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Deal, no deal, deal.

The Days Ahead: Earnings season kicks off.  

One-Minute Summary We were out of town most of the week and holed up at home while the power was out. But, boy, a lot of headlines. First, the trade war escalated, then had a breakthrough. Second, the Brexit proposal that agreed Northern Ireland remains part of the EU and there’s a border somewhere in the Irish Sea. So goods would enter Northern Ireland under the EU no-tariff rules but if sent on to the U.K. would be subject to tariffs. It’s the same idea that the last Prime Minister proposed and lost her job for her troubles. Third, economic numbers continue to point to a slowdown but nothing that overly worried stocks or bonds.

Short-term rates fell causing the yield curve to not invert. That’s all to do with the Fed announcing more purchase of short-term paper…no, not QE4 but just more liquidity and reserve management. Still, all the talk about yield curves inverting, run-for-the-hills nonsense has taken a back seat. Quite right too.

Stocks snapped back on Friday to end the week up 0.6% but, as we've noted, the S&P 500 is bouncing between 2700 and 3000 without a break out. Earnings will soon take over as the main market driver. We're not expecting anything startling. The consensus is for a 3% decline. European stocks had a strong week. The big ones, like Germany, France and Switzerland are up 18% this year, about the same as the U.S.

The on/off trade talks had a breakthrough on Friday. The White House playbook has been to say how well trade talks are going late on a Friday after a bad week of politics. Normally, it’s the “China will buy more soybeans and we’re winning” rap. It’s effective. Nice headline. No details. What we got was “a substantial Phase One deal”. No idea either. But it’s likely the White House will postpone the $250bn of tariffs schedules for October 15th. So that's a good thing.

The soybean thing is kind of important. Two years ago, after the soybean fall harvest, the U.S. was selling $2.5bn a month to China. That went to $0 last year. So it’s likely this truce will hold up at least until December. China has been hurting, with weak imports, and wanted a deal as much as the U.S. It’s likely all the Intellectual Property (IP) and industrial subsidies, which have so irked the U.S., will be kicked down the road. And Treasury Secretary Mnuchin has already hinted that the currency manipulation charge will be dropped. Good thing too as China did not remotely meet the criteria stipulated under the Trade and Competitiveness Act of 1988 (h/t Brad Sester)

1.     How’s inflation doing? Well on the core measure, not very well. That is if you're the Fed. We're at low and falling rates,  wages are decent, full near employment and consumer expectations are strong (sort of). So if you're reared in the Econ 101 classes of, say, 1965 to, well, now, you’d expect inflation. That’s what the Phillips curve said and it makes sense. More workers, more money, more demand, prices rise.

But that relationship probably died years ago and there are powerful forces keeping inflation low. First is demographics. Older people spend less. Second is import competition. There’s a reason manufacturers outsourced to cheaper places. Then there’s our old friend hedonic adjustments. And, more controversially, income equality. If you're in the 0.1%, you're less affected by gas prices and more by Gulfstream 650s.

All this has kept inflation low and it “disappointed” last week, coming in below expectations. Here’s the chart:

Headline inflation was 1.7% driven in part by lower gas prices, down 8% on the year. Core inflation less food and energy was 2.4%.

Housing still runs higher. That’s the black line. It’s not been below the rate of core inflation for years and it's  25% of the index. Also this was a bit of a shock:

The black line is the cost of insurance to companies. They’re up about 5.5% and declining. The green line is consumer insurance premiums, up 18%. They were running at 0% for a few years but shot up in 2019. Why? That’s the ACA, which penalized taxpayers for not having health insurance. It started as a penalty of $285 in 2014 and was $975 in 2018. It's now $0. So, of course, the young and healthy left the risk pool and premiums shot up. 

We'd expect this to hit consumers more than the 1.2% weighting of health insurance in the CPI. Our guess is that medical premiums will cost employers more. And where insurance costs go, medical and hospital costs tend to follow. 

Bottom line: inflation is not an issue for bonds and capital market. But it is for financial planning.

2.     How’s Small Business doing? Not as well as a few months ago but still reasonably well. It’s an index, which is driven by the stock market and how they feel about the four big things that worry them: big business, regulation, insurance and inflation. The outlook for labor is slowing: 22% of companies said it was a good time to expand. But it was 34% a year ago and 30% in the spring.

It all seems to be tied to the on/off trade talks. Tariffs certainly hurt small businesses. Not because they export but because they use raw materials sourced from overseas. Remember the original list of U.S. tariffs from China? It was 200 pages long. It’s difficult to think of any company not affected.  

It may get a bounce from trade resolutions. But for now, rather like manufacturing, this is late cycle stuff with companies wary of what’s coming.

3.     Anything in the Fed minutes? Not really. We know the risks in the economy by now. Although Chair Powell was too polite to mention it in his mid-week speech.  There are three camps in the Fed:

  1. Doves: Low inflation and a commitment to kick it up to 2%

  2. Hawks: All the current uncertainties won't derail the economy

  3. Super Doves: There’s a risk of low rates, low growth and low inflation. Do something now.

So there’s the i) leave it at one cut ii) do another and iii) do another big one. We'd say it’s likely to be “do another” but they are going to have to remain very flexible given the exogenous risks.

Bonds didn't do too much which suggest this was all priced in.

Bottom Line:  Earnings season kicks in. The consensus is for a 3% decline led by big energy earners and tech, particularly the notoriously volatile semi-conductors. We'll be on the lookout for margin pressures and outlooks. Bonds could drop a small amount if the trade/Brexit deal sticks.

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Reading

Missing tourists taken by wolves in NYC

 

Artist: Eileen Agar (1899-1991

 

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

 

Prices of Napa Cab about to increase

The Days Ahead: Small business survey. Fed minutes.

 One-Minute Summary Two of the three big economic data disappointed last week. The two ISM surveys for the manufacturing and service business showed caution and weakness. The third, employment, was ok. That's all. Just ok. Other data like trade were weak but anyone keeping tabs on tariffs knows this number is heading in the wrong direction. The U.K. prime minister put forward an unfeasible deal on Northern Ireland knowing full well the EU will reject it. There are 27 days until Brexit. The U.S. placed tariffs on European aircraft and some agricultural goods. Not unexpected as it was the result of a subsidy claim filed over 15 years ago. Impeachment? Markets don't know how to price in politics.

Bonds had a good week, with the 10-Year Treasuries at 1.51%. That's about where it was a month ago. The yield curve points to a slowing economy and some Fed easing. Nothing new there. Stocks had a 4% sell-off midweek but then recovered with just a 0.3% loss for the week.

Let's’ face it. Stocks are drifting in the 2700-3000 range. They can't really break out until either trade, EU fiscal or political risk look a whole lot better. We’re not holding our breath.

1.     How’s manufacturing doing? Well, you know…terrible. We've known for a while that manufacturing was having a tough time with the global slowdown, China and the trade talks. Manufacturing accounts for around 12% of GDP. It employs around 12.8m people or 10% of the workforce. That’s lower than it was in the depths of the 2009 recession. Automation, offshoring and trade have continued to erode the manufacturing base. But it’s still important because it has a high multiplier effect. A service job can exist on its own. Manufacturing tends to provide ancillary jobs, such as transportation, raw materials, suppliers and distribution.

Thanks to the trade war, confidence has fallen to its lowest since 2009 (the blue line):

And export orders (black line) are at the second lowest level seen in 30 years. I mean, who would have guessed? If you hike import prices by 20% you’ll either see inflation or a collapse in demand. You certainly won’t see companies increase their exports.

Some of the comments from respondents were telling. Here’s one:  

“We have seen a reduction in sales orders and, therefore, a lower demand for products we order. We have also reduced our workforce by 10 percent.”

Not one company said that the cost of capital was a problem. So lower rates won't make a difference. We'd note the ISM index has triggered false alarms before. But if these numbers continue then, yes, the Fed will cut rates for sure.

On the investment side, companies in the industrial chemicals, machinery, energy, auto parts and machinery sectors have had a miserable 12-month performance. We've underweighted those for the most part and would continue to do so.

2.     Any tariff update? Yes, all sorted. We won. Nothing to see. Ha, no, of course not. Last week the WTO agreed with the U.S. that the EU unfairly subsidizes Airbus. This has been an open case at least since 2005 with i) Boeing claiming unfair annual subsidies for Airbus running at $7bn to $10bn and ii) Airbus claiming unfair military contracts for Boeing. But guess what? The WTO, which the U.S. doesn't like much anymore, said, “Yes, U.S. you have a point and you can take countermeasures up to $7,496,623,000”. Curiously specific but there you go.

So on the same day, the U.S. issued their own tariffs. Basically it’s 10% on big planes and 25% on a ton of agricultural and manufactured goods. Long list here. It includes wines, olive oil from Spain, France and Germany but not Hungary.

The Airbus side of the case will rule next year so the likelihood that the EU will retaliate on Boeing seems very high. Meanwhile, we have a case study of what happens with tariffs from January 2018 when the Administration passed a 20% tariff on washing machines.

Now there are only four companies selling washing machines in the U.S. and Whirlpool (who also make Maytag) liked this deal very much. They immediately increased prices by around 20% that ended up costing consumers around $1.5bn. There it is. That rather large spike in prices in early 2018. The amount raised by the tariffs? $82m. They also increased prices on dryers. Hey, why not.

Our guess is that every Napa wine owner is planning a 24.99% price increase for October 19th.

So do tariffs hurt consumers? Yes.

All of this continues to upset markets. The immediate reaction was for the big airline stocks to fall around 5%. We have some exposure through Berkshire Hathaway but it’s small and the airlines have other problems.

3.     So on the “soft” data not so good. How about the “hard” data? Better. Friday’s job report was below estimates but still at 136,000. The labor force grows at around 100,000 a month so anything more than that will reduce unemployment. That’s a very raw description, I know and it’s horribly seasonal but it’s roughly in line with the census information.

A few quick points:

  • Private sector employment was down. We'll watch this closely as census employment starts in earnest in a few months and it can add 300,000 temp workers to the new jobs list

  • Average hourly earnings did not grow at all over the month but are still 2.9% up on the year

  • The two ISM reports last week point to less hiring.

Here:

This just shows new jobs and the ISM numbers for employment intentions. We advance the latter just to show its relationship to actual results. It clearly points to a slow down in hiring at the back end of the year.

As we've said, there is a huge difference between hard data (actual jobs, wages, sales) and soft data (confidence, intentions, expectations). Last week was bad on the soft side but ok on the hard side. That’s what makes the timing of the Fed’s next move tricky. It will be October or December. Perhaps both. Either way, there is more upside potential in Treasuries than downside risk.

4.     WeWork Bonds. Yes, they're a thing. So far only Softbank, some venture firms and employees have taken a hit. But WeWork issued bonds last year that S&P and Fitch just downgraded to junk.

Why do we keep going on about a non-public company that had fraud and mismanagement written all over it? Because we think it’s good sign that the public markets said “No”. Loudly and clearly. And that tells us that investors remain cautious. As are we.

Bottom Line: The only surprise last week was the manufacturing business confidence took a dive. It’s nearly all trade and China. And it’s nearly all self-inflicted. We expect things like GDP, job growth and wages to slow in Q4. But all of that’s priced in.

Please check out our 119 Years of the Dow chart  

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The vintage football jersey business

(h/t FT Alphaville) 

Artist: Suzanne Valadon (1865-1938)

  --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.  

Why WeWorks woes works for markets

The Days Ahead: Non-farm payrolls and ISM numbers

 One-Minute Summary Constitutional crisis in the U.K., impeachment launch in the U.S., Chinese companies banned from U.S. stock listing, middle of the road economic numbers, oh, and a big merger called off (MO and PM)…that’s a lot to throw at markets. But stocks have held up at around with the S&P 500 at the 3000 level and a sell off on Friday on the China listings news. The price action is far from convincing though. Bonds had a good week even though Fed speakers put a damper on further rate cuts.

The GDP update confirmed we’re back in the 2% world. Estimates for Q3 are about the same. Housing did well. Personal income is slowing. Core PCE inflation, the one the Fed follows, was 1.8%. The target is 2% so that will keep the Fed steady. All pretty much in line with current thinking.

Markets are driven by the big stuff we mentioned in the opening. That’s a whole lot of unknowns but reminds us of one of our favorite stock market rules: Don't trade on headlines. All major markets are in a bit of a holding pattern but with solid year to date gains.

 1.     How’s Brexit doing? Ugh. We won't go through all the Brexit permutations, except to note that there if the current government leaves without a deal, it will break the law. The law is the Benn Act, and here it is. Basically, if the House of Commons (roughly, the House of Representatives) does not approve a deal, then:

“The Prime Minister must seek to obtain from the European Council an extension…”

 There is a constitution in the U.K. and its principles are documented in the Erskine May procedures. It’s about to be tested again. Right now, all and no options seem to be on the table but any compromise looks unlikely. Sterling took another hit. It’s down 16% since Brexit and a major reason why we continue to underweight international.

2.     What’s WeWork up to? Nothing good. Hey, we like noting more than a ripping success from venture capital to public markets. Bring on the unicorns, we say. But this one, a bit like Uber, was beginning to look like a “hey, come off it, you expect us to fall for that?”.

Quick background. WeWork is a property company with a tech spin. It has a great mission. And says things like “Community is our catalyst” and “We foster human connection through holistic happiness”. Great, why not. The basic business was buy some long term leases, make them funky and fun and rent them out on short-term leases.

Here the business plan:

Ok, one might say. “You're a landlord. I mean not to Dell and HP and Microsoft. Ha, no, that’s just for illustration purposes. But you're a landlord”

But as everyone in real estate knows, that means two things: 1) you need cash flow to pay the leases and 2) you need a ton of capital to pretty up the offices, advertise and lease them

And that was the problem. Its filing showed revenue of $3.2bn, expenses of $6bn and losses of $4bn. Against negative equity of $2.4bn. Again, fine until the banks say, “er, we’re getting a little nervous about your ability to pay us back. Help us out here.”

The help was to go public and raise new equity so they could go on buying long term leases, prettying up the offices and renting them at high, short leases. How do you value a company that sells $1 for 50cents? Tricky. The last round of financing valued the company at $47bn. The bankers were ready to go with an IPO of $50bn and the roadshow commenced.

That’s $50bn, which would make them the third largest real estate company in the country. Bigger than Simon Properties, which has $30bn in assets and $500m of income.

But then investors pushed back. And pushed back hard when they found out the CEO (Adam Neumann, don’t Google him, you’ll get depressed) had a $60m private jet, a Maybach, owned some of the buildings that WeWork leased, copyrighted the use of the word “We” and licensed it back to the company, took out $700m in loans and generally used the company as his personal piggy bank. He also had said he wanted to be the world’s first trillionaire and President of the World but, hey, gotta admire the stretch goal.

So, short story. The IPO is pulled. The new valuation may be around $10bn. Neumann steps down, largest shareholder, Softbank, says enough, new management, fires a lot of people and moves to Plan B.

Now, yes, ok, we laugh at these stories because the only people who got hurt were some VC guys and investment bankers (and staff, which is a problem). But this company nearly took $50bn off retail investors, funds and wealth advisers. From $50bn to maybe $10bn in a week. It’s great that investors said “enough” and we didn't see another dud IPO and investor losses.

And it also tells us that this market is very short on exuberance. There is no “throw money and ask questions later” like the late 90s.

Caution all round is a good thing.  

3.     Consumer confidence, still ok? Yes, but peaking. Consumer confidence is a precarious thing. It can prove ephemeral, driven by news, taxes, jobs, politics…just about anything that can leave people nervous. Last month we saw quite drop from 134 to 125 and a setback in the jobs plentiful less jobs hard to get index (a mouthful, but indicates confidence in the labor market).

It’s not a concern yet but discretionary spending on things like autos, furnishings and recreation are about 14% of GDP. Tariffs are the likely culprit here with the people the “expecting things to worsen over next 6 months” index at a six-year high (h/t Pantheon Economics).

Consumer confidence is not a leading economic indicator. It’s just that it may lead to lower retail sales and home buying.  It’s all part of the gradual slowdown. Bond yields fell. A textbook response.

 4.     Bubble Update. One of the things we like about the current market is that are no real bubbles. We've written about these along the way, here, and the criteria for a bubble here. We made one exception: Venture Capital (VC).

VC used to be about funding gritty start-ups and as soon as they were fledglings, kick them out of the private nest into public markets. But since around Facebook time, it’s been start them out as a gritty start ups, fund billions of dollars until the companies own 100% of their market and then kick them out to the unknowing punters on the street.

Yes, Lyft, Uber (taxis), Snap (photos) and Slack all bombed. Last week it was the turn of Peloton (down 18%) and Smile Direct (down 40%).

We don't think there’s a knock-on effect to the public markets. That's a good thing.

Bottom Line: Remember that oil price scare last week? It's  liked it never happened. Oil is back to where it was two weeks ago. Markets have big things on their mind but can't decide which direction to take. We'd say that’s going to go on for a while.

 Please check out our 119 Years of the Dow chart  

If we use too much jargon, check out our Glossary and let us know if we haven’t explained things. It will help make us better!

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Transcript of that call

“I wish I had never invented the labradoodle

 Artist: Sonia Delaunay (1885-1979)

  --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

RIP Robert Hunter - Birdsong

Fed dials it back

The Days Ahead: PCE inflation and home sales

One-Minute Summary The Saudi attack (see below), Brexit deadline, trade, the funding problem (also below) are all flashpoints. We know with some certainty that they lead to two things: 1) a general reluctance to hire, invest and grow and 2) a demand for safe assets.

Stocks were down 0.5% on the week. Fixed Income markets are back to where they were a month ago. The 10-Year Treasury trades at 1.72% compared to 1.5% at the end of August. We'd put most of that down to some large auctions combined with maturing Treasuries. So it does not change our view that bonds are expensive, but likely to stay that way.

We'd remind ourselves that, yes, stocks are up 19% this year but only up 2% over the last 12 months and 8% since January 2018. Even after the summer rally, 191 stocks in the S&P 500 are 10% below their 2019 highs. There is no exuberance in this market. More of a general caution and sitting on the sidelines

1.     Should we worry about the oil price spike? No. There was a large spike in oil prices on Monday after the attacks on Saudi facilities. Here’s the chart:

That's a 20% move and the largest one-day rise since the Kuwait invasion in 1990. Not surprising since the attack removed about 5.7m barrels a day of production out of a global total of around 90m. But there are a number of reasons not to worry:

  • This move only takes oil back to where it was in May and still 15% below year ago levels.

  • Saudi said it could repair the facility within 30 days, which sounds optimistic but…

  • They and the U.S. have plenty of stockpiled reserves, the U.S. at 664m and Saudi at 180m. So, that’s 150 days of supply. Other countries have their own stocks…as much as 1.5bn

  • The U.S. can quickly bring more oil on line; the number of rigs in place is 55% below what it was in 2014

  • The global economy is less dependent on oil than it has ever been. Here's the growth of the world economy against oil production.

In the last 46 years, oil production has grown 70% but global GDP has grown nearly 400%. That's a combination of service growth, efficiency and alternative sources.

The initial market reaction was for interest rates and the dollar to rally but 48 hours later, markets were back to where they started. The impact on inflation is negligible. Energy stocks rallied but quickly fizzled for a net gain of 0.8%. That’s noise.

So, no real worries on the economic front. On the geopolitical side? Well, “War in Iran” has been a Top 10 market risk for 40 years. We don't see it happening.

2.     Money markets went awry this week. Should we worry?  Sort of, yes. It all happened in the repurchase or repo market. What’s that? Say you own Treasuries. You need overnight cash. You sell the Treasuries to an investor (usually a bank) and promise to buy them back the next day. You have just entered into a “repo”. They’re a big deal in the money markets and the Fed uses them all the time to manage the money supply and bank reserves.

Normally this sort of plumbing in the money markets goes on smoothly and behind the scenes. The repo rate is more or less tied to the Fed Funds rate. But occasionally things go wrong. In this case, the story goes like this:

  1. Banks are sitting on a lot of reserves because of QE. Remember in QE a bank sells Treasuries to the Fed and receives cash in return.

  2. But these reserves are declining because the Fed is shrinking its balance sheet

  3. Their funding needs don't change but they now have less reserves.

  4. So, we have a situation where there’s less reserves but unchanged cash requirements. That puts upward pressure on overnight rates. But…

  5. Banks have plenty of Treasuries (caused by increased issuance) so can get liquid by entering into repos. Everything should work. Until…

  6. An unexpected cash need comes along.

  7. And it did in the form of i) tax payments due September 16 ii) a big settlement of maturing Treasuries and iii) Saudi Arabia selling down reserves as revenues from the facility attack fall (that last one is a guess…sovereign trades are pretty discreet). Which….

  8. Is another way of saying there was a temporary mismatch in demand and supply

And that's why repo rates hit 8% on Monday and Tuesday. Remember they normally trade around the Federal Funds rate, which was 2.25% then. So, 8% will get your attention.

The Fed stepped in with some liquidity programs for the next three days and all seemed quiet by Thursday. That’s all fine but repo rates are tied to the Secured Overnight Financing Rate or SOFR. And SOFR is the planned replacement to LIBOR, which is the rate to which loans, including mortgage ARMs and interest only mortgages, are all tied. If those loans were tied to SOFR (they're not yet but that's the plan) imagine if your ARM just shot to 10% from 3% overnight. See the problem? It’s more than just “oh, those banks being banks again.”

Here’s what it looked like (from NY Fed):

Trouble in money markets is like a “Get Out” moment for 2008 alum. We think the Fed is on top of it. Late. But on top of it. Our worry is that the weaker parts of the chain, like hedge funds and marginal lenders, may get hurt if this happens again. So, another reason to keep caution and protection to the fore.

3.     How was the Fed meeting? Anything new?  Well, they cut rates, which everyone expected. We've now retraced two of the four hikes made in 2018 and back to where we were last September. This was a “hawkish cut” as in, “we've given you a rate cut but don't expect more.”

That makes sense. On the “let’s have another cut” side, you have i) the prospect of trade really hurting the economy ii) low capital expenditure by companies and in real estate (the non-residential kind), iii) slow manufacturing iv) the yield curve and v) low inflation.

But on the “let’s hold” side we have i) robust consumer spending and ii) tight labor markets. The Fed can't really keep cutting on the fear that trade policies will disrupt the economy. We think trade is a problem but the evidence so far is limited. They've probably gone as far as they can on the worry about “uncertainty”.

It was a split decision with three dissenters. Two voted to not raise rates and one to lower by 50bp. Consensus is overrated at the Fed and split votes common. So, we’re not worried there.

The “dot plots” or summary of economic projections also came out. Here they are with the December numbers.

It’s a bit tough to read, other than all the dots are lower, but we’ll give you the highlights:  

  1. In December, they thought Fed Funds would be 3.2% for 2020. Now it's 2%.

  2. They thought the long-term rate, which is the “everything humming along nicely neutral rate” would be 3%. Now it's 2.5%

  3. No change in 2020 GDP; it remains at just below 2%

  4. Or inflation at 2.1%

We think they'll revise those down later in the year. It’s possible we may see one more cut in December but the talk over the summer that there would be three cuts this year are gone for now. The White House isn't pleased but the Fed’s holding its ground.

Overall? Markets did not react. This was all in the pricing. No changes to allocations or to our forecasts.

Bottom Line: We're going to sound like we never change our mind but, hey, the facts haven’t changed much. Markets are numb on the trade wars. We see five things that would send the markets 15% higher:

  1. Pick up in inflation

  2. Better economic data

  3. Trade confidence

  4. Brexit resolution

  5. Fiscal policy in EU

But you’d have to do one of those David Blaine feats to see any of those coming due soon.

Please check out our 119 Years of the Dow chart  

If we use too much jargon, check out our Glossary and let us know if we haven’t explained things. It will help make us better!

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Uber lay offs

Artist: Jacqueline Marval 1866-1932

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data

Peace Piece, Bill Evans

Touching zero

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The Days Ahead: Short week and jobs numbers.

One-Minute Summary: Market took on a lot. Again. The U.K. suspended Parliament pending the last round of Brexit negotiations. And if that sounds extreme and constitutionally questionable, it is. There was another attack on Fed independence. We think the Fed will weather it all but it's unsettling. Treasuries rallied again but this is very much part of a global trend. Stocks are up on the week but we’re writing this on Wednesday so time for more action.

Meanwhile, before heading out of the office for a break, this is a summary of all the stuff  that’s gone on

1.     Is the U.S. economy weakening?  Yes, partly through slowing manufacturing (because of trade uncertainty). Lower net exports (same). Durable goods (same). Business confidence (same). Housing and consumer spending are sideways. Consumer confidence good. The latest report yesterday showed a solid recovery from the government shutdown days:

That’s all good but consumer confidence is a flighty metric. It can turn quickly and remains well below pre-crisis levels. Neither does confidence always lead to action. So we don't expect retail, auto or other sales to take off.

Another sign the economy is in the not-great phase was the announcement that there were 510,000 fewer jobs in the 12 months to March 2019. Such revisions are normally in the plus or minus 20bp range. This one is 30bp. It means the BLS overstated growth by around 41,000 jobs a month. In 2017-18, monthly job growth was 203,000. In 2018-19 it was 209,000. The revisions put them at 168,000.

Bottom line: the job market was not as strong as the Fed thought. So another reason to ease up next month.

2.     Should we worry about Japanification? Not yet. This goes back to the property and stock market crash in Japan in the early 1990s from which Japan has never fully recovered.

From then to now, employment has grown from 62m to 67m, an average of 14,000 new jobs a month. Unemployment peaked at 5% and is now 2.3%. GDP growth averaged 1.2%. There have been seven recessions and numerous periods of negative GDP growth. Inflation has averaged around 0.6% and only occasionally jumped when the government raised VAT. Government debt has grown from around 100% to 225% of GDP. Bond yields are negative. The Japanese 10-Year Treasury bond hasn’t been above 2% in 28 years.

So Japanification is a constant battle against deflation and low growth. The Bank of Japan (BoJ) has given new meaning to loose monetary policy. They've targeted 0% for the Ten-Year and bought bonds for the last 20 years. The BoJ’s balance sheet is over 100% of GDP. The Fed is at 16%. They also bought real estate, stocks and ETFs. The Bank of Japan owns 70% of the ETF market and is the largest shareholder in Japan’s listed companies.

Could it happen here? Well, the demographics are better because we don't have Japan’s aging problem. The economy is certainly more dynamic. The credit and bond markets are deeper and highly competitive. The stock market is broader and with a wide range of investors.

Bottom line: So, no. But we’re facing slower growth and lower rates are not a panacea. As investors, it means we still see value in bonds, especially as the Fed loosens, and would expect stocks to maintain decent margins and growth.

3.     Are bonds expensive and stocks cheap? Not yet but it’s beginning to look that way. When bond yields fall it’s meant to help kick start the economy. You know, get all those borrowers on the sidelines moving. The trouble is that a drop from, say, a 3.25% to a 3.0% loan makes precious little difference to the IRR of an investment project. For a house buyer thinking of a $200,000 30-year mortgage, it’s a difference of $28 a month. Hardly an attractive margin.

Lower rates make equities look attractive. First, the discount rate applied against future earnings is lower, which raise the present value (price of the stock) without anything else needing to change. Second, dividend yields now exceed 10-Year Treasuries by about 40bp. The green line here shows the difference between the two. When it’s below 0%, stocks yield more than bonds.

In the past, that seems like a reasonable entry level. Another measure is the earnings yield (explained here), which also suggests stocks are not expensive.

But the reality is the last four weeks have caused tremendous strain with plummeting bond yields, incoherence on trade and economic policy, a Renminbi fixing, a Fed under pressure and political crisis (looking at you U.K. and Italy) all to the fore.

Bottom line: U.S. stocks not overvalued. 

Bottom Bottom Line: As we mentioned last week, markets are becoming numb on the trade wars. We have a month before the Fed (almost certainly) reduces rates. Bonds are rich, for sure, but likely to stay that way.

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How low bond rates hurt pension funds

Artist: Barbara Rossi b1940

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

 

Bond bubble? No.

The Days Ahead: More on talk about trade and tax cuts but we don't expect anything significant.  

One-Minute Summary You know how it goes. The market picks itself up from Arctic real estate deals and creative policies from the Administration and then….one of these comes along:

We don’t need China and, frankly, would be far...better off without them. Our great American companies are hereby ordered to immediately start looking for an alternative to China

Ordered? Did he? Will he? Can he? The U.S./China trade in goods and services is $910bn or 4.2% of GDP. A 25% reduction would put the U.S. economy into recession. After the close, the USTR raised tariffs again, to as much as 30% on consumer goods and another 5% across the board.

And that was enough to take 2.8% off the S&P 500. By close, all but 12 S&P 500 companies and 29 of the 30 Dow companies were down on the day.

The Fed came through with a speech from Chair Powell spelling out that trade was the single biggest challenge to the economy. Just to emphasize he added “We have not seen unsustainable borrowing, financial booms, or other excesses…” All that points to a 25bp cut in November.

The FOMC minutes said the same although there was more dissention than previous meetings. We’re not worried about that. Richard Fisher, the Dallas Fed President and FOMC member in 2008 and 2011, voted against lowering rates in every meeting he attended. No one really cared.

Stocks were down on the week but that was all due to Friday’s action. Bonds and international markets were mostly unchanged but had the advantage of closing before the tweet.

1.     How are European banks doing?  Not well. European banks and financials remain a very large part of any European stock market. Around 21% for the Eurozone as a whole. It was larger but European banks took a big hit in the financial crisis. In the U.S. banks used TARP to remove bad assets (which for a bank means non-performing loans). They also consolidated.

But in Europe, the 2010 crisis extended the maturity of many of the bad loans. That meant, unlike the U.S., banks kept the bad assets. They then had to raise capital to stay in line with new regulations. The mix of more capital and bad assets meant profits and returns plummeted. So did the share prices.

Here's the chart (look away if you're long European banks):

The bottom line is that if you put $100 into European banks 30 years ago you would have $68 today. There have been a few short-lived rallies, such as 2017, but nothing sustainable.

European banks now face two problems. One, a central bank at zero rates and two, a very competitive landscape. Zero rates mean that deposits pay negative rates and any loans made at narrow spreads. And for competitors, many, like the Landesbanks in Germany, are state owned and don't care about profitability.

So, pity the European banks. The only way out is to find other sources of income, like fees, credit cards or investment management. Most tried and failed. If the ECB cuts rates more, the banks make even less money. If there’s a recession, and Germany just reported a negative GDP quarter, the bank’s credit losses soar.

The stock market is ahead on this. You could buy nearly every (not just one) major European bank, for half a Facebook and have change left over. It’s an object lesson that low rates can lead to a failing banking industry. The same is true in Japan. We've dialed down European exposure this year already.

 2. Are bonds in a bubble? No. Yes, 10-Year Treasuries are at 1.5% and the ETF to track Treasuries we use was $99 last fall and is $113 today. So, tidy profit. But to have an asset bubble you need some conditions:

  1.  Leverage: cheap, available debt to buy the asset of choice.

  2. Extended valuations: where prices far exceed their intrinsic value

  3. A story: something new, a hook, to keep new investors coming

  4. FOMO: a “fear of missing out”

  5. Euphoria: we’re all going to get rich

  6. Panic: big liquidations and no new buyers

Now, do these exist in bonds and more specifically Treasuries?

  1. Leverage: some companies, especially in the High Yield and BBB space are taking on cheap debt. But no one is really leveraging to buy Treasuries (leave aside swap markets for now)

  2. Extended valuations: some companies sit on some cheap debt especially the casino, oil and gas markets. But Treasuries? No. The yields are historically low for historically good reasons

  3. FOMO: anyone buying Treasuries is buying safety and real yields. They’re not buying to get rich

  4. A story: none. There’s no talk of a “paradigm shift”, “making the world a better place” or “disruption”. It’s more a savings pool looking for predictability.

  5. Euphoria: quite the opposite. Investors are buying because they’re liquid, risk-off havens.

  6. Panic: none

The U.S. 10-Year Treasury is not alone. Here’s a chart showing the 39 year grind to low rates for all major sovereign borrowers:

We would argue that rates will remain low, as in under 2.5%, for a while. Why?

  1. The U.S. economy is slowing for cyclical and secular reasons. Sure, a tax hike may bounce it higher and trade wars will certainly push it lower. But this is a 2% economy.

  2. Central banks are very dovish.

  3. There’s no fiscal demand anywhere

  4. Inflation may have occasional burps from oil but the trend remains low

  5. Trade wars have everyone on edge

  6. The trend to lower real interest rates has lasted decades and likely to continue as reverse. You know we’re fond of long-term charts so here’s inflation and real rates for 100 years.

That black line is real yields, or the nominal 10-Year Treasury less inflation. It’s been around this level for 20 years. But during that time, inflation has clicked along at a metronomic 2% for even longer (h/t John Authers and Robin Harding).

So put it all together. We're not in a bond bubble. Bonds merely reflect expectations for low growth and uncertainty. If we get a trade deal, a hike in wages and a rise in core inflation, then, yes, bonds could reverse up to 2.5% or 3%. If…

3.     Recession watch, any update? Not really. We had a preliminary PMI report for manufacturing below 50, which means more respondents saw output contracting than expanding. But these are preliminary numbers and track below the ISM equivalents (h/t Cameron Crise). And we knew about the woes of the manufacturing sector. We saw updates on existing and new home sales, both unchanged year over year.

Inspired by a WSJ article via the folk at BMO, we looked at some of the debt overhang with consumers, especially student debt. 

It shows different types of loans that are 90-days delinquent. At the top are student loans at 11% and mortgages at the bottom at 0.9%. We're not concerned about defaults crippling the rest of the economy. It’s just that graduates with debt tend to postpone buying houses, building homes, marrying and having children. Or to put it bluntly, their peak spending years never happen.

Another reason to believe the economy won't respond much to lower rates.

Bottom Line:  The Fed and other central banks will do all they can to keep rates down and ready to cut further if there is more trouble on the trade side. Markets may become numb on the trade wars, which makes sense because they've had two years of high tension. And you get tired from that. Still, we’re in the cautious and defensive camp for risk assets.

Please check out our 119 Years of the Dow chart  

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Don't store $ on a Starbucks card

Artist: Faith Ringgold b1930

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

 

Dusty recesses

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The Days Ahead: Fed minutes and lead up to Central Bankers’ Jackson Hole meeting

One-Minute Summary: Trade talks took a welcome break from the news last week as investors’ confidence in a settlement rose.

No, no, no. We'd like to write that one day and our guess is we probably will. But for now it's trade and economic policy on the fly. If there’s a grand strategic plan, please let us know.

Argentina kicked off the week with the crushing of the reformists and likely reelection of the disastrous Peronists. Emerging Markets bond funds were particularly hard hit.

We'd summarize the trade talks as the U.S. blinking. The good news is that the 25% tariff on the $300bn of consumer goods will take place in December, not September. Full list here. That was good news for the likes of Apple and chipmakers like Micron, Qualcomm and Roku and for the wider market. The tariffs are showing up in inflation. Prices for things like appliances, furniture, auto parts, flatware and lighting are up 4% more than the broader CPI. They're likely to continue to do so. Average tariffs with China have risen from 3% in 2017 to 21% by December 2019. It's going to show up in inflation, lower wages and  lower corporate margins.

There’s really no good news in the tariffs. Rolling them out slowly is better than all at once. But this issue will hang over markets for a while.

Market reaction was predictable. We had intraday swings of over 1% every day with a net loss of 0.9%. We're down 4% from the ding-dong highs in July but up 15% for the year. Bonds had another strong week with the 10-Year Treasury at 1.5% and the 30-Year Treasury below 2% for the first time since its launch in 1977. It’s been a good year for bond and particularly Treasury investors.

1. What's with the inverted yield curve?

We've talked a lot about the inverted yield curve over the last few months. A few years ago, curve inversion was the talk of the geeky corner of Fixed Income desks. Interesting in a technical way but not great predictors of wider events. Now it’s gone mainstream. In the last big yield curve inversion in 2006, when the inversion was nearly 100bps, the New York Times mentioned it a total of 20 times. Last week, the Treasury 2s/10s inverted briefly. It mentioned it 80 times.

The 2s/10s was almost the last one to invert. The more important 3m/10 year inverted back in March. So here’s an update of our thinking.

Do other countries have inverted yield curves?

Yes. Germany, Japan, France, U.K., Switzerland and Australia

Is the inverted curve a recession indicator for them? Are they in recession?

No and no.

Is the inverted curve a good recession indicator?

Erm…not really. The curve has inverted 7 out of the last 9 recessions. But its timing is lousy. It can be up to two years early, which is not helpful, and it gives false signals.

Does it cause recessions?

No. The fact that short-term rates are higher than long rates usually means the Fed is behind the market in rate expectations. Low confidence, inflation and, critically, unemployment cause recessions (that’s over simplifying, we know).

Could this time be different?

Yes. Rates were much higher in past cases. In the 1950s the 10-Year Treasury averaged 4.5%, in the 1970s 8% and 1980s 9%. Now Ten-Year rates are around 1.5%. The absolute level does matter. The Fed also all but ignored past inversions. They're paying attention to this one and likely to do something.

Are there better recession indicators?

Yes. Debt service, claims, employment, housing sales and starts, hours worked and consumer confidence.

Are they indicating a recession?

No

So what now?

We know the economy is slowing. Trade, manufacturing, housing, consumer confidence have all stopped rising but they're not falling much either. That doesn't mean “all clear” and data can deteriorate quickly. But we’re well positioned for the slowing growth.

2. “Is this the end of the bull market?”

Is what you would have heard tuning into, well anyone, last week. But wait, what bull market? Bull markets have exuberance, irrationality, quick wealth, swapping jobs to day trade. You know, moron stuff. But this bull market is a decidedly dull affair. Take a look at the following:  

That’s a nice chart, no? Up from 700 or so at the 2009 bottom and now 2850, or +256% growth. But a few points:

  • The market fell from 1600 in 2007, so the return from then is +41%

  • The snap back from the bottom to mid-2015 was +105%

  • Then the market went sideways for a year and rose +36% from mid-2016 to January 2018.

  • Since January 2018, the market has done precisely nothing (excluding around 4% in dividends)

And finally, the rolling 5-year return is a healthy 10% but the rolling 20-year return is 6% (see below)…respectable but not a bull market.

What we've really seen in stock since late 2016, is a one-off adjustment for lower tax rates. All things being equal, the S&P 500 corporate tax rate dropped from an effective 28% to 18%. Corporate taxes now bring in around $800bn compared to $1,600bn in 2016. Put the stock market multiple of 17x against that, net out dividends, and you're at around the increase in total stock market capitalization since then. So, it's a straight transfer of tax revenues to shareholders.

This is all to show that we’re not in a bull market and haven't been for nearly 20 years. What we've been in is an extended sideways market with some upward trends. Beating inflation, beating bonds, beating international. But also settling into flat trends for long periods. We're in one now.

We expect it to break upwards and there will be short-term corrections. But it’s not a bull market.

3. Is a rising stock market good for everyone?

No. The general opinion is that a strong stock market is one of those rising tides, all boats things. Everyone benefits. It all rests on the wealth effect theory. People feel wealthier because of strong house or stock prices. They feel more confident. They buy more stuff. The trouble is that the top 1% of earners own 38% of the stock market. And 50% of all families own less than $54,000 in stocks. That upper group, the 1%, have a “low propensity to spend”, which is another way of saying, they look at the stock market and say “meh…what’s for dinner?” They don't adjust their spending one iota.

Anyway, courtesy of an old friend of the firm, David Ader, here's an update on the number of hours the average guy needs to work to buy the S&P 500.

It’s bounced around for the last two years but remains high by past measures. So what? It simply says the average worker has to work a lot to keep up with stocks. And the wealth effect is irrelevant for most people.

Bottom Line: Stop-start and bluffs on trade. We used to think Presidents’ had little effect on markets…more just stay and keep out of the way. This is, well, different. Companies seem to be keeping a cool head but we’d stay defensive.

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T.E. Lawrence 131 years old today

Google maps pictures

Artist: Euphemia Charlton 1885-1969

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Ten Years After

Market Corrections – here we go again

Market Corrections – here we go again

We're not minimizing the concerns around market corrections. We've seen the market drop by around 6% in recent days although we’ve had a bounce and they’re now down 3.3% from record highs at the end of July.

We think this is all down to the trade, slowing economy and not-so-great news coming from overseas. One thing we do know is that small corrections are frequent and part of the pattern of stock market investing. We've also seen this before.

Take a quick look at the table below. In all the corrections going back to 1970, most market dips have seen quick recoveries.

So the message is, whatever today’s cause for stock market weakness, dips happen and happen often. You just don't need to react to them all.

  --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Once a jolly swagman

The Days Ahead: NFIB will tell us how small businesses are doing

One-Minute Summary Political interference in the markets reached a new high last week. We go into further detail on the Monday sell-off below. By Friday, the latest twist was that the Administration said Huawei, the Chinese 5G company considered a security risk, was still not approved…but could be if there is a trade deal. So the normal off/on again. For the week, the market was down 2.5% but at one point was down 6%. 

We’re not concerned about stocks. Most of the moves are in normal ranges. There was a spike in volatility as measured by VIX but we’re skeptical of its reliability as a risk measure and don't feel it warrants much attention until it gets into the high 20s and stays there.

Bonds had a remarkable week with the 10-Year Treasury trading as low as 1.64% and the 30-Year Treasury below the Fed Funds rate. It’s only done that four times in 40 years and a rate cut normally follows. That alone puts a September rate cut back on the table. And keeps us invested in Treasuries.

Other central banks also cut. India, New Zealand and Thailand. The U.S. remains the high interest economy (all relative!), which is why we don't see much relief on the dollar or big downside on bonds.

1.     Trade wars easy to win? If you target a single number and outcome, and in the U.S. case it’s China’s exports, you have to be prepared for retaliation and consequences. It came on Monday when this happened:

There’s a long history of the Renminbi and the U.S. dollar. Some 20 years ago it was at 8.0. Then, with years of growth, exports and surpluses, it appreciated to 6.0 (it goes backward in the FX world). At that point, China began to accumulate U.S. Treasuries, with meant selling Renminbi, and it depreciated to 6.9, which is where it's been for most of the last three years. During most of that time, the Bank of China (PBOC) regularly intervened to stop the Renminbi weakening.

Why would it weaken? Because of capital flight and the necessary buying of U.S. Treasuries from trade surpluses. China is still the world’s largest holder of Treasuries at around $1.2 trillion.

On Monday, it drifted past 7.0 for a depreciation of about 3%. You don't really get a 3% currency move in a liquid market unless someone wants that to happen. So, yes the Chinese stepped aside and let the currency find a proper clearing level. And yes, it was a move directly tied to the tariff threat. As was the Chinese government’s decision to stop buying any U.S. agricultural products.

We'd say the currency move is not that important by itself but tells us:

  1.  China is willing and able to retaliate

  2. China can shift some of the tariff damage around to other countries

  3. We may see more capital flight from China to the dollar

  4. It will accelerate the trend of a lower China-U.S. trade imbalance, down $18bn from a year ago, to a higher “All-Other-Countries’” – U.S. trade imbalance. Deficits with Europe, Mexico, Japan and others are up $55bn from a year ago. 

Later on Monday, the U.S. Treasury declared China an official currency manipulator. This is a completely meaningless gesture as all it does is push the issue over to the IMF. Who won't and can't do anything. In effect, the U.S. Treasury is saying “Hey, China, you kept the currency from depreciating all this time. You stopped. Can you please restart?” Yes, bonkers, I know.

By Friday, things had settled down a bit. We think China will keep the rate around 7.05 and we won't see any major disruptions. But it shows that there are many rounds left until the trade war is “won.”

2.     That bond rally…can't last can it? Oh yes. We like long term charts around here. It often helps to take a headline “this has never happened before” and tell us, that, well, yes it has and it's not that surprising. Let's look at the 10-Year Treasury since the beginning of the end of the great inflation era.

For 35 years, we've seen a bond bull market. Indeed if you’d bought a 30-Year Treasury in 1982, held it until maturity, you would have probably beaten every other asset class. There’s an obvious trend here. Yields have fallen and since 2009 have bounced between 3.5% and 1.5%. If they cross a moving average (here at 100 months and 200 days) they tend to keep going for a while.

So what would make it change? Well, for higher rates, say 4% on the 10-Year, we'd have to see:

  • Higher inflation, well over 2.5%

  • Higher growth, over 3% consistently

  • Other Central Banks increasing rates

  • Global growth

  • More fiscal response from surplus countries (looking at you Germany)

  • Strong growth in U.S. housing, spending and borrowing

  • Higher oil prices

But we don't see any of those. And we’re late cycle. So, we'd prepare for another long period of trading in the same range. And at the bottom of that range for the next few months.

3.     Are defensive stocks the answer? If you can find them. When markets crack, there’s usually a move into the fear or safety trades. The classic examples are Treasuries, gold, the Yen and the Swiss Franc. They all were up last week but nothing like what they did in 2008. So, the fear level seems contained.

In the U.S., the defensive stocks are usually real estate, utilities and consumer staples. The first two are bond proxies. Staples are just what you have to buy regardless of economic conditions. So far so straightforward but the problem is that there are fewer defensive stocks around:

Thirty years ago, defensive stocks were 25% of the stock market. Five out of the top 10 companies were defensive stock. At the height of the dot-com, they were less than 10% and there were no defensive stocks in the top 10. Today it’s 12% and, again, none in the top 10.

We wrote about this a year ago and it meant that, in our view, the market was more vulnerable to a correction. We're in some defensive sectors, such as Aristocrats and Berkshire (it has $122bn or 25% of its market value in cash).  We'll keep it that way for now. But remain wary of overpaying for defensives.

Bottom Line: We started to lighten up on international. The dive to lower rates won't help economies until the trade issues look clearer. It's a real-time experiment in game theory without the rationality. So caution remains.

Please check out our 119 Years of the Dow chart  

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FedEx and Amazon part company.

Artist: Eileen Agar 1899-1991

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

Market Outlook: 2019. Video version

Click here for our take on markets and economy for rest of 2019

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5.50 Fixed Income

7.13 Stocks

11.14 Federal Reserve

20.20 Fed in 2020

20.30 Europe

28.00 Volatility

31.00 Brexit

50.00 Yield curve inversion

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Tariffs spoil the party

The Days Ahead: Light economic calendar. Focus on Germany and Japan.  

One-Minute Summary Things were going so well. Until Thursday when a tweet appeared saying that the China tariffs were back on for September. Guess when the tweet went out?

Now, there’s a story going round that goes like this:

  1. The Fed cut but, in the Administration’s view, not enough

  2. The Fed uses employment and inflation to set rates except…

  3. On Wednesday, the Fed said they cut because of the “implications for global development”

  4. The Administration controls trade tariffs and “global development”

  5. Higher trade tariffs cause more concern and a slowdown

  6. The Fed cuts more

  7. Administration gets its way

Who knows? But it worked. The 10-Year Treasury rallied on Thursday and stayed at around 1.86% on Friday.

We still think a China trade deal will happen but perhaps the tactics are to delay. Or provoke more? Markets were a little complacent in the last few months. After all, trade is slowing, and leading indicators like airfreight, rail movements and shipping containers have all trended down. Trading in August always over reacts so all this may calm down.

We'll continue our defensive strategy. We're likely to trim anything to do with Asia Pacific and return assets to the U.S.

1.     Did the Fed surprise anyone? No. On Wednesday, the Fed announced a 25bp lowering of the Fed Funds rate. That was as expected a few weeks ago but, as always, the market overreached itself and wanted more. This was the first cut in the cycle since September 2007. That’s nearly 12 years. Remember the average Wall Street trader has been in the business for 8 years and the average portfolio manager in place for 10 years. This is the first cut many have seen.

As we've discussed, the economy has slowed but not stopped. Employment is fine. Most consumer activity is fine. So why the cut? It’s all about worries that trade is holding corporate confidence back. And about the lack of inflation.

Here’s what the move looks like (Federal Funds rate in yellow):

The only times that remotely look like 2019 were the mid-cycle cuts in 1995 and 1998. The 1995 cut was from a much higher level, when Federal Funds had doubled in 15 months and with two quarters of weak growth. The 1998 cut was all about the fallout from a hedge fund called LTMC (here’s the full horror story). So both were insurance cuts as in “things aren't too bad, but they look like they could be, so here you go.”

So all pretty much expected. The key parts of the announcement were:

  1. Two governors dissented. That’s more than usual and in the collegial Fed, it’s a problem

  2. Chair Powell talked about a mid-cycle “adjustment” not a “lengthy cutting cycle.” This means he’d like to be done.

  3. The run off in the Fed’s balance sheet will stop. Since late 2018, it’s declined at an annual rate of 12%. That means more Treasury buying as bonds mature.

Initial market reaction was a yawn for the long end, so 10-Year Treasuries barely moved, but a spike in the 2-Year Treasury from 1.80% to 1.96% (that’s a big move in the Treasury world). And that meant, of course, a flatter yield curve. Stocks sold off. They wanted more.

On Thursday, however, the 10-Year moved down to 1.89%, equivalent to a 1% price change. That was down to a tweet announcing an initial 10% tariff on the $300bn of trade not yet subject to tariffs. The price action was probably overdone but it confirms our confidence in Treasuries.

But putting this all together, we’re probably done on the rate side for a while. Unless the growth really deteriorates between now and late fall, or inflation drops, we think rates will stay where they are for the September meeting.

2.     Aww, come on. This is something you don't see often.

That yellow line is the yield curve of the German Government Bond market (Bunds). It’s not also inverted (that's old news) but it’s entirely below zero. So if you buy a 6-month bill, you will receive €996 in time for the Holidays. If you buy €1,000 of a 10-Year Bund at par, you will receive €950 in 2029. And if you go all in and buy a 30-Year bond, you will receive no coupon and your €1,000 back in 2049. With a big thank you from the German government (h/t FT Alphaville).

There seems no end to the era of negative and zero rates. For us, this points to very mediocre growth in the world’s fourth largest economy.

3.     Update to our South Korea story.  Japan took South Korea off the “white list” of preferred export markets. This means the vital raw materials for chip production won't find their way to South Korea easily. The Korean stock market was an ocean of red on Friday.

4.     How about the employment report?  Normally a headline grabber, but this month’s employment report was overshadowed by trade tweets. The headline number was in line. This is how it looks:

  1. But all was not good. Here's a quick take:

  2. Downward revisions of 41,000 for the prior two months.

  3. The three-month total is down to 421,000 from 521,000 earlier this year.

  4. No dent on the underemployment number or…

  5. Average hourly earnings

The market had other things on its mind. But this shows slowing but not stopped job creations.

Bottom Line: Some caution is needed. Bonds have rallied fast and far. The economy is not going to respond to lower rates. International has had a good run this year and it's perhaps time to take some money off the table.

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Uber layoffs

We’ll start attributing the art in the blogs. This week:

Art: Elaine de Kooning (1918-1989)

--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Chumbawamba - Tubthumping

The U.S. earnings machine.

The Days Ahead: Earnings with Apple on Tuesday close. Fed meeting.

One-Minute Summary Good earnings week. The ECB committed to lower rates. They’re worried about the lack of inflation and slower growth. They should be. Government bond yields of six major economies in Europe are negative. There isn't a single country in Europe that pays more than a U.S. Treasury. That includes Greece, Italy, Spain and Ireland, all given an undeserved acronym a few years ago. European markets were up around 1.3% with Germany leading the way.

The U.K. got its third Prime Minister in three years. Boris Johnson was elected by the party, not the country with a mandate to exit the EU by October 31st. Despite his bluster, we'd put the odds as follows:

60% - Prolong the negotiations

10% - Hold another referendum

10% - Hold an election

20% - No deal exit

We've been out of the U.K. since 2016 and see no upside in equities or sterling.

The S&P 500 hit another record high. It's now up 21% for the year but, lest we forget 2018, up 6.5% over 12 months and only up 10% since January 2018. As we've noted, the market is not expensive and lower rates help valuations.

The dollar continues to strengthen. That’s bad for Emerging Markets and good for inflation. The Administration came out on Friday to say they would not try to intervene in the FX markets to drive the dollar lower. We'd stress that the Fed has no mandate or public view on the dollar. That’s the Treasury’s job. If they want to weaken the dollar through intervention, it would take massive cooperation with other central banks to make that happen. It won't. 

1.     How’s the trade war going? No not that one. That one is all about “talks are going ahead, not going ahead” and which bureaucrats are in Beijing this week. No, there’s another trade dispute between South Korea and Japan. And it’s getting quite serious what with one country evoking “national security” issues to stop trade. It’s what the Administration said about steel tariffs last year and is a time-honored way to dodge Article XXI of the GATT.

So, what’s it all about?

 It goes likes this:

  • In 1965, South Korea and Japan signed the Treaty of Basic Relations and agreed on war reparations. All claims were“settled completely and finally”. However, South Korean courts ruled it applied only to governments, not to individuals. So victims of forced labor could still apply for compensation.

  •  Japan disagreed and asked for arbitration. South Korea refused. In late 2018 the Korean Supreme Court said it was ok to confiscate Korean assets of Japanese companies to repay victims. So the stage was set. Meanwhile…

  • South Korea is the world’s third largest supplier of memory chips. Two Korean companies, Samsung and SK Hynix, make 70% of the DRAMs used for temporary storage of data so your smart phone, PC and servers work. South Korea also makes 50% of NAND chips, used for storing photos and videos. Unlike DRAMs they don't need power to retain data. In memory chips South Korea has 60% of global revenue.

  • To make memory chips, you need specialty chemicals (fluorinated polyamide, photoresists and etching gas, since you ask). Japan is the leading producer of all three.

  • Japan exports stuff to South Korea on a “white list” basis, which means Japanese companies don't need an export license. Japan has said it intends to remove South Korea from that list. That would require a lengthy bureaucratic process for companies to sell to South Korea. The reason they gave was that some of the chips made their way to North Korea. But no one’s really buying that…it's  a good old fashioned tit-for-tat.

  • In the world of highly complicated supply chains, we now have the prospect of South Korea unable to produce semi-conductors. And to add more knock-on effects, 25% of South Korea exports go to China. They fell 24% last month. Prices for semi-conductors also rose 12% in the last few weeks as smartphone, PC and computer companies scramble to keep their supply coming. If this isn't settled expect price increases.

So all a bit of a mess. Right now, both countries are at the WTO in Geneva trying to sort it all out.

We've gone into some detail here because we think this highlights two things. One, that a small change in supply chain logistics can have far-reaching consequences. Two, that South Korea is a highly important conduit to world and Emerging Markets trade. If it’s not doing well, chances are that most of Asia isn't either.

Recent trade between the two countries is down 12%, which is rare outside a recession. Last week, the Bank of Korea cut rates for the first time in three years. We think South Korea is a very good bellwether for Emerging Markets. This recent news isn't helping.

2.     How’s U.S. GDP? Slowing but not bad. Second quarter GDP rose by 2.1%. The first quarter was 3.1%. Most people were expecting more but there were some outliers. Nondefense government spending rose 16% and consumer expenditures were up 4.3%. It’s the last one that's important because the U.S. consumer accounts for 69% of GDP. So nice beat and here it is:

So why is the Fed easing?  Because the corporate sector is hurting. Inventory wind down detracted 0.86% to the 2.1% growth and net exports another 0.63%. Without those, GDP would have risen 3.6%. Investment in non-residential structures (so, retail, offices, plants etc) decreased at a 10% rate.

And that's the basic story. Personal side and government ok…anything to do with business, manufacturing, capex, not ok. The Fed is trying to help the latter to keep the whole thing going.

Meanwhile, the Fed’s chosen measure of inflation came in lower than expected at 1.8% and Q1 was revised down to 1.1%. That also gives the Fed the reason it needs to cut next week.

3.     How are earnings going? Well. Earnings are lower than last year but we've had some monster beats by some very large companies. Of the top 10 companies, seven have handily beaten estimates. And not through EPS manipulation. Amazon, Microsoft and Google showed between 12% and 19% revenue growth… remarkable for three out of four of the world’s largest companies. Nearly half of the S&P 500 companies have reported, showing average growth of -2.6%. Three quarters have “beaten” estimates.

As expected, those companies with overseas sales have underperformed those with a U.S. base. Mostly in the tech, materials and energy sectors. But investors expected that so we’re not seeing big revisions down. 

Bottom Line: The Fed will lower rates. We'll watch for any language that may hint they’d go more than 25bp this year.

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Why your TV looks worse than the demo models in shops

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Lowdown

A slip of the Fed

The Days Ahead: ECB meeting…will probably announce a cut

One-Minute Summary Stocks were off less than 0.6% over the week. They were down 1.5% mid-week but good results from index heavyweights like Microsoft, JP Morgan and Phillip Morris all reported good numbers.

The economic data was mostly in line with expectations. Retail sales ahead, consumer confidence fine, housing starts and industrial production slightly below. No great dramas. But the Fed governors kept up the dovish talk with three leading voters implying rates could go lower than the 25bp cut already baked into prices. There was an unusual gaff from Governor Williams who said:

“If inflation gets stuck too low — below the 2% goal — people may start to expect it to stay that way, creating a feedback loop, pushing inflation further down over the longer term and it pays to act quickly to lower rates at the first sign of economic distress.”

Ok clear enough. Jump on rate cuts if inflation is running low. The 10-Year Treasuries dropped 4bps and the expectations for a 50bp cut went from 39% to 51% immediately. But then the New York Fed said, er, no, he didn't mean that.

“This was an academic speech on 20 years of research. It was not about potential policy actions at the upcoming FOMC meeting."

And bonds gave up their gain and the probability promptly fell to 20%.

Now we know the problems of reigning in the opinions of 17 regional governors and board members. But can we please get this straight? The market is reacting to every comment as if it was guidance and they are not all on the same page. Thankfully, there’s a blackout period next week pending the July 30th meeting.

All that Williams stuff meant gold had a run of 3.5%…it tends to do well if rates go to zero for the simple fact that a zero yielding asset looks better. But it didn't last.

1.     How’s small cap doing?  Could be better. We like to use the S&P 600 as our small cap benchmark, not the Russell 2000. It’s less well known but has a quality bias, which we like. The main differences are that the S&P 600 i) is slower to include IPOs ii) company must have four quarters of net income (so no tech companies selling $1 bills for 80 cents) and iii) no multiple share classes (so no companies where founders retain control with minority positions). The S&P 600 has comfortably outperformed the Russell 2000 over long terms but the Russell is easier to trade and gets most of the headlines.

Which brings us to this.

Small caps have underperformed since mid 2018

This shows the Russell 2000 compared to the S&P 500 over the last five years. An up line means small cap has done better. A down line means large cap has done better. Even if you’re not into charts (h/t Cameron Crise) you’d notice small caps have had a rough time recently, trading at the bottom of their 5-year range. They're still up around 15% this year but not as much as the S&P 500 at 19%.

Why?

  1. Small companies aren't cheap. The S&P 500 trades at around 17 times earnings. Small companies at 48 times.

  2. They've been harder hit with tariffs. Though they only have around 16% of sales overseas compared to the S&P 500 at 40%, they have less room to work around or avoid tariffs.

  3. They also don't make as much money. In the list we scrubbed, 614 out of 1861, or 32%, were loss making, compared to 5% for the S&P 500.

  4. The tax cuts were kind to small companies last year but that effect has worn off

We'd say that the small company sell off is overdone. These are fiendishly difficult timing calls but we’d look for some relative outperformance if the macro data improves.

2.     How’s business dealing with the trade issues?  Not well. We came across this report from the U.S.-China Economic and Security Review Commission about how some companies are trying to work around tariffs. Basically, it's hard to do without very deep pockets. Currently, more than 90% of Apple’s products are produced in China. It probably has the most entrenched supply chain in China of any manufacturing company, and it's going to take them 18 months to move 20% of production to India and China.

So, if it’s hard for Apple, it was no real surprise that in the latest Beige Book, a survey of companies in each of the 12 Fed districts, that uncertainty, tariffs and trade were cited 37 times. We'll admit this is not the most scientific method to measure concern but this compared to 31 times a year ago. So companies have had this looming over their heads for quite some time.

The overall message is “modest” growth and widespread concerns. Which is the same story coming out of the earnings reports.

3.     How’s the recession watch? Close but not there. We've talked about the Dow Transportation index as an indicator of goods moving around the country. One of the measures is “inter-modal” traffic, which simply means a container moving from ship, to rail to truck without any handling of the freight inside.

So, anything going on?

Freight volumes falling

This shows the one-year change in freight ton-miles (the weight of a good multiplied by how many miles it’s moved) and a broad freight index. Both are down, by 14% and 0.2%. That's more than normal for a pre-recession period.

Last week CSX, one of the four pure-play railroads in the S&P 500, reported. It runs freight rail up and down the East Coast and over to the Mid-West. Their CEO had some interesting points on the earnings call and this caught our eye:

 “The present economic backdrop is one of the most puzzling I have experienced in my career…many of our industrial customers’ volumes continuing to show weakness with no concrete signs of these trends changing…[and we] are seeing a range of conflicting data points and economic indicators…”

We looked at FedEx a few weeks ago and that’s shown weakness in volumes and revenues. We also looked at the Los Angeles port traffic where the basic story is that volumes have fallen steadily since last October.

None of this is a surprise. It’s linked to uncertainty, manufacturing and trade. The concern is that the slowdown might spread. But meanwhile, jobless claims are around the 200,000 to 220,000 range, down from recent highs in the January government shutdowns. So nothing to see or worry about.

Maybe the Fed is on to something with this “insurance” cut?

Bottom Line: Full blown earnings reports coming up. ECB meeting will probably confirm the easy stance. The U.K. will get a new Prime Minister and more Brexit purgatory. Oil may come under renewed pressure but it will be short lived. Stay invested. We're quite defensive already so no major changes to portfolios.

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“In all honesty, profitability is not one of our metrics”

 --Christian Thwaites, Brouwer & Janachowski, LLC

Art work is Burghers of Amsterdam Avenue 1963, by Elaine de Kooning

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Maconi Union - Weightless 

The Lawyer's Financial Stages - Stage 1 - The Early Career

We work with many associates and partner attorneys in large firms. There is often a professional and financial lifecycle as lawyers progress. Here’s what we see:

Early Career: Congratulations! Graduating fresh out of law school and passing the bar exam is an accomplishment. You start at a leading firm in a practice you always wanted. Starting salaries are generous and there are usually annual bonuses of up to 30% of base. Expenses are high. Some of that is setting up a new house, often with a new spouse, and becoming familiar with regular household expenses. Housing, travel and food expenses can run as high as 50% of income (more if you’re in New York, the Bay Area or Washington).

And there’s one big and often intimidating expense. Yes, student loans. It’s best if you can consolidate these (but be careful you don't run afoul of the community property commingling principles) for nothing else than ease of repayment. You may also pay a lower rate.

Start with the basics. Create a budget. Stick to it. Start saving some cash reserves. Three months of expenses is a good number to start with. That’s mostly so you can pay for emergencies or any time off work without having liquidate investments.

Set up a low cost investment savings account. Use ETFs or low cost index funds. Invest $100 a month. Saving $100 a month at a 5% return can grow to $80,000 in 30 years and $192,000 at 10%. So save more if you can. Get into the habit of “paying yourself first”.

You’ll never miss $100 but it can grow considerably with time. If your firm offers a 401(k), invest as much as you can. It's a gift from the IRS and they are not in the habit of gifting. Do not borrow from your 401(k).

Investment and saving success is about time, discipline and patience. You may get Facebook at $5 and retire early. Or you may get Yahoo at $125 and retire late. But with either, you hear about it more than you see it. Most of what we see is consistent saving and staying in the market. So start now.

And watch your expenses. Yes, again with the expenses. You will be working 60 hours a week so simplify your life where you can. Stuff like expensive phone plans, dining out, Uber, cable bills and club memberships can run into hundreds of dollars a month. Get into the habit of managing all expenses. Sweat the small stuff.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

Smart Counsel: For our Attorney Clients

We have worked with attorneys and their financial needs for many years. Attorneys have a unique career trajectory. Typically, this means peak earnings come later than other professions but can also last longer. It's also a profession which never lets up. Hours are long and challenging. So creating financial independence as soon as they can. See the attached for a quick review of what we do. 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

The Lawyer's Financial Stages - Stage 2: The Associate, On and Up

Senior Associate: Work is familiar but not easier. The hours don't let up and you now know the pressures of keeping clients happy, the price pressures and workloads. You may have looked at moving to the corporate world. But maybe a corporate legal department is not for you. Not enough variety.

You like your firm. It’s big enough to attract corporate clients and interesting litigation. You’re now known in your specialty and you’re starting to be cited and published. You may even start helping on the recruitment drive, which is a good way to keep in touch with your school and alumni friends. You know some senior partners who you respect and start to work with more. You like your team and the cut and thrust of big law.

You should now be on your way to financing your first house, apartment or condo. Try to pay at least 20% as a down payment so that your mortgage runs to an 80% loan to value. Do not borrow from your 401(k). You're not paying yourself back. You're stealing from your future retirement. That might be a pipe dream in the Bay Area or metro New York but at least try. Don't fall for ARMs unless you really intend to sell inside of four years (or inside the adjustment period). Also try not to use interest-only repayment periods. It just takes longer to pay it all off.

Now is the time to start a basic financial plan. What you spend and what you save. You're already maxed out on the 401(k) because, well, we covered that in Stage 1 and if you're not, then stop reading now. Remember this is a financial plan. Not a document that you prepare once and stick in a drawer. Just like a business plan, you need to check that you’re on track. Are your assets growing? Do you have the right allocation? Is your credit score strong? Grade yourself. This is a test.  

By now, you should have a low-cost index fund investments strategy well under way. By your mid 30s try to have your savings amount to around 100% of your annual earnings. You can include your 401(k). Buy your life insurance at work. It’s a group rate and cheap. Check to see if it’s portable. Still sweating the small stuff? Good. Because you're about to enter your peak earnings years.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

The Lawyer's Financial Strategies - Stage 3: The Partner and Quest for Time

Partner: You’ve made it. It’s a heck of an achievement to make partner in a major U.S. law firm. It’s competitive and mostly an “up or out” culture. You're now one of the decision makers in the firm so it’s not just your own practice area you're looking out for. You think about the firm. You're an owner.

You are probably in your 40s now and have 10 to 15 years of peak earnings ahead of you. You could work longer but age 60 to 65 seems a reasonable time to dial back and you want to build options. You will have to make a capital contribution to the firm. It’s at-risk capital and probably funded by a loan. Nevertheless, you know about firms that went under and where you stand in the capital structure so it’s a gulp when you sign on the line.

But the firm’s remunerations are generous. You should now be eligible for a Defined Benefit Cash Balance Plan (see here for recap), which should start you at about 5% to 10% of your annual income. Remember these plans have a capped balance but it will take some years to get there. You should also be eligible for a separate partner-level 401(k), which provides more firm contributions and allows you to get close to the maximum of $54,000. There may also be deferred compensation plans or venture funds that you should review.

Yes, these are peak earnings years. But they are also peak spending years. You may have resisted the temptation to upgrade to a large house but school, college and any extracurricular activities cost money. You may also have other dependents, with parents high on the list. And a spouse may no longer be in full-time work. Always check in with your plan. Are you on goal for assets, investments and paying down debt? The big wealth destroyers are divorce, losing your job and a family illness. You can't plan for those but you can put some defenses in place.

By now your low-cost index fund and ETF investment program is well underway. You never missed the $100 a month you started with 15 years ago and you don't miss the $2,000 a month you invest now. You never went for the private equity and hedge fund pitches that came round the office so you're way ahead. Your net worth, excluding residence, should start to climb to four to five time your income. It should ramp up quickly in your late 40s and 50s.

That empty nest is coming up but it’s bittersweet. Yes, the tykes cost you an arm and a leg but you're justifiably proud. The money is good but the hours don't let up. But now you have options.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

The Lawyer's Financial Strategy - Stage 4: Senior Partner and choices

Senior Partner. You are a senior and seasoned leader…how did it all creep up so quickly?  But your colleagues certainly think of you as the expert in your field. You probably have many junior partners who seek you out for your wisdom. You may have spent time on the Executive Management Committee so you know how to run a professional and complex firm. Your clients know you well and reach out when they need help, advice and guidance. You have become everything you admired in the legal profession. Respected, focusing on people and their needs, a communicator and always intellectually curious.

The law is your domain. Sure the pressure on fees and billing never seems to let up. You’ve been through several recessions when companies start to hire in-house legal talent. But for the thorny, difficult cases and complex settlements, they turn to you. It’s not an easy profession but it keeps you mentally alert and sharp. Where you need to be.

You have had a decade or more in your firm’s partner-level 401(k) and cash balance plan. These have been good for $75,000 to $100,000 a year. These balances make up most of your liquid net worth although that low-cost index fund and ETF investment program that started years ago and you tell all junior associates to start, is looking pretty good. Recently you may have contributed to the firm’s deferred compensation plan. It’s not a lot because you still have at-risk capital in the firm. But you understand the firm’s finances and appreciate the prudent financial management of the firm. You earned enough to pay for your kid’s college without extensive loans and the mortgage has an end in sight. Your net worth is more than you imagined when you started out. You may not have the “capital event” of a stock plan coming up but you have earned well. But those hours...however much you delegate, you're still in charge of the team and responsible for its direction and results.

You have options. Maybe teach or join Some non-profit boards. You also can choose to be “at counsel” which means some free-up of your capital and more control on your time. You may want to work for another year or three years. You're not quite sure what you will do with your time. Travel, time with the family, perhaps some writing all sound good. But you don’t have to make that decision yet and there’s enough money so no need to rush anything.

By now, you are thinking of legacies, drawing down your savings and working out when and how you take from your 401(k) and qualified assets. There are a lot of moving parts and you're also rethinking your asset allocation. It was fine to have risk assets when you were earning…you were saving every month and buying on every dip. But now you probably need less volatile assets because who wants to be withdrawing funds at a market bottom. Some expenses you never paid much attention to can now play a big part in your life. Healthcare for you. Perhaps still for your parents.

So there’s lots to do. Manage the money, make sure it’s there when you need it and watch the small stuff. But you have played the game of life and won. Your finances weren’t everything in your life but they’ve given you the freedom to make your own choices.

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

Powell delivers

The Days Ahead: Retail sales and manufacturing numbers

One-Minute Summary Market at record highs. It’s all down to that curious mix of a slowing (not recessionary) economy and lower rates, both here and in the major economies in Europe. Recent numbers on CPI and employment, the two biggest market moving data points, have come in above estimates. The yield curve steepened especially in the 5s/10s, so that takes some heat off recession fears.

Nothing remarkable in the details. Energy did well but that reflects a bounce in the oil price not some big global-growth-demand story. Stocks that did well were health care related and all to do with the ups and downs of the Medicare for All story.

1.     What will the Fed do?  Cut but not by much. We're writing this just as Chair Powell is wrapping up two days of Congressional testimony and the latest Fed minutes from June are out. We'd summarize the Fed’s position as i) the economy is fine ii) but we can't see inflation anywhere iii) we hear about some bad stuff especially trade iv) an “insurance” cut seems like a good idea and v) that will get the President off our backs. Ok, we made that last one up. But the direction is for easier money.

One interesting note was that Powell’s written piece (here), felt the need to stress the Fed’s independence. Then there was this:  

“I urge Chairman Powell and other Federal Reserve Board governors not to submit to the high pressure tactics of this President who continues to push reckless and harmful economic and social policies,” House Financial Services Committee Chair Maxine Waters, a Democrat, told Powell.

She asked Powell what he would do if Trump asked him to resign.

“Of course I would not do that,” Powell said, and repeated that he fully intends to serve his four-year term.

We cannot recall anytime where the Fed has had to state its own independence. I mean it’s one of those things, right? Most economies run independent central banks, no?

We felt it was Chair Powell laying down a marker. Not daring Trump to fire him. He seems too sensible for that. But calmly stating he’s holding his own and not intimidated. Of course, Trump could force the Fed’s hand by going all out on tariffs, inducing a slow-down and recession. The Fed would then cut rates, restoring the economy to health around, oh, say mid-2020. But he wouldn't do that.

We don't feel the Fed will cave nor do we think Trump will force a resignation. We don't think the rate cut is necessary. Employment is fine, inflation low but not heading into dangerous or negative territory. When we look for trouble, we look for depth, duration and dispersion. We see no material, widespread slowdown in any major leading indicator.

The Fed did not surprise the market, so full marks for communicating well. Here’s the 10-Year Treasury:

Yields rose which means the market expected a little more from the Fed and gave up some recent gains. But here’s the 2-Year Treasury:

Yes, it moved in the opposite direction. What’s happening is that i) the long end of the curve was overbought and ii) the front end could move down on the confirmation that a rate cut is coming.

Here’s how the yield curve moved with the blue line as of writing on Friday, compared to a week ago (yellow) and for grins, 18 months ago (black):

What does it all mean? Rates dropping. Long end looking cooked. The 30-Year Treasury popped up. It’s very inflation sensitive. Keep the floaters because we’re getting more coupon than the Ten-Year and stay in the middle of the curve.

2.     Top of the market. Should I buy? Yes. One of our favorite analysts, John Kemp, over at Reuters, had some interesting stats as we sail/crawl by the 3,000 mark on the S&P 500.

Here we go, with the S&P 500 going all the way back to 1929.

There’s an upward bias to the stock market. It reflects nominal GDP, inflation and productivity. Even if U.S. industry stopped making any productivity growth, the market would probably rise by 2% just to track inflation. Add in another 2% for dividends and 2% for share buybacks and you're in the 5% range without too much effort.

So, the long-term trend is up and the short-term trend is about the cycle, greed, fear and the thousand natural shocks we’re all heir to.

The S&P 500 has traded at record highs eight times in 2019. In 2018 it was 19 times, 2017 62 times and 2016 18 times. On average, the S&P 500 trades at a record level 13 times a year.

The current trend is not concerning. It’s come on a little fast in 2019, but it was oversold in late 2018. The average return for the last 5 years is 8%, which is slightly more than we use in our plans and projections.

So, yes, you can buy at these levels.

 3.     How’s the budget deficit going?  Ha, not well. The deficit is up 23% from last year and at this rate will hit $1tr, around 5% of GDP by year-end. Receipts are up 2.6% and spending up 6.6%. Interest payments on debt are up 16%... although some of that is due to the Fed running down its QE balance sheet.

The bond market seems not to mind but then the volume of new Treasury securities don’t drive rates much. Inflation and growth do.

We bring this point up because the debt runaway seems not to bother many people in Washington. In the week that Ross Perot died, we recall his charts and warnings when we ran deficits of around $300bn. Now it’s three times that and you don't hear about it. Or as Mr. Perot said:

“The debt is like a crazy aunt we keep down in the basement. All the neighbors know she’s there, but nobody wants to talk about her.”

We also bring it up because the debt ceiling runs out in September and, guess what, there is no agreement on raising it. So, we’ll put a pin in that.

Bottom Line: Earnings season starts in earnest with the big banks all reporting next week. Equities have come a long way. We'd like to see some consolidation.

Please check out our 119 Years of the Dow chart  

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Last of the beetles

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

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