The Days Ahead: More on talk about trade and tax cuts but we don't expect anything significant.
One-Minute Summary You know how it goes. The market picks itself up from Arctic real estate deals and creative policies from the Administration and then….one of these comes along:
We don’t need China and, frankly, would be far...better off without them. Our great American companies are hereby ordered to immediately start looking for an alternative to China
Ordered? Did he? Will he? Can he? The U.S./China trade in goods and services is $910bn or 4.2% of GDP. A 25% reduction would put the U.S. economy into recession. After the close, the USTR raised tariffs again, to as much as 30% on consumer goods and another 5% across the board.
And that was enough to take 2.8% off the S&P 500. By close, all but 12 S&P 500 companies and 29 of the 30 Dow companies were down on the day.
The Fed came through with a speech from Chair Powell spelling out that trade was the single biggest challenge to the economy. Just to emphasize he added “We have not seen unsustainable borrowing, financial booms, or other excesses…” All that points to a 25bp cut in November.
The FOMC minutes said the same although there was more dissention than previous meetings. We’re not worried about that. Richard Fisher, the Dallas Fed President and FOMC member in 2008 and 2011, voted against lowering rates in every meeting he attended. No one really cared.
Stocks were down on the week but that was all due to Friday’s action. Bonds and international markets were mostly unchanged but had the advantage of closing before the tweet.
1. How are European banks doing? Not well. European banks and financials remain a very large part of any European stock market. Around 21% for the Eurozone as a whole. It was larger but European banks took a big hit in the financial crisis. In the U.S. banks used TARP to remove bad assets (which for a bank means non-performing loans). They also consolidated.
But in Europe, the 2010 crisis extended the maturity of many of the bad loans. That meant, unlike the U.S., banks kept the bad assets. They then had to raise capital to stay in line with new regulations. The mix of more capital and bad assets meant profits and returns plummeted. So did the share prices.
Here's the chart (look away if you're long European banks):
The bottom line is that if you put $100 into European banks 30 years ago you would have $68 today. There have been a few short-lived rallies, such as 2017, but nothing sustainable.
European banks now face two problems. One, a central bank at zero rates and two, a very competitive landscape. Zero rates mean that deposits pay negative rates and any loans made at narrow spreads. And for competitors, many, like the Landesbanks in Germany, are state owned and don't care about profitability.
So, pity the European banks. The only way out is to find other sources of income, like fees, credit cards or investment management. Most tried and failed. If the ECB cuts rates more, the banks make even less money. If there’s a recession, and Germany just reported a negative GDP quarter, the bank’s credit losses soar.
The stock market is ahead on this. You could buy nearly every (not just one) major European bank, for half a Facebook and have change left over. It’s an object lesson that low rates can lead to a failing banking industry. The same is true in Japan. We've dialed down European exposure this year already.
2. Are bonds in a bubble? No. Yes, 10-Year Treasuries are at 1.5% and the ETF to track Treasuries we use was $99 last fall and is $113 today. So, tidy profit. But to have an asset bubble you need some conditions:
Leverage: cheap, available debt to buy the asset of choice.
Extended valuations: where prices far exceed their intrinsic value
A story: something new, a hook, to keep new investors coming
FOMO: a “fear of missing out”
Euphoria: we’re all going to get rich
Panic: big liquidations and no new buyers
Now, do these exist in bonds and more specifically Treasuries?
Leverage: some companies, especially in the High Yield and BBB space are taking on cheap debt. But no one is really leveraging to buy Treasuries (leave aside swap markets for now)
Extended valuations: some companies sit on some cheap debt especially the casino, oil and gas markets. But Treasuries? No. The yields are historically low for historically good reasons
FOMO: anyone buying Treasuries is buying safety and real yields. They’re not buying to get rich
A story: none. There’s no talk of a “paradigm shift”, “making the world a better place” or “disruption”. It’s more a savings pool looking for predictability.
Euphoria: quite the opposite. Investors are buying because they’re liquid, risk-off havens.
The U.S. 10-Year Treasury is not alone. Here’s a chart showing the 39 year grind to low rates for all major sovereign borrowers:
We would argue that rates will remain low, as in under 2.5%, for a while. Why?
The U.S. economy is slowing for cyclical and secular reasons. Sure, a tax hike may bounce it higher and trade wars will certainly push it lower. But this is a 2% economy.
Central banks are very dovish.
There’s no fiscal demand anywhere
Inflation may have occasional burps from oil but the trend remains low
Trade wars have everyone on edge
The trend to lower real interest rates has lasted decades and likely to continue as reverse. You know we’re fond of long-term charts so here’s inflation and real rates for 100 years.
That black line is real yields, or the nominal 10-Year Treasury less inflation. It’s been around this level for 20 years. But during that time, inflation has clicked along at a metronomic 2% for even longer (h/t John Authers and Robin Harding).
So put it all together. We're not in a bond bubble. Bonds merely reflect expectations for low growth and uncertainty. If we get a trade deal, a hike in wages and a rise in core inflation, then, yes, bonds could reverse up to 2.5% or 3%. If…
3. Recession watch, any update? Not really. We had a preliminary PMI report for manufacturing below 50, which means more respondents saw output contracting than expanding. But these are preliminary numbers and track below the ISM equivalents (h/t Cameron Crise). And we knew about the woes of the manufacturing sector. We saw updates on existing and new home sales, both unchanged year over year.
Inspired by a WSJ article via the folk at BMO, we looked at some of the debt overhang with consumers, especially student debt.
It shows different types of loans that are 90-days delinquent. At the top are student loans at 11% and mortgages at the bottom at 0.9%. We're not concerned about defaults crippling the rest of the economy. It’s just that graduates with debt tend to postpone buying houses, building homes, marrying and having children. Or to put it bluntly, their peak spending years never happen.
Another reason to believe the economy won't respond much to lower rates.
Bottom Line: The Fed and other central banks will do all they can to keep rates down and ready to cut further if there is more trouble on the trade side. Markets may become numb on the trade wars, which makes sense because they've had two years of high tension. And you get tired from that. Still, we’re in the cautious and defensive camp for risk assets.
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Artist: Faith Ringgold b1930
--Christian Thwaites, Brouwer & Janachowski, LLC
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