December 2018 – Monthly Commentary

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December 2018

As we expected, the Federal Reserve lifted the overnight lending rate by 25 basis points in December and indicated that they would lift rates two more times in 2019, backing away from their forecast of more frequent rate hikes.  Also, as we expected, Fed Chair Powell gave a dovish assessment of the Fed’s view of the economy and markets.  However, that did little to calm investors, with December being another “bloodbath” for equity holders.  As measured by the S&P 500, stocks fell 9.20% for the month.  The period was challenging for fixed income as well, driven primarily by a widening in credit spreads.  The panic was so widespread that it seemed there was no place to hide from the selling.  However, despite the credit widening and loss of faith in the Fed, our Reserve Cash Management (RCM) strategy survived the market weakness and profited for the period.  Given that positive outcome, we would like to use this monthly update to give an overview of the RCM strategy.

As of year-end, we estimate that the reserve cash management (RCM) composite portfolio has a yield to maturity of approximately 3.24% and an average effective duration of 71 days.  We find the characteristics of the RCM particularly attractive given that the Barclay’s Aggregate Bond Index has a yield to maturity of 3.28% and an average duration of maturity of 6.2 years.  The Federal Reserve’s base case is for two additional rate hikes in 2019.  Thus, we think that short maturity portfolios continue to offer a better risk reward over the next 6 to 12 months.  

As we start the new year the 3-month LIBOR interest rate stands at 2.80%. Overwhelmingly, 3-month LIBOR is the reference rate for floating rate notes.  The increased volatility in the capital markets, and the reversal of Fed Chairman Powell’s hawkish tone from early October precipitated a shift out of floating rate notes and into fixed rate bonds.  An investor should be indifferent between holding a fixed rate note versus a floating rate note, if the expected return of each note is the same given the investor’s outlook for interest rates. 

Based upon trades that Halyard has observed in the market, there appears to have been indiscriminant selling in this space with floating rate paper trading at less than fair value relative to its fixed rate counterpart. Halyard believes this may be the effect of asset allocators shifting from floating to fixed rate coupon bonds using ETFs.  The allocators sell the ETF and then the ETF sells bonds to meet the redemption – often at levels below fair value.  While the ETF investor is expressing his interest rate view, the ETF’s are selling floating rate assets at price levels that seem to imply a sharp decline in LIBOR during the note’s average life – which seems inconsistent with the view of possible interest rate hikes in 2019. 

We favor floating rate paper maturing in 2019 and 2020.  Following the equity drawdown and Chairman Powell’s recent less hawkish tone, the Fed Fund’s futures market is no longer implying any interest rate hike in 2019 and a possible interest rate cut in 2020.   While we acknowledge the possibility of fewer interest rate hikes, we still see front end interest rates moving higher.  If the Fed’s base case for two additional interest rate hikes in 2019 comes to pass, 3 month LIBOR should move higher and possibly approach 3.25% by late 2019.  A further increase in LIBOR will increase the coupon income of floating rate notes.  In that scenario, we expect the yield on the RCM strategy to rise commensurately.

Copyright 2019, Halyard Asset Management, LLC. All rights reserved.

November 2018 – Monthly Commentary

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November 2018

As the fourth quarter began, the S&P 500 index sat just below an all-time high, with expectations that earnings would continue to surprise to the upside and Q4 GDP would again post 3% or greater growth.  But those expectations were almost immediately dashed by a trifecta of confusing news in the form of Chairman Powell backtracking on his hawkish comments from a month earlier, plunging oil prices, and the trade war with China. 

In the first paragraph of last month’s market update we describe Chairman Powell’s October 3rd speech as the most hawkish in a decade.  So hawkish that we wrote “one wonders if the Fed is prepared to raise the Fed Funds above the 3.0 to 3.5% neutral range.”  On the back of that comment and the stock market plunge that followed, President Trump took to criticizing the Fed Chairman for jeopardizing the sustainability of the economy.  Apparently, Powell took the criticism to heart because just a month later, at his presentation to the Economic Club of New York, he softened his tone materially.  In the speech he described the current Funds rate as being just below the lower end of the range of estimates for the neutral rate.  With the overnight rate currently targeted at 2.0% to 2.25%, Powell’s comment suggest that investor perception of the neutral rate is too high and the “risk-off trade” (stock prices lower) reversed.  That was the initial reaction to the comment and the stock price rally continued into the next week as investors were cheered by comments that the U.S. China trade spat was showing signs of easing.

However, that wasn’t the only issue concerning the markets.  The second “spur in the side” of investors was falling oil prices.  Historically a fall in the price of oil was deemed a net benefit to economy as it was the equivalent of a tax cut for consumers.  However, the U.S. has become a large producer of the commodity; so much so that last month the country exported more oil than it imported for the first time ever.  With the price of the oil falling, the profitability of domestic producers falls as does the credit quality of those companies.  Over the two-month period ending December, West Texas Intermediate prices have fallen about 30%, prompting worries that banks exposed to the sector could experience a wave of defaults.  With that worry came broad based weakness in stock prices.

The third source of investor anxiety has been the ongoing trade war with China.  The sabre rattling which had intensified for the first two months of the quarter seemed to subside somewhat following the G-20 meeting in early December.  A meeting between Trump and China President Xi yielded a delay in further sanctions for 90 days with the hope that the entire matter could be resolved in that time.  However, the arrest of Huawei CFO Meng Wanzhou, the daughter of the founder of Huawei Telecom, has complicated matters.  The charge is that she circumvented trade sanctions with Iran and is being held without bail, being deemed a flight risk.  The Chinese government has been vocal in their displeasure with the arrest and the company has denied wrongdoing.  At the time of this writing, she remains in custody and the impact that will have on trade negotiations is not clear.

What is clear is that investors don’t like the degree of uncertainty that’s arisen in the capital markets.  The economy continues to generate jobs at a robust pace as the number of unfilled jobs remains at an elevated level.  Moreover, with inflation continuing to tick higher, we believe that Chairman Powell’s comments in October were a true description of monetary policy.  But given the heightened market volatility and his walking back of those comments at the economic club luncheon, we expect that the Fed will raise the overnight rate by 25 basis points in December, as expected, but will sound a dovish tone at the post-meeting press conference.  Moreover, we now think that rate hikes in 2019 will be limited to two.

Copyright 2018, Halyard Asset Management, LLC. All rights reserved.

October 2018 – Market Commentary

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October 2018

In recognition of the strength of the economy Fed Chairman Powell delivered the most hawkish speech of any Central Banker in the last ten years on October 2nd.  Speaking before the National Association of Business Economists he described the economy as operating with “limited slack” and that “the Fed would act with authority if inflation expectations shift.”  There are many observers who would describe the Fed’s current pace of rate hikes as already acting with authority.  One wonders if that is a warning that the Fed is prepared to raise the Fed Funds above the 3.0% to 3.5% neutral range that is the current expectation.

It would appear that equity investors fear that to be the case.  October was a dreadful month for stock prices and has been dubbed “Red October” for the viciousness of the selloff.  At its nadir, the S&P 500 index touched 2603, more than 11% lower than the 2940 peak reached just a month earlier.  That drop masks some of the even larger price corrections in individual stock prices, with Biotech and Financial shares taking more than their share of the punishment.  Investors have latched on to a narrative that rising interest rates are going to cause financial services firms to suffer a decline in net income, despite actual results showing otherwise.  As we pointed out several months ago, the relative flatness of the U.S. Treasury yield curve is not what drives bank results.  It’s their net interest margins and we’ve seen them mostly expand through this earnings season.

Of course none of that matters with the results of the mid-term election and the retaking of the House of Representative by Democrats.  With a Democratic House and a Republican Senate, the President is going to face an uphill battle to get anything done.  There had been grumblings that if the Republicans had been successful, Trump would continue with Keynesian policies by cutting taxes further and quite possibly revive his desire for an infrastructure plan.  Now the Democrats have the votes to block any future plans and gridlock is likely for at least the next two years.

The impact to the market has been mildly favorable, with the Dow Jones Index rallying more than 500 points on the day after the election.  Equity investors, it would appear, believe that gridlock is the most favorable outcome.  Bond investors seem to have come to the same conclusion, as well.  Namely, that the expected rate of growth will not accelerate and, therefore, the Federal Reserve will not be forced to push the lending rate above its equilibrium rate.

Indeed, we agree with the immediate reaction as we view the economy as being on a self-sustaining course and that the expected gridlock will actual be beneficial to that sustainability.  It’s important to remember that the U.S. Government is already running a $1 Trillion deficit and there is an enormous amount of stimulus still in the system from years of bond buying.  Moreover, with the economy at full employment and the number of unfilled jobs continuing to total more than seven million, we are still at risk of overheating.  Especially going in the holiday season.  Again, one wonders if the Fed will need to raise their targeted neutral interest rate.

 

Copyright 2018, Halyard Asset Management, LLC. All rights reserved.

September 2018 – Monthly Commentary

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September 2018

The Federal Reserve releases the value and composition of their Open Market holdings every Wednesday afternoon.  These are the securities the Fed bought when, in their judgement, the economy demanded artificially low interest rates.  On Wednesday September 5, the value of the Open Market holdings fell below $4 trillion dollars for the first time since peaking at $4.24 Trillion in April 2017.  That represents a reduction of approximately 5% and a milestone in monetary policy, though the Fed is unlikely to champion it as such.  Namely, because there are plenty of critics that argue the size of their emergency monetary policy should have never reached that size.  The program to reduce the reinvestment of maturing securities has now been in effect for a year and, as of October, the amount of maturing debt not reinvested has reached the Fed’s stated goal $50 Billion a month.   That’s up from $10 billion a month when the program began last October.  At the commencement of the program investors feared the absence of Fed buying would pressure interest rates higher, especially when the amount reached full effect.  To date, it could be argued that the impact has been muted as rates have only risen marginally.  However, with the ten year note above 3% and the economy continuing to run hot, one wonders if the reduced demand will finally push interest rates materially higher.  An important consideration is the growth in the budget deficit.  Over the last twelve months the United States has run a budget deficit of $1.2 trillion dollars.  That’s roughly an additional $100 billion a month, when combined with the Fed’s $50 billion roll-off, adds to the supply of treasuries that needs to be absorbed by the market.  Also of consideration, the Fed has never defined exactly what they would deem a normalized balance sheet.  At the start of the crisis, the assumption was that it would fall back to the pre-crisis level, but it’s now assumed that the steady state amount will be more like $2.5 to $3 Trillion.

Two months ago, we wrote about the global emerging market bond rout and the illogic of the lopsided risk/reward tradeoff of the sector, especially when global interest rates are at very low levels.  Since then we’ve heard conflicting arguments of “it was only a matter of time before the emerging markets corrected” (the Halyard opinion) versus the opinion that the recent correction is a “buying opportunity.”   What’s certain is emerging market bonds share a similar risk/reward profile to high yield debt and investors have largely ignored that similarity.  To the contrary, the high yield bond market has rallied with the Bloomberg Barclays U.S. Corporate High Yield Index generating a total return though September of 2.56%, despite rising interest rates.  That has driven the yield spread to 310 basis points, the lowest level since prior to the crisis.  The price action has been achieved despite a deterioration of aggregate credit quality.

Even more perplexing is the price rally in high yield bank debt.  The sector proved disastrous to investors during the crisis.  Prior to October 2008 bank debt was thought to be the safest form of high yield debt. The securities were marketed as being higher in the capital structure than high yield bonds, thereby insulating it from first losses, and touted as having never fallen below a price of 90 cents on the dollar.  That is, until investors dumped the paper en masse and no buyers surfaced to take the other side of the liquidation.  When the dust cleared, many individual loans traded as low as 60 cents on the dollar.  Fast forward to 2018 and much of the same nonsense that was occurring prior to the crisis is happening again.  New issue bank debt will set a record this year and the vast majority of that debt is structured as covenant lite loans, securities that don’t require the borrowers to maintain certain financial standards to avoid having the debt called.  S&P estimates that 78% of loans currently outstanding are covenant-lite deals.  Demand for the debt is being driven by Collateralized Loan Obligations (CLO’S).  You’ll probably recall CLO’s from the financial crisis.  They’re similar to an ETF in that many small loans are bought and packaged into a CLO wrapper and marketed as being less risky than individual holding’s.  The pitch is the same as it was in the years before 2008.  It may not be the same situation as that which faced emerging markets over the last two months, but it’s eerily similar.  While there is no immediately recognizable catalyst that would cause a panic in the sector, the debt is priced for perfection.

Copyright 2018, Halyard Asset Management, LLC. All rights reserved.

August 2018 – Monthly Commentary

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August 2018

The U.S. economy continues to chug along with the second quarter growing at a revised 4.2% annualized rate.  That strength has carried into the third quarter with the Atlanta Federal Reserve forecasting 4.3% growth for the period.  That growth seems to have emboldened equity investors as the S&P 500 posted an all-time high of 2,916.50 on August 29th.  The index has since pulled back marginally, but all signs suggest that new records are likely with the release of third quarter earnings, set to begin only a few weeks from now.  Despite the ebullience of equity investors, the mood of Bond investors is anything but upbeat.  The 10-year and 30-year notes haven’t budged from the yield levels at which they sat in June.  Granted the short end of the market has shown some life with rates approximately twenty basis points higher for the same period.  With the Fed signaling two more rate hikes before year-end and a   continuation of hikes in 2019, one would think that rates across the yield curve would be higher.

Especially perplexing is the lack of movement in 3-Month LIBOR.  The reference rate is unchanged from the beginning of the summer and is actually three basis points lower than the recent high touched in May.  To be fair, there is a material chance that LIBOR will cease to exist at some point in the future.  For now, however, trillions of dollars of securities reference the LIBOR rate to determine their price, making it a critical benchmark.  Historically, in a rising rate environment, LIBOR has risen at a faster rate than Treasury bills as investors speculated on future rate hikes.  The TED spread, as the spread between LIBOR and Treasury Bills is known traded at an average spread of 30 basis point for much of the last five years.  However, following Jerome Powell’s elevation to Federal Reserve Chairman, the spread widened more than 60 basis points as investors began to discount a more aggressive rate hiking cycle.  That widening has reversed and has since narrowed to 21 basis points.  We believe the collapse in spread reflects a return of complacency by fixed income investors, and a belief that the Federal Reserve is close to the end of the rate hiking cycle.  We do not entirely agree with that logic.  Our forecast is that the Fed will raise rates later this month and again in December, followed by two more hikes in 2019.  Beyond that, forecasting becomes more challenging.

Year-over-year economic growth for 2018 is likely to be the fastest in some time but the bigger question is will it be sustainable into next year and beyond?  The short answer is that it’s not likely.  Tax cuts juiced the economy this year and we may feel the benefit into next year but the U.S. is a developed economy and with population growth of only about 1.0% and a de facto moratorium on immigration, current economic growth is going to be nearly impossible to sustain.  Perhaps, if taxes are lowered again, economic growth would accelerate, but that’s not likely to happen given the deteriorating fiscal state of the U.S.  What’s for sure is that at some point sequential growth, which is how the economist’s measure GDP growth, is going to be negative.  We have argued on numerous occasions that year-over-year growth is a better measure of activity as it compares “apples to apples,” but the convention in the United States is sequential comparison.  The policy reaction to that decline in activity is dependent on the cause of the downtick.  For example, we could have a robust Q4 2018 followed by a decline in activity in Q1 2019, especially if the country experiences a harsh winter.  In that instance, investors might not like it, but it would be no reason to call for a recession.  Growth would likely return in the next quarter.  On the other hand, if the decline is precipitated by a crisis of investor confidence, the stock market and its heady valuation could be at risk for a meaningful pullback.  As always, we remain vigilant to those risks.

July 2018 – Monthly Commentary

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July 2018

The dog days of summer are upon us and the U.S. market has been relatively calm despite the daily barrage of news from around the globe.  That’s not to say that global macro events are not on the mind of investors.  Quite to the contrary.  Donald Trump’s trade war is making the headlines daily, the health of the European banking system continues to be a worry, and the drama of The United Kingdom’s divorce from the European Union is entering its third year with no agreement in sight.

Also on the minds of investors is the continued collapse of emerging market economies and the value of the currencies that they represent.  Quite often Investment advisors recommend emerging market debt as a way to diversify risk and add yield to a portfolio during times of calm.  We’ve written on numerous occasions that the additional yield is not worth the added credit risk.  The history of emerging market default is long and painful.  At the time of this writing, the Turkish lira is in freefall due to the political missteps of their questionably elected leader and his attempt to manage monetary policy.  Similarly, Russia again finds itself in the midst of a currency crisis based on the sanctions imposed by the United States. While that has pushed the value of the Ruble lower, the Russian economy is heavily dependent on oil revenue, and with the elevated level of oil prices the fallout is not nearly as bad as that of Turkey.

Also dragged down with the other emerging economies, the currencies of Korea, Thailand, and Singapore have all fallen versus the U.S. dollar.  The driver behind the Asian currency selloff is decidedly China.  The value of the Chinese Yuan versus the U.S. dollar is managed by the deep-pocketed Chinese government and has fallen nearly 8% in the last two months despite strict currency controls.  The Chinese government claims they are taking steps to slow the decent of the Yuan but it continues to lose value.  We believe that the devaluation is a thinly veiled attempt to retaliate against the tariffs put in place by the Trump administration.  Just three years ago, the International Money Fund elevated the Yuan to World Reserve currency status and yet the Chinese government continues to manipulate its value.  While not surprising, the IMF and its Chair, Christine Lagarde, have been mum on the subject.

As we wrote earlier, despite the perpetual diet of news, markets are enjoying a relatively quiet summer, with the S&P 500 index sitting just below an all-time high.  That performance comes on the back of another terrific earning season in which sales grew 11%, and operating income rose an “eye-popping” 26% versus Q2 2017 results.  What’s been conspicuously absent this season is the idea of “peak earnings” the media embraced to describe surprisingly strong Q1 earnings.  Were pundits embarrassed to have gotten the call wrong or has investor sentiment changed and the opinion is now that the U.S. economy has shifted into high gear?  We’re of the opinion that it’s a little bit of both.  The tax cuts enacted late last year are absolutely contributing to bottom line growth as corporations are paying less in taxes.  Moreover, they’re likely to support year-over-year growth for the rest of 2018 until comps become more challenging in April of 2019.

As the summer comes to a close and investors return to their trading desks, we expect that volatility will return.  The question, as always, will it be upside volatility or downside?

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.

March 2018 – Monthly Commentary

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March 2018

March has followed the pattern of the previous two months, with heightened equity market volatility creating worry for anxious investors. Despite that worry, the bond market has been a bastion of calmness with the 30-year bond trading in a relatively benign range of 3.22% to 3.00%. Given the continued strength of the U.S. economy, we had expected the bond to come under price pressure pushing the yield closer to 3.5%. That price action has been befuddling, especially given the steadily deteriorating budget deficit. On April ninth, the Congressional Budget Office announced that the deficit would likely hit $1 trillion dollars in 2020, two years sooner than earlier forecast. Investors didn’t blink an eye, which really is no surprise given the complacency that has swept over the public with regard to the U.S.’s profligate spending. The reaction was much the same last month when Republicans pushed through the $1.3 trillion spending bill.

American’s seem to have come to the conclusion that the Fed has and will continue to ensure prosperity for all and the idea of fiscal responsibility has become nothing more than an old fashioned notion. However, we got a glimpse of the future last month when the Treasury Department flooded the market with Treasury Bills. With the risk of a government shutdown earlier this year, Treasury reduced bill issuance in an attempt to stay under the borrowing cap. Because of the prospect of a shortage of T-bills, the yield to maturity in the secondary market plunged below the low end of the Fed Funds range. As a result, the Federal Reserve’s reverse repo program, which is available to select institutional clients and a de facto loan to the U.S. Government, skyrocketed to nearly $500 billion dollars. When a shutdown was averted and the debt cap lifted, Treasury issued nearly $300 billion in additional T-Bills, a 38% increase over the amount issued in February. As a result, T-Bill yields rose sharply and traded above the upper bonds of the Fed Fund range as investors sought to digest the additional supply.

With the increase behind us, T-Bills maturing in early June have fallen in yield by 15 basis points despite the rate hike in March and the expectation of another rate hike in June. The open interest in the reverse repo program also plunged from $500 billion at the peak to $4 Billion at the time of this writing, a nearly 100% plunge in open interest! The message here is that large moves in supply and demand will move the market, despite the Fed’s manipulation. It just so happened that with the freeze in the Bill market there was an alternative investment. We wonder who’s going to be the alternative source of buying when the Treasury is issuing a trillion dollars of additional debt year after year.

There are those who believe that should interest rates rise meaningfully in the face of supply, the Federal Reserve would restart their bond buying program to absorb the additional supply. While that may be sustainable in the near term, it’s a deeply flawed solution longer term for a number of reasons. First one trillion dollars is approximately 5% of GDP and as interest rates rise the compounding effect is going to cause the debt load to rise at an unsustainable pace. Secondly, as rates rise, the value of their existing portfolio is going to fall in value and that is likely to come under congressional scrutiny. Under the current spending regime both of those outcomes have a material probability of coming to pass. The fiscal irresponsibility of the U.S. Government resembles an individual getting caught up in the vicious circle of credit card debt. The debt is sustainable in the beginning but as spending exceeds income, it ultimately overwhelms the borrower.

In the history of money there have been numerous instances of countries pursing such a policy and in the vast majority of cases, the country was forced to either default on their debt, devalue their currency, or both. One has to wonder what will be the outcome for the U.S. dollar. It currently enjoys the status of being the world’s reserve currency and it’s bonds the store of wealth for many nations. That is unlikely to change overnight, but there’s a very good chance that it will erode. The big question is to what extent?