The Days Ahead: Shorter week. No major economic news.
One-Minute Summary: When the Fed announced it would stay patient a few weeks ago, some tired punters thought, “Aha Trump got to them.” But, the Fed was actually spot on. The economy is weakening (no, not recession). This week we saw a low CPI report at 1.6%, the NFIB (a proxy for small businesses) optimism index plunged, retail sales came in very low and on Friday, industrial production (IP) fell 0.6%. The last one is all about China. As the China index falls, so does the U.S. The business equipment sub-component of IP was down 1.5% and automotive down 15%. That’s all trade war related. The folk over at the Atlanta Fed revised down expected growth for Q4 2018 to 1.5%. It had started at 3.5%.
So growth is slower and one of our favorite Fed Presidents (here she is), reiterated the China, European, Brexit, trade and growth risks and underscored the whole “patient” mode. The 10-Year Treasury traded in a very narrow and bullish range. It’s now 2.67% and yielding only 25bps more than 3-month bills. A year ago, that was 120bps. That’s why we’re in the Treasury FRNs.
Hey, look, it’s all on trade right now. How are the talks going (“great”)? Are there concessions and commitments from the Chinese (probably)? Will the tariffs be delayed (yes)? The market feels a little nervous for sure and most indicators of liquidity are well below 2018 levels. That feels like a market wanting to go up but worried about being caught out. We're still 5% below the ding-dong highs of August but up 11% from the December lows. Again, Small Cap has outperformed by even more and Emerging Markets are up 8%.
For the record, we’d like to see a consolidation. But as we've learned along the way, “rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
There are lots of problems with government shutdowns. One is that the IRS missed 16 days of tax refunds. So far this year, there has been $21bn of tax refunds compared to $29bn at the same time last year. It may continue. The IRS thinks only 10% of taxpayers itemized in 2018 compared to 30% in 2017. It seems fewer people over-withheld so the normal March-April boost in retail sales may not happen (h/t Cap Eco).
1. The war on buybacks. It’s a tough life being a S&P 500 CEO. You know, you go along for years doing things that shareholders like. You announce a share buyback and everyone claps and say’s “Yay, this guy read his Jensen and is returning cash to us in a tax efficient and orderly way”. Actually, they probably stop at “Yay” but you get the picture. And for a while, all was good in the land of investors. Heck, they even built ETFs around it: IPKW and SPYB but please don't buy. But of course, buybacks lost favor, both ETFs went pear shaped and underperformed the S&P 500 by very big amounts.
We're often rude about buybacks because one big problem is “are they buying back stock because they really can't find anything else to invest in or is it just to increase earnings per share without increasing earnings?” By the time you find out, it’s too late. IBM, Foot Locker, Yahoo, Halliburton and many others made very large buybacks and never saw much change in their share price.
This is how they work. The company below, Tweeyelp, makes $50m a year and has 100m shares in issue. It decides to buy some shares. It buys 10m shares for $100m. Now there are fewer shares (90m) with the same earnings. All things being equal (they never are but stick with us), the price is now 11% higher. Yep, that's all it is.
Anyway, people don't like them as much anymore. The 2018 tax cut aimed to increase capex, wages and employment (any day now) but a lot went to share buybacks instead. No surprise really, the same happened with the 2003 Bush tax cuts when buybacks more than doubled in the next two years.
There is a small but growing “buybacks are bad” crowd and it just recruited a new member on Wednesday.
Stocks reacted immediately.
That move was worth about $101bn. Which tells us two things. My, this market is nervous. A small thing like that was enough to upset investors. Two, expect more talk about corporate governance and some rollback on the corporate tax front. It may not happen soon but I suspect there’s more bipartisan agreement than meets the eye. And if this all keeps bad buybacks at bay (there’s a bumper sticker there), then…good.
2. Is the big increase in the deficit going to be a problem for Treasuries? No. Sure there are some very serious people who think that all debt is bad. Last week the total amount of U.S. public debt reached $22 trillion (here's the debt clock and here’s the Treasury’s more sober view). For those who worry about these things, this was a bad number as it now exceeds U.S. GNP. You would think that if the U.S. keeps running deficits and issuing more Treasuries, that investors would demand ever-higher rates.
You would think but it ain’t necessarily so. In Japan, public debt is 220% and has doubled in the last 20 years. But the yield on the Japanese Government 10-Year bond has fallen from 2% to 0% and it hasn't moved for three years. The debt in the green line and the 10-Year bond in blue.
Now there’s a vigorous debate about all this. On one hand, there’s the “we owe it to ourselves don't worry” school and MMT has found some fans in Congress. On the other, there’s the belief that high government borrowing crowds out other investments and threatens basic freedoms.
Without getting into the theory, here’s why we like Treasuries right now even though supply is growing:
Compared to other major high credit sovereign borrowers, the U.S. provides a very attractive rate of interest. The 10-Year Treasury is now 2.7% compared to Germany at 0.1%, Switzerland at -0.3% and Japan at 0%.
The Treasury is very good at managing auctions and has come up with a number of innovative ways to sell debt. These include inflation protected and Floating Rate bonds and Cash Management Bonds. There is talk of a 20-year bond (there’s only 10 and 30 year bonds at the long end), zero coupons and bonds indexed to health care or college inflation.
The ratio of public debt to GDP is overstated. The headline number is 104% but really, it’s 74% because Social Security and various government pension funds hold about $6 trillion of the debt (Schedule D on the attached if you're interested). Nearly every commentator omits this point.
Inflation is low. If a risk free bond yields more than inflation, we’re off to a good start.
Demand for risk-free securities remains high. If you’re a bank, insurance company or pension fund, a guaranteed, liquid non-callable investment looks pretty good. Especially with new capital ratios.
Non-financial corporate debt rose to 46% of GDP last year up from 40%. There’s no sign that they're being crowded out.
We could go on. But for now, the easing off of the economy, a patient Fed, tame inflation and low global growth all make Treasuries a very attractive investment. And we’ll argue all day against the debt doomsayers.
Bottom Line Earnings are coming in well. Up around 13% so far. Fewer companies issue guidance these days (a good thing) but those that have tended to guide lower. That’s to be expected. Valuations are fine. We've set the portfolios up for downside.
Please check out our 119 Years of the Dow chart
Subscribe here for our investment updates
How to wreck a pension plan
--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.
Daniel Hart - Theme