August 2017 – Monthly Commentary

August 2017
On August 2 the Treasury Borrowing Advisory Committee (TBAC) released, via the U.S. Treasury Department website, its roadmap for reducing the Federal Reserve’s balance sheet. The TBAC is a liaison of senior members of money center banks and investment firms and the Treasury Department. The goal of the group is to keep the Treasury informed as to the thinking of the largest buyers of U.S. Government debt. Typically, the group focuses on supply and demand trends and the appetite for Treasury bills, notes, and bonds, and other matters concerning government debt. But the most recent report was much more surprising in that it laid out a plan for how the Federal Reserve is expected to unwind the roughly $4.5 trillion in Treasury bonds and Mortgage-backed securities the Fed has bought over the years.

The first expectation that surprised us was that the TBAC would view a reduction of Treasury holdings to $1.7 trillion from the current $2.5 trillion as a return to normalization. We had anticipated a balance sheet of well below $1 trillion.
The second surprise was that as the mortgage-backed securities mature, the proceeds would be reinvested into Treasury Bills. In doing so, the Fed would reduce their MBS holdings at a faster pace than they’d be reducing their Treasury holdings. Nevertheless, to invest maturity proceeds in Bills is continued quantitative easing, and arguably irresponsible monetary policy. The group did not offer insight as to how long they expected the bill reinvestment to continue.

The third surprise was that the group anticipates that once the Fed reaches its normalized balance sheet, the Central Bank will reinvest maturing Treasuries on a pro-rata basis across the yield curve in the amount of $100 to $200 billion per year. As with the reinvestment of MBS into Treasury bills, this is not normalization but continued quantitative easing.

The fourth eyebrow raising item, not so much of a surprise as a revelation, was the expectation for budget deficits in the near term. The TBAC expects that the U.S. Government budget deficit will again rise above $1 trillion by 2020. That’s nearly double the official administration forecast and represents a sizeable amount of additional bonds that will need to be absorbed by the market. Of course, if the government plans to continue to print dollars to buy a portion of that debt, the burden is eased somewhat.

After reading the 42 page report which offers a degree of granularity that has not been detailed by the Federal Reserve, the obvious question is what impact will the expectations have on the market if they come to pass? The TBAC delineated those risks in three tidy parts. Part one is where we currently find ourselves; declining bond risk premium, with a corresponding decline in credit spreads, reflective of investors reach for yield in a low interest rate environment. Part two forecasts a partial reversal of part one, and envisions that a small increase in yield could result in an accelerating rise of risk premium. Part three is described as simply “Let markets clear.” The group anticipates that under this scenario a meaningful decline in risk assets would occur but that it wouldn’t pose a systemic problem. We assume that by systemic risk the group is referring to banks and given the build-up in Tier 1 capital and on-going stress testing, they would probably be right. But given the trillions of dollars that have been plowed into every sector of the bond market and the lofty valuations in the stock market, investors would likely take a massive hit. Those investors, many of whom are rapidly approaching retirement, would instantly pull back spending, and with that, pose a high likelihood of tipping the economy into recession. Of course the Fed could save us from a deep recession by cutting interest rates sharply as they have done in past recessions. The only problem is that they can’t follow their traditional playbook because there is only one percentage point between the current rate and zero. Alternatively, they could again crank up quantitative easing, except that they’re still engaged in quantitative easing and to accelerate the program would be to expand their already growing balance sheet at an even faster rate. The Fed has backed monetary policy into a corner and the Wall Street elite, as represented on the TBAC, have illustrated that in their most recent report. Only they don’t want to offend the Fed and suggest that when they let markets clear that it won’t be systemic. It may not be systemic, but you can bet your bottom dollar that it will be painful.

July 2017 – Monthly Commentary

July 2017

The equity market remained a bastion of tranquility in July as the S&P 500 rallied 1.9% and the volatility index (VIX) touched an all-time low of 8.84 late in the month. A telling example of the complacency was on display in a Bloomberg TV interview. The analyst being interviewed was asked how she could offer a buy recommendation on a stock with such a lofty Price/Earnings ratio. The analyst responded that yes, the stock price is expensive from a P/E perspective, but not as expensive as other stocks in the industry. We worry that when analyst’s start justifying buy recommendations on expensive stocks based on relative value, the market is at risk.

Similarly, bonds posted a benign month, with 2-year interest rates a few basis points higher and ten-year notes a few basis points lower. All eyes were on the Federal Reserve mid-month in anticipation that Chair Yellen would further flesh out the start date of balance sheet reduction. But rather than offer details, she stressed that the Fed would move slowly in normalizing policy. Despite that, we expect that the start date is likely to be detailed at the September meeting and will commence in October.
In the foreign exchange market, the action was anything but benign. The Euro staged an impressive rally, rising 3.36% in price, finishing the month at 1.1811. Recall that at the start of this year the cost to buy one Euro stood at $1.04 and the vast consensus was that the cost would ultimately fall below $1.00. The logic had been that with negative interest rates in Europe, investors and savers would sell the Euro and buy U.S. Dollars to earn the interest rate differential. As we’ve written previously, that logic is flawed due to cross-currency interest rate arbitrage. Nonetheless, there seemed to be more than enough of those Europeans in search of yield to push the value of the Euro down to near parity. In hindsight, that had become a very crowded trade and with European economic prospects brightening, the Euro shorts needed to cover. As we mentioned in last month’s update, ECB Chief Mario Draghi briefly floated the idea of trimming the emergency quantitative easing in which the central bank has been engaging.

At the time of this writing, we are about half way through Q2 corporate earnings, and they have been broadly positive, which has further served to support stock prices higher. The problem is that stock prices have reached nosebleed levels as measured by the Price/Earnings ratio. The current 2017 estimated P/E for the S&P 500 stands at approximately 19 times earnings. While elevated by historical standards, the divergence of the 500 stocks in the index brings to mind the adage that one can drown in a lake that on average is only two feet deep. That is to say that the average P/E masks the wide valuation divergence among stocks in the index. For example Intel, Ford, and General Motors, to name a few, trade well below that average, while so-called large cap value stocks like Procter and Gamble, Colgate, MMM, and John Deere all trade well above it. We sarcastically refer to the large caps as value stocks because at current prices we see no value at all. Each of the four stocks has suffered a decline in revenue over the last four years. A quick and dirty measure of value is the Profit/Earinngs ratio divided by the Growth rate (PEG) ratio. As a rule of thumb, a PEG ratio of one offers fair valuation for slow growing corporations and the ratio rises for faster growing companies. Logically investors are more willing to pay a higher price for a faster growth. Why, then, do we have slow growth companies trading at a PEG ratio of four. We believe that the answer is index fund buying. Since those companies represent large weightings in the S&P 500, they represent a bigger share of the index and hence a bigger resultant purchase when an investor buy an S&P index fund. When demand for index funds explodes as it has in recent years, demand for those shares correspondingly explodes. In essence, the index fund managers become price insensitive buyers. In that sense, who cares how expense the underlying stocks are; they need to be purchased. Price insensitive buying rarely ends well!