The Days Ahead:
Still on the Fed chair. And jobs numbers.
Another Thursday column so if we miss something on Friday, be sure to check back. It was a big week for earnings and we saw strong reports from Caterpillar, always a bellwether industrial play on global growth, 3M and then on Thursday after-hours, the tech giants Google, Amazon and Twitter. Full disclosure, I own Google (or Alphabet as I will one day end up calling it) and so do most of the funds we use. It’s been a good earnings season so far with no major setbacks. We even saw some big M&A talk with CVS ($75bn) apparently making a bid for Aetna ($60bn). A few years ago, that sort of merger would have headed straight to the DOJ but these days anti-competitive horizontal integration gets a pass.
Elsewhere, the background was on tax reform where the main story is about corporate tax rates and the deducibility of interest payments. But highly leveraged companies did not have a bad week so the market may not think it probable. For us, the most important political decision is the next Fed chair. Here’s a decent summary. It seems as if Yellen and probably Cohn are out. We believe the best choice would be Powell with Taylor as the Vice-Chair. The name you don’t want to see is this guy, who would be a disaster.
1. Can we afford a tax cut?
We’ll leave aside the issue of a) whether we need one b) that there is zero evidence that tax cuts increase growth (granted they tend to mix up where that growth comes from but that’s about it) c) that they decrease tax revenues d) increase deficits and e) have little effect on capital expenditures (if you can expense capex at 100%, your tax rate makes no difference, which this guy seems not to understand). Oh, and increase inequality.
No, this is a simple, can we afford it? And the answer is, yes.
The blue columns are interest payments per quarter paid by the U.S. Treasury. The overlaid line shows interest payments as a percent of GDP and the lower black line, the rate on the 10-Year Treasury. We're interested in the overlaid line. It’s hovering around levels not seen since the early 1970s.
We could easily double that number which would be a function of a) higher rates b) more Treasury issuance or c) a combination of both. Would the market accept more Treasury bonds? We think so. It’s all down to the demographics of savings, the scarcity of quality assets and the real rate of return. So, we think any sharp upturn in bond yields, specifically anything above 3%, is years away.
2. How are things in Japan?
In another surge of populism, an unexpected election outcome…nah. This is Japan. They just reelected Prime Minister Shinzo Abe for the fourth time and his Liberal Democrats, who have been in power for all but four of the last 63 years. So, yes, things are going pretty well in Japan. We’ve discussed the “Three Arrows” economic program before, which is a combination of monetary and fiscal stimulus and “structural” reform. The first has been impressive, a high-powered QE which includes stocks and targeting, with considerable success, and a 0% 10-Year Government Bond yield. The second spotty. The last glacial. But the market was fine about the result and the Japanese market pushed to a 21-year high.
Japan has been a curious place to invest in for three decades. It’s had zero bound rate policies, a strong currency, shrinking population, low growth, and massive government debt but at the same time decent GDP per employed person growth and almost zero unemployment. There is a good explanation of it all here.
So, given all that, it’s no surprise that Japanese stocks, despite being the world's third largest market, have traded at a discount for years. But things are changing slowly and we pick this chart for an update:
Historically, and I mean 30 years ago, company management worked for customers, society, employees and their creditors. Shareholder came a distant last. But now we’re seeing record profit margins at just under 8% as the market (the blue line) climbed even higher after the election. Those numbers are still below U.S. company margins of around 9%. The bottom chart is the payout ratio (dividends as percent of earnings) at 30%. Again, the U.S. stands at around 40%. So, there is clearly room to increase dividends and profitability.
We’re not about to dive into Japanese stocks. We started to increase our weighting earlier in the year and have been fine with results so far. Nothing happens quickly in Japan. And we’ve already seen an 18% return in 2017. But we’re patient.
3. Oh darling it’s a flat world:
One very interesting feature of the bond market is the flattening of the yield curve. This is what it looks like:
The bottom green line at the left is the yield curve a year ago. One-year rates were around 0.5% and 30 year bonds at 2.9%. The top blue ine is the yield curve today, showing one-year rates at around 1.5% and 30-year bonds pretty much unchanged at 2.9%. Hence the curve has “flattened” or simply less steep.
Why and what does it mean? The Fed controls short-term rates so the increase in the policy rate feeds right through to short rates. But market demand drives long-term rates and they’ve stayed down. We think it reflects the market’s reluctance to believe a growth story and that debt, low inflation, productivity and investors’ general aversion to risk. It’s also, of course, the flipside of this being the “most unloved equity bull market.”
The Dow hit another record with some good earnings from industrials. Earnings drive the market right now and companies are turning in good numbers.
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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.