The Days Ahead: New jobs numbers. Unless it’s a shocker, the Fed will raise in December
One-Minute Summary: We never like markets when they depend on a single outcome or announcement. It makes for very nervous trading whenever you hear “markets are waiting on X for direction”. Last week it was Chair Powell on the outlook for rates and, of course, the President on whether there would be progress on trade talks with President Xi. That’s fine. The trade talks are front and center of any discussion about the direction of global trade and economic well-being. But just as these problems took many years to develop, they’re unlikely to be solved over a dinner. We can hope for some sort of delay on the January tariffs. Markets would like that. If it's “no deal”, we would expect risk assets to take a step down.
Just for the record here is a quick summary of trade positions coming from the Administration in the last week or so:
Trade Representative Lighthizer: says he would be surprised if China dinner fails
National Economic Council Chair Kudlow: China must do more
National Trade Council Director Navarro: If Wall Street is involved and continues to insinuate itself into these negotiation there will be a stench around any deal that is consummated
Treasury Secretary Mnuchin: Trying to reach a resolution
President Trump: ready to take it to a more serious level
So, we’re all clear then.
Generally, we feel the stock market over corrected in October. This was partly because Chair Powell said on October 3rd, that “we’re a long way from neutral”. Wham. The S&P 500 fell 10% in two weeks, NASDAQ fell 12% and growth small caps 13%. That was somewhat corrected this week when Powell made an excellent speech about Financial Stability but also mentioned rates were “just below the broad range of estimates”. That made all the difference. The 10-Year Treasuries fell below 3%, down from its oversold high of 3.23%. And stocks picked themselves up. The S&P 500 was up 4.8%.
It was a good clarification but doesn't change our view of the markets. The Fed Fund Rate is 2.25%. It’s going to 2.5% next month. The Fed’s range of estimates is 2.5% to 3.5% so there is going to be somewhere between none to four hikes next year. It will also depend on the data. So far the early data, such as housing, trade, yield curve, the lower oil price, ISM Manufacturing are all pointing lower. But the Fed is not responsible for those. They watch unemployment and inflation. Unemployment is lower than they would expect and inflation is not a concern. Our view is that rate increases will come only gradually in 2019.
1. How is trade with China going? Not well. We saw preliminary trade numbers for October and the deficit reached $77bn, the highest it’s been in years and 20% above a year ago. Remember that net trade was a drag of 1.9% on GDP in Q3 so it looks like the trend will spill into Q4. Tariffs cannot fix this problem. The trade account is a subset of the current account and the current account, in turn, is just the difference between what a country spends and what it saves. The U.S. spends more than it saves and so runs a deficit. Tariffs may change the deficit level but only at the expense of higher prices for consumers or lower margins for businesses.
Meanwhile, this is what has happened with the goods trade with China:
The top lines show U.S. exports to China. They're down 10% on the year. The green line shows China’s exports to the U.S. They're up 10% over the year. The bilateral trade balance is at a record monthly high of $40bn. The overall trade deficit is running at $869bn, with China at $480bn or 55% of the total. At the end of 2017 it was $810bn, China at $375bn and 46%.
2. How important are bond spreads? Very. Many investment blogs tell of the dangers of interest rate increases to bonds. Rates go up. Bonds go down. Why would you buy bonds if rates are increasing? But in our view, interest rates are a distant third when discussing bond risks.
First, is liquidity. The bond market may be very large. Treasuries alone are $14 trillion and there’s another $15 trillion in corporate bonds, munis, mortgages and various asset-backed securities. But individual bond issuances are not large. As an example, take John Deere (DE). It's a well-recognized borrower with a solid A rating. Its market cap is $48bn and it has some $38bn in outstanding bonds. But those are made up of different coupons and maturities. Each one of those is small. The 3.45% of 2023 is only $300m and we’d bet half of that is held by buy and hold investors. If an investor has to sell under pressure, they will find liquidity very difficult to come by.
Second is credit. Most bonds trade as a spread over Treasuries and the size of the spread depends on the creditworthiness of the issuer. That Deere bond trades 75bp over its Treasury equivalent. But GE recently went through a downgrade to BBB and its bond spread jumped from 140bps to 600bps in a month. The price meanwhile fell $110 to $85. So credit quality can wreak a lot more damage to a bond portfolio than an interest rate hike.
Why is this important? Well the credit cycle is beginning to turn, especially in High Yield. Here’s the spread of High Yield bonds over Treasuries:
They have rocketed up from 350bps to 420bps in less than a month. Some of that is the concern about a general economic slowdown, and thus ability to pay, some down to big mergers (companies are usually downgraded if they pay for mergers with debt) and some due to the bond market catching up with stocks.
The lesson, of course, is to make sure to invest in very high credit at this point of the cycle and that’s why we continue to like Treasures and Treasury FRNs.
3. Microsoft. Microsoft took over from Apple as the world’s largest company. Here’s a chart from the time of Microsoft’s IPO in 1986.
Apple was a go-nowhere stock for much of the ‘90s while Microsoft quietly took over the corporate world. It was the other way round in the 2000s. But Microsoft has come a long way since the Zune and annoying clippies . It’s now a powerhouse in corporate cloud services, databases and its Office suite. It really is a testament to technology, capitalism and free markets.
Bottom Line. Trade. The market is considerably cheaper than a few months ago. We would expect some recovery before the end of the year but we’re not going to do better than low single digit returns in stocks for the year.
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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.