The Days Ahead: Jobs numbers and Fed meeting
One-Minute Summary: At the time of writing, equities were in a good mood. Seven out of the last 10 trading days were up and the S&P 500 is up 6.3% this year. That's roughly back to early November levels and up 12% from the miserable December days. Small Cap is up even more…up 15% from the lows.
The White House announced the end of the government shutdown but it was conditional and we could end up with the same problem two weeks from now. In the last nine shutdowns going back to the 1970s, stocks haven’t reacted much. You can barely find them on a graph of the S&P 500. This time stocks have risen around 9% so we’re not expecting a big rally.
We thought markets had over-reacted to recession fears last year. What we’re seeing now is the market retracing some of its losses and preparing for a slow down, a neutral Fed and low rates. It's not a signal that we’re all back to happy 2017 and early 2018 days but more of a measured response to an orderly slow down. There’s no good news from Europe and China and that places the U.S. in front for growth and upside.
Earnings season is going well. They're up 11% for the 100 or so S&P 500 companies that have reported. They might be guiding lower but markets expected that. Last year’s tax cuts were meant to lead to a capex boom, more domestic investment, wage increases and more jobs. That was nonsense. But it led to very large stock buybacks. They won't be around in 2019 but markets expect as much.
U.S. Treasuries have had a good three months with the 10-Year Treasury falling from 3.25% to 2.75%. That's about a 6% return excluding the coupon.
The three big things on our mind are:
Government: new rapprochement or ongoing divisiveness (not really a question) and a China deal
Fed: on hold for three months, six months or more?
Economy: how much of a slow down?
We think these are all manageable. So we continue to like Treasuries, the U.S. and some protection on risk assets.
1. How’s’ Europe doing? Not so good. European stocks had a very strong 2017 but a torrid 2018. The U.K. dominates European stock markets. It’s nearly one third of the all-European index. Germany, Switzerland, France and The Netherlands make up another half. We tend to invest in the Eurozone-only stocks, which excludes the U.K. (handy while Brexit drags on), the Nordic counties and Switzerland. The case for Europe some 12 months ago was:
· Pickup in activity and global growth
· Ongoing easy monetary policy from ECB
· Politics calmed and labor market reforms
· Relatively cheaper stock markets
· Brexit would work
Fast forward and we had 1) Italian elections and a huge row with the EU over the budget deficit 2) the “gilets jaunes” or Yellow Vest protests in France which took aim at just about every reform President Macron had in mind 3) trade tensions with the U.S., especially autos at 20% of the index, and 4) banks, another 20% of the index, which struggled with low rates and bad loans.
The ECB announced this week that the outlook had weakened and would keep rates low. But rates are already 0% and the central bank charges negative rates on its deposit accounts. It has stopped buying bonds through the QE program mainly because there are fewer bonds to buy. So what next? They'll keep reinvesting coupons on the bonds they own and keep the guidance low. They can use the TLTROs, which are incentives for banks to lend. And they can switch QE back on gain. So, they have plenty of options.
Meanwhile, we've also seen some slow pickup in inflation and wages:
That lower green line is a sign that wages are increasing and could feed into more consumer growth. We also like the relative value of European stocks. They yield nearly twice as much and trade at a 25% discount to U.S. stocks. According to one respected street analyst, the share count of European stocks was negative late last year. That's a good sign as it means companies are buying back shares and not issuing new equity finance.
We’re somewhat cautious on Europe. Its ties to the U.S. and China are strong so it’s getting caught in a very uncomfortable middle. We're looking at some protection strategies. Watch this space.
2. Long View on the bond market. There are two important themes in the bond market, which we think investors should know.
Treasuries. We know that 2017’s tax cuts increased the deficit and that the Fed is drawing down its balance sheet. So that's two important sources of Treasury supply. Right now, U.S. Treasuries are about 40% of the broad bond market indexes. It’s going to rise to around 50%, according to one very respected strategist. More and more bond assets are in ETFs. Those ETFs match an index and must buy Treasuries. They will be a steady source of demand. They have no choice, unless the index compilers re-write the rules.
It’s a weird inversion of normal supply and demand rules. There are other reasons we like Treasuries (low inflation, Fed on hold, relative yield, safe haven etc.) but this index thing is a real force and we wouldn't underestimate its impact.
BBB Bonds. BBB bonds are one notch above junk. They've also grown to be a very large part of the bond market. They were 35% a few years ago and they're now closer to 50%. There are worries that in a recession, many borrowers will be downgraded and tip into junk status. So what, you may ask? I liked it at as a BBB and I like it at BB. But many investors, including our friends the index providers, cannot buy or hold junk bonds. So, yes this is genuine concern. A bunch of bonds that were considered good credit but slip into bad credit means a lot of forced sellers. Which, you know, is usually not good.
But, many of these BBB borrowers are banks with better capital than they ever had. Citibank, Barclays and JP Morgan alone account for 21% of that growth from 35% to 50%. Another 50% comes from four companies: GM, Ford, AT&T and Verizon. These may not be the greatest companies around but it tells us that “the whole bond market is about to implode” story is very over done. It's not a system wide problem. It's about five companies that have plenty of financial clout.
So, we’re not worrying about non-junk credit and you shouldn't either (h/t Columbia Threadneedle).
3. Are flash crashes still a thing? Yes. These are unexplained sudden and very large price movements. There are post-hoc diagnostics, which never make much sense other than “stuff happens”. Last week, Jardine Matheson, one of the largest companies on the Singapore stock exchange had an 80% pre-opening drop.
It’s a bit difficult to see because, well, being a flash crash, it was all over in minutes. But a mighty, blue chip stock closed the previous evening at $69 and was traded at $10 just before the open. The actual trade loss for one investor was $9m. It doesn't seem as if any ETF or mutual fund was affected and certainly no investments that we held. The Singapore authorities reviewed but did not cancel the trades.
Sure, these things are rare but if you're caught in one, you could be wiped out.
Bottom Line. Another good week despite the dearth of economic data…mostly because the various agencies were closed. The Treasury market should stay in recent ranges of 2.7%.
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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.
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