In the past week, Goldman's warnings about an imminent market correction have been coming out on almost daily basis. Two days ago, Goldman's cross-asset strategist Ian Wright warned that "The Last Time Correlations Were This Low Was Just Before The Financial Crisis", followed overnight by a report by Goldman's Jan Hatzius, in which the chief economist cautioned that due to the market complacency manifest in the easiest financial conditions in two years despite two rate hikes in recent months, the Fed will likely have to engage in "shock" monetary policy (if only to confirm that Janet Yellen has not lost control of the market).
Now, in yet another note from Goldman, the bank has released its "worst-case survival guide to uncertainty, taxes and trade", from which we previously showed one chart demonstrating just how concentrated the S&P's return is in 2017, but which is sufficiently informative to merit a full breakdown.
In the report, the Goldman strategist writes that plunging vol coupled with policy uncertainty are "cause for pause" and adds that "low volatility at this time presumes a pro-cyclical success story in DC", which however is looking increasingly unlikely and is happening against a lack of clarity on direction of Trump's future policy, especially after this week's sacking of Comey which appears to have infuriated Democrats even more.
This, in turn, is creating headwinds for M&A, capex and lending. Furthermore, one of Goldman's favorite straw man argument, the emergence of "animal spirits" has yet to translate into improved growth at home (witness Q1 GDP) while market breadth narrows, as we showed earlier with the chart demonstrating that only 10 stocks accounts for half of the S&P's YTD gains.
Some of the material items Goldman is tracking at the moment:
- The clock is ticking on tax reform with the House in session for 39 days before the August recess.
- The 10 states hit hardest by a repeal of the State & Local Tax deduction have 46 Republicans in the House, one more than the GOP’s current majority.
- Corporate spending is showing signs of fatigue with M&A on pace to be down 25% YoY and bank loan growth slowing materially since the Election.
- With improving growth and potential reflationary policy we sit at a crossroads for duration assets, a potential taper tantrum overseas and commodities delinking from commodity equities
Below we lay out key excerpts from the presentation, including the key supporting charts.
2017: Modern Art for the Portfolio Manager
The flat S&P 500 index performance over the last 2+ months belies a large amount of sector rotation under the surface. We note:
- The Odd Couples: Tech, Consumer Discretionary, Health Care and Utilities are currently leading the market. This is a strange mix as Tech and Consumer Discretionary have historically been negatively correlated with both Health Care and Utilities.
- Commodity-driven weakness: Energy stands out given how much it has lagged over the last three months and more recently the spill-over into other commodity-driven sectors (Industrials and Materials) has become more evident.
- The Great Unwind: Financials momentum has faded significantly. We note the sector has given back all its relative outperformance since the day after the US Election (~600 bp since the high-water mark on December 8, 2016).
A Worrisome Disconnect? Uncertainty but no Fear
The juxtaposition of rising policy uncertainty vis a vis declining fear in risk assets raises cause for pause in our view. With investors focused on the ‘Art of the Possible’ as it relates to Trump’s pro-cyclical agenda the market is giving a pass on the negative impact Policy Uncertainty has on corporate spending, M&A and by extension economic activity. Indeed with quarter-over-quarter annualized GDP growth of 0.7%, animal spirits failed to materialize into economic activity in Q1. With much of the optimism priced into the market today hinging on a more complete Washington agenda we note progress may be slow with the House in session for just 39 working days before the August recess.
Further elements of the upcoming tax plan raise questions specifically as it relates to the deduction of State and Local taxes where the top 10 states most impacted yields not a single Republican senator but 46 members of the House. We note that is one more than the GOP’s current majority. Below we frame the history of Policy Uncertainty, its relationship with corporate spending and provide a deep dive on the state of (the lack of) volatility. Lastly we map factor and sector impact in the face of rising fear.
- Policy Uncertainty spiked around the US Election to levels last seen in 2013 and remains above the post-Lehman average. The recent decline in Small Business Future Business Conditions helps illustrate the potential linkage with activity. In its April release, NFIB President and CEO Juanita Duggan noted, “The tax system is a major burden …and an impediment to economic growth… Without clarity on future rules, it is likely difficult for business owners (of any size of company) to make spending decisions.”
- M&A activity, which has historically shown a strong correlation with policy uncertainty, is on pace to be down 25% YoY. In their 1Q17 calls, Lazard CEO Kenneth Jacobs commented, “The M&A market has been uneven this year as corporate decision makers cope with uncertainties regarding U.S. policy under the new administration,” and Evercore Chairman of the Board John S. Weinberg said, “You will see what I would call smaller transactions, there is no hesitation…I think large transactions will be influenced somewhat by tax policy.”
- Bank loan growth has also slowed materially since the Election (down from ~7% YoY to ~3.5%), with business (C&I) and CRE lending showing some of the sharpest declines. This could be indicative of a CapEx slowdown, which has also been correlated with Policy Uncertainty in the past (though with a lag). See Exhibit 13.
Despite elevated levels of Policy Uncertainty, the traditional market proxy of uncertainty – the VIX – is near all time lows. SPX 1M implied volatility hit its lowest level ever this week (note, index options started trading in 1983). This is not just an equity phenomenon as many fear gauges across most asset classes (e.g. US rates, G9 FX, US High Yield) are below average.
Furthermore, positioning suggest investors are positioning for volatility to move lower. AUM of inverse VIX Exchange Traded Products (such as the XIV) has grown ~$600 mn YTD while AUM in long VIX products have declined $460 mn. In addition, short positions on the VXX, the largest ETP product, are currently in the 87th percentile vs. the last year.
Tax Reform: Where to from here?
Congress has a number of issues on its plate and is running out of days ahead of the summer recess to address tax reform. It is also unclear how much consensus there is around key issues. Furthermore, both the House and President Trump’s proposals to repeal the State and Local Tax deduction (which costs the government ~$100 bn/yr) look to disproportionately impact Democratic states. An analysis of the top 10 states likely to see their tax bills go up yields not a single Republican Senator, but 46 members of the House of Representatives. That is one more than the Republican’s current House majority.
What’s the timeline? Republican leadership has committed to getting tax reform done in 2017, but may struggle to accomplish this task with the House in session for only 39 days until the five-week August Recess (and 87 days through the end of the year).
Can tax reform get done? It is unclear how much current consensus there is between the House and Senate, and there are also differences compared to President Trump’s proposal. Key differences have emerged in regards to deficit neutrality (and over what time period), Border-Adjustment (BAT), the marginal individual tax rate, corporate tax rate and the State and Local Deduction.
A word on the State and Local Deduction (SALT). The SALT is one of the largest federal tax expenditures with a cost of ~$100 bn in 2017. However, the deduction is used more by higher-income households (about 45% goes to taxpayers with incomes over $200K). It is also concentrated in certain states, with California and New York accounting for one-third of the deduction claimed and about 20% by number of returns. The top 10 states are responsible for almost 2/3 of the deduction and slightly over 50% by number of returns.
If SALT were to be repealed, the average tax increase for someone claiming the deduction is estimated to be $2,348 by the Tax Policy Center, a joint project of the Urban Institute and Brookings Institution. Not surprisingly, those states with a higher tax rate would be impacted more, with the average tax increase in Connecticut, New York, New Jersey, California and Massachusetts projected to be over $3K/person (if the deduction is used).
In Exhibit 20 we leverage our Macro to Micro Compass (introduced in November 2016) to analyze which sectors and factors have historically been most sensitive to shocks in VIX and Policy Uncertainty. As always, past performance isn’t an indication of future results and we note that positioning, momentum and divergent macro trends (among other inputs) may play a role.
The Art of the (Trade) Deal
With support for the Border Adjustment Tax waning in recent months, focus on trade more broadly has for all intents and purposes faded into the background. We remind investors about the potential (and likelihood) for the Administration to flex its Executive Powers. Indeed, trade imbalances were a key focus throughout President Trump’s campaign and the administration has the power to take action without Congress. We note recent commentary from Commerce Secretary Wilbur Ross stating that “[trade rule] enforcement will be one of the major tools for fixing things.” To that end, the need for portfolio managers to understand import/export dynamics is arguably greater than ever. In a bid to help frame the debate we leverage both macroeconomic industry data and our bottom-up analysis to identify the most exposed global sectors and companies.
The liberalization of global trade throughout the post-war era has been a major driver of both US and global economic growth (see page 12 for a brief history of US Trade Policy). As highlighted in Exhibit 21, from 1960 to today total US trade volumes (imports plus exports) increased from less than 10% of GDP to nearly 30% of GDP. We note that during this same time period the United States has gone from a modest trade surplus to a trade deficit surpassing 2.5% of GDP or approximately $500bn per year (see Exhibit 22).
A word on the President’s authority over trade: The US Constitution provides Congress the authority to regulate international trade and to collect taxes, duties and tariffs. Congress has periodically given the president the authority to negotiate tariff reductions (e.g., the Reciprocal Tariff Act of 1934, the Trade Expansion Act of 1962, the Trade Act of 1974), but this delegated authority has always been limited in scope and duration. Thus, any trade-related action by the President must find statutory basis and could potentially be challenged in court.
Free Trade or Fair Trade 101 Revisited
The administration remains focused on the US’s $500bn annual trade deficit. To that end, below we once again identify the net balance of trade in goods via both an industry and a regional lens. We note that while China and Mexico are commonly the focus of political rhetoric, we remind investors that the United States is a net importer of goods from nearly all regions and all sectors.
Further, with investor sentiment towards Eurozone growth clearly improving vis-à-vis the United States, as evidenced by the +10% move in the STOXX 600 year-to-date and the +3% move in EUR vs. the USD over the same time frame, we pause for a minute to highlight that the Eurozone runs an annual trade surplus of more than $100bn (2014 figures) with the United States, driven primarily by Chemicals ($39.5bn), Transports ($30.9bn) and Machinery ($27.0bn).
Global Equity Spotlight: Mapping Cross-Border Sales & US Trade
Considering the administration’s explicit focus on reducing the trade deficit, below we leverage our global coverage footprint to develop a bottom up perspective of US sales exposure and identify which sectors and stocks may have the most at stake. Focusing specifically on non-US domiciled names, Exhibit 26 identifies the 10 sectors that derive the largest percentage of their aggregate sales from the US (ex. Energy & Financials). Further, in Exhibit 27 we highlight the top 25 international companies by total US Sales ($, millions).
We acknowledge that this analysis focuses solely on end-market sales and does not address where the products are produced as there is likely some local manufacturing.
When the P leads the E, Should We Applaud Revisions?
The S&P 500 has staged an impressive 12% rally since the US Presidential election though earnings revisions have not kept pace. The net result? Significant multiple expansion bringing the index P/E to near the highest on record (18.1x). While estimates have started to move higher over the last month we note that in many cases the market has pre-traded this. With multiples elevated across much of the market, we look for companies where estimates have moved higher (though the stocks many not have) and our analysts see further upside vs. consensus including STZ, CMI, BK, MA and LRCX. However, we do see risks out there, particularly as operating margin forecasts look optimistic against a backdrop of higher labor and commodity prices (on a yoy basis). We see downside revision potential for GIS, SEAS, SPR and PCLN.
Putting the S&P 500 multiple expansion in context:
- 2017 earnings estimates are down 1.5% between November and April, while prices are up 11%. The S&P 500 P/E (2017E) is now 18.1x, up from 15.9x pre-Election. On 2018 estimates, the P/E has similarly expanded about 2 points (14.6x to 16.3x).
- Multiple expansion has been evident across the vast majority of sectors, with Energy the lone exception. It has been most pronounced in Materials, Consumer Discretionary and Health Care which have all rallied over 10% at the same time that estimates moved more than 5% lower. The only sectors with positive earnings revisions have been Financials and Industrials.
- Earnings do drive stocks. Indeed, companies with positive estimate revisions have outperformed those with negative by 16% at an index level since the election. This delta is consistent across all sectors and was most significant in Consumer Discretionary (24% delta), Industrials (22%) and Real Estate (21%).
Earnings have started to follow, but will it be the start of a trend?
Consistent negative revisions have become somewhat of a given, with S&P 500 estimates moving lower during nine of the last ten years (2010 was the exception). On a monthly basis, things do not look much better, with estimates moving higher in just six individual months of the last five years. Though estimates are down in aggregate since the election, the latest data point provides a glimmer of hope acknowledging the magnitude was small and one month does not make a trend. In addition, positive revisions outpaced negative revisions by 15%, the highest ratio since 2014. On a sector basis, the balance was skewed positively across most of the market, with Telecom and Energy the outliers on the negative end. See Exhibit 31.