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Not happy about it but…

The Days Ahead: More corporate earnings. Initial estimate of Q2 GDP.

One-Minute Summary: There should have been plenty to upset markets this week. The President questioned the level of the dollar and Fed policy, trade tariffs rose again, the EU made a strong trade deal with Japan, housing starts were down, retail sales weak and one of the regional Fed surveys showed that companies are seeing higher prices which they do not expect to be able to pass on (which means a margin squeeze). The yield curve continued to flatten. Netflix had a bad quarter. Yet things kept moving along well enough. Why?

Let’s deal with the first one. The President can criticize the Fed for raising rates but we think Chairman Powell will disregard any and all such comments. He’s going nowhere and the Administration can do nothing about Fed policy. They're stuck with him.

On the others, the market is growing sanguine. The trade pressures are built into the market’s wall of worry for now. Sure, things could get worse but the underlying economy is moving slowly forward and, as we've said before, companies are reporting great earnings. Thank the tax cuts. The path of rate increases is steady and Chairman Powell reassured markets and politicians not to expect policy surprises.

We did see some increase in short-term rates with 3-month Treasury Bills trading above 2% for the first time since September 2009. This was expected. So far this year, the Treasury market has had to absorb $720bn of net new public debt. That’s what happens if you cut taxes in a late-cycle economy. In the same period last year it was -$74bn. Last week, there was $22bn of T-Bill (i.e. 3 month bills) net new issuance and there’s $130bn coming in the next two months. So why aren't rates higher? Because the economy is expected to slow, real wages are flat and because the Fed has clearly signaled where it expects equilibrium rates to settle: not much above where we are.

One item that got our attention was this:

This shows the yield on the S&P 500  (blue) inching below the rate now available on 3-month bills. That hasn’t happened for a decade. You would think equities should yield more. They're more risky. But dividends grow and bond yields do not and for much of the previous 50 years, from 1959 to 2009, equities consistently yielded more than bonds. Equity investors did a lot better, in real terms, than bond investors. It’s too early to say if this is a major signal but at its simplest, it shows that cash is now a viable asset.

1.     How’s Berkshire Hathaway doing? Quite well. Berkshire has never been a modish company. They only authorized share buybacks in 2011. Dividend? No. If investors want cash, they should sell the shares on the basis that dividends are i) taxed at higher rates than capital gains and ii) taxed twice, first by the corporation and again by the shareholder. They did pay a dividend once, in 1967, and Mr. Buffett said he must have been in the bathroom when it was authorized.

As for share buybacks, the Buffett philosophy was i) why would the company buy shares that are overvalued because it’s a waste of shareholder money and ii) even if they're undervalued, shareholders would be selling at a discount and why make shareholders mad at you by making them sell at a bad price? (This is horribly simplified and you can read his original thoughts here and here) So, you make money with Berkshire if the underlying investments and operating companies do well. And they've succeeded.

If only more companies followed those rules things would be simpler and executives would not waste shareholder money on over-priced buybacks.

But Berkshire also has a secret weapon. Its book value is one thing (the cost of assets less depreciation and liabilities) but its intrinsic value is much higher. It’s a subjective number but is basically the value of i) its stock portfolio ii) the cash generated by its operating companies and iii) the discounted cash flows of retained future earnings. The good thing about Berkshire is that for much of its life it has traded well above book value and well below intrinsic value.

It slipped to around 88% of book value (so a discount) in 2009 and in 2011 to 109%. Mr. Buffett then said, fine, we’ll make sure that doesn't happen again and in 2010, approved the buying back of shares if the stock traded at less that 110% of book value. He then bumped that to 120% in 2013. The black line in the middle chart above shows the threshold and you can see that the stock has consistently traded above 120%. Since 2011, the company has bought back less than $1.8bn in shares. Compared to its market cap of $490bn and the average buyback in the S&P 500 of 2% a year, that’s next to nothing. What Mr. Buffet was saying was he didn't need to use money buying back shares when he can earn a much higher return for shareholders. Shareholders were happy. The top chart shows Berkshire (blue bar) handily beating the S&P 500 (green) over most rolling 5 and 10-year periods.

Last week, the company announced it could repurchase shares at “any time”. That’s great news. The company has $100bn of cash so could use some to close any valuation gap. Berkshire is no high flyer. It’s a slow growing but predicable company with great franchises. It’s also “cheap” compared to the value of its business. We like it.

And if you're keeping score, you would have made more money in Berkshire than Apple since Apple went public. One -hundred dollars invested back in 1981 in Apple is worth $50,000 today. For Berkshire, it's  $61,700.

2.     Are those Fangs big? Well, yes, they are thank you for noticing. The story of the FAANGS dominance (so that’s Facebook, Apple, Amazon, Netflix and Google) has been around a while now. The race is on for the first company to break $1 trillion in market cap (which was actually done a few years ago by PetroChina back in 2007 but it fell 80%.)  While fun, the landmark is irrelevant.

 Performance of those six has been up between 25% and 90% in the last year. They're now giants and worth more than the bottom 300 companies of the S&P 500. They don't make nearly as much money. The sum of their earnings is around $184bn compared to $461bn for the bottom 300 (h/t John Authers via Michael Batnick).

Should we care? Well, they’re growing, of course, and are near monopolists in their respective businesses. They generate huge cash flows and are generally asset light. So that's all nice. But their dominance is high, they're expensive and the top 5 or 10 companies in the S&P 500 tend to change quite a bit over time. So, you know, probably won't stay that way. 

 Bottom Line: Stocks continue to move higher and become cheaper. It's all because earnings are coming through. Watch the dollar, if that begins to correct as the Administration wants, overseas markets will recover quickly.

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The last time a President pushed around a Fed Chair

--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.

Sophie Hunger

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

One-Minute Summary: We’re in earnings season and it’s going to be a cracker. In most earnings seasons, companies “beat” expectations because that is how the game works. Analysts put out an estimate early in the season, the CEO (well actually normally the IR guy) sucks their teeth and says, “dunno about that…”, the analyst revises down (this can repeat a few times with knowing winks), and then the company comes in and beats. Everyone happy. That’s why 70% of companies beat every quarter. It’s not that CEOs are great or analysts incompetent. It's just how it’s played.

Anyway, if you're a CEO of an S&P 500, 400 or 600 company, you didn’t even have to show up in the first and second quarter and you would have a 10% to 15% gain in earnings just from the lower corporate taxes. But if you did show up and threw in some growth and buy-backs, then your earnings will be up 22% YOY this quarter.

So, we’re celebrating a great earnings season. But most of that was in the price of the S&P 500 seven months ago, which is why stocks haven’t moved much so far this year (although up 7% from the February mini-crash). Yes, small company stocks and growth had another good week.

There were good economic numbers as well. Job openings were strong, inflation moderate, producer inflation in control but the headlines were dominated by the latest round of tariffs, which now includes onions, buffalos and maleic acid (no idea, sorry) but not cell phones or computers. And of course NATO and BREXIT. Normally, when these stories dominate the fireworks are in FX markets and that was somewhat true last week. It seems as if markets are “What’d he jus’ say? He can't mean it. We hope he doesn't mean it. He doesn't mean it.” That cycle takes about two hours these days. Tailor made for neurotics.

Stocks were broadly higher here and in Europe but on summer trading, which always has a torpid feel. The 10-Year Treasury was flat but 30-Year Treasuries strong.

1.     The next recession. One of our favorite commentators over at Financial Intelligence asked this question recently.  One lore is that recessions do not die of old age; the Fed murders them.  Which is nonsense. Recessions are normally preceded by over leverage, inflation and crisis of confidence. The Fed is merely the instrument that starts the rate cycle.

 The Fed started hiking rates in 1972, 1976, 1986, 1993 and 2004, all without triggering a recession. And in some cases, as in 1973, 1984 and 1994 they started to lower rates some two years before a recession. And that points to another problem: insufficient data. Whenever you hear someone say “a recession always come when…” you can quietly muse that there have been eight recessions in the last 64 years (so 12% of the time) and 18 in the last 103 years. If a researcher from one of the hard sciences showed up with a theory based on 18 data points, you might politely sigh.

Anyway, here’s what we think might cause some problems:

  1. Politics and trade
  2. The fiscal stimulus from the 2017 tax changes running out sooner than expected
  3. High federal debt
  4. Corporate leverage

We don't really think the consumer is a problem this time round. Yes, things like student debt are off the charts and consumer and mortgage debt are at all-time highs in absolute terms. But so is GDP and we’re fine with personal debt growing in line with nominal income. Consumer and mortgage debt is now around 70% of GDP from a 2009 peak of over 90%. Also, we’ll stick to our belief that the forces causing the recession last time don't get to do it again. So, the consumer gets a pass this time round.

Corporate debt is a different story. Here it is:

This shows corporate bonds owed by non-financial companies (blue bars) doubling from 2008. But they've also increased cash so the net borrowing is around $4.5 trillion. That reached a record level of over 20% of GDP two years ago and has since plateaued (bottom graph).

We've excluded other corporate debt, like bank loans and payables. We'd add that not all these companies are financially stretched. Still, it’s a high number and at some point, rising rates, if only at the short end, are going to make life difficult for companies. That’s why we've been lightening up on corporate credit for the last few months.

2.     What's inflation up to? Not much. Last week’s report showed headline inflation at 2.8% and core (so knock out food and energy) at 2.2%. This is above the Fed’s goal but i) the Fed uses the broader PCE measure of inflation and that’s at 1.9% and ii) there are some important base effects going on, that we've written about. The main one is cell phone rates, which fell sharply last year when Verizon cut prices, and used cars, but both are pretty much done. The Fed’s, rather difficult, job is to differentiate between temporary and entrenched inflation.

The Atlanta Fed tries to do this with its Sticky and Flexible measures of inflation. Sticky prices are ones that don't change too much. The classic example is coin-operated laundries, which change their prices once every six years. The list also includes fees, rent and medical costs. Flexible prices are those that change a lot. So things like vegetables, gas and clothes change prices every few weeks. This is what’s going on with the two:

As you would expect, Flexible prices are volatile with prices swinging from -3.0% to 3.5% in the last year. Sticky prices are moving much more slowly and haven’t changed their rate of growth much in the last four years. We think it's likely to stay that way. And as for wages?

They're not keeping up with inflation (black line). To some, this is a puzzle. Low unemployment, low participation and a tax change trumpeted as good for workers and their wages should lead to wage increases. But, no. There has been some increase in hours worked, so take-home pay is up. But it's by a very small amount. For us, real wages have to increase to push inflation up meaningfully and, so far, ‘aint ‘appening.

Bottom Line: More good earnings numbers coming up. Stocks are within a whisper of all time highs but, if companies report concerns about tariffs, expect some weakness. We still favor small company stocks

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SEC drops whistleblower prog

Young billionaires

 --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.

Detectorists

Vacation Week Trading

The Days Ahead: Corporate earnings kick off. It’s going to be another strong quarter.  

One-Minute Summary: U.S. Treasuries had a good week with the 10-Year Treasury at 2.82% and the 30-Year Treasury well under 3.0%. The gap between the two is now 11bps, the lowest in 11 years. Stocks had a good week and we’re now in positive territory for the S&P 500 year to date with small company and tech stocks way ahead…up over 11% in both cases. International markets recovered but Emerging Markets again struggled.

On the one hand, yes, the trade issues continued but markets have had plenty of time to adjust to the threats so nothing really new. On the other, international markets stand to lose more from trade so will take longer to adjust. Things got a little better when a story went round that Trump’s Ambassador to Germany offered zero tariffs on all auto trades. Could happen. And on the other (see what we did there), the dollar weakened and bonds rallied on an employment report that showed no increase in wages and more people looking for work. That would seem to shut the door on the whole wage inflation, labor shortage argument.

We'd remind readers that summer trading can be very thin and misleading. The short holiday week and a heat wave on the East Coast meant volumes were light. Markets can and will overreact to news. And as we say, “prices move faster than fundamentals… don't confuse the two” (h/t David Ader)

1.     "Trade wars are easy to win". You might say to yourself, if you measure the country’s trade deficit since the phony trade war started in January and moved into a more serious phase a few months ago. And if you were into charts, you would point at this and say, let’s Make American Exports Great Again.

Because of the way the BEA calculates GDP, the improvement from January to May would account for about a 0.7% improvement in GDP. Pretty good work. What shall we solve next?

But this month’s trade figures give us the excuse to bring out one of our favorite charts: U.S. soybean exports. And here they are:

The U.S. is a big exporter of food. Around $150bn a year out of $1,400bn in total goods exports. The U.S. sells a lot of soybeans, corn and meat products and imports wine, fish and fruits and vegetables. They tend to balance each other out. But one big export earner is soybeans. And they all go to China. The green line shows the trend. They rocketed from $2bn to over $4bn. That’s a very big change on an annualized basis, which is how GDP will measure it.

They have spiked before, notably in 2016 when there was a poor harvest in Brazil. But this increase is even bigger and there’s no mystery why. Chinese importers were buying ahead of the tariffs imposed today, which were in retaliation to the $34bn of Chinese goods targeted by the Administration. We certainly don't expect these numbers to improve in coming months.

So, the headline looks good for now and will help the Q2 GDP numbers for sure. But by the middle of Q3 the deficit will start to worsen.

Look, we know U.S. trade is a mess right now. Companies don't know whether to change suppliers, move overseas, expand or prepare for price increases. The ISM data on manufacturers’ prices paid has risen for 28 straight months and is by far the highest indicator in the dozen metrics tracked by the ISM. Trade talk is going to continue to dominate capital markets for the rest of the summer. We think that eventually businesses, politicians and consumers are going to protest at higher prices and the overall disruption. But it’s only the last constituent that counts for this Administration. And they have yet to feel the pressure.

2.     Are bonds good value? We'll preface this timeless question with the normal “it depends.” But by one measure, yes. We looked at the yield on the S&P 500 and compared it to the 10-Year Treasury. Here’s the chart:

The black line is the 10-Year Treasury yield at 2.84%. The blue line is the yield on the S&P 500 at 2.04%. When equities yield more than bonds (which is not often), they tend to be very good times to buy stocks. When bonds yield 200bps more than equities, it tends to be a good time to buy bonds. We're not there yet. It’s only around 80bps. But here’s the point. Stocks these days don't offer a great dividend payout. Some 100 of the S&P 500 don't even pay a dividend. Many would rather use buybacks to boost share prices because they're more tax efficient and tied to executive pay (color me skeptical, I know).

So, bonds at around 3%, which they were a few months ago, seem very fair value against stocks. We've seen a lot of the bond bears reverse position in recent months. Some of that is shorts caught out but some is down to bonds, especially Treasuries, just representing good value right now. As clients know, we've been investing in the mid-part of the Treasury yield curve for some months now and we’re inclined to remain there.

 Bottom Line: Good earnings numbers coming up but export traders (BA, CAT etc) will remain under a cloud. Large cap will probably remain in the 2600 to 2800 trading range. It closed 2750 on Friday.  Emerging Markets remain the weak point.

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Drone over Tesla, Fremont

 --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.
Friday on my Mind
 

100 Year of Inflation and Real Rates - Updated July, 2018

We looked at 100 years of inflation. This chart shows: 

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

Our takeaway is that inflation remains low by historical standards and that it has not been much of a problem for nearly 30 years. The level of real rates looks very low and suggests more deflationary than inflationary forces.  

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.

Hog Wash

The Days Ahead: Employment report and probably some trade talk. Shorter week.

One-Minute Summary: Markets lost their patience with the trade issues. Ye gods, on Friday the rumor was that the U.S. will withdraw from the WTO. That actually require an act of Congress so no immediate threat. The market recovered from its lows but there was a general risk-off theme.

The 30-Year Treasury had a good week, with yields falling from 3.08% to 2.96%. Why? Well, we’re in the middle of a great quarter for growth. We know this because 1) first quarter GDP was revised down to 2% 2) since the crisis, there are some very weird seasonals not captured in Q1 that flow through to Q2 and 3) with things like a lower trade deficit, the GDP now model is flashing around 4% growth.  There have been some quarters of 4% growth since 2009 but they have very quickly rolled over to the lower average growth of 2.0% to 2.5%. We think that’s going to happen again. The decline in the 30-Year Treasury yield tells us the market is not convinced growth will last.

A rough week for Emerging Markets, which are dominated by the dollar, interest rate and trade issues. We're watching to see how China reacts. They may impose more tariffs. But they could just 1) weaken the Renminbi 2) sell U.S. Treasuries or 3) go after U.S. companies doing business in China from China. Apple has 18% of its sale in China and another 18% in Asia Pacific. Any iPhones sold there are made there. If China was to start making life difficult for firms selling in China, then goodbye Queensberry and hello cage fighting.   

1.     Markets are jumpy – maybe because there are fewer defensive stocks around. Stocks feel like they're volatile but the standard deviation and VIX numbers are pretty much in line with levels from two years ago. It’s only against the unusually low 2017 levels that it feels more risky.

 But in some ways the market as a whole is a more risky animal than in past years.

 We looked at the classic defensive sectors of the S&P 500. So, that’s utilities (e.g. DUK, SO) telecommunications (T, VZ) and consumer staples (PG, WMT, KO, MO). We took their combined market capitalization as a percent of the S&P 500 market capitalization. Here it is:

Defensive stocks have indeed fallen to a near all-time low of 12% of the market from 21% in the pre-crisis era. Some of that is because these companies face more competition and they’re just not great businesses. But some is because big companies keep getting bigger because, well, they are good businesses and there has been little to no anti-trust enforcement.

So, Amazon is 25% of the Consumer Discretionary sector and accounts for 35% of the gain in the S&P 500 this year. The top 10 growth companies account for 100% of the gain. And the top four tech companies (AAPL, GOOG, FB, MSFT) are 42% of the tech sector.

It’s going to get worse too. In the fall, S&P will create a new sector called “Communication Services” by taking some stocks away from tech and consumer sectors. When that's done, the top five stocks of each of those three sectors will account for 50% to 70% of those sectors.

So, yes, the market has become less defensive which means the market is more vulnerable to any correction in non-dividend paying, momentum stocks (h/t David Ader).

2.     Bought a washing machine lately?  So how much will the tariffs cost us in the end? We're more concerned about the on/off mixed messages of the tariffs. If we take a more or less worst case scenario and all imports from China are taxed at 25%, we would see a about a $125bn cost to the U.S. economy. Sometime in the second quarter of this year, the U.S. economy passed $20 trillion. So that’s a 0.6% hit to GDP. The economy will grow around 3% this year. A drop from 3% to 2.4% does not remotely qualify as a recession. Of course, we can play with even bigger numbers. How about 25% on all auto imports? That’s 0.2% of GDP. Or the EU throws a 20% tariff on all U.S. exports? That’s 0.3%.

But of course, it’s much more than keeping score on who can raise the most or who blinks. The real problem is in the complex global supply chains of modern companies and flow of intellectual property. So, if Harley Davidson, which was in Twitter’s sights last week, faces a 20% increase in its prices in the EU and higher steel prices in the U.S., it must divert production to its existing overseas plants. To do otherwise would surely be a breach of its responsibilities. The stock (HOG) is down 25%.

We don't really know yet what the impact of the trade disputes will be. We do know that tariffs are a tax. Someone has to pay the tax. If companies pay the tax, margins are squeezed. If consumers pay the tax, prices go up. Back in January, the administration imposed a 50% tariff on washing machines and 25% on solar panels. Consumers ended up paying for this one. This is how washing machine prices have changed:

That top green line shows prices accelerating by 83% in the last few months. That's after many years of price declines. This tariff was targeted at LG Electronics and Samsung. Both companies’ share prices fell 13% to 25% this year and showed up in South Korea’s exports to the U.S. (in the blue bars).  

So, all together, tariffs hurt consumers. The question now is how will consumers, businesses and politicians respond to the trade talks? If there’s enough of a blow-back, we might get less bluster and more thought. But it will take at least six months to show up in the data. (h/t Ian Shepherdson at Pantheon Economics)

Bottom Line: Large cap will probably remain in a trading range. The S&P 500 should remain above its 2700 support level but expect some rapid moves.  Emerging Markets remain the weak point.

Please check out our 119 Years of the Dow chart  

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NIMBYism San Francisco style

Rodents in ATM

 --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.

Dreams

Summer trading starts in fits

The Days Ahead: Some durable goods orders. But trade will dominate as a problem.

One-Minute Summary.  We were unchanged on the week but had some odd days when the market fell at the open but closed higher. That seems to be a lot of quants at work (h/t Cameron Crise), which is leading to higher volatility.

Markets are trying to make sense of the increased taxes coming their way. They're in the guise of tariffs, of course, but they have exactly the same effect as a tax. Take steel. It’s up 53% from a year ago and 25% since March (the date the first tariffs came out). Someone has to pay the tariff. It will either come in higher prices to importers, which are then passed on, or in margin compression. Or both. The market doesn't know how all this will work out yet but last week’s Philadelphia Fed survey suggests there are price pressures around the corner. 

Meanwhile the U.S. will have another strong quarter ending in a week’s time. Most earnings estimates are for a near 20% annual gain. At least half of that is down to the lower corporation tax but a 3.5% GDP rate is certainly helping. Small caps and the NASDAQ index (confusingly it’s not the NASDAQ exchange but a warehouse for tech stocks) reached record highs. Europe is struggling with politics in Germany and, of course, trade concerns. The 10-Year Treasury marked time at the 2.85% to 2.95% range. Every time it tries to break through 3%, it rallies.

1.     Markets are jumpy – Emerging Markets edition: Not a great week for Emerging Markets. It’s nearly all tied to trade and the escalating tariffs. First, it was the U.S. imposing 25% tariffs on $50bn of Chinese imports (here’s the full list). Second, China came back with an unspecified tariff on $50bn of U.S. imports. They’ll probably target agriculture and autos. Third, the U.S. thought carefully and said they would charge a 10% tariff on another $200bn of goods. Fourth, the U.S. (well the White House) said, fine, we’ll charge the EU 20% on tariffs on all cars coming into the U.S. It’s true the U.S. can hurt China more than the other way round, for now, simply because imports from China are four times greater than exports to China.

Chinese large cap stocks fell around 11% (in thin markets, there was a national holiday). But Chinese small cap stocks “only” fell 7%. It’s the same story in much of the developed and emerging markets: small cap, domestically focused and non-financial companies have done much better than the large export, headline companies. This makes sense. They're more insulated from the trade problems and benefitting from domestic growth.

A good example of the complexity of the situation is Daimler Benz, Germany’s fifth largest company. It gave a profit warning not because of the U.S. threat of tariffs on cars from Europe, but China’s tariffs on imported cars from the U.S. because…Daimler makes a lot of cars and trucks in the U.S. for the Chinese market. So, it’s a roundabout Emerging Market story. And it's a good example of trying to target one trade sector and not knowing the complex global supply chain of a major U.S. employer.

There’s some short-term uncertainty in Emerging Markets right now. Not just trade. There’s an election in Mexico that will bring in a reformist administration that may not be good for business. The U.S. dollar is still strong and oil still high. Both will hold Emerging Markets back. Again, small caps are doing well, which is why we like the exposure. But we’re investing in protection for our large cap exposure.

2.     Why is everyone talking about the yield curve?  When you buy a bond, you're a lender. You want your money back. Lending overnight should be cheap and safe. Lending for 30 years should be more expensive and riskier. There’s a lot of discussion about what this “term premium” should be. For a five year bond, should it be an extrapolation of the 2-Year note? Or with some adjustment for inflation? Or other macro risk? If so, how much? The number has declined in recent years. We think it’s because investors don't require a lot of premium to lend long because they feel rates will ultimately settle at lower levels. And that the economy won't grow at the rate it used to. Think of it as a sentiment indicator.

A hard indicator, however, is the yield spread between two bond maturities. The most commonly used is the 2-Year Treasury and 10-Year Treasury. Here it is:

That spread is down to 36bps from 130bps at the beginning of 2017 and 71bps in early 2018. That means an investor only paid an additional 0.3% for lending money for five times as long. Why? Well, here’s a quick summary:

  1. The Fed is raising rates at the front end. It’s the only rate they control. The market sets all others.
  2. The market thinks that short-term rates will go up but either that or other things (think trade) will slow the economy, so…
  3. The Fed will start lowering rates long before that 10-Year Treasury matures, so…
  4. The spread or premium will be back to where it should be because short-term rates will fall, while the 10-Year Treasury will not change.
  5. In 2018, we think it means i) yes, the economy is growing gangbusters now, but ii) the Fed is worried about tight labor market so iii) will continue to hike but iv) trade/budget deficits/length of cycle/debt will slow the economy and v) we’ll be back to a Fed cut cycle.

In the past, when short-term rates rise above long-term rates, a recession is just around the corner (the shaded parts in graph). But here’s the thing: you can have a low or inverted curve for a couple of years before the recession hits. It’s all up to the Fed. If they wait too long to cut when the spread inverts, the worse the recession.

We think the rate hike cycle may stop in 2019 and it’s one reason why we’re cutting exposure to corporate credit, and using a short bar bell strategy of 2- Year and 10-Year Treasuries. Or simply, we're unconvinced this late cycle boomlet is going to run for long.

So, here’s a reminder:

h/t Macro Market

Bottom Line: U.S. large cap stocks will struggle to break out of a trading range. European stocks should recover from some of the trade shocks this week.

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GE out of the Dow

Senegal’s triple fist bump

 --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.
Football's (ok soccer's) best actor awards

Why the markets are now interested in trade

This is a recording of our June 2018 conference call. If you want to join us live next time or get future updates about new episodes, subscribe to our email newsletter: bandjadvisors.com/subscribe

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Hike but no spike

The Days Ahead: Fed meets Wednesday. Yes, they will raise rates. Bonds won't move much. New dot plots will be important

One-Minute Summary.  After flirting with crossing below its 50 and 200-day moving average (better known by its Wagnerian title, The Death Cross), the S&P 500 had a solid week and is up 4% for the year. The Small Cap world of the S&P 600 and Russell 2000 reached all-time highs and are up around 10% this year. Bonds hung in the 2.90% to 2.95% range. Pretty much unchanged for the last month.

Europe is still worried about the Italian politics, debt and bond world. Italian banks were down over 6% and even the news of a merger of Unicredit with SocGen was not enough to stop a 2.5% drop in the share price. The trade news was not good. One would expect the markets to freak out at the retaliations, a very grumpy G-7 meeting and rate pressure. But the trade war has not changed the generally good narrative. Why? Well 1) the devil is in the details on trade and until we know what they are, it’s tough to put a number on growth and 2) perhaps markets are in the “take it serously, but not literally” world.

Something very definite came in last week from Commerce Department on Chinese steel flanges. You know, the things that look like this. If it goes ahead, U.S. customs will charge importers around $50m. But imports would quickly take up the slack so the final cost to consumers will be negligible in a $20 trillion economy.

Meanwhile, the U.S. ISM numbers were good. Job openings were up. The trade deficit narrowed. The FANG basket of tech stocks has outperformed the S&P 500 every month this year except April and have done it again in June. This won't continue but there’s a trend in place.

1.     Markets are jumpy (Part 3): This week was the turn of the Brazilian stock market.

The basic story was that the government imposed fuel price controls following the trucking strike, which has been going on for weeks. The central bank stepped in with some aggressive currency swaps to try to prop up the Real. But inflation is on the rise (hence the price controls) and there’s an election in October. Throw in trade problems, the Emerging Markets (EM) debt problems, and one wonders why it took so long for the market to wake up.

We think the EM story is solid but the recent weakness is because:

  1. Core yields have risen in developed markets and EM’s track the increases. We think these will moderate.
  2. The dollar has strengthened which hurts EM’s debt management. We expect the US dollar to soften over time.
  3. Crude has been on the rise which hurts more EM economies than it helps. We think that’s about to end.
  4. Trade tensions are high. They will remain so but we don't expect them to affect intra-EM and EU trade.

So, it’s been a test of resilience for sure but Emerging Markets remain an excellent asset class for solid growth.

2.     There’s an awful lot of debt. Yes, but not in the usual places. If we’re looking for the next bear market, one place you can pretty well know is that’s it’s not going to be in the same place as the last time. So, as we said last week, don't go looking at the MBS world. In fact, don't even go looking at consumers. The new snappily-titled Z.1 report came out this week. It was called the Flow of Funds report, which describes exactly what it is. But, hey, I’m not a branding expert and someone came up with Z.1. And who can blame them? It’s a ton of information that gives us plenty of blog subjects if the markets aren't really doing anything or we need a break from tweets and headlines like this.

Here’s what caught our eye:

The blue line is household debt. That’s all the mortgages, credit card, auto loans, and home equity lines thrown in together. You can see the peak of 120% of GDP a few years ago. Since then, households have taken the message of running down debt very much to heart. It even fell more last quarter. So it seems consumers are a) not following through on the confidence they say they have and b) not using the tax cuts to borrow more.

The other line is non-financial corporate debt (we need to exclude banks who need debt for capital and loan growth). It’s at an all-time high. Now we know one of the themes of the last few years was for companies to borrow at low rates to offset cash held offshore and pay for share buy-backs. And we know that we should probably adjust the number for cash and cash equivalents held by companies (remember Apple’s $100bn cash pile).

But still, that’s a fair amount of borrowing and we think it’s one of the main reasons why stocks have been tepid in recent weeks. Yes, the tax cuts have helped a lot. Estimates for S&P 500 earnings in 2018 made in early December were $146, up 11%. By January, they were $158, up 19%. The difference was entirely due to the lower tax rate. So in a high-leveraged world, companies with lots of pricing power (think software, personal products, pharma) do well. Companies with less pricing power and leverage (think energy, transportation, autos) will not. And there are a lot more companies in that second group than the first.

So what? We're keeping a close watch on the leveraged companies. We’re out of some of them (like REITs) and expect more sideways market action until the story is clearer.

Bottom Line: Yield curve is flattening again. This time in the 5s and 30s. Europe will struggle with the trade news. Volatile but sideways stocks.  

Light blogging only next week. Heavy travel. Back in two.

Call 415 435-8330 or email at cthwaites@bandjadvisors.com if you need anything. 

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Why farm-raised salmon are deaf

G6 plus one, more than G7

--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.

Weekend Music: Band Apart

A lot of action but not much change.

Available on Apple Podcasts • Soundcloud • Google Play


The Days Ahead: Quieter week for big economic numbers. Watch for trade and updates on the Eurozone.

One-Minute Summary.  When markets crack, we know two things. One, the problems don't come from the last crisis (so no need to look in the MBS world). Two, they come from things you barely notice. Last week it was Argentina and Turkey. This week, it was Italy (see below). U.S. bonds promptly rallied 4.5% and the 10-Year Treasury yields, which many predicted would soar to 3% and beyond, fell to an intra-day low of 2.79%. Bonds got medieval on Tuesday and one Bond King had a very bad day.

Domestic and international stocks and U.S. bonds finished more or less unchanged on the week. But there was plenty of action along the way. Small caps had another good week (they tend to not get riled by trade stuff) and are now some 500bps ahead of the large caps so far this year.

The trade talk is not good. The U.S. went ahead with tariffs on steel from Canada, Mexico and the EU. We don't think they're going to take this one lying down. In past years, the parties would have taken the issues to the WTO and talked about it for a couple of years. This time Cecilia Malmstrom, the very accomplished EU Trade commissioner fired right back with, “When they say American (sic) first, we say Europe united.” So far markets have tended to view the trade talks as bluff followed by climb down. That’s worked. So far. Still, expect a lot more disconcerting headlines.

1.     Markets are jumpy (Part 2): Here’s something you don't see very often. A G7 sovereign bond crashing in a single morning’s trade. As everyone knows by now, Italy is trying to form a government on a coalition of two parties. The Northern League (secession, pro-Russia, anti-GMO, lower taxes, Eurosceptic) and the 5-Star Movement (guaranteed minimum income, Green, unsure about immigration and mostly Eurosceptic) tried, failed and tried again to form a government. In Italy, winning parties must present their cabinet and government candidates to the President. He has veto power. And he used it. The fear then was another election in the fall with both parties running on an explicit “out-of-Euro” platform because…that’s the only thing these guys really agree on.

Now we've seen Italian governments come and go and, with 42 Prime Ministers since 1945, a change of government in Italy passes as a Cabinet reshuffle elsewhere. And we don't really think this time is different. A government will form, it will make a few changes and it will argue with the EU about debt, growth and bond restructuring.

So why did this happen?

That spike on the right is the spread between Italian (BTP) and German bonds (Bunds). Both Euro sovereigns. Both have never defaulted in 70 years. Both with rapidly improving current account surpluses. But the spreads “blew out” (technical term) from 120bp to 270bp which meant the price of an Italian bond dropped from €102 to €89. Stocks took a smaller hit and investors dumped Italian banks, who, of course, must hold BTPs for capital. Some of the big-name stocks were down some 25% from their late-April peak.

By week’s end, things had settled down. The 5-Star and League parties will get their people in. The problems from the Berlusconi years (see famous Economist cover) will remain. Italy’s GDP per capita hasn't risen in 20 years. It seems unlikely a rancorous split from the EU will achieve much. And markets probably don't expect Italy to take it that far.

We don't own foreign bonds and this week was a good reason why. You can lose much more of your principal on a spread-widening event than you can on rising rates. To us, fixed income allocations should reduce the risk of a portfolio, not increase it. But expect this to play for a while.

2.     Jobs, jobs, jobs: Yes, the numbers were good. So good the President leaked them an hour before they were released. Which, I dunno, suggests why he may give Martha Stewart a pass. Here they are:

The headline unemployment number is now at a 20-year low. Last time it was this low, the 10-Year Treasury was 6.5%. So why is it only 2.8% now? And didn't even move on the day? Sure, some is because of the Fed’s QE and low inflation. But we think the market is not wholly convinced about this labor market. We've touched on some of these in the past but here goes:

  1. The uninsured part of the labor force is the lowest it’s ever been. If you're not insured to receive benefits, you don't register for them.
  2. Wage inflation is barely moving in nominal terms and flat in real terms.
  3. Quit rates have not reached their pre-crisis level. You tend to quit a job if you're sure you can get another, so it's a confidence thing.
  4. The U-6 (underemployed) rate is nowhere near a 20-year low.
  5. Participation in key age cohorts is way down.

To which, critics respond, well the labor market has changed, if you want a job you can get one and look this week’s Beige Book says St Louis is even hiring convicted felons. So, it's  a tight labor market.

Fair enough, but nearly six months into the stimulus we’ve yet to see big consumer spending numbers, even though people are paying a little less tax (in aggregate, not in California). As one of the best analysts put it, “the longer the stimulative benefits of those particular policy changes [tax cuts] take to show up, the less likely it is that they will.”

Bottom Line: The Spain and Italy markets support our belief that U.S. Treasuries will remain well-bid and the 2-Year Treasury looks attractive above 2.5%. U.S. economic numbers last week were good but seemed more to be catching up with a run of less-than-great reports.

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Other:

Musk: public safety too important too important to abide by the government’s rules.

Robo advisors web sites don't work

--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.

Something for the weekend

A small dose of nerves

The Days Ahead: Jobs number on Friday. Short trading week.

One-Minute Summary.  Bonds were up, large and small cap stocks up a small amount and international stocks off around 1.5%...much of that was because of autos (see below), which are around 20% of the German and Japanese stock markets. Emerging Markets had a troubled week mainly because of the bad news coming out of Argentina and Turkey (we talk about it in our podcast here).

There are really two tracks going on in Emerging Markets. One, those countries with high U.S. dollar borrowing, budget deficits and importing oil. Two, those that don't. In the first category are Turkey, Argentina and the Philippines and in the second, China, Taiwan and South Korea. We're oversimplifying, we know.

Right now, there’s a great deal of concern about the former and they're overshadowing the better story from the others. It’s also a problem that a lot of Emerging Market investing is done en bloc, meaning investors buy a single ticker and they're either all in or all out. We think some of this will settle down but in the meantime are looking to protect our Emerging Markets exposure.

1.     Markets are jumpy. Combine coming up to a long weekend, month-end positioning, little company news and some unpredictable headlines, and markets can move very quickly. Here are two examples from last week. First, the 2-Year Treasury when the Fed minutes were released at 2.00pm on Wednesday:

It’s highly unusual for the 2-Year Treasury note to move that much. The reason was that the Fed said:

 “It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective. “

Which is Fed-speak for inflation may run a little hot for a while rather than hiking rates as soon as we see a CPI print of over 2%. So it was “dovish” and the 10-Year Treasury promptly dived back under the 3% level, which people got so worked up about a few weeks ago.

The second was this:

The catalyst was the Commerce Department announcing an investigation into automobile imports under the same Section 232 of the Trade Expansion Act of 1962 used in the case of steel a few months ago. Immediately, foreign car manufacturers fell and wiped off around $20bn in market cap from the five companies shown.

Now, the world auto market is a little tricky to get your arms around. Global production is around 97m units a year. But companies have multi-country supply chains. Germany, for example, exported around 450,000 cars into the U.S. but made 804,000 in the US, some for the U.S. market and some for export. European tariffs on U.S. autos and U.S. tariffs on European autos are about the same if you adjust for America’s high tariff on trucks (SUVs are “trucks” in the U.S. and cars everywhere else).

Similarly, Ford makes a lot of cars in Mexico and Canada and imports them to the U.S. In fact, the only car producer that makes 100% of its cars in the U.S. is Tesla and they account for 1.2% of U.S. total production.

It will be fiendishly difficult to target companies and levy the right amount of tariffs. Expect a lot of carve-outs or indeed nothing at all. This all may blow over. Meanwhile, it shows us the hyper-reactive phase the market’s going through.

2.     Volume Smile. We're big fans of ETFs. Sure, there are some dopey ones  and the clue is normally in the ticker. But they're generally great vehicles and do their job efficiently.

We talk a lot around here about whether they distort markets. I mean, look, they’re multi-billion dollar behemoths and to some extent transform liquidity, which means making something inherently illiquid, liquid. Here’s a good write-up of how the folk at Blackrock manage  their $55bn Aggregate Bond Fund (AGG), which tracks 10,000 bonds but “only” buys 7,000 of them.

What we look for is, a) are they distorting markets in b) a way that can harm investors? The answer to a) is emphatically “Yes.”  So, far the answer to b) “Not sure, don't think so.” In recent years we’ve seen the emergence of the “trading smile.” Here it is:

This shows the volume for SPY, which is the mother of all ETFs and tracks the S&P 500. It's $264bn, has 2,000% turnover and accounts for around 6% of NYSE volume (even more on a dollar basis). It's a good proxy for the market. The chart shows the volume for Thursday of last week and, there it is: a large volume at the beginning (9:30am but shown here 6:30am PST) and end of the day (4:00pm or 1:00pm PST)) and a very large drop off from around 7.00 am to 12.30am. And that’s a badly drawn smile on top (hey, no one hired us for Microsoft Paint skills).

What’s going on? Well, you would expect a drop-off around lunch but this looks like traders do their thing in the opening and closing half hour of the trading day. The answer is that passive products and complex algorithmic investors realign their portfolio at these times so active managers stay away from the market. Bob Mincus of Fidelity (here but behind FT pay wall and also here) sees an opportunity here and he should know, he manages billions in equities:

“We view the close as an opportunity. As more volumes migrate towards the close, we will follow it.”

This clearly creates some problems because a big buyer coming in mid-day will almost inevitably run into a liquidity shortage, which means more volatility. So, we have a weird situation where an efficient market vehicle (an ETF) creates an inefficient market. Some people are calling for a shorter trading day. In Japan, the stock market opens from 9:30 to 3:00 and closes for an hour at lunch. All very civilized. Their market is a lot less volatile.

Anyway, we don't much like this trade funneling and try to stay away from ETFs that we think might not do well under “smile” conditions (and SPY is one of them).

Bottom Line: The market lacks a theme. Emerging Markets will move on any bad news even though the likes of Turkey and Argentina are hardly mainstream investment destinations. But otherwise, we think markets will drift for a while. They may also become inured to some of the sillier headlines and tweets. 

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Other:

Shrieking lynx

Ship caught in trade talks  does two gigantic U-turns

No, Uber is hopelessly unprofitable

 --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.

Emerging Market Debate

This is a recording of our May 2018 conference call. If you want to join us live next time or get future updates about new episodes, subscribe to our email newsletter: bandjadvisors.com/subscribe

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Small Caps deal with rising rates

The Days Ahead: Fed minutes but otherwise a quiet week.

One Minute Summary There is one stock index at a record high. Take a bow, U.S. Small Cap stocks, which are up 6% this year and climbed over their January 24th record high. We actually prefer the S&P 600 as a small cap index, for reasons we explained here.  That has also hit an all-time high and is up 7%, mostly because it excludes speculative, blowout companies that don't make money. Why the small cap love-in? Well, put most of it down to recent dollar strength. Small companies don't have the same overseas exposure of the S&P 500 large cap so are less affected by a strong dollar.

Stocks had a sideways week. We kind of expected that because economic news has been fair to middling and the trade stuff is very much in the background. Total containers moving from the Port of Long Beach jumped 16% in April. We think that’s down to exporters and importers trying to get ahead of the announced trade restrictions from March 1.

Housing, retail sales and industrial production all came out. They were steady, not spectacular. We think we've reached the peak in housing for this cycle. It’s at 1.26m compared to the pre-recession record of over 2m. Higher mortgage rates will keep housing demand flat for a while.

European markets struggled mostly with the news from Italy. Italian stocks had been one of the best performers but investors sent bond yields up by 40bp in less than two weeks. It’s all down to politics. U.S. bond yield also climbed. The economic news seems to confirm the Fed outlook. Steady growth and interest rate hikes.

1.     How are the tax cuts going?  Well, one area you’d expect to thunder ahead would be retail sales. Lower taxes, more take-home pay, more discretionary income, stable inflation, more confidence. Personal consumption is 68% of the $19.9 trillion U.S. economy. Knock out some essentials like food, housing and health care and there is around $7.5 trillion of spending. We were waiting for the April numbers because the tax refunds were done, the new withholding sorted and the distortions caused by the hurricanes (where people bought forward purchases of furnishings and autos) were over.

Surely the new confidence was at hand? Last month’s retail sales (blue column) were up 4.6% YOY, which was down on the prior month but marginally better than the start of the year. We also took a look at what people spend on necessities.

That number was also up 4.6%. What stood out was the 12% increase in spending at gasoline stores (the lower chart). Now, we know, not all sales at gasoline stores are of gasoline but neither are they big-ticket sales reflecting solid confidence. Our read is that basic household items absorb much of the increase and that discretionary spending remains weak.

We're in the minority in thinking these retail sales were pretty meager. The Atlanta GDP Now model raised its estimates for Q2 growth and the 10-Year Treasury bond yield rose 8bp to 3.08%. We're going with around 3% GDP in Q2, less than most. But there is still half the quarter to go.

2.     Does the run up in bond yields change our outlook? No. We fully expected three hikes from the Fed this year. It may even be four. So, two or three to go. Our view on rates is built on inflation, growth and credit demand.

We also look at simple break-evens that measure how much yields would have to rise in a year to lead to an annual return of zero. Low yield and high duration numbers (which we had in January) mean lower break-evens and vice versa. An example is the current on-the-run (i.e most recently issued) 10-Year Treasury, which has a yield to maturity of 3.01% and duration of 8.41 years. The break-even is 3.01/8.41 = 36bp. So the 10-Year note yield would have to rise to 3.37% for the bond to return zero over the next 12 months.

The shorter the maturity the lower the duration. So a 2-Year Treasury yielding 2.55% with a 1.9 year duration has a break-even of 134bps. At the other end, a 30-Year Treasury at 3.13% and 19.19 years is only 16bp.

There’s always a risk of continued curve flattening (where there is not much difference between 2-Year and 10-Year rates) as this shows.

In an expanding economy the difference between a two and 10-year rate is more like 200bp, not the 49bp we see now. A flattening yield curve would mean long term bonds don't change much as front-end yields rise.

So what? Well this all means that we prefer the short to medium end of the curve, at the 7-10 year maturity or six-year duration. The break-evens are higher and the risk/reward looks attractive.  And that’s where we've positioned most of our bond portfolio.

3.     Women in the workforce. We talk a lot around here about demographics and the economy. One sure thing about demography is that you kind of know what’s going to happen. Today’s twenty somethings will, in 20 years a) still be alive and b) buying life insurance, savings products and sensible stuff. It gives you some idea of the overall direction of the economy. But one data item that really strikes us is this:

The top section shows labor force participation by sex in the U.S. The female work force has declined pretty drastically since the recession after years of climbing up. Japan is on the lower chart. That upward slope on women working is impressive. Japan has a real demographic problem. Its population has declined and the average age has crept up. Nearly 30% of the population is over 65. The government has put a lot of effort into attracting women into the workforce. And it’s working. We like where Japan is going for a number of investment reasons and this week’s slip in GDP does not overly concern us. The increase of labor participation seems a very good forward indicator.

Bottom Line: We'll be looking at news from Europe. Growth has stalled but we think it’s temporary. Next week will tell us more.

Please check out our 119 Years of the Dow chart  

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Other:

Stealing owls

--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.

 

 

Back to light again

The Days Ahead: Housing and retail sales  

One Minute Summary Low inflation numbers from both consumers and producers meant bonds rallied from the 3% level. We haven’t seen the 10-Year Treasury decisively break 3%. We don't put a lot of store in that number. It’s a nice round number but it’s not really relevant to the average Treasury buyer. We were pleased to see the bond market absorb a very large refunding week of $166bn in bills up to 30-year bonds.

There are a few technical moves going on. Small Cap stocks had a good week. They’re up about 5% this year compared to the S&P 500 at 2%. The S&P 500 also managed to bounce off its 200-Day Moving Average. Emerging Markets tracked sideways. The combination of dollar strength, some highly indebted companies and Argentina and Turkey trying to salvage their currencies by ramping up short-term rates, sentiment took a hit. Turkey’s weighting in the Emerging Markets index is only 1.3% but it’s enough to give some concern.

The biggest winner of the week were energy stocks, up around 4%. We think stocks are still trying to gauge where bonds are headed and where the next big catalyst will come from. We're not entirely sure ourselves except we’d say (stop us if you've heard this) growth is not particularly robust, inflation is low, the Fed’s going to raise rates slowly and all that can be undone with a single Tweet. We're still looking at protection and getting paid for some months of a sideways market.

1.     What's going on in with inflation? Not much. The Fed thinks inflation is easing up hence the well-telegraphed three to four rate increases this year. We had a minor scare in January that Average Hourly Earnings (AHE) were rising too fast. But subsequent reports put paid to that notion and the January number was revised down.

Inflation is probably the single most important driver of bond yields. Obviously, if you're paid a fixed coupon and fixed maturity, inflation eats into real returns. Equities, of course, are a very good inflation hedge until inflation gets out of hand and consumer demand flattens (the 1970s). Treasury Inflation Protection Bonds (TIPS) are also great hedges and we use them. But they don't provide much current income.

The inflation story since 2009 has mostly been “it’s just around the corner.” Half the Fed thinks that way and most sell-side economists enjoy a healthy living predicting inflation surges. The given reasons boil down to:

  1. Unemployment is low. Wage inflation must come soon.
  2. QE flooded the market with M2 money and there’s a decent and lagged connection with money supply and inflation.
  3. The twin trade and budget deficits will push up prices.

But inflation just seems to be stubbornly in the 2% range and has had trouble even breaching that in the last decade or so. Here’s the latest inflation numbers reported on Thursday:

The core CPI (so take out Food and Energy) is up 2.1% and headline inflation is 2.4% with a lot of that driven by higher energy prices (up 13% to 20%) and the base effects of very low cell phone and medical expenses a year ago. We talk about this a lot but the story hasn't changed.

What does this mean? We ran some very long inflation numbers here  and would stick with our view that inflation will not take off and that the current 10-Year Treasury rate, which has flirted with 3% for a few weeks, will stay in a 2.8%-3.1% range for a while. The bond bull market may be over but there is no big uptick in yields coming.

2.     “Good earnings, guys.” So you’re a CEO hanging up on a great earnings call (unless you're Elon Musk in which case you send them over to YouTube) after you reported a 25% earnings increase. You’re looking ahead to a permanently lower corporate tax rate, lower cost of capital and pretty friendly regulations. So your choices are:

  1. Pay higher salaries or bonuses
  2. Hire more people
  3. Kick up the capex
  4. Go do some M&A
  5. Increase your dividends
  6. Announce some share buybacks

Now there are some pretty fierce arguments about the merits of each of these, especially the last one. In the “they're great, stop complaining” camp there’s Cliff Asness at AQR and in the “they kill prosperity” camp there are, well pick your number, but one of the more rational ones is William Lazonick at UMass.

We'll not get into the merits because we're only really concerned about how the choices affect stock prices. And here, there is a clear winner: stock buybacks. Apple was the latest to announce a $100bn buyback and its stock rose 14% in a week. Not all share buybacks are received with the same enthusiasm. Some stock buybacks are basically self-liquidation exercises, with IBM being the most famous example. It spent $50bn of its $130bn market cap on buybacks and the stock fell 29%.

What we don't see is much hiring. We watch the NFIB survey, which asks employers if they're going to hire more people in coming months. Here’s the chart:

Last week’s NFIB report was a cracker. Optimism increased, profits up and nearly 60% announced hiring plans. But recently those plans have not resulted in increased employment. Usually when that green line (good time to expand) goes up, employment growth follows soon after. But not in the last few years. In 2017, the “good times” line jumped very high but there’s been no follow through in bigger job numbers.

What this means to us is that companies are keeping margins and profits as high as possible and are very reluctant to add to fixed expenses. The tax fix was meant to change all that but for now the benefits are mainly accruing to shareholders.

Bottom Line: Eyes on the dollar. It has reversed in recent week and is now pretty much unchanged year to date. More strength will be bad for Emerging Markets and U.S. stocks. Bad news on the trade front will send it up.

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China is changing the way trade is shipped.

--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.

 

Tech saves the day

The Days Ahead: Inflation number and the tail end of earnings.  

One Minute Summary A run of not-so-great economic news but there were good reasons for most of them. The trade deficit narrowed a bit, which lends support to the arguments that lower import demand would follow from the unusually high levels after the hurricanes last fall. The ISM Manufacturing and non-Manufacturing indexes both fell and, worryingly, in the employment sections of the reports. It just seems that employers are very unwilling to start hiring in big numbers. The core (PCE) inflation numbers inched towards 2.0% but there’s a big base effect going on from low hospital services (now up 7%) and energy prices (now up 8%) this time last year.

The Fed met and acknowledged slightly higher inflation but slower growth. There was no press meeting but we feel they must be twitchy about trade tensions and some slower growth in the world economy. We'll know more the next time they hold a press conference in mid-June. We feel the Fed will be fine with a few months of the core PCE at 2% and will wait until late summer for any signs of lasting inflation. We think inflation will remain low, which is why we like bonds at these levels.

Stocks were mixed but had a big Friday. Apple had a monster week announcing another $100bn share repurchase and a 16% increase in the dividend. It rose 12% in the week and it's now worth $900bn. U.S. stocks are up 1.6% this year but there’s no momentum or theme. Nearly all U.S. and foreign markets are around plus or minus 1.5% so far. The only outlier is China, which is trying to solve some of its own trade issues.

1.     How about those new jobs?  Not as well as expected. Non-farm payrolls came in at 164,000. Most people were expecting closer to 200,000. But the prior month was revised up. Here’s the chart: 

We're less focused on the absolute numbers these days and more on the hourly earnings and labor force participation. Why? Well, the reported unemployment numbers are about as low as they can go but that alone doesn't mean there is full employment or wage pressure just around the corner. Hourly earnings rose 2.6% (the lower line in the above chart). Given that non-core inflation is only just below that, it means real earnings are flat. And average weekly hours worked was unchanged. Participation slipped a bit.

All in all, nothing for markets to run on in any direction.

2.     Are U.S. stocks expensive? About 6% less than they were a few months ago. What we've had is a run of very strong earnings. The blended earnings growth in Q1 was 24% and that's the highest since 2013. The energy sector grew earnings by 93%. They're still important to the economy at 6% of the S&P 500 but with 10% and 8% of the S&P 500’s sales and earnings.

Here’s an important chart we look at:

It shows the earnings yield of the S&P 500 at 6.3%. We then reduce that number by the level of inflation. The higher that lower black line, the cheaper the stock market relative to inflation and bonds. Right now it’s cheaper than it was for most of 2017 but not as cheap as it was in the 2012-2015 period.

No one stock market measure is infallible, of course, more’s the pity. But we think the market is adjusting to the gradual rate rise as well as the less than stellar global macro news.

3.     How’s the Treasury doing? Meh. So, every year the Treasury tells the markets how much it’s going to borrow. The amount is basically refinancing of maturing debt and raising of new debt. Early estimates are for $950bn in 2018.

This should be fairly straightforward except the forecasts of what the budget deficit varies by who’s doing the talking. A few weeks ago, we highlighted the CBO’s estimates and they had a chart showing the deficit like this:

But the Treasury recently put out deficit estimates and their graph looks like this:

They both agree the number was about 3.5% for 2017 but then, you know, they kind of take different roads. Basically, the Treasury says growth will rip along at 3% and more and raise lots of tax revenues with no recession and the CBO says, er, probably not. The CBO is a pretty independent, bi-partisan and objective body. Steven Mnuchin runs the U.S. Treasury.

So we’re dealing with a bit of a movable number here and the markets were surprised when the Treasury announced they would only borrow $75bn in Q2 compared to an estimate of $176bn a few months ago and $488bn borrowed in Q1. So that was a bad day for Treasury bears and the 10-Year Treasury rallied some 10bp (or up 1.5% in price).

Does this mean tax receipts are in great shape and the deficit okay? No. The Treasury prefunded some of its needs and April brings in a lot of tax payments, so we don't get to sound the all clear. It demonstrates the seasonality of Treasury bonds (and therefore the bond market). They tend to be weak in the first quarter of the year. Why?

  1. Inflation tends to come early in the year. If businesses raise prices, they’ll get it done as soon as they can.
  2. Japanese investors repatriate dollars by selling Treasuries ahead of the end of the fiscal year in March.
  3. High refunding needs ahead of tax deadlines (h/t David Ader, IFI Research).

Anyway, with all this, we would expect the 10-Year Treasury to stay well below 3% in the near term, despite the expected Fed hiking in June. So, we’re okay with the level and sentiment in the bond market right now.

Bottom Line: We don't expect any break out from the range bound market we've had for three months. We'd be worried about another round of big and leveraged M&A activity (looking at you T-Mobile/Sprint). That tends to typify late cycle activity.  We'll probably look to reduce portfolio volatility again soon.

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Mount Trumpmore

Elon Musk does not like questions

Beating Harvard with index funds

--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.

 

A look at some bubbles

The Days Ahead: More earnings and jobs numbers.  

One Minute Summary: A lot more economic news to feed off this week but not a lot of action. GDP numbers were soft with consumer expenditures and almost every category weaker than the last quarter of 2017. The high point was a build-up in inventories, which makes sense because consumers went on a mini spending binge last year and companies then had to build inventories back up. Anyway, the market yawned as they did with disappointing factory orders and lower home sales.

The S&P 500 was flat. Some oversold sectors like staples and telecomm did well. Europe was mostly flat but we think they're likely to outperform this year. Emerging Markets were flat but off 2% in dollar terms as the dollar rallied, particularly against the Euro. The 10-Year Treasury hitting 3% was not unexpected and soon retraced.

What we’re seeing with earnings is a pattern of selling on the news. Some of the biggest moves this week were companies that reported perfectly fine numbers but gave weak outlooks. Caterpillar (CAT) was a good example…down 9% on multiyear margins and net income. 3M (MMM), Teradyne (TER) and Freeport McMoRan (FCX) were the same. What’s going on? A lack of the next big thing. Earnings are good, economy okay, inflation ticking up gradually. These are all fine but there’s no big catalyst in the wings so stocks are taking a breather. No reason for any portfolio changes

1.     Bubbles: The problem with bubbles is that they're difficult to spot when you're in them (post hoc is a piece of cake). Having gone through two out of the three worst market corrections in the last 80 years, let's just say we’re on the lookout for any signs of exuberance, rational or not.

Two areas that have given us some concern are commercial real estate and (some) tech and we’ve written about both at length. The two came together spectacularly in a bond offering from WeWork, a company that creates a world where people work to make a life, not just a living. It’s basically shared office space for the tech firms, the gig economy with a lifestyle twist (like free beer and foozball) and has raised plenty of equity money to value it at $20 billion, which would make it the 150th most valuable company in the S&P 500, if it were listed. But to get into the S&P 500 you kinda have to make money, which WeWork does not. The 342 offices are all over the world and in some pretty nice locations too.

They came to market with a 7.85% seven-year $500m bond, with a rating B+, which is pure junk or as S&P put it, has:

“Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.”

No kidding. You’d think with all those offices, it would be an asset intensive business. But WeWork doesn't own the properties, it leases them. So it’s more of an operating real estate company and should be asset light.

Why, then, does it need the money? Because it's tearing through cash. In 2017, it had revenues of $822m and lost $883m. At that rate, it will eat up its cash assets in two years. It has no equity cushion, unless SoftBank chips in another $4bn. Its EBITDA is so awful that the company has to adjust it like crazy:

Source: WeWork Prospectus via FT Alphaville

GAAP says you must produce a real, accountant certified earnings number. That’s around $771m in the above. But GAAP also says you can restate EBITDA if there are one-off expenses (like stock options you grant once), or you expect some earnings to come through for a full year (instead of a partial year). You don't have to disclose exactly how you got there but, from the above, all that gets WeWork to a $193m loss.

They then put in a “Community Adjusted EBITDA” to get it to a $233m profit (the bit in yellow). How did they get there? By adding back in all the sales and marketing expenses saying, in effect, they won't happen again. No investor has ever heard the phrase “Community Adjusted EBTDA” before or quite so aggressive an income restatement. Neat trick: turning a $933m loss into a $233m profit. 

Enough on accounting. But suffice to say it’s a very dodgy way to report your expenses but because it’s a private company, you have to go with it. So how did steely-eyed irascible bond investors take it? They over-subscribed and the company looks set to raise $702m.

So why are we concerned? Mainly because it's:

  1. A hunt for yield
  2. A basic business model (it's a landlord) masquerading as something new age
  3. A ton of debt sitting on a ton of debt because the properties they lease don't belong to them but leveraged real estate companies.
  4. An eye watering valuation

So, leverage on leverage, novel accounting and demand at-any-price is not a great combination. Add in that seven of the world largest tech companies are tech and that never before has one sector dominated the large cap universe, that tech is now 27% of the index (it was 33% at its peak) and, you know, the general euphoria around tech, and well, color us skeptical.

It's another reason why we focus on quality, dividends and companies with management discipline.

2.     ETF Screens: We attended a meeting with a major index provider and asset manager the other day, somewhat under Chatham House rules. The topic was social investing and index managers. Blackrock has made a big splash about corporate responsibility asking that companies account for their societal impact or risk the ire of the world’s largest asset manager. But Blackrock is the largest shareholder in multiple firearm manufacturers and doesn't have much of a choice except to invest in them as long as they are listed companies.

On the firearms side, we ran the performance of the four listed manufacturers (there are others but they're mostly private or foreign) against the Russell 2000 small cap index. They're terrible investments but that’s not really the point.

Most of them are small market capitalizations and together they're only 3 basis points (so, $15 for every $50,000) of the index. The lower line shows the performance of the four companies and, clearly, they have not performed well at all.

What we wanted to explore was whether we could use an ETF that excluded either i) firearm manufacturers ii) retailers of firearms or iii) some broader definition of societal good and responsibility. We'd like your thoughts and please let us know either here and jump to the comments section or here.

Bottom Line: We're in a range bound market for bonds and equities. We expect it to stay that way. We'll be looking for wage and hourly earnings increases in the job numbers. We don't expect to find any.

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Stuffed anteater disqualified

--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.
 

Budget Deficits and Trade

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First, check your index

The Days Ahead: Big earnings week.  First look at Q1 GDP.  

One Minute Summary: A quieter week on the economic front but what there was uninspiring. Housing starts were fine but most of the increase was in multi-family housing. Industrial production was up but flattered by energy and mining, which are 20% of the index.  We saw new nominees for the four (!) open positions at the Fed. We like them so no drama there.

The S&P 500 was up for the week. Small company stocks, Emerging Markets and International all had a better week and all three are ahead of the S&P 500 year to date. The best market was the U.K. It’s by no means out of the Brexit problems but the stock market has a heavy 22% weighting to mining and commodities, which have been on a roll recently.

Earnings were positive. But the market has distinguished between “bad, good earnings” which would be better net income mostly due to lower taxes and “good, good earnings” which would be better because of margins or volume. In the first camp put Philip Morris and IBM (down 17% and 8%) and in the latter, Netflix and industrial supplier Grainger (both up around 6%). Generally, earnings are having a barn- storming quarter with companies showing 18% annual growth. The 10-Year Treasury rate rose to 2.95% but some of that is because of a heavy refunding week coming up. We don't expect it to continue to rise.

1.     How’s that curve flattening going?: We know, pretty much, that the Fed will raise rates another two or three times this year. But this is not the risk in the market. The main concerns are will the Fed Funds rate exceed the 2-Year Treasury and how will the market react? Here's a chart showing the Fed Funds policy rate and the S&P 500.

A few things jump out:

  1. A rising rate environment need not harm stocks. See the period of the 1980s, early and late 1990s and 2003-2004
  2. If the Fed Funds rate catches up with the 2-Year Treasury, stocks will begin to correct or at least tread sideways.
  3. he Fed has for the last 30 years, had a “put” in place. It started with Greenspan and continued right through 2016. Basically, if the market stalled, the Fed cut rates.

We think the Fed “put” is unlikely to happen this time.  As one of our favorite commentators put it,  “The Fed will accept a recession before it allows high inflation.” What we’re seeing now is the gradual flattening of the yield curve and that means the economy is slow and money is tight. The Fed seems ready to pounce if we get a few reports of accelerating inflation. They're unlikely to be concerned if the market swoons. Providing, of course, the Fed can keep its independence.

What does it all mean? Slower growth and range-bound rates…and probably stocks.

2.     What's in an index? Quite a lot actually. We're big fans of indexing but perhaps the most important decision, even before fees, is what index are you going to use? Most indexes are built by:

  1. What stocks do you think are going up?
  2. Decide if you want to rank them by market cap or not
  3. Build an index.
  4. Launch an ETF

But step 1 is kind of important. The classic example is the U.S. Small Company index from Russell or S&P. The Russell is by far the better known and older, arriving in 1984 and just in time for when the small-company effect was identified. Some 93% of the $1 trillion in small company funds and ETFs are benchmarked to the Russell 2000. But a few years later, S&P came up with their version of a small-company index. This is how the two have done since then:

We're interested in the blue bar, which is the S&P 600 and you can see it outperforms the Russell 2000 in 17 of the 23 years since 1994. It gets even better because its margin of outperformance on the downside is larger than its upside performance so the volatility, risk and things like Sharpe ratios are also superior.  

So how much more did one earn using the S&P 600 versus the Russell 2000? Well, a $10,000 investment made in 1994 would be worth $131,000 in the S&P 600 and $86,000 in the Russell 2000. Now S&P knows their index is better so they charge for it. But that cost is absorbed by the ETF provider and doesn't show up in the expenses paid by the shareholder.

How do they do it? Here’s a rundown:

B&J60secondiinsights 4-20-18 LECH edits.jpg

Basically, the S&P 600 has a quality bias and because it rebalances more frequently it’s less prone to front running. This happens because an active manager can identify what companies are likely to fall out or be included in the Russell 2000 and start to trade it ahead of the July 1st date knowing that, on that date, some $750bn of funds will be forced buyers and sellers. In fact the rebalance effect alone accounts for 0.6% of the 1.9% annual outperformance.

So if the S&P 600 is so much better, why is it still around? Well, two reasons. First, there is a place for an index that just takes all the listed companies and basically says “this is what’s available, use it if you want.” Second, it's an easy index to beat so active managers tend to like it.

The lesson? Indexing is great but always ask how the index works. There are many ways to construct an index and, as you’d expect, some are distinctly better than others.

Bottom Line: There is profit taking going on as well as some sector rotation. Energy is a favorite sector right now. At the risk of sounding like a broken record (what’s the digital equivalent?), the tweets and politics could unsettle the market very quickly.

 

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Robert Mercer and the police

Theranos still misbehaving

 --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.

 

 

Excuse me, have you seen the Budget Deficit?

The Days Ahead: Earnings season starts up. Financials and Energy stocks should be good.

One Minute Summary: The Fed published the minutes from its March meeting. They think growth will accelerate later on this year and made the usual cautionary noises about inflation. The bond market ignored it. Bonds were also unfazed by the inflation report (see below). Markets were also not terribly surprised by the CBO report, which calculated that the 10-year cumulative deficit will rise 32%. Most economists had worked that one out.

The market was mesmerized by tweet storms. Some historians went back to the Cuban missile crisis to see what happened there (a 7% drop then recovery) or with the NATO bombings in Yugoslavia in 1999 (the market rose 12%). The placatory remarks from President Xi Jinping helped. Stocks rose 3.2% through close on Thursday. It was a good week for most sectors except utilities and REITs, which tend to be rate-sensitive.

U.S. small cap, Emerging Markets and International are all ahead of the S&P 500 year to date. Russia had a bad week, down 14%...which happens if you get hit with sanctions. Russian stocks are only 3% and 2% of the Emerging Markets equity and bond indices (we don't use Emerging Markets bonds).

There has been no direction to the market for over a month. Some of this is because of a news cycle that's more noise than signal. Earnings season starts soon and it will be good. Expect big numbers across the board and especially energy. No changes to our portfolios.

1.     How’s the CBO doing? Pity the staff at the Congressional Budget Office. They have a hard-earned reputation for non-partisan work but had to rush through an analysis of the tax cuts in December 2017, days before the bill was passed. Their best estimate at the time was that the bill would add some $1.4 trillion to the deficit over 10 years.

But it's actually quite a bit worse. This time last year, the CBO report said that the 10-year projected deficits would be $9,422bn (here, page 89). Fast-forward to December and it was, well, if you go and cut taxes, it will add $1,454bn to that number.

Last week, they had a chance to run the numbers again and it's $3,000bn more than this time last year. So, now instead of the 10-year deficit being $9.4 trillion, it’s going to be $12.4 trillion, Oh, and debt held by the public (which is all the federal debt except that owned by trust funds like Social Security, Medicare and Retirement funds) will grow from 75% of GDP to 95%.

Anyway, here’s the chart of budget deficits as a percent of GDP to 2028, heading up to 5% of GDP from a 50-year average of 3%. In fact, the deficit has only been over 5% of GDP five times since 1946 and four of those were in the depths of the 2007-2009 recession.

Why are deficits growing? Well, it comes down to lower revenue from corporate taxes of course which are permanent, and lower income taxes up to 2026, after which they jump because they expire in 2025. And it’s also because of mundane things like higher interest rates on the higher deficit.

Does it matter? You tend to get three answers:

1.     No. We owe it to ourselves. See Japan etc.

2.     Heck, yes. No family budget can go on spending like that.

3.     It's complicated.

 There were an awful lot of people who were on the side of #2 but they've gone to ground/retired recently. Answer #1 can be true if you have a nation of savers and don't rely on outsiders to finance your debt. As for #3, the CBO puts it best:

 “Such high and rising debt would have significant negative consequences, both for the economy and for the federal budget”

We've had deficit panics in the past. But then we had higher growth and higher inflation (which reduces the real cost and value of debt). Today we have neither of those. Put it all together and we would say this is another reason to expect low growth for many years.

2.     Do we have an inflation problem? Not yet. We had two major inflation reports, Producer (PPI) and Consumer (CPI) prices. The headline numbers were 3.0 % and 2.4%. On the CPI side, we’d note that there’s a “base effect” especially in three areas. First, in energy. This time last year, prices for gasoline and energy were flat or down. But oil is now 26% higher than a year ago (lucky California drivers are paying 30% more than 18 months ago), so energy prices are up 7% but from a low base. Second, cell phone prices dropped sharply last year (we wrote about it) but now they've stopped dropping. Third, medical care expenses rose from a year ago when the ACA had negotiated lower hospital costs. Those too have started to rise. Together these three are around 15% of the index.

Here’s the chart with the cell phone expenses at the bottom now rising.

Take some of these base effects out and we’re looking at core CPI at 2.1%, which is unchanged. Over on the wages side there is no real movement either. Any increase is in more purchasing power not increased wages. Remember the BLS puts you down for a wage increase if your wages don't change but prices fall.

So we remain in the camp that inflation won't really take much hold although the Fed will talk about it.

Bottom Line: We don't think business and consumer confidence is running very high. Stocks are going to react and overreact to very bit of news. Look for what CEOs say in earnings calls. We feel we’re well positioned for a rough few weeks.

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Takahata Isao and Grave of the Fireflies

And Gillian Ayres died

--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.

 

Letting the trade waters go by

The Days Ahead: US inflation. Watch for German and China trade.

One Minute Summary: Markets were slow. Many traders and investors were off for the week. Europe was all but closed. The trade and political stuff makes for big jumps in volatility. This is good for bank trading desks and option writers. For long-term investors it’s not a problem unless they react to it. As we’ve mentioned before, this volatility feels unsettling because it’s been quiet for much of 2017. In fact, volatility is bang in line with its long-term average. Welcome back my friend, to the show that never ends.

U.S. Treasuries were up. Bond spreads ticked up. That's the credit worries at work. The S&P 500 was down 1.2% for the week. It’s down 2.5% so far this year but up 11% on the year. Small caps have done comparatively well this year. Tech was down again. It’s mostly fear of regulation because we don't expect earnings to be hit soon. We would still buy the protection we put in place for clients recently.

Europe and Emerging Markets were positive and have outperformed the U.S. by around 2% this year. Japanese exporters had a tough week. They're in the trade crossfire. Last year, Prime Minister Shinzo Abe gave President Trump a hat with a logo reading “Donald & Shinzo, Make Alliance Even Greater.” He may ask for it back.

1.     What a mess with China:  You may have noticed there was some chat on trade with China last week.  Some 99.99% of economists believe trade wars hurt the world economy. The others don't. We found it useful to try and unpack some of the talk, ‘cos , you know, you might think we have a $500bn trade deficit with China. (Skip to the end if numbers are not your thing). 

1.     The U.S. has a $375bn goods trade deficit with China. That is made up of $506bn of stuff we buy from China and $130bn of stuff we sell to them

2.     The U.S. has a massive $38bn surplus in services with China. Bigger by far than any other country. It's mostly travel, IP licenses and business services (do a consulting gig for Alibaba without even leaving your San Francisco office and it shows up here)

3.     The trade deficit is thus $337bn. Still large but not $500bn.

4.     Most of what the U.S. sells to China is food, aircraft, cars and capital goods. They're 52% of all exports.

5.     Most of what China sells the U.S. is cell phones (some $65bn a year), computers and telecomm equipment and toys.

6.     The U.S. has 25 products that account for more than $1bn in sales to China. China has 68 coming the other way.

Now it would seem that China is in a very good position here. The U.S. has targeted 25% tariffs on some $50bn of goods coming in from China.  So that's $12.5bn. Here’s the full list, starting with Thorium. They left off the cell phones because because that “Designed in California, assembled in China” on the back of your iPhone means exactly that. Apple and others would have a fit if those were part of the deal.

China, of course, retaliated last time on the steel tariffs with 25% tariffs on $3bn of stuff from the U.S. That's the wine, ginseng and pork products one. So, that’s $750m. This time, they've targeted the big ones like soybeans, aircraft and cars. They floated a tariff rate of 25%, which would cost U.S. exporters around $22bn.

Put this all together and we’re looking at around $45bn of cost for U.S. exporters and U.S. consumers. That’s around 0.2% on a $20 trillion economy. If the U.S. goes with the $100bn increase we heard about last night, then add another $25bn for a total of 0.3% of GDP.

But this is not the point. What worries businesses is how far this can go, whether supply chains will have to be redesigned or business strategies rethought. So Boeing, John Deere and Caterpillar were all down around 12% recently. The stock market reaction, down some $1.5 trillion since February, is way out of proportion. But then it nearly always is.

The foreign exchange market, however, is not rattled. If markets get really scared about this, expect the dollar to strengthen and the Yen and Renminbi to weaken. It’s been the opposite.

Anyway, here's the trade deficit with China. It’s 50% of the U.S.’ entire trade deficit. If I were a betting man, I’d say the U.S. will have a tough time winning this one.

2.     How about those jobs numbers? Meh, not so good. It was just 103,000 compared to 326,000 in February. We have a kind of love-hate relationship with the jobs numbers. On the one hand, they're a big, market-moving event. The Fed follows them because it’s part of their mandate. And you’ll occasionally hear an administration mention them. But they're subject to huge variations from initial to final, have weird seasonals and tend to over or under report against consensus by 50,000. Yes, a 100,000 estimate produces a 50,000 to 150,000 result. And that's considered fine.

Anyway, here they are with the bottom line showing average wage increases.

That’s the number that got everyone worked up two months ago when it spiked. We thought then it was a seasonal thing and it certainly looks that way now. Average earnings were up 2.7% but these are nominal not real increases and skewed to supervisory workers. The non-supervisory workers saw a much smaller increase and lower weekly earnings.  Which means they had a modest pay rise but got to work less.

The market had other things on its mind and gave the numbers a big yawn. It was mildly bullish for Treasuries with rates at 2.78%. It all supports our low growth low inflation outlook.

Bottom Line: Expect markets to react a lot to bellicose trade talk. Mr. Zuckerberg will visit Congress. Probably best to stay clear of big tech for a while.

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Tearing up Econ 101

--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.