- John Velis is a senior multi-asset strategist at State Street Global Markets, the brokerage arm of the asset management firm with $US2.56 trillion in assets under management.
- He says this bull market could continue to rise for much longer, provided the Federal Reserve doesn’t spook investors and inflation stays low.
- Passive investing, which grew tremendously in 2017, could likely be one of the first areas to be hit in the event of a market correction.
- Cryptocurrencies, on the other hand, are likely unsustainable at the current rate and have yet to find their perfect niche, Velis said in an interview with Markets Insider.
State Street, one of the largest Wall Street financial firms, was doing big data before big data was a thing.
As the exclusive provider of Massachusetts Institute of Technology’s PriceStats data, the brokerage and investment research firm sees daily inflation data for dozens of countries on a multitude of products and industries.
The firm puts this data to work for clients every day, alongside its traditional sell-side equity research, to find profit in today’s very expensive stock market.
Markets Insider recently sat down with John Velis, a senior multi-asset strategist at State Street’s Global Markets unit to discuss the current bull market, where investors could still find a place to profit, and cryptocurrencies.
Here’s what he had to say:
This interview has been lightly edited for length and clarity.
Graham Rapier: What’s your biggest worry in markets right now? What keeps you up at night?
John Velis: It’s not very original, but it is a worry even though it doesn’t really keep me up at night because I don’t think there is likely risk in the short term, and it’s inflation.
We’ve got daily inflation data for like 20 countries, and what we’ve seen, not just in the US but also in other developed markets, is that inflation is back to healthy levels, but not excessively high levels. I’ve done more higher-end work, looking at different ways to extract inflation data from the main statistics that PriceStats produces, and I just can’t find a lot of worryingly high inflation anywhere in the world.
The good news is that the Fed’s equilibrium target for inflation is 2% and we’re hovering around it in the high 1’s right now with US growth at two, maybe 2.5%. For the moment, the US is growing at its trend equilibrium growth rate, which I would peg between two and 2.5%. You’ve got trend inflation and trend GDP, which means the Fed can raise rates in this gradual, as-promised, and so far demonstrated, manner. Three or four rate hikes, and I won’t argue on which of those it should be, is a gradual, well-telegraphed, and well-priced into the market at this point.
If inflation spikes above 2%, and again that’s not my main scenario, but if inflation does go higher, we’ve got to start to think the Fed might have to get more aggressive. In that case, the expected path for hikes would get much steeper. That could bring things to an ugly conclusion.
We’re clearly in the late stages of a bull market and not just in equities, in all risk assets. History shows that these bull markets end when the Fed has done enough or maybe even a bit more than necessary tightening.
History shows that these bull markets end when the Fed has done enough or maybe even a bit more than necessary tightening
If inflation looks like it’s going to get out of control and the Fed really has to step on the brakes quickly and everyone starts to worry about that, that could be the biggest risk in my opinion.
Rapier: So the Fed has done everything correctly so far?
Velis: That’s why this rally has really persisted despite everything that you could throw against it and argue that it shouldn’t be: Political risk, North Korea, Robert Mueller, Congress, the White House, all of that stuff seems to be shaking off because when you look at the main two macro-fundamentals and what they imply for policy – steady growth and steady inflation – that’s the most positive cocktail you can have for a sustained risk rally.
Rapier: What’s an inflation level that might start to worry you?
Velis: It’s less the inflation level and more the pre-cursors to inflation, like wage growth. You want to see some wage growth because you want to keep demand buoyant. If people don’t have fat paychecks they’re going to be reluctant to spend. But if you start seeing [inflation] in wages, or in some of these statistical precursors we look for – like prices that have been very sticky over the last year – if they start to pop out of their sticky range, that could mean there’s an underlying growth in inflation. This would be medicines and things like that.
People say “well if producer prices are falling, then consumer inflation is going to be contained,” but the data over a long time show that producer prices are lousy predictors of consumer prices.
The data over a long time show that producer prices are lousy predictors of consumer prices
They’re affected by supply things like oil and commodity prices, or factory backups, so they don’t translate directly into higher prices. A low inflation rate would make my worry even more remote, and that’s good.
Rapier: You said we’re in the late stages of a bull market currently. How much longer can it continue?
Velis: These things can go on for a long time. I’m dating myself, but Alan Greenspan made his comment about irrational exuberance in the equity market in 1996, and the thing kept going until mid-2000. If we’re at this equilibrium, this can go on for a long time as long as nothing happens to upset the apple cart. One of those things could be inflation, or a political development, or perhaps Chinese growth slowing down. Again, there aren’t a lot of signs of those things so this could go on for a long time.
From the custody data, we can see how institutional investors are positioned. They have been loading up on risky assets: equities, high-yield bonds, high beta currencies with high volatility, all those sorts of things. Now they’re very very full, and full positions can also endure for a long time, until they don’t. When they don’t, all of these full positions have to get closed quick, and that’s how you get the rush for the exits and the bottom drops out. Luckily, trying to predict that without a catalyst is difficult.
Rapier: Can volatility come back without a slump in markets?
Velis: There are plenty of theories to explain how volatility is so persistently low. It’s not just in equities, but for currencies or bonds too. They’re all super low. A lot of hedge-funds and sophisticated investors made a lot of money from shorting volatility, and that trade has built its own momentum. It will keep making vol go lower because people are going to keep selling it. The same momentum trades that happen for equities happen with vol’s. You have this momentum that’s keeping things compressed, but at some point you would expect a turnaround. When this unidentified catalyst ever occurs, things will get ugly and they never end well. The trick is, and it’s difficult to pull off, is figuring out when and why that’s going to be.
Rapier: Speaking of volatility, what do you make of this huge explosion in cryptocurrencies?
Velis: I’ve got four talking points, and I’m not sure what the conclusion to extract from them is, but the first is that they look highly speculative. When your friend who’s not a financial insider starts talking about whether they should buy a bitcoin ETF you kind of know it’s the equivalent of my early days of buying something with a dot com at the end of it. That’s clearly what’s been driving it.
They’re also very narrowly held. A lot of them are Asian investors, particularly Japanese. It’s very analogous to the mid 90s to early 2000s, when this mythical Mrs. Watanabe, who’s sort of the cliché Japanese housewife that would manage the family’s finances, would buy Australian currency because those interest rates were higher. Now, it seems like the 21st century Mrs. Watanabe is buying cryptocurrencies. Because a large percentage of cryptocurrency holders – particularly bitcoin – are Japanese, Chinese, or Korean, it means the rest of us are kind of playing on the margins and are beholden to what the Mrs. Watanabe’s of the world want to do.
Three: what’s their purpose? If they’re a speculative vehicle, I don’t really like that. If they’re a store of value, an alternative to these debased fiat currencies in the developed world that central banks have manipulated through quantitative easing and so-forth… A store of value that has the kind of volatility that these things have day-to-day is not a good store of value because you want to be able to account for what your holdings are going to be worth one day after another. That doesn’t seem to be the case in cryptocurrencies.
The fourth is they may be the 21st century version of gold and precious metals in that they’re sort of hedges against central bank policy errors.
Cryptocurrencies may be the 21st century version of gold and precious metals in that they’re sort of hedges against central bank policy errors.
It seems that when interest rates go up, cryptocurrencies see sell-offs, and that’s very similar to gold. You don’t offer a rate of return, so when a competitive rate of return is higher, you might prefer to hold those. Short term cash is going to yield more than a cryptocurrency or gold, and as that short-term cash rate goes up, you’re going to get more out of a low-risk asset than this poorly understood, speculative, high-volatility asset.
My last point is that they’re incredibly energy intensive. Central banks are doing research into cryptocurrencies, they want to understand it and think that in the future they may have to have a cryptocurrency and it might make monetary policy easier to do. Bitcoin has geothermal power plants in Iceland, and they consume as much energy in a short period of time as the nation of Ireland consumes in a much longer period of time. To run these blockchains is very intensive, so there will be physical constraints even on a virtual currency.
You’ll probably see cryptocurrencies continue to be an attractive play for investors with high risk appetite.
Rapier: Are there areas of the equities market where there’s ample room for outperformance?
Velis: If the yield curve continues to steepen – as long as 10-year yields don’t spike insanely high – you’ll see banks continue to do quite well. They kind of map almost one-for-one to the slope of the yield curve. Energy, of course, is bolted to the oil price, but oil prices are going up. As long as those look sustainably high then that’s a place for outperformance. What you really want to look for is value. Late cycle, when stuff has already been bought like crazy, you’re looking for stuff that’s on the discount rack, sort of the cheap, end of season stuff. That would be things like healthcare, which had a rough year with Obamacare sort of always in question.
Politically, it looks like for the time being, most of the congressional-White House interaction is going to be around infrastructure and immigration, so maybe Obamacare doesn’t get the focus any longer, and that allows some of these attractively valued healthcare stocks to start to outperform because they’re a place to park money.
There’s not a lot of cheap equities in the US, so the valuation trade is actually better served by going abroad. Emerging markets were of great value on a comparative basis in the last year or so, and their performance has reflected that value seeking bias of the last year.
Japan is another place to exploit value. The Japanese economy is also looking attractive relative to its own history. Europe was quite attractive for the first months of last year, but it got priced in very very quickly. Europe doesn’t offer a lot value any more, so you’re really looking at regional places, some of these neglected emerging markets that didn’t partake in the rally because of idiosyncratic risks like Turkey and South Africa. They might be places that begin to look attractive, but that’s when you’re really buying undervalued stuff, and things are undervalued for a reason. Whenever the correction comes, those are the ones that will get hammered first and hardest.
Rapier: State Street was one of the first ETF providers. Will passive investing continue to see these massive inflows? Can active managers once again beat the market?
Velis: You can get corrections. 1987, for example, was a correction. That was in October, but by the end of the year and in January, we were back to healthy places. Then you have 2000 and 2008, those were corrections and then bear markets, and people lost a lot of value. Bear markets require some big misalignment in some asset price or balance sheet item. In 2008, it was housing and credit derivatives; in 1999, it was corporate debt and internet technology. You look around for what could be the big mismatch or excess that will need to be quickly liquidated, and there aren’t many candidates, but passive could be one. Passive product providers have seen huge inflows. And since they’re benchmarked to the market, if you have to sell to keep on the benchmark, then you create this downward momentum. Retail investors are ultimately the owners of these passive assets, and you could see them getting spooked and cashing out, and the selloff could be large.
On the other hand, what it has done is it has been indiscriminate with how it values asset prices, and that probably has created some sort of stable equilibrium. There has been talk, since most of these passive instruments focus on large cap stocks, that small caps have been neglected. Alpha seekers, active managers who are looking for unexploited, idiosyncratic places to bet on, may be rewarded by looking at some of these other assets that aren’t included in the big passive envelope.
It’s a hypothesis that hasn’t yet been born out by the data, but it’s worth considering. Small cap performance has not been great, so it kind of flies in the face of that.
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