The More Things Change, the More They Stay the Same

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Lissa Rurik, CFA, CAIA

Recently some market prognosticators have alluded to similarities between today’s investment environment and that of the mid-1990’s (among others, Liz Ann Sonders at Charles Schwab). Remembering back to that time, the three predominant forces that all strategists addressed in their commentaries were technology (the internet), falling interest rates and globalization (the fall of the Berlin Wall and the rise of the Asian Tigers). Of course, these trends weren’t necessarily independent from one another, and our economy today reflects the continued impact of all three elements.

Globalization continues to progress and expand as places such as Vietnam and countries in Africa replace the former developing markets of China and countries within Latin America. Interest rates have arguably bottomed, but remain low (notwithstanding the vastly increased levels of global debt – another topic for another day). Perhaps most importantly though, technology advances driven by the internet have continued to evolve, encompassing smart phones and other mobile computing devices along with the emergence of the cloud.

As an angel investor I hear many pitches from startup ventures, and I have noted that a significant proportion of new business ideas entail a use of the mobile device /cloud platform model. Some that come to mind include:

  • a system for police evidence gathering, data management and diagnostics;
  • a process for emergency room response and patient data management;
  • online educational assessments and in-classroom diagnostics;
  • health care supply management with wearable bar code apparatus for inventory ordering; and
  • data collection and management for use in preparing environmental impact statements.

Granted, this paradigm has been in play for at least four or five years. But the level of innovation unleashed – as it permeates almost every business field and process – reminds me of the impact those early internet innovations had on that mid-1990’s economy… the productivity enhancements therein, and the consequential investment opportunities that resulted for many years to come.

A recent publication by Berkeley Professor John Zysman encapsulates the importance of the cloud concept. Essentially he finds that the internet was a catalyst for productivity because it enabled a decomposition of sorts in the production and delivery of goods, a reallocation of resource inputs to their cheapest source, and subsequent formations of global supply chain networks. Productivity growth was robust as this occurred. Today, the cloud not only extends the potential for enhanced productivity, but it almost leverages that productivity back upon itself and expands from there.

As noted by Sand Hill Group, the McKinsey Global Institute, and Deloitte Access Economics, the most obvious element of this process reflects the fact that the mobile/cloud platform can be used by anybody, whether consumer, employer, or coder on-the-go, because cloud support can be accessed independent of location and computing infrastructure.   That means we can work while riding a bus, we can collaborate with our colleagues at any place and time, and we can launch a new business with a relatively limited capital investment regardless of that business’s potential for growth.

Zysman’s piece discusses the cloud in its beginning years as a concept of architecture, in other words, a new way of organizing computing, that has now evolved to include implementation features around how those new architectural concepts are put to work.  And as production was deconstructed with the aid of internet, services on the cloud platform can now be segmented into each step, reconfigured and customized into entirely new elements of enhanced value for the user (thus leveraging productivity back upon itself).   Intense resources are now widely available and technological innovation is accelerated by the access and deployment of big data, design tools, analytics, prototyping, and sophisticated logistics and algorithms.  And as the development of applications on the cloud can be decoupled from the infrastructure, it lessens the investment requirements and speeds the time-to-value for any given business or technical innovation.

The investment community in the mid-1990’s pondered the economic importance of the internet with comparisons to the industrial revolution. The truth around that allusion may remain debatable…. However, the innovation and disruption arising as the cloud develops, and the resulting ongoing productivity gains, are at least as impactful to the economy and financial markets today as were those dot.com investment opportunities we all marveled upon two decades ago.   Maybe that’s where the 1990’s mid-bull market similarities align.

Is the innovation of the cloud platform as important as the internet was before it? (Comment below)

Are Wall Street and Main Street on the Same Block?

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Back in 1972 after Nixon’s landslide re-election Pauline Kael, the film critic at the time for the New Yorker magazine allegedly quipped “I can’t believe Nixon won. I don’t know anyone who voted for him.” While it’s a matter of debate if she actually said this, the point is still clear—sometimes we let our own circumstances and biases cloud our interpretation of data.

For instance we were listening to one market prognosticator that said that he thought that we might be seeing a new level of frugality among consumers that we have not seen in several decades, which might explain some of the recent data and resulting market action. While we believe that the consumer is more cautious than in time’s past, we also think that the data has reflected consumer caution for a while. Why the discrepancy? In our observation since us investment types make our living in part off the performance of the market, sometimes we confuse a rising market with rising fortunes for Americans in general. Therefore it can be easy therefore to neglect data that contradicts our own personal experiences even though it might not reflect what the rest of the country is experiencing.

One such brief example may be comparing the New York Wall Street bonus average per employee to that of various income level increases in the United States. While the bonus of the average Wall Streeter has remained relatively strong as of late, the real median household income has not been as robust. While admittedly the latter is inflation adjusted, one gets the general idea. Plus we haven’t seen much of inflation the last several years. Plus GDP data has been arguably mundane the past few years.

NYC Wall Street Bonus Compensation, % of Total Compensation

2013nycsecuritiescompasperc

(Click above image to view larger graphic)

Real Median Household Income in the United States

fredgraph

Gross Domestic Product

fredgraph gdp

Therefore sometimes we investors might have to be cautious in interpreting a strong market with a strong consumer or a strong economy.

When Doves Cry

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Credit is a funny asset class. It is part risk-on, part risk-off, and sentiment in and around the sector reflects its Jekyl and Hyde nature. This past week was a case in point. We’ve had dovish comments recently out of both Yellen and Draghi, both suggesting that current economic activity allowed for plenty of flexibility on monetary policy. The prospect of continued or even further stimulus gave risk assets a bit of a boost, and credit spreads did well for a few days. Not coincidentally, it was the same period in which equities did well.

Then the market saw a couple of days of bad news – mixed signals from the economy, and weak earnings out of Wal-Mart sent stocks lower, and credit followed suit. 10 year bank credits are usually the most visible in the cash markets, and they widened by about 5 basis points.

As a result, credit markets were very receptive to new issue in the early part of the week, but supply tapered off as spreads moved wider. $40 billion in investment grade corporates came to market, and follow-on secondary trading activity has been mixed. Most new issues look like they’re trading wider, some are trading tighter. Pfizer was among the biggest issuers, bringing $4.5 billion across five tranches, and Volkswagen did $3.5 billion. Pfizer bonds are lagging since their deal priced on Monday, with spreads wider by 3-5 basis points. The Volkswagen deal priced amid some spread weakness on Thursday, which perhaps explains why their bonds are trading 3-5 tighter.

At the same time, interest rate levels dropped to the low end of their range – 10 year rates dipped below 2.5%. Bottom line, even though credit felt squishy going into the end of the week, the average spread month to date has barely changed, and prices of investment grade bonds have moved higher. As one trader commented, in spite of the spread weakness, the market still feels constructive.

Or maybe the market just doesn’t know what else to do. It is totally hooked on central bank stimulus. Maybe I’m just 2 demanding, but it’s hard to see valuations surviving a hawkish attack.

Nuthin But a “B” Thang

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It was just last week that Apple came to market with a $12 billion bond deal, presumably to fund its share repurchase program. The market (as readers may recall) breathed a sigh of relief that the deal was significantly smaller than the $20+ billion that had been speculated.

And now, just a few days later, Apple is again in the news, this time on speculation that it will be paying $3.2 billion for Beats Electronics LLC, the maker of expensive, hip headphones and sponsor of a new streaming music station. We will leave it to the equity analysts to decipher whether this is a good deal for shareholders. We are trying to sort out whether it means anything for bondholders. The short is answer is: probably not. For a company with $150 billion in cash, a $3 billion deal is simply not large enough or transformative enough for it to have any impact whatsoever on credit quality. Credit spreads haven’t budged (one way or another) on the news. Even the 10 year from last week, which we noted was the weakest performer, is trading about 2 basis points tighter than new issue.

The potential transaction does underscore the danger of owning bonds of high quality issuers. There is an enormous range of potential outcomes, a whole host of nasty things that Companies can do with their cash. So which poison would we pick? Acquisitions are generally scarier – they can dramatically and suddenly alter a company’s risk profile. But share buybacks can result in death by a thousand cuts. As we move through the credit cycle, anemic growth and deteriorating margins tends to drive managers increasingly into the realm of financial engineering. Credit risk’s single tail becomes ever longer.

But for the past week, there was little sign of heightened risk. Or return, for that matter. Corporate bonds generated total returns for the weak of -0.06%, and excess returns were about the same. The new issue calendar was very average – about $22 billion of deals, and no big blockbusters this week. JP Morgan brought $2 billion of a new 10 year bond, which priced at +100, and did not really perform. Caterpillar Inc. came with $2 billion, with 10 year, 30 year, and a 50 year. The 50 year is not a typical maturity, and we think the pricing was very attractive – bonds traded 11 basis points tighter in the secondary. Next week looks like it will be more of the same – spreads continuing at tight levels, an average calendar of $20 billion….

….and the beat goes on…..

I Miss Earnings Season!!!

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If there is one thing I hate more than earnings season, it’s when it’s not earnings season. Why? Because then more often than not we investors, and especially the talking heads on the financial news networks, bloviate non-stop about macro data in between company quarterly reports. After this has gone on for several weeks, I actually find myself BEGGING for earnings season to start.

We feel this way because much of the discussions on these macro data points often end up as being so much noise. Take for instance the discussion on first quarter GDP. Most would agree it was lackluster, with a good percentage of analysts blaming the performance on the weather. Really? Earlier in the year we discussed that weather doesn’t really have much of an impact on retail sales. Additionally, if weather really does have a sizable impact on the economy, why was it not anticipated as estimates for the first quarter off by so much as the consensus was 1.5% with the actual tally being 0.9%? Conversely, when GDP is more than forecast, how come we never hear that absolutely great weather biased results upward? Our point is that when you have something as complex and organic as the US economy, it’s difficult to shrug off any result to just one factor.

Perhaps the bigger question is what comes first; unexpected GDP changes or unexpected corporate results changes? Usually in our observation GDP is fairly coincident as corporate earnings are an important part of the real economy. Sometimes we think of it as slightly lagging as we often hear from companies and their supply chains what they are seeing and expecting on Main Street before the official GDP data is released. For reference here’s one example, the S&P 500 revenues plotted against nominal GDP. We used this chart as we believe revenues are a better indicator of demand than earnings, which can be more influenced by accounting assumptions, cost controls, and changes in capital structure.

shoutout_earningsseason

However, we also think that one completely ignores these macro data points at their own peril. Macro data can help confirm or deny an investment thesis and there are plenty of quantitative and algorithmic strategies that can influence your positions, at least in the short-term. Our best use for them is to help confirm or deny existing theses we have on individual sectors or companies as some of our companies are influenced less by US macro data than others, e.g. large multi-national companies are less influenced by US data than, say, a small cap retail chain.