A volatile year to date seems to be resolving itself into a cautiously positive market backdrop, presenting the possibility of a better-than-usual summer for stocks. The underlying causes of volatility are still present — primarily the tug-of-war we have described several times, between rising interest rates (which are challenging for stock valuations) and accelerating GDP growth and rising corporate profits (which support higher stock prices). Therefore we don’t believe that the rest of the year will lack further episodes of volatility.
The question for investors, as always, will be whether to view those episodes of volatility as opportunities or as alarm bells for a coming crisis. Having a picture of the real, fundamental economic and financial backdrop can help steady investors’ minds during periods when outright panic or chronic anxiety are troubling the waters.
To that end, we monitor a set of critical financial and economic variables, which we have described in our letters and in our periodic conference calls. (If you have not seen the Recession Watcher’s Guide that we produced earlier this year, please reach out and request a copy.) Our reading of these variables suggests that a recession and its associated bear market are not imminent, in spite of increased stock-market volatility in 2018.
Besides watching the economic and financial fundamentals in real time, we also try to develop a “big picture” understanding. Put simply, we would like to make sense of market behavior — to have a grasp of the most powerful trends that are driving markets, and to have a sense of the big ocean swells that are moving beneath the surface waves of day-to-day market responses to news and events. Making sense of markets in this way also helps investors to navigate them with less anxiety.
The Big Story
One of the most useful “big picture” views has been suggested in recent months by Canaccord Genuity analyst Brian Reynolds. While this big picture is certainly not the only thing going on, we believe it is insightful enough to be worth paying attention to.
In the view of Reynolds, and many other analysts, the fundamental cycle influencing markets is now a credit cycle — that is, the U.S. economy and U.S. markets are fundamentally driven by the expansion and contraction of credit. As long as credit remains in expansion mode, it is the ocean swell beneath all the smaller ups and downs of the surface waves.
Although public attention is focused on the policy of the Federal Reserve, and analysts and pundits around the world are all talking about monetary tightening by central banks, the credit cycle directly affecting U.S. markets is still “up.”
This credit up-cycle is being driven by a powerful force arising from long-term trends in demographics, politics, and monetary policy. It isn’t just Social Security that is facing funding challenges as Boomers move into their retirement. Public pensions — for example, for state and municipal workers — are also in a bind.
Public Pensions and Their Woes
These funds are financial giants. In 2016, they covered 21 million members (both working and retired) and held assets worth about $4 trillion, or about 22% of total U.S. GDP. Many of them enjoy legal standing that makes it extremely difficult, if not impossible, to curtail the benefits that have been promised to their members. In many states, the inviolability of these pensions is written into the state constitution and would require an amendment to that constitution to change. And yet it can spell political trouble for politicians to raise enough money to fund them.
Broadly, they are under-funded (some of them severely so). In 2016, state pension funds, on average, had only 66% of the funds they need — and only four states were at 90% or more.
Public pension funds have been built to function with an anticipated return on their investments of 7–8%; this is their “actuarial assumption.” However, the past decade of market history has not been kind to these assumptions; on average, they have returned just over 5%. (The decade before that wasn’t much better.) That difference may not seem significant, but it is. At a rate of 8%, a portfolio would double in nine years; at 5%, it would take more than 14 years to double. The bottom line is that the pressure to meet the actuarial assumption is extreme.
Source: The Pew Charitable Trusts
Therefore, increasingly, pensions are tilting their allocations towards more aggressive investments. “More aggressive investments” does not mean equities. At the margin, pension funds are actually decreasing their allocations to equities. Instead, their boards are following the advice given to them by their consultants: they are increasing their allocations to leveraged credit (among other forms of more aggressive investment). That is, they are trying to meet their needed returns by investing in corporate credit funds where the returns will be magnified by leverage.
As you can see, this phenomenon has ballooned since the financial crisis.
Source: Canaccord Genuity
Leverage, as we know, magnifies returns — until the music stops and the unwind begins. Then the decline is just that much more severe.
This demand on the part of pension funds for leveraged credit products is, predictably, being met with supply. Corporates have been happy to issue debt during the years of incredibly low interest rates. And where have the proceeds gone? Into stock buybacks.
The chart below shows that essentially the only net buyers of stock during the post-crisis rally have been companies buying back their own shares.
Source: Canaccord Genuity
In a structure of corporate governance where executives’ salaries consist primarily of stock options, with stock options granted to further incentivize management in reaching earnings-per-share targets, this process is a no-brainer. Earnings per share targets can be reached and exceeded not just by increasing earnings, but by decreasing the number of shares.
In this way, the management’s incentive to buy back shares, coupled with the demand of pensions for leveraged credit products, means that the “up” credit cycle has also propelled stock prices higher during the long post-recession rally.
What It All Means
Broadly, this view strikes us as correct — it is an accurate perception of some important, large-scale forces at work in the U.S. economy and in U.S. markets. But what does it mean?
First, it means to us that this area is likely to play a significant role in the next downturn. Eventually there will likely a global financial “event,” perhaps originating in Europe. This would likely result in the unravelling of leveraged credit funds, and the evaporation of the bid that corporates have placed under the stock market by buying back their own shares. In short, we see that this is one area where the end of the current bull market is coming into view.
But second, the forces that have been driving the bull market are far from exhausted. Pension funds’ needs are being driven by huge demographic trends and by deeply entrenched politics. Neither of these factors will change quickly. Corporates’ desire to boost earnings per share by issuing debt at still historically low interest rates and using that cash to buy back stock, is not waning. Many also now have large amounts of overseas cash that has been freed up by lower taxes on repatriation in the current tax law, to deploy as well. State and municipal governments are engaging in creative “refinancing” of pension obligations — for example, issuing debt which is then used to buy public employees out, save money, and improve their standing with credit agencies. Pension funds’ demand for leveraged investments will likely accelerate before the next crisis occurs, and put simply, that is bullish for U.S. stocks.
Of course, some companies — those ready to benefit from the improving economic environment and those that generate significant cash flow — will be better positioned to handle the debt, and they are the ones which will engage in stock buybacks. The ongoing bull market will likely reward growth companies with strong, visible free cash flow.
Investment implications: The U.S. stock market remains fundamentally driven by the credit cycle, and the credit cycle remains “up.” Public pension funds, facing dire shortfalls and struggling to meet their targeted 7–8% return, are increasingly tilting their asset mix towards aggressive, leveraged credit funds. This appetite will continue to lead corporates to issue debt and to buy back shares. This process, which has undergirded the entire post-crisis rally, is likely to continue and to intensify, and we believe it will put a “bid” under U.S. stocks in the face of rising volatility. The exuberance from retail investors that we expect to see at the end of a cycle has not yet emerged. We do not see signs of a turn in the credit cycle, and as long as it continues, we will be fundamentally bullish on U.S. stocks. When a turn does occur, we will be sure to warn clients of an impending sell-off of magnitude. It will be a time to be out of stocks. However, that time is not now, nor is it in the immediate future.