The Weekly Economic & Market Recap
May 22, 2020
With cases of COVID- 19 totaling more than 5,000,000 around the world, the entire global economy has been devastated by this horrific disease. According to the International Monetary Fund, real global GDP is expected to wither by 3% in 2020, which would surpass the economic contraction caused by the global financial crisis between mid-2007 to 2009. Regional growth projections for 2020 range from positive 1.5% in South Asia to negative 7.3% in Western Europe. Unfortunately, economic momentum in Western Europe was already deteriorating heading into this year as the trade war of 2019 weighed heavily on the region’s exports. Moreover, the past decade has been tenuous for the European Union (EU) as it has dealt with a sovereign debt crisis, an immigration wave and Brexit. However, the lockdown recession caused by the coronavirus represents the greatest challenge the EU has faced since World War II. The European Central Bank has been aggressively implementing accommodative monetary policies for over 8 years through low to negative interest rates and a massive expansion of its balance sheet, but more undoubtedly needs to be done. Eurobonds and the mutualization of debt have been proposed in the past but has not gained traction as the more solvent nations within the EU have not wanted to burden their taxpayers with the debts of less frugal nations. Difficulties have also arisen in the EU since there is no common treasury to direct funds to where they are needed the most. The nations that have been heavily impacted by the pandemic unfortunately have less capacity from a fiscal perspective to stimulate their economies. Also, European countries in the currency bloc are precluded from devaluing their currency during times of economic hardship, which can prolong their recoveries. But, with the recent agreement between Germany and France to support a €500 billion recovery fund, there is hope on the horizon. If the recovery fund is approved by the EU members, the proceeds would flow to the areas in greatest need in the form of grants. At this point, not all EU members are behind the recovery fund; however, France and Germany have made tangible progress towards creating EU debt and alleviating, to a degree, some of the economic imbalances that have evolved in Europe over the years.
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May 15, 2020
The economic indicators released this week continue to reflect the dramatic impact the economic lockdown caused by Covid-19 virus has inflicted on the economy. The record drop in retail sales was especially awful, but very predictable given that more than 30 million people have filed for unemployment assistance since February and the massive disruption to retailers caused by forced store closings. The statistics are suggesting that this economic contraction will be extremely severe, perhaps matching the recessions seen in the 1920’s and 1930’s. Federal Reserve Chairman Jerome Powell spoke this week (virtually) at the Peterson Institute taking a somber tone regarding the economy and making the case for more fiscal support. He suggests that now is not the time for deficit hawks to allow debt concerns to restrict fiscal stimulus as long-term structural economic damage can be minimized by more federal spending. Although we are concerned about the implications of government deficits and effects of debt in the long run, in our view, it seems prudent to do whatever is necessary to avoid the tail risk associated with a prolonged recession. Additional support, especially if it is well targeted, will also lessen the duration of the downturn. The length of the recession is an important factor because there is a strong correlation between the length of the recession and the required amount of time needed for the economy to fully recovery. Research suggests that actual depth of the contraction does not have a large impact on the time to recovery. It makes sense when you consider the longer the recession, the greater the impact on supply chains, job skills, cash cycles, etc. The goal for fiscal and monetary authorities should be to make sure this is an average recession from a duration perspective. This would limit the corrosive structural financial damage caused by a protracted economic downturn and lessen the human cost as well.
May 8, 2020
With economies gradually embarking on the long and uneven road to reopening, people around the world are wondering what the future may hold given the dramatic lifestyle changes that have come about to combat the pandemic. The recent risk-on sentiment in the equity market, which was largely induced by massive amounts of fiscal and monetary policy accommodation, may be masking the fact that the journey to a full recovery could be years from now. The best case study available to gauge what the path forward might resemble may come from China. With the corona-virus originating in the city of Wuhan back in the later stages of 2019, China was the first country to confront the virus. China moved rapidly to suppress the outbreak by locking down cities in late January of this year. The lockdown had a tremendous impact on economic activity with the Chinese Composite PMI dropping precipitously from 53.0 in January (anything above 50 signifies expansion) to a dismal 28.9 in February. However, with lockdown measures easing in certain parts of China in March, the Composite PMI re-bounded back to 53.0. At a surface level, it appears that China successfully contained the coronavirus within the first quarter of this year, but many believe their numbers are misstated. Moreover, it is certainly suspect that China’s population is four times the size of the U.S. but they reported one-fifteenth the amount of coronavirus cases. Therefore, a better indication of the true health of the Chinese economy is commentary of Chinese operations through first quarter U.S. company earning reports. Generally speaking, consumer-oriented companies have reopened a majority of their stores, but capacity has been limited, store hours have been reduced and consumers have been cautious to spend. In order to incentivize consumer spending, the Chinese government has expanded unemployment benefits and issued spending vouchers to many of its citizens, but the Chinese consumer is showing signs of trepidation and may not resume their previous spending patterns anytime soon. The abrupt evolution of the global recession does not fore-tell a rapid recovery at this point, but progress is certainly being made.
May 1, 2020
Despite horrible economic data last month, April proved to be a stellar month for equity investors. The rally off the March 23rd lows has been almost as breathtaking in speed as the roughly four-week bear market that preceded it. The equity market has rallied over 30% from the March lows through the end of April, and the S&P 500 was down only 9.9% on a year-to-date basis. Equity investors have been able to look beyond the output contraction of 4.8% in the first quarter as indicated by the GDP report released this week, and a second quarter that will be demonstrably worse. The equity market seems to be anticipating a V-shaped economic recovery with a sharp and strong economic lift in the second half of 2020. The massive liquidity that has been provided by both the Federal Reserve and the federal government is a logical justification for this optimism. On top of the CARES Act, which will provide $2.3 trillion in fiscal stimulus, the Federal Reserve has expanded its balance sheet by $2.4 trillion to over $6 trillion in only a few months. With current Congressional mandates, the Fed has the capacity to expand its balance sheet to $10 trillion if it feels the need to do so. To provide perspective on a $10 trillion Fed balance sheet, the entire U.S. economy is only slightly larger than $20 trillion. The Fed has traditionally acted as a “lender of last resort” and would provide liquidity to banks to encourage the extension of credit to the financial system. With the creation of the Primary Market Credit Facility and the Secondary Market Corporate Credit Facility, the Fed has the potential to act as a direct “lender of last resort,” which extends its mandate not just to the problem of market liquidity, but to providing support for insolvent companies. The Fed cannot generally solve a solvency problem caused by a lack of revenues, at least not for any extended length of time. The massive fiscal and monetary stimulus will not resolve all the economic difficulties that lay ahead. There will be residual economic damage, and it is doubtful that the recovery will be V-shaped.
April 24, 2020
The emotional, physical and economic hardship that Covid-19 has inflicted on people around the world has been immense to say the least. The disease has now infected roughly to 2.8 million individuals globally, which is presumably an understatement due to asymptomatic carriers and a lack of adequate testing in certain portions of the globe. With the absence of a medical solution to Covid-19, social distancing and lockdowns have been implemented in an effort to slow the spread of the disease and flatten the curve. Here in the United States the economic impact has been devastating even with the massive fiscal and monetary stimulus that has been enacted thus far. Furthermore, working Americans have a bleak outlook at this point with 25% believing they are likely or fairly likely to lose their jobs in the next 12 months according to a Gallup poll. The previously mentioned statistic is not surprising given the total number of people filing for unemployment insurance over the last five weeks has climbed to a staggering 26.5 million. The only way to truly heal the economy is to open it back up, but to do so without herd immunity poses significant challenges. Therefore, the guidelines for reopening the American economy are based upon data driven criteria at the state and regional level, preparedness to meet the medical needs if the virus reemerges and phased guidelines that will be followed at the local level. The reopening process will not be immediate, nor will it be linear, but it will take time and encounter numerous hurdles along the way. A key to the reopening process will be mass testing and tracking to identify, isolate and monitor any new Covid-19 outbreaks. The good news is that the daily growth rate of Covid-19 cases appears to have peaked in the U.S. and there is some light at the end of the tunnel. Also, with approximately 83 Covid-19 vaccines currently in development globally, a medical solution is becoming more probable and could add a well needed tailwind to reopening the economy.
April 17, 2020
The reality of the recession is starting to bleed through into the economic data. High-frequency data series such as unemployment claims reflected the significant and sudden impact the coronavirus has inflicted on the economy. This week another 5.25 million people filed for unemployment benefits. Over the last four weeks, 22 million new claims have been filed implying that the unemployment rate is currently a staggering 16%. A few March economic reports came out recently indicating how widespread the economic damage has become. Industrial production plunged 5.4%m/m, which was the sharpest contraction since 1946. Several regional Fed surveys (Empire and Philly) suggest that the collapse of the industrial economy will continue through the second quarter. The U.S. economy at its core is led by consumer activity, and with the job destruction over the last month, consumer demand will inevitably be severely affected. Real consumption fell by approximately 5% annualized in the first quarter, and in March, headline retail sales saw their sharpest monthly drop on record. We expect the economic data to continue to worsen as the recession deepens. The scope of the economic damage and potential residual risks to the economy are not lost on the Federal Reserve and federal government officials, who have combined to commit more than $6 trillion to arrest the economic recession caused by the pandemic. To understand the magnitude of the government’s response, consider that it is larger than the entire GDP of the U.S. economy in the fourth quarter. The nonpartisan Committee for a Responsible Federal Budget projects that the combination of the stimulus spending and the recessions' effect on federal revenues will cause a budget deficit of $3.8 trillion this year. The response, particularly by the Fed, has been unprecedented in both the size and scope. The government initiatives and a seemingly flattening of the coronavirus case curve have provided temporary relief to markets allowing for a powerful rally. Opening the economy will take time and will be difficult given the uncertainty created by the virus. The prospects for the equity market’s continuing recovery depend on a medical solution limiting the fear of the virus and a fully functioning economy.
April 10, 2020
Risk assets performed extremely well this week as markets became encouraged by signs that the spread of COVID-19 may be decelerating. Lockdowns and social distancing appear to be working; however, the economic impact has been devastating. As of April 4th, weekly initial jobless claims rose by 6.6 million to bring the total over the past three weeks to just shy of 17 million. With respect to the service sector, Markit U.S. Services PMI, which was in expansionary territory back in January dropped precipitously to 39.8 in March. Also, the University of Michigan Consumer Sentiment Index declined dramatically to 71.0 in April from 89.1 one month prior and was the largest monthly drop on record. Although it has not been formally announced, it is quite apparent that an economic recession has begun. According to Bloomberg research, the duration of a recession matters more than its depth regarding equity market declines. Moreover, history suggests that the current sharp economic downturn can be contained to a degree if it is short lived. Unfortunately, we are dealing with a pandemic that has a forward path plagued with uncertainty. The U.S. government and central bank realized the severity of the situation and reacted rapidly. On top of all the fiscal and monetary measures taken to date, the Fed recently announced a new $2.3 trillion lending program that will target cities and states along with small to midsized businesses. The goal of the recently enacted monetary stimulus is to stabilize the financial system, muffle volatility and keep municipalities and businesses solvent during the lockdown phase. On a different note, it is important from a portfolio perspective to keep a long-term focus. A study of monthly observations since 1950 shows that a portfolio’s risk profile tends to decrease as the holding period increases. During periods of volatility like the one most recently experienced, it can be difficult to hold the course and not deviate from the targeted asset allocation. But if liquidity needs, time horizon, tax situation, return expectations and risk tolerance have not changed, then staying the course from an investment perspective is the prudent thing to do.
April 3, 2020
Last Friday, the House of Representatives approved the Coronavirus Aid, Relief, and Economic Security (CARES) Act by a voice vote and the President signed it into law. The CARES Act is a massive $2.2 trillion bill in response to the economic damage caused by the Covid-19 pandemic. One of the major components of this financial-support package is the Small Business Administration’s Paycheck Protection Program (PPP). The PPP would provide SBA lenders up to $350 billion in government-guaranteed loans to cover up to eight weeks of payroll and other expenses, and importantly, if businesses keep their workforce intact the loans would be forgiven. The SBA expects that business owners will be able to apply for loans as soon as today, but many details of the program remain unclear, and banks are pushing back on the start date until important parameters are more well defined. Lenders want to participate in the program to support local businesses in their communities, but lack of clarity regarding the program details and the program’s questionable economics for banks has created a hesitancy for some banks. Interest rates for PPP loans were initially set at 0.5%, which is too small to cover the financing and cost of administering the loans. At the request of community banks, Treasury Secretary Mnuchin said on Thursday night that the interest rate would be raised to 1% to entice banks to participate in the program. A well-functioning support program that can provide the needed financial assistance to small businesses to bridge them to the economic recovery is vitally important. Small businesses employ 59 million people in the U.S., which makes up 47.5% of the country’s workforce. Last year, in the SBA’s signature 7(a) and 504 programs, the SBA approved 58,000 loans totaling$28 billion. The PPP is a massive escalation in lending activity that will require millions of loans and it needs to scale very quickly to provide the desired safety net. Undoubtedly, there will be trials getting out of the gate and there will be unintended consequences. CARES Act programs will require midcourse corrections, but implementing these important pro-grams are critical to limiting the economic damage of the pandemic and setting the stage for a recovery sometime in the second half.
March 27, 2020
Due to the lack of an immediate medical solution to Covid-19, governments around the world have resorted to social distancing and lockdown measures in order to mitigate the spread of the virus. Moreover, approximately 50% of the U.S. population is now subjected to some form of governmental restraint, which is substantially impacting the economy. The first glimpse of the economic damage arrived when initial jobless claims for the week ending March 21st skyrocketed to 3.28 million and easily surpassed the previous record of 695,000 back in 1982. Both the Fed and the government officials are cognizant that economic data is going to deteriorate further and they have been extremely active this week. In terms of monetary stimulus, the Fed expanded its quantitative easing program by removing the cap and making it open ended while adding agency CMBS to its pool of eligible assets. The Fed also established two facilities to purchase investment grade corporate debt on both the primary and secondary markets, resurrected the Term Asset-Backed Securities Loan Facility and created the money market mutual fund and commercial paper funding facilities. On fiscal front, both sides of Congress passed a $2 trillion stimulus bill that will be broad reaching and help individuals, businesses, states and local governments as well as other entities cope with the economic hardships to come. With that being said, the level of fiscal and monetary stimulus is monumental in terms of its breadth and size. But there is little doubt that the true recovery will come when the rate of new Covid-19 cases begins to meaningfully fall which means we must rely heavily on the medical community in the weeks and months to come. The Milken Institute currently estimates that there are 58 institutions working on Covid-19 treatment therapies and 43 are embarking on the development of a vaccine. Thus, the amount of resources and talent devoted to addressing Covid-19 is sizable and even though successful results are not right around the corner, the medical field should be able to provide some much-needed relief in the near future. In the meantime, the dramatic and timely monetary and fiscal measures taken thus far can help ease the pain of the pandemic.
March 20, 2020
On Thursday this week, the market finally broke an unprecedented string of nine consecutive trading days with swings up or down of greater than 4% in the equity market. The selling pressure has been extreme due to uncertainty caused by the coronavirus outbreak and undefined economic consequences. As a society, we have decided to prioritize containment of the virus over the economic impact. Travel bans and the shutdown of businesses deemed nonessential, coupled with consumer demand destruction has wreaked havoc across the entire country and has created a tremendous economic shock. The slope of the yield curve and the level of rates suggested that the market was already nervous about an aging bull market. The conditions were ripe for a correction of some magnitude, but obviously, a global pandemic was not expected to be the catalyst for a potential global recession and the end to the longest bull market in history. The speed of the market drawdown and the change in market expectations have been breathtaking. So, where do we go from here?Timing is always very difficult, but history can provide us with an idea of the sequencing of events to follow. After an event-driven crisis, the central banks act first and aggressively to provide liquidity and confidence in the durability of the financial system. That has already occurred, and we are likely to see additional action if necessary. This is followed by a painful period of indecision by governmental authorities that causes additional financial market turmoil; ultimately, corrective fiscal measures are taken that helps boost demand and confidence. We are still waiting for a comprehensive, cohesive set of fiscal policy steps to stabilize the economy and lift growth on the other side of the containment efforts. These fiscal policy tools will come. Typically, financial markets bottom soon after authorities have put in place sufficient economic safeguards. Investors need to maintain a long-term orientation and use normalized earnings to get comfortable with valuations. Smoothing out the cyclicality of earnings and applying an average multiple suggest there is more reward than risk for investors with a reasonable time horizon.
March 13, 2020
Since 1945, the S&P 500 has experienced 10 bear markets, (a peak to trough decline of 20% or more) which equates to one occurring every 7.5 years. On average, the peak to trough has taken approximately 17.5 months; however, the unforeseen and rapidly evolving nature of COVID-19 caused the current bear market to occur in just 16 trading sessions. The market turmoil of recent weeks even caused a dislocation in the U.S. Treasury market. Typically, during times of market stress, investors sell assets and buy Treasuries for their safety and liquidity, but during times of times of panic liquidity can dry up in most asset classes and investors are forced to sell Treasuries in order to obtain cash. This was evident a few times this week when Treasury yields escalated while equities sold off. The Fed took action on Thursday to support the Treasury market by modifying its Treasury reinvestment and $60 billion monthly purchase program to include Treasuries across all maturities. The previously mentioned action may open the door to additional quantitative easing when the FOMC meets next week, which will help less liquid corners of the market clear in a more orderly fashion. The markets will need more than ultra-accommodative monetary policy to combat the supply chain disruptions and reduce consumer demand caused by COVID-19. With that being said, President Trump declared a national emergency and announced a range of actions to help soften the economic impacts from the outbreak. An additional hint of good news is that, market and economic support is coming from all over the globe in the form of mortgage forbearance in Italy, 0% interest rate loans in Sweden, bond purchases in Japan and the reduction of required reserve ratios for some banks in China. According to Bloomberg, COVID-19 cases total 80,813 in China, however, the number of new cases have declined to the point where there were no new cases reported today. China took drastic measures to stop the spread of the virus and as their economy gradually returns to normal, they provide hope that COVID-19 can be contained.
March 6, 2020
Extreme volatility continued to grip financial markets last week. Apart from the ongoing spread of the Covid-19 virus, the most notable development was that the Fed cut interest rates in between FOMC meetings for the first time since the financial crisis. The timing of the cut was surprising, but the fact that the Fed felt the situation warranted a 50-basis point cut was striking as well. The Fed cut its key Fed Funds rate to a range of 1% to 1.25%. It was highly unusual for the Fed to take such bold action, but it is not unprecedented. The Fed also moved aggressively after the 9/11 attacks, the 2001 tech stock bubble, the Russian financial crisis and the collapse of Long Term Capital in 1998. The pre-emptive rate cut is intended to provide insurance against future economic weakness. Economic data continues to be relatively strong as evidenced by February’s non-farm payroll report. The domestic economy’s current momentum and the Fed’s aggressive rate move failed to have much impact on the long end of the yield curve. In fact, as investors attempted to lower portfolio risk in the face of economic uncertainty caused by the coronavirus’ impact, the 10-year U.S. Treasury reached an all-time low yield of 0.66% this week. Perhaps more astoundingly the two-year Treasury yield was 1.3% just two weeks ago, but fell to 0.39% with the decline in yields over the last two weeks. The bond market is suggesting additional rate cuts and more financial market volatility ahead. The Fed Fund futures is predicting another 50-basis point cut at the March FOMC meeting. Since much of the expected economic softness caused by the virus is due to a supply shock, the Fed’s rate cut will be providing only a modest economic lift. Fiscal stimulus in the form of a credit facility for businesses affected by the transitory impact of the virus would be more efficacious and would bring confidence to financial markets.
February 28, 2020
The financial markets this week focused on the potential economic impact of the coronavirus (Covid-19). With 83,694 confirmed cases (62 in the United States) and 2,809 deaths globally, the virus has now spread to 50 countries. Its estimated fatality rate is 2.3% and is highest among older adults with pre-existing medical conditions (fatality rate is well under 0.5% for patients under 50 years old). For comparison’s sake, in 2003, the SARS pathogen had 8,096 total cases and 774 deaths with a similar transmission rate profile (just as contagious).
The economic impact from Covid-19 will take several quarters to work through the global economy. Absent another exogenous shock it could take over a full year from the initial recognition of the virus in early December 2019 for its economic effects to be fully realized. The virus will affect the economy as people are unable to pursue economic interests due to illness or from containment efforts to control the virus’ spread. Consumer spending is also likely to be reduced as consumer behavior adjusts, while individuals avoid situations that potentially expose them to the virus (for example, people stop dining out and taking cruises). Finally, supply chain issues can reduce activity as manufacturers cannot produce products without input sources.
The magnitude of the Covid-19 triggered downdraft is uncertain given the unpredictability of the virus’ progression and economic impact. After a 30% plus year in 2019, we had expected the equity market to provide modest returns in 2020. The weakening domestic economy and the supply chain disruptions could meaningfully impact earnings growth. New earnings estimates for 2020 will likely be flat or up only modestly. Equity price levels and valuations are in the process of incorporating revised earnings expectations. The S&P 500 is down over 10% and has entered correction territory since reaching a new all-time closing high of 3386 only last Wednesday (02/19/2020). The blended 12-month forward price to earnings ratio was 19.0x last week and is now approximately 16.8x – its median going back to 1990 is 15.1x. Historically, 5% to 10% corrections occur a few times per year. In previous equity corrections, dating back to 1945, the average peak to trough has taken 4.1 months and the average peak-to-peak lasted just under 8 months. With today’s advances in technology coupled with algorithmic trading, however, markets move much faster than in the past.
February 21, 2020
One of the main questions vexing markets, is the degree to which the coronavirus will weigh on growth in the world’s second largest economy. With a fraction of the Chinese economy functioning at this point, certain businesses are finding it increasingly difficult to meet their financial obligations. Back in 2016, President Xi Jinping embarked on a deleveraging campaign that led to a crackdown on shadow banking. Since then, the credit cycle has accelerated and defaults have increased dramatically. Moreover, both investment grade and high yield borrowers have seen credit spreads over government debt escalate to the highest figures since November of 2019. Even though the Chinese government has responded with easier liquidity policies, the funding is not finding its way to smaller private companies, which accounted for more than 80% of the defaults in 2019. With domestic market bond defaults totaling a record 137.6 billion yuan ($19.7 billion) last year, the impacts of the coronavirus will only exacerbate the credit cycle. But, based on 5-year Chinese sovereign credit default swaps, which are trading at 35 basis points (bps) and is well below the 17-year average of 70 bps, the market is confident that the central government has the financial means to absorb the economic impacts from this epidemic. An additional headwind to growth facing China pertains to the country’s aging demographic profile. Back in 1979, China enacted the one-child policy due to food and housing shortages the nation was facing at the time. In 2016, however, China revised the policy to allow for up to two children, but it has not helped increase birthrates. Furthermore, there were only 14.6 million births in China in 2019, which was the lowest figure since 1961. It is projected that by the year 2030, China’s population will peak at 1.45 billion people and in 2040 24% of the population will be 65 or older. There is no question that China is facing a demographic headwind and even though it has the capacity to handle the issue now, it could unfortunately become progressively more difficult.
February 14, 2020
Growth stocks have dramatically outperformed value stocks in 2020. Year-to-date, the Russell 1000 Growth index has risen 8.4% versus only 1.1% for the Russell 1000 Value index. That is a stunning divergence in a relatively short period. The top five companies in the growth index also happen to be the top five in the S&P 500. From a market cap weight perspective, these stocks account for roughly 29.7% of the Russell 1000 Growth index and 16.8% of the S&P 500. The performance of these top five companies has contributed almost 60% of the year-to-date return for both indexes. The top five companies are Apple, Microsoft, Alphabet, Amazon, and Facebook. The weighted average return of these companies is over 12% in 2020 and has driven the S&P 500 index up 4.6%. In contrast, the equally weighted S&P 500 index is up only 2.5%. The concentrated nature of this equity market has been a concern for many investors. There have been several reasons that have resulted in investment dollars flowing disproportionately into relatively few names. Better organic revenue growth is a major reason but share buybacks have also been a significant driver of out-performance for these top companies. The tax reform initiated in 2018 unlocked foreign cash holdings with the hopes that the repatriated dollars would go into capital investment, but far more money has gone into enhancing shareholder returns through share repurchases and dividend increases. Share repurchases have been a huge source of liquidity for the equity market, with repurchases totaling $700 billion in 2019. The buybacks have also been highly concentrated, with just 25 companies accounting for over half of the total. According to DataStream, Apple, Microsoft, and Alphabet collectively repurchased $116.7 billion worth of stock. Share buybacks are likely to slow and be less supportive of equities over the next few years. First, for at least two-thirds of top 25 companies, the amount of the buybacks are greater than net cash flow after capital expenditures and dividend payments and therefore are not sustainable. Second, it becomes harder to make a compelling case that share repurchases are an effective use of capital as PE multiples rise.
February 7, 2020
Global economic growth, which increased last year at the weakest pace since 2009, is going to again be pressured by the duration and severity of the coronavirus. With several Chinese provinces extending the Lunar New Year holiday to help contain the spread of the coronavirus, roughly two-thirds of China’s economy remained closed this week. Confirmed cases escalated past 31,000 and some fear that the figure is much higher as hard-hit provinces like Wuhan and Hubei are overwhelmed and lack a sufficient supply of tests. The Chinese government is taking the threat extremely seriously and has instituted a travel ban that encompasses over 50 million people. China’s central bank (PBOC) has also taken action by flooding banks with short-term liquidity and reducing the interest rate charged for money. It is also believed that the PBOC will decrease the loan prime rate and reduce the reserve requirement ratio for banks in the near future. At this point, the impact to China’s first quarter GDP is difficult to forecast; however, Bloomberg Economics predicts that growth could slow to 4.5%. If the steps taken thus far to contain the virus prove successful, then the loss of global GDP growth should be limited, which is what global equity markets are currently suggesting. On a different note, a long-term theme that has been weighing on global GDP pertains to the slowdown in population growth. Here in the U.S., the population grew by just 50 basis points annualized through July of 2019. The previously mentioned figure is estimated to be the slowest rate of growth over the past 100 years. There are extensive implications to a decline in population growth due to the fact that it tends to limit overall demand as well as the ability to satisfy demand. With U.S. GDP growth hovering just above 2% as of the fourth quarter of 2019, maintaining that growth rate in the face of declining population growth will undoubtedly be an uphill battle.
January 31, 2020
Equity markets were under pressure last week as investors try to assess the effect of the coronavirus on the global economy. The growing global contagion has created uncertainty and will likely cause earnings expectations to be reduced. Although fourth quarter earnings reports have generally been in line with forecasts, investors are concerned about forward earnings. Historically, the economic and market related impact for global contagions have tended to be relatively contained and short lived. From a longer perspective, the bipartisan Congressional Budget Office (CBO) released their latest baseline budget projections. The CBO forecast federal deficits will exceed $1 trillion each year over the next ten years. Over the period from 2021 to 2030, the U.S. will amass another $13 trillion in debt, adding to the $23 trillion that we currently owe. More worrisome is that the forecasts expect that the annual deficits will be accelerating over time. Net debt-to-GDP at the end of 2019 was 79% and is projected to be 98% by the end of the forecast period. The only other time the debt/GDP ratio was this high was due to WWII. The U.S. is producing a large debt burden during a time of economic stability. The deficit issue is being driven by rapid growth in spending caused by an aging population, rising healthcare costs, and interest costs. In fact, the fastest growing portion of the budget over the forecast period is net interest costs that will grow from $383 billion per year in 2019 to an estimated $819 billion in 2030. As the debt burden increases, it could lead to less public and private investment, reduced fiscal flexibility and slower overall economic growth. Financial markets are not concerned about debt levels at this point. The sooner the legislators in Washington address the nation’s fiscal situation, the easier the solution will be and the more acceptable the societal cost.
January 24, 2020
The European Central Bank left policy unchanged this week which was widely expected. The deposit rate remained at -0.50% and QE at E20B per month. What struck us was the ECB’s announcement that the central bank would conduct its first strategic review of policy since 2003. The review will address a range of relevant topics but will center on inflation. Despite aggressive stimulus for many years, the ECB has failed to lift inflation to its inflation target just below 2%. Some analysts have cynically suggested that it was not a failure of monetary policy, but rather measurement error and that inflation is running hotter than indicated. Lower than expected inflation, as predicted by classic econometric models such as the Phillips Curve, is not unique to Europe. Inflation is running stubbornly below the Federal Reserve’s desired level as measured by the core PCE index. Additionally, wage growth disappointed in December growing at a tepid pace of only 2.9% year-over-year. Employment growth has been strong with the U.S. economy on average producing 160,000 new jobs per month over the last year, which should be sufficient in a late-cycle environment to provide support for additional wage and consumption growth. Financial markets are not pricing in any inflation risk. The real existential threat to the bull market is inflation and rising inflation expectations. Equity indexes will experience drawdowns and corrections related to geopolitical tensions, the outbreak of viruses and political uncertainty. Generally, these types of issues will not cause economic dislocations sufficient to drive the economy into a recession. Rising inflation can force a significant enough change in interest rates and Federal Reserve policy to imperil the economy, and in turn the bull market. We are a long way from inflation sparking the next recession. There are other reasons for equities to correct, such as earnings disappointments. The market will be focused on forward guidance from the earnings’ reports.
January 17, 2020
Since 2018, the global economy has been hindered by the expansive ramifications of the trade war between the U.S. and China. Over the previously mentioned timeframe, global trade has declined, tariffs have been implemented, supply chains have been rerouted, manufacturing has suffered, business confidence has plummeted and monetary policy has eased. A nascent resolution to the trade war became official this week when Phase One of the deal was signed. As part of the agreement, the U.S. has arranged to cut in half the 15% tariff rate on $120 billon of Chinese imports and not place a 15% tariff on $150 billion of primarily consumer goods, which was scheduled to go into effect last month. The U.S. will still enforce the 25% tariff on $250 billion of Chinese imports.
January 10, 2020
January 3, 2020
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.
December 21, 2018
We have been cautioning clients that we would expect to see a period of heightened volatility in the financial markets as we approached the later stages of the bull market. The nine-year equity bull market has been supported by strong corporate profits, generally declining interest rates, low inflation and extremely accommodative central bank policy. Quantitative easing and zero interest rate policies in many international economies (Japan went a step further an instituted a negative interest rate policy) forced investors toward risk assets to generate more suitable levels of income. Valuations expanded to levels well-above historic averages, but were seemingly justified by low discount rates and solid underlying fundamentals.
December 14, 2018
In March of 2015 the ECB embarked on a quantitative easing program to fight off the threat of deflation. The goal of quantitative easing was to push down market interest rates to encourage economic activity and reignite inflation. Since 2015, the ECB’s balance sheet has grown by 2.6 trillion euros and currently stands at 4.7 trillion euros, which equals roughly 40% of European GDP. The ECB announced that it will end its bond buying program at the end of December, however, the size of the balance sheet will not change as maturing debt will be reinvested and bond purchases can be reinitiated in the future if necessary. The announcement was not a complete surprise as Mario Draghi has been prepping the market, but the decision comes at a tenuous time as GDP growth in Europe is expected to decelerate from 1.9% this year to 1.7%in 2019. Moreover, the Markit Eurozone Purchasing Managers Composite Index which started the year at 58.1 (any measure above 50 signifies expansion) has steadily declined to 51.3 in December. Also, headline inflation is expected to slow from 1.8% in 2018 to 1.6% next year. At the current juncture the ECB expects to keep borrowing rates extremely low until at least September of 2019, but given the slowing economic momentum it would be very surprising to see the ECB raise rates in 2019. With risks perhaps shifting to the downside in Europe and increased market volatility, the normalization of interest rates may prove to be extraordinarily difficult. Furthermore, if the ECB is unable to raise rates meaningfully it will lose a key tool for combating the next recession.
December 7, 2018
The financial markets have been extremely volatile during the fourth quarter. The proximate cause for the equity market weakness has been Federal Reserve messaging following the September rate hike. In early October, Federal Reserve Chairman Powell shocked markets by stating the Fed funds rate was well below neutral, and given the strength of the economy, the Fed could raise rates beyond neutral on its path to rate normalization. Powell’s hawkish statement caused Treasury yields to spike as investors became concerned over a potentially more aggressive rate path in 2019. John Williams, President of New York Fed, added fuel to the fire by suggesting that a yield curve inversion would not be “worrisome” or a “deciding factor” in setting future policy. Investor sentiment was also negatively impacted by a softening global economic growth environment. Growth concerns have been amplified by the deleterious effect of a trade war. In our view, the October to December correction has largely been a function of two overly zealous policies. First, the Fed went from its data dependent approach to rate setting to a much more aggressive stance. The Fed funds rate had to get above neutral despite little apparent evidence of an acceleration of inflation. The comments by Powell and Williams were an unforced error. In November, Powell tried to ameliorate some of the damage by suggesting that perhaps rates are close to neutral already. But the damage was already done. Second, the trade rhetoric has been too public and too antagonistic to not create concern. Tariffs raise the price of products for imported goods and provide a pricing umbrella for domestic producers. Higher prices dampen demand, thereby lowering economic activity. Costs for producers also rise due to higher input prices and supply chain disrupt-ions, negatively affecting corporate margins and earnings. The Trump administration has raised legitimate trade concerns that need to be addressed. To not create additional problems, it is sometimes better to negotiate issues less publicly. The Fed and trade concerns could moderate as we get into 2019 allowing for better market sentiment and less volatility.
November 30, 2018
World leaders are heading to the G20 summit which will focus on investment, infrastructure and development. Investors will be keenly focused on the Saturday night dinner between Chinese President Xi Jinping and President Trump. The face-to-face meeting between the two leaders will be the first in over twelve months. The trade war between the U.S. and China started the year as simply talk, but has evolved to encompass tariffs on $250 billion of Chinese goods. China quickly retaliated by placing duties on almost all the goods that enter the country from the U.S. Narrowing the massive trade gap between the U.S. and China is not the main driver of friction between the two countries. Instead, the U.S. is looking for China to stop stealing intellectual property, subsidizing industries and dumping in-expensive products abroad. If talks do not progress as planned, the U.S. could further intensify the situation by raising the tariffs on $200 billion of Chinese goods from 10% to 25% and add an additional $267 billion of goods to the tariff list. Escalation of the trade war is beginning to impact global growth and the IMF has reduced its global GDP forecast in 2019 by 20 basis points due primarily to trade tensions. Moreover, if tensions escalate further, the IMF estimates GDP in China could be negatively impacted by 1.6%. With China already experiencing a slowing economy, stumbling stock market, depreciating currency and deteriorating credit cycle, one would have to imagine that Xi will be highly receptive to a possible resolution. We believe that progress on a framework to move forward will be made this weekend between Trump and Xi, but a full solution to a trade war will take time.
November 16, 2018
We have frequently commented that one of the most significant risk factors that we focus on is the slope of the yield curve. When the U.S. Treasury yield curve inverts, yields of short-dated maturities are greater than long-term rates, it is a clear signal that the economy will begin to slowdown. The Fed’s effort to contain inflation by pushing up the real fed funds rate produces a higher probability of a recession, and institutional investors respond by lowering long-term bond yields. The yield curve has inverted before each of the last nine recessions. The slope of the yield curve has a powerful predictive value, yet the timing between inversion and recession is relatively variable. The current yield curve has flattened with the 10-year U.S. Treasury yield only approximately 75 bps above the 90-day Treasury Bill yield. However, the predictive efficacy of the yield curve may be less robust this cycle. First, the Fed is not fighting inflation. The Fed tends to be aggressive when they are concerned about inflation, but currently, inflation expectations are well-anchored. The Fed is trying to normalize their balance sheet and interest rates ahead of the next recession. The Fed does not want to create the next recession due to normalization since they would have to reverse course on rates. Second, yields at the long end of the curve remain artificially low because global central banks, except for the Fed, continue to pursue policies that constrain intermediate to long yields. A legitimate argument can be made that the information provided by the slope of the yield curve today is compromised by, or at least obfuscated, by central bank actions. As the Fed lifts rates, we expect that they will become data dependent and more circumspect regarding additional rate increases.
November 9, 2018
The midterm election is now behind us. Investors were reassured as election results were largely consistent with the market’s expectations prior to the election, so equity markets experienced a strong relief rally. In direct contrast to the October selloff, which to some degree was precipitated by the uncertainty regarding the election and fear over a potential significant shift in economic policy, the rally this week was a recognition of the likelihood of legislative gridlock ahead. Given the rancor in Washington, it will be difficult to find bipartisan compromise in many areas, but infrastructure spending seems to be an interest shared by both the administration and House Democrats. Pharmaceutical pricing and health care spending is another area that could present common ground for both parties to work together. The equity market overall may benefit as a divided government has traditionally provided a constructive environment for investors. A divided government tends to hamstring the more extreme ambitions and constrain policy shifts. Historically, the six months following the midterm election has been a good time to be invested in equities. Despite growing concerns over more constrictive monetary policy, current economic fundaments remain favorable for equities. As a final thought, the election outcome was not surprising, but it was striking how engaged the electorate was and how much money was spent. According to the Federal Election Commission, campaign filings indicated that $4.7 billion had already been spent on the midterm elections through the middle of October and spending was projected to top $5.2 billion by the November election. That marks a significant increase from just four years ago when politicians spent a midterm record of $3.8 billion.
November 2, 2018
The Federal Reserve operates under a statutory mandate, which “seeks to foster maximum employment and price stability.” With the recent escalation in market volatility and tightening financial conditions, some have begun to question whether the Fed’s forward guidance regarding rate hikes is too aggressive. Looking at the employment figures, there is no question the Fed should be raising rates. Moreover, the unemployment rate resides at 3.7%, which is the lowest level since 1969 and well below the Fed’s long run projection of 4.5%. Tightness in the labor market is also starting to impact the cost of labor with average hourly earnings up 3.1% on a yearly basis. Looking at the latter portion of the Fed’s dual mandate shows that inflation is running at the Fed’s 2.0%target according to core personal consumption expenditures (core PCE) and has been at this level for the past five months. The previous statistic also indicates that the Fed should be raising rates at the current juncture. Furthermore, the implied probability of a rate hike at the December 19th meeting currently stands at 74.6% and we strongly believe that the Fed will raise rates for a fourth time in 2018. Looking out into 2019, the Fed has indicated it will hike rates 3 times, but with elevated trade tensions and slowing global growth the market is only projecting 2 rate hikes. Looking at market based inflation expectations moving forward, the 5-year break-even rate is 1.90% and implies that inflation will actually moderate as time progresses. Also, U.S. GDP forecasts for 2019 show growth decelerating to the 2.5% range due to the fading benefits of tax reform. With that being said, the Fed should be more vigilant with rate increases in 2019 and beyond.
October 26, 2018
The drawdown in October has taken both the S&P 500 and Nasdaq down slightly over 10% from recent highs. Both the Dow Jones Industrial Average and the S&P 500 erased the indexes gains for the year. The volatility experienced this week has heightened the growing unease that investors are feeling. The selloff has been amplified as companies have reported third quarter earnings. Earnings reports have been more than solid. According to Zacks Investment Research, 139 companies have reported through Thursday with year-over-year earnings growth approximately 22% and revenue growth has been 8.7%. The preponderance of companies are exceeding expectations with 82% of companies reporting above consensus estimates. Investor sentiment turned negative regarding earnings due to deteriorating forward guidance. During investor conference calls many management teams are citing the potential for slower earnings ahead due to a rising dollar, higher input and trade related cost. We have pointed out the spark that caused the correction was a shift in expectations toward a more aggressive path forward after the Fed raised rates in September. Less central bank support from quantitative easing and artificially low interest rates will cause all risk assets to trade more closely with fundamentals. Ample liquidity has lifted markets and provided stability to the equity rally. With the Fed and the ECB reducing monetary policy accommodation, risk assets are going to be appreciably more volatile. This is the primary difference between 2018 versus 2017. Fortunately, economic fundamentals remain strong. U.S. third quarter GDP rose 3.5%and has good momentum heading into 2019.
October 19, 2018
The Chinese economy has numerous headwinds to keep pace with its historical growth rate. Third quarter GDP showed the economy expanded at 6.5% on an annualized basis, the lowest figure since 2009. A vast majority of the slowdown in GDP is domestically driven and is not attributable to the trade war with the U.S at this juncture. Manufacturing, which grew at 6.0% in the second quarter, increased only 5.3% in the third quarter. A major issue facing China is its massive accumulation of debt since the financial crisis. Chinese debt, which was approximately 160% of GDP in 2008 has now ballooned to 266% of GDP. China has approximately $10 trillion of debt in its shadow banking system that is unregulated and highly risky. S&P mentioned this week that local governments have amassed $5.8 trillion in Local Government Financing Vehicles (LGFVs), which are off balance sheet debts to fund infrastructure spending. LGFVs once had the implied guarantee of the Chinese government, which has now been removed. As a result the default cycle has begun and investors have become wary of these investments. Equity weakness is another issue facing China this year. The Shanghai Composite Index is down 28% from its January high. Moreover, 11% of market capitalization is pledged as collateral for loans. If the market declines much further margin calls could force additional selling, which would further weigh on equity returns. On a different note, Chinese 5-yr sovereign credit default swap levels suggest a market view that the Chinese government has the resources to manage the economic turbulence. We will be closely monitoring how this situation evolves.
October 12, 2018
“Inflation this year is shaping up weaker than expected despite Fed assurances that inflation will rise above 2% in the next couple of years” said FTN chief economist Chris Lowe. Bond yields are a barometer of where investors think economic growth and inflation are headed. Recently, longer-term interest rates have moved higher with the 30-year mortgage hitting nearly 5%, the highest level in 7 years. If inflation figures are not as strong as expected then why are interest rates rising? Recently, the unemployment rate came down to 3.7%, the lowest since 1969. It is expected that with a tight labor market, there is going to be greater pressure on wages to rise and that could lead to inflation. The Federal Reserve has been raising short term interest rates since December 2015 and it wants interest rates to return to “normal”. The common belief is that rates should go up because the economy is strong. Federal Reserve Chairman Powell recently commented that the Fed had a long way to go before short-term rates could be considered normal. An important factor will be inflation figures. If inflation looks to be falling short of the Fed’s 2% target, the Federal reserve could hold off on increasing short-term rates.
October 5, 2018
The devastating impacts of the financial crisis were widespread and extreme. Between 2008 and 2009 more than 8 million U.S. jobs were eliminated and GDP declined by 4.7%. Moreover, home prices fell over 30% from 2006 to 2009, which caused foreclosures to skyrocket and a large loss of home ownership. Both fiscal and monetary stimulus were instituted in an enormous and innovative fashion to stabilize the economy and mitigate the depth and duration of the recession. For the past decade, the Federal Reserve has remained extremely accommodative by taking rates to historic lows and building its balance sheet to over $4 trillion. Banking regulations increased dramatically in the aftermath of the recession and risky borrowers searching for leveraged loans found it extremely difficult to obtain funding. The need for funding and the lack of sources caused non-bank lenders to step into the market and fill the void once occupied by banks. Since leveraged loans reside high in the capital stack, are secured by physical assets and are floating rate, investors had little concern funding the deals. However, as time progressed and liquidity continued to pour into leveraged loans, the maintenance covenants, which allow lenders to review and manage the financial stability of a loan, were dropped and they became known as covenant-lite loans. The insatiable appetite for leveraged loans has allowed the debt to EBITDA ratio to reach an all-time high at the middle market level. With interest rates on the rise coupled with weaker balance sheets, it is our belief that the default rates on leveraged loans during a time of economic stress will be higher than what has been experienced in the past.
September 28, 2018
Much like the equity market, the yield of the U.S. 10-year Treasury is at new highs. Both bond yields and equity prices have benefited from the recent strength in economic indicators suggesting the domestic economy will sustain a robust momentum into 2019. Both the manufacturing and the consumer sides of the economy have been very solid. Despite all the tariff discussion, the ISM manufacturing PMI, which is an excellent contemporaneous gauge of the industrial economy, has been extremely strong. The Conference Board’s Consumer Confidence Index just jumped to another cycle high in September. With core CPI running at 2.2% year-over-year, inflation is running at or slightly above the Federal Reserve’s target. These data points give the Fed plenty of reason to continue with gradual tightening. This week, once again, the Fed raised its target range for fed funds which now stands at 2% to 2.25%. Fed futures and a recent CNBC survey of economists suggest the market is betting that a December hike is extremely likely. Economists surveyed expect two more rate increases next year bringing the target range for fed funds to 2.75% to 3.0%, which would roughly match what many economists believe is the economy’s neutral rate. The neutral rate is the interest rate that is neither restrictive or accommodative. Almost 60% of economists expect the Fed to ultimately push rates above the neutral rate to slow the economy down. The Fed’s risk of over-tightening is compounded by the trade dispute, which has the potential to slow the global economy, and the fact that the actual neutral rate is not precisely known. The neutral rate changes throughout the cycle. The risks to the expansion will be significantly larger as we get out to next year.
September 21, 2018
Despite trade concerns and softening economies in Europe and China, domestic equity markets have rallied strongly in the third quarter. The DJIA has lifted from 24,271 to over 26,700 since the end of June. The prospect of a 5% to 10% pullback in stocks as we approach the November election cannot be dismissed and some would argue that consolidating recent gains would be healthy from a market standpoint. However, the equity market is not showing any sign of stress from a technical or volatility perspective. In fact, the VIX (a measure of the market’s expectation of 30-day volatility) has been in a trading range between 11 and 15 for the entire third quarter and has been trending lower since the January/February market correction. The capital markets overall are not indicating concern. The spread between high yield bonds and comparably dated U.S. Treasuries remain extremely tight. Typically, ahead of market turbulence we see these spreads widen noticeably. Equities have been very resilient as investors have focused on the strength of the underlying U.S. economy and the lack of a substantial pickup in inflation. The Labor Department reported that initial unemployment claims fell to the lowest level since 1969, which is remarkable considering the size of the civilian labor force has increased by more than 60 million people. The Federal Reserve will appropriately raise rates next week. Barring a change in the Fed’s gradualist approach to normalization, or a geopolitical blowup, it is difficult to foresee a reason for a major shift in investor sentiment. To be clear, there are challenges on the horizon such as Brexit and slower economic growth in 2019, but for now investors are not focusing on these future potential concerns.
September 14, 2018
Economic activity, according to the most recent FOMC statement, “has been rising at a strong rate”. A sizable contributor to the current economic strength is the Tax Cuts and Jobs Act which was signed into law in December of 2017. Many economists questioned the rationale for pushing through tax cuts at such a mature phase in the economic cycle, however, federal receipts have actually increased $26.2 billion in the first 10 months of the fiscal year. Examining the breakdown of federal revenue reveals that receipts from companies are lower compared to a year ago (mostly from accelerated depreciation due to capital expenditures), while individual tax receipts have more than compensated for the lower corporate tax receipts. Even with slightly higher revenues, the budget deficit has expanded dramatically due to the increase in spending that was authorized by Congress. Moreover, the Congressional Budget Office (CBO) estimates that fiscal 2018 will result in a deficit of close to $800 billion. The gross national debt is projected to be $21.5 trillion by the end of fiscal year 2018 and the net federal debt is 78% of GDP. Based upon the projection of national debt growing faster than GDP moving forward, the CBO expects the net federal debt to be 100%of GDP by 2030. The two main ways to solve the issue would be to either cut spending or raise revenue. On the spending side, more than 60% of the budget is directed towards entitlements (Medicare, Medicaid and Social Security), which are politically very difficult to touch. On the revenue side, the goal is for GDP growth to accelerate, but without a meaningful increase in productivity lasting GDP growth will be hard to achieve. The current growth rate of the federal deficit is not sustainable and it will be a headwind for long-term secular economic growth.
September 7, 2018
Housing is an important sector of the economy. Prices in many local real estate markets have recovered from the Great Recession lows. Housing activity, however, has not approached the highs of early 2006. In January of 2006, U.S. housing starts reached an annualized run rate of over 2 million units, yet since April of 2015, the U.S. economy has been creating new housing at roughly a 1.2-million-unit rate. The housing sector has softened this year as affordability has become increasingly stretched largely due to higher mortgage rates. Housing analysts have attributed some of this weakening to a lack of supply, but there are other elements at play. The marginal buyer drives market activity and sets the price that clears markets. This is true for financial assets and real assets such as housing. The marginal entry-level buyer creates a market that leads to a chain of other real estate sales and housing construction. Despite a strong job market, statistics indicate the millennial buyer is delaying purchasing homes compared to prior generations. Student debt is the likely reason. A recent Federal Reserve study indicated that student debt hit $1.52 trillion this year up a staggering 9.5% annualized rate for the last decade. More than 44 million people are burdened by student debt, and the average American student owes $37,000. The College Board estimates that the annual all-in cost of a private non-profit college is$70,000. Student debt is having a deleterious impact on housing, household formation, and other significant economic decisions. Education costs have become a problem with broad economic implications that needs to be solved.
August 31, 2018
Second quarter GDP, which initially came in at a robust 4.1% annualized pace on a quarterly basis, was revised up 10 basis points (bps) to 4.2%. The revised GDP figure reiterated that trade activity gave GDP a rare boost as exports surged in the anticipation of an escalating trade war. Personal consumption from the GDP revision was down 20 bps to 3.8%, but increased investment more than offset this decline. Thanks to the tailwinds of tax reform, after-tax corporate profits increased 16.1%annualized in the second quarter, which positions businesses well to further invest in capital expenditures, increase salaries and/or buy back shares. While a 4.2% GDP figure certainly confirms the U.S. economy is on sound economic footing, it will be difficult to maintain the current pace of economic growth as the benefits of tax reform dissipate. Also, household income creation has not grown to a level that can support 4%GDP growth in the long run. According to Bloomberg, the median projection of GDP growth for the 3rd and 4th quarters of 2018 are currently 2.9% and 3.0%, respectively. We believe that economic growth should slow from the very strong second quarter figure, but it will still be above trend with respect to the current economic expansion. On a different note, the risk-on trade was in full force early this week as investors pushed the S&P 500 to an all-time high on optimism that the U.S., Mexico and Canada will come to an agreement on an updated version of NAFTA. While the likelihood of a deal being reached has improved, it may not bring as many jobs back to the U.S. as initially hoped.
August 24, 2018
Emerging markets made a comeback this week with the MSCI Emerging Market Index up roughly 2.5% through Thursday. Domestically, record corporate revenue, earnings and margins coupled with solid economic fundamentals (low unemployment along with strong consumer demand and confidence) pushed the S&P 500 to a record intraday high on Friday of this week. Bloomberg indicates the probability of the U.S. entering a recession over the next 12-month is only 15%. However, one of the major risks that could slow the current economic expansion is an escalating trade war with China. The two governments met this week and little progress was made after both countries enforced an additional$16 billion of tariffs on one another. Furthermore, an additional $200 billion of tariffs could be imposed after the comment period ends September 6th. It is our view that the trade war between the U.S. and China will take time to work out and could become tenuous along the way. Another risk we are closely monitoring is inflation and the potential for inflation to overshoot the FOMC’s forecast, given its gradual pace of tightening. At this juncture, the market is not overly worried about runaway inflation as the TIPs market indicates the forward 5-year inflation rate to be close to 2.0%. But, if the current pace of Fed tightening is not fast enough to contain wage growth, then inflation expectations will rise and cause the Fed to adjust their current pace of tightening, which could weigh on future economic growth.
August 17, 2018
The primary election cycle ends in a few weeks. There are only a handful of state primaries remaining with Florida being the most notable. Mid-term elections produce a high level of uncertainty and corresponding heightened volatility. According to recent academic research by Terry March from the University of California, the Dow Jones Industrial Average has produced an annualized return of just 1.4% in the six months preceding a midterm election in contrast to 21.8% annualized in the six months afterward. Domestic equity markets have produced acceptable returns compared to the muted returns that historically precede midterm elections. The returns are especially notable given the uncertainty created by trade tariff concerns. Equity prices in the third quarter have been very good, the DJIA up over 5%, driven by robust corporate earnings and a lessening of trade tensions. According to Thomson Reuters, second-quarter earnings growth for the S&P 500 will be a healthy 24.4%. Roughly ten percent of this earnings growth is related to the tax law change. Nonetheless, double-digit earnings growth and a solidly expanding economy have been very reassuring to domestic investors. A strong dollar and trade tensions, however, have created divergences in global equity markets. Emerging market equities are well into correction territory with the MSCI EM Index down over 14% in the last six months. Financial stress from currency and interest rate differentials are likely to expose economic problems such as Turkey. If the underlying fundamentals remain favorable, the ultimate path will be upward for equity prices.
August 10, 2018
Financial markets have been remarkably resilient throughout the bull market run. In only a handful of notable periods have an investor’s confidence and resolve been tested. The “taper tantrum” which resulted from the Fed’s decision to gradually reduce the size of quantitative easing in 2013 was one such example. As we approach the mid-term elections, it would not be unusual for market volatility to increase. There is typically an identifiable catalyst that creates some uncertainty in the markets that precipitates a market drawdown. As we examine the horizon for potential investment risks, the most obvious concerns are a policy mistake by a major central bank or a full-blown trade war. The spark that causes a correction, however, is often less obvious (e.g. a currency crisis in a small emerging market economy). This week the equity markets sold off on Friday due to the dramatic plunge of the Turkish Lira. Turkey depends heavily on borrowing from foreign sources to fund growth, so its economy can be damaged by capital flight creditors lose confidence. Additionally, Turkey does not have the necessary reserves to pay foreigners back. Turkey’s economy has overheated, with inflation running at an astonishingly high 16%. The market’s risk appetite can be damaged for a time by the deepening problem of an emerging economy like Turkey. In our view, Turkey is unlikely to lead to a systemic economic issue, but it is worth paying attention to.
August 3, 2018
July 27, 2018
The U.S. economy grew a robust 4.1% in the second quarter, driven by a sharp rebound in consumer spending which was aided by stimulus from the tax package. Export growth rose almost 10% indicating that concerns over the impact of tariffs pulled trade activity forward into the second quarter. The improvement in net exports added roughly 1.06% to GDP in the quarter. Final sales during the first half of 2018 averaged 3.5%, which are not impacted by the transitory effects of exports, and are more reflective of the actual underlying growth trends. The trade issue is also beginning to have a negative impact on the micro level for some companies. For example, GM cut its profit outlook for 2018 when it reported earnings this week, citing higher cost for raw materials. Prices for steel and aluminum, two key raw materials for the automakers, have been rising globally since tariffs were imposed. Rising material costs are affecting other industries as well causing investors to focus more closely on the potential deleterious margin impact that could result from a trade war. President Trump and EU President Juncker met this week to discuss the framework for a trade deal that went surprisingly well. Few specifics were offered after the meeting, but it was encouraging to hear both sides strike a more conciliatory tone. Given the vague agreement and the fact that talks between the U.S. and China seem to have broken down, it is too early to signal the “all clear” on the trade situation.
July 20, 2018
Investors were heavily focused midweek on Fed Chairman Powell’s testimony before Congress. According to the most recent FOMC statement, “economic activity has been rising at a solid rate” with the consumer showing renewed signs of strength and business fixed investment increasing strongly. With inflation (annualized Core PCE index) running at 2%, there was concern that Chairman Powell would indicate a more hawkish monetary policy tone. The domestic markets reacted well after digesting Chairman Powell’s comments and his continued commitment to gradual rate increases moving forward. Even though the current unemployment rate is running 50 basis points (bps) below the Fed’s longer run projection, there still appears to be some slack in the overall labor market as average hourly earnings are up only 2.7% on a yearly basis. Possible reasons for the muted overall wage growth given the low unemployment rate may be due to the deflationary impact of evolving technology and new entrants to the labor force who were not previously counted as unemployed. However, given that monetary policy is still considered accommodative, we do expect the labor market to tighten further and it will prompt the Fed to raise interest rates. At this juncture, the Fed funds futures market shows the December of 2018 contract trading at 2.21%, which indicates the Fed will increase rates 25 bps roughly 1 to 2 more times this year. One of the major risks to the previous prediction is if the trade war with China escalates and the Chinese economy decelerates more rapidly than expected. Right now the default cycle in China is ramping up and the Shanghai Composite is in a bear market, but China is beginning to loosen monetary policy to combat its current headwinds.
July 13, 2018
The unofficial beginning of the second quarter earnings reporting season kicked off on Friday as several major banks reported second-quarter earnings with mixed results. Trading revenue and loan growth were generally solid, but interest expenses are growing faster than interest income due to the flattening yield curve. The yield differential between the two-year Treasury and the ten-year Treasury continued to compress this week to roughly 25 basis points. This is the tightest spread level since July of 2007, which was just before the Great Recession. Although not an infallible indicator, an inverted Treasury curve has been a solid predictor of a recessionary environment ahead and typically offers investors at least a six-month lead. The persistent decline of the treasury spread over the last 18 months has been disconcerting. In our view, the flattening yield curve is probably not as meaningful a signal as in the past. Due to the distortive effects of quantitative easing across the entire yield curve, but especially regarding intermediate maturities, the flatness of the yield curve is not providing investors with historically correct information. We feel that we are in a typical cycle that has been elongated due to the depths of the last economic recession and impact of central bank action. As the economic cycle continues, we expect the typical pattern of inflation followed by higher long rates, and ultimately over-tightening by the Federal Reserve to play out.
July 6, 2018
The trade war became real on Friday as the United States instituted a 25% tariff on $34 billion worth of Chinese goods, and China responded with tariffs on imports from the U.S. on cars, soybeans, and lobsters. Given the size of the economies involved, the impact of these trade actions will be negligible, but the threat of escalation is meaningful and could have a more demonstrable effect on global growth. Despite the potential modest drag on economic growth, tariffs could also create some inflationary pressures by providing a pricing umbrella to domestic producers and through supply chain disruption. A trade war would significantly complicate the decision-making process for the Federal Reserve. The Fed is on course for possibly two additional rate increases this year which seems justified by the June employment report. Friday’s jobs report was very robust and a clear indication that labor conditions continue to tighten. Wage pressure could be an issue in the second half of the year. According to the Department of Labor, there are 6.7 million job openings and there are more jobs available than there are unemployed workers. Companies across many industries are already complaining that it is difficult to find qualified workers, and at the current pace of job creation, this problem is likely to intensify. It is hard to imagine that we will not see additional wage pressure. The current dynamic will be beneficial for consumers as wages rise, but are likely to contract corporate margins.
June 29, 2018
June 22, 2018
Global equity markets have been flat to down since the tariff and trade policy discussion began at the end of February. Equity investor sentiment and the short-term trading pattern for stocks have been dominated over the last four months by the potential for an escalation of a trade war between the United States and our global trading partners. A leveling of unfair trade obstructions is desired, however to the extent the effort may cause an exacerbation and heightening of artificial trade cost that has real-world consequences, the trade strategy has significant risks. There are of course other concerns that investors need to consider. Central banks’ policies will increasingly become less supportive of global economies as they normalize interest rates and their balance sheets. Corporate margins are likely to trend lower over the next few years as wage pressure, due to tight labor markets, and an increase in debt service from relatively high corporate debt levels begin to negatively impact earnings growth. These are secular issues that will likely dampen equity returns, bringing them below long-term historic averages. However, the fundamentals remain solid with positive economic momentum driving earnings growth. S&P 500 earnings are projected to grow 22.3% in 2018 and 9.7% in 2019, according to Lipper. With valuations less onerous (S&P 500 is trading at 16.9x FPE), we would expect equities to work higher assuming the trade issue recedes.
June 15, 2018
Investors had several interesting and pertinent news items to digest this week. The Federal Reserve raised their benchmark rate another quarter of a percentage point, as expected, but the forward rate projections suggest a slightly more hawkish tilt. Fed officials expect an additional two hikes this year and three more next year. If these anticipated rate increases come to fruition, the fed funds target would increase to 3.0% to 3.25% by the end of 2019 and will probably exceed the neutral interest rate. The neutral interest rate is the rate that is neither stimulative or restrictive regarding policy. The more hawkish tone caused the treasury yield curve to flatten as the 2-year to 10-year treasury spread hit a cycle low of 35 basis points. The European Central Bank also met this week and announced their intention to phase out its QE program by the end of the year. The ECB also indicated that they would not consider raising rates until the summer of 2019 which financial markets interpreted as dovish. But from a broader perspective, markets are beginning to take notice of the growing divergence in central bank policy. The one-year Treasury bill has climbed from 1.97% to 2.31% over the last three months, and the U.S. dollar has appreciated 6.3%. Emerging market sovereign debt has been especially hard hit this year as much of their debt payments are dollar denominated. As economic growth paths and the pace of central bank policy normalization diverge, asset class correlations will as well.
June 8, 2018
Geopolitical and trade events will occupy the market's attention over the next few days. This coming weekend the 44th G7 summit will be held in Quebec, Canada. Given the recent tariffs imposed by the United States on steel and aluminum against the EU and Canada, talks are likely to be tense and potentially combative. On Tuesday, President Trump will meet in Singapore with the North Korean leader to discuss denuclearization. Investors will pay attention to these important meetings, but it is likely that these discussions will not culminate in a definitive agreement or resolution in either situation. The Federal Reserve and the ECB both have critical “live decision” meetings next week. Fed futures indicate that the Fed is almost sure to raise the fed funds rate another 25 basis points. Fed officials have signaled the hike, and it seems justified given the tight U.S. labor market, and the anecdotal evidence emerging of bottlenecks and capacity constraints increasingly crimping corporate supply chains. The commentary and press conference will be carefully scrutinized for signals of future Fed action. The meeting that has the potential to be provocative from a financial market perspective is the ECB meeting. The ECB’s quantitative easing program is scheduled to end in October, and except for the meeting next week they only have meetings in July and September. The ECB will probably want to prepare the markets well before a change in policy, so an announcement in June or July seems likely.
June 1, 2018
Despite relatively positive economic releases this week, the financial markets were extremely volatile, buffeted by both geopolitical events in Italy and renewed trade concerns. As the week began, the DJIA dropped over 391 points as anti-establishment political leaders in Italy struggled to form a new coalition government. Some pundits even express concern that rising nationalism in Italy represented an existential threat to the European Union. These fears are significantly overblown. There is legitimate concern regarding the continued weakness of the banking system in the EU, but a fracturing of the EU will not happen over any reasonable investment horizon. Later in the week stocks sold off again as concerns of a trade war emerged with the U.S. announcing tariffs on aluminum and steel imports from Canada, Mexico and the EU. We believe that the prospect of a major trade war developing is remote. It is clearly not in the interests of any of the major developed economies to allow a meaningful trade breakdown, including the U.S. Additionally, there are facilities such as the G7 Summit to ameliorate trade tensions. Canada will host a G7 meeting on June 8-9 with the focus on investing, job creation, advancing gender equality, etc. Easing trade tensions will obviously be an important subtheme. Investors are getting distracted by very low probability events that pose a significant tail risk. In our view, we think investors should be focused on economic fundamentals which remain solid. The real threat to the market is potential rising inflation expectations and central bank normalization.
May 25, 2018
The FOMC minutes released on Wednesday gave further insight into the Fed’s stance on the current inflationary environment. It was noted that a majority of the FOMC members expect inflation to potentially overshoot the 2% target for a period of time given the recent economic momentum provided by years of extremely accommodative monetary policy, tax reform and deregulation. However, they are not overly concerned that it will significantly overshoot the target.
May 19, 2018
The equity markets were an absolute roller-coaster in the first quarter. Since the S&P 500 made a double-bottom at the 2580 level in early April, the broad market index has established a trading range between 2625 and 2780. Within the trading range, the S&P 500 has been volatile, and leadership appears to be more dispersed and less well-defined. The S&P 500 is down 5.6% from its January high. Lost on many investors is the underlying strength in the small cap stocks which made a new all-time high on Friday. Small cap stocks are benefiting from a handful of macro tailwinds. First, the Trump administration has placed significant emphasis on reducing regulation. The cost of meeting arduous regulatory mandates is disproportionally burdensome for smaller companies that have a lower revenue stream to support the added costs. Second, the tax reform bill should be more helpful to smaller companies. Generally, smaller cap companies are less able to shelter earnings from taxes. Finally, smaller companies that have less critical international business operations are more insulated from the uncertainty created by recent trade negotiations. Although valuations are not overall compelling for the small cap segment of the market, the divergence between small caps and their large cap brethren could continue for a while. Historically, small cap stocks have typically outperformed after the economic cycle has bottomed and during the initial phase of rising interest rates.
May 11, 2018
Global equity markets finished higher on the week despite concerning geopolitical headlines. Two key inflation reports released in the U.S. came in slightly below expectations and gave market participants comfort that the Fed was not behind in tightening monetary policy. The long end of the U.S. Treasury yield curve, which increased to start the week, pulled back when the annualized headline Producer Price Index (PPI) decreased 40 basis points on a monthly basis and was below economist expectations. The decline in the headline PPI was surprising given the recent increase in energy prices along with bottlenecks in the transportation sector, however, the headline number was more heavily influenced by declines elsewhere. The recent pause in the rise of inflation data may be short lived as the current unemployment rate of 3.9% is well below the Fed’s longer unemployment expectation of approximately 4.5% and should lead to wage pressures as time progresses. But, given the deflationary impact of technological innovation along with a portable and global labor pool, we do not expect wage pressures to escalate dramatically and therefore the removal of monetary policy accommodation should continue on a gradual path. Globally, the only other major developed market central bank to increase rates in the recent past was the Bank of England, but after a weak first quarter, policy makers voted 7-2 this week to keep rates unchanged and will most likely hold rates at current levels until economic momentum regains traction. It is interesting to note that with the financial crisis over nine years behind us, central bankers outside of the U.S. are still having a very difficult time normalizing interest rates.
May 4, 2018
The U.S. and China held two days of trade talks this week in Beijing. The U.S. trade delegation included senior-level representatives from the Trump administration, headlined by Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, and National Economic Council Director Larry Kudlow. These are important trade discussions being conducted at the highest levels. Although some analysts had suggested the potential of a short-term deal being reached in a specific area, such as in the automotive industry, it was unrealistic to expect a comprehensive resolution of complex trade issues after one set of meetings. The differences regarding trade policies and practices have evolved over many decades and will take a while to resolve, especially given the national political realities both Chinese and American officials face at home. The U.S. and China are the two largest economies representing over 30% of global GDP, so the trade issues themselves are complex. But the U.S. concerns extend well beyond tariffs into thorny areas like intellectual property rights and cyber theft. Further compounding the negotiations, each country operates on a competing political ideology and differing national aspirations. The stakes are high. It is extremely likely that trade tensions will be a market factor well into 2019. Ultimately, we expect a negotiated solution, perhaps a series of small deals which will settle the issue. In the meantime, investors will have to accept some volatility related to the mercurial nature of a complex trade deal being negotiated in a social media-oriented world.
April 27, 2018
Equity investors and bond traders were closely tracking the 10-year Treasury this week as the yield breached the 3% level for the first time since 2011. A strengthening domestic economy, which features a tightening labor market, is not only pushing longer interest rates higher but is also partially responsible for the exceptional earnings reports equity investors have experienced recently. The countervailing factors of rising rates and strong earnings have caused the choppy trading pattern in equities. This week exemplified these forces. As rates increased, investors become concerned with the potential for a higher discount factor. When rates flatten out, earnings surprises improve equity market sentiment. Although we have a constructive view on the economy over the next 12 to 18 months, it is unlikely that the economy will accelerate enough to let inflation fears cause a dramatic backup in the 10-yr Treasury. Earnings should have the predominant influence over equities for the time being as earnings reports should continue to be favorable through the balance of the year. Perhaps the more significant drag for equities will be at the short end of the curve. The 2-yr Treasury currently yields approximately 2.5% which has become a viable capital allocation option for investors that were forced into equities because of low rates.
April 20, 2018
We often focus our comments on issues likely to impact the financial markets over the immediate 12-month investment horizon. Over the next year, there does not appear to be a systemic concern that will derail either financial markets or the economy. Interest rates remain historically low, global GDP growth is solid and corporate earnings are accelerating. Other than geopolitical events, which are by nature unpredictable, inflation expectations getting ahead of the Federal Reserve seems to us to be the most meaningful risk. As we expand the time horizon from three to five years, global debt becomes a significant consideration. The International Monetary Fund said that global debt is at a historic high reaching 225% of GDP. Global debt has exploded since the Great Recession mainly related to the fiscal policy response to the crisis, as well as increased spending in emerging economies. The debt concern is heightened because the two largest economies, the U.S. and China, are major culprits in the growing debt problem. China is responsible for three-quarters of the expansion of global debt since 2008. The U.S. national debt currently exceeds $21 trillion (roughly$174,200 per taxpayer), and we are running a deficit that will approach$750 billion in 2018. The IMF predicts deficits will average over $1 trillion in the next three years. Investors have largely ignored the growing debt burden both in the U.S. and globally. If current trends are not addressed, especially with potentially higher interest rates, the cost of interest rate servicing will eventual impact standards of living and economic activity.
April 13, 2018
The risk-on trade regained momentum this week as trade war tensions simmered between the U.S. and China. Chinese President Xi Jinping’s speech on Tuesday was well received by the market participants as he discussed expanding foreign company access to Chinese markets, reducing tariffs on imported cars and enhancing intellectual property protections. President Trump spoke favorably of Xi’s speech, which is a welcome development given that just last week, the two largest economies in the world were proposing sizable trade tariffs on each other. Trade tensions between the U.S. and China are far from being resolved at this point, but the positive progress is certainly a step in the right direction. With that being said, large cap domestic equity valuations made a comeback this week. Looking at the S&P 500 Index on a price to forward earnings (Bloomberg blended 12-month forward) multiple, the current level of 16.5 times is up from the recent low of 16.0 times on 4/2/18. With our belief that a majority of this year’s equity returns will come from earnings growth and not multiple expansion, it is encouraging to see that the recent pull back in the price to earnings multiple has subsided and is beginning to reverse. However, a major headwind for further multiple expansion will be rising interest rates and inflation. The release of the most recent FOMC minutes tilted hawkish as the participants acknowledged the outlook for the economy has strengthened recently and the implied probability of a rate hike in June increased to 88.6%. The market is currently pricing in 2 additional 25 basis point Fed funds hikes in 2018 and based upon the current economic environment, the prediction seems very reasonable.
Click below to listen to this week's Peapack-Gladstone Bank Market Report as heard on WCBS NewsRadio 880.
March 30, 2018
It is incredible the difference a year can make. Risk assets, which performed extremely well in 2017, have hit a bit of turbulence through the first quarter of 2018. The 20-day realized volatility of the S&P 500 Index in 2017 averaged an incredibly low 6.75% according to Bloomberg, with the highest level reaching 10.78% in early September. Through the first quarter of 2018, the 20-day realized volatility of the S&P 500 Index has averaged 16.15%, which is more than double 2017’s figure. However, when 2018’s 20-day realized volatility is viewed from a longer-term perspective, it is in line with the average of 15.32% dating back to March of 1928. The previously mentioned data leads us to conclude that risk assets are behaving as expected year-to-date in terms of volatility and that 2017 was truly an abnormal year. The two main drivers of increased volatility this year have been the elevated uncertainty of the future path of interest rates and the potential for a global trade war. With respect to the future path of interest rates, market participants are concerned over increased fiscal easing in the U.S. in an economy that is at or near full employment. This could cause inflation to increase faster than current expectations and push the Fed to shift from a position of gradually removing monetary policy accommodation to proactive tightening. The FOMC released their updated monetary policy projections last week and even though the median Fed funds rate projections increased by 20 to 30 basis points in 2019 and 2020, the median projection for 2018 stayed the same at 2.125%. At this point it appears that the Fed will be able to continue on its path of gradually removing accommodative monetary policy, but we will be keeping a close eye on inflation measures moving forward.
March 23, 2018
Global equity markets sold off sharply last week largely related to increasing concerns regarding a potential trade war. Trade fears were stoked when the Trump administration announced an additional $60 billion in tariffs and tighter restrictions on technology transfers. According to the U.S. Trade Representative Robert Lighthizer, the U.S. will impose 25 percent duties on selected Chinese products to compensate for harm caused to the American economy from Chinese trade policies. Additionally, the U.S. action is a response to past Chinese efforts to obtain technology from U.S. companies through intimidation and state-financed acquisitions. Clearly, the Trump administration holds a core belief that the Chinese are not fair traders. China answered with$3 billion worth of retaliatory tariffs, which seems to be a very measured response. Commerce Secretary Wilbur Ross suggested that the strong stand on trade will bring negotiations and concessions without escalating into a broad-based trade war. Hopefully, Mr. Ross’s assessment is correct. Trade tensions between the two largest economic powers is certainly a cause for investor concern. The timing of increased economic tensions coincides with a period where the Chinese have become much more assertive regarding their interests in the South China Sea. Apart from purely economic considerations, rising trade tensions introduces another element to geopolitical risk.
March 16, 2018
There are important meetings next week that investors will be focusing on. The G-20 finance ministers and central bankers meet in Argentina, while the Fed’s Open Market Committee will be considering adjusting monetary policy in the United States. With the global growth forecast at a relatively robust 3.9% this year, some central banks are shifting their stance regarding accommodation. There is also concern over potentially rising trade tensions. Domestically, the focus will be on the Fed’s commentary regarding projected conditions and the pace of future rate increases. It is widely expected that the Fed will increase the Fed Funds rate another 25 basis points. Although inflation gauges are continuing to drift higher with the core consumer price index at 1.8%, currently there is no significant upward pressure on inflation. Import prices have lifted due to dollar weakness, but the market’s focus has been on wage growth. Many economists are surprised at the tepid wage increases that we have seen given an unemployment rate at 4.1% and an economy that has produced over 2.2 million jobs in the last 12 months. We believe there are a couple of plausible explanations. First, the expanding economy has brought disenfranchised workers back into the labor force helping to contain wage increases. The household survey indicated that the labor force rose by 806,000 leaving the unemployment rate unchanged. Second, there is anecdotal evidence that employers are using technology and lowering the labor component of their products. As labor market conditions tighten, we expect wage rates will move higher. It is very possible that higher wage costs will not be entirely passed on to consumers and corporate margins may get pinched.
March 9, 2018
Market participants had a great deal of information to interpret and discount this week with the most important being the potential spread of protectionism and the degree of labor market tightness. Investor anxiety started high this week when President Trump’s top economic advisor, Gary Cohn, resigned as his attempt to sway the President on imposing steel and aluminum tariffs faltered. Cohn is a proponent of globalism and with his departure there is fear that future potential trade restrictions could weigh heavily on markets as trade wars have a tendency to slow overall economic growth. On Thursday President Trump signed the steel and aluminum tariff order, but stepped back from his hard-lined stance by giving both Canada and Mexico exemptions and opening the door for future potential exclusions. Trade war talks abated Friday morning as the U.S. employment situation took center stage. A little over one month ago volatility spiked when average hourly earnings increased unexpectedly to 2.9% on a yearly basis and thoughts that the Fed would have to increase rates at a more robust pace escalated. The previously mentioned fears were muffled when average hourly earnings reversed their upward trend and slipped back to 2.6% and risk assets rallied. With domestic interest rates entering a trading range and moving laterally over the past few weeks, volatility has trended lower, but that trend could easily be disrupted as protectionism evolves and the Fed continues to tighten monetary policy moving forward.
March 2, 2018
The news flow this week was especially busy. Jerome Powell gave his first Congressional testimony as Fed Chairman. Like most observers, we were especially interested to see if the tone of comments would represent a shift from Janet Yellen. Although some traders interpreted his comments as more hawkish than expected, he reaffirmed maintaining the gradual course that the Federal Reserve has been following. Over the last two years, the financial markets have consistently priced in fewer increases than Fed officials’ guidance. With increased inflation expectations over the last six months, markets are now priced to match the three-rate increases being suggested by Mr. Powell. The most significant news of the week was President Trump’s comment that the U.S. will announce new tariffs of 25% on steel imports and 10% on aluminum imports next week. The equity markets’ acute negative reaction was concern over potential retaliation from China, Canada and the EU. The Trump administration has already slapped tariffs on solar panels and washing machines, so clearly this is an emerging trade policy. Tariffs are essentially a tax on specific competitors (foreign) in the selected market. In the case of steel, for example, foreign steel will become more expensive relative to domestic steel. U.S. steel producers will receive a pricing umbrella and are likely to take advantage of that. Ultimately, these price increases will be passed along to consumers. This is just one of the reasons that an expansive use of tariffs in trade policy is regarded as negative for the global economy.
February 23, 2018
The recent market volatility continued to subside this week as domestic equities traded mostly sideways, U.S. Treasury yields remained relatively range bound (even with $258 billion of new issuance) and the CBOE Volatility Index (VIX) compressed further to roughly 16.5 after spiking to over 50 on February 6th. Even though the domestic economy is on sound fundamental footing (leading economic indicators for January were up 6.2% on a yearly basis), the recent increase in interest rates and wage gains could impact corporate profit margins and weigh on earnings if revenue fails to keep pace. According to Bloomberg, the trailing 12-month profit margin for the S&P 500 is currently 8.84%, which is well above the average of 6.56% dating back to 1990. However, the trailing 12-month S&P 500 profit margin has compressed 46 basis points since the end of August, which corresponds very closely to the recent upward march in U.S. Treasury yields and wage gains. At this point, the market is projecting that further interest rate increases and wage gains will be manageable as earning projections for 2019 are up over 10% compared to the 2018 estimate. We will be keenly focused on monitoring any future modifications to 2019 earnings estimates moving forward.
February 16, 2018
The equity market melt-up in December and January was caused by optimism over economic expectations and earnings for 2018 as investors assessed the positive economic impact of corporate tax reform. The S&P 500 index rose 8.7% from Thanksgiving to New Year’s Day. The increase was uncomfortably fast for many traders and technicians. Some fundamental analysts cautioned that valuations were extended and ahead of the fundamentals. Rising real bond yields and modestly higher inflation expectations created a brief market dislocation in February as market participants considered the appropriate discount rate for equity earnings. Equities were ripe for a drawdown. Investors have been speculating that the equity market was “due for a correction” for many months. Often the collective psychology of investors creates the very condition that is feared. Fundamentals ultimately emerge and drive markets in the appropriate direction. Despite higher rates, equities recovered this week as investors became more comfortable with valuations after robust earnings releases. According to Zacks Research, total earnings for the S&P 500 for the fourth quarter are expected to be up 13.9% from the same period last year. The days of extremely low inflation and interest rates are over, for now, so we can expect high volatility and very limited multiple expansion for equities. For the near-term, fundamentals remain solid.
February 9, 2018
Volatility is back! The Dow Jones Industrial Average is down 9.1% from its high two weeks ago, and wide market fluctuations have appeared for the first time in a number of years. The most commonly used measure for market volatility is the Chicago Board Options Exchange Volatility Index (VIX). This is also considered a gauge of investor “fear” level. Historically, a VIX reading over 30 constitutes high volatility, and a VIX reading below 20 denotes low volatility. During the depths of the Great Recession panic in 2009, the VIX rose to almost 90, and it has generally trended downward ever since. In 2017, the average was 11, the lowest in 27 years. Last Tuesday the VIX jumped to 50, reflecting an increased level of volatility and anxiety in the marketplace. As global central banks reduce or unwind their quantitative easing efforts, we can expect to see greater volatility going forward. The nearly one-directional stock market with ever-lower volatility that we experienced over the past nine years will most likely adjust to a more normalized operating environment in the future.
February 2, 2018
Equity market volatility picked up markedly this past week due to investor concern over rising interest rates. The 10-year U.S. Treasury yield broke above the 2.80% level and approached a four-year high. Since the end of last August, the 10-year Treasury yield has risen from 2.05% to 2.84% or roughly a 35% increase in yield. Inflation expectations are tightly correlated with the 10-year Treasury yield and a key driver of the recent increase in bond yields. Tightening labor market conditions coupled with a weak dollar and poor productivity are creating an environment that should lead to higher inflation. The fiscal stimulus provided by the recent tax cut and the prospect of a $1.5 trillion infra-structure proposal from President Trump adds fuel to inflation expectations. The Fed Reserve concluded its first policy meeting of 2018 on Wednesday (which was Janet Yellen’s last as Fed Chair). The Fed left the fed funds rate unchanged, but it expects inflation to continue to rise and approach their 2% target. The magnitude of the recent rate move is meaningful, but there have been more extreme rate moves in recent memory. The bond market corrected over 100 basis points during the 2013 taper tantrum and after the 2016 presidential election. During the taper tantrum, the U.S. 10-year Treasury broke 3% and the S&P 500 corrected over 10%. At a certain point, rising interest rates will create volatility regardless of short-term earnings momentum.
January 26, 2018
Abundant and freely flowing liquidity coupled with coordinated global economic growth fueled the risk-on theme that drove investment returns in 2017 and has continued thus far in 2018. Year-to-date, the global equity market is up over 6.6% in less than one month. From a valuation perspective, the global equity market is trading at 21.3 times trailing 12-month earnings, which is expensive when compared to the 10-year median of 17.1. However, forward 12-month earnings expectations are extremely robust which allows the forward price to earnings ratio to fall closer to the 10-year median. If earnings expectations continue their upward trajectory, equity valuations should be supported but there are other risk factors to consider. One of the main risks apparent in the domestic market right now centers around inflation. Moreover, with consumer confidence high, leading economic indicators accelerating and the dollar depreciating, inflation could increase more rapidly than the Fed currently anticipates. The 5-year forward break-even inflation rate according to the Treasury Inflation Protected Securities market (TIPS) currently stands at 2.02%, which is up 18 basis points in the last month, but is still slightly below the 1-year high of 2.06%. With the FOMC scheduled to meet next week, it will be interesting to see if they make any adjustments to their inflation expectations.
January 19, 2018
A remarkable element of financial markets over the last couple of years has been the lack of volatility. The most often cited measure of equity market volatility is the CBOE Volatility Index which has been abnormally placid since the beginning of 2017. In our view, two primary factors have led to the lack of volatility. First, financial market conditions have been stable for many years, so the expectations of market participants have been relatively consistent. Market volatility is caused when investor expectations change. The economy has been stubbornly stuck at two percent GDP growth since the Great Recession ended. Inflation has remained modestly below the Fed’s target, and interest rates have been extremely low. Second, global central banks have continued to provide new liquidity. Investors have become conditioned to use any weakness as a buying opportunity. The factors that have dampened market volatility are unlikely to persist through 2018. U.S. GDP growth seems to have accelerated to approximately 3% and implied inflation expectations are beginning to increase. Interest rates have recently lifted to reflect better economic growth. Central banks are likely to guide markets to anticipate a reduction of accommodation in 2019. These conditions, coupled with elevated equity valuations, lead us to expect equity prices to be more active as 2018 unfolds.
January 12, 2018
Investor optimism regarding economic growth has been lifted by the recently passed tax reform bill. As economists have adjusted their estimates for real GDP growth for 2018, expectations for Federal Reserve rate increases over the near-term have been rising. The two-year Treasury note is heavily influenced by Fed rate expectations and is a barometer of current economic health. This week the two-year Treasury broke the two percent level for the first time since the 2008 financial crisis. The fiscal stimulus generated by over a trillion dollar tax reduction should have a positive economic impact in 2018 and 2019, driving the U.S. economy to above-trend growth. Although wage growth has been a disappointment, labor markets with unemployment at 4.1% seem relatively tight. An accelerating economy, given the tightening labor conditions, has the potential to finally translate into higher wages. Perhaps in anticipation of this, a number of large companies (Target and Walmart) that typically employ people at the lower-end of the wage spectrum have announced increases in their starting pay. As the trend in wage growth picks up, inflation should drift towards the Federal Reserve’s two percent inflation target. We expect that the Fed will have good reason to justify three rate increases in 2018. In the meantime, better economic growth is lifting earnings expectations. The Bloomberg forward earnings estimate for the S&P 500 has risen from$146.56 at the end of 2017 to $151.45 today. According to Zacks Investment Research, index earnings are expected to be up 13.7% in 2018, notwithstanding the tax cut, this earnings growth expectation seems to us to be a high bar.
January 5, 2018
Despite the attention received by the Tax Cuts and Jobs Act (TCJA) we are only expecting a modest increase in 2018 GDP growth. Quarterly GDP figures should surpass 2.00% in 2018, but without a pickup in productivity growth it will be a challenge to achieve 3.00% growth for the entire year. Productivity did move higher in the third quarter, but it has only advanced by 1.5% over the last year and 0.8% over the last five years. Business equipment spending is a key component of productivity gains, and this segment has picked up significantly over the last twelve months. We like to focus on “core” shipments (non-defense capital goods ex-aircraft) and these figures have increased by approximately ten percent over the last year. Another important component will be job gains and improvement in the labor force participation rate. The unemployment rate is currently at 4.1%, and the participation rate is now at 62.7%. We also keep a close eye on the U-6 measure of unemployment, which topped out at 17.1% during the Great Recession and now resides at 8.0%. In the past year payrolls are up an average of 173,000 per month. Monthly employment gains should be similar in 2018, with the average settling in between 150,000 – 160,000. The consumer enters 2018 on strong footing, as we have seen confidence levels soar, retail sales data post impressive numbers, and monthly job gains very consistent month to month. On the negative side the personal savings rate has plummeted to 2.9% a 10 year low, and the lowest level since just before the last recession began in late 2007. Historically speaking when savings rates get down to 2% - 3% it usually implies that there is no more pent-up demand, and the economic expansion is running out of steam. Recently personal income and consumption figures were reported and the year-overyear numbers were impressive (+3.8% and +4.5%). Finally and probably the biggest wild card for 2018, the Federal Reserve. The Fed has been increasing interest rates, and will continue to do so. It appears the Fed will increase rates 3-4 times in 2018, and the increases will be modest (+25 basis points). At the moment inflation is under control (core CPI +1.7% year-over-year), but if inflation data comes in stronger the Fed will have to be more aggressive with their rate increases. A more aggressive Fed is positive for fighting inflation, but not positive for an economic expansion now entering its tenth year.
December 29, 2017
Top 10 Financial Stories in 2017 | Factors that influenced the financial markets:
10) Geopolitical Risks – Geopolitical events never impacted the financial markets in a meaningful way despite pundit’s predictions.
9) Washington Dysfunction – Washington faced a tough year with lawmakers struggling to come to an agreement over many significant policy initiatives.
8) Rise of the Cryptocurrencies – Cryptocurrencies saw large inflows from speculators looking to make astronomical returns in a short period of time.
7) New Fed Chair – Jerome Powell was elected to take the place of former Fed Chair Janet Yellen. Fed Chairman Jerome Powell is expected to continue the Fed's path to interest rate normalization.
6) U.S. Treasury Curve – The flattening of the yield curve has continued throughout the year. The yield spread between the 2- year and 10-year treasury yield is at its lowest level since 2008.
5) Inflation Remains – Using the Consumer Price Index (CPI) to measure inflation, the U.S. inflation rate was above 2.1%. This is the highest rate of inflation since 2012.
4) Fed Normalization – The Federal Reserve is normalizing rates and reducing their security holdings.
3) Dollar Weakness – The dollar declined approximately 9.8% this year, the first annual decline in five years and worst performance since 2005.
2) Earnings – The S&P 500 Index is estimated to have earnings of $131.50 for 2017 compared to $106.26 in 2016, an increase of approximately 24%.
1) Tax Reform Drives Equities – The restructured tax bill will make America more competitive by reducing the corporate tax rate from 35% to 21%. Individuals are expected to benefit from the tax reform as well.
December 15, 2017
There were several noteworthy and potentially market-moving events this week. Both the Federal Reserve and the European Central Bank had rate meetings, and Congressional Republicans continued to wrestle with reconciling the House and Senate versions of tax reform. Relative importance is a matter of perspective. Bond investors were more interested in the Federal Reserve’s forward rate view and their economic forecasts. The Federal Reserve, as expected, raised their target on Fed Funds by 25 basis points and maintained their guidance of three more rate increases in 2018. The Fed has done such a good job telegraphing their intentions that there was little market reaction. Equity investors remain focused on the news regarding tax reform. Investor sentiment lifts as the confidence of passage of tax reform grows. The House-Senate conference committee working on the tax bill is working on modifications that will bring the remaining Republican holdouts on board. Major sticking points have been the size of the child tax credit (Marco Rubio and Mike Lee) and the elimination of the tax deduction for healthcare spending. Passage of the bill can be scuttled by just one or two holdouts. We expect Congressional Republicans to be able to navigate the remaining issues. The equity market has priced in much of the successful passage of tax reform.
December 8, 2017
The FOMC meets this upcoming week and the markets are pricing in an extremely high probability that they will lift the Fed funds rate another 25 basis points. If the FOMC does hike rates on December 13th, it will be the third rate hike of the year and will take the Fed funds rate to between 1.25 to 1.50%. It is interesting to note that according to the FOMC’s most recent statement, both headline and core “inflation measures have declined this year and are running below 2%.” So, why is the FOMC raising interest rates while inflation resides below its 2%target? The answer may reside in the fact that the Fed’s preferred inflation measure (personal consumption expenditures or PCE) does not take into consideration real and financial asset prices and relies mainly on a dynamic consumption bucket. Moreover, the staff at the New York Fed has developed a new inflation gauge that now incorporates asset values along with a consumption bucket, which shows that inflation is actually up roughly 3% on an annual basis as of October. If this new inflation gauge does measure inflation more accurately than PCE, then the Fed may have more data to support further interest rate hikes.
December 1, 2017
U.S. equity markets hit record highs this week with the progression of tax reform through the Senate being the main short-term catalyst. At this point, it is looking probable that this week’s negotiations will produce the 50 votes that are needed to move the bill forward in the Senate and allow for the reconciliation process to begin. The last hurdle to pass the tax bill will be to reconcile both the House and Senate versions of the bill in order for it to be sent to President Trump for approval. There are still some major sticking points between both sides of Congress with respect to the tax reform bill; however, we anticipate that Republicans will come together and gather enough support to pass the bill in early 2018. On a more cautious note, emerging market equities were down almost 3% for the week as some signs of liquidity stress are beginning to surface in China. Moreover, short-term funding costs for smaller borrowers have increased recently as the People’s Bank of China works on reigning in the shadow banking sector. Chinese officials are watching this situation closely and will most likely provide liquidity if credit spreads widen too quickly. The market is not too concerned with the minor liquidity stress surfacing in China as 5-year sovereign credit default swaps ended the week at only 57 basis points (bps) which is well below the year-to-date average of 75 bps.
November 17, 2017
The Trump Administration’s goal is to pass a tax reform bill by year-end. It strikes us that this could be too ambitious unless House and Senate Republicans are considerably more willing to compromise than they have been on other major legislative initiatives. The House of Representatives on Thursday passed a sweeping reform bill that will be the largest change the tax coded in 31 years. The Senate’s recent version is broadly similar to the House bill, but there are several fundamental differences that need to be reconciled. One of the major stumbling blocks will be the deduction for state and local taxes (SALT deduction). The House version allows the deduction with a cap, but the Senate version scraps the SALT deduction altogether. Eliminating the SALT deduction is a significant problem for House Republicans from high-tax states such as New Jersey. The Senate bill repeals the individual mandate that forces healthy people to buy insurance. This is very unpopular for some moderate Republican Senators because it would result in higher premiums and a drop in insurance coverage. Another major problem is that ultimately the reconciled bill will have to comply with the budget resolution that has already capped the deficit increase at $1.5 trillion over the next ten years. If the tax bill does not meet this test, it would require a full 60 votes in the Senate, which the Republicans do not have. The Republicans are very motivated to pass a tax reform bill, but their narrow majority in the Senate and their need to appeal to competing interests will make for delicate negotiations. We think they will pass a tax reform bill, but it will likely slip to next year and will be a somewhat watered down version.
November 10, 2017
Domestic equity markets took a break from their recent upward trajectory as the details of U.S. tax reform started to emerge from both chambers of Congress. Moreover, key differences in the two proposed bills thus far are likely to make the passage of tax reform rather difficult in the near term. Credit markets reacted to the news in a risk-off fashion with the high yield option adjusted spread widening approximately 20 basis points on the week. A real-time indicator that we closely follow to gauge the degree of risk-off sentiment is the level of generic high yield credit default swap spreads (CDX HY). Currently, the CDX HY is approximately 329 basis points, which is up roughly 20 basis points since November 1st, but is still extremely low. The 5-year high of 600 basis points was reached in early 2016, when domestic large cap stocks were down roughly 10% to begin the year. Much of the rally in the equities in September and October was predicated on the prospect of tax reform; it is not surprising to see modest profit-taking on the uncertainty created from the legislative process.
November 3, 2017
Consumers and investors are brimming with confidence. The consumer confidence index for October increased to 125.9 which was the highest reading in seventeen years. Both the current conditions and the expectations components rose to levels we have not seen since prior to the Great Recession. It is relatively easy to understand why consumers are feeling so positive. Jobs are plentiful and wages are rising faster than the general level of prices. In the consumer confidence survey 36.3% indicated that jobs were easy to find which was the highest level since January of 2004. Conditions seem good for healthy retail spending over the holiday season. Investors’ confidence has allowed the financial markets to shrug off uncertainty that would normally cause consternation and concern. The naming of a new Fed Chair during a period of rising interest rates and extended valuations would usually cause some financial market volatility. Typically, concern would show up in credit markets first, but credit markets are remarkably sanguine. Credit spreads in the 5-year tenor for both corporates and high yield sectors of the bond market are exceptionally tight, with investment grade and high yield spreads above treasuries only 58 and 249 respectively. Tight spreads indicate that bond investors are extremely confident in the near-term future. History suggests that when investors become too confident and do not demand a reasonable risk premium, markets find a reason to correct and bring a dose of reality to investors.
October 27, 2017
Interest rates have been driven to historically low levels as global central banks have purposefully ballooned their balance sheets to create liquidity to reinvigorate economic growth. As an example, the European Central Bank has expanded their balance sheet by over 2 trillion euros over the last 18 months. The German 10-year bund trades at a yield around 0.38%. Low yields and cheap capital have certainly encouraged risk-taking and asset speculation. The efficacy of central bank efforts to lift economic production has been hotly debated, but clearly, there is an element of diminishing returns. Without a doubt, the incremental liquidity is also causing asset prices to rise and waning asset price volatility. Coincident with the flood of liquidity from central banks, and perhaps to some degree because of it, many more investors have embraced passive investing. Passive investors tend to be more insensitive to valuations, especially in low volatility environments. Price discovery is lacking. Value investors have had a very difficult time as equity market returns have become increasingly narrow and focused on a select number of growth names. The preference for growth stocks in a low-growth world made sense at some point, but now valuation differentials are so extreme between growth and value that we would expect money to shift to value-oriented sectors.
October 20, 2017
The risk-on trade continued this week with large cap U.S. equities hitting new highs and U.S. Treasury yields widening approximately 10 basis points at the longer end of the curve. The main catalyst behind the bullish equity sentiment was the forward movement of possible tax reform with the Senate approving a fiscal 2018 budget. The next step will be for the House of Representatives to vote in favor of the budget, which will then open up a special procedure that allows the Republicans to potentially pass tax reform without the necessity of Democratic support. Looking back on how the Republicans were not able to reach a consensus on repealing and replacing Obamacare, some may question their ability to agree on tax reform. However, the markets are indicating that the Republicans will be more willing to compromise with each other on tax reform because failure to do so could hinder the party going into the 2018 midterm elections. At this point, a rough framework for tax reform has been proposed and it will be up to the House and Senate tax-writing committees to fill in the details of the legislation, which will then be heavily negotiated by numerous interests given the tremendous weight of what is at stake.
October 13, 2017
Rising equity values and the absence of volatility has been a consistent theme this year even with the U.S. Fed slowly increasing interest rates and beginning the process of gradually decreasing the size of its balance sheet. The previously mentioned statement should come as no surprise given the enormous amount of liquidity that has been pumped into the U.S. economy since the financial crisis. Moreover, according the Federal Reserve, the aggregate amount of reserves above the penalty-free band at depository institutions stood at over $2.16 trillion at the end of September. This is roughly $500 billion less than the peak achieved in August of 2014, but still incredibly high. Ample liquidity has made it inexpensive for consumers, corporations and the public sector to increase or refinance their debt loads. Using the U.S. commercial paper spread to T-bills as a proxy for liquidity availability, the current spread of 24 basis points (bps) is 18 bps below the average going back to 1996. By comparison, the aforementioned spread increased to over 300 bps in September of 2008. Moving forward, we believe the Fed will continue to gradually remove excess liquidity from the economy as long as inflations stays within close proximity to their 2% target.
October 6, 2017
We have frequently discussed equity market valuations that appear extended by most metrics. Valuations can remain uncomfortably elevated for extended periods of time. Waiting for the inevitable inflection point when valuations correct, either by stock prices falling or earnings rising, can be lengthy and very costly from missed investment opportunities. We indeed seem overdue for an equity market correction, but the conditions for a bear market are not evident. The economy continues to grow without significant excesses, and global central banks remain accommodative. There is less discussion in the business press of bond market valuations which seem high as well. Recently, former Fed Chair Alan Greenspan said, “the bubble is in bonds, not stocks.” Interest rates remain very low considering the domestic economy is operating with an unemployment rate of 4.2%, and we are many years from the crisis that caused the need for quantitative easing. With negative yields abroad and inflation expectations anchored below the Fed’s 2.0%inflation target, demand for treasuries remains strong. We do not anticipate a meaningful valuation adjustment for either fixed income or equity markets until higher inflation systematically manifests itself.
September 29, 2017
The Trump Administration released their framework for tax reform on Wednesday. Unlike the many failed Republican attempts at repealing and replacing Obamacare, there seems to be a strong coordination between Republican leadership in Congress and the Administration regarding tax reform. Passing tax reform requires a high willingness to compromise because the margins for success are so thin. If the Democrats vote as a block, the Republican Party can only afford to have two senators or 22 congressmen defect. There are several controversial aspects that make tax reform a heavy lift. The impact on the deficit will be dependent on how much economic growth is generated from tax reform and the revenue offsets that are selected to reduce the budgetary impact of lower rates. Estimates of the effect on GDP growth of lower corporate and personal tax rates vary widely and will be vociferously debated on both sides of the aisle. The Freedom Caucus contains 36 Republican members in the House that are budget hawks and are unlikely to go along with a significant expansion of the deficit. Additionally, eliminating or limiting deductions for state and local taxes will pit high tax states versus low tax states. Given the complexity and the myriad of constituencies, we expect a lengthy process before a potentially workable bill can be produced.
September 22, 2017
The current state of extraordinarily accommodative monetary policy was dealt a blow this week, with the official announcement of the start date of the Fed’s balance sheet normalization process. Starting in October the Fed will allow up to $10 billion per month, comprised of up to $6 billion of U.S. Treasury securities and up to $4 billion of agency debt and agency mortgage backed securities, to mature from its $4.2 trillion securities portfolio. Up until this point, the Fed has been maintaining the size of its enormous balance sheet by reinvesting all the principal payments by purchasing new bonds. The Fed intends to increase the pace of portfolio roll off by $10 billion per quarter up to a maximum monthly amount of$50 billion. With that being said, the Fed’s securities portfolio is not projected to drop below $4 trillion until August of 2018. The Fed raised its GDP forecast for 2017 from 2.2% back in June to 2.4% and stated that economic activity has been rising moderately and risks moving forward in the near term appear to be balanced. Moving forward 12 of the 16 FOMC members would like to hike interest rates at least 25 basis points in December, so at this point another rate increase this year is looking probable.
September 15, 2017
Inflation reports (August CPI) this week gave investors an indication that the Federal Reserve was correct in its assessment that softening inflation gauges in the second quarter were transitory. After an initial boost in inflation early in 2017 due to a rebound in energy prices, pricing measures consistently came in below estimates which lowered investors’ anticipation of additional rate hikes this year. Fed funds futures are suggesting that another rate hike in December is a real possibility. Regardless of additional rate increases, we expect the Fed to announce the reduction of its $4.2 trillion balance sheet at their meeting next week. We also envision other central banks to begin moving in a less accommodative direction. On Thursday, the Bank of England signaled its intention to raise rates soon to restrain accelerating inflation pressure in the United Kingdom. The Eurozone economy is growing at its fastest rate since 2007 and suggests less need for the ECB’s QE program expanding at €60 billion per month rate. By early 2018, we could have three major central banks becoming more restrictive with their monetary policy.
September 8, 2017
With European economic momentum gaining strength in 2017, the ECB had an opportunity this week to address the future of its quantitative easing program, but decided to delay the announcement until it meets again in October. The ECB left rates unchanged and increased its GDP growth forecast for 2017 to 2.2% which, if achieved, would be the fastest rate of growth in 10 years. The recovery in Europe is largely attributable to the extraordinary accommodative monetary policy that the ECB has instituted over the past 2.5 years, which has been comprised of negative interest rates along with asset purchases of over $2 trillion euros. Even with the aforementioned accommodation, inflation in Europe has been elusive and is not expected to hit the 2% target through 2019. The recent appreciation of the euro currency has been an additional headwind for inflation and has reduced recent inflation forecasts by 10 basis points over the next 2 years. The ECB is going to have to gradually tighten monetary policy in the near term by reducing the pace of its asset purchases. The markets will be keenly focused on the October ECB meeting with respect to any hints at the shape of the quantitative easing program for 2018.
September 1, 2017
Investors received two important indicators on the current status of the domestic economy this week. The U.S. Commerce Department released their revised estimate of GDP growth for the second quarter on Wednesday. Real GDP increased 3.0%, revised up from 2.6%, with consumption accounting for most of the revision, but almost every category was adjusted higher. The August employment report was modestly weaker than expected with nonfarm payrolls up 156,000. Despite the slight disappointment, the economy is continuing to produce an average of 175,0000 new jobs per month over the last 12 months. Collectively, these two reports indicate that the U.S. economy is in solid shape as we head into the back half of 2017. The domestic economy is growing at a reasonable pace and should not alter the Federal Reserve to maintain its measured approach to normalization. The situation can be characterized as a “goldilocks” environment for financial markets. There does not appear to be anything on the near-term horizon to meaningfully shift the path of the economy. The concern for financial markets will be the challenge as pressure builds on central bankers to adjust policy. We expect both the Fed and the ECB to be more demonstrative regarding rate and balance sheet plans in the next few months.
August 25, 2017
Chinese Government 5-Year credit default swaps are currently trading around 60 basis points, which is the lowest level since December of 2012 and is an indication that market in not worried about a hard landing in China anytime soon. Moreover, capital outflows from China, which had been in a downward trajectory from June of 2014 through January of 2017, have reversed course recently and grown approximately $80 billion over the course of 2017. Much of the current economic momentum in China has been fueled by accommodative monetary policy along with fiscal stimulus. Policy makers in China realize that the recent pace of credit expansion cannot continue in perpetuity. Last month China’s central bank released figures on the size of the shadow banking system and the results were more than double previous figures. Furthermore, President Xi Jinping has placed financial stability and prudent credit growth as priorities moving forward, which may add headwinds to Chinese GDP growth moving forward. However, with GDP currently growing at a year-over-year pace of 6.9% through the second quarter of 2017, China has a great deal of economic momentum to help it through its current transitionary period.
August 18, 2017
Risk assets started the week on a positive note with North Korean tensions subsiding, however, volatility returned to the market on Thursday as terrorist attacks in Barcelona and dysfunction in Washington took center stage. Moreover, Trump’s response to the violence in Charlottesville caused outrage across the country and led to the dissolution of two advisory groups that were designed to give corporate leaders a direct line to President Trump. Matters only intensified when rumors spread that Gary Cohn, the National Economic Council Director and key player in pushing forward potential tax reform, had resigned. This rumor was quickly discredited, but it left investors questioning the probability of Trump being able to pull through with his pro-growth policies. Another headline that caught our attention this week was that Mario Draghi will not discuss tapering the ECB quanti-tative easing purchase plan at Jackson Hole later this month and will wait to address the topic in the fall. Draghi’s patience with regard to the tightening monetary policy fully aligns with our view that monetary policy normalization will evolve at an extremely slow pace and may slow further if political leadership cannot work together in a coordinated manner.
August 11, 2017
The flare up in tensions between the United States and North Korea, over North Korea’s nuclear ambitions, roiled the financial markets this week. Conflict is an inherent element of the human condition, so geopolitical risks are always a concern for investors. We have highlighted in the past the potential spike in volatility that a geopolitical incident could cause. The increase in volatility can be especially pronounced when valuations are uncomfortably high. Indeed credit-oriented fixed income has been trading at historically tight spreads, and equities are at the top of recent trading ranges. The timing of geopolitical events and their long-term significance is highly unpredictable. Given the inherent uncertainty in geopolitical events, investors tend to over react and return correlations for higher risk assets tend to migrate upward. The speed with which this process happens is often surprisingly rapid, which is why we advocate well-diversified portfolios for risk control.
August 4, 2017
The U.S. dollar Index (DXY), which is an index of the value of the dollar relative to a broad basket of foreign currencies, has significantly weakened over the last five months. The DXY is down over 7% from the end of the first quarter. Most of this decline has been driven by the appreciation of the Euro relative to the U.S. dollar. The Euro/$ exchange rate has gone from 1.065 to 1.175. The sentiment from forex traders is that dollar weakness will continue for a while despite the Fed raising short-term interest rates three times since December. The fundamental issue that seems to be at play driving the dollar lower is the relative economic growth expectations for the U.S. versus Europe. International economies, including the EU, are accelerating relative to flat growth domestically. Ultimately, better European growth will cause the ECB to be more hawkish. Another plausible explanation is the political train wreck Washington has become. Political risks in the U.S. certainly have risen which is creating uncertainty for the global investor. Regardless of the cause, the weaker dollar will be supportive of S&P 500 earnings due to both a translation effect and ultimately from an economic impact.
July 28, 2017
With the three main developed market central bank balance sheets (U.S. Fed, ECB and BOJ) holding approximately $14 trillion in combined assets and benchmark interest rates on the front end of the yield curve hovering around 0% for close to nine years, one would think inflation would be an issue. However, year-over-year inflation at the core level in the developed markets mentioned above currently range from a low of negative 0.2% in Japan to 1.4% in the U.S. Moreover, the U.S. Fed is the only central bank in the developed market that has embarked on a very slow path of monetary policy normalization by raising rates 4 times since December of 2015. As a result, core inflation has dropped 40 basis points since February of this year, which exemplifies the moderate pace of the current economic expansion. Just last month the Fed released details on how it plans to shrink its balance sheet moving forward. It was vague on the start date by saying it should start relatively soon provided the economy evolves in line with its economic projections. Nevertheless, if core inflation does not reverse its recent downward trajectory, monetary policy normalization will be pushed further off into the future.
July 21, 2017
Complacency reigns. Implied volatility of both equities and bonds are at new lows. Financial markets are clearly unconcerned regarding the potential for a meaningful shift in economic fortunes. The markets seem to be predicting continued modest economic growth, low inflation and benign central banks that will remain supportive of markets. The 5-year real yield on TIPS (Treasure Inflation Protected Securities) is only at 0.15%, indicating the market does not expect a significant pick up in either growth or inflation over investors’ typical investment horizon. Additionally, there is almost $12 trillion in bank savings deposits earning meager interest which suggests many people are reticent to take market risk. There are plenty of short-term risks to be concerned with from geopolitical risks to a major policy mistake. A systemic concern is the crushing debt burdens in many regions and markets that will potentially impact long-term growth prospects. On the other hand, financial markets are not pricing in the potential for a fundamental shift in tax policy that could adjust the trajectory of the domestic economy and earnings. We are hopeful, but not optimistic, that the Trump administration and Congress can get something done before the congressional election cycle begins.
July 14, 2017
Earnings reports for the second quarter are just beginning. It is broadly expected that earnings momentum in the second quarter will continue after a very strong first quarter of greater than 10% earnings growth. According to Zacks Investment Research, total 2Q earnings are expected to be up 5.6% versus a year ago on 4.6% revenue growth. Analysts expect earnings in energy and industrial sectors to be especially strong as they continue to recover. Technology companies should continue to post strong relative earnings as well. Given the competitive disruption caused by internet retailing and a weakening in automotive sales, earnings in the consumer discretionary sector will probably show some deterioration. Speaking broadly, domestic growth is sufficiently strong to allow for modest earnings expansion for the domestic equity market. We would not expect significant multiple expansion in a moderately rising rate environment, so solid earnings growth is extremely important to drive the equity market higher.
July 7, 2017
Investors had the opportunity to review and digest minutes from the last Federal Reserve Open Market Committee meeting in June. Coincidentally, the European Central Bank released their minutes as well this week. The impression we were left with, both from reading the minutes and from recent comments by global central bankers, is that central bankers are becoming increasingly focused on balance sheet and rate normalization. There appears to be a shift in the mindset. The Fed has already raised rates 3 times in the past 7 months, and despite weaker than expected economic growth and eroding domestic inflation forecasts, the Fed clearly seems committed to continuing the process of normalization. The Fed believes the economic softness is transitory. They received some evidence to support this view with a relatively strong employment report on Friday. The change in sentiment regarding additional accommodation from central bankers will be a headwind to both the bond and equity markets.
June 30, 2017
Equity and fixed income investors were both treated to favorable markets in the first half of 2017. Positive earnings surprises in the first quarter and accommodative global central banks have been the key drivers of solid returns this year. Financial markets have been accustomed to central banks providing liquidity whenever economic conditions soften or risk concerns creep into investor’s psychology. The second half of the year is likely to be more difficult as central banks are becoming less of a supportive factor. Recent rhetoric from the Bank of England, Bank of Canada, and even the ECB is suggesting a shifting attitude toward tightening. Perhaps, the central banks are finally getting concerned with potential asset inflation as reflationary forces take hold. Regardless of the reason, it is likely to be an additional challenge for both the bond and equity markets.
June 23, 2017
Dominating the financial news this week was the Federal Reserve’s decision to raise its target on the Fed Funds rate by one quarter of a point to between 1 and 1.25 percent. The Fed also gave specifics regarding its plan to reduce the $4.3 trillion balance sheet. Notably, the yield curve continued to flatten. Over the last three months, the Treasury 2-to-10 year spread has contracted 40 basis points (bps) to 83 bps. The Fed’s three rate increases over the last six months and anticipated future rate hikes have lifted the short end of the yield curve. Declining inflation expectations and a weaker first half domestic economic environment have caused yields for longer maturities to decline. The 2-to-10 year spread that we monitor closely is a predictor of economic health. It would be disconcerting to see this indicator continue to decline, especially with implied 5-year inflation expectations at 1.50%. Indicators that have been reliable in the past may have less predictive value in the future due to the market distortion caused by global central banks.
June 16, 2017
Dominating the financial news this week was the Federal Reserve’s decision to raise its target on the Fed Funds rate by one quarter of a point to between 1 and 1.25 percent. The Fed also gave specifics regarding its plan to reduce the $4.3 trillion balance sheet. Notably, the yield curve continued to flatten. Over the last three months, the Treasury 2-to-10 year spread has contracted 40 basis points (bps) to 83 bps. The Fed’s three rate increases over the last six months and anticipated future rate hikes have lifted the short end of the yield curve. Declining inflation expectations and a weaker first half domestic economic environment have caused yields for longer maturities to decline. The 2-to-10 year spread that we monitor closely is a predictor of economic health. It would be disconcerting to see this indicator continue to decline, especially with implied 5-year inflation expectations at 1.50%. Indicators that have been reliable in the past may have less predictive value in the future due to the market distortion caused by global central banks.
June 9, 2017
The equity market has been a very pleasant surprise for most investors this year. Few market pundits expected the market to be as strong as it has been in the first half of 2017. There is clearly an element of disbeliefon the part of some investors. That is partially related to the divergence within the market. Investors with a value orientation have not experienced the same ebullient market as have investors that concentrate on growth opportunities. Through May, the Russell 1000 Value index is up only 1.9% versus the Russell 1000 Growth index which has rallied 13.6%. That is a striking divergence. The difference is largely related to the strength of five large technology stocks (Facebook, Apple, Amazon, Microsoft and Alphabet). Collectively, these five stocks haveaccounted for an astounding one-third of the gain for the S&P 500 (YTD). Return clustering in a handful of names has occurred four other times in the last 20 years. We would be more comfortable to see a broader-based market advance.
June 2, 2017
The release of the Non-Farm Payroll report was rather disappointing relative to expectations, with only 138,000 jobs created in the month of May. This number was significantly below ADP’s 253,000 projection and a consensus estimate of 185,000. In addition, the results for the prior two months were cut by a total of 66,000 jobs. The unemployment rate fell from 4.40% to 4.29% but the participation rate also declined to 62.7%. Average hourly earnings grew by .2% which met expectations but a revision to April’s data kept the year over rate of increase at 2.5% below the expected 2.6%. Upon the Bureau of Labor Statistics release, the dollar sold off and Treasury yields rallied with further curve flattening. Overall, we feel May’s employment numbers were strong enough to keep the Fed’s anticipated June rate hike on track but additional sub-par economic results could cloud the picture for the rest of this year. Several Fed officials commented this week that the Fed tightening cycle will accelerate. We will be closely listening to the commentary after the next Fed meeting to see if there is any moderation in their rate views, after the weaker job report.
May 26, 2017
It was interesting timing that the Organization of the Petroleum Exporting Countries met in Vienna to discuss extending production cuts immediately after President Trump’s successful visit to Saudi Arabia given his outspoken desire to drive U.S. energy independence. OPEC’s efforts to moderate production, assuming members have the discipline to adhere to the cuts, have the potential to do little more than modestly impact the oil inventory cycle. OPEC’s real problems are secular.
May 19, 2017
Volatility picked up dramatically this week as the financial markets reacted to the turmoil in Washington. Allegedly, President Trump asked FBI Director James Comey to drop a probe of his former national security advisor. That revelation ultimately prompted the Justice Department to appoint a special prosecutor to review the matter. President Trump is losing control of the political agenda as he becomes mired in political infighting with both Democrats and establishment Republicans. Given the dysfunction in Washington and the poisonous atmosphere, it appears that tax reform and fiscal stimulus could be sidelined for the time being. The financial markets have been expecting, and perhaps to some extent pricing in, a lift to earnings from tax reform. Tax reform, if done correctly, has the promise of changing the trajectory of economic growth by driving incremental capital formation and indirectly fostering innovation.
May 12, 2017
Markets have been able to shrug off news and events that in the recent past would have rattled market participants. The dysfunction and contention in Washington had minimal negative impact on the equity markets. More significantly, it was not too long ago, investors worried that Federal policy would be too constrictive and would damage the economic recovery. This week, Kansas City President Esther George said not only should the Fed continue to raise rates gradually, but it should begin to shrink the balance sheet later this year. Both fixed income and equity markets largely ignored her comments. It seems that investors are increasingly tuning out the Fed, even as the Fed is actively withdrawing accommodation from the financial system. The market’s complacency is clearly related to the very strong first quarter earnings. With over 90% of companies in the S&P 500 having reported first quarter earnings, year-over-year earnings are up over 15%, and 74% of companies exceeded earnings expectations. The insensitivity of financial markets to central bank policy is somewhat disconcerting.
May 5, 2017
The domestic equity markets have been trading in a relatively flat and tight trading range since the third week of February. The listless trading pattern has evolved as the expectation of an economic regime shift, due to new political leadership, has confronted the difficulty of enacting real change. This week the House Financial Services Committee voted along party lines to submit the Financial Choice Act to the full House. The bill would rollback significant elements of the Dodd-Frank law. The banking and financial services industries strongly support lifting some of the burdensome restrictions of the Dodd-Frank law. The Financial Choice Act should easily pass out of the House, but Senate approval seems problematic. This is one example of the plodding efforts under way in Washington. Many asset classes have embedded in their valuations the expectations of significant reduction in regulation and tax reform. Given the political climate, the timing and magnitude of implementation remain highly uncertain. In the meantime, we sense some market complacency creeping into investor psychology regarding international economies, especially in regard to China. If financial market volatility picks up in China as Chinese officials begin to address high debt levels and risks to their banking system, investor attention could quickly shift away from Washington.
April 28, 2017
It is not unusual for a barrage of headline news to grab the attention of equity investors. In the past few months, concerns about future Fed rate hikes, geopolitical tensions in Syria/North Korea, French elections and the Trump agenda have had an impact on investor sentiment. This is a legitimate reaction as any one of these events could have significant economic implications. What seems to have been under-reported, however, are more fundamental factors that dictate the valuation of individual companies and the market as a whole. Currently, about 287 companies have reported their 1st Quarter results. Earnings for the group are up 15.6% with revenues advancing by 7.9% over the same period last year. Approximately 80% of the reports have beaten analyst expectations and 65% have exceeded top-line expectations. Factoring in the estimates for the companies yet to report, S&P 500 earnings growth for the quarter could be 9.7% with revenues 5.9% higher than last year. Importantly, these results are broad based with multiple sectors contributing to the uptrend. Also, this is not a one quarter phenomenon as the trajectory began in last year’s 3rd Quarter and could continue over the balance of 2017. Obviously, it is necessary to incorporate both internal and external factors in any investment evaluation.
April 21, 2017
First quarter GDP expectations continue to drift lower as economic releases indicate the U.S. economy softened at the beginning of the year. The Atlanta Fed has an econometric model they update as economic statistics are released. That model suggests the economy grew a negligible 0.45% in the first quarter. There are also a number of indexes we track that examine economic surprises and have some predictive value for future economic releases. These surprise indexes point toward continuing weakness into the current quarter. Despite the tepid beginning to 2017, the Fed appears to be committed to at least two more rate hikes this year. Fed officials speaking at public events have been consistent and firm in their intention to raise rates. It would be difficult for them to reverse course without eroding credibility. Investors remain skeptical as “Fed funds” futures suggest that there is only one more increase likely in 2017. The Fed has a history of not delivering on rate hikes due to economic weakness and financial market instability. We expect them to deliver on at least another hike given the recent resilience of the financial markets and better economic strength in Europe. In the meantime, the markets will be focused on the French election this weekend that could spark some near-term volatility.
April 14, 2017
Tax season comes mercifully to an end on Monday. Through last week, tax receipts are running ahead by 5.5% as compared to last year. The growth rate of tax receipts in 2016 was 3.0%. Tax receipts are tightly correlated with the growth rate of nominal income and that has been growing at a 4% annualized rate since the last recession. Nominal income is largely driven by employment, wages and hours worked. Strong tax receipts are indicative of a healthy employment situation. Despite the generally positive jobs environment, we have noted an increase in the number of consumer defaults. Subprime auto loan defaults have risen dramatically and there is some evidence that default rates are edging higher in other consumer loans. During the middle-to-late portion of the business cycle the relationship between consumer spending and delinquencies is tenuous. Our concern would be heightened with the emergence of credit tightening. Currently, available credit is not an issue, but it bears watching since consumer spending is such a large component of the economy.
April 7, 2017
Despite a bevy of interesting and meaningful news items this week, financial markets were generally quiet. Equities drifted slightly lower with some volatility around the release of the minutes from the Federal Reserve’s March meeting. Insight into the current thinking of Fed officials was arguably the most significant news event. FOMC minutes indicated that a number of Fed officials believe the process of normalizing the Fed’s $4.5 trillion balance sheet should begin later this year. After the financial crisis the Fed aggressively purchased MBS and Treasuries to provide support for the recovery, causing their balance sheet to dramatically expand. Whenever they do begin unwinding the unusual stimulus, the Fed will likely take up to five years to reduce the balance sheet down to a level they feel is optimal. An elongated approach will minimize the impact on the long end of the yield curve. As global growth trends slightly higher, the Fed should have room to continue to gradually increase rates at the short end of the curve. Given the overall tepid economic growth and the approach we anticipate the Fed will pursue, we expect the yield curve to moderately flatten as the year progresses.
March 31, 2017
Although returns were unevenly distributed, global equity markets generally had a robust first quarter. The fixed income markets offered modestly positive returns as well. Looking ahead to the second quarter, clearly political uncertainty has risen in both Europe and the United States since the beginning of the year. The political environment in Europe is clouded due to concern over election outcomes and the long, slow breakup of the European Union and the United Kingdom. Despite these concerns, latest investment flows out of domestic equities into European equities has been quite strong. The macro economic news has been steadily improving in Europe and the general perception is that European equities are undervalued compared to U.S. equities. European equities outperformed U.S. equity markets by slightly less than 300 basis points in March. With a more hawkish Federal Reserve and an uncertain hand-off from monetary and fiscal policies domestically, we would expect more capital flows into European equities assuming the French election resolves itself favorably.
March 24, 2017
The financial markets have been keenly focused on the progress of the Obamacare replacement bill constructed by Speaker Paul Ryan, and championed by President Trump, that has struggled to find enough support to pass a predominantly Republican House. The difficulty that the Republicans have had on repealing and replacing Obamacare has made many observers question their ability to accomplish tax reform in a reasonable timeframe. While this has the potential to have meaningful short-term market implications, we are also watching China’s reaction to last week’s Fed rate hike. Rate increases by the Federal Reserve put pressure on China to also increase rates to support the yuan. The yuan has been eroding against the dollar since the middle of 2014. The Chinese have spent roughly 1 trillion dollars in foreign reserves in an attempt to support the yuan. Additionally, as China cuts back on infrastructure spending in an effort to transition toward a more consumer-led economy, it is counting on the private sector to ameliorate the economic slowdown. Rising rates would be an impediment to private sector growth. Although the Chinese have raised some secondary rates after the Fed hike, they have left the benchmark 1-year lending rate unchanged. We think China’s reaction to rising short rates in the U.S. has very important implications for financial markets.
March 17, 2017
Monetary policy was in the headlines this week with the FOMC announcing a 25 basis point (bp) rate increase in the Fed funds rate on Wednesday afternoon. Markets had accurately priced in the 25 bp increase, but were surprised by the lack of a hawkish tone. The FOMC reiterated their guidance of two more 25 bp rate hikes in 2017 even though headline inflation has moved close to the Fed’s target. The Fed pays considerable attention to core Personal Consumption Expenditures (PCE) and according to their numbers, core PCE was little changed since they last met and is still running slightly below their two percent target. The FOMC predicts that GDP will grow by 2.1% in 2017 and if global economic conditions continue to strengthen, volatility remains low and core inflation does not increase much, we believe the Fed funds rate should end the year up an additional 50 bps.
The rise in populism took a pause with the Dutch voters not showing much support for Geert Wilders and the Freedom Party. With the Netherlands being one of the EU’s six founding members, the election showed the EU still has unity at its core. That unity will be tested in April and May when France goes to the polls and again in September with the German elections. However, we feel that the French and German voters will follow the Netherland’s lead and populism should remain contained in both countries.
March 10, 2017
Market participants are looking for the Fed to hike the Fed Funds rate at their March 15th meeting. According to the Reuters poll of more than 100 economists, the economic data is strong enough to support this rate hike. The Bloomberg implied probability of a rate hike next week is now at 100% after a number of hawkish comments last week. If the Fed is able to orchestrate three rate hikes this year at 25 basis points each, the Fed Funds target rate would be 1.25%-1.50% by year-end. The commentary from the meeting and the update to the Fed’s economic forecast will be closely watched and compared to what was released at December’s meeting. Mario Draghi announced on Thursday that the European Central Bank is maintaining its benchmark rate and will continue with the monthly asset purchase program at a reduced level. The tone was more positive on the Eurozone economy and gave a lift to the European banking sector. The rise in U. S. interest rates and change in policy is a break from the coordinated global stimulus since the 2008 financial crisis. The Fed will be closely watching and balancing interest rate normalization with economic growth and financial stability. We expect that there will be increasing volatility in both the fixed income and equity markets as the Fed embarks on this new course.
March 3, 2017
Once again, the market’s focus has been drawn back to watching the Federal Reserve. Since the election the equity markets have rallied on expectations of fiscal stimulus, and the underlying fundamentals for both the economy and earnings have modestly improved. Market participants, despite the Fed rate increase in December, have been heavily focused on the Trump Administration and less on the Fed. This week, Multiple Federal Reserve officials have signaled in speeches that the Fed will be raising rates at their March meeting. A March increase opens the door to perhaps as many as three increases in 2017. Is the Fed feeling pressure to raise rates? Using CPI as the inflation gauge, the real yield on the 10-year Treasury bond is currently barely positive. The effective Fed funds rate is 0.63% and with inflation north of 2.0%, real rates are negative at the short end of the curve and have been for a long time. These low rates have driven equity valuations, as future equity cash flows are being discounted back at very low discount rates. Given today’s low rate structure, the next few rate increases will not materially impact valuations. At some point, it will matter to the markets and they will be very focused on the Fed.
February 24, 2017
We are all aware that the U.S. Equity markets have been on fire with the S&P 500 increasing by 5.25% year to date. Less apparent is the fact that the 10-Year Treasury has also advanced in value with its yield declining from 2.45% to 2.31% over the same period. This is somewhat unusual as these two asset classes tend to be negatively correlated. We think the current relationship may be routed in a difference in the timing of current market expectations. Since last November’s presidential election, stock investors have been focused on the prospects of a dramatic increase in GDP and corporate earnings growth resulting from fiscal spending policies, tax reform and the relaxation of various business regulations. The bond market is not totally discounting these potential growth catalysts as rates overall have risen since Trump was elected President, although signaling it may take longer than expected to become reality. This week, Treasury Secretary Mnuchin acknowledged that his goal for significant tax reform by August was ambitious. Furthermore, Arios Media cited Republican sources saying infrastructure could fall into 2018 because of prioritization of healthcare changes, immigration policies and regulatory reform.
February 17, 2017
Corporate share buybacks have been an important component to equity market performance over the last five years. Since 2011, companies in the S&P 500 have repurchased more than $2.7 trillion of their own stock. During that same time period, both individual and institutional investors have been net sellers. The share repurchase programs, in many cases, have used borrowed money for the repurchases. The end result is a modestly higher per share earnings at the cost of a risky capital structure. Operational performance, as measured by aggregate operating earnings, has not been good over the last five years; operating earnings on an annualized basis are only marginally higher. At current equity valuations, it is harder for corporate boards to justify continuing to purchase stock. Back in 2011, the S&P 500 was trading around 1100 and was trading at a price-to-earnings multiple of roughly 13x trailing earnings. Today, the S&P 500 is trading at 2,340 with a trailing P/E of 23.9. Over the next few weeks, we expect to hear some details emerging regarding tax reform. We would hope to see an investment tax credit to incentivize companies to invest capital in their businesses rather than using excess cash flow to repurchase shares. In the long run, by making investments that enhance their productivity, companies will be strengthening their growth potential – which is a far more productive use of capital.
February 10, 2017
The current financial market environment is fraught with uncertainty and seems to be overly responsive to marginal news. Many asset classes have been oscillating due to poor visibility for their potential outcomes. Emerging markets clearly have been subject to this volatility. The EM asset class sold off post election largely as interest rates adjusted higher on expectations of U.S. fiscal stimulus. As rates have stabilized, emerging markets have reversed and are approaching pre-election levels. Emerging market equities rose 11.2% last year, but remain inexpensive after a multi-year bear market. With confidence for improved global growth, especially with respect to the United States, it seems logical that emerging market equities should tangentially benefit. We believe investors should opportunistically add to emerging market equities on weakness. Exogenous risks, such as rising protectionism and Chinese structural changes, remain a concern that could cause corrections in this asset class. Overall, we see value in emerging market equities, and adding exposure will allow portfolios to become more diversified.
February 3, 2017
Equity markets in developed countries have moved sideways since the second week in December. Despite a noisy and contentious start of the Trump presidency, implied volatility of equity indexes fell to very low levels. Does this calm indifference by the financial markets indicate too much complacency on the part of investors? We think muted market action perhaps reflects current valuations and a dearth of concrete proposals that will have a meaningful impact on the macro environment. The caustic relationship developing between President Trump and the Democrats in Congress could potentially damage or delay the chances of a major fiscal stimulus program. With the domestic economy already exhibiting some acceleration off a tepid level of growth, a delay in fiscal stimulus could negatively impact business confidence. An element in Mr. Trump’s control however is regulation. On Friday, at a White House meeting with corporate leaders, Mr. Trump promised major reductions in financial regulations. The Dodd-Frank and the creation of the Consumer Financial Protection Bureau have been often cited by opponents as government overreach. Lowering financial regulation should allow capital to flow more freely and increase economic activity.
January 27, 2017
The U.S. Bureau of Economic Analysis released GDP statistics for the fourth quarter of 2016 on Friday. GDP growth was modestly below expectations growing at an annualized rate of 1.9 percent despite solid consumer and investment spending. The disappointment stemmed from a 4.3 percent annualized decline in exports that reversed a 10 percent increase in the third quarter. Net exports is a relatively small contributor to the overall domestic economy, but the GDP release does highlight the importance of the trade environment. Obviously, the global trade system is complex with many influences. Generally, goods should be produced to provide the product at the lowest possible cost. It raises everyone’s standard of living. The Trump administration’s desire to forge mutually beneficial bilateral trade agreements would be very helpful in constructing a healthy trade environment. Punitive border-adjusted tax levies have the potential to be incendiary and could lead to retaliatory trade action. The result of a trade war would be higher-priced products for everyone and a lower standard of living. The real driver of secular growth would be a more competitive corporate (and personal) tax structure. It will be a much more demanding lift given the various fractions in Washington and the current animosity. We would prefer the new administration to focus their efforts on tax reform.
January 20, 2017
As the new Trump Administration grabs hold of the levers of power in Washington, financial markets wait for clarity regarding economic and regulatory policy to emerge. For over a month many financial pundits, us included, have tried to assess the potential global impact of the various proposals that have been suggested. We would expect the process of sweeping overhauls to the U.S. tax code and broad and invasive laws, such as the Affordable Care Act, to be messy. Given the toxic and contentious tone in Washington, we expect it will take awhile for Congress and the Administration to converge on workable legislation. Investors should expect heightened headline risk and potentially greater volatility in the months ahead. Trade policy is an area where we could see relatively quick action. New trade agreements require congressional approval, but modifying or undoing existing commitments does not. We still have few details on Mr. Trump’s intentions regarding specific trade policy, but would expect him to renegotiate components of NAFTA (rules of origin) and undo the Trans-Pacific Partnership almost immediately.
January 13, 2017
Aspects of the Trump rally seem to be unravelling to some degree. The dollar has been very strong since the election. The U.S. Dollar Index (DYX) rallied from 97 in early November to over 103 in early January, but weakened to around 101 this week. Dollar selling was more pronounced after Presidential-elect Donald Trump’s press conference on Tuesday. To a large measure, the financial market’s post-election reaction has been predicated on the expectation of tax reform and infrastructure spending. Mr. Trump’s first press conference since being elected president focused on Russia and “fake news”, as opposed to the anticipated economic and tax policy changes. Another sign of reversal has been in the Treasury market. After a selloff that took the 10-year Treasury to a 2.65% yield, Treasuries reversed and the 10-year settled at 2.40% as the week closed. The equity market sectors and industries that have been strong post election have begun to see some consolidation (such as banks). It would not be surprising to see a broader price adjustment as the new administration takes office and confronts the hard work ahead. Often expectations get ahead of reality and financial markets are susceptible to this human behavior.
January 6, 2017
Expect Tax Reform in 2017
Tax reform has been a frequent topic of discussion in Washington over the last decade. Many members of Congress, both Republicans and Democrats, recognize that the U.S. current corporate tax code places domestic corporations at a competitive disadvantage globally. The combined U.S. federal and state corporate tax rate is over 39% versus roughly a 25% average for other developed nations. Both the Bush (Economic Growth and Tax Relief Reconciliation Act of 2001) and Clinton (Taxpayer Relief Act of 1997) tax cuts were proposed, went through Congressional committee, and were signed into law by summer. Both of these laws were also passed by the controversial budget reconciliation that requires only a 50% majority approval. Given the Republican control of both the Senate and the House, we expect to see a sweeping tax law approved by August. We expect a meaningful reduction in the corporate tax rate (very good for earnings) and perhaps a provision allowing for the immediate expensing of capital equipment (very beneficial for technology companies). The Trump Administration may attempt to affect trade policy through the tax code by creating different levels of deductibility depending on the location of production inputs. This would be very contentious and would delay the process.