalizing the Fed Fund rates. Given the meager growth numbers, this seems like a very reasonable approach to us at this point, but the Fed is also concerned with asset values. While real growth in the economy remains weak, asset prices continue to benefit from cheap financing rates. In addition, wage growth is outpacing CPI growth, which could trigger margin compression for corporations. Generally, we don’t see the US equity or bond markets as an attractive opportunity currently, as the Federal Reserve is raising rates, wage growth is strong, demand growth is weak, and earnings multiples are high. Ultimately, we think that the repression of interest rates, once over, could trigger large declines in asset values currently supported by cheap financing.
We are also closely monitoring some negative developments in the credit market for short opportunities, specifically in commercial mortgages, subprime auto securitized bonds, and consumer credit. In the commercial mortgage market, we see signs of distress in the retail sector, where malls are hurting from a shrinking market for physical retail stores. E-commerce is rapidly changing the way consumers shop. This fact, coupled with a maturity wall next year of commercial loans issued in 2007, have impacted pricing of mortgage pools with heavy retail exposure. In addition, we see some stress in the performance of subprime auto loans, a market that has grown considerably in the past 5 years. Morgan Stanley recently stated on an industry call that in 2016, 33% of auto loans were to people with credit scores below 550, compared to just 5.5% in 2010. Finally, consumer credit levels (the amount of credit extended to consumers in the US) just matched their 2007 highs and are growing much faster than incomes. We think this will set the stage for consumer lending losses in the future as consumers over borrow due to their perceived confidence in the economy. We are actively searching for ways to profit from these developments.
Outside the US, political uncertainty continues to abound. French elections in April will be a focus for macro investors, as people are concerned that a win by Marie Le Pen could start a Frexit (or potentially a “Frau Revoir” or “adiEU’). In addition, as I write this, the market is digesting the new air strikes carried out by the US upon the Assad regime. Finally, North Korea continues to lob ballistic missiles into the Sea of Japan. Despite geopolitical concerns, economically, growth in Europe, Asia and Latin America look much better than it did two years ago as a modest recovery in growth appeared. Also, inflation in Latin America triggered by the stronger dollar appears to be abating, as many Central Banks hiked rates aggressively, helping their currencies outperform the US dollar this year. Fears of a full-blown trade crisis with Mexico abated as well, and the Mexican peso is about 10% stronger YTD vs the US Dollar. In India, where the market went through a scare due to the demonetization of the cash market, equities have rebounded substantially, with the MSCI India index gaining 17% year to date.