February 2018

Six weeks ago, as we closed out January, the S&P 500 Index settled just below its all time high. Financial pundits
at the time were saying that a healthy correction would be good for the market. The term healthy correction
has always seemed an oxymoron. How can a decrease in the value of one’s investment portfolio be
described as healthy? Yet, the term has been in the lexicon of Wall Street for as long as traders have been
able to short stocks. The state of the market since the first of February is a telling example of the lunacy of a
healthy pullback. Stocks plunged more than 10% in the first two weeks of February and despite having
bounced off of the low, nervousness still abounds as witnessed by the sharp intraday spikes higher and lower.
Anecdotal evidence suggests that ETF’s were at least partly to blame for the panic. We’ve written on
numerous occasions of retail investors bemoaning that stock valuations were too high and rather than buying
expensive stocks, have invested in an ETF instead. To be clear, the SPDR S&P 500 ETF invests in every stock in the
S&P 500, even the overvalued ones. To maintain the correct proportions, the ETF manager must buy in the
open market. When demand rises for an ETF, the buying pressure lifts the entire market. Conversely, when
investors dump the ETF, the manager must dump all of the stocks and in the instances we saw in February, the
result is a precipitous drop in the overall market value. Compounding the selloff was an excessively large short
position in stock index volatility (VIX and VIX-like) products. These products have become a fad with active
traders and we believe that many of those trading them did not fully understand the ramification of the risk.
The VIX is a proxy for the expected annualized volatility of the S&P 500 and has traded mostly below 10% since
last summer. Investors had been collecting income by buying an inverse structured note that went higher in
price as implied volatility fell. Viewed as a “no brainer” money maker, retail investors piled in. The problem was
that when stock prices fell, implied volatility rose, inflicting losses on the VIX sellers. The market makers of the
products were forced to buy offsetting positions in the open market which pushed the value of implied volatility
higher and had the collateral effect of further spooking ETF holders. In short order a vicious circle developed
which drove the price of the broad market 10% lower in the course of a week. Happily, corporations stepped
in to buy back stock at a ravenous rate, staunching the selling and emboldening investors with the confidence
to do what they’ve been conditioned to do since 2009. Namely, buy the dip!

While not directly responsible for equity weakness, newly sworn-in Fed Chairman Powell made his first public
comments in testimony before Congress and his remarks were interpreted as being decidedly hawkish. Before
the testimony, consensus opinion was for three rate hikes this year, with some members of the FOMC arguing
that even that was too hawkish. Since the testimony, the market now reflects 100 basis points of tightening this
year including one later this month at the March 21st meeting. That has translated directly into higher interest
rates, with 3-month LIBOR crossing the magical two percent level. Also adding upward pressure to short
maturity interest rates is the sharply higher amount of new T-bill issuance coming to the market. As we’ve
discussed last month, the U.S. government is going to need to finance their continued excessive deficit
spending and that means more debt issuance.

Also catching the eye of investors was the rise in the yield of the 10-year note as it approaches 3%. This is the
third time since 2012 that the yield has approached 3% only to reverse direction. We’ll be watching that level
closely. Quite often in markets when a price, or in this case yield, breaks through a resistance level on its third
attempt, it usually follows through in meaningful way. If we get through 3%, we could very well see 3.5% before
too long.

December 2017

While the team at Halyard evaluates the economic and market backdrop on a daily basis, we like to commit those thoughts to paper periodically, and especially so as we kick off the new year. Our starting premise this year is that the United States economy closed out 2017 with unmitigated strength. From a sector by sector perspective, we’re delighted to find the strength was broad based and not concentrated in any one sector or industry.

While too early to tally the result of the just ended holiday selling season, it’s seems likely that retail sales set a record with internet sales clogging the delivery channels late in December. Holiday shopping seems to have been forever changed, as the madness of black Friday has decidedly been replaced by cyber Monday which really was more like cyber December. Many of the individuals with whom we spoke said they happily avoided visiting the mall altogether this year. Nonetheless, sales were strong and UPS, FedEx, Amazon, and Walmart took an outsized share of the spoils. The very high level of consumer confidence and the robust jobs market were directly responsible for the success of the season as consumers felt confident about their prospects for job retention and wage growth.

Consumer confidence also benefited the housing market as new home sales sold at a pace not seen since pre-crisis. Despite the uptick in sales, new home construction is still well below the peak rate registered in 2005, which should be supportive of further industry gains. Moreover, the builders have carefully managed inventory to avoid a repeat of the oversupply witnessed during the peak. Similarly, the inventory of existing home sales continues to dwindle as sales outpace offerings. With the relative tightness of inventory, home prices, as measured by the Case Shiller index, closed the year with a 6.3% annual rise in price. The phantom wealth gain of rising home prices is contributing to a virtuous circle of ebullient consumer confidence and their propensity to spend.

Manufacturing continued its renaissance as the sector continued to grow, adding 79,000 new employees in the fourth quarter and registered employment gains in every month of 2017 save one. That’s a pleasant change from the month after month job cuts witnessed in the 2000’s.

With the backdrop of full employment and strong consumer confidence we believe the economy will continue to expand at least at a moderate pace. Moreover, as the Trump tax cuts work their way through the economy, the potential exists that the moderate growth could expand into a consistently greater than 3% annualized GDP growth. That’s a scenario that we believe would alarm the Federal Open Market Committee and perhaps cause them to consider more aggressive tightening. For the foreseeable future, however, we expect they will continue on the path of slow and steady rate hikes with three or four hikes in the coming year. Similarly, we expect that their bond purchase tapering will continue at the stated pace. One nuance that could be changed is the mix of asset purchases related to the recent flattening of the yield curve. Much talk has focused on the yield curve flattening as portending a recession or at best resulting in a drag on the financial sector. In thinking about the flattening, it’s important to keep in mind that it’s a direct result of the Fed’s manipulation of interest rates in the open market. It’s also important to remember that the Fed has an open dialogue with the money center bankers and considers their concerns when developing monetary policy. Given those considerations, we would not be shocked if the Fed decided to buy less of the longer maturities and allow that rate to drift higher, thereby steepening the yield curve. The challenge they face, should they decide to follow that course of action would be the size of the reduction and to what level they would like to see the yield curve move.

As for our portfolio construction, we continue to be of the mind that interest rates are too low and long duration exposure should be avoided. Currently we’re keeping maturities under three years and focusing heavily on floating rate notes. With the expectation that the Fed will continue to tighten, floaters will perform well as their coupon adjusts higher with each rate hike, thereby anchoring their price at close to par. Finally, given the relative expensiveness of riskier assets, we are limiting our exposure to investment grade corporate and municipal issuers while avoiding European banks, emerging market debt, and high yield issuers.

October 2017

Last month marked the 30th anniversary of Black Monday, October 19, 1987, prompting us to take a look back at how the Dow Jones Industrial Average has evolved since that infamous day. Of the 30 stocks in the index at the time, Bethlehem Steel, Eastman Kodak, GM, Union Carbide, U.S. Steel, and Woolworths have all gone through bankruptcy. Some reorganized and reemerged, but most didn’t. Sears, which also was part of the index in 1987 is quite likely to be gone in the next six months. Digital Equipment Corporation (DEC) was not in the index, but as the leader in mainframe computer production, it was the premier technological company at the time. Unfortunately for DEC investors, the utilization of mainframes dwindled as minicomputers sales soared, and a significantly diminished DEC was bought by Compaq computer in 1998. At the time of the time of the DEC purchase, Compaq was a pillar of the tech industry, and together with Dell, Microsoft, Intel and a host of other tech companies were represented in virtually every growth portfolio. Four years later, Carly Fiorina, the one-time Presidential hopeful and then Chairwoman of Hewlett Packard engineered an $87 Billion “friendly” merger between HP and Compaq. The integration of the two companies did not go well and it wasn’t long before investors were punishing the stock which, in turn, led to the ousting of Ms. Fiorina.

One would think that such woeful performance would weigh heavily on investors as they evaluate the riskiness of the current stock market as it rallies to new highs on a nearly daily basis. Last month we wrote about Warren Buffet’s proclamation that the Dow index would probably hit 1,000,000 in the next 100 years. The “Oracle of Omaha” in his promotion of buy and hold investing, didn’t mentioned that the Dow Jones Index is not a buy and hold index and regularly drops underperforming companies. The theory of a buy and hold portfolio completely ignores what to do when a company starts to show financial strain or loss of competitive advantage. To hear Buffet tell it, investors would be best served by buying and never selling. However using the 1987 Dow Jones index as a proxy for a buy and hold portfolio, an investor in that index would have had 20% of their 1987 portfolio fall to zero. Of course that’s taking portfolio construction to an extreme and the investor would have been well served by simply rebalancing their portfolio to mirror the new index components. The point is, setting it and forgetting it, as Mr. Buffet suggested, is a perilous plan; and that goes for the bond market as well. With interest rates pegged at artificially low rates and credit spreads at the low end of their long term range, it’s easy to be lulled into a false sense of security. We see it in abundance across the various sectors, both domestically and internationally, high yield and investment grade, emerging market and sovereign debt. Driven by the incessant search for yield, appetite for return is forcing investors to take risks that aren’t commensurate with the measly returns offered. While it’s plausible that the low rate environment could last for the foreseeable future, we believe that investors will ultimately be punished for imprudent investing.

Turning to the economy, data reported during October painted a picture of unmitigated strength. The litmus test for economic health is the labor market and despite hurricanes Irma and Harvey-related hiccoughs, the economy continues to create jobs at a rapid pace. The unemployment rate fell to 4.1% as 261,000 new jobs were gained in October, and the prior month’s job figure was revised higher by 51,000. Equally encouraging was the 3.0% GDP growth rate registered in the third quarter. Economists had warned that the aforementioned hurricanes were likely to trim as much as one percent from that growth rate and were shocked to see the three “handle”. To summarize the state of the U. S. economy, the labor market is at full employment, manufacturing is booming as is the tech sector, inventories are lean, and home builders can’t build houses as fast as they’d like because of a shortage of workers. Historically, at this stage of the economic cycle, the Fed would have overnight interest rates at a level 75 to 125 basis points above inflation. That would translate to a short term rate somewhere between 3.00% to 3.50%, instead of the 1.25% level at which it currently stands. Our concern is that the economy is at risk of a spike in wage growth that spooks the Fed and it’s bevy of new governors and they respond by speeding up the pace of rate hikes or more sharply curtailing the quantitative easing still in place. That would undoubtedly destabilize stock and bond prices. As we said earlier, investors will ultimately be punished for imprudent investing.

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.

June 2017

We knew it had to come at some time, but the elusive question has always been when?  The question we refer to is when the European Central Bank (ECB) would finally signal that they were going to ease off of ultra-stimulative monetary policy.  At the late June press conference ECB President Mario Draghi took the first step, albeit a tiny one, and hinted that quantitative easing could be tapered at some point in the future.  Recall that when the Federal Reserve first broached the subject of pulling back from emergency monetary policy in 2013, investors staged what has been dubbed a “taper tantrum,” in which the U.S. 30-year Treasury yield skyrocketed by 110 basis points in the two months that followed.  Compared to the U.S., the Europeans reaction was far more muted.  Since Draghi’s comments, the German 30-year yield is 38 basis points higher and the DAX index of German stocks is less than 1% away from its all time high.  Hardly a tantrum!  Nonetheless, a day after the comment, ECB sources said that markets took the words out of context and that the central bank is not currently considering reducing the stimulus program.

Further adding to investor confusion, Bank of England Chairman Mark Carney explicitly said that the U.K Central Bank would need to raise interest rates in the not too distant future.  Moreover, he described the global recovery as having become “broad-based.”  Although, he followed that by saying the BOE would “wait and see” how the economy develops which we translate as suggesting that a rate hike will not occur this summer.  Rounding out the suddenly hawkish tone of policy makers, Carney’s previous employer, the Bank of Canada raised their overnight lending rate for the first time in seven years this month.

Undoubtedly, the comments and actions of the various Central Banks are a departure from the accommodative policy that’s been in place since the financial crisis.  However, we anticipate that they’ll follow the Federal Reserve and reverse policy at a glacial pace.  Despite that, we expect that market volatility will likely tick higher as investors attempt to decipher how soon and by how much interest rates will rise.  In doing so, it’s important to understand that as global central banks begin to back away from emergency monetary policy they are not actually tightening policy.  The ECB and BOE are suggesting that they will slow their buying of assets while the Fed is planning on reinvesting less of the interest and maturity payments generated from their portfolio.  All three will continue to buy assets in the open market, thereby impacting prices and keeping interest rates artificially low.  It they were to endeavor to tighten policy, they would be outright sellers of securities held in their portfolio.

The Fed laid out its plan for balance sheet reduction at the conclusion of the last FOMC meeting.  Their plan is to trim reinvestment by $10 billion in the first three months after implementing the operation (when that will be has not been communicated), with the reduction split between Treasury notes and mortgage-backed securities, 60% and 40% respectively.  They plan on increasing that amount to $20 billion in the next quarter, and continuing to increase by $10 billion each quarter, until they top out at $50 billion a quarter.  The stated intention is to keep the 60%/40% ratio throughout the operation.  When the Fed ultimately reaches $50 billion a quarter, the annual amount of proceeds not reinvested will represent about 4.5% of their total portfolio.  Of course, they will be shrinking the portfolio at about half that rate because their existing holdings will continue to generate income of about 2% a year on the remaining balance.  The point is that it’s unlikely that the Fed portfolio will return to pre-crisis levels for a very, very long time.