The Days Ahead: Big 10-Year Treasury auction. Inflation numbers.
One-Minute Summary: One of those weeks when you think lots of stuff happened, markets must be going bonkers. But stocks had a good week. Earnings continued to do well and of course, Apple, had a strong week. It’s now 4% of the S&P 500 and $1 trillion. It’s an even higher weighting in 8 out of 10 of the largest ETFs, ranging from 4% for an S&P 500 tracker and 15% in the Technology Sector fund (ticker XLK). Not to spoil the party, but we’d remind readers that Altria has been a much better stock since Apple’s IPO back in 1980. One hundred dollars invested in Apple back then is worth $55,000. For Altria it’s $88,000. The slow and steady increase in Altria along with dividends was a better investment than the long no-dividend policy of Apple and the 17 wilderness years. Still, great company and justifies much of the run-up in the S&P 500 in the last few weeks.
Trade was front and center again. The U.S. Trade Representative raised the stakes by increasing tariffs on $200bn of goods from 10% to 25% but not until September. The Chinese shot back announcing yet unspecified tariffs on $60bn of U.S. imports. The U.S. exports around $120bn of goods to China every year so, yes, the Chinese may be running out of retaliatory measures.
There’s a sort of trade truce with the EU right now so expect more on the China trade for a while. If markets seem numb to the trade issues it's because there’s still a big gap between what’s been threatened and what’s been implemented. However, the Yuan/$ rate is getting a lot of attention. The Yuan has weakened by 8% since April, negating much of the effects of higher tariffs. That's one reason why we’re a little cool on Emerging Markets right now and taking protection.
Elsewhere, the job numbers were lower than expected and average hourly earnings didn't move much. The numbers won't change the Fed’s mind on a September hike. The 10-Year Treasury broke through 3% for one day and settled back to 2.95%. If a 3.9% unemployment rate isn't enough to push yields higher, what is? We'd say earnings and wages (not increasing), a better trade deficit (no), more confidence from the Manufacturing and Non-Manufacturing sector (no), more aggressive talk from the Fed (not there either), or higher inflation (see next week but probably not).
1. Should we care about the budget deficit? Yes, but not yet. One of the ironies of the last year is that the normally fiscally disciplined politicians signed on to a very big tax cut in the last stages of an economic cycle. The argument for such a move was that lower taxes would spur investments spending, growth, productivity, all sorts of good things and, of course, lead to higher tax revenue. So:
Step 1: Cut taxes
Step 2: Wait
Step 3: Higher growth and more tax revenue
Tax revenue is down $150bn in Q1. It will be more in Q2. Corporate tax receipts are down 48% and, as a percent of GDP, at a 70-year low. The OMB announced that the deficit in 2019 is now $1 trillion or around 5% of GDP.
We'll stay away from the soundness of such a policy and point to two things.
First, here’s a chart of the deficit and unemployment since 1948.
We've inverted the unemployment rate to show the relationship. As the economy enters a recession (the shaded bars), unemployment rises and deficit spending increases to make up the shortfall. There’s a drop off in tax receipts, of course, but the general approach is to smooth out demand when the economy most needs it. Once the recession eases, stimulus is removed and the deficit improves.
What's remarkable about the last year is that the two lines have gone in wildly different directions. This means that if there is a recession, there’s little scope to increase spending when it's most needed.
Second, there’s the increase in borrowing. The Treasury just announced funding needs for Q3 and Q4. It’s a very big number. In Q3 the Treasury expects to borrow a net new (i.e. after funding maturing debt) amount of $329 bn, up $56bn from April estimates. And in Q4 it expects to borrow $440bn. Again, net new. That compares to $72bn in Q2 and $192bn and $204bn in the same time last year.
The Treasury is doing all it can to help the process. They're introducing 2-month bills for the first time. They’ll come in November at a rate of $25bn for seven weeks. They increased the amount of 5-Year Treasuries by $1bn a month and the amount raised from bills (so less than 12-months) from 18% to 27% of the total. That should make it easier to absorb and keep longer-term rates from rising as fast.
What does it mean? One, we like the short end of the Treasury market. It’s a strong risk adjusted place to be in the yield curve. Two, we also like medium term (7-10 year) Treasuries as we think rates will peak some time in 2019 and not affect the middle of the yield curve.
2. Why are asset managers not good investments? I mean, you know, they manage money for a living so you might say to yourself, “these guys know what they're doing, I’ll buy the stock and get a nice alpha-laden return on the S&P 500.” But no. The public fund companies have been pretty awful investments. Here’s a composite of some of the biggest (we left out Invesco and Blackrock but they are not the exception…we just ran out of names):
Over the last 10 years, an investment in some leading asset managers underperformed the S&P 500 by about 45%. It doesn't get better if we change the dates. Year to date, three, five and 15 years are no better. Are they just bad managers? Erm…no, but they're in a tough business. What has been investors’ gain in the form of low cost index funds has been asset managers’ loss. Many are caught between low cost providers, like Blackrock, State Street, American Funds and Vanguard and specialist hedge, private equity and venture funds. ETFs and low cost funds are now around 20% of all managed funds and take an even greater share of flows.
Many will adapt. Either by merging, shrinking or finding new areas of growth. But for now, it’s probably more disruption and declining margins.
Bottom Line: Earnings are still doing well. The Yuan, trade and macro numbers will drive sentiment. Meanwhile, stocks, as we’ve mentioned, stocks are trading on forward P/E of 16.6 cheaper than all of 2016 and 2017.
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--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.
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