April 2017 – Monthly Commentary

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April 2017

Last month the Commerce Department reported that the U.S. economy expanded at a 0.7% annualized rate, below consensus forecast of 1.0%.  Much was made in the media that such anemic growth is an indication that the economy is at risk of tipping into recession.  It seems like that proclamation is made this time every year.  At first glance the outcome was disappointing, but we caution readers not to place too much credence in the report for a number of reasons.  First, the initial report is an estimate that only captures a very small percentage of actual activity, with the balance based on assumptions.  Moreover, both the activity they have in hand and the activity that has yet to be tallied are subject to revisions.  Given the massive size of the U.S. economy, it takes a very long time to tally economic activity which means that GDP itself is revised numerous times before it is finalized.  Therefore, the first look at GDP is not much more than a hunch.

The second problem is the manner in which GDP is reported in the media.  The standard is sequentially, on an annualized basis.  That means that we’re comparing first quarter economic activity, which is usually dampened by cold, snowy weather with fourth quarter activity, which is packed full of holiday gift giving, entertaining, and feasting.  The two periods are not comparable from an economic perspective.  But, undeterred, the Commerce Department attempts to adjust the disparately differing periods by seasonally adjusting activity.  In essence they assume that economic activity is more robust in the first quarter than it actually is, then compare it to the fourth quarter.   That makes no sense whatsoever!  We think a more logical way of comparing the period is to compare activity to the same quarter of the previous year.  On that basis, Q1 GDP rose 1.9%, more than twice as fast the headline would suggest.

Looking past GDP, we have been pleasantly surprised by earnings for the first quarter.  Since the collapse in energy prices several years ago, aggregate earnings have been pulled lower as the bottom fell out of energy producer’s profits and the spillover effect that had on banks and lenders. At the time of this writing, 90% of companies in the S&P 500 have reported, and the average operating margin of the index has topped 10% for the first time since 2014.  Moreover, the percentage of companies beating their estimate was in excess of 73%, while the percentage of companies missing their estimate fell to 18.8%.  To be sure, CEO’s often play the game of low balling estimates so that they can claim a beat when they report.  Nonetheless, the estimated aggregated earnings, based on companies reporting to date is $28.09, up sharply from the $21.72 recorded in q1 2016.

On the back of the better than expected earnings and the S&P 500 setting all time record highs, the VIX index traded down to a level not seen since 2006.  The VIX is the weighted average implied volatility of a number of strike prices on the S&P 500 across several nearby expirations.  To clarify, implied volatility is a component of an option price that is an estimate of the annualized standard deviation of the underlying security.  In this case, the VIX is the implied volatility of the S&P 500.  Quite often the uninitiated refer to the VIX as the fear gauge.  While we are not fond of the term as it oversimplifies the information imbedded in implied volatility.  But in this current market environment we view the very low VIX as an indicator that investors are complacent about the downside risks to the stock market.  The message is that with the S&P 500 pushing to record highs and VIX trading close to record lows, now may be the time to protect portfolio gains with put options.

March 2017 – Monthly Commentary

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March 2017

The Federal Reserve didn’t disappoint last month, delivering the third rate hike of this cycle, pushing the overnight Fed Funds rate to 0.90%.  However, at the post-meeting press conference Chair Yellen delivered a “wishy washy” assessment of the economy which did little to instill fear in the bond market.  In fact, instead of tightening policy, the move actually eased monetary conditions.  Since raising overnight rates on March 15th, prices of Treasury notes and bonds have risen on all maturities two years and longer.  Historically, a rate hike causes prices to fall.  Even more bizarre, on the afternoon of the announcement stock prices soared by nearly one percent.  Some dubbed the move a “buy the fact” short covering rally, which seems likely.  But, the rally fizzled as the Republican effort to repeal ObamaCare, a central tenant in President Trump’s campaign agenda, began to go awry.  The seemingly “half baked” Republican solution would cut government spending and many of the taxes associated with the current plan, but at the expense of millions of currently insured Americans.  In what had been thought to be a “slam dunk” for the President became an embarrassment as the Republicans were forced to withdraw the legislation.  Ironically, it was the conservative Republican bloc known as the Freedom Caucus that torpedoed the legislation.  Given the failure to amend ObamaCare and his inability to implement the much touted travel ban, investors have begun to question Trump’s ability to successfully reform the tax code.  The President would like to lower Corporate and personal tax rates, and lower taxes on repatriation of foreign-earned revenue.  The thought is that by cutting corporate taxes, business would see more revenue fall to the bottom line, and the anticipation of that added revenue has been one of the catalysts for the sharp rise in equity prices since the election.   With the probability of Trump tax reform being called into question, investors have been taking profits on what is arguably an overvalued stock market.  However, continued favorable economic data offset some of that worry, resulting in a roughly unchanged S&P 500 for the month.  As we begin earnings season anew, we anticipate that investors will scrutinize results closely to ascertain if the lofty price/earnings multiples are warranted.

Now that the Federal Reserve has begun to normalize interest rates in earnest, the next question is when the committee will begin to normalize their inflated balance sheet.  Prior to the crisis, their portfolio of Treasury and Mortgage-Backed notes and bonds was less than $800 Billion.  That amount has ballooned to $4.5 trillion since 2008.  As the Fed takes in proceeds from coupons and the repayment of maturing issues that it owns, the Fed’s open market desk reinvests those proceeds back into the market.  Historically, when the Fed wanted to raise interest rates, they did so by selling an amount of their Treasury holding into the market until supply and demand of overnight reserves rebalanced at their targeted interest rate.  In this rate cycle the Fed has changed the methodology.  Rather than selling securities and forcing the market to reprice, the Fed accomplishes the rate hike by crowding borrowers out.  We’ve previously written about the Fed’s Reverse Repurchase (RRP) facility, a program in which the Fed pays qualified institutional lenders an interest rate equal to the lower bound of the 25 basis point Fed Funds range.  After the latest rate hike, that rate stands at 0.75%.  Without that facility, the Fed would be helpless at raising interest rates given the vast amounts of liquid reserves in the system.  The U.S. T-Bill market is not large enough to absorb the liquidity and if the Fed simply suggested that they would like to see rates higher, nothing would happen.  However, now that the Fed is paying 75 basis points for a risk free U.S. Government investment, the risk free investor is incentivized to sell T-Bills and invest in the higher yielding Fed RRP.  Problem solved?  At least in the short term!  Longer term, however there are two problems.  First, the goal of raising rates is to drain the excess supply of money from the system.  The RRP operation doesn’t touch reserves so excess reserves are allowed to continue sloshing around in the system, keeping borrowing costs low and encouraging excess risk taking.  Secondly, in paying interest on reserves, the Fed incurs a cost and that cost rises as they raise rates.  All of this argues that the Fed should begin to normalize their balance sheet or, at the very least, end the reinvestment of coupons and maturities.  They have begun to publicly discuss doing exactly that, but the question remains as to whether they will have the temerity to act?

February 2017 – Monthly Commentary

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February 2017

Economic data released last month was solidly robust, with manufacturing continuing its recent expansion, non-farm payrolls surging, initial unemployment insurance claims touching a 17-year low, and consumer confidence continuing to hit post-crisis highs.  Even the Dallas Fed Manufacturing index outlook skyrocketed to 24.5.  That measure is a diffusion index and indicates that a full 91% of respondents view business as improving or remaining the same – while only 8.7% suggested the economy slipped.   To put that into perspective last year the measure bottomed at -35.8, when only 61% of respondents were looking for business to improve or remain stable. That’s directly attributable to the improvement in energy prices over the last year and the impact they have on the region.

Also noteworthy during the month was the continued uptick in inflation.  Headline CPI rose 2.5% compared to the same period last year, and CPI ex-food and energy, the so called core measure rose 2.3% over the same period.  The core measure is significant in that it is a better representation of the trends in inflation.

The accelerating data seems to have been enough to convince the perpetually dovish Federal Reserve that monetary policy is way too accommodative.  Over the course of the last three weeks, Fed speaker after Fed speaker have said that March was a “live” meeting and that Fed Funds target rate could be raised if economic data continued at the current pace.  For further emphasis, they’ve all suggested that the markets should be prepared for a total of three rate hikes this year.  Judging by valuation in the stock and bond prices, the capital markets seem skeptical of the hawkish talk.  For February bond yields were modestly higher, while equity indices continued to soar.  Similarly, the major foreign exchange pairs have been remarkably stable, despite the significant divergence in monetary policy in Europe, the United Kingdom, and Japan.  The U.S. dollar has traded in a fairly narrow range since the rate hike, frustrating forecasters who predicted a much stronger “buck.”  Many of those forecasters have based their targets on the expectation that negative interest rates in Europe would force Euro savers into the U.S. market.  The problem with that thesis is that to do so, European investors inherit an equity-like risk to generate the approximately 1.5% U.S. deposits offer over the average European savings rate.  As for the idea that a European investor could make a dollar denominated investment and hedge the currency exposure, that is flat wrong.  The foreign exchange market is highly efficient at arbitraging away that advantage with the cost of the hedge wiping out nearly all the interest rate differential.

While it’s seems likely that there will be a rate hike at the March meeting, attention will quickly shift to the post meeting press conference and Chair Yellen’s comments on the pace of hikes going forward.  If the board decides that an additional rate hike at the June meeting may be needed, she’ll need to articulate that possibility now.  We get the sense that markets aren’t exactly prepared for such a discussion.  Stock indices are trading close to record highs, buoyed by corporate buy backs and the seemingly insatiable appetite of price insensitive ETF buyers.  Equally vulnerable is the bond market.  With CPI at 2.50%, the 10-year U.S. Treasury note under normal circumstances would be yielding 4% to 4.5%, not the 2.5% that it offers today.  The same goes for short term interest rates.  The one year Treasury bill currently yields 98 basis points.  That’s implying one rate hike and a small probability of a second.  Working through the math, that security would underperform the market should the Fed raise rates three times.  With so many “crowded” trades in the market, caution is warranted.

January 2017 – Monthly Commentary

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January 2017

The election of Donald Trump to President of the United States continues to pose challenges to forecasting and investing in the capital markets.  Arguably, the world order has been turned on its head in ways that could not have been predicted.  The prevailing view prior to the election was that the European economy was to be forever mired in economic malaise; the U.S. economy was growing, albeit at a less than spectacular sub-2% annual pace; equity valuations, as measured by the price/earnings ratio were expensive; and the Republican Party had lost its way and had no clear leadership.  None those assumptions have held true.  The Trump win in conjunction with the Republican control of both houses of Congress has left the Democratic Party in disarray, with that party’s most senior leaders at a loss for how to counter the new President.

The biggest surprise, aside from Trump’s victory, has been the revival of the European economy.  Manufacturing in Europe, as measured by the Purchasing Managers Index is at the highest level since the index was launched two years ago and stands at a very healthy 56.1 level.  Similarly, the Euro Stoxx index of 50 blue chip European stocks has rallied 20% from the low touched last summer.  That’s not to say that it’s smooth sailing for all members of the Euro.  Significant structural hurdles remain and the popularity of French Presidential candidate Marine Le Pen is worrisome.

The forecasts for economic armageddon that followed the United Kingdom’s vote to exit the European Union have not come to pass either. In fact, the roughly 17% devaluation of the British Pound witnessed since the vote has given U.K. exporters an unexpected competitive advantage versus their trading partners.  However, despite the vote, the English government has not yet formally pulled the trigger to begin the process of severing ties with Europe.  Assuming they ultimately will, they will need to renegotiate trade agreements with a European Union (EU) that has said that they don’t want to make it easy on the English.  Conventional wisdom holds that the EU wants to ensure that no other members are tempted to follow the U.K.  Indeed, were it not for the great unknown of Brexit, the Bank of England would have likely raised overnight interest rates by now.

Domestically, investors have given Trump a resounding “thumbs up” vote of approval, as evident by the rally in stock prices.  The chief beneficiaries have been manufacturing and infrastructure companies.  The investment thesis of the bulls, as we discussed last month, is that Trump will be successful in implementing his infrastructure spending plan and that will percolate through the broader economy, boosting economic growth above the elusive 3% annual rate.  Another equity sector that has rallied is bank and finance.  Trump’s intention to roll back Dodd-Frank regulations would reduce costs at financial firms, boosting profits.  Goldman Sachs CEO Lloyd Blankfein said on a Bloomberg television interview when asked about the possibility for changes that “he’d like to hold less reserves” on his balance sheet.  All things being equal, less reserves equals more leverage.  Certainly, government oversight of banking has proved onerous to the management of financial services firms.  oweveH However, given the severity of the financial crisis, we do not think reducing bank leverage ratios is in the best interest of anyone.

Given the improved growth prospects and the rally of stock prices to new all-time highs, one could expect that the Federal Reserve would feel more comfortable in lifting interest rates.  That doesn’t seem to be the case.  Comments following the February meeting were not much different than the December narrative in which they describe risks as balanced and failed to give an indication of when we can expect the next move.  With the continued strong employment sector and rising average hourly earnings, the Federal Reserve under Alan Greenspan would have likely raised rates several times by now.  But the Yellen Fed seems much more willing to allow the economy to run hot. Our guess is that the committee is worried that Trump’s trade bravado could back fire and harm the economy.  That’s certainly a distinct possibility.

December 2016 – Monthly Commentary

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December 2016

The post-election euphoria in the stock market continued in December, lifting indices to just below all-time record highs.  The catalyst for the buying has been investor expectations of a more favorable business environment and, with it, accelerated profit growth.  Bond investors, on the other hand, have been grappling back and forth on President Elect Trump’s impact on the economy and the markets, engaged in a seeming circular logic.  Consensus seems to agree that Trump’s infrastructure plans, while vague, will be stimulative to economic growth.  However, as always, the “devil is in the details.”  If he is going to pay for the spending by stepped up borrowing in the bond market, which seems likely, then the additional borrowing is also likely to have a crowding effect and push interest rates higher.  However, a sharp rise in interest rates would be detrimental to economic growth and could cause stock prices to fall.  When economic growth slows and stock prices fall, the Federal Reserve usually steps in pushes interest rates lower.  The Fed has added to the confusion by indicating that there will be three rate increases in 2017.  Just last fall the committee stressed that rate hikes would be gradual and measured.  We have long believed that the Fed has fallen behind in normalizing interest rates and think that rate hikes should have been earlier and more frequent than the cumulative 50 basis points we’ve seen since 2015.  Now it seems that several, if not the majority of the FOMC has come to the realization that interest rates are way too low, especially if Trump is going to open the Keynesian floodgates.

That brings us back to the circular logic troubling bond investors.  We mostly agree with the thought that added deficit spending is likely to push rates higher.  Despite claims otherwise, the annual budget deficit has not registered less than $400 billion since Obama took office and is forecast to rise steadily under current assumptions.  Assuming Trump finances the $1 trillion infrastructure build out with debt, rates are going to need to rise to attract buyers.  Also, assuming that Trump is successful in getting “shovels in the ground,” he’ll be doing so at a time when the United States is arguably at full employment, average hourly earnings are rising at the fastest pace in six years, and inflation is steadily ticking higher.  Given those circumstances, it’s easy to understand why bond investors are worried.  Following the sharp rise in interest rates after the election, 10-year rates have drifted lower in the New Year, retracing about 25% of the rise since November.  We think that the downward drift will be temporary and expect that we’ve now entered into a rising rate environment.  Moreover, we think that rates will rise in a backing and filling fashion, with yields ultimately stabilizing at higher levels until investors fully understand Trump’s policy.  A pattern not dissimilar to the way bonds traded before Quantitative easing and the Fed’s manipulation of interest rates.  While there’s no doubt that higher interest rates will be less stimulative and likely to have unintended consequences, we think that the economy is on strong enough footing to continue to grow.  The one wild card is the stock market.  As we mentioned earlier, stocks have rallied sharply since the election on expectation that earnings will accelerate.  Should that not come to pass, stock prices are likely to fall back to a more normalized P/E multiple.

November 2016 – Monthly Commentary

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November 2016

The landscape for fixed income changed dramatically with Donald Trump’s election victory.  While polling was close going into the election, the market seemingly priced-in a Clinton victory and a continuation of the steady, albeit modest economic growth of the Obama Presidency.  Instead, investors reacted swiftly to the change in leadership concluding that Trump’s rhetoric will translate into profit growth and an accelerating economy.  Industries that have seen the strongest reaction are banking, building, mining, transportation, and manufacturing.  Stock prices in those sectors have jumped in anticipation that infrastructure spending will accelerate, government regulation and intervention will lessen, and climate change control efforts will fall by the wayside.

While investors took stock prices higher on the news, bond prices plunged in anticipation of more deficit spending and higher inflation.  Trump campaigned on spending $1 trillion dollars on infrastructure rebuilding, paid for by private funding.  It remains to be seen where that funding will come from.  The most likely source is the U.S. bond market either directly through Treasury notes, Municipal bonds, or some hybrid.  With the U.S. debt standing at approximately $20 trillion and the government running a $500 billion annual deficit, investors concluded that it’s going to be impossible to keep rates ultra low in the face of a growing supply of new debt.  Further weighing on bond prices has been a reacceleration of economic activity since summer’s end.  The economy continues to generate jobs at a brisk pace, wages are rising, manufacturing is expanding, consumers are consuming and with the election out of the way, a degree of uncertainty has been swept aside.

One of the big questions of the Trump Presidency is how he will behave towards the Federal Reserve.  During the campaign he repeatedly berated Fed Chair Yellen for her excessively loose monetary policy, saying that she should be “ashamed of herself” for penalizing savers with ultra low interest rates.  Since the election, he has been mum on monetary policy and the Fed chief.  He may have changed his mind on low interest rates, realizing that easy money would be beneficial to his plans to accelerate economic growth.  His pre-election economic advisory team of Larry Kudlow and David Malpass have both been critical of the Fed for holding rates at emergency levels.  That wise advice may be diluted now that Trump is seeking the council of Jamie Dimon, Lloyd Blankfein and other Wall Street CEO’s.  They are likely to advise Trump that Yellen’s game plan of gradually raising interest rates will be beneficial for all, as income returns to the bond market, but not at a pace that slows growth.  He will also have an opportunity to shape monetary policy with his filling of the two vacant Fed Governor positions.  Given the current make up of the committee, we hope he opts for individuals with industry experience rather than the academic economists that have been favored in recent appointments.

What seems nearly certain is that the Federal Reserve will raise the Fed Funds rates in December for the second time in two years.  We warn, as we did last year, raising interest rates two weeks before year end is risky, and creates trading distortions in already thin, illiquid trading.  Last year the initial reaction to the well-telegraphed rate hike was slight downward pressure on equity prices.  That is until the first trading day of the New Year when stock prices collapsed, trading down by more than 10% by mid month.  That’s not to suggest that we’re forecasting a correction in stock prices.  We raise the subject to illustrate the risks inherent in policy changes made during periods of illiquidity.  Looking into the New Year, we intend to be vigilant in risk management, as the country adapts to the New President and what is likely to be a dramatic departure from the last eight years.

October 2016 – Monthly Commentary

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October 2016

Prior to the release of the October employment report, Bloomberg television welcomed a prominent economics professor to the show, asking him to give his first impression of the then soon to be released economic data.  During their idle chatter prior to the release, the professor reminded viewers that years back, Jack Welsh, the former CEO of General Electric had insinuated that the employment report was “made up” and not an actual reflection of employment.  The professor clearly thought that Welsh’s comment was preposterous.  We found that ironic because the number is absolutely made up.  The initial report is the Bureau of Labor Statistics (BLS) best guess, based on phone sampling and is reported after being massaged with seasonal adjustments.  To arrive at a number more reflective of the employment situation, we look past the headline number to the subcomponents of the report and compare that data over several months.  In that way, we’re able to identify a trend.  To look at a single month and declare the economy weakening or strengthening is myopic.

The October employment report was a glaring example of why the headline non-farm data belied a much better employment situation than the report suggested.  Economists were expecting 173,000 new jobs for the month but the BLS reported a below expectations increase of 161,000 workers.  Investors initially reacted by pushing fixed income prices higher, as usually happens when economic data falls short of expectations.  What investors failed to understand was that nearly 200,000 people weren’t able to work during the month due to weather, primarily because Hurricane Matthew shut down a whole swath of the eastern United States.  The BLS estimates that on average, 45,000 workers will be prevented from working due to weather in any given October.  In the most recent report, the Labor Department calculated that figure at 193,000.  Add those workers back to the number reported and you have robust job growth of 354,000.

Digging further into the report yielded more signs of a strong and growing economy.  Namely, the unemployment rate for men and women 25 years and over fell to 4.0%, and for those with a college education, the rate was 2.6%.  But that’s not to say that only college-educated people are participating; average hourly earnings for the entire workforce grew 2.8% year-over-year.  That’s the fastest rate of earnings growth in more than seven years.  The October employment report has done nothing to dissuade us that the U.S. economy is in a virtuous circle of employment growth, consumer spending and rising GDP.

During the month AT&T announced another blockbuster merger, this time seeking a tie up with Time Warner, paying $85 billion for the media content king.  Recall that AT&T paid $48.5 billion for DirecTV last year.  The merger is the latest round of consolidation in the amorphous television/telecom industry, as the number of competitors continues to shrink.  The remaining few have invested mightily to build out their infrastructure to deliver voice, wireless, television, data, and home services such as security and climate control.  To support their ravenous capital investment budgets, they’ve upped the ante on an already fierce competition for new customers.  Ordinarily, such intense competition would drive prices down, but as most wireless subscribers will attest, the array of new services, subscriptions, and fees seems to only go higher.  Clearly, AT&T is betting that by expanding their offering base, they’ll reap a commensurate rise in profits.  What’s troubling is the staggering amount of debt AT&T has taken on to fund acquisitions and their infrastructure expansion.  Assuming the Time Warner purchase closes, AT&T’s liabilities will total approximately $330 billion, that’s more than a 100% increase over the $157 billion they were on the hook for at year end 2010.  Of course, with interest rates artificially depressed the interest expense to the company is manageable, at least for now.  The bigger question is will AT&T be able to manage the debt load when interest rates normalize.

September 2016 – Monthly Commentary

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September 2016

To state the obvious, capital markets are complicated and susceptible to occasional problems related to supply and demand imbalances.  Typically, the problems become magnified at quarter-end, and the just-ended quarter was especially so.  With the October 14th money market reform deadline looming, money funds continued to flood the market with corporate and municipal note sales, while boosting their demand for Treasury Bills and Notes.   That demand added to the quarterly “window dressing” that banks engage in to give their balance sheets the appearance of being of higher quality than would otherwise be the case.  The confluence from banks and money funds drove the yield to maturity of T-bills down to 0.00% in the days prior to quarter end.  Simultaneously, the Federal Reserve’s reverse repurchase facility, designed to help financial institutions invest excess funds during times of stress swelled materially.  Typically, the average balance deposited at the facility is in the $50 billion area.  At quarter end, that number rose to $412 billion.  Since quarter end, demand has waned modestly with the size of the operation on October 10th still sizable at $226 billion.  The importance of the increase is that it is a direct expense to the U.S. government with the current interest paid of 0.25%.  While immaterial compared to the yawning annual deficit, it nonetheless is an unnecessary expense and distortive to the market.

Compounding the quarter-end madness was the U.S. Justice Department’s announcement of the intention to levy a $14 billion fine on Deutsche Bank for its role in the sub-prime mortgage crisis.  The equity capital at Deutsche is only $67 Billion, so a $14 billion dollar hit to equity would put the German bank’s capital well below regulatory requirements.  With the specter of issuing additional shares to meet some or the entire penalty, Deutsche’s stock price plunged to a 52 week low of $11.18, well below the $30 at which it was trading last fall.  German government officials said they had no intention of coming to the aid of the lender, which exacerbated the selling.

Several analysts have said that Deutsche Bank is very small compared to other money center banks and that regulators should allow the bank to go under.  Granted, at a market capitalization of about $15 billion, the value of the bank is less than 10% of J.P. Morgan.  However, we think to focus on market capital is to ignore the opacity and enormity of the risk on its balance sheet.  Total assets held, at $1.6 trillion, are equal to approximately one half of Germany’s annual GDP, and derivative exposure totals more than one half trillion dollars.  Arguably, the $67 billion of equity is not nearly enough to support such a balance sheet, which is why the bank’s stock price has been falling for years and the credit rating has fallen from Aa1 in 2007 to the current Baa2 – just two notches above junk.  The argument in favor of such a large derivative book is that it’s mostly paired off with hedges and in many instances over counted.  Our counter to that argument has been that if counterparties deem Deutsche too risky and it loses access to liquidity, there’s no telling how those securities would be valued.  Moreover, there’s no way of knowing the impact they would have on Deutsche Bank’s solvency or the risk it would pose to the global banking system.

Given that unknown, we wonder what the Federal Reserve and the European Central Bank were thinking.  The U.S. has the concept of a “living will” for the banking system, which details how a bank would dismantle itself in the event of a solvency crisis without collapsing the financial system.  Deutsche is one of five foreign banks that are subject to the living will concept, but the Fed and the ECB have been conspicuously silent on the matter.  Given the direness of the situation, it seems as though the Central Banks should have either been supportive of the bank or should have wound it down.  Is the concept of “living will” no more than a panacea to quiet the concerns of Senator Elizabeth Warren, Bernie Sanders, and others critical of Wall Street?

Deutsche bank has since stabilized amid talk of a much lower DOJ fine and the sale of $4.5 billion senior unsecured debt, but that doesn’t do anything to address years of seemingly poor management and their enormous derivatives business.

August 2016 – Monthly Commentary

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August 2016

With the Federal Open Market Committee scheduled to meet on September 21st, investors find themselves debating, yet again, whether or not the Fed will raise short term interest rates.  Recall, we were in a similar situation exactly one year ago.  Chair Yellen’s comments at last month’s Jackson Hole, Wyoming gathering of Central Bankers were interpreted as being mildly hawkish just as they were last summer, and the markets reacted accordingly.

The yield-to-maturity of the 30-year Treasury bond has moved sharply higher during the first two weeks of September, and stocks, while trading just shy of an all-time high, are also under selling pressure; as they were a year ago.  The selling pressure has been exacerbated as a number of long term bond bulls changed their opinion during the month and now view current interest rates as too low.  We’ve been of that opinion for some time now.  Core inflation year-over-year, the measure the Fed has historically cited as their preferred measure, has traded in excess of 2.0% every month this year, and is averaging 2.3% for the last 3 months.  With inflation climbing at that rate the 1.7% yield offered by the ten year note results in the investor losing 0.50% of buying power per year.  That means that a $1,000 investment would only buy $994.88 of goods and services when the note matures in ten years.  Under normal circumstances, with that level of inflation, the yield on the 10-year note would be approximately 3.5%.  Instead, by keeping short term interest rates at the emergency, near zero level, the Fed is forcing investors to seek higher rates by investing in riskier investments to overcome the loss of purchasing power.  To accomplish that, investors are investing in lower credit quality debt and/or extending the maturity of their investment portfolio, both of which mean greater risk.  That heightened risk appetite has caused the yield differential between overnight interest rates and the 30-year bond to compress, known as yield curve flattening.  The problem with that is the 30-year bond’s sensitivity to interest rate movements is 2.3 times greater than that of the 10-year note.  To put that into risk terms, should interest rates rise by a mere 1.0%, the price of the 10-year note would lose 9.2% of value; not a very attractive outcome.  However, under the same rate rise scenario, the 30-year bond would lose 21.4% of its value.  In the most basic terms, to increase investment yield by 0.67% by replacing 10 year notes with 30 year notes, investors are assuming enormous risk.  However, the average investor is unaware of the sensitivity of bond prices and is simply desperate for additional income.  The paradox is that the Fed worries that a rate rise may slow economic activity, as borrowing cost go up and consumers pull back from consumption.  Equity investors would likely view a rate hike unfavorably, and a short term correction could possibly ensue.  But it’s unlikely that a recession would follow.   On the other hand, if the economic fundamentals improved to the degree that inflation begins to trend materially above the Fed’s 2% target, the Fed would be forced to raise rates at a more rapid pace or risk an overheating economy.  In that scenario, investors would dump bonds, and given the heightened risk sensitivity explained above, would realize large losses in their historically stable portfolio.  With interest rates so low, the price drop could be steep, and given the aggregate size of the bond market, that could cause a recession.

Arguably, we are in the middle innings of the rising inflation scenario, but the Federal Reserve continues to hold interest rates close to zero.  Some on the FOMC have become quite vocal in calling for the committee to deflate some of the bond market bubble by raising the Fed Funds rate at the September meeting.  However, that is not a unanimous opinion and those favoring keeping rates lower for longer have been equally vocal.  If history is any guide, the Fed will stand pat next week and talk will shift to whether the Fed will raise rates in December, just as they did last year.  But then again, that rate hike wreaked havoc with the stock market in the weeks that followed, so maybe they’ll skip that one as well.

July 2016 – Monthly Commentary

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July 2016

Summer finally caught up with the bond market in July with the 10-year Treasury note virtually unchanged for the month. The benign backdrop was beneficial for the S&P 500, as the index finally broke to a new all time high, closing the month at 2,174. That rally came amid confounding economic data. Favorably, the employment report registered 287,000 new jobs in June assuaging concerns that job growth was stalling. Recall that the April and May reports initially showed job growth of 38,000 and 11,000, well below the 228,000 average monthly gain registered in 2015. Those reports have since been revised to 144,000 and 24,000, respectively. Moreover, the report for July further drove home the point that economy is on sound footing with a gain of 255,000 new jobs and another 2.6% year-over-year rise in average hourly earnings.

On the other hand, investors were not prepared for the first look at Q2 GDP. Forecasters had expected the broad measure of economic activity to show an annualized quarterly gain of 2.5%, bouncing back from the previous two quarters, both of which registered sub 1.0% growth. Indeed, anecdotal evidence, including retail sales, home sales and unemployment insurance seemed to indicate that 2.5% was a safe bet. However, the first estimate of activity registered well below that number, coming in at 1.2%. Digging into the number revealed that growth was not nearly as anemic as the headline number suggested. In fact, consumer consumption grew at a quite healthy annualized pace of 4.2%. Roughly two thirds of the U.S. economy is driven by consumer consumption, so if one judged economic activity on that measure alone, the conclusion would be that growth is robust. The drag on the overall number came from inventory liquidation and a decline in residential construction, with each subtracting 1.16% and 0.52% from the total, respectively. When producers use inventory without replacing it, that amount subtracts from economic growth, as it did last quarter. While it initially subtracts from the calculation, as that inventory is replaced back to sustainable levels, it becomes additive GDP. We’re expecting that to be the case in the current quarter.

Fearful that Great Britain and their impending exit from the European Union would be a negative shock to the economy, the Bank of England took extraordinary steps to stimulate economic activity within the country. The action was a trifecta of accommodation; the overnight lending rate was reduced from 0.50% to 0.25%, bond buying in the secondary market was expanded by GBP70 billion, including GBP10 billion in corporate debt, and a term lending scheme designed to encourage banks to expand lending will be implemented. In the post-meeting press conference, BOE Chairman Mark Carney explained that the committee believed that the growth outlook had deteriorated materially since the vote and that uncertainty was likely to weigh on investment and consumer spending until clarity is reached with the European Union. The committee left their forecast for GDP growth this year unchanged, which didn’t seem to comport with their assessment that activity has already slowed, and they cut their 2017 GDP forecast from 2.3% to 0.80%. To further drive home the BOE’s conviction to protect the English economy from the downside, Carney said that he expects the overnight lending rate to be cut to 0.00% by the end of this year.

Given the return to robust growth in the hiring sector and the strength of the equity market, we believe investors will begin again to debate the timing of the next rate. However, with the uncertainty surrounding BREXIT and the coming U.S. presidential election, we expect the FOMC will likely continue to delay a rate hike. We are looking to Chair Yellen’s speech at the monetary policy gathering in Jackson Hole, Wyoming later this month for clues.