Wall Street's Best Minds

Byron Wien: 2 Speed Bumps Slowing the Bull Market

A reduction in worker productivity and central bank liquidity works against equities, writes the Blackstone strategist.      

By Byron Wien             

I continue to believe that the two most important issues receiving inadequate investor attention are productivity and the role of central bank liquidity in the performance of financial markets. Productivity is critical to both earnings improvement and a rising standard of living. Central bank liquidity has driven price earnings ratios higher and kept interest rates low.

Productivity has been declining everywhere during the past decade compared to the 1996–2006 period, with the exception of China and India. This has placed the burden of profit growth either on existing customers spending more or on new products and new markets. Improving profitability is increasingly difficult in a slowly expanding business environment. The intention behind central bank balance sheet expansion has been to stimulate economic growth but, by my estimate, three quarters of the monetary accommodation over the past decade has gone into financial assets with only one quarter invested in the real economy.
A major reason for the weak productivity numbers is that no major technological innovation improving productivity has occurred since the internet and the smartphone in the 1990s. The next major positive change will probably result from the introduction of the driverless car and truck. Unfortunately, almost any innovation that improves productivity has the concomitant characteristic of eliminating jobs, leading to human hardship and increasing government costs for social support programs.
Skeptics believe the productivity numbers are flawed because some improvements in worker output as a result of software applications and greater use of medical technology are hard to measure, but there seems to be little question that the productivity gains of the 1995–2005 internet/smartphone period have slowed in the past decade.
The Bank Credit Analyst has conducted a study which concludes that low productivity gains ultimately lead to higher inflation and interest rates. The emerging markets exemplify this. We will have to see if this model applies in the current cycle. The BCA economists conclude that low productivity keeps interest rates from rising at the outset but eventually leads to higher inflation and interest rates as savings are depleted. Some believe the large amount of time millennials spend on Instagram and Facebook actually detracts from productivity. The decline in mathematics proficiency for graduates of American public high schools could also be a contributing factor. Low investment in capital equipment has also lowered worker output per hour worked. There is also evidence of declining entrepreneurship. The birth rate of new companies has declined by 50% since the 1970s and now roughly equals the general business death rate. Despite these negatives, there is some hope that productivity will improve in the second half of 2017 with a stronger economy.
One aspect of the productivity issue is reflected dramatically in the U.S. equity market. Through the middle of June the so-called FAANG stocks ( Facebook (ticker: FB), Apple  (AAPL), Amazon.com (AMZN), Netflix (NFLX) and Google (GOOG), now renamed Alphabet) represented 13% of the capitalization of the Standard & Poor’s 500, but accounted for 33% of the appreciation. These companies were in the 90th percentile of all companies in the index, based on return on invested capital (close to a 100% return). The median was 20%. Investing in the companies with the highest return on invested capital and with the highest margins has paid off. It helps if they are in a dominant position in their respective industries and can maintain their market share. Looked at another way, Amazon and Wal-Mart Stores (WMT) stocks were selling at about the same price in 2008. Since then, Amazon has soared and Wal-Mart has stayed roughly flat. Today, Amazon has a market cap of $476 billion and Wal-Mart’s is $230 billion. Amazon has 351,000 employees and Wal-Mart has 2.3 million. Technology enables some businesses to build profits with a minimum of human capital and enjoy high margins as a result. That will be the shape of the future, with serious implications for the economy and the market.
As for central bank liquidity, it has increased 13% year-on-year for the four major industrial regions – the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. The total of the balance sheets of those four is $12.8 trillion today compared with $3 trillion in 2008 before the financial crisis. We know, however, that the Federal Reserve is tightening its posture, having increased short-term rates twice this year with the promise of further increases to come later. The Fed is also planning to slowly shrink its $4.5 trillion balance sheet by letting maturing bonds be redeemed without buying replacements in the open market. This has the effect of reducing the supply of money in the economic system with bearish implications. The European Central Bank under Mario Draghi is also considering switching to a less accommodative stance. Draghi is going to the Jackson Hole economic conference at the end of the summer where he may announce a change in European Central Bank policy. If the Fed chooses to become more aggressive in its tightening process, Janet Yellen may use Jackson Hole as an opportunity to announce that change to the world as well.
Fortunately, earnings are coming in better than expected. After several years of modest increases, primarily because of poor performance in the energy industry, S&P 500 earnings are expected to break out and be up 10% this year to close to $130, or possibly even higher. Earnings improvements in the financial services industry will also help increase 2017 profits for the index. Continued double-digit earnings increases should not be expected, but I could see S&P 500 earnings exceeding $150 by the end of the decade if no recession takes place. While the current expansion is more than eight years old, few excesses are apparent and I am optimistic that the next serious downturn is several years away. If a recession should occur before then, determining what policy steps could be taken to get us out of it will be difficult. With interest rates already so low, the Fed has little room to create stimulus by dropping the Fed funds rate. Also, a Republican Congress is unlikely to pass bills providing significant fiscal stimulus. As a result, the best policy course is one that attempts to defer the next recession for as long as possible. 

During the past few weeks, the yield on the 10-year Treasury has increased from 2.19% to 2.31%, and many observers are concerned that the yield is finally headed to 3% or higher. At the beginning of the year, the consensus was that higher interest rates would be encountered during 2017, but that view was largely based on Donald Trump getting his pro-growth agenda passed in Congress, and that has not happened. The big financial surprise of the year has been the decline in intermediate-term rates, but the recent rise suggests that trend may be reversing. At the level of 2.5% or below on the 10-year Treasury, my dividend discount model (which is designed to determine when stocks and bonds are equally attractive) indicates that the S&P 500 equilibrium point is above 3000, so stocks at present level of 2460 would appear to be very attractive.
If the 10-year Treasury yield climbs above 3%, the index at present levels would be overpriced based on the model. While the model has the appearance of precision, it is actually a somewhat crude estimator. Until now, interest rates have not played much of a role in the performance of the equity market. One of the reasons the market may be consolidating recently could be that investors are apprehensive about the possibility of rising yields providing bond market competition for stocks.
The optimistic earnings projection of $130 for 2017 was originally based on the assumption that the Trump administration would get a good part of its pro-growth initiative passed in Congress. We are now six months into Trump’s first term and his team has been preoccupied with controversies over Russia, cabinet and other appointments, Twitter postings and other non-legislative matters. It has proven to be almost impossible to get a revision of the Affordable Care Act approved within the Republican Party. Some observers believe Trump made a mistake by trying to tackle health care first rather than other items on his agenda like tax reform, but I disagree. The Affordable Care Act is unworkable in its present form with so many insurance companies dropping out of the program. I believe we must know the cost of the revised program before a new budget can be agreed upon or tax reform can be accomplished.
While the United States economy appears to be strong, there are some signs of weakness that are worth watching. The employment report for June was better than expected, but average hourly earnings were flat, and this seems to have discouraged consumers. The University of Michigan Consumer Sentiment survey is at a nine-month low and this is likely to be reflected in Christmas retail revenues. Automobile sales have been strong for a long period of time, but they are finally showing signs of peaking. Capital spending has improved, but this is largely because of increased expenditures in the energy industry. With the recent soft price of oil, energy companies may pull back on capital projects until the outlook improves. Retail and food service sales are in a clear downtrend. Some of these weaknesses are viewed favorably by investors in the hope that they may persuade the Fed to go slow on raising rates. Softness in the economy will also help keep inflation low, dampening any tendency for interest rates to rise. One of the anticipated drivers of the economy for this year and next is housing, and the data for this sector have been mixed. Overall, the tone of the economies around the world is favorable, keeping an eye on potential areas of weakness is useful.
There is always the danger of a geopolitical event unsettling the world’s economies and markets. North Korea testing a long-range ballistic missile capable of carrying a nuclear warhead and reaching the Unites States is one possibility. Russia taking a hostile position in the Baltic States, as it did in Ukraine, would test NATO.
The lingering question of Russian involvement in the 2016 presidential election may be hampering the [Trump] administration’s ability to pass legislation in 2018 as well as 2017, creating further problems for the market and the economy. Many attribute the current market’s rise to confidence in Trump’s pro-growth agenda. After all, the rally started with his election. If the administration were unable to get even part of its program passed in 2018, there is the danger that the Republicans would lose a significant number of seats in the November 2018 congressional election and I think the markets would find that unsettling.
Since 2009, there has been a strong congruence between the expansion of the Federal Reserve balance sheet from $1 trillion to $4.5 trillion and the rise in the S&P 500. Since the beginning of 2017, the balance sheet has remained flat and the index has risen almost 10%. This divergence is disturbing, particularly since the Fed is contemplating a balance sheet shrinkage starting in September. The combination of small increases in productivity and tighter monetary policy represent an obstacle to the market for the second half of 2017.
Earnings are coming though impressively, however, and I still believe that we will see higher highs for the index before Christmas.
Wien is vice chairman of Blackstone Advisory Partners, a subsidiary of the Blackstone Group.

Europe’s Investment Banks Suffer American Envy

Across the board, most European banks’ revenues are falling further behind

By Paul J. Davies

Credit Suisse stood out as having a particularly rough second quarter, mainly due to a much worse performance in both equity and bond trading in Asia. Photo: Michele Limina/Bloomberg News

Life isn’t getting any easier for Europe’s investment banks.

A string of results on Friday showed they are falling further behind U.S. rivals in the key business of trading bonds and currencies, although some are doing better in equities. Low volatility at home and a lack of scale in the more active and profitable U.S. market are taking their toll.

In investment banking, advising on deals and capital raising, Europeans are performing worse, too, with only UBS getting close to the revenue gains reported by the U.S. banks.

The trouble for the Europeans is that the more money U.S. banks make in their domestic market, the more firepower they will have to deploy on winning business elsewhere. As banks like Morgan Stanley and Citigroup return to strength, the White House’s deregulatory agenda for banks might give this extra impetus.

Credit Suisse stood out as having a particularly rough second quarter, mainly due to a much worse performance in both equity and bond trading in Asia, a market on which it is pinning its turnaround story.

Low volatility in currencies and weak activity among clients in interest-rate related trading hurt all banks. Only Deutsche Bank , which reported Thursday, did marginally better than the U.S. average, although the German bank fell down on its equities business, which saw the biggest revenue fall among its peers.

One bright spot for several banks was the business of funding equities trades for hedge funds, which makes Deutsche’s major loss of ground there look doubly painful. BNP Paribas appeared to benefit most from Deutsche’s woes with its equities revenue up 24% from the second quarter of 2016 in dollar terms, although it said strong equity derivatives results were also a big part of that.

BNP’s revenue gains were far ahead of the pack. Barclays and UBS both managed to do a little better than the U.S. average of a 1% increase. Barclays’ equity revenue was up 4% in dollar terms and UBS’s up 3%.

There is a further threat to European banks in the form of planned changes to global capital rules that could increase equity requirements. This has become somewhat less of a concern since rule makers announced banks are likely to have up to 10 years to meet updated rules.

Meanwhile, European banks’ best hope is that U.S. regulators don’t loosen the leash on American banks too much. Otherwise, the Europeans will have little chance of recovering their lost ground.

How to Profit With VIX at 1993 Levels

Given the CBOE Volatility Index’s recent drop to 8.84, this VIX call trade looks too good to pass up.

By Steven M. Sears

Tim Boyle/Bloomberg
The CBOE Volatility Index, or VIX, dropped to 8.84 on Wednesday after the Federal Reserve finished a two-day rate-setting committee meeting. That marked its lowest level since December, 1993.

The intraday low sparked a shock-and-awe moment as a generation of investors had never seen the fear gauge at such an extraordinarily low level. The reaction among many traders was to buy relatively inexpensive upside VIX calls before everyone else got the same idea.

While there is always a brisk market in VIX $20 strike calls, interest in the trade is peaking as VIX ebbs ever lower. VIX was recently around 9.30. For investors in a fully invested portfolio this is tantamount to buying cheap insurance trades that pay off if VIX rises above 20. The fear gauge’s long-term average is around 19.

What could cause VIX to rally? A sharp drop in the stock market. What could cause stocks to drop? Your guess is as good as mine, but these are the cold facts about VIX calls.

The September $20 VIX call is trading around 43 cents. The October $20 VIX call is trading around 70 cents. The calls are relatively inexpensive and the expirations capture two of the most volatile months in the stock market.
Larry McMillan, a respected voice in the options market, told clients that yesterday’s sub-10 VIX close was the 10th consecutive day VIX had closed below 10 — an all-time record.

“Previously, the Standard & Poor’s 500 Index did respond with a short-lived correction, but that has not been the case on this lowest and most severe probe below 10 by VIX,” McMillan, president of McMillan Analysis Corp., wrote in a premarket note to his clients.

In the past, we’ve cautioned investors against trading VIX.

Many people think they are trading the fear gauge that everyone quotes when they are buying VIX calls. They don’t realize VIX options track VIX futures and that they cannot really trade the fear gauge.

But frankly, upside VIX call trades seem too attractive these days to pass up. Timing is a big difficulty, though. Who knows when, or if ever, stocks will snap lower and VIX will pop higher?

While much is always made about big VIX trades, it is critical to understand that the vast majority of the flows are related to investors hedging stocks, high-yield investments, and even structured products. We’ve done our best to talk some sense to nonsense, but a cottage industry now exists that twists VIX trades into doomsday predictions for the stock market.

About a week ago, for example, Bank of America Merrill Lynch executed a huge VIX trade. The bank bought 260,000 VIX October $15 calls, and sold about the same number of VIX October $12 calls, and then sold about 500,000 VIX October $25 calls. The trade generated a credit of $5 million. The bank crossed about 80% of the trade — that means taking the other side — and the VIX crowd handled the rest. The trade was portrayed in some media reports as someone making a massive bet VIX would soon surge. The reality is less dramatic.

“A hedge for sure,” said someone with close knowledge of the trade. “I suspect versus long stock or a structured product. It’s too big a trade to be a speculation.”

Because the VIX market is tough for most investors to analyze and track, our standard recommendation for investors who ask about trading volatility is to advise them to sell puts and buy shares of CBOE. The exchange-operator CBOE Holdings (ticker: CBOE) owns the VIX complex and thus makes money off the growing fascination that now surrounds the fear gauge.
STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

The Axis of the Sanctioned

By Jacob L. Shapiro


Albert Einstein’s definition of insanity was doing the same thing repeatedly and expecting a different result. In January 2002, U.S. President George W. Bush famously declared Iraq, Iran and North Korea the axis of evil in his State of the Union speech. This week, with the passage of a bill to impose expanded sanctions on Russia, Iran and North Korea, the U.S. has effectively replaced the axis of evil with the axis of the sanctioned – the only difference being that Russia has replaced Iraq on the list of sinners. But if Washington is expecting to see different results this time around, it’ll soon learn how misguided this expectation is.

The U.S. House of Representatives approved the sanctions bill on July 25 with an overwhelming majority (419-3). It was passed by the Senate on July 27 by an equally decisive margin (98-2). Because of the strong majority with which it passed both the House and the Senate, it’s unlikely President Donald Trump can veto the bill.

All three countries targeted by the legislation have been the subject of sanctions before. Many have debated whether this tool is an effective way to influence a country’s actions. A study updated in 2009 and published by the Peterson Institute for International Economics examined 174 case studies and determined that sanctions were partially successful 34 percent of the time. According to the study, the success rate varied based on the goal. If the goal was modest and specific, such as the release of a political prisoner, the success rate approached 50 percent. But if the goal was regime change or significant policy reforms, the success rate was only 30 percent.

The bottom line is that sanctions are an ineffective way of achieving foreign policy objectives in two-thirds of cases, according to this study. They can be a powerful tool, alongside other measures, to encourage a country to halt a certain action, but on their own they can achieve little and might actually make a situation worse.
Sanctions Won’t Change Reality
It is with that in mind that the geopolitical implications of the sanctions bill should be evaluated. Of the three countries included in the bill, Russia has drawn the most attention because of the Russian cloud that has cast a shadow over Trump’s administration since he came to office. But the bill was originally designed to levy new sanctions against Iran; North Korea was also subsequently added. These three countries arguably represent the United States’ most significant geopolitical challenges today. They also happen to be intractable issues that the U.S. does not currently have the will or power to change in any meaningful way – and sanctions won’t alter that reality.

Consider North Korea. The U.S. has been hoping that partnering with China and expanding international sanctions against North Korea, which has already been subject to sanctions for decades, could convince the regime to stop its pursuit of nuclear weapons. The existing sanctions were ineffective, in part because the regime is willing to endure some discomfort to ensure its survival, and giving up its weapons program could put that in jeopardy. China, meanwhile, is either unwilling or unable to bring Kim Jong Un to heel. In the first half of this year, it even increased its exports to Pyongyang by 20 percent year on year, according to a report by the Korean International Trade Association on July 26. (The same report also indicated that Chinese imports from North Korea have decrease by 24.3 percent in the same period.)

The Chinese government itself has also reported increased exports to North Korea in the first and second quarters of 2017. Trump even accused China on Twitter last month of not living up to its sanction pledges against North Korea.

The U.S. is beginning to get the impression that Beijing isn’t willing to apply financial pressure on Pyongyang, and some say the next step should be to impose sanctions against China. But sanctions won’t force China to handle the problem the way the U.S. wants. The dirty little secret is that China’s prestige as the chief negotiator with Pyongyang far outweighs its actual power. That becomes abundantly apparent in situations such as these.
Shared Enemy
Or consider Iran, which has been a foreign policy disaster for the United States since the 1953 military coup that the U.S. helped organize. Many believe the “unprecedented” sanctions (as they were described by U.S. officials at the time) imposed in 2010 have been effective. After all, just five years after they were implemented, Iran signed the much-maligned nuclear deal. Proximity, however, is not causality. Iran did not capitulate because of sanctions.

Iranian President Hassan Rouhani (C) arrives at parliament ahead of presenting the proposed annual budget in the capital, Tehran, on Jan. 17, 2016, after sanctions were lifted under Tehran’s nuclear deal with world powers. ATTA KENARE/AFP/Getty Images
This is not to say sanctions were irrelevant. They were no doubt painful for the Iranian economy, and they became a major political issue in Tehran. But what compelled Iran to sign the deal was that Iran’s strategic plans were disrupted after the Syrian war broke out. In 2010, a Shiite arc of influence, led by Iranian-backed proxies, seemed poised to spread from Tehran all the way to the Mediterranean. But then Bashar Assad’s government came under attack in Syria, and it continues to fight a bloody civil war that has permanently fractured the country. More important, out of the ashes of the U.S. intervention in Iraq, a force arose that would eventually become the Islamic State.

It’s this reality – not the economic impact of sanctions, significant as it may have been – that convinced Iran to enter into the nuclear deal. Iran was wary of a potential Sunni Arab power rising on its border, one with an ideology that saw Iran as an enemy equal to if not greater than the West. The rise of IS meant that suddenly the United States and Iran had a common enemy; IS threatened the national security interests of both countries.

Now that the Islamic State is on the defensive, the subtle ties between these strange bedfellows are beginning to show signs of fraying – on both sides. The issue is that Iran wants to be the dominant power in the Middle East, while the United States doesn’t want any single country to control the region. Defeating Iran by military force is not a realistic option for the Middle East, and by toppling Saddam Hussein’s regime in 2003, the U.S. eliminated the natural balance to Iranian power in the region. The U.S. is trying to reconstruct a regional balance of power to deal with Iran, but the Saudis are weak, the Turks have little desire or need to enter the fray at this point, and no one else is up to the task. Sanctions are not going to induce Iran to stop testing ballistic missiles or to stop funding its proxy groups throughout the region; in fact, they may have the opposite effect.
Easier Said Than Done
And then there’s Russia, which has become something of a U.S. media obsession. Like George W. Bush and Barack Obama before him, Trump came to office hoping to build a better relationship with Russia, only to realize it’s much easier said than done. Trump may have thought that a positive personal relationship with Russian President Vladimir Putin was going to be enough to accomplish what his predecessors couldn’t. But niceties don’t change the fact that Ukraine is a national security interest to Russia, and that the United States – even under Trump – has shown no signs of bending on the Ukraine issue. In fact, Trump has met with Ukraine’s president and has declared his support for Ukraine multiple times. The State Department’s new special representative to Ukraine even said July 25 that the U.S. might consider providing Kiev with defensive arms.

The sanctions bill won’t convince Russia that it can abandon Kiev to the West’s orbit, and it may even embolden Ukraine. It may be coincidence, but Ukraine’s recent decision to cut off electricity to Donetsk, amid other markers of tension, suggests that these sanctions could encourage Kiev to push back against Russia with an expectation of U.S. support. Russia will have to retaliate in some way. In light of this possible escalation, we at GPF may even have to re-examine our forecast for 2017, which saw Ukraine as a frozen conflict.

This is not to say that sanctions are ineffective or that they don’t have any geopolitical import. They do, and we’ll be publishing more on their impact in the near term. But by relying on sanctions that have had only a marginal effect in the past, the U.S. is insisting on forcing square pegs into round holes. That will have ramifications, but the underlying problems – North Korea’s pursuit of nuclear weapons, Iran’s pursuit of regional hegemony and Russia’s need to maintain Ukraine as a buffer – will remain long after these sanctions are lifted.