Dear Valued Clients and Friends,
By the time you are reading this, the first quarter of 2019 has come to an end, and what a quarter it has been. Markets moved up and down this week, and I don’t have a great feel for how the market will end net-net on the week, but it is somewhat positive as of press time. I will have a pretty comprehensive recap of the quarter in next week’s Dividend Cafe, but for now, we will focus on what is going on in the world. We’ll talk a little Mueller/collusion/Russia (just because I can’t resist), but I really want this week’s commentary to caffeinate you and educate you, so naturally, we’ll spend a lot of time talking yield curve, global economics, and so much more.
So without further adieu, jump on into this week’s Dividend Cafe …
Dividend Café Video
Dividend Café Podcast
Colluding with the Yield Curve
Okay, you will have to get to the Politics & Money section below for some comments about Mueller, collusion, and all that good stuff. But everything in my world right now is yield curve oriented – it is the key to understanding the stock market, the bond market, and the economy at large. And as you will soon see, it is the key to understanding the global economy as well.
First things first – the yield curve has inverted. I wrote months ago why I wasn’t of the opinion that the 5-year yield and 3-year yield inverting necessarily counted. But as I type, the yields on the 1-month treasury, 3-month treasury, 6-month treasury, and 1-year treasury are all higher than the yield on a 5-year, 7-year, and 10-year treasury. There is no denying the classic inversion we see here.
Now, there is a significant basis for blaming this on overseas buyers. As you will see just below, Germany is in free-fall, and this has led to a real drive for a longer duration from global investors looking for safety and higher yields. Those investors had been on the sidelines out of fear of dollar volatility, and let’s just say that tune has changed. Imagine not buying a 10-year treasury at 3.25% because you are worried about rising rates, but buying one at 2.5% just a few months later? That is the state of affairs.
What is happening?
I have not seen a situation like this in my career. U.S. bond yields are coming lower even as growth is accelerating. Why? Because bond yields are collapsing in Europe, pulling U.S. bond yields down with them. And why are yields collapsing in Europe? Because projections for growth are collapsing, particularly in Germany. Yes, Germany is the strongest economy in Europe, but I will quote the legendary economist, Charles Gave, in unpacking what this has created:
“Germany is also Europe’s weakest link. Its industry has been supported for too long by artificially low interest and exchange rates, and an unsustainable system of vendor finance to southern Europe which is now coming apart at the seams. Amidst apparent prosperity, capital is being destroyed on a massive scale in Germany.” (1)
* Bloomberg, Bear Traps Report, March 22, 2019
It is tough to formulate a bond thesis around all of this, because if the same buyers who just got comfortable with the dollar were to see the dollar soften, panic buying of Treasuries could turn into panic selling really quick (which would push yields higher). But the major issue I am highlighting here is that things are not good in Europe, especially Germany, and that really does have an impact in the United States Treasury bond market. (Note how German bund yields have collapsed; yes, I am stating this has pushed U.S. yields lower as well).
The Fed’s Special Counsel Investigation is called the Bond Market
Look, I have offered as much commentary about the Fed as any advisor or portfolio manager could muster for years and years, but all pontificating notwithstanding, the yield curve is now telling the Fed, “you tightened too much.” It is tough to be overly critical of the Fed. Wages are at record levels. Economic growth has substantially improved in the last couple of years. And monetary policy was not aligned with an economy as strong as we are often told it is. So one can forgive the Fed for attempting to take advantage of the good times of 2017-18 to normalize rates and excess reserves, or at least take steps towards that normalization. But what we have now is a yield curve that reflects Fed policy at the short end of the curve and disagreement with Fed policy at the 5-30 year end of the curve.
So what next?
Could the Fed cut rates out of this? It’s not out of the question, but we believe it would be a policy mistake. Long rates get their signal from short rates, too, and all a cut does is further reiterate to the bond market that the Fed views the economy in the context of a long-term (secular) low rate environment. It further weakens the Fed’s hand when the next recession comes. And it risks malinvestment in credit markets. So all that said, will it happen? The futures market now has a 60-70% chance of some rate cut before the end of the year. The forecasts there are all divergent in the magnitude and timing of the cut, but nevertheless, that now becomes the more prevalent scenario. Markets never sleep, and neither should advisors.
What about markets?
I would not advise paying close attention to anyone who would project what this all means for risk assets with high confidence. On the one hand, an inverted curve has always preceded a recession, but on the other hand, the time between the point of inversion and the onset of recession has varied from nine months to three years. Additionally, the Fed has now promised the end of its balance sheet reduction (so-called quantitative tightening), which could very well enhance credit market conditions and boost risk assets further.
Hey, over here!
Lest we forget, there is a little thing called a China/trade deal looming over markets as well. The latest development is that China is now offering to open data centers to U.S. companies, which is a big deal … The hang-up continues to be that on the rather substantial concessions they are offering to make around technology and new markets, they are asking for legacy tariffs to be removed, and the U.S. is not there yet. Meetings are taking place as I type, and the story remains in flux. A reminder of our view: Much of a final China deal is already priced into markets, but there exists certain elements of a deal that could make it better than markets have priced.
Growth story for the next decade
One of my Market Epicurean writing assignments for next month is going to be an extensive piece on the secular growth story that is U.S. oil (and gas) production (and the need/opportunity to export that production). I call this a secular growth story, not merely because of the growth it brings to those who profit from the actual increase of production in oil, but because of what it means for the entire ecosystem – the need to transport the oil and gas, the need to store it, the need to ship it, and the various markets that can be opened with global customers craving U.S. product and delivery. There is a geopolitical story here, too, no doubt, but the economic story is vast, and must be understood from an investor standpoint.
Bank loan demand
What happens to demand for floating rate instruments when the Fed says they are done raising rates?
* Bloomberg, March 25, 2019
The chart above reflects a healthy chart for high yield bonds, meaning, the fear is not credit, yet the floating rate market has seen demand evaporate in the aftermath of the Fed’s recent declarations of halting rate hikes. Now, is the only reason to own floating rate instruments the lift that their yields enjoy when interest rates rise? Of course not. They possess a high coupon, low duration risk, and huge seniority in the capital structure of a company (so better credit protection). But that said, much of their appeal is subject to volatile market treatment in the months ahead as the Fed retreats from tighter monetary policy. Across the credit spectrum, the rate market is just another source of uncertainty in a space already saddled with uncertainty.
Here is what we know: The March 29 deadline has been moved to April 12, and the European Union has said they will not force a hard “no-deal” Brexit at that time. We also know the sterling pound is the second best-performing currency in the world year-to-date, even with all this uncertainty and fear-mongering. What else do we know? Nothing.
Theresa May could end up in a constitutional crisis with her Parliament, but it is not likely. We do not know what happens April 12, but we do know that some of the market-disruptive outcomes (not all) are either less likely now, or off the table. So we wait.
Politics & Money: Beltway Bulls and Bears
- I really recommend you listen to this week’s Advice & Insights podcast if you are interested in why the market shrugged off the Mueller report and its vindication of President Trump. In a nutshell – the market never worried about the special counsel’s investigation to begin with, so didn’t carry the idea of a relief rally with its benign ending (relief from what?). I unpack more of the political reality here in this week’s special podcast.
- The Senate Banking Committee began hearings this week to discuss the idea of mortgage-backed securities competition for Fannie Mae and Freddie Mac. There is a tough legislative path to getting there, but some credible ideas are being tossed about. President Trump entered the fray Wednesday by ordering Treasury to come up with a plan for ending the government’s control of Fannie and Freddie (and with it, the vast majority of the nation’s mortgage industry.) They listed conditions in the memo for how they wish to see Fannie/Freddie untangled from government control, and it will be interesting to see how this plays out. For those who lost their watch, it is currently March of 2019. Fannie and Freddie fell into conservatorship bailout in September of 2008.
Chart of the Week
How significant is the health of the overall economy to the way markets respond to earnings news? Consider how the market has performed for the twelve months after two quarters of earnings growth contraction: If the earnings recession came during an economic downturn, the stock market performance has been negative (makes sense); but if the earnings contraction came in the middle of a still expanding-economy, the performance has actually been higher than average market performance.
Quote of the Week
“If your private life conflicts with your intellectual opinions, it cancels your intellectual ideas, not your private life.”
~ Nassim Taleb
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I will leave it there for the week. I enjoyed a weekend of March Madness last weekend (23rd annual trip) and am hoping to catch more of the tournament this weekend. There have not been a lot of big surprises yet in the brackets, though there have been some close calls! Surprises in the market are a different story, though, because it should never be a surprise that there are always surprises (I suppose you could actually say the same thing about the college basketball tournament as well, come to think of it). The trifecta of pertinent issues right now – a China/trade deal, the yield curve, and earnings growth – will each in and of themselves carry various “surprises,” and there will be other issues that didn’t make that “top three” which surprise markets as well.
Well-constructed asset allocation prepares for all surprises, and it is to that end that we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
(1) Gavekal Research, The Cheat Sheet, March 24, 2019