David Kotok is the chairman andchief investment officer of Cumberland Advisors. The views and opinions expressedin this piece represent only those of the author and not necessarily those of S&PGlobal Market Intelligence.
As thesecond half of 2016 unfolds, politics seem to be the single dominant global force.Markets either ignore politics or panic in the face of them. Let's take an inventory.
Certainlyall eyes will watch continually as the evolution of Brexit changes the governmentof the U.K., and maybe ultimately of Scotland and Northern Ireland. Both of theseare component parts of the U.K. Both have active majorities that voted Remain.
Manyask what will happen to London as a financial center. There are already indicationsthat certain financial institutions are rethinking their London activities. Thosefrom elsewhere in the world are altering the amount of credit exposure they willhave in the United Kingdom. The surprising Brexit outcome has changed the risk profilepermanently.
Meanwhile,competitors line up for their pieces of the London pie. Among the elements involvedin that competitive financial global arena is relative regulation. The United Statesmay have a competitive disadvantage against other centers worldwide.
Willnewcomers attempt to obtain market share from London? The answer is yes. Will Londonbe able to negotiate a role with the EU so as to preserve its existing status? Thatoutcome doesn't seem to be in the cards, but uncertainty is high. What will happenwith Frankfurt or Paris? We have more questions than answers about Brexit's ramifications.What we do know is that 2016 will be a year in which history is made as disunioncommences in Europe.
Financialmarkets absorbed the Brexit shock as central banks immediately responded with liquiditybeyond any observable requirements. Interest rates fell, and negative interest ratesexpanded globally. It seems as if the only responses that can come from crisis areadditional quantitative easing and monetary stimulus. Governments seem stymied inthe fiscal realm; therefore, monetary policy reduces the cost of the indebtednessby lowering the interest rate to near zero.
MoreNIRP will evolve over the course of the second half of the year. Globally, we haveabout US$12 trillion equivalent in negative-rate debt. The number is growing byseveral hundred billion USD equivalent a month. An inventory of global central banksreveals that all advanced economies except the U.S. are easing. Those are Japan,the U.K., New Zealand, Australia and the eurozone's ECB. Among emerging economies,China, India, Indonesia, Korea, Hungary, Poland, Russia and Turkey are easing. OnlySouth Africa, Brazil and Mexico have some tightening bias, and they have now delayedany further activity because of Brexit.
The Fedhas provided some confusing messages this year. In January 2016, Vice Chairman StanleyFischer suggested to CNBC that there could be as many as four rate hikes this year.(Click here to watch theinterview.) So far we have not seen a single one, and the likelihood of any ratehike in 2016 has diminished enormously. When the messages from the Fed are profoundlylacking in clarity, confusion inevitably results. St. Louis Federal Reserve PresidentJames Bullard just released a paperthat discusses the difficulties of policymaking and the fact that the appropriatedirection of policy seems to be difficult, if not impossible, to determine, giventhe moving forces that are at work in the world. Bullard's paper has caused someconsternation within the Fed. Readers may want to review it and especially the mentionof risks to forecasts.
Bullardnotes that market-based estimates of inflation expectations are not working. Contrastthat with his April paperthat discusses them. He doesn't say why the estimates are failing. He doesn't mentionthe scope of NIRP's influence. Nor does he refer to the flattening of yield curvesglobally, even as spreads between the Treasury curve and NIRP curves widen whileall flatten. Perhaps a lot more explanation will be forthcoming from St. Louis.
The phrase"data dependency" is now a cliché. It is invoked often and means differentthings to different folks. We could say that central-bank policies are always data-dependent.How do you make policy without data? And how do you have data today that can tellyou what the data will be tomorrow? Trying to make forward-looking policy basedon historical data is like driving using only the rear-view mirror. No wonder marketagents are confused.
Todaywe have forces at work that are rendering forecast models ineffective. Lacking clarityin message and policy puts the Fed in a position of being a political target ina political year. And the two presumptive presidential candidates are not Fed-friendly.
Neitheris the Congress. Remember, the Fed is already saddled with certain payments thatCongress has positioned to bypass the appropriations process. What will happen toour central banks as their independence erodes and their political vulnerabilityincreases? That is a subject of debate. The Fed will reveal more in the second halfof 2016. The only thing we can depend on is that interest rates will be very lowfor longer than Stanley Fisher led us to anticipate when he made his comment aboutthe four hikes in early 2016.
PuertoRico will come under federal oversight; seven members will be appointed to the PROMESA-authorizedboard. That legislation will take from Puerto Rico political powers it enjoyed andimpose on Puerto Rico a governing system it resists. Why? Because the commonwealthhas failed on its own. Twenty years of neglect and fiscal irresponsibility willcome to an end. The final version of PROMESA allows this board to attempt a settlementfirst with claimants and with the government of Puerto Rico negotiating. If thatsettlement cannot be reached voluntarily by all parties, then the board will takepower away from the government of Puerto Rico and can impose solutions or seek courtaccess for certain decisions.
PuertoRico's $70 billion of indebtedness will be restructured. Only two states, Californiaand New York, have greater liabilities than Puerto Rico does. In addition, PuertoRico's unfunded pension and other promised benefit liabilities exceed $40 billion.These, too, will be restructured. Thus, the commonwealth, with its population ofapproximately 3 million, has an impossible task ahead. That means haircuts are inorder.
Notwithstandingthe recent evolution of the Puerto Rico situation, the entire municipal bond markethas seen a huge rally as interest rates have fallen to levels without modern precedents.A second derivative of NIRP and monetary easing is these remarkable lower muni yields.The trend has little to do with improved state and local governments. Witness NewJersey or Illinois or Kentucky or Connecticut. All four are now poster childrenfor irresponsible fiscal management.
Municipalinvestors now face some very difficult decisions. They can place their money ina high-grade, floating interest rate credit and earn one-half of 1% or slightlyless. Or they can place their money in a 30-year maturity and earn 2%. Thus, thedifference between a cash equivalent, or a one-week floater, and a 30-year-durationrisk is an added compensation of 1.5 points. What does the tax-free investor dowhen faced with those choices? Interim and shorter-maturity possibilities yield1% or so, perhaps a little more. These are the options that municipal investorsface in the second half of 2016.
At thesame time, credit quality is more important than ever under circumstances wherevery low interest rates are masking credit troubles and investors are chasing yieldanywhere they can find it. Investors are bidding up prices and lowering interestrates on weaker credits. More evolution and challenges to bond management lie instore as the proliferation of very low interest rates influences investor decisions.
The marijuanainitiatives in progress in nine states are an added political force in 2016. Withsome excellent data, ConvergEx has followed the growth of the marijuana industry— and it is really growing. Hereis the link to their latest report. We thank ConvergEx for allowing us to sharetheir work with readers. Now think about the Electoral College and how turnout willbe affected this year in those nine states. I wonder if Donald or Hillary has a"toke" policy position paper.
Politicsin Asia are huge now. We think that developments around Japan's policies will becritically important to global financial and market conditions. There are expectationsthat the Bank of Japan (BoJ) will expand its monetary stimulus program in a varietyof ways at its July 28-29 meeting. Japan has disappointed market participants fora number of months. While statements suggest that a more negative interest ratebase and wider purchases of assets by the central bank will occur, the Bank of Japanhas not yet acted in that way.
In addition,Japan faces political changes, including the proposal to amend its 1946 constitution.This amendment would allow Japan to expand its military activity from solely defensiveto more global or offensive efforts as well. It is logical for the Japanese to expandhigh-tech capability in the military arena, especially with the threatening activityoccurring around them.
Lookat the South China Sea and at North Korea's behavior to see why Japan feels threatened.We in the United States would feel threatened, too, if an ancient enemy fired arocket over our heads. Japan holds an important key to financial markets since itis the world's third-largest economy, its second-largest mature economy and itsthird-largest reserve currency economy. Japanese activity becomes more criticalgiven the activities in the U.K. as well as expanded risk concerning the pound andthe Bank of England.
We expectthe BoJ to take its negative interest rate policy threshold to somewhere betweennegative 0.3% and negative 0.5%. We also expect the BoJ to widen the tiers suchthat the lowest level would be negative 0.5, but there would be a tier at zero.Essentially, the BoJ would construct their version of a program similar to MarioDraghi's at the European Central Bank.
The Japanesestock market, by all valuation measures, seems extremely cheap. One can projectthat the interest rate in Japan will be zero for many years. If the interest rateis zero, then asset prices and their valuation will be determined relative to thesovereign debt risk at a zero interest rate.
Thathas been the case in Japan for some time. However, the evolution of that policyhas been gradual, and Japan has struggled with the debate over deflation versusinflation. Japanese policy makers have not been able to achieve their inflationtargets, even after years of trying. Thus, Japan views itself in one context whileit administers a monetary policy in which it purchases baskets of stocks and Japanesemarket REITs in addition to fixed-income assets. We would expect the BoJ policyto be more expansive in that area.
The Japanesestock market as a whole shows that the equity risk premium in Japan is over 7%.At the same time, the earnings yield is over 7%. It is an extraordinary situationwhere the equity risk premium calculation based against the earnings yield resultsin a higher number than the earnings yield itself. That can only happen in a climatewhere the projection of negative interest rates extends for years into the future.Such is the case for Japan.
The US election
By theend of July, both political parties will have completed their conventions; and thepresumptive nominees, Hillary Clinton and Donald Trump, will have running matesand platforms. We know that platforms are documents mostly ignored in the electoralprocess. We also know that the outcome of this unpredictable political year is opento debate and discussion. Long-shot possibilities include an indictment of Clintonand an independent or other challenge to Donald Trump. The most likely outcome isthe presumptive nominees' battle in the battleground states through to November.
Thosewho follow electoral politics closely know it is the Electoral College that reallycounts. The important economic outcomes are seen in states that alter the balancebetween Clinton and Trump. Trump seems to gain from weakening economies and fallingemployment, while Clinton seems to benefit from states that have a flourishing economy.Bill Clinton's adviser James Carville once offered the infamous quote, "It'sthe economy, stupid." It seems to apply.
A secondaspect is what will happen in the Senate and maybe in the House. Certainly a Trumpdebacle (á la Barry Goldwater) could put the House in jeopardy as well.
Whatwill happen with serious policy discussions? In our view, very little. The appealsto voters' emotions will determine outcomes. We have candidates with record-highnegative voter ratings. Most voters will not dig deep into the analysis of taxes,budget deficits or the types of policy questions that some of us wish were the centerpoint of debate. For discussion in depth, please see Maya MacGuineas' article on taxes andbudget, "Appropriations Watch" from July 1. In addition, we publisheda commentary on MacGuineas' work here.
CumberlandAdvisors' view of the world and the economic recovery in the United States is reflectedby our U.S. sector weights. As shown in Table 1,we are overweight the technology, consumer discretionary, and utility sectors ascompared to the S&P 500 weights.
Withinthe consumer discretionary sector, Cumberland Advisors continues to be overweighthousing. We expect the housing recovery to accelerate and become more robust forthe rest of this decade. Several million more housing units need to be built beforesome new equilibrium level is reached. Remarkably low housing finance interest ratesare in effect. We are bullish on the housing sector and all the things that cometo pass because of it.
Utilitieshave been continuously and progressively stellar performers. This sector's outperformanceis attributable to several characteristics including its yield relative to risklessU.S. Treasury yields, its predictable single-digit compounding growth rate — predominantlyin electric power — and the fact that nearly the entire business of the sector isconducted within the U.S. in U.S. dollars. There is every reason for utilities tohave continuous stellar performance. The cause for concern is that on valuationmetrics utilities are exceeding historical levels by a large margin. Price/salesratios, for example, are at extremes not seen for many decades. What does one dowith a winning position embedded in portfolios that are performing well? Remainnervous, watch closely and on any given day perhaps decide to put the profits inthe bank and move on.
Underweightsectors are a different matter. Table 2shows that Cumberland Advisors is underweight the financial and energy sectors comparedto the S&P 500.
The energypatch continues to struggle. Natural gas is doing better, but oil is not. Worldforces continue to suppress price pressure and thus moderate the rise in oil prices.There is no way to know what oil prices will be. There can be an argument for a$30 low or an $80 high. Geopolitical risks are enormous, whether in Venezuela, Nigeria,or the Middle East. Meanwhile, new technologies have made major changes in the abilityof the energy sector, particularly oil, to rebound quickly if prices rise. The olddays of long waiting periods have become mere stories in the history books. We remainunderweight the energy sector. We think it is too soon to go to market weight, letalone overweight, in the energy sector.
The secondhalf of 2016 has many moving parts. Politics seem to be driving most of them. Whenpoliticians prowl, market agents have good reason to worry. We are fully investedthanks to a Brexit entry opportunity. That could change at any time.