June 2018 – Monthly Commentary

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June 2018

In the days and weeks leading up to the recent imposition of tariffs on China, nervous investors sold stocks and pushed bond yields lower.  However since the tariffs went into place stock prices have risen, with the S&P 500 just ticks away from its recent high and less than 3% away from an all-time high.  Apparently, investors have chosen to look past the immediate trade rhetoric and are focusing on the coming earning season, expecting it to be another terrific one.  In addition to the initial $50 billion in tariffs, President Trump is threatening to impose sanctions on another $200 Billion of Chinese goods later this summer.  In considering how to best position our client portfolio’s for the fallout from a potential trade battle, we consider the best and worst case scenarios as detailed below.

Obviously, the worst case is that the tariffs turn into a long-term trade war between the U.S. and China, resulting in a pronounced uptick in the price of goods sold in the United States.  Pushing inflation higher has been the mandate of the Federal Reserve since the financial crisis ten years ago.  However, with inflation now above their targeted 2%, a rise meaningfully above that level is unlikely to be a welcome outcome.  Arguably, the Fed has enjoyed engineering inflation higher, but it is unlikely they would equally enjoy the uncontrollable effects of tariff-inflated prices.  Some estimate that the uptick in inflation would amount to no more than one or two percent.  It is nearly impossible to offer a definitive estimate but what is certain is that a rise of that magnitude would not be welcome by equity investors.  In that instance, we expect there would be a meaningful pullback in stock prices.  However, we also view the possibility of a meaningful drop in bonds yields as somewhat limited because the inflationary uptick would not likely influence the Fed predisposition to raise interest rates.  In fact, it could have the opposite effect and embolden them to raise their target neutral rate.

At the other end of the spectrum, the possibility exists that the trade gambit is actually a net positive for the U.S.  We can envision a possibility in which the trade battle is short lived and China opens up their markets to greater competition and improved intellectual property rights.  Under this scenario, American corporations would have the opportunity to participate in the rapid growth China has experienced and is likely to continue to experience as it moves from an emerging market into a developed one.  In this instance, the Federal Reserve would likely continue with their plan for measured rate hikes and ongoing monitoring of the domestic economy.

What is certain, the U.S. economy continues to grow at a rapid pace as witnessed by the June employment report.  For the month, the economy added 202,000 new jobs.  That puts the average monthly gain over the last year at just a shade under 200,000.  That’s remarkable for this stage of the economic cycle.  Even more encouraging, 499,000 people reentered the workforce.  Because of those additional workers, the unemployment rate actually ticked back above 4.0% from the prior months 3.8%.  While we prefer to see unemployment tick lower, in this instance, we interpret the move as unambiguously positive.  This late in the economic cycle the unemployment rate typical ticks up because people are losing their jobs, not because they are being hired.

May 2018 – Monthly Commentary

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May 2018

The bastion of calm that swept over capital markets evaporated in May, as a number of emerging market economies and their markets suffered under the strain of bad policy.  After years in financial purgatory following their 2001 default, Argentina is again facing financial strain.  The serial defaulter returned to the global bond market two years ago with a $16 billion multi-tranche deal that received $70 billion in orders.  Investor demand had grown so strong that last year the Republic issued $2.75 billion 100-year bonds in another wildly oversubscribed new issue.  With interest rates at artificially low rates in the United States and a voracious appetite for risk, investors ignored the history of the borrower.  The euphoria wasn’t limited to the bond market.  The Argentine stock market has been on an upward trajectory similar to that of developed market stocks.  Foreign money flooded into the country in anticipation that the party would continue indefinitely.  Of course, it rarely does when imprudent policy rules the day, as has been the case in Argentina.  The Republic has followed a policy of borrow and spend (not dramatically different from the U.S. policy) for years and with their reentry into the capital markets, the profligacy has accelerated.  That was until it dawned on investors that Argentina is again over her skis.  With inflation solidly in double digits and the debt piling up, investors are on the verge of panic and have begun to sell equities, the Peso, as well as local and dollar-denominated bonds.  The repatriation of assets has caused a rout in the peso.  As the value of the peso falls, the servicing cost of the debt rises, which effectively increases their dollar denominated debt exposure.  In an effort to combat the currency weakness the government raised overnight interest rates to 40% and bought Pesos in the open market.  The action seems to be stabilizing the situation for the time being, with each greenback fetching 25 pesos, a 20% plunge in the last month.

Turkey and Brazil are facing similar situations as deficit spending, rising debt and double digit inflation panicked investors and, similar to Argentina, the value of those currencies have fallen by more than 20% versus the U.S. dollars.  The irony is that the panic in emerging markets can be directly tied back to the ultra-loose monetary policy of the U.S., European and Japanese Central Banks.  In their thirst for yield, investors in the developed markets were willing to invest in risky emerging markets to capture a higher return.  When they realized they weren’t being compensated for that risk, they sold and threw the EM economies into disarray.  The problem the emerging markets face is that in order to keep their currencies from plunging, they need to intervene and buy their currency and hope that their buying is enough to push the value of it back up.  So far, intervention alone has not been enough and all three have been forced to raise short term interest rates in an effort to squeeze short sellers.  The problem with implementing an onerous interest rate is that it risks running the local economy into a recession.

At the time of this writing, the International Monetary Fund has announced an agreement to lend Argentina $50 Billion in an effort to stabile their currency.  The reaction by the market was to send the Peso to a new low.  Despite the emerging market woes, contagion to the developed market seems unlikely, given the momentum of the domestic economies.

April 2018 – Monthly Commentary

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April 2018

Now that we’re well into the new year and the first quarter earnings season is almost fully behind us, it makes sense to pause and try to understand where we are in the economic cycle and what we should expect in the near term future.

The most notable recent change is the stock market.  Compared to February, volatility has diminished markedly.  However, the “buy the dip” mentality that drove stock indices to ever higher levels since 2009 seems to have vanished.  Indeed, since reaching an all-time high in January, the S&P has basically moved sideways, with a few scary price drops followed by “melt up” rallies.  Going into earnings season, we had expected that stock prices would be at or above the previous high by now if earnings came in anywhere near our expectations.  In fact, earnings came in much better.  Through May 5, year-over-year sales are up 9.5% and of those that have reported, 77% have beaten expectations while only 17% have disappointed.  Operating margin during the quarter expanded to 11.56% from 9.84% prompting Standard and Poor’s to boost their 2018 earnings forecast to $157.65, a 26% rise over the $124 earned last year.  S&P forecasts that earnings will rise another 10% to $173 in 2019.  By all measures, this earnings season has been stellar.  What’s perplexing though is that a number of analyst’s have discussed the concept of peak earnings; the idea that this is as good as it gets.  The concept came about on the Caterpillar Corporation’s quarterly conference call.  Several days after the call the CEO clarified the comment to imply that he meant the company had a stellar quarter not that it is likely to be the best quarter of this year or this cycle.  Nonetheless, the media focused on the concept for the better part of a week.

At the other end of the spectrum is the bond market.  The Federal Reserve has raised the Fed Fund interest rate 5 times and has indicated that they’ll probably hike three more times this year.  What’s not received much focus is that the bond market is starting to feel like it’s entering a bear market.  The Barclays Aggregate index has been down 6 of the last 11 months and year-to-date is down -2.19%, while the 10-year Treasury Note briefly traded above 3% recently.  Making the case for higher interest rates, headline inflation registered 2.5% year-over-year in April.  With inflation now trading above the Fed’s stated target, the FOMC has changed the tone of it language, indicating that they’ll tolerate inflation that runs at 2% plus or minus some unspecified amount.  That should be an unmitigated bearish signal to the bond market that inflation is at risk of moving materially higher.  Despite the rising specter of inflation, the interest rate differential between the 2-year notes and the 30-year bond, known as the yield curve, has fallen below 0.60% for the first time since the financial crisis.  As discussed in previous updates we don’t consider the flattening of the yield curve as a leading indicator of a recession.  Instead, we believe it’s just another side effect of the flawed monetary policy.

With regard to employment, the jobs market simply could not be better.  The number of unfilled jobs has risen to an all-time high of 6.5 million positions while the unemployment rate stands at 3.9%, just 0.1% above the all-time low.  Goldman Sachs has forecast that they expect that given current dynamics in the economy, the unemployment rate will fall to 3.25% by the end of 2019.  To put that into perspective, unemployment reached a low of 4.4% during the pre-crisis housing boom.  If Goldman’s forecast comes to pass average hourly earnings and inflation are likely to continue to climb.  With that, we expect inflation will continue to climb, providing a tailwind for the Fed’s interest rate normalization.