Midterm Elections and the Markets
Hedge fund veteran Craig Drill figures the most important impact of the 2012 midterms will be a boost in Pentagon spending.
Once a quarter, we receive an investment update from Craig Drill, one of the old hands of the New York hedge fund world. Drill is not one of those flashy, fame-loving fund managers you see on Bloomberg or CNBC all the time. He is just a pro's pro, respected for his firm's probity and deep research. Here are some direct excerpts from his Q3 letter, sent out earlier this week.
I have bolded some of the more significant comments, but there are many more great insights in every paragraph. Consider that this is not just anyone talking, but one of the wise elders who has been through more bull and bear cycles than you can count and lived to tell the tale.
-- Last Friday, the Bank of Japan, amid significant internal opposition, unexpectedly expanded its version of quantitative easing. ... It is fighting risks of deflation and weak demand after the value added tax increase, with the sales tax set to rise again in 2015. Not only was the timing a major surprise, its substantial scale stunned the financial world. If people thought the Federal Reserve's balance sheet was large, they have not looked at Japan's.
-- With the BoJ move, expectations have increased that the European Central Bank, facing the core inflation rate slipping in the eurozone, will be forced to become more aggressive, despite the recalcitrance of Germany and other members . The impact of such unconventional monetary policies is difficult to track or quantify. Yet, directly and indirectly, these policies, with which we have little experience, clearly have boosted asset prices.
-- In contrast with the ongoing weakness of Japan and the eurozone, the U.S. economy is expected to grow at a 3% or faster rate in the second half of 2014 and in 2015, up from the 2.2% average rate since the end of the Great Recession in June 2009. Inflation remains low and longer-term inflation expectations are well-anchored, but not with the downside risks facing Japan and the eurozone.
-- With monetary policies diverging between the U.S. and other major economies, the U.S. dollar (USD) has been strengthening, helping to subdue inflationary pressures here. ... Besides interest rate differentials, overseas investors remain confident in the United States, given its competitive manufacturing base, spirit of innovation, increasing oil and gas production, position with the world's reserve currency, deep and liquid securities markets, stable social/political system, and military might. Also, not to be underestimated is a system of contract law that provides equal protection to non-U.S. investors.
-- The benchmark 10-year Treasury is yielding approximately 2.3%, down from 3% at the beginning of the year, helping to offset the deflationary influence of a strong dollar. Historically, the U.S. economy is more sensitive to interest rates than to the currency level. Contributing to the fall in yields has been the status of Treasuries as a safe haven. Al Wojnilower calls them "financial teddy bear" -- hugged when people are afraid and kept nearby even when circumstances seem safe. And they pay a higher interest rate than German Bunds and Japanese government bonds and about the same as the 10-year Spanish note!
-- The price of crude oil has been pressured by the dollar's strength, surging crude output (from the U.S., Saudi Arabia, and elsewhere), an abundance of natural gas, and a slowdown in global demand. Lower oil prices help some of the Persian Gulf nations squeeze their enemies: Iran, Russia, and the Caliphate. ... Lower prices also act as a tax cut for US consumers via lower gasoline prices (now below $3.00 per gallon versus $3.60 in June) and home heating oil bills, and reduce a wide range of production and distribution costs.
-- Last Wednesday in the US, the Federal Open Market Committee quietly announced the completion of the last installment of its $3 trillion plus asset purchase program. ... That morning, former Federal Reserve Chairman Alan Greenspan further warned that he "does not think it's possible" that the Fed can unwind years of extraordinary stimulus without causing turmoil in financial markets. But the Fed will keep -- not sell -- what it has bought, reinvesting interest and rolling over maturing securities. With this sizable cash flow, the Fed will continue to be a large bidder in markets.
-- The Fed is further expected to initiate its first increase in interest rates in 2015. If for nothing else, raising interest rates will allow the Fed to gather ammunition ahead of the next crisis. But, lest we forget, the stock market has tended to rise for more than two years after the first rate hike, because this initial tightening usually signals a stronger economy. Monetary policy normalization is good for the stock market if it reflects a healthy business cycle.
-- Although monetary policy has passed the point of maximum ease, the Fed is likely to continue to err strongly on the side of accommodative financial conditions. The real (after inflation) level of interest rates will remain low for a considerable time.
-- U.S. fiscal policy is no longer a major restraint on growth and is not a market mover. For next year's Congress, it may be an accomplishment just to avoid a needless debt-ceiling crisis, with threats of a government shutdown or default, which helps to explain the market's apathy about this week's midterm elections. (Above, Craig Drill at Bipartisan Policy Center meeting, 2013.)
-- No matter the outcome, defense spending and domestic discretionary spending are likely to rise. Recent comments by former Defense Secretaries Leon Panetta and Robert Gates have added momentum to increases in defense spending above current "sequester caps." It is highly unlikely though that defense spending will increase without some increase in domestic programs as well.
-- Should the GOP win both chambers, the Republicans will have more members on every committee and subcommittee than the Democrats, and Republican Senators will also assume all chairmanships. There will be a profound shift in firepower to the Republicans for Supreme Court appointments, investigations, and legislation.
-- Some contend that this will enable attempts at wide-ranging legislative changes, and often mentioned is the legislative procedure called "reconciliation," which prohibits (with restrictions) Senate filibusters under the Budget Act. Yet, any legislation on the Keystone XL Pipeline, rolling back EPA coal restrictions, fracking on federal lands, many tax changes for individuals, and reform of the Dodd-Frank Act and the Affordable Care Act will face possible Presidential vetoes and the likelihood that neither the House nor Senate will be able to overturn them.
-- In the stock market, the overdue technical correction arrived at lightning speed, falling almost the proverbial 10% from September 19 to October 15. Corrections in bull markets have the psychological effect of reminding investors that markets are a two-way street. Once purged, markets can rapidly rally back to being a one-way street. This is a classic bear trap, and many hedge funds were caught short.
-- Using rough math, earnings per share could grow at a 6% rate (4% core in line with nominal GDP and sales growth and 2% from share repurchases). Adding a dividend yield of 2%, the S&P 500 Index could hypothetically return in the mid- to high-single digits. This assumes no change in profit margins or the price/earnings multiple.
-- Currently, valuation in the stock market may be stretched, but it does not appear to be in bubble territory. Valuation tends to be less important during a bull market, but more important when the uptrend ends.
-- Monetary policy continues to drive market participants to get out of cash and to reach for higher returns, comforted by the view that stocks are in a TINA market (There Is No Alternative). The problem with these types of markets is that few investors have any protection if things go wrong. They assume that they will be able to exit safely and that the exits will not be crowded.
-- Since World War II, bull markets in stocks have not died of old age, complacency, or valuation alone. They generally have fallen victim to accelerating inflation and the Fed's retaliation with tight money. Interest rates rise and the yield curve flattens or inverts. The economy enters a recession and corporate profits fall sharply. Such developments seem unlikely in the current environment.
-- Bull markets have also ended as a result of a shock to the financial system (e.g., the Lehman failure) that causes a credit crunch, severe asset price deflation, and a profound loss of trust and confidence. Such a shock can come from anywhere -- inside or outside the financial system -- and is invariably described as unpredictable by the many who were caught off guard.
My bottom line on the letter: Valuations are not challenging, central banks are on investors' side, and lower inflation and the higher dollar will lead to higher price/earnings multiples. So while there will be threats and fears from time to time, stocks should be able to continue to make progress over the next year at least, in Drill's view. I'll follow up with his Q4 letter early next year.