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Highs in the Slow Lane

The Days Ahead: First estimate for Q4 GDP

One-Minute Summary:  Man, it was slow this week. The U.S. Treasury market hasn’t seen this low level of volatility since late 2017 and it's at its fourth lowest level since 1988. It’s all because we know the economy is slowing and the Fed on hold. Until either of those expectations shifts, we don't see much reason for a breakout. What news there was, lower capital good orders and home sales, confirmed the slow down. The Fed is making it good for risk assets and equities continue their rise. The S&P 500 is up 11%, Small Caps up 17% and even European stocks, which had a tough 2018, are up 8% to 10%. 

The market is getting used to an earnings slowdown. After growing at 22% in 2018, most expect around 4% to 6% in 2019. That makes the market reasonably priced to us and no portfolio changes.

 1.     How are we going to fight the next downturn? Er…good question. This came up at one of our recent client meetings. So, if the Fed Funds rate is at 2.5% and the deficit at 5% of GDP and growing (thank you tax cuts) what do you do if there’s a recession? Because rates are already low and the deficit grew $1.2 trillion last year. It’s a fair question. Let's start with what happened in the past.

Here’s the last nine recessions from the last 61 years. The current expansion is 127 months old, beating the record of 120 months in the 1990s by a few months. But two points.

 One, the 1990 recession was relatively shallow and quick so the expansion was more like 1982 to 2001 or 212 months (not all agree with this!).

Two, as we've said many times, we've had a not-so-great recovery since 2009. There was nothing like the snap back we saw in earlier recoveries. That suggests a mild recession when it does come (which is not yet).

The average expansion and recession since 1857 is 38 and 17 months. Since the 1940s, it has been 58 and 11 months. And since the 1980s it’s been 95 and 11 months. Generally, expansions are longer and recessions shorter. That may be because the Fed is Johnny-on-the-spot when it comes to managing the recessions. The amount the Fed has cut its rate on average is 400bps and, in the case of a sharp recession, as in 1980 and 2008, as much as 550bps (that's the right hand column).

Here’s a long term graph with the Fed Funds rate.

Clearly, with Fed Funds at 2.5%, over there on the right, the Fed cannot cut anything like the amount it has in the past. So what to do?

There’s a lot of debate but we’ll focus on the stuff which we think effects investments.

Monetary Policy

  1. The Fed could go to zero and negative rates. Not great for savers but would probably work.

  2. Quantitative easing again. It worked before and there could be scope for more especially, in equities and private bonds

  3. Targeting interest rates or yield curve targeting. Japan targets the 10 –Year bond at 0%, from which every other rate takes its cue

  4. Inflation targeting: the Fed could raise its inflation target

  5. Macroprudential management: include managing bank capital or mortgage loan ratios

  6. Forward guidance: telling the market the Fed would hold rates down for specific and long periods.

 Fiscal Policy

  1. Project and infrastructure planning. A missed opportunity in 2009 but perhaps next time.

  2. Relaxing lending restrictions.

  3. Easing of employment laws.

  4. Changes in regulation

  5. Distributive tax cuts with time limits, to encourage spending over saving
    Extension of unemployment benefits. Again, worked in 2009.

  6. More borrowing. As we've discussed the U.S. has considerable and unique borrowing rights

  7. Global coordination.

Of course, many of these would require a political will not currently in evidence. Nor is the list remotely complete. Good economists could generate many good ideas in double-quick time. But our point is that despite debt and low rates, policy options abound. We are not at all worried about low rates. We think they’re the norm. We'd prefer not to have the level of deficits but a downturn is very manageable.

We’re not preparing our portfolios for a recession. While possible, it’s unlikely. We like our current Treasury, fixed income and equity allocation.

2.     What did the Fed minutes say? Ha, no, no-one asks that. But it was a slow week for news so more people read them than normal. Also, the Fed delayed publication because Washington had snow, which counted for a big news day.

But what was on people’s minds was whether the “we’re going to be patient” announcement in January was shared by the whole Fed or was just Chair Powell gone rogue.

So, they not only said they were going to be patient but said it 13 times and started to use the word “strong” a lot less. Our takeaways are:  

  1. Inflation for both price and compensation is low

  2. The Fed is well tuned into the equity and credit markets (more than we thought). This means a market slide would trigger more easing.

  3. Shrinking the balance sheet (the opposite of QE) will probably stop….that’s more indications of easier policy.

The market barely moved. We've been a in a range of 2.65% to 2.75% since January after the very big move down from 3.2% in November. We think it will stay around here. By historical standards, rates remain very low in real and nominal terms.

Bottom Line: The broad narrative is unchanged. Some of the best performing stocks in 2019 are those that cratered in 2018. Our own PG&E is one (down 83% in 2018, up 175% in 2019). Exxon, Philip Morris, Haynes, Xerox are some others. The big leaders in 2018, especially the big tech stocks, have lagged the S&P 500. Most of the news will be on lower economic numbers, which is priced into the market, and trade, which is not.  

Please check out our 119 Years of the Dow chart  

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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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