The Weekly Economic & Market Recap Archive
December 20, 2019
December 13, 2019
Over the last few weeks, global uncertainties, such as the U.K. elections and the December 15th deadline for additional Chinese tariffs, have been weighing on markets and have caused equity markets to be listless and the Treasury yield curve to flatten. The major elements that have produced uncertainty for financial markets have been the outlook for monetary policy and the escalation of global protectionism. Regarding monetary policy and the Fed, financial markets now seem to have clarity. The Fed would need to see a substantial acceleration above its long-term inflation target of 2% to warrant an increase in the fed funds rate. After having to make a mid-course correction this year by lowering rates, quickly reversing most of the four rate increases from 2018, the Fed will not want to repeat the same mistake. Lowering rates seems to be more likely but would require the economy to materially falter off its 2% growth path. The announcement of a phase one trade deal between the U.S. and China on Friday will reduce trade tensions. We expect things to be relatively quiet on the trade front in 2020. Investors can now focus their attention on the economic and market fundamentals for next year. Economic growth will be modest with perhaps a slight pick-up in inflationary pressure due to a gradual tightening of labor markets. Inflationary conditions are not likely to be sufficiently strong enough to meaningfully drive rates higher or the PCE deflator above the Fed’s 2% target. There is not a compelling reason for price-to-earnings multiples to adjust, so that domestic equity returns will be a function of earnings growth. With the potential relief from a trade deal, international markets that have lagged for many years may be more rewarding for equity investors.
December 6, 2019
Back in late August of this year, the aggregate amount of negative yielding debt across the globe surpassed $17 trillion, which represented a quarter of all investment grade debt. Prior to the financial crisis, negative yielding debt was just a theory as it was believed that no rational investor would pay a borrower to utilize their funds and guarantee a loss. However, Europe’s struggle to recover from its double dip recession prompted the ECB to push deposit rates below zero. The idea behind negative rates was to encourage investment by disincentivizing banks from parking their funds at the ECB. Banks would instead lend the funds which would facilitate economic expansion and ward off the threat of deflation. However, negative rates drove down returns on loans and many banks elected not to pass negative rates along to their depositors for fear of deposit runoff, which compressed net interest margins and weighed on bank profitability and their ability to extend credit. Negative rates have also adversely impacted pensions and bond funds who, regardless of yield, are chartered to hold risk free assets. Asset bubbles also become a potential issue when rates are negative as it pushes investors to take on additional risk just to obtain a positive return and has the ability to distort financial stability. The subzero interest rate experiment has few proponents at this point and the near-term solution to negative rates appears to be expansionary fiscal policy. Just this week Japan’s Prime Minister Shinzo Abe announced a multiyear fiscal stimulus package worth approximately $120 billion to help revive growth. Europe is another area of the globe that could use a boost from increased fiscal policy. Right now, Brussels is reluctant to unleash expansionary fiscal policy in the European Union, but as the limits of monetary policy become increasingly clear it is our belief that government spending will be utilized to rekindle growth and alleviate the damage that has been caused by negative rates.
November 22, 2019
The two primary drivers of the financial markets over the last two years have been trade tensions and monetary policy. Risk assets, such as equities and high yield bonds, have had an exceptional year because global central banks have eased, and trade tensions have not continued to escalate as many investors feared. The monetary response was triggered by sluggish global growth. The U.S. economy has slowed from 4.1% growth in 1Q ’18 to an estimated 1.9% in Q4 ’19. The recent rally in stocks suggests that equity investors are pricing in a stabilization and reacceleration of growth in 2020. The case for continued growth next year credibly rests on the support of three fed rate cuts in 2019 and the transitory nature of the causes for economic softness this year. Much of the slow-down has been related to inventory deaccumulation and manufacturing that has been impacted by the GM strike and Boeing’s 737 Max problem. These issues could prove to be temporary, but none the less, there are worrying signs that should be noted. The inverted yield curve is a classic warning that signals a potential recession could be ahead. Leading economic indicators are another important data point that have been deteriorating, but are not yet in recession territory. We believe the U.S. economy will continue to generate modest growth next year, which is consistent with the market’s expectation. However, a major caveat is that a trade deal needs to be done relatively quickly. Corporate America does not seem to have much conviction regarding a soft-landing for the economy as reflected in declining fixed investment spending and CEO confidence. CEO confidence has fallen since the trade war began and is at levels that have occurred during earnings recessions.
November 15, 2019
U.S. GDP growth has been on a downward trend thus far in 2019 shrinking from 3.1% in the first quarter to 1.9% in the third quarter. The main tools that are used to combat slowing economic growth are monetary and fiscal policies. In terms of monetary policy, the Fed has embarked on a mid-cycle adjustment and lowered interest rates 75 basis points (bps) since July of this year. Typically, beyond asset price appreciation, the benefits of interest rate reductions work on a lag, but one of the first sectors to rebound is the interest sensitive housing sector. Moreover, third quarter GDP data revealed that housing made a positive contribution to GDP growth for the first time in over two years. According to the Bankrate 30-Year Mortgage Rates Index, the rate on a 30-year mortgage had dropped 78 bps to 3.73% from the beginning of the year through Thursday of this week. Unfortunately, the recent housing market boost will have a minimal impact on overall economic growth as the housing sector accounts for just 1.9% of total employment and only 3.7% of nominal GDP. On a different note, fiscal policy can be very stimulative to economic growth when an economy has the capacity to service additional debt and the proceeds are directed toward financially productive endeavors. Regrettably, the U.S. is not in an ideal fiscal position as its gross debt-to-GDP ratio is over 100%and the most recent annual fiscal deficit came in at 4.6% of GDP, which was just below $1 trillion.
November 8, 2019
The U.S. Treasury yield curve from 3-month to 10-year had been inverted since the end of May with the yield on the 10-year Treasury bond being below the 3-month treasury bill. Since the yield curve has inverted before every recession since 1975, the sustained inversion rightfully had investors nervous. The yield on the 10-year Treasury spiked higher in November with the yield jumping from 1.70% to 1.93%. After the Federal Reserve cut the fed funds rate at the end of October, the movement of the short end of the curve has been muted. The combination of rising intermediate-to-long rates and almost no change at the short end of the curve has caused the yield curve to normalize. There are multiple reasons for the bear steepening of the yield curve. First, the U.S.-China trade situation seems to be improving and hopes for a partial trade deal are rising. Both sides have strong economic and political reasons to make progress toward a trade deal. The intellectual property and forced information transfer will be challenging to resolve, but financial markets only need a de-escalation of tariffs to make progress. Second, economic indicators have begun to stabilize. It is too early to suggest that the global economy growth slump is bottoming, but it was encouraging to see German factory orders rising 1.3% in September. Additionally, last month’s domestic employment report also eased concerns regarding the pace of slowing in the U.S. The risk-on sentiment has driven yields higher and equity markets to new highs. Bond yields are still low relative to heuristics that bond investors have relied upon in the past but have been artificially constrained due to central bank intervention. We would expect the 10-year Treasury yield to be closer to 3%, with inflation running close to 1.70%. The signal from the bond market with regard to the health of the economy is being confused due to negative rates across the globe. Our base case is for the economy to continue on a moderate growth path assuming a partial trade deal gets completed.
November 1, 2019
October 25, 2019
October 18, 2019
The repurchase (repo) market is a short-term financing venue where more than $3 trillion of cash and collateral are swapped each day and is a critical element which allows the U.S. financial system to function properly. On September 17th, the overnight repo rate spiked briefly to 10%, which was roughly 8% higher than its one-year average. There were three main causes that came together to drain enough liquidity out of the system to shock overnight rates. First, a vast sum of Treasuries settled on dealer’s balance sheets, which had to be paid for. Second, corporations withdrew cash from money-market funds and banks to make quarterly tax payments. Lastly, banks were holding onto cash to satisfy quarter-end reporting requirements. The lack of cash that caused the drastic increase in the overnight repo rate sent alarm bells off throughout the financial system and prompted the Fed to inject emergency liquidity into the system for the first time since the financial crisis. It is interesting to note that the repo market meltdown in September of 2008 significantly contributed to the financial panic at the time and it begs one to question whether the recent spike in the overnight repo rate is a telling sign of more ominous things to come. We do not think the recent dislocation in the overnight repo market is a harbinger of funding pressure ahead as the Fed has numerous tools to restore reserve levels and create the necessary buffers that are needed during times of stress. Just recently the Fed announced that it will be purchasing $60 billion of Treasury bills per month through the second quarter of 2020. The expansion of the Fed’s balance sheet will not be similar to quantitative easing since the Fed is only purchasing short duration Treasuries to enhance market liquidity and not drive down rates further out on the yield curve. Also, the Fed will continue to engage in term repo operations until at least January of 2020. The Fed’s recent actions have pacified the overnight repo market as the average rate since September 17th has been just under 2%.
October 11, 2019
The core CPI, which excludes the volatile food and energy component, rose 0.1% in September, and year-over-year is running at up 2.4%. The September headline CPI increase was slightly less than expected as energy prices declined, and a lower than anticipated increase in used car prices helped keep overall price pressures in check. On the surface, it does not appear that tariffs are having a significant impact on consumer prices even after the introduction of an additional $150 billion of tariffs on Chinese imports. Slowing demand due to a weakening global economy is weighing on prices in several major categories. Despite the unemployment rate dropping to 3.5%, its lowest rate since 1969, wage growth has leveled off at 2.9%. This is well below the 4% rate where the Federal Reserve becomes concerned. The Fed cut the fed funds rate 25 basis-points in both July and September, but it has not lifted inflation expectations. There is a stark disconnect between market expectations for rates and the Fed’s expectations as indicated by its “dot plot”.
October 4, 2019
Major equity indexes fell again this week on several weak economic reports that rekindled recession fears. The Institute of Supply Management released September’s manufacturing data that suggested the manufacturing economic segment, suffering from the trade war, was continuing to contract. It was the lowest reading of the ISM index in ten years. The manufacturing ISM index is closely watched because it provides an early warning of economic troubles ahead. But the manufacturing ISM index represents a relatively smaller segment of a very broad economy, so unless the weakness bleeds into other elements of the economy, a weak ISM can give a false recession signal. Equity bulls have argued that economic weakness has been confined to export-related industrials and manufacturing companies that are more exposed to the impact of the trade war. The relative sector performance within the equity market suggests a deeper concern regarding an economic slowdown. Over the last 12 months, the best performance came from interest-sensitive sectors utilities and real estate, both up more than 20%, and by recession-resistant consumer staples, that is up roughly 16%. Economically-sensitive sectors such as industrials, materials, and financials are all down. The non-manufacturing PMI for September fell as well, perhaps indicating that economic softness is beginning to affect other areas of the economy. On balance, the probabilities of recession next year have risen slightly, but slow growth still seems to be the most likely outcome. The Fed will continue to ramp up accommodation by lowering rates and expanding its balance sheet to assist the economy and to provide a buffer due to economic uncertainties. As the economy slows, the possibility rises that an exogenous shock will dislodge the economy’s growth path and causes the U.S. economy to tip into a mild recession. Equity indexes are likely to be trapped in a trading range until the investors have more clarity regarding the fundamentals that will impact earnings growth in 2020 and 2021. The underlying growth potential of the economy and the resolution of shorter-term issues such as the trade war and Brexit will ultimately determine returns for equity investors over the next year.
September 27, 2019
Brexit is little more than a month away and a solution does not seem to be apparent. This week a court ruled that British Prime Minister Boris Johnson illegally suspended the U.K. Parliament and misused his authority. The unprecedented judicial rebuke was a unanimous decision that has put intense political pressure on Johnson. Johnson has promised to press ahead with his plan to leave the E.U. on October 31 with or with- out a deal. The fractured Parliament has rejected several proposed deals already, and it does not seem to have enough political resolve to coalesce around a workable solution that is palatable to everyone. The ultimate outcome is extremely uncertain, but we would not be surprised to see Brexit delayed again. The Brexit issue is potentially coming to a head at a time when world economic growth is fragile and is being threatened by global trade tensions. The Organization for Economic Cooperation and Development recently downgraded its outlook for world economic growth to the slowest rate since the financial crisis. Recent PMI numbers suggest that the German manufacturing sector is already in recession. The European Central Bank on September 12th cut the deposit rate by 10 basis points to -0.5% to help support the economy. The additional rate cut is unlikely to have much of an impact at this point. Monetary policy in Europe has run its course and further monetary easing will be largely ineffectual. Weak European economies and the ineffectiveness of monetary policy has left the eurozone vulnerable to large external shocks such as Brexit. Increasingly we hear calls for fiscal stimulus from Germany, France, and Italy. The European Commission’s new leadership is pro- growth and seems open to fiscal expansion. We would become more constructive on European equities if the EU and the U.K. can somehow navigate past the Brexit quagmire, the trade war settles down, and European economies become less reliant on central bank intervention.
September 20, 2019
Datadog, the developer of an IT analytics platform, came public this week selling 24 million shares at $27 that valued the firm at $7.83 billion. With fewer companies today electing to come public due to burdensome listing requirements, increased regulatory scrutiny, and to avoid investor’s short-term mentality, it was encouraging to see the company opt for a public listing. It was especially encouraging since immediately before its IPO, Datadog had a $7 billion acquisition offer from Cisco. Large, deep-pocket-ed companies, especially in the IT space, have been acquiring non-public companies in attractive growth niches to augment their growth prospects or to defend their products from rival offerings. A lower number of corporate IPOs and acquisitions are just a couple of factors contributing to the broader concern of the shrinking U.S. equity market. Today, there are 3,600 publicly-listed companies in the U.S. compared to 8,000 in 1996. Another primary reason for the decline in the number of public companies is the availability of capital from private equity sources. Every single year since 2011, U.S. companies have bought more shares than they have issued. The aggregate share count in 2018 shrunk by roughly 3% due to the significant shift in the relative cost of debt versus equity. Even before the recent compression of rates over the last three months, Citigroup calculated that the cost of debt in the U.S. is 4.1% while the cost of equity is 6.7%. The shrinking of the U.S. public equity market has several disturbing consequences. First, companies today are much larger, and profits are increasingly becoming more concentrated. A study by the University of Arizona highlights this issue. In 2015, the top 200 companies by earnings accounted for all the profits in the stock market and the remaining 3,281 publicly-traded companies, in aggregate, lost money. The second issue is that as the equity opportunities shift toward private equity, where the average investor does not have access, retail and smaller investors are losing the ability to participate in early-stage growth companies. Regulators will eventually need to address this structural issue.
September 13, 2019
Equity markets have rallied over the last several weeks as both the United States and China have made several conciliatory gestures in the trade war. China has decided to exempt purchases of U.S. soybeans and pork from punitive tariffs. Relief on soybeans and pork certainly removes some political pressure on President Trump. Chinese agriculture imports of U.S. products are down dramatically since the trade war began hurting farmers, which are an important Trump constituency. The move by the Chinese follows the Trump administration’s two-week postponement of tariff increases on $250 billion of Chinese goods that were scheduled for October 1st. There has been some speculation in the press that an interim trade deal may be in the works that is limited in scope and focuses strictly on trade issues. An agreement, even an interim one, would partially remove some of our concern regarding corporate profits and margins in 2020 and would allow market valuations to continue to lift. However, we do not believe a trade deal that effectively addresses the thornier issues regarding national security and intellectual property is on the horizon. It is hard to know if the Trump administration would be willing to accept a limited trade deal. The S&P 500 currently trades at a roughly 17 times earnings (forward 12 months). Although the current multiple is above the average multiple over the last 20 years, valuations are not extreme and arguably reasonable considering the current level of interest rates. Interest rates have been compressed largely due to central banks driving short-rates down and distorting the term structure due to quantitative easing. This week the European Central Bank kicked off another round of stimulus by lowering rates 25 basis points and restarting QE. The ECB will be buying €20 billion worth of bonds per month starting in November. The Fed is widely expected to lower the policy rate 25 basis points at next week’s meeting. The predominant reason equities have risen back to old highs has been the dramatic shift from policy normalization back toward boundless accommodation.
September 6, 2019
Over the past decade, global central banks have reduced interest rates in aggregate more than 700 times and pumped trillions of dollars into the economy through bond purchases. Even with the extraordinarily accommodative monetary policy previously described, price pressures in major developed economies remain muted and fall short of policymakers’ inflation targets. The Fed’s preferred measure of inflation is core personal consumption expenditures (PCE) and ultimately looks to achieve a symmetric target of 2.0%. Over the past ten years, core PCE has averaged approximately 1.60% and has only breached 2.0% briefly in 2011-2012 and 2018. Given the economic deterioration abroad (particularly in the manufacturing sector) and subdued inflation pressures, the Fed has embarked on a new rate cutting path. However, the market has doubts that the Fed will be able to resuscitate inflation through conventional rate cuts as the 10-year break-even inflation rate currently resides at roughly 1.55% - 46 basis points below its mean over the past decade. With current monetary policy tools appearing incapable of reigniting inflation, there has been renewed talk of a concept called helicopter money that could potentially help drive inflation higher. Helicopter money was coined back in 1969 by Milton Friedman. The idea centers on the one-time creation of money by the central bank that is either directly deposited into individual’s bank accounts or obtained through tax rebates. The theory is that consumers now flush with new funds will go out and spend, which will drive up demand and cause prices to rise. One of the main shortfalls of helicopter money is that it devalues the currency due to the increase in money supply and could lift inflation beyond its intended target. Nevertheless, the potential implementation of helicopter money is a long way off and accommodative monetary policy coupled with fiscal stimulus remains the safest way to solve the inflation predicament.
August 30, 2019
The financial markets have been trading all year on investor sentiment driven by the potential outcome of the trade war between the U.S. and China, and the anticipated direction of interest rate policy by the Federal Reserve. These two dynamics directly impact the global economy, so they are inexorably intertwined. The rhetoric around the trade war has been unpredictable and has caused much of the volatility we have experienced in markets. Although Fed policy is a moving target, due to the vagaries of economic growth, the objective of Fed policy has always been clear. The Fed sets monetary policy to facilitate its dual mandate of price stability and full employment. An independent Fed that is acting in the best long-term interests of those goals has been a vital component of well-functioning financial markets. Investors depend on a Fed that will take measured action guided by the pursuit of its dual mandate. This past week the former president of the Federal Reserve Bank of New York and vice chairman of the Federal Open Market Committee, William Dudley, suggested that the Fed should ignore the potential negative economic impact of the trade war in setting policy and should send a clear signal that the Trump administration will own the consequences of the trade war. Mr. Dudley also suggested that the Fed officials should consider how their decisions will affect the political out-come of the 2020 elections when setting rates over the next year. The Fed was quick to distance itself from such an idea, and it was right to do so. Remaining apolitical and non-partisan is critical to the central bank’s credibility. Mr. Trump’s attacks on Fed Chair Jerome Powell have not been helpful and has only made the Fed’s job harder. Unfortunately, Mr. Dudley has piled on and complicated things even more. The Fed should ignore them both.
August 23, 2019
The current U.S. economic expansion became the longest on record this summer. Despite a reasonably strong consumer and low unemployment, there are growing concerns of a possible recession. The yield curve is flashing caution, as the trade war continues to weigh on the global economy. The Trump administration is considering several options to give the economy a lift. One measure they are considering is a reduction of the capital gains tax. Capital gains tax reductions are often proposed as a policy that will increase savings and investment, provide a short-term stimulus, and boost long-term economic growth. In our opinion, the economic benefits are probably relatively small and largely temporary. Overall, from a longer-term perspective, economic benefits are created by higher levels of aggregate savings and investment. National savings is made up of public savings and private savings. The impact on the budget deficit, and in turn public savings, from a capital gains tax rate cut is dependent on the multiplier effect and on capital gain realizations. The multiplier effect is the greatest in the first year or two following the tax rate cut. Economists do not agree on the size of the multiplier and, as a result, disagree on the potential impact. It is likely (in our opinion) that higher after-tax returns due to a lower capital gain tax rate would incentivize enough additional private savings to have a modestly positive long-term impact. Although the impact from an economic perspective may be relatively small, from the point of view of the investor, it is worth considering lowering or indexing the capital gain tax rate. Capital gains taxes discourage selling assets and adjusting portfolios because capital gains are only taxed when realized. The “lock-in” effect causes investors to hold suboptimal portfolios and forgo investment opportunities with better pre-tax returns.
August 16, 2019
There is no question the global economy is decelerating and the main culprit is the escalation of trade tensions between the U.S. and China. Moreover, the JPMorgan Global Manufacturing Purchasing Managers’ Index resided at 49.3 in July (any figure below 50 signifies contraction) and has been falling consistently since April of 2018. Just this week German second quarter flash GDP declined by 10 basis points on a quarterly basis and China reported the weakest growth rate in industrial production on an annual basis in 17 years. Rising concerns of weak inflation coupled with slowing global economic growth has caused investors to flock toward safe haven assets and high quality bond yields have plummeted particularly on the long end of the yield curve. Early on Wednesday morning, the yield on the 2-year U.S. Treasury briefly elevated above the 10-year U.S. Treasury yield for the first time since 2007. Yield curve inversions have historically been a fairly accurate indicator of a looming recession. Moreover, the last five 2-10 inversions have ultimately resulted in recessions and the recessions have on average arrived 22 months after the initial inversion. However, after the onset of yield curve inversion, equity markets have historically performed quite well. Dow Jones Market Data shows that one year after initial inversion the S&P 500 has returned on average roughly 13.5% according to the past five instances of inversion. Also, outside of the manufacturing sector, the U.S. economy is on stable ground. Initial jobless claims are close to a 50-year low, household balance sheets are healthy, corporate default rates are extremely low, the banking sector is well capitalized and financial excesses appear to be contained. With that being said, trend GDP growth of roughly 2% in the U.S. is expected in the short run, but global risks are certainly mounting and warrant close monitoring.
August 9, 2019
Volatility returned to financial markets this past week as investors grappled with the potential deleterious impact of the escalating trade war between the world’s two largest economies. The U.S. and China trade dispute comes at a period of economic uncertainty. The global economy has slowed over the last twelve months, partially related to a deterioration of global trade, but also related to a general economic malaise. Despite the best efforts on the part of central banks to stimulate global growth, economic activity has been running below long-term average growth rates since the Great Recession. Generally, slower secular global growth that we are experiencing today is the outcome of factors that have been at work for three or four decades. The key factors: 1) Demographics – falling birth rates and aging populations lead to a smaller labor supply which lowers economic output. 2) Supply Side Issues – heavy regulation and higher taxes lead to lower capital investment and capital formation. 3) Fiscal Deficits – as debt levels rise, the opportunity for additional fiscal stimulus diminishes. Although the factors that are pressuring secular global growth are in every developed economy, as well as in China, both the U.S. and China have been more resistant to the secular growth slowdown than other countries. The economies in China and U.S. are inherently more dynamic than other major economic blocks, and they do not have the structural challenges facing Japan (surplus savings) and Europe (common currency). Another positive aspect for the U.S. and China is that the PBOC and the Fed are both in a stronger position to use monetary tools to provide economic support. Assessing many possible outcomes of the trade war is difficult, but the odds still favor that the two largest economies will avoid a recession in the near term.
August 2, 2019
The monetary tightening cycle in the U.S., which began in December of 2015, officially came to an end this week as the FOMC cut the Fed funds rate by 25 basis points and terminated its balance sheet runoff two months earlier than expected. The rate cut was initiated due to the “implications of global developments for the economic outlook as well as muted inflation pressures.” The market, which was looking for the rate cut to be the beginning of a longer easing cycle, was disappointed when Chairman Powell hinted that further rate cuts this year were not guaranteed, but that the FOMC will still be data dependent and will act as necessary to keep the expansion going. Lowering interest rates certainly has the potential to prolong the economic expansion in numerous ways. First, lower interest rates encourage consumers to borrow and increase their consumption as their cost of debt is reduced. Second, businesses that are faced with new demand will be incentivized to hire and invest in new capital expenditures. Third, corporate debt costs are reduced which leads to higher corporate profits. Lastly, lower interest rates reduce discount factors which effectuates higher asset prices. However, the benefits of lower rates may have less efficacy moving forward given the fact that the upper bound of the Fed funds rate resides at a relatively low level of 2.25% (less than half the level it was during prior downturns). Structural issues such as aging demographics, high debt levels and technological innovation have been headwinds against elevating inflation. Moreover, the U.S. 10-Year break-even rate (a measure of inflation expectation) currently resides at only 1.65% and is roughly 31 bps below the mean dating back to 1998, which indicates doubt that the Fed will be able to achieve its symmetric 2% inflation target anytime soon.
July 26, 2019
The U.S. domestic economy has slowed, but we expect growth to stabilize close to its long-term growth trend of approximately 2%. The consumer side of the economy has been solid with generally favorable economic conditions. Unemployment remains very low, and monthly non-farm job gains have averaged a relatively robust 172,000 new jobs in 2019, driving consumer spending in the second quarter. The manufacturing segment of the economy, on the other hand, has deteriorated due to the impact of the trade war. Weak business-fixed investment and the deteriorating ISM manufacturing index numbers suggest that the manufacturing side of the economy has been the economy’s primary vulnerability. The problem has been far more pronounced in Europe because the European economy is far more dependent on trade. The Eurozone exports goods and services worth 28% of its economic output each year versus only 12% for the United States. On a per-capita basis, Germany exports ($21,000) three times as much as the U.S. ($6,800) and according to the Organization for Economic Cooperation and Development, one in four jobs in Germany depend on exports. Additionally, exports to China from the Eurozone represent a much more significant portion of their total exports. The contraction of global trade has had a dramatically greater impact on Europe. This week, the ECB strongly signaled its intention to cut rates at its September meeting which would be the first time since 2016. The Federal Reserve is widely expected to take the lead by lowering the target on the fed funds rate next week. Central banks have a limited capacity to fight a full-blown recession with the monetary policy tools currently available to them. They may feel it would be better to act early and prescriptively to prevent a downturn, than to risk a recession.
July 19, 2019
Earlier this week China announced its second quarter GDP figure, which was up 6.2% on an annualized basis, but was the slowest pace of growth in 27 years. The headwinds facing China are formidable and range from$250 billion of trade tariffs being imposed on their exports by the U.S., to overwhelming debt loads that were largely amassed after the financial crisis to assist in hitting growth targets. The rapid growth of Chinese corporate debt was staggering. In 2007, corporate debt to GDP was 101 percent and over the course of 10 years it ballooned to 160% of GDP. To deal with the excessive debt issue, China embarked on a deleveraging campaign and cracked down on the shadow banking sector, which made it more difficult for certain firms to raise funds to repay their liabilities. The shortage of funding caused defaults to more than quadruple from 2017 to 2018 to a record amount. Increasing credit risk has caused a lot of lenders to avoid extending credit to smaller private companies. The Chinese government has taken notice and cut the required reserve ratio for banks numerous times this year and has encouraged lenders to extend credit to smaller firms. However, as Chinese economic growth decelerates, funding issues are expected to become more pronounced for weaker companies and should lead to repayment pressures that should exacerbate the default cycle. But, the market is not expecting China to have a rough economic landing as its 5-yr sovereign credit default swap trades at a very low 42 basis points, which is well below the high of 248 basis points that was recorded back in February of 2009. Even though the issues facing China are significant, it is our belief that Chinese officials will be able to provide the necessary stimulus in the near term to keep their economy moving forward in a controlled direction.
July 12, 2019
During this week’s semiannual monetary policy testimony, Fed Chair Powell strongly suggested that the Federal Reserve was ready to pull the trigger on a rate cut at their July 30-31 meeting unless economic data showed improvement. The fixed income market is fully pricing in a rate cut. Equity markets responded with a rally to new highs, and the S&P 500 broke through the 3000 level for the first time. Assuming the Fed does cut rates, it will mark the most significant and rapid shift in central bank policy without the impact of a major exogenous event (i.e., war). In December, the Fed was guiding markets expectations toward two rate hikes in 2019, which created a drawdown in equity prices. The trailing price-to-earnings multiple on the S&P 500 bottomed at 15.5 times. After the roughly 19%rally in equities, the trailing multiple on the market today is over 19 times. At some point, multiple expansion due to the prospect of lower interest rates and central bank accommodation will no longer provide a lift to equity prices. Earnings growth will ultimately need to drive valuations higher. Companies will begin to report second-quarter earnings in the next couple of weeks. According to FactSet, 114 companies have issued earnings forecasts, and 77% of them have issued negative earnings guidance. The primary reasons being cited are lingering trade uncertainty and slowing global economic growth. Analysts have revised estimates lower for the second quarter. Heading into earnings reports, analysts now expect earnings to decline by 2.9%. By comparison, when the year began estimates for the second quarter were for earnings growth of 5%. The equity market has so far been able to look past the earnings slowdown because of the shift in Fed policy. News regarding the trade situation has been very light since the end of the G20 Summit, but the potential harmful impact on profit margins caused by trade tariffs will get investors’ attention. For the equity market to maintain momentum given current valuations, companies’ earnings guidance for the second half will be crucial.
June 28, 2019
During the first half of 2019, we have seen several surprising shifts in the investing landscape. The dramatic pivot of the Federal Reserve from a relatively hawkish position in the middle of December to its outright dovish attitude today is an obvious example. The collapse of the trade talks and the looming potential for a full-blown trade war has also caught many by surprise. Despite the above travails, investors have enjoyed positive returns in the equity and fixed income markets. The S&P 500 has produced a total return of almost 18% and the Barclay’s Aggregate Bond Index has returned roughly 6%. Outside of geopolitical event risk, the biggest near-term threat to investors is the trade war between the U.S. and China. The economies of both countries have already sustained damage. Higher tariffs on Chinese products have increased the cost to U.S. consumers and have marginally slowed GDP growth in both countries. Manufacturing indexes globally have been under pressure suggesting that the manufacturing industries have been especially impacted by the deteriorating trade situation. The potential impact on profits is worrisome. If the trade war continues to escalate and the U.S. does add tariffs on an additional $300 billion of Chinese goods, the impact on consumer prices has been estimated to be roughly 1%. Price pressure could be mitigated slightly by some product substitution if there are suitable alternatives. Higher costs for consumers in aggregate, at the margin, will crowd out spending on other products resulting in lower corporate revenue growth. As companies attempt to deal with the distortions created by tariffs, supply chains and the location of production will change, causing additional costs for corporations. Lower revenue and higher costs will weaken margins and slow profit growth. Financial markets are hopeful that this weekend’s G-20 meeting will produce some positive momentum toward a long-term resolution to the trade dispute. The harsh and demanding nature of the trade rhetoric in May makes a deal very unlikely in the short-term. Our view is that we will exit the week-end largely in the same place we are now, but perhaps the conversation will be more constructive and the optics will improve.
June 21, 2019
Back in June of 2009 the U.S. economy officially began to heal from the devastation of the financial crisis in large part due to extraordinarily accommodative and innovative monetary policy. If the expansion continues into July, which appears highly probable, it will mark the longest economic growth cycle since records began back in 1854. While the length of the current economic expansion is impressive its aggregate growth has been subdued. Moreover, total GDP growth during the current expansion is 22%, which is approximately half of the growth experienced during the first 39 quarters of the expansion from 1991 to 2000. A major reason for the anemic economic growth since the financial crisis has to do with consumer deleveraging. Household debt to GDP peaked in the third quarter of 2008 at 98% and has declined to 75% by the end of 2018. Since consumption is roughly 70% of GDP, consumer deleveraging has weighed on economic growth. An additional headwind to this expansion’s GDP growth has been the lack of robust productivity growth, which has only averaged 1.4% and is 100 basis points lower than the productivity growth experienced during the 1991 to 2001 growth cycle. Even the fiscal stimulus from the 2017 tax reform has had a fleeting impact on economic growth as the nearly 3.0% growth in 2018 is predicted to gravitate towards 2.1% in 2019 according to the median estimate of the FOMC. On a different note, the most evident threat to the current expansion is the escalation of trade tensions between the U.S. and China, which is disrupting global supply chains, weighing on business sentiment, negatively impacting global manufacturing and will ultimately hurt aggregate corporate earnings. Prior economic cycles have often been cut short due to an overly aggressive Fed; however, the Fed is closely monitoring incoming economic data and will look to cut rates in order to keep the expansion moving forward.
June 14, 2019
We have spent a significant amount of time discussing the rapid shift in the language used by Federal Reserve officials over the last few months. The Fed seems to be preparing the market for a possible rate cut if the economy slides south due to a weak manufacturing sector or trade issues. The change in the market’s expectations regarding the future level of fed funds has been stunning. In October, fed funds futures were pricing in three rate increases, which was consistent with the Fed’s dot plot. Immediately after the rate hike in December, and despite the negative equity market draw-down in the fourth quarter, fed fund futures were still pricing in one increase in 2019. After the dramatic deterioration in the U.S.-China trade situation in May and the heightened probability of a prolonged trade dispute, the market is now pricing in roughly two-and-half cuts to the fed funds rate. As the market becomes more convinced that the Fed’s next move will be to lower rates, equity indexes have rallied and once again approached old highs. Price-to-earnings multiples are a function of investor confidence and interest rates. As interest rates drop, the discount rate for equities decreases driving PE multiples higher along with stock prices. The relationship between lower interest rates and higher PE multiples hold if the interest rate decline is not the harbinger of a recession. Investor confidence will erode if investors become concerned that a weak economy will cause earnings to fall. A meaningful downdraft in the equity market is the result of a process that begins with PE multiple compression that ultimately gets amplified as earnings estimates get revised lower. The steep decline in interest rates is concerning and is signaling a global economic slowdown with increased downside risks - the yield on the 5-year US Treasury declined from 3.04% at the beginning of November to 1.84% today. Economic indicators, however, seem to imply that the economy has enough forward momentum that a recession does not appear to be imminent. We expect that the U.S. economy remains on a modest growth path of 2% real GDP growth.
June 7, 2019
The Core Personal Consumption Expenditures Index (Core PCE) is the Fed’s preferred inflation gauge and in an ideal world the Fed would like to see it reside as close as possible to its 2% inflation target. Unfortunately, since the end of the financial crisis Core PCE has only exceeded the Fed’s target 5% of the time and it currently resides at 1.6% on a year over year basis. The dearth of inflation, even after taking interest rates to historically low levels and flooding the economy with massive amounts of liquidity through quantitative easing, has been extremely troubling for the FOMC. Moreover, Fed Chairman Powell has stated that the lack of inflationary pressures is “one of the major challenges of our time”. It is difficult to explain the exact reason for the muted inflation the U.S. economy has been experiencing but it may be partially due to the following factors. First, union membership has been on the decline which has lessened workers ability to demand higher pay. Second, U.S. workers are competing in a global workforce which has vastly broadened the supply of labor. Third, the advancement of technology has increased productivity and driven down unit labor costs. Lastly, the FOMC might have pegged the neutral interest rate (the theoretical rate that neither slows down nor speeds up the economy) at a level which is too high. The Fed is currently working on new ways to spur inflation and one idea that is gaining traction is called average inflation targeting. The premise behind average inflation targeting would be to let inflation run higher than the 2% objective to make up for periods where it ran below 2%. In the current economic environment, it would mean rates would stay lower for longer with the goal of bringing both inflation and inflation expectations higher. The probability of a Fed rate cut according to Effective Fed Funds Futures is close to 80% at the July FOMC meeting and we would not be surprised to see a Fed Funds rate cut in the near future.
May 31, 2019
May has been a challenging month for financial markets, especially for equity investors, as global growth expectations continue to ebb lower. Recent reports on durable goods orders and the purchasing managers’ index suggest a meaningful soft patch in the U.S. industrial economy. Worry over the global economy has been exacerbated by the negative tone in recent trade rhetoric. Given the hardening trade positions with escalating retaliatory threats, it appears that the relationship between Washington and Beijing is souring rapidly. The risk-off sentiment has caused a minor correction in equities and has pressured Treasury yields lower. The yield on the 10-year Treasury has declined almost 50 basis points over the last six weeks as investors seek safety. Money flowed from corporate bonds into higher quality fixed income as investors anticipate spread-widening from a weakening economy. Demand for Treasuries is also coming from profit-taking in equities. The bond market is suggesting the economy is vulnerable to a more pervasive slowdown. Fed funds futures are now pricing in three rate cuts from the Fed by mid-2020. President Trump increased the market’s angst when he opened a new front in the trade war. Trump tweeted on Thursday evening saying the U.S. would impose a tariff on all imports from Mexico. The rate of the tariffs would be ratcheted higher unless Mexico took substantive action to stop the flow of illegal aliens. The U.S. imported $346.5 billion worth of goods from Mexico in 2018, so this would have a meaningful impact. A rapid escalation of protectionism against one of our largest trading partners when incoming data already suggests that economic activity is materially slowing is a concern. The ultimate effect on the market would likely be weaker earnings growth and PE multiple contraction in equity indexes. If the Mexican tariffs do go into effect, certain industries that built manufacturing facilities and supply chains based on rules established under NAFTA will be significantly impacted. The automotive industry, for example, would be especially hard hit.
May 24, 2019
As the tensions between China and the U.S. simmer, both sides are looking beyond tariffs to inflict greater economic pain on their opposition. One idea that has surfaced in the past few weeks revolves around China selling a substantial portion of its massive $1.12 trillion U.S. Treasury hoard. The risk to the U.S. resides in the fact that a massive budget shortfall has caused Treasury issuance to surge and if China further adds to the supply by selling its Treasuries it could cause U.S. borrowing costs to rise. A rise in Treasury yields would crowd out government spending in other areas of the economy and negatively impact growth. However, there are numerous reasons why it would not be in China’s best interest to liquidate a large portion of their Treasury holdings and interfere with U.S. interest rate levels. First, accommodative monetary policy around the globe has caused interest rates to fall below zero on over $10.5 trillion of debt. Even though Treasury yields are extremely low on a historical basis, they are still highly attractive compared to alternative sovereign debt yields. Second, if the Chinese flood the market with Treasuries it would weight on the dollar and cause Chinese exports, which are already inflated by tariffs to be more expensive on U.S. soil. Third, China runs a sizable trade surplus with U.S. which causes it to have an abundance of dollars. Moreover, China manages its exchange rate to a set band versus the dollar and to do so it must be constantly buying and selling both yuan and dollars. Owning Treasuries allows China to efficiently engage in its exchange rate management process. Lastly, the Treasury market is the largest and most liquid debt market in the world and if the risk-off trade were to escalate due to rising tensions between the U.S. and China, we would expect demand for Treasuries to surge and counter any additional added supply.
May 17, 2019
Economic theory suggests that a country’s optimal tariff or trade restriction is zero regardless of other countries’ trade policies. Despite well-reasoned economic theory, trade tariffs are frequently not zero, and trade wars do happen largely due to political considerations. There is a compel-ling argument that if the U.S. can shrink its trade deficit, we could boost economic growth meaningfully above the 2% trend line rate. Our current annualized net trade deficit is roughly $600 billion, which is 3% of our $21 trillion economy. China is by far the most significant contributor toward our trade deficit. The U.S. has a negative trade balance of $420 billion with China. The U.S. imports $540 billion worth of goods and services, and exports only $120 billion to China. The Trump administration would like to oblige the Chinese to buy more products from us, which would boost our exports to China, thus reducing the negative economic drag of such a large trade deficit. The actual trade deficit element of the dispute can be solved relatively easily. The non-trade aspects such as intellectual property protection, forced technology transfer, software piracy, and export controls will be far more challenging to resolve and even more difficult to enforce. Intellectual property (IP) theft can be accomplished through several methods, such as corporate cyber attacks and espionage. The U.S. Trade Representative has estimated that the annual loss to China is between $225 billion to $600 billion. Not only is IP costly for companies, but it has a dampening effect on product development, and it inhibits innovation. IP issues and the trade deficit have been a concern for over two decades – why has it become a kerfuffle that the Trump administration feels the need to address today? China, along with the U.S. and the EU block, has become an economic power and has the potential to dominate high-valued manufacturing (artificial intelligence, robotics, etc.), much like how it took over low-valued manufacturing a decade ago. That is why the U.S. wants to level the playing field. The stakes are high and will have significant ramifications regarding economic and global leadership.
May 10, 2019
Prior to this week, the dovish pivot of the Federal Reserve coupled with stabilization of the Chinese economy and progress between the U.S. and China on trade negotiations had muffled equity market volatility. The Chicago Board Options Exchange Volatility Index (VIX) has averaged 14.4 over the past 3 months, which is 25% below the long-term average dating back to 1990. The lull in volatility vanished this week when President Trump accused China of attempting to walk back portions of the previously agreed upon trade negotiations. Furthermore, President Trump threatened to increase tariffs on $200B of Chinese goods from 10% to 25%by today if progress was not made during this week’s negotiations. Unfortunately, not enough advancement was made to avert the previously mentioned tariff hikes and China has vowed to retaliate although specific details have not yet been released. Escalating trade tensions between the U.S. and China will weigh on global growth moving forward. More specifically, Bloomberg Economics estimates that Chinese GDP growth will fall 0.9% based on the tariffs currently in place and could decrease as much as 1.5% if 25% tariffs are placed on all of China’s exports to the U.S. Also, U.S. GDP growth is expected to be impacted to a lesser extent with a decline of roughly 0.2% according to the International Monetary Fund. The escalation of trade tensions will weigh on business confidence, forcing companies to reconfigure their supply chains and increase U.S. import prices. However, it is important to note that the recently announced tariffs do not apply to goods currently in transit, which could heighten the sense of urgency for progress to be made. Moreover, although trade tensions have recently escalated, this may be the catalyst to reach a trade resolution sooner rather than later.
May 3, 2019
Federal Reserve Chairman Powell’s comments at his press conference following the Fed’s meeting on Wednesday dominated the headlines. The fed chair stated that transitory issues are playing a significant role in the decline in core inflation. The equity market reacted negatively, and rates rose as the Fed struggles with how to appropriately convey a very nuanced message that the direction of rates remains uncertain. The Fed’s thinking remains at the forefront for investors and an important variable that can drive markets. But there is a growing and ongoing debate regarding the long-term relevance of central banks. The standard monetary tools used by central banks are interest rates and quantitative easing. With interest rates in many countries already near zero or at the lower bound, the potential stimulative impact of lowering interest rates is negligible. The balance sheets of central banks are bloated, and the efficacy of additional balance sheet expansion seems limited. Proponents of modern monetary theory (MMT) suggest governments should manage their economies through spending and taxes. If inflation remains subdued as it is today, countries can print money to finance infrastructure and public-works projects to stimulate their economies. MMT advocates suggest that governments can, and should, bypass the traditional debt-financed approach. During periods of recession, countries can print money and deliver cash directly to the public to support consumer spending (so-called helicopter money). We think this concept is remarkably risky. First, politicians would have the power to create and allocate money. Currently politicians are limited fiscally by the tolerance of the electorate to be taxed. The discipline imposed by the ballot box would largely be removed. Second, as the currency becomes worthless the overall economy would face the existential threat of runaway inflation. MMT would work for a while until a tipping point is reached.
April 26, 2019
The risk-on market environment thus far in 2019 has allowed high yield bonds to return approximately 8.6% year-to-date according to the Bloomberg Barclays US Corporate High Yield Total Return Index. One of the major drivers of high yield bond performance has been the incredibly low corporate default rate, which resides slightly above 1% and compares very favorably to the 30-year average of 3.7%. The high yield option adjusted spread, which typically widens in anticipation of an uptick in defaults, is currently only 355 basis points and is 155 basis points below the mean dating back to 1994. As the above-mentioned figures indicate, investors have not been bashful when it comes to investing in high yield bonds, but although the sun is shining on the asset class now numerous storm clouds are positioned on the horizon. First, historically low interest rates since the financial crisis have encouraged companies to issue debt for share repurchases, acquisitions and other corporate purposes. Moreover, BBB-rated bonds which are one step above high yield have ballooned to roughly $3.4 trillion and are 2.8 times the total high yield market. If there are a multitude of downgrades in the BBB space during the next recession, it will cause forced selling as many institutional investors will have to exit their high yield holdings to maintain investment grade credit quality. To make matters worse, due to regulations that were enacted after the financial crisis, broker-dealers are limited in the inventories they can hold which means major buyers during times of stress are no longer available and further diminishes liquidity in an already-illiquid asset class. It is our expectation that high yield bonds will experience excessive spread widening through the next economic down-turn due to elevated supply and limited demand dynamics and it is our preference to favor high quality fixed-income securities at the current stage of the business cycle.
April 19, 2019
The healthcare sector had been outperforming the broad market for many years until recently. A key factor influencing the relative performance of stocks over the less few years has been relative earnings growth which has helped lift healthcare stocks. Additionally, investors sought safe havens such as healthcare stocks during last year’s market volatility. By the end of last year, the healthcare sector made up 15.6% of the S&P 500 due to its relative out-performance. The political winds shifted as the next presidential cycle kicked off at the start of 2019. The changing political climate caused the sector to badly lag the overall equity market. Healthcare stocks are now down slightly for the year compared to the broad equity market which has advanced 16%. Several issues are negatively impacting investors’ perception of health care stocks, but clearly the uncertainty regarding the direction of U.S. health-care policy is the most significant factor. The demands for change have come from both sides of the political spectrum. The Trump administration is pushing for better price transparency and for the elimination of rebates paid by pharmaceutical companies to the pharmacy benefit managers. Rebates distort the behavior of consumers and health insurance companies with the result that patients get steered to costlier branded drugs. Congressional Democrats, some who have launched presidential campaigns, have announced plans to expand Medicare coverage to everyone. There are several competing versions of the “Medicare for All” approach, but in its extreme form it would effectively eliminate the role for private insurance and represent a massive reformulation of roughly 18% of the U.S. economy. The volatility exhibited by the healthcare stocks is reminiscent of the of the draw-down we saw from the companies with significant international exposure when the trade war began to heat up last spring. The significant selloff is an indication of the potentially damaging impact that a change in policy (even when its implementation is many years in the future and highly uncertain) can have on specific industries and on equity performance.
April 12, 2019
Slowing global growth is a key risk that we are currently monitoring. This week, the International Monetary Fund (IMF) reduced its forecast for 2019 global GDP growth from 3.5% down to 3.3%, which is the lowest projection since 2009. A critical area of concern for global growth is Europe and the IMF slashed its 2019 European growth projection down 30 basis points over the past three months to 1.3%. Some of the major contributors to Europe’s slowdown include aging demographics, decelerating global trade, Brexit uncertainty, Italy’s troublesome fiscal situation, the threat of escalating trade tensions with the U.S. and a contracting manufacturing sector. The European Central Bank (ECB) met this week and acknowledged the precarious economic situation that Europe faces and confirmed that interest rates will remain on hold through at least 2019 and its balance sheet runoff will continue to be reinvested for an extended period. Moreover, the ECB President, Mario Draghi, mentioned the first line of defense to combat the slowdown will be a long-term loan plan, which will start in September. The terms of the plan have not been decided, but according to economists surveyed by Bloomberg, the lowest interest rate could reside below the ECB’s benchmark, which would allow certain lenders to be paid to access funding. ECB officials are also calling on governments to utilize fiscal stimulus to help generate economic growth. Additionally, it was noted that ECB officials will examine the side effects of negative interest rates on bank profitability and whether it hinders lending. The headwinds facing Europe are substantial at the current juncture, but a near-term key to a potential growth rebound exists in China as it is a major destination for Europe’s exports. Thanks to expansionary fiscal and monetary policy, the latest economic figures out of China show some stabilization and if they persist it could partially alleviate European growth fears.
April 5, 2019
The risk-on trade has been in existence since the beginning of the year. Because the shift in market sentiment was caused by a sharp change in direction regarding monetary policy from both the Federal Reserve and the European Central Bank, the risk-on trade did not rowel the bond market. In fact, through the end of the first quarter, rates have dropped precipitously with the yield on 10-year U.S. Treasury 27 basis points lower to 2.41%. Credit spreads, consistent with the risk-on market attitude, have dropped to extremely tight levels. The dollar has been relatively flat. It would seem to be the perfect formula for emerging market stocks to begin to perform better due to a benign dollar, a more accommodative stance by the central bankers and lower rates across the curve. Emerging market equities have dramatically underperformed U.S. equities over the last decade. The MSCI EM Index has returned only 6.95% over the last ten years versus the S&P 500 which has returned 15.43%. The bull market has driven the market capitalization-to-GDP ratio to roughly 134% for U.S. domestic equities from its bottom of 57%in 2008 (using the Wilshire 5000 as a proxy for the market). The current level is only modestly below its prior peak of 136.5% immediately before the dot.com bubble burst in 2000. By comparison, emerging markets have a stock market capitalization-to-GDP ratio of only 58.1%. Emerging markets account for only 25% of aggregate global market capitalization but makeup over 43% of global GDP. There are valid reasons for developed markets to trade at higher valuations. Developed markets are politically more stable and offer better legal protections for providers of capital. Most importantly, investors in emerging markets need to accept currency risk and are exposed to less liquid markets. At some point, the dynamics of higher economic growth, more attractive demographics and a reasonable valuation will begin to drive capital into emerging markets. A trade deal that lifts pressures on the Chinese economy could be the trigger that turns investor interest.
March 29, 2019
The spread between the 3-month U.S. Treasury bill and the 10-year U.S. Treasury note inverted last Friday for the first time since August of 2007. Market participants and economists often view yield curve inversions as a warning signal that a recession may be looming. Moreover, an inverted yield curve has preceded each of the past seven recessions dating back to the late 1960’s; however, there have been some false signals along the way. The predictive power of an inverted yield curve consists primarily of the size of the negative spread and the amount of time the curve remains inverted. The recent yield curve inversion only averaged less than 4 basis points and had a lifespan of just 5 days. Furthermore, there is additional data which leads us to believe that the current yield curve inversion is giving a false indication of a future recession. First, the front end of the U.S. Treasury yield curve is artificially high due to heavy Treasury bill issuance to fund the expanding U.S. budget deficit and pay tax refunds and the back-end of the yield curve is being partially compressed by technical dynamics from negative interest rates overseas. Second, corporate credit spreads, which typically expand in anticipation of a rise in defaults and economic stress, are still extremely tight by historic standards. For example, the Bloomberg Barclays U.S. High Yield OAS is currently 402 basis points (bps), which is 110 bps below the mean dating back to 1994. Lastly, the change in leading economic indicators on a year-over-year basis stood at 3.0% as of its most recent release. Historically, when year-over-year leading economic indicators fall below 0%, a recession is highly probable in the near future. It is our belief that predicting a recession is not an inconsequential task and it is often fraught with error; but based on the evidence above, a near-term recession appears improbable at the current juncture.
March 22, 2019
The Federal Reserve lowered rate expectations again regarding the fed funds rate. The “dot plot”, which shows the projections of the members of the rate-setting Federal Open Market Committee, indicates the current level of interest rates is appropriate. Fed Chair Powell said he believes that the Fed has failed to achieve its 2% inflation target, and suggested that inflation expectations may be at the margin shifting lower. Global interest rates reset lower based on the announcement. Rates have been drifting lower since early November as evidence has mounted that the global economy is materially slowing. Equities have rallied to a degree based on the appearance of some thawing of positions in the trade talks between the U.S. and China. But from our perspective, most of the recovery in stock prices has been more directly related to the dramatic reversal toward a dovish posture by the Fed. Much of the good news has been priced into valuations. The forward price-to-earnings multiple of the market has moved sharply higher this year and is now 16.4 times. Earnings growth is slowing markedly as the global economy downshifts and it is possible that margin pressure may further impact the prospects for earnings. Although the risk metrics that we follow closely are not signaling extreme caution, investors need to pay attention to a few notable risks (such as Brexit). On the positive side of the equation, equity valuations are being supported by very low real interest rates and monetary policy that will remain very simulative into 2020. The Fed’s balance sheet would will be roughly $3.5 trillion in September when the runoff ends, which is still a hefty 17% of GDP. Real interest rates are remarkably low compared to the end of the Fed’s last tightening cycle (0.25% vs 2.75%), which is constructive for equity risk premiums.
March 15, 2019
In late 2017 and early 2018, the global economy was enjoying coordinated global growth thanks to years of extraordinarily accommodative monetary policy that allowed economies to heal from the devastation of the financial crisis. With growth moving in the right direction, global central banks slowly began the arduous process of normalizing monetary policy. Unfortunately, the global economy began to experience tightening financial conditions and escalating geopolitical risks, which triggered global growth to decelerate as 2018 came to an end. Moreover, the Organization for Economic Cooperation and Development (OECD) recently downgraded its 2019 global GDP forecast to 3.3% from 3.5%. One of the main contributors to the waning global growth predicament is the deteriorating Chinese economy. Chinese retail sales recently increased at the slowest pace in 7 years and industrial output grew at 5.3%, which is the weakest figure since 2009. An additional concern to Chinese officials is the recent 40 basis point rise in the unemployment rate, which brings the unemployment rate to the highest level in 2 years. Furthermore, Chinese officials recently met and lowered the annual growth rate target for 2019 to between 6 and 6.5%. To curb the economic slowdown, Chinese officials are loosening both fiscal and monetary policy. Some of the initiatives policymakers have taken include a 3% rate cut to the value-added tax for manufacturers, a push to encourage banks to lend to private companies that employ the most workers, temporarily halting its deleveraging campaign to clean up the shadow banking system and lifting government spending quotas to increase infrastructure investment. The market has taken notice of the efforts policymakers are making to stabilize growth and the Shanghai Composite is up roughly 20% since late December. It is our view that the recent policy measures Chinese officials have taken will help avoid a hard landing, however, a significant rebound in growth is not probable given the global risks and uncertainties that still abound.
March 8, 2019
The European Central Bank sharply lowered its forecast for regional economic growth this year to only 1.1% from 1.7%. Inflation expectations were also reduced to 1.2%, which is well below the ECB’s target of 2%. In prior Weekly’s, we have detailed the remarkable lengths the ECB has gone to in its attempt to reinvigorate the Eurozone economy since the global financial crisis. Negative interest rate policy in conjunction with a massive quantitative easing program have failed to lift the European economy to an acceptable growth trajectory. In our view, deflationary forces in Europe are clearly the most obvious risk factor to the overall health of the global economy. This week’s ECB announcement amplified investors’ deepest fear concerning a global economic slowdown. The reaction of the financial markets was predictable. Interest rates fell as bond markets across the global rallied; equity markets fell on earnings worries and the dollar strengthened. We will be monitoring the developments in Europe closely and would expect Europe to be one of the more likely causes of heightened volatility. From a longer-term perspective, Europe’s prospects increasingly appear similar to Japan – very low secular growth and deflationary pressures. The U.S. also faces our own economic challenges. Demographics, income inequality, rising government debt, and unsustainably large unfunded obligations will inhibit the secular growth potential of the U.S. as well. The broader implications of muted global growth are significant and have real-world implication regarding financial planning applications. Asset prices and returns across all asset classes are likely to be compressed by low rates and weak growth. For example, with interest rates at 2.64% (U.S. Treasury 10-year), a reasonable return expectation would be roughly 3.25% ─ the coupon plus some modest positive roll. Assuming the long-term average equity premium, equity returns over the next decade could be less than 7% based on the current rate structure. Historically, large-cap equity returns have approached 11%, but in today’s environment we believe that returns greater than 8%could be difficult to achieve.
March 1, 2019
Labor productivity, which is the growth of output per worker hour, has been anemic for over a decade and threatens to lower living standards moving forward if it does not make a noticeable recovery. Over the past 150 years, transformative innovations, such as the internal combustion engine and the telephone, have dramatically enhanced lifestyles, revolutionized societies and increased productivity. However, productivity is currently growing at 1.0% using a 20-quarter moving average, which is well below the average of 2.2% dating back to 1946. One of the main causes of low productivity growth has been the failure of Corporate America to adequately fund its capital investments. Companies have instead elected to buy back shares and boost dividends in lieu of investing in capital expenditures. The Tax Cuts and Jobs Act intends to boost capital expenditures by allowing a 100% deduction of the cost of certain equipment purchased after September 27, 2017. Moreover, the most recent 4-quarter moving average private nonresidential investment figure shows that capital spending by businesses is starting to pick up, which could signify a future rebound in productivity gains. A second reason for current state of low productivity growth is due to the lag effect of certain innovations being adopted into the workforce. Take for example the computer, which debuted in the 1950’s but did not become widely utilized in businesses until the 80s and 90s. A technology that has been advancing recently and has the potential to dramatically change society and enhance productivity is machine learning. Machine learning can boost output with less human labor input, which bodes well for the owners of capital but not for the displaced worker who needs to repurpose their skills. It is our belief that productivity will slowly pick up moving forward due to a renewed commitment to investment and the adoption and implementation of promising new technologies.
February 22, 2019
Almost a full five years ago, the European Central Bank lowered its deposit facility rate to a -0.1% embarking on a negative interest rate policy (NIRP). Negative interest rates are an unconventional policy tool that essentially charges European banks to hold reserves at the ECB which encourages banks to lend more. Negative rates, in theory, dissuade businesses and consumers from keeping cash and encourages both consumption and investment. The ultimate intention is to stimulate economic activity and raise economic growth. The Bank of Japan announced a negative interest rate approach as well in January of 2016. Over $11 trillion worth of bonds in Japan and Europe currently carry a negative rate of interest. The transmission mechanism between interest rate changes, the level of interest rates and economic effects in the real world is complicated. Investor and consumer behavior are affected by numerous factors and not just interest rates. Additionally, when rates are negative, the market participants’ behaviors change depending on the length of time rates stay below zero. As negative rates persist, the market will ultimately interpret NIRP as a drastic measure that indicates the central bank is afraid that the economy is at risk of falling into a deflationary spiral. Due to low returns in an aberrant rate environment, investors become concerned that savings will not grow enough for future needs and they increase savings. So NIRP eventually has the opposite effect that the policy intended. It can also weaken the banking sector over time. Banks generally are liability sensitive and they feel constrained by the zero-bound rates. Thus, bank lending actually decreases as margins are squeezed. With NIRP and the astounding expansion of the ECB’s balance sheet, it is concerning how anemic economic growth has been in Europe and inflation expectations are well anchored below 2%. Some countries such as France and Italy, that have experienced GDP growth averaging 0.8% and 0.5%, respectively, since the end of the Great Recession, are hurting and seeing rising political unrest. It is perhaps unfair to say that the negative interest rate experiment has been a failure, but NIRP has not worked as Europeans had hoped. The ECB has also effectively lost its primary tool to combat the next recession.
February 15, 2019
Global growth deceleration was one of the triggers that caused risk assets to correct in the 4th quarter of 2018. China, the world’s second largest economy, recently released its 2018 GDP growth figure, which slowed to 6.4% on a yearly basis and was the slowest pace of growth since 2009. There are numerous headwinds facing China and one of which is the deleveraging campaign that is shrinking the shadow lending sector and making it more difficult for certain companies to refinance their debt. Moreover, the liquidity crunch that is taking place precipitated a record 119.6 billion yuan (approximately $17.7 billion) of defaults in 2018. Chinese officials are attempting to halt the credit cycle from deteriorating further by adding cash to the financial system by lowering banks’ required reserve ratios and introducing a new bank-perpetual-debt swap program. Although credit availability is still limited for certain borrowers, we feel that the steps taken thus far should help boost credit growth. Another headwind impacting China has to do with its demographic profile. There have been numerous studies about the relationship between age and productivity and the results have found that people aged 40 to 49 tend to add the most to productivity growth. China’s aging population will require increasing amounts of support and will weigh on longer-term economic growth. A final headwind for China pertains to the trade war with the United States. Both sides have been working feverishly to come to terms and progress is being made, however differences still remain. The current deadline of March 1st could be pushed back for 60 days, but if it is not then tariffs on $200 billion of Chinese goods will increase from 10% to 25% and it could negatively impact Chinese GDP by roughly 30 basis points. Due to the willingness of both sides to reach an agreement, we believe the trade war will be resolved, but given the complexity of certain issues a full resolution will take some more time.
February 8, 2019
Equity markets turned down toward the end of this week caused by an intensification of trade concerns and investors becoming increasingly worried about global growth. The latest January PMI surveys, as well as other economic data, for both China and the eurozone, indicate that manufacturing in these regions is rapidly falling toward recessionary levels. Europe is a concern due to the economic impact of slowing trade and the looming possibility of a hard Brexit. Conversely, the U.S. economy manufacturing surveys strengthened in January and are at levels that suggest continued solid industrial output and are consistent with GDP growth of approximately 3%. The U.S. economy is somewhat insulated from global slowing because it is relatively closed and service-oriented, but ultimately there will be some impact from slowing global growth. Domestically, the Fed’s latest Senior Loan Officer Survey suggests, after many years of loosening credit standards, banks are beginning to tighten standards on a range of loans. Banks tighten standards because of lower risk tolerance and in anticipation of deterioration of credit quality and weaker collateral values. Invariably, as the extension of credit tightens, economic activity becomes more difficult to finance, and the economy slows. Perhaps GDP growth could even dip below trend for a few quarters. With the global economic weakness and the anticipated softening of growth in the U.S., it is not surprising the Fed has decided to stop hiking rates. The tightening of financial conditions in the fourth quarter has yet to run its course, and until there is evidence that global growth is no longer contracting, it is very likely that central banks will be on the sidelines. Forward progress for equity prices will also be more difficult.
February 1, 2019
Only six weeks ago Fed Chairman Powell roiled already stressed financial markets when he mentioned that the runoff of the Fed’s balance sheet was on autopilot and that further gradual rate increases in 2019 were necessary. Market participants were hoping Powell was going to address tightening financial conditions, slowing global growth and heightened volatility by signaling the Fed was ready to pause rate hikes moving forward. Powell’s rather hawkish comments after the December FOMC meeting raised fears amongst investors that the Fed was going to over-tighten monetary policy and induce a recession. The Fed took notice of their monetary policy communication misstep and reversed course this week by emphasizing patience with respect to raising rates given minimal inflation pressures and a decelerating global economy. Powell went on to mention that the Fed’s balance sheet run-off is not on a preset course and adjustments can be made if financial or economic conditions warrant it. We feel that the Fed made the right decision to pause rate hikes for now, given that the tailwind of tax reform is largely behind us, liquidity is being drained from the economy (excess depository reserves are down approximately $500 billion over the last 12-months) and inflation is below the Fed’s 2.0% target even with a very strong labor market. It is interesting to note that according to Effective Fed Funds Futures, the implied probability of a rate hike at March’s FOMC meeting is 0.9% and the highest probability for a rate hike in 2019 is a mere 1.4% in the middle of the year. It is our belief that based on current market and economic data, the FOMC will not increase rates in 2019; however, if inflation starts to rise and growth stabilizes, we would not be surprised to see one 25-basis point rate increase in the second half of 2019.
January 25, 2019
Since consumer consumption makes up almost 70% of the domestic economy, it is a major macro driver. Consumer spending is a function of the ability to spend and the willingness to spend. Factors that impact the consumer's ability are things like disposable income growth and consumer debt levels. Whereas, confidence in job prospects and the wealth effect have a significant influence over the consumers’ willingness to spend. Our analysis indicates that these factors are in good shape at this point in the economic cycle. We focus intently on wages since it is such a critical element for the health of consumer spending. Wage growth has accelerated sharply over the last year with wage increases of 3.2% year-over-year in December. This is the fastest rate of growth in wages since the recovery began and growth has been over 3.0% for three consecutive months. The Federal Reserve watches these trends closely as well. The Fed gets concerned when wage growth becomes too robust and threatens to impact inflation expectations. Typically, wage growth would have to reach and be sustained at 4% before the Fed takes more aggressive action to blunt inflation pressures. Technology has created the opportunity for greater globalization and automation that has elongated the process of low unemployment leading to higher wages. Several factors have shifted bargaining power from the employee to the employer, thus reducing the sensitivity of wage rates to job growth. It is difficult to predict when wage growth will be high enough to threaten economic growth, but currently it appears to be in the sweet spot. Wage growth is sufficient to matter to the consumer, but not too rapid to create pressure on the Fed to raise rates.
January 18, 2019
Back in 1973, the U.K. joined the European Economic Community (the EEC was eventually absorbed by the EU) to become part of a free-trade zone which helped forge a global political force. As time progressed, people of the U.K. began to believe that the independence and freedom they had given up by being a member of the EU started to outweigh the benefits. The main issue of concern that was used to increase public support to leave the EU related to control over immigration. The movement gained so much momentum that a referendum was held in June of 2016 where the British people voted 52% to 48% to exit the EU. The U.K.’s decision sent its currency tumbling, which produced financial shock waves around the globe and caused the Bank of England to initiate additional accommodative monetary policies to assist with the uncertainties which resided ahead. The U.K. Prime Minister at the time, David Cameron, resigned and left the herculean task of negotiating Brexit up to Theresa May. This past Tuesday, the Brexit plan that May had been devising for almost two years was defeated by a margin of 230 votes, which was the biggest British legislative defeat in over a century. On Wednesday, May survived a no-confidence vote and must work diligently with members of Parliament and the EU to devise another Brexit plan. At this juncture, the road ahead is far from certain. One of the potential outcomes is a no deal Brexit, which would cause extreme economic hardship and possibly a recession. We feel that a no deal Brexit is an improbable outcome and believe that if an amenable agreement cannot be reached, then the current deadline of March 29th will be extended until both sides come to an agreement or another referendum is initiated.
January 11, 2019
As we enter 2019, investors’ nerves are raw after two major equity market corrections in 2018 and the historic December draw-down. The S&P 500 fell 13.5% in the fourth quarter and domestic equity investors experienced the first negative calendar year of -4.4% in 2018 in over a decade. Global equity markets were also extremely volatile last year with 50 trading days with over a 1% move in MSCI ACWI index. So, what will 2019 look like?
January 4, 2019
Equity markets in 2018 proved to be a wild ride that took most investors by surprise. The year both began and ended with tremendous market volatility, but investor psychology was starkly different as the year concluded with pessimism and negativity. Equity investors started the year with great hopefulness that the synchronized global economic recovery would continue. Additionally, expectations for earnings and domestic economic growth were being boosted by the recently passed Tax Cuts and Jobs Act. With the $1.5 trillion tax cut and $390 billion in incremental deficit spending, fiscal stimulus drove forecasts of 3% growth for real GDP.