The Days Ahead: Fed meeting. They’ll raise.
One-Minute Summary: The on-off trade talks dominated market sentiment. But nothing substantive. Job openings were up. Inflation came in as expected. The budget deficit for the first two months of the fiscal year, increased from $201bn to $305bn. But, hey, everyone knew that was coming. It will come up in around 6% of GDP. Remember France and Italy? They’re arguing whether their deficit can go up to more than 2.5%. We’ve shown this chart before but we want to stress just how unusual it is:
Normally, deficits go up as unemployment rises…think unemployment benefits and lower income taxes. So, you know, they tend to move with each other until 12-months ago. This is now the biggest non-recession deficit in 70 years.
Oil went sideways and European stocks rallied when the ECB announced the beginning of the end of its four-year QE program. They have neither achieved their growth or inflation targets of 2% so they're going to keep reinvesting maturities for a while. U.S. industrial production grew but the manufacturing component peaked three months ago. For those following housing, here’s an excellent summary of what’s going on and why Robert Shiller is probably off. It’s one reason why we don't believe in the Cassandra-like calls for a 2019 big recession.
And on that note, there will be many such 2019 forecasts vying for attention in the press, Twitter and Facebook feeds. Even in the more sober press. On the Bloomberg site alone, one can find conflicting outlooks for 2019. The more outlandish the more clicks. We’re here for our clients and try to keep things in perspective. Send any articles our way that you think we should read to firstname.lastname@example.org
1. It feels like a bear market. Is it? No. The definition of a bear market is a 20% fall from peak to trough. The S&P 500 fell from its September peak of 2940 to last week’s intraday trough of 2598. A 13% decline. But it didn't close there so the record books will show a 9.5% loss. Year to date the market is down around 1.6% in price but up 0.5% including dividends. Both numbers are changing daily.
If the market feels worse, it’s because of more volatility. In the last 10 days (we’re writing this on Friday) we've seen six days where the intraday move was more than 1.8%, with three up days and seven down.
It also feels worse than the headlines because in 2018, 130 companies in the S&P 500 are down 20% or more and another 73 are down between 10% and 20%. A full 301 companies (so 60% of the S&P 500) are down for the year. Only 60 stocks are up over 20%. For 2017, 240 stocks were up over 20%. Here's what the top 10 winners and losers look like in 2018:
And in 2017
The axes are not the same. The top-10 winners in 2017 were up between 87% and 366% while in 2018 they were up 46% to 82%. So yes, it all feels much worse than the headline change in the S&P 500.
Macro or political events have driven markets in 2018. Corporate earnings were strong and, while they may have peaked for now, most forecasts are for growth of 10% or more in 2019. The economy is softer, rolling down from a peak growth of 4.2% in Q2 to 2.4%, but not close to recession. Unemployment and inflation are close to all-time lows. They may edge up but not by much.
So what caused all the problems? Trade, Brexit, Italy, France and, most important of all, China. All are events that markets cannot price. They create general uncertainty and all round derisking. It’s one reason why top-quality sovereign (so US Treasuries, Japanese and German) bonds have done well in the last few months.
We think 2019 will be better if only because the market is now nearly 20% cheaper than a year ago. But we'll need some relief on those macro issues.
2. How are banks doing? Not well. Normally banks chug along with the economy. Loan growth goes up as more people take out more mortgages and companies take out loans for expansion. Margins are low but predictable. Regular dividend payments.
Wait, no, nonsense. That was half a generation ago.
Banks discovered leverage and all sorts of high-margin businesses like securitization, investment banking and prop trading desks. It was grand for a while. It all crashed and new regulations were meant to take it back to the old boring days. So why have financials in general (the black line which includes insurance companies and asset managers), the big banks and the regional banks (the other two lines) fallen by over 25% in the last few months?
What's been the problem?
Credit quality: business debt, including commercial real estate, is at record levels. But the quality of a loan taken out when rates were 2% is a problem when rates are 5%. Most corporate margins are very low. There are 92 companies in the S&P 500 with margins less than 3% and the average debt to equity ratio is 165%. The same numbers for small cap are 228 companies and 204%. Higher interest payments simply mean bigger headaches for banks.
Capital Markets: trading volatility, equity underwriting and M&A have all been weak and are highly cyclical.
Net Interest Margins: tend to come under pressure if yields flatten
Cost of deposits: much higher in the world of fintech and cross selling
We could go on. Regulation and capital constraints have also played their part but we feel those are less important. Financials still count. They're 13% of the S&P 500 down from a peak of 22%. But they don't look like they're going anywhere.
3. Is there anyway Brexit can turn out well for the U.K.? No.
Bottom Line. We still think the market is over-playing the economic slowdown. Treasuries are holding up well and outperformed equities by 2.25% last week. It’s certainly been a year for stretching patience but patience is generally well rewarded in the stock market.
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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.
‘Cos we all need a Guiding Light right now.