Mnuchin’s Warning

by John Authers

Steve Mnuchin, the US Treasury secretary, says that stocks will fall if Congress does not pass tax reform. This manoeuvre is a little bit like a spoilt little girl threatening to cry unless she gets what she wants.

Should members of Congress be intimidated into giving Mr Mnuchin what he wants? He contends that there is “no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform”.
It is debatable whether he is right about this. The most direct method to do this, comparing high-taxed companies to low-taxed companies, suggests that faith in a tax cut has dribbled away almost entirely.

If we look at US performance relative to the rest of the world, we see that it is lagging slightly since election day (when a corporate tax cut suddenly became a viable prospect). There is no sign here that anyone is banking on the US getting any advantage beyond the pick-up in global growth:

But if we look at the relative performance of smaller companies (seen as the greater beneficiaries of a tax cut), there is a clear improvement in hopes in recent weeks.

And it is plain that something other than earnings is driving share prices. Capital Economics last week published this assessment, which tends to support Mr Mnuchin's scare tactics:

Although the Republicans’ proposals would raise aggregate S&P 500 earnings, this boost may have already been largely priced into the market. After all, we estimate that the median effective tax rate paid by companies in the index last fiscal year was nearly 28%. If it had been 20%, operating earnings per share would only have been about 10% higher. The S&P 500 has already risen by more than that so far this year.

This “back of the envelope” calculation is clearly very simplistic. But we find it hard to see why the S&P 500 should continue to rise sharply, given that much of its strength so far in 2017 appears to have relied at various times on the prospect of tax reform, the passage of which remains uncertain.

Finally, stocks are being driven by more than earnings. This is how the historic price/earnings multiple has moved since election day.

As for prediction markets, where political wonks use real money to wager on an outcome, the outlook does not look good. This is how the Predictit market's estimation of the chance of a corporate tax cut by the end of the year has moved over the last three months:

There are different ways of looking at this, but I still concur with what a majority of people on the Street seem to think. The risks are broadly symmetrical; a successful tax cut would create as much upside as a failure would create downside. If anything, the implicit odds are less than 50 per cent.

Between BlackRock and a hard place

BlackRock have done their best to make the case that market-cap indexing is not distorting markets.

Most importantly, there is nothing new about high levels of correlation. They were higher in the 1930s, long before indexation was even thought of, than they are now. And indeed correlations have actually fallen post-crisis as money has flooded into passive funds.

BlackRock is also keen to point to the low turnover of passive funds compared to their active equivalents. This implies that they are not setting prices at the margin.

I would like to add one footnote to this, however: the total market cap of the US stock market is currently about $26.6tn. US ETFs hold assets of $3.075tn, according to ETFGI. So according to the data, trading volume of stocks is not quite triple that of ETFs, while the total value of stocks is more than eight times that of ETFs. The whole point of ETFs is that they can be traded through the day, which is not a traditional aim of "buy-and-hold" index investing, and it would appear that ETFs have, indeed, encouraged more people to trade through the day.

At least one of BlackRock's exhibits seems to me to argue against the notion that indexing is not distorting markets. It shows that the most successful active funds are still taking in money:

Thinking about this, I am not sure why BlackRock thinks this improves their case. First of all, there has always been a problem with returns chasing, with investors blatantly putting money into whatever manager or sector has been hot recently. We all know that indexing has been handily beating most active funds, and so a lot of the appeal of indexing is, I suspect, a sub-set of returns chasing, rather than a new sober approach to buy-and-hold investing, with no attempt to pick winners. These numbers emphasise that returns chasing continues.

Further, a net $108bn has been removed from poorly performing mutual funds, which were presumably somewhat more invested in losing stocks than were the index. That has substantially all gone into ETFs. That means, at the margin, that money has flowed from recent losers to the recent winners — which is the very definition of momentum. Also, the mutual funds that suffered outflows held far more cash than the ETFs they moved into — probably a good three percentage points more.

So that transition meant a net $3bn or so moving from cash to equities.

Momentum has always been around, and investors have always been inclined towards herding, and chasing the hottest recent performance. It looks to me from this data as though indexing is exacerbating these flaws.

Hawks, beige in tooth and claw

The Fed's Beige Book, its relatively subjective and anecdotal tour of conditions in the different Fed branches, is out. Big Data techniques, searching for words and patterns, make it easier than it used to be to discern a message.

What we can say about this Beige Book is that, first of all, perceptions of the overall strength of the economy continue to be upbeat, and have improved a little of late. This chart is from RBC:

Meanwhile, the Fed is as worried as ever about tightness in the labour market. This could in the long run, via the fabled Phillips Curve relationship, translate into inflation as workers are able to bid their wages higher. The degree of concern may have dipped in the latest edition of the Beige Book, but the trend remains firmly upwards. The Fed's governors are worried about a tight labour market:

In all, the Book tends to confirm the impression of a Fed predisposed, but not convinced, to err on the side of the tightening. The odds are still on a rate rise in December. Some surprisingly bad numbers for wage growth could still change that.

Dow 23k

The Dow Jones Industrials has passed another round number today. The landmarks come quicker as a smaller percentage gain is needed to reach them. How to remember this latest round number? Here is a good mnemonic for British readers:

And American readers, if you are not quite sure who David Beckham is, you probably do recognise this guy:

The number 23 associates itself with some great and successful athletes. Beyond that, there is no other reason to care about this landmark.

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