Wall Street Week

March 7, 2016

Good news is good news
Don’t look now, but the U.S. economy is actually doing pretty well. Even more significant, though, is the fact markets are treating the good news as, er, good news!

First, the data. This week February auto sales volume reached its highest level since 2001, the U.S. manufacturing sector contracted more slowly, the Fed Beige Book showed evidence of upward wage pressures and a better-than-expected monthly jobs report highlighted the health of the U.S. labor market.

The big one, Friday’s non-farm payrolls report, revealed the U.S. economy created 242,000 jobs in February (versus expectations of around 190,000) while an increase in labor force participation caused the unemployment rate to hold firm at 4.9%. The only negative aspect of the report was wage growth, which declined year-over-year.

There were even more bullish details hidden deeper in the report, like the household survey showing employment gains of 530,000 and the construction unemployment rate falling to its lowest seasonally-adjusted level since 2006. The economy has now recorded positive job gains for a record 65 straight months (the previous record was 48). The raft of strong data prompted the Atlanta Fed to revise its Q1 GDPNow forecast up three basis points to 2.2%.

What does it all mean? After the financial crisis the Federal Reserve reflated asset prices by moving interest rates to zero and introducing quantitative easing. It worked, but also conditioned markets to look at every piece of economic data through the prism of what it meant for monetary policy. Good data was bad for the market because it meant the Fed might take away the “punch bowl.” Stocks rallied on bad data because it meant QE might grow or last longer.

Investors held a deep-seated anxiety about what would happen when the Fed exited the market, like agoraphobics scared to leave the house without benzodiazepines. Chairman Ben Bernanke increased the Fed’s communication to help wean stocks off the drugs, and the Federal Open Market Committee (FOMC) made a largely symbolic rate hike in December 2015 to expedite the normalization process.

Heading into 2016, the consensus among economists was that risks of recession over the next 12-18 months were low. The Fed’s dot plot even forecast four interest rate hikes in 2016. However, a flight to safe-haven bonds indicated financial markets weren’t buying into the rosy outlook. Over the past few weeks, though, that trend has changed as the spread between economist and market views has started to tighten.

The fact markets are responding more rationally to fundamentals is a positive development. The fact good news is good news is good news. Part of it boils down to the eroding credibility of central banks, but perhaps that shift was necessary to force local governments into fiscal stimulus and structural reforms.

This week’s data moved up the timetable for a 2016 rate hike, but the market didn’t seem to care. Investors have been yearning for a market where things make sense, and at least in the U.S. we have taken the first steps in that transition – for better or worse.

Industrial evolution

The narrative goes that ‘China is killing us on trade.’ But the same forces of globalization that led to the decline of North American industry are actually starting to reverse with a vengeance due to currency fluctuations. Chinese manufacturers are moving factories to Mexico and South Carolina, which more than any other state has experienced the pain and gain of globalization. As Donald Trump wrote on his Trump University blog, outsourcing jobs is not always a terrible thing in the long run.

Overall global trade, though, has grown at a lackluster pace for five straight years, a trend not seen since the 1970s. Much of the blame has been assigned to slowing demand from China, but a growing number of economists are researching the correlation between the growth of the digital economy and the slowdown in global trade. As automation like 3-D printing continues to disrupt traditional labor-intensive manufacturing, the trend could accelerate.

The flow of digital information around the world more than doubled between 2013 and 2015. Companies have begun bringing production closer to home or concentrating it in bigger markets. Digital transfer of information is replacing cargo ships. While the developed world will be forced to adapt to the structural decline of industrial jobs, the diversity of the U.S. economy means the current manufacturing recession isn’t really a big deal in the grand scheme of things.


Chinese markets got in on the act this week, recording their biggest weekly gain of 2016 in spite of an unconvincing performance at the G20 summit, a credit outlook cut from Moody’s (its first negative action on China’s credit rating since 1998) and large-scale public sector layoffs. Maybe it helped that the government reportedly intervened in the stock market Friday.

The worst kept secret in the world is that the Chinese banking system has a lot of bad debt on its hands. But that isn’t stopping bankers from packaging those loans into securitized products. Smell like subprime? Sort’ve, but in this case there are no illusions about these assets being AAA-rated.

China’s bid to restore confidence also rumbles on, with the government this week muzzling an outspoken business man on social media and seeking to humanize President Xi Jinping by highlighting the four known times he cried.

Sweet oil

With oil languishing in the $30s, a wave of bankruptcies in the energy sector is inevitable, with well-capitalized firms waiting in the wings to scoop up distressed assets. This week, Exxon said I’ll see your $450 million IPO and raise you a $12 billion bond offering. Amid the looming threat of a credit downgrade, the oil giant decided to go ahead and start building its war-chest.

Meanwhile, the U.S. shale industry tells OPEC: if oil gets back above $40, we’re coming back. While shale producers at one time had break-evens of around $60-70/barrel, technological advancements have continued to drive down production costs. Saudi-led OPEC has been attempting to drive “uneconomic producers” out of business before agreeing to any production cuts, but has, more than anything, just shot itself in the foot. Exhibit A: Saudi foreign exchange reserves are tanking. When oil prices do rise, those West Texas shale wells will just come back online under new ownership, anyway.


They did it. Argentina reached a deal with its remaining holdout creditors, who will receive 75% of their claims and enjoy handsome returns on their 15 year-old investment. The deal is contingent on the Argentine congress repealing legislation blocking the government from paying late holdouts better terms than those in earlier restructurings, but that is expected to be a formality.

To pay for the deal, Argentina will raise the $15 billion in overseas bond markets, to which it will have access for the first time since 2001. After 15 years of bad-faith negotiations, though, the holdouts are still skeptical of Argentina and will push for the payments to take place before the injunction preventing Argentina from issuing bonds is lifted.

It’s been emotional, but this is a win for everyone, including new Argentine President Mauricio Macri, who has targeted a series of structural reforms to boost the nation’s moribund economy. The fate of his administration’s business-friendly approach could have major implications throughout the region.

Indexing vs the Yale (Endowment) Model

If you have a truly long-term investment horizon, you can outperform liquid index funds by investing in a portfolio of mostly private, levered, illiquid securities. That is the belief underlying the Yale (Endowment) Model pioneered by David Swensen in the late 1980s.

The problem is that after two decades of outperformance (which ended spectacularly in 2009), the institutional investing world caught on, piled into private equity and eliminated much of the illiquidity premium. The Yale Model is flawed and unsustainable according to the former and current CIOs of Hewlett-Packard (HP).

Failure to see the big picture

Two weeks ago we talked about Neel Kashkari’s well-marketed, misguided plan to regulate Wall Street banks like nuclear reactors. This week, the Wall Street Journal’s Greg Ip wrote ‘too big to fail’ critics go too far on banks. “In their zeal to stamp out any possibility of future government bailouts, policy makers risk creating new vulnerabilities that could undermine the economy and make the next crisis worse.”

Especially if those policies are crowdsourced.
The idea that stringent regulation would solve the financial industry’s ills has been put to the test this year as big bank stocks have been pummeled under pressure from slow growth and negative interest rates. Bill Gross thinks Wall Street should just start getting used to a new, lower-margin normal.

Emerging opportunity

Last week we talked about PIMCO’s view that emerging markets could be the “trade of the decade.” This week, investors continued to make the case that emerging markets (EM) have gotten “so bad they’re good.” The best time to diversify into an asset class is after an extreme period of underperformance, not outperformance, wrote Charlie Bilello, making EM an attractive play right now. EM Looks Terrible—Time To Buy, wrote Larry Swedroe.

Perhaps the most troubled emerging market of the bunch, Brazil, found out this week that its economy shrank by 3.8% last year – its steepest contraction in 25 years. The International Monetary Fund (IMF) predicts a further 3.5% decline for the Brazilian economy in 2016, which would mark the country’s worst recession since 1901.

However, Brazil’s Ibovespa benchmark index rallied an eye-popping 20% this week amid news the crackdown on systemic government corruption is gaining steam. Former President Luiz Inacio Lula da Silva was detained and questioned, increasing pressure on his hand-picked successor President Dilma Rousseff, whose defiance in impeachment proceedings has prevented the implementation of structural reforms needed to resuscitate the Brazilian economy.

The complicated legacy of Aubrey McClendon

One day after being charged with conspiracy to suppress prices for oil and natural gas leases, former Chesapeake Energy CEO Aubrey McClendon died in a fiery single car crash in Oklahoma City. Although his career was somewhat tainted by his 2013 ouster from Chesapeake and the recent conspiracy charges, in his heyday McClendon was known as a charismatic, swashbuckling innovator who spearheaded the U.S. shale revolution.
In other news

Bloomberg’s Luke Kawa kindly created a user guide for Warren Buffett’s annual Berkshire Hathaway shareholder letter.

JP Morgan GEO Jamie Dimon conducted a rare, wide-ranging interview with Bloomberg News editor-in-chief John Micklethwait in which he gave a frank assessment of the future of finance.

For the first time, Google accepted blame for an accident involving one of its self-driving cars.

Nobody is eating at steakhouses in New York’s Financial District anymore because Wall Street has moved north to Midtown.

Meet the $18 million Yahoo exec you’ve never heard of. Yahoo! might be hemorrhaging money, but at least its executives are making out well.

In case we need another reminder about the no-brainer case for infrastructure investment, Mark Thoma laid it out very eloquently.

Robots are coming for Wall Street: The New York Times put together an insightful series on how technology is reshaping the workplace.

Weekly Roundup
Markets rally on oil, financials
Global stocks rallied for the third straight week amid signs of a strengthening U.S. economy and waning fears over China’s economic slowdown. The small-cap Russell 2000 led the way with a 4.3% gain, followed by the Nasdaq (2.8%), S&P 500 (2.7%) and Dow (2.2%). After a three-week rally totaling 7.4%, the S&P is now down only 2.2% year-to-date.

As risk appetite flooded back into the market, U.S. treasurys sold off ten basis points to 1.86% while junk bonds capped off their largest seven-day inflow since such record-keeping began in 2002. Oil certainly played its part in the equity and junk bond rally, with West Texas Intermediate (WTI) crude rallying nearly 11% for the week to $36.33/barrel. Equity and credit in beaten-down energy names enjoyed large rallies from depressed prices, an example being Chesapeake Energy (CHK), which spiked more than 40%.

Economic Data

Friday’s jobs report capped off a week of strong economic data (more on that above). The U.S. economy added 242,000 non-farm jobs in February (versus expectations for 190,000) with upward revisions to January and December. The bad news was wage growth declined 0.1% year over year. By Friday, Fed Funds Futures markets were predicting around a 50% chance of a September rate hike, whereas expectations at the beginning of the week favored a December hike. The raft of strong data prompted the Atlanta Fed to revise its Q1 GDPNow forecast up three basis points to 2.2%.


Asian markets also enjoyed impressive gains for the third straight week.

Japan’s Nikkei 225 rallied 5.2% and is now more than 12% off its recent lows, although still down around 10% in 2016. For the first time ever, the Japanese government sold 10-year notes at negative interest rates – and the $19 billion auction was three times oversubscribed! Japanese officials touted the merits of negative interest rate policy (NIRP) while leaders at the G20 summit pledged to pursue more structural and fiscal reforms in place of unconventional monetary policy.

China’s Shanghai Composite rallied 3.9% while Hong Kong’s Hang Seng Index gained 4.2%. After assuring global finance chiefs at the G20 summit it had the tools to cope with slowing growth, China eased pressure on its banking system by cutting its reserve requirement ratio to 17% from 17.5%, a move expected to free up more than $100 billion.


Europe’s Stoxx 600 Index rallied 4.4% as pressure on bank shares subsided. While U.S. markets rallied on strong data, European markets are being boosted by expectations for further stimulus from the European Central Bank (ECB) next week. Eurozone consumer prices fell at an annualized rate of 0.2% in February, doing nothing to change the ECB’s thinking.

Emerging Markets

Former Brazilian President Luiz Inácio Lula da Silva (“Lula”) was detained by federal authorities in connection with the corruption and fraud scandal that has ravaged the country’s economy. Current President Dilma Rousseff, the Workers Party’s handpicked successor to Lula, faces the increasing likelihood of impeachment, a fact cheered by Brazilian markets eager to put the catastrophic era behind them. In fact, the benchmark Ibovespa index finished the week up around 20% despite news the country’s economy contracted by the widest margin in 25 years.

After 15 years of negotiations, Argentina reached a deal with holdout creditors over defaulted debt pending approval from the Argentine congress. President Mauricio Macri’s new government moved swiftly to resolve the quarrel only three months into his term, allowing Argentina to once again tap global credit markets.

Corporate News

U.S. exchanges, Intercontentintal Exchange Group (ICE) and CME Group, are reportedly considering bids for the London Stock Exchange (LSE) to rival its advanced merger talks with the Deutsche Boerse.

Wall Street Week


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