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October flash backs

The Days Ahead: Earnings continue. Also look for wage news and jobs.

One-Minute Summary: Another roller coaster week. Stocks managed to recover earlier losses and on Thursday halted a six-day losing streak. Economic numbers were generally slow but investors weren’t paying much attention to the macro. The pullback was wide-spread. Some 40% of S&P 500 companies are now down 20% from their highs.

Treasuries were stronger. Overseas markets were down too for many of the same reasons: geopolitics, tighter financial conditions (the ECB said it would start to raise rates in 2019) and some weaker earnings.

U.S. earnings have been in line and…remarkably strong, especially if we use year over year numbers. Companies reporting so far have shown a 22% gain in earnings. But investors focused on peak margins, the dollar, weak housing and a fear the Fed will make a policy mistake i.e. hike rates too soon. Bear in mind, too, that we are in a blackout for share buybacks. Companies cannot buy their shares in the weeks leading up to earnings. So a notable buyer has been noticeably absent for some weeks. That will change soon.

Here’s a deeper dive:

1.     Psych 101 – Stock Markets: Ha, just joking. We don't know anything about psychology. But we do know markets…how they mess with you, and are your frenemy. The news cycle obviously loves this stuff. Quoting Dow Points because “Dow down 1000” is way more dramatic than “Dow down 6% and back to August levels…but readers, please be aware that the Dow is a deeply flawed price weighted index and should not be used for performance measurement purposes”.

And while we’re on the subject of hyperbole, verbs like plunging, collapse, panic, rout and bloodbath (OKfelev, we know you can use a thesaurus already) and pictures of exhausted stock traders really don't help. By the way, all those verbs were in Bloomberg last week…and they're meant to be a voice of reason.

We know investing is tough. As we like to say, stocks go up by the stairs and down in the elevator and the emotional cycle looks like this:

We'd say that we’re somewhere between the two circles. And we’re not trivializing the emotions that come with losing money but here are some things we know.

  1. All major asset classes have fallen: that usually means it’s a broad, sweeping move. The down days are not driven by analysts reading through Caterpillar’s 10-K and concluding their business is worth 30% less today. It’s a large push-one-button trade.

  2. U.S. Treasuries rose: that’s the way it’s meant to work. A typical 10-Year Treasury note rose about 1% in price last week.

  3. Defensive sectors outperformed: Staples and Utilities. Again that’s the way it’s meant to work…a move to relative safety.

  4. Tech was hit: about time. It was a one-way trade for nearly two years. Google beat earnings by 30% but revenue missed by $160m, which sounds a lot until you realize that Google’s daily sales are $360m so they missed about 10 hours of sales. The stock fell 3%. Same story with Amazon. We' think tech had got well ahead of itself and profits were there for all to sell.

  5. Volatility felt bad: but that’s only because of the extraordinary calm that preceded it. We've written at length about the lack of volatility in 2017. We only had two days from 2012-2017 when stocks fell 3% and so far in 2018, we've had four such days and two of those in October. But, this is normal for equities. And we’d expect more volatility as interest rates rise.

  6. The market is not behaving irrationally: the Fed said they think rates should be higher than they are today (and they said it again last week, here) at the same time as the housing market slowed, the trade deficit shot up, the budget deficit widened and retail sales were off. Higher rates and lower growth mean lower earnings.

  7. Rotation: some of the biggest gainers in the nine months to September have corrected the most since mid- September. On the other hand some of the biggest gainers in the last month had a torrid 2018. Again, we'd expect that. A company like LBrands, a fine company but right in Amazon’s cross hairs, is down 50% this year but up 20% since September. Investors were simply seeking out bargains.

 So what do we do? It comes down to four choices:  

  1. Do nothing

  2. Buy

  3. Sell

  4. Get defensive

We've already made a move to #4 earlier this year. Because it's a lot easier to make decisions under calm than duress. We like the dividend payers and the fortress balance sheet types, like Berkshire. We also invested more in Treasuries. We may trim some positions where the fundamentals have really changed but there aren't many of those.

 Finally, we'd share a chart in which we take some comfort.

The black line is the S&P 500 price. It's had some pretty big swings. See 2015 to 2016 and, of course, this year. The blue bars and green line are the earnings and dividends of the S&P 500. There is an unmistakable upward slope to both and a surprising lack of volatility. Prices do indeed change more than fundamentals. Forward price-earnings ratios are now at their lowest since 2016. It doesn't mean there won't be more corrections but corporate America is generally in good shape.

2.     The mystery of lower job participation. Labor participation has fallen by 5% since 2000 and never recovered from its pre-crash highs. Some said that was all down to demographics. The baby boomers were retiring in big numbers…some 10,000 a day.

Well, that’s correct up to a point but it’s not the main reason. Turns out the biggest decline in labor force participation is in the 25-54 age group. The peak workers and earners. Here it is:

The blue line is the biggest cohort of prime-age workers. It’s the same size it was 12 years ago. The other line is workers aged 55 and over. That's up by 10m or 42%. We get that older workers may choose to stay employed for financial or lifestyle reasons and that service and non-manual jobs mean workers can stay employed longer.

But the decline in prime age workers is more concerning. We think one economist we know has put his finger on it (here but behind a paywall). It’s the opioid crisis. It kills 70,000 a year so there are probably around 1.2m to 1.6m people using opioids (no one keeps count). They have dropped out of the labor force. If they were in, participation would be around 1.5% higher.

Aside from the sheer human misery of it all, it means there is a smaller and tighter labor force than there should be. The 55 and over group will retire and that will lower the country’s growth potential. Not this year but certainly in two to five years.

3.     GDP. Great quarter guys. Yes the third quarter estimates of GDP came in at 3.5%. Here it is:

It’s lower than Q2, as everyone expected. As we’ve noted before, the tax cuts were front-end loaded meaning they put immediate cash in hand for the corporate and personal sectors. That showed up in Q2 with higher investment and spending. There was also the boost from trade as exporters rushed to fill orders before the tariffs kicked in.

All those rolled over in Q3. The numbers would have been worse but companies rebuilt inventories and government spending rose 3.3%. The net trade position also fell sharply, as we thought it must. We look forward to the spin on this as the trade deficit is now $40bn worse than the beginning of the year and $100bn worse since the tariffs.

All told, there is nothing in the numbers to prevent the Fed raising rates in December.   

Bottom Line: October has been rough. Midterm elections have usually been a good time for stocks. In the last 13 midterms, back to 1966, there has been only one down market in the October to February period. The average return is 12%. Credit is also holding up well. We'd be a lot more nervous if we saw things like leveraged loans, banks, credit defaults swaps or High Yield having problems. They're not. And that’s a good sign.

Please check out our 119 Years of the Dow chart  

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Pile of leaves, pile of leaves

 --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.

Brian Protheroe - Pinball

The Lift then the Drop

The Days Ahead: Inflation and a short week for the bond market

One-Minute Summary: U.S. equities fell for the second week. This hasn't happened since last June and we would note that too was a quarter-end trade. We expect some recalibrations of portfolios.

Small caps came under some pressure. They’re down 6% over the last month but still well up on the year. We also saw corrections in the Consumer Discretionary, Tech and Communication Services sectors. We’d put that entirely down to the new sectors that came into being a few weeks ago (we wrote about it here), where tech companies moved around and probably threw off sector allocations for managed and index funds.

The market has faced some pressing issues recently. Trade talks, some hawkish Fed talk, Italian bond yields, QE tapering in Europe, oil. Take your pick. Caution is called for while we go through the next few months.

 1.     Jobs, less than expected but more than enough. The number was less than expected at 134,000. There are two surveys in the monthly employment numbers and the differences are important when bad weather strikes.

One, the household survey (basically people answering a phone survey), which is taken the 12th of the month and counts anyone employed full time, even if they didn't work because of bad weather. Two, the establishment survey (businesses answering a questionnaire), which asks about average weekly hours and will record fewer hours if employees can't get to work. So, in the first, weather has no real impact on full time workers but does on part-time and in the second, the amount of work can change and throw off the trends.  

 And that was the case with the September numbers. Florence hit between September 10 and 13, and so the official numbers would not have caught part timers who could not work because of the storm. Similarly, while the average hourly workweek did not change, it fell for high labor intensity industries like wholesaling and construction. Overtime hours also fell which you would expect if you can't get to work. All in all, the low headline number probably underestimates the strength of the labor market.

 Putting this all together and we get this chart:

Unemployment fell to a near 50-year low, annual wage growth fell a little on a base effect (it rose this time last year) and the broader measure of unemployment rose and is not close to its multi-year lows.

The headline numbers are strong and won't dissuade the Fed from moving rates up again in December. We don't totally buy into the increase in earnings because a) it’s all employees and so is skewed by high-end earners and b) it's not inflation adjusted so doesn't really tell us if purchasing power is increasing (it's not).

 2.     The Bond Market corrected. Last week we wrote about how the Fed seemed to be all on the same page. Steady growth, slowly tightening and inflation behaving. This week we saw a speech from Chair Powell that revived the whole Phillip’s curve debate which suggests they are more worried about the low unemployment rate leading to increased wages. Hey, he even put in a nice equation:

 Inflation(t)=−BSlack(t)+CInflation(t−1)+Other(t)

Which looks impressive until we dig in and see that a) slack is notoriously difficult to measure b) Cinflaiton (sic) is the tendency for inflation to linger, so also tough to measure and c) Other, is, well, “unspecified factors”. Clear? No, nor us.

We're not there yet with increase wages and, to us, that relationship seems so very 1970s.

But along with good numbers from the Manufacturing and Service Industry surveys (the latter at a record high), the 10-Year Treasury yield spiked from 3.08% to 3.23% for about a 1% capital decline. Some of this may be technical…weird stuff happens at quarter end...what with window dressing and rebalancing.  The 2-Year Treasury only moved up 8bps and for the issue that we’ve been buying recently, the price fell $0.05 from $99.13.

It seems one of two things must happen as rate hikes continue.

Either, the yield curve inverts, and that can be any part not just the popular 2s/10s, and the economy weakens.

Or, the curve shifts upwards as growth and inflation take off.

The market shifts between the two and last week the latter had the upper hand. The employment and ISM numbers supported the second version. The disappointing trade number (the deficit with China was at a record level…we’ll leave it at that), supports the first.

We'd also keep an eye on this. This shows the spread for U.S. Investment Grade Corporate bonds over Treasuries:

It’s fallen in recent weeks. Now, call us cautious but it does not seem that U.S. corporate debt became less risky recently. It’s 90% industrial and financial companies and 50% of the index is BBB rated: one notch above junk. One thing we know about this cycle, is that companies have rushed to load up on debt at low rates. Normally, around 7% to 15% of companies are downgraded at the end of a cycle. Assume it will be at the top end of the range this time, then we’re looking at 15% of BBB bonds will be junk. And then ETFs and Funds will be forced sellers at the bottom. That’s not a good place to be and keeps us firmly overweighting short term Treasuries.

Bottom Line: There is a collection of exacerbating factors driving capital markets right now. Most of these are known but sometimes the market stops, weighs them all up, takes some profits and rethinks it all. Nothing major happened but some traders are getting out of positions that didn't work last quarter. We'd continue to buy insurance for our long equity positions. China was closed all week so there may be some catch-up on Monday.

Please check out our 119 Years of the Dow chart  

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Oddly satisfying videos

 --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.

Dario G - Voices 

Fed on the same page

The Days Ahead: Jobs number on Friday. PMIs on Monday.

One-Minute Summary: No drama from the Fed. Rates and bonds barely moved. Most stock markets were lower with economic sensitive sectors like financials and materials down 4%. China and America agreed not to talk for the time being. The Mexico trade deal looks good and Canada may join up in the next few weeks. We're often asked why trade is not a bigger issue for the market. It is a big deal but nothing irreversible or financially catastrophic has happened yet. Frayed patience and tempers for sure. But we've not seen many large companies come out and say i) it’s a major problem and ii) we don't know what to do about it.

Another good quarter for U.S. equities. The rolling 1, 3, 5, and 10-year performance are all in double digits and the 10-year rolling return is now 11.5% compared to 10.1% at the end of the second quarter. That would turn a $100,000 investment into $293,000 and $261,000 respectively…a 12% improvement. Yes, time and small differences matter.  

1.     The Fed met and… Raised Fed Funds rate by 25bps to 2.25%. To no one’s surprise. Fed watching used to be a nuanced inspection of language. They meant to keep markets on the back foot. As Alan Greenspan famously said “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I said.”

 Things are very different now. The Fed embraced “forward guidance” some years ago, and now talks openly about what’s going on and what’s going to happen. That’s all fine. The only trouble is that it may delay policy changes (because they won't have communicated it) and give the Fed less room to maneuver. That's not a problem right now. But in the next few years, there’s going to be a time when what they say they're going to do and what they must do will be very different.

 Here’s what we think was important:

  1. Growth: revised up for 2018 and 2019. They now agree with the Administration that we’ll see 3% growth in 2018. But they also expect growth to peter out sometime in 2019. In other words, very different from the Administration. We'd certainly agree on that point. It’s difficult not to see the current growth spurt as merely bringing purchasing decisions forward by a quarter or two.

  2. Unemployment: has bottomed out for this cycle. They don't see any further improvements

  3. Inflation: coming in lower than they expected a few months ago

  4. Rates: will top out at 3.5% in 2020, implying three more hikes in 2019 and two in 2020.

 On the dot plots, we compared forecasts made in March and the latest one. Here it is:

It’s a bit hard to read (the Fed doesn't like graphic designers) but you can see i) the Fed Funds rate moving up by some 50bps more than they thought a few months ago and ii) more agreement among the Fed members. Back in March, the dots were more dispersed. Now they're clustered. The Fed Governors are singing from the same hymn sheet.

 Two more interesting points. One, Fed policy is still accommodative, in our view, even if they removed the actual word.

The top lines show the Fed Funds rate and, in blue, the real Fed Funds rate (i.e. deflated by inflation). Anytime that's below zero, it’s an easy monetary policy. Two, the danger for the stock market is when tight policy starts to go easy, as in 2000 and 2008. We're a way off from that happening.

 So bottom line? Good for equities and a smooth upward rise in rates. We’ve been advocates of the front end of the curve. The 2-Year Treasury yields 2.83%. You only get paid 13bps more for investing in 5 year and 22bps for 10 years.

 2.     How’s the Japanese stock market doing?  Is something you need not have asked in the last 27 years. As readers know, Japanese stocks had a spectacular 1980s, peaked in 1990 and have been on cyclical ups and downs ever since. An investor putting money in at the top would still be nursing a 50% loss today.

Japan has faced demographic challenges. Its population peaked 12 years ago, its labor force 20 years ago and it has a labor force participation rate some 20% below the U.S. Things move slowly. But in recent years we've seen:  

  1. Real attempts at labor market and business reform

  2. Very loose monetary policy, low rates and a weaker yen. The yen is a haven currency…tough to break the habits of flight investors

  3. Rejuvenated business sector

 Put those together with trade, ahem, talks, that mostly ignore or benefit Japanese companies, and we’re looking at a good outcome. Here’s the long term chart on Japan. In the short term, it tends to move with the yen: weak yen, strong market. And that's mostly what’s happened since 2013.

So far this year, Japan stocks are up 5% compared to the broad MSCI-EAFE market of -3%. It’s up 18% in local price and 8% to U.S. investors since the March lows. Japanese business is very competitive right now. It has become a major force in global M&A. Japanese companies have bought Shire (a major pharma company), Uber (through SoftBank), Irvine Scientific and Integrated Device Technology as well as our neighbor, Glassdoor. Japan’s small companies have done well…up 50% in the last two years and outperforming large caps by 18%. Small caps tend to reflect the domestic economy well. They're less dependent on the exchange rate.

Did we mention, things move slowly in Japan? This isn't one of those rush-in-now-and-buy stories. But it does reinforce our confidence in Asia ex the China is-all-that-matters, which has not worked well in recent months.

3.     “We've fixed U.S. trade.”  Possibly but it’s not showing up in the numbers. The revised Q2 GDP numbers came through. They were unchanged at 4.2% of which Net Exports contributed 1.2%. By comparison, they have not contributed more than 0.3% for more than six years. So the latest trade in goods number looks like this:

The deficit jumped from $72bn to $75bn, and way more than the $71bn consensus. This is enough to hold GDP back by 1% in Q3. The problem is that the tax cuts created demand which the U.S. cannot fill. No amount of tariffs will change that for the time being. Trade is set to look worse in coming months.

Bottom Line: Facebook and Tesla had a very bad week. In each case, it’s management not macro or business issues that did it for them. That’s a risk with some of the biggest tech stocks. Bonds will probably stay in narrow ranges for the next few weeks. Only a very bad employment number would upset the market.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

 Other:

Self-solving Rubik’s cube

 --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.

Nick Drake - Northern Sky

Record Highs. But elections coming

The Days Ahead: Fed meets and will raise rates.  

One-Minute Summary: Stocks reached another record high. We're now up 10.1% for the year and up 15% since the mini correction in February. Small caps have done even better at 16.1% and 19%.

We've seen stocks rotate. That's when stocks that were previously unloved come back in favor. We looked at sectors like Consumer Staples, one of the worst performing sectors, which was down 5% to the end of August but rallied 2.3% so far in September. Tech, the clear winner for most of this year, is down for September.

It’s happening at the stock level, of course. Exxon, the sixth largest company in the S&P 500, was down 4% from January to August. It’s up 6% so far in September. It’s the same story with companies like Caterpillar, Altria, Cigna and some major insurance companies. What this tells us is that prior favorites like Tech and Small Cap are taking a breather or open to profit-taking and lagging companies are having their day. It doesn't change our Small Cap outlook…Tech is different, it’s under some regulatory pressure and much more expensive. Small Caps have a relatively high exposure to REITs, Financials and Specialty Retail…all of which have come under recent, temporary pressure.

The dollar looks like it peaked a month ago. It was up 9% from February but has since weakened against some key currencies…down 4% against the Swiss Franc, 3.5% against the Euro, 2% against the Yen and 3% against sterling. Yes, the dollar has the rate advantage but exchange rates are also driven by confidence, diversification and capital flows. The U.S.’s twin deficits (current account and budget deficit) are heading the wrong way and eventually they’ll show up in the exchange rate.

We don’t think anyone’s winning the trade war. Despite the big numbers from the Administration, the tariffs amount at worst, to $60bn, which is less than 0.3% of U.S. GDP and a drop in the bucket compared to the $220bn of tax cuts coming into the U.S. economy. Because so much of the imports from China are intermediate goods (here’s the list, it’s 195 pages), the costs may show up in higher prices or squeezed margins some months from now. But it won't be big and it won't solve the broader “Made in China 2025” problems.

Also big news: the sector definitions for the S&P 500 will change on September 24. We’ll no longer have a tech sector at 28% of the index. Instead we’ll drop Telecom and have a new Communication Services group. It will bring in some companies which are now Consumer Discretionary, like Comcast and Netflix, and some which are now in Tech, like Google and Facebook and will be around 11% of the S&P 500. Expect some rebalancing trading on Monday.

 1.     “Tax Cuts will lead to pay increases”. Said some and indeed there was a 2.9% increase in hourly earnings (AHE) in the August payroll numbers. Hooray said some. Not so fast, said others.

There are a few ways to get a pay increase:

 1.     You're paid more

2.     You're paid the same but work less

But we’re not interested in nominal increases. We want to see increases in real purchasing power and wages, otherwise you're just pushing money around the economy, not really increasing broad wealth. And there are a few way you get a real pay increase:

3.     You're paid more than the increase in inflation

4.     You're paid the same but inflation falls

5.     You're paid the same but work less or get more benefits

It’s only #3 that matters and the results are mixed. The tax cut was meant to lead to higher investment, productivity and wages. It was one of those “it pays for itself” programs. As we pointed out at the time, that was a big ask because the tax cuts caused the deficit to increase by 1% of GDP immediately and by another 1% over 10 years.

We've seen companies increase share buy-backs. We've seen some increases in bonuses and time off. But wage increases have been very slow, even as the Fed frets about a sub 4% unemployment rate. Here’s the wage picture in one chart:

The blue bars are what’s reported in the payroll numbers with average hourly earnings up 2.9%. But if we deflate that by the CPI so get a picture of real purchasing power, we see a less impressive 0.23% (black line). And if we separate out the very large cohort of Non-Supervisory Employees from the All Employees category, we see the real hourly wage at $9.24, lower than a year ago.

Now, we bring this up again because of headlines like “U.S. wages grow at fastest pace in nine years” (Financial Times) and “Bumper Wage Growth”. Hey, we’d like nothing more. The U.S. consumer drives 70% of GDP, perhaps more than any other economy in the world. But it’s not showing up in things like retail sales or housing and it’s very likely personal consumption will grow a lot less than the 3.8% it showed in Q2.

2.     So, 3% on the 10-Year Treasury. Now what? Probably not much. There are some seasonal aspects to the Treasury market. They have to do with when new auctions come around, corporate cash needs, repatriation and even national holidays in China and Japan. This year, U.S. companies with pension deficits could deduct the cost of funding them using the old 2017 corporate tax rate up until September 15. That meant a CFO could save some 15% on buying Treasuries. We feel that kept the 10-Year Treasury under 3% for most of August. That buying has now stopped.

 We've discussed the inverted yield curve. After moving relentlessly from 60bps in January to a low of 19bps in late August, it has now reversed back up to 27bps. Here's the chart:

We're not sure if the move to inversion (i.e. the upper blue line falls to below zero) is a solid indicator of a recession. Sure, looking back over 30 years, there it is…the spread falls to below zero and a recession appears some 14 to 26 months later. So that’s three times in 30 years.

But here’s the thing: being early and right is the same as being wrong. There is no point heading to the long part of the curve in the expectation that all the price weakness will be at the short end.

 And as for coming out of equities, well, we’re not timers and markets can have strong and late rallies for quite some time. Here’s the curve shown in stark terms…compare the yellow line to the shape of the curve a month and year ago. It’s only the 2 to 10-Year Treasury spread which is flattening. We'd argue years of QE and low absolute and real rates mean that any inversion will have to look at 3-month bills and long-term bonds. And we’re not close there.

Meanwhile, here’s how we look at the Treasury market:

All we did here was look at several U.S. Treasury prices today and work out how much rates would have to rise in order to lose money on a Treasury trade over 2, 5, 10 and 30 years. The duration measures how much the price of the bond would fall if rates increase 1%.

The best risk/reward right now looks like the 2-Year Treasury (actually it’s about 19 months, maturing in April 2020). It yields 2.38% for a risk/reward of 0.56.

Another way to look at that is that rates would have to rise 1.7% immediately for that investment not to have a positive return. For a 30-Year Treasury, rates would only have to rise 0.16%. To be clear, we’re not ringing any alarm bells here. We're just taking advantage of the recent rise in yields, which makes a short-term Treasury investment look quite attractive and, for the first time in a while, a valid asset class.

3.     Any relief on Emerging Markets yet? Some. Performance in 2017, when Emerging Markets were up 45%, seems distant. So far in 2018, we’re down 8% but up 4% from the bottoms just two weeks ago. We've discussed before what’s happened (basically a dollar, interest rate and trade problem) but the question now, of course, is what next? Here are some quick thoughts.

  1. Buying into Emerging Markets is not an exchange rate or trade story. It’s about growth, demography and expanding economies.

  2. Turkey and Argentina are basket cases. They're not in the Emerging Markets asset class to any meaningful weight but their stories grab headlines. We don't believe the financial contagion story for a moment but agree there’s a sentiment problem.

  3. Drawdowns in Emerging Markets are common.

  4. 50% of global growth comes from Emerging Markets.

  5. The new NAFTA with Mexico is good for Mexico.

  6. The 22% annual increase in oil prices has hurt Emerging Markets but the supply issues (Iran and Venezuela) are no longer driving up prices.

  7. Seasonal patterns happen in Emerging Markets especially after a bumper year like 2017.

  8. China stocks had their best day in two years on Friday…these things move fast.

So while the short-term can stretch patience, the longer-term strategic case remains.

Bottom Line: Fed meeting. Much will depend on whether the Fed removes the “accommodative” wording. They’ll also review the long-term projections for the Fed Funds rate. It’s currently at 2.3% to 3.5%. If that heads up by 0.5% we may see some pressure on bonds.

 Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

 Other:

Instagram can kill you

 --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.

 

Karl Hyde - 8 Ball 

While Away...

The Days Ahead: Trade and more trade. Unemployment numbers.  

One-Minute Summary: We're away but not absent. Off on a short recharge break. Back in two weeks.  While we’re gone, this is what we’ll be paying attention to:

1.     Trade Talks. China, Canada and Europe. We'd look for a de-escalation with China and some progress with the EU. There’s a sort of “good cop (Treasury), bad cop (Commerce)” play going on and Treasury is up first. We'd also look for Canada to be included in the “just don't call it NAFTA” discussions. There seems to be some urgency going into the midterms to get something done.

2.     Growth. We talked about some so-so housing numbers last week but Industrial Production keeps chugging along. The Q2 GDP revised numbers came out. They went up a bit from 4.1% to 4.2%. You can see from the graph what a rapid departure Q2 was from prior quarters (blue bars):

The big question is, how much is growth borrowed from the future? We'd say at least 0.5% but admit this is a very rough estimate and we’re not economists. Take a look at the second line. That’s GDI (Gross Domestic Income) and is an alternative way to measure GDP. They should be the same but there is a very big discrepancy right now. In the second quarter, investments in “Intellectual Property” were revised up by a whopping 2.8%. That’s basically software. But personal consumption and imports were revised down.

The theory behind the tax cut is that companies’ lower tax bills lead to increased profits, which mean more investment, which grow employment and wages. The first one is happening. Pre-tax corporate profits were up 7% YOY and post-tax up 17% (these are national numbers…. S&P 500 companies are way ahead). Investment growth slowed and the personal side is back to where it was a year ago.

So far the consensus is for another 3.5% GDP growth Q3 but the latest trade numbers were not great and are set to be a net drag in Q3.

3.     Employment and the Fed: First Friday in the month so jobs numbers next week. We would expect around 180,000 but given the margin of error on this number, +/- 40,000 would not make much difference to the market. Hourly earnings will also be mostly unchanged at 2.5% but down and close to zero in real terms. The Fed doesn't meet until September 26, at which time they’ll almost certainly raise the Fed Funds rate by 25bp to 2.25%.

Meanwhile, we’d expect 10-Year Treasuries to trade around 2.8% to 3.0%.

4.     Stock market breadth: We've seen some improvement in the advance/decline ratio. What we look for is wide participation in the market. A “bad” participation day would be if a few stocks are enough to push the index up but the majority of stocks fall. Recently it’s been about half the stocks up and half down on an upday, which is good.

5.     Emerging Markets. Markets bounced 4% this week, based on the Mexico trade deal and a weaker dollar. The big three influences are at work: trade, rates and the dollar. None of those will disappear overnight. But we’d look for some relief on the currency side. And on Emerging Markets….

6.     We had an interesting question come up in our Emerging Markets call-in (it’s here)

Is the term “Emerging" accurate? Or are the so-called "emerging markets" comparable to the time-honored description of Argentina, i.e., "has a great future and always will have?"

The Argentina reference comes from the fact that at the turn of the 20th century, Argentina was the world’s 10th largest economy. Now it's not even in the top 20.

We don't think the term “Emerging” is terribly helpful. It was 40 years ago but when you have the second largest economy (China) and South Korea or Taiwan all called “Emerging” there is a definitional problem. Just to confuse things further, Argentina is Emerging with some index providers and “Frontier” for others. Same goes for South Korea. Some say “Developed,” others “Emerging” and the differences are down to the Chaebols, not to South Korea’s heft in the world economy.

The “Emerging” definition these days is as much about governance as economic size. So countries with restrictions on foreign ownership, non-GAAP reporting standards, cross-holdings or voting shares are all in the Emerging bucket. When they start to address those they're promoted into Developed.

There are some real powerhouses in emerging markets: China, South Korea, Taiwan and India. They're 65% of the index. And even eastern European countries (12%) are pretty advanced these days.

We don't think there are many that are perennial hopefuls (i.e. probably not going to do much in coming years) and not one of those countries is more than 2% of the index. Here’s what it looks like:

So, yes, while “Emerging” has a nice ring to it, “Less developed” is probably more accurate. 

7.     And finally: In a month when we hit several all-time highs, we’d remind ourselves of the long term. Here’s the Dow Jones stock index back to 1900 (the S&P 500 is a better index but only goes back to the 1950s). Through some bad times, the market has powered ahead. On the 10th anniversary of the Lehman crash, it’s worth looking at how well the market has done over time.

As always, if something comes up please feel free to call Rita on 415 435 8330.

 Bottom Line: Stocks are trending up but with no big stories or conviction but on macro and political headlines.

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Five lessons from the ultimate innovators

 --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.

Summer Sun (Plein Soleil)

A lot of action but not much change.

Available on Apple Podcasts • Soundcloud • Google Play


The Days Ahead: Quieter week for big economic numbers. Watch for trade and updates on the Eurozone.

One-Minute Summary.  When markets crack, we know two things. One, the problems don't come from the last crisis (so no need to look in the MBS world). Two, they come from things you barely notice. Last week it was Argentina and Turkey. This week, it was Italy (see below). U.S. bonds promptly rallied 4.5% and the 10-Year Treasury yields, which many predicted would soar to 3% and beyond, fell to an intra-day low of 2.79%. Bonds got medieval on Tuesday and one Bond King had a very bad day.

Domestic and international stocks and U.S. bonds finished more or less unchanged on the week. But there was plenty of action along the way. Small caps had another good week (they tend to not get riled by trade stuff) and are now some 500bps ahead of the large caps so far this year.

The trade talk is not good. The U.S. went ahead with tariffs on steel from Canada, Mexico and the EU. We don't think they're going to take this one lying down. In past years, the parties would have taken the issues to the WTO and talked about it for a couple of years. This time Cecilia Malmstrom, the very accomplished EU Trade commissioner fired right back with, “When they say American (sic) first, we say Europe united.” So far markets have tended to view the trade talks as bluff followed by climb down. That’s worked. So far. Still, expect a lot more disconcerting headlines.

1.     Markets are jumpy (Part 2): Here’s something you don't see very often. A G7 sovereign bond crashing in a single morning’s trade. As everyone knows by now, Italy is trying to form a government on a coalition of two parties. The Northern League (secession, pro-Russia, anti-GMO, lower taxes, Eurosceptic) and the 5-Star Movement (guaranteed minimum income, Green, unsure about immigration and mostly Eurosceptic) tried, failed and tried again to form a government. In Italy, winning parties must present their cabinet and government candidates to the President. He has veto power. And he used it. The fear then was another election in the fall with both parties running on an explicit “out-of-Euro” platform because…that’s the only thing these guys really agree on.

Now we've seen Italian governments come and go and, with 42 Prime Ministers since 1945, a change of government in Italy passes as a Cabinet reshuffle elsewhere. And we don't really think this time is different. A government will form, it will make a few changes and it will argue with the EU about debt, growth and bond restructuring.

So why did this happen?

That spike on the right is the spread between Italian (BTP) and German bonds (Bunds). Both Euro sovereigns. Both have never defaulted in 70 years. Both with rapidly improving current account surpluses. But the spreads “blew out” (technical term) from 120bp to 270bp which meant the price of an Italian bond dropped from €102 to €89. Stocks took a smaller hit and investors dumped Italian banks, who, of course, must hold BTPs for capital. Some of the big-name stocks were down some 25% from their late-April peak.

By week’s end, things had settled down. The 5-Star and League parties will get their people in. The problems from the Berlusconi years (see famous Economist cover) will remain. Italy’s GDP per capita hasn't risen in 20 years. It seems unlikely a rancorous split from the EU will achieve much. And markets probably don't expect Italy to take it that far.

We don't own foreign bonds and this week was a good reason why. You can lose much more of your principal on a spread-widening event than you can on rising rates. To us, fixed income allocations should reduce the risk of a portfolio, not increase it. But expect this to play for a while.

2.     Jobs, jobs, jobs: Yes, the numbers were good. So good the President leaked them an hour before they were released. Which, I dunno, suggests why he may give Martha Stewart a pass. Here they are:

The headline unemployment number is now at a 20-year low. Last time it was this low, the 10-Year Treasury was 6.5%. So why is it only 2.8% now? And didn't even move on the day? Sure, some is because of the Fed’s QE and low inflation. But we think the market is not wholly convinced about this labor market. We've touched on some of these in the past but here goes:

  1. The uninsured part of the labor force is the lowest it’s ever been. If you're not insured to receive benefits, you don't register for them.
  2. Wage inflation is barely moving in nominal terms and flat in real terms.
  3. Quit rates have not reached their pre-crisis level. You tend to quit a job if you're sure you can get another, so it's a confidence thing.
  4. The U-6 (underemployed) rate is nowhere near a 20-year low.
  5. Participation in key age cohorts is way down.

To which, critics respond, well the labor market has changed, if you want a job you can get one and look this week’s Beige Book says St Louis is even hiring convicted felons. So, it's  a tight labor market.

Fair enough, but nearly six months into the stimulus we’ve yet to see big consumer spending numbers, even though people are paying a little less tax (in aggregate, not in California). As one of the best analysts put it, “the longer the stimulative benefits of those particular policy changes [tax cuts] take to show up, the less likely it is that they will.”

Bottom Line: The Spain and Italy markets support our belief that U.S. Treasuries will remain well-bid and the 2-Year Treasury looks attractive above 2.5%. U.S. economic numbers last week were good but seemed more to be catching up with a run of less-than-great reports.

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Musk: public safety too important too important to abide by the government’s rules.

Robo advisors web sites don't work

--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.

Something for the weekend

Back to light again

The Days Ahead: Housing and retail sales  

One Minute Summary Low inflation numbers from both consumers and producers meant bonds rallied from the 3% level. We haven’t seen the 10-Year Treasury decisively break 3%. We don't put a lot of store in that number. It’s a nice round number but it’s not really relevant to the average Treasury buyer. We were pleased to see the bond market absorb a very large refunding week of $166bn in bills up to 30-year bonds.

There are a few technical moves going on. Small Cap stocks had a good week. They’re up about 5% this year compared to the S&P 500 at 2%. The S&P 500 also managed to bounce off its 200-Day Moving Average. Emerging Markets tracked sideways. The combination of dollar strength, some highly indebted companies and Argentina and Turkey trying to salvage their currencies by ramping up short-term rates, sentiment took a hit. Turkey’s weighting in the Emerging Markets index is only 1.3% but it’s enough to give some concern.

The biggest winner of the week were energy stocks, up around 4%. We think stocks are still trying to gauge where bonds are headed and where the next big catalyst will come from. We're not entirely sure ourselves except we’d say (stop us if you've heard this) growth is not particularly robust, inflation is low, the Fed’s going to raise rates slowly and all that can be undone with a single Tweet. We're still looking at protection and getting paid for some months of a sideways market.

1.     What's going on in with inflation? Not much. The Fed thinks inflation is easing up hence the well-telegraphed three to four rate increases this year. We had a minor scare in January that Average Hourly Earnings (AHE) were rising too fast. But subsequent reports put paid to that notion and the January number was revised down.

Inflation is probably the single most important driver of bond yields. Obviously, if you're paid a fixed coupon and fixed maturity, inflation eats into real returns. Equities, of course, are a very good inflation hedge until inflation gets out of hand and consumer demand flattens (the 1970s). Treasury Inflation Protection Bonds (TIPS) are also great hedges and we use them. But they don't provide much current income.

The inflation story since 2009 has mostly been “it’s just around the corner.” Half the Fed thinks that way and most sell-side economists enjoy a healthy living predicting inflation surges. The given reasons boil down to:

  1. Unemployment is low. Wage inflation must come soon.
  2. QE flooded the market with M2 money and there’s a decent and lagged connection with money supply and inflation.
  3. The twin trade and budget deficits will push up prices.

But inflation just seems to be stubbornly in the 2% range and has had trouble even breaching that in the last decade or so. Here’s the latest inflation numbers reported on Thursday:

The core CPI (so take out Food and Energy) is up 2.1% and headline inflation is 2.4% with a lot of that driven by higher energy prices (up 13% to 20%) and the base effects of very low cell phone and medical expenses a year ago. We talk about this a lot but the story hasn't changed.

What does this mean? We ran some very long inflation numbers here  and would stick with our view that inflation will not take off and that the current 10-Year Treasury rate, which has flirted with 3% for a few weeks, will stay in a 2.8%-3.1% range for a while. The bond bull market may be over but there is no big uptick in yields coming.

2.     “Good earnings, guys.” So you’re a CEO hanging up on a great earnings call (unless you're Elon Musk in which case you send them over to YouTube) after you reported a 25% earnings increase. You’re looking ahead to a permanently lower corporate tax rate, lower cost of capital and pretty friendly regulations. So your choices are:

  1. Pay higher salaries or bonuses
  2. Hire more people
  3. Kick up the capex
  4. Go do some M&A
  5. Increase your dividends
  6. Announce some share buybacks

Now there are some pretty fierce arguments about the merits of each of these, especially the last one. In the “they're great, stop complaining” camp there’s Cliff Asness at AQR and in the “they kill prosperity” camp there are, well pick your number, but one of the more rational ones is William Lazonick at UMass.

We'll not get into the merits because we're only really concerned about how the choices affect stock prices. And here, there is a clear winner: stock buybacks. Apple was the latest to announce a $100bn buyback and its stock rose 14% in a week. Not all share buybacks are received with the same enthusiasm. Some stock buybacks are basically self-liquidation exercises, with IBM being the most famous example. It spent $50bn of its $130bn market cap on buybacks and the stock fell 29%.

What we don't see is much hiring. We watch the NFIB survey, which asks employers if they're going to hire more people in coming months. Here’s the chart:

Last week’s NFIB report was a cracker. Optimism increased, profits up and nearly 60% announced hiring plans. But recently those plans have not resulted in increased employment. Usually when that green line (good time to expand) goes up, employment growth follows soon after. But not in the last few years. In 2017, the “good times” line jumped very high but there’s been no follow through in bigger job numbers.

What this means to us is that companies are keeping margins and profits as high as possible and are very reluctant to add to fixed expenses. The tax fix was meant to change all that but for now the benefits are mainly accruing to shareholders.

Bottom Line: Eyes on the dollar. It has reversed in recent week and is now pretty much unchanged year to date. More strength will be bad for Emerging Markets and U.S. stocks. Bad news on the trade front will send it up.

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China is changing the way trade is shipped.

--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.

 

Letting the trade waters go by

The Days Ahead: US inflation. Watch for German and China trade.

One Minute Summary: Markets were slow. Many traders and investors were off for the week. Europe was all but closed. The trade and political stuff makes for big jumps in volatility. This is good for bank trading desks and option writers. For long-term investors it’s not a problem unless they react to it. As we’ve mentioned before, this volatility feels unsettling because it’s been quiet for much of 2017. In fact, volatility is bang in line with its long-term average. Welcome back my friend, to the show that never ends.

U.S. Treasuries were up. Bond spreads ticked up. That's the credit worries at work. The S&P 500 was down 1.2% for the week. It’s down 2.5% so far this year but up 11% on the year. Small caps have done comparatively well this year. Tech was down again. It’s mostly fear of regulation because we don't expect earnings to be hit soon. We would still buy the protection we put in place for clients recently.

Europe and Emerging Markets were positive and have outperformed the U.S. by around 2% this year. Japanese exporters had a tough week. They're in the trade crossfire. Last year, Prime Minister Shinzo Abe gave President Trump a hat with a logo reading “Donald & Shinzo, Make Alliance Even Greater.” He may ask for it back.

1.     What a mess with China:  You may have noticed there was some chat on trade with China last week.  Some 99.99% of economists believe trade wars hurt the world economy. The others don't. We found it useful to try and unpack some of the talk, ‘cos , you know, you might think we have a $500bn trade deficit with China. (Skip to the end if numbers are not your thing). 

1.     The U.S. has a $375bn goods trade deficit with China. That is made up of $506bn of stuff we buy from China and $130bn of stuff we sell to them

2.     The U.S. has a massive $38bn surplus in services with China. Bigger by far than any other country. It's mostly travel, IP licenses and business services (do a consulting gig for Alibaba without even leaving your San Francisco office and it shows up here)

3.     The trade deficit is thus $337bn. Still large but not $500bn.

4.     Most of what the U.S. sells to China is food, aircraft, cars and capital goods. They're 52% of all exports.

5.     Most of what China sells the U.S. is cell phones (some $65bn a year), computers and telecomm equipment and toys.

6.     The U.S. has 25 products that account for more than $1bn in sales to China. China has 68 coming the other way.

Now it would seem that China is in a very good position here. The U.S. has targeted 25% tariffs on some $50bn of goods coming in from China.  So that's $12.5bn. Here’s the full list, starting with Thorium. They left off the cell phones because because that “Designed in California, assembled in China” on the back of your iPhone means exactly that. Apple and others would have a fit if those were part of the deal.

China, of course, retaliated last time on the steel tariffs with 25% tariffs on $3bn of stuff from the U.S. That's the wine, ginseng and pork products one. So, that’s $750m. This time, they've targeted the big ones like soybeans, aircraft and cars. They floated a tariff rate of 25%, which would cost U.S. exporters around $22bn.

Put this all together and we’re looking at around $45bn of cost for U.S. exporters and U.S. consumers. That’s around 0.2% on a $20 trillion economy. If the U.S. goes with the $100bn increase we heard about last night, then add another $25bn for a total of 0.3% of GDP.

But this is not the point. What worries businesses is how far this can go, whether supply chains will have to be redesigned or business strategies rethought. So Boeing, John Deere and Caterpillar were all down around 12% recently. The stock market reaction, down some $1.5 trillion since February, is way out of proportion. But then it nearly always is.

The foreign exchange market, however, is not rattled. If markets get really scared about this, expect the dollar to strengthen and the Yen and Renminbi to weaken. It’s been the opposite.

Anyway, here's the trade deficit with China. It’s 50% of the U.S.’ entire trade deficit. If I were a betting man, I’d say the U.S. will have a tough time winning this one.

2.     How about those jobs numbers? Meh, not so good. It was just 103,000 compared to 326,000 in February. We have a kind of love-hate relationship with the jobs numbers. On the one hand, they're a big, market-moving event. The Fed follows them because it’s part of their mandate. And you’ll occasionally hear an administration mention them. But they're subject to huge variations from initial to final, have weird seasonals and tend to over or under report against consensus by 50,000. Yes, a 100,000 estimate produces a 50,000 to 150,000 result. And that's considered fine.

Anyway, here they are with the bottom line showing average wage increases.

That’s the number that got everyone worked up two months ago when it spiked. We thought then it was a seasonal thing and it certainly looks that way now. Average earnings were up 2.7% but these are nominal not real increases and skewed to supervisory workers. The non-supervisory workers saw a much smaller increase and lower weekly earnings.  Which means they had a modest pay rise but got to work less.

The market had other things on its mind and gave the numbers a big yawn. It was mildly bullish for Treasuries with rates at 2.78%. It all supports our low growth low inflation outlook.

Bottom Line: Expect markets to react a lot to bellicose trade talk. Mr. Zuckerberg will visit Congress. Probably best to stay clear of big tech for a while.

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Tearing up Econ 101

--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.

 

Always something happening and nothing going on

The Days Ahead: The European long holiday keep things quiet. Jobs number on Friday.

One Minute Summary: We had three out of four trading days where the market moved by more than 1.3%. But there was no change over the week. Bonds had a good week. European markets were up but Asian stocks are still trying to figure out what the trade talks do for them. Companies like Toshiba, Sharpe and Nintendo were down 6% to 8%. The Euro and the Yen took a break from their steady rise this year but that was probably due to some cross-currency funding needs of major banks (the rule on overnight funding changed with tax reform).

Stock volatility feels high. But it's no different from its long-term average. Stocks have gradually got cheaper these last few weeks. We've seen no downward revision of earnings. While the economy is not quite the tear the tax cut crowd thinks, we’re a long way from recessions and economic downturns. Sentiment is shaken but if that flushes out some of the fast money especially at a quarter end, then… good.

1.     Tech Wash Out. When companies grow big and dominant they attract attention. In Europe, it tends to come with taxation. In the U.S., it's regulation. The driving themes of tech in the last few years were a mix of i) almost measureless scalability ii) the network effect (i.e. the more people use something, the more valuable it becomes to the community) iii) growth and iv) real oligopoly. These are exactly the same arguments in the last tech boom, the IBM and BUNCH stocks in the 1970s and all the way back to the Bell System in the 1900s.

It was perhaps inevitable that one or more of the current tech leaders would trip. It happened to be Facebook. It wasn't the first to break the rule of corporate communication (don't let the lawyers run your PR) but it did an outstanding job of going to ground and coming up with a sort-of-sorry mistakes-were-made-apology. But when investors are looking to sell stocks that had massively outperformed the market over the last three years, then any news becomes a reason to sell. Europe thinking about imposing a sales tax on tech companies. Sell. Tesla’s debt downgraded. Sell. Nvidia, a stock that has risen 700% in two years, said it won't be testing autonomous vehicles for a while. Sell. Twitter and privacy. Sell.

Tech has had phenomenal run. And it’s not nearly as overbought as in the 1990s. Here’s a chart showing the performance of tech against utilities, the ultimate defensive sector, in the 1990s and in the last 10 years.

It certainly looks like a bubble but on a much smaller scale. What concerns us is that many investors have left conservative investments and put an awful lot of faith in a few growth stories. For the last five years, tech has beaten utilities hands down, up 150% against utilities up 54%. But since the 2000 tech peak, it’s a very different story. Tech has risen 78% and utilities by 224%. It took 14 years to get back to break-even if you’d bought tech in 2000. For utilities it was just over four years.

So? Well we’d just reiterate the theme that diversification is very important. And we’d expect this period of volatility to continue.

And from the history rhymes library, here’s a pretty fierce response from the head of AT&T when the government started the breakup of the Bell companies in 1981.

2.     What’s the bond market saying? That growth isn’t going to last. And that inflation won't be a problem. We feel pretty confident about the second. Primarily because we think there’s more slack in the labor market than many realize. We wrote about it here. On the first, though, you've probably heard about the yield curve flattening. This is when short-term rates increase but long term rates stay sticky. There are lots of ways to measure it but here's the spread between 3-month Treasury bills and 10-Year Treasury notes.

Even at the height of QE when the Fed bought every Treasury and MBS in sight and so pushed yields down, the spread was 2.25%. After the election, in the heady days of growth, deregulation and tax cuts, it steepened sharply. But it's been falling ever since and especially so this year. It's now down to 1.02%.

To us, the market is saying that i) tough trade talk may sound good but there is probably nothing economically constructive that can come out of them ii) the twin deficits are going to need financing and the financing is going to come at the short end of the market and iii) the markets are nervous about growth. So, why not hold longer term Treasuries because they're not going to change…only the short end will.

That's our view certainly. We really don't believe in the “bear market for bonds” hype. We think rates are pretty well underpinned at the 2.7% to 3.0% range and will stay there for much of the year.

Bottom Line: Another short week. Asian markets grappling with the trade tariffs. As clients know, we’ve placed some protection on U.S. stocks. Expect volatility to remain high.

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Berkshire Hathaway is now the country’s second largest realtor

--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.

 

Fed makes it the first of three

The Days Ahead: Shorter trading week and Europe will be very quiet. Asian markets on watch after the trade news.

One Minute Summary: Trade issues hung over stocks again. The Fed was generally hawkish and clearly thinks “gradual” increases are on the way. So, another two this year and maybe three. Tech came under tremendous pressure. The sector was down 8% with Facebook down 14%. It’s now the cheapest it’s been since the IPO. Financials had a bad week too. Normally, they do just fine as rates increase. This time there seems to be a funding problem and overnight rates climbed sharply. This might be a result of changes to how banks fund themselves post tax reform.

We're now in a higher volatility era for equities. So far this year average volatility has been 17 and it closed at 23 on Friday. It's long term average is 18. In 2017 it was 11. That’s clearly the outlier. Our list of things to worry about now includes tech, trade and earnings in addition to the normal phase of the cycle, U.S. politics and rates.

European and Asian markets performed better than the U.S. Emerging Markets held up well despite the trade issues. The dollar weakened again. It’s down about 3% this year.  

1.     Meet the New Fed.  The Fed met for the second of its eight meetings this year and the first with Fed chair Powell leading. The Fed holds a press conference in four of those meetings, which tend to fall two weeks before the quarter end. One feature the Fed has developed in the post-crisis era is that it has given very clear forward guidance on its thinking. The idea being that markets could afford few surprises. So, it was no news that they announced a 25bp increase in the Fed Funds Rate range to 1.50%-1.75% from 1.25%-1.50%.

But what the market was hanging on to was the “dot plots” and economic projections. And answers to the big questions: does the Fed see the economy growing, is there inflation and will there be more rate increases? Well, the short answers are “a bit”, “not really” and “possibly”. Here's the most important graph, the dot plot, which shows where the FOMC thinks rates should be in coming years.

A couple of things jump out:

1.     The wide dispersion of views. In just a few months, the range for rates in 2019 jumped from 1.2% to 3.5% to 1.5% to 3.8%. There was an even broader dispersion for 2020. Clearly the board thinks the tax cuts and stimulus are going to work and will need correcting.

2.     The Longer Run. The Fed sees the cycle peaking in the next two years and sees the long term Fed Funds Rate at near 3%. This seems wishful thinking to us. The economy would have to show a growth or inflation spurt that’s been absent for a year.

There is a dot for each member of the FOMC and the regional Governors. But one declined to vote and there are four Fed Board Governors still to be confirmed. And, to us, that's important. This Fed is woefully understaffed right now and new members could easily change the Fed’s outlook and hawkishness.

Other standout points were that the Fed acknowledged growth had slowed in the first quarter (so, points to the doves) but that the economic outlook “has strengthened”. They also saw inflation as benign and, in the Q&A, as far as bubbles go:

“So, in some areas, asset prices are elevated relative to their longer-run historical norms. You can think of some equity prices. You can think of commercial real estate prices in certain markets. But we don't see it in housing, which is key. And so, overall, if you put all of that into a pie, what you have is moderate vulnerabilities in our view.”

Which is good.

The takeaway is that this is benign for the markets and we saw 10-Year Treasuries rally after the meeting. We don't see this Fed as wanting to raise rates dramatically and so hold to our view that rates will stay in the 2.75% to 3.00% range for a while.

2.     More on Trade: The latest round of trade tariffs hung over the market. While we’re not sanguine about the whole trade war talk, the latest news on the steel tariffs is better. Remember just two weeks ago? It was a full on/bring it on global 25% tariff on all steel. Now, there are reprieves and exemptions on six of the ten top steel importing counties, and 28 members of the EU. That’s 56% of the total imports or around $5.2bn of additional annual costs. Of course, that’s now. It will change.

 So it may be the same with China. Rattle the sabre, invite retaliation, wait for other industries to lobby, wait some more and quietly climb down. Of course, China is a bigger game than steel:

The U.S. exports around $185bn of goods and services to China. It imports round $523bn. That blue bar is the monthly deficit in goods and that’s what the Administration has in its sights. It's around $35bn a month and was $375bn in 2017. Again, there was some pretty fierce talk about the theft of American prosperity and they targeted around $50bn of that $375bn. It’s not the whole amount. It’s tariffs of 25% on about $50bn, so $12.5bn of costs. Still, China came out swinging and will probably target Republican sensitive districts. They've already started with food products, wine and some steel but those were in retaliation for the steel tariffs, not the latest ones.

No wonder the likes of Apple, Microsoft, Starbucks, GM and Nike are in the firing line and will probably remain so. If we just do the math, the two announcement amount to around $19bn. That’s 0.1% of GDP. But the fall in stocks has been more like $1 trillion.

Bottom Line: Short week. We're looking at how Asian markets react to the escalation in the trade tariffs. As clients know, we’re placing some protection U.S. stocks right now as we expect volatility to remain high.

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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.

And it all came right

The Days Ahead: The market is inflation sensitive right now. Tuesday’s CPI number will be important

One Minute Summary: Mixed economic numbers. Blow-out job numbers (but yes, some caveats). The trade deficit widened, although there may be some relief on the oil side in coming months. Productivity stalled. The Fed’s Beige Book, a report that lives up to its title, was mostly more of the same “modest to moderate” (mentioned 193 times in a 32-page document) growth from the 12 districts. There were some reports of compensation increases but we put that down to state minimum wage increases coming into effect in January. Some 29 states have minimum wages above the Federal level (which is unchanged for nine years) and 18 of them raised them for 2018.

The week started with major concerns on the Administration’s policies but markets settled down mid-week. We're not out of the woods, of course. Thursday’s decision to limit steel tariffs to non-NAFTA partners means those issues now become part of the NAFTA discussions. The ECB said it would keep buying bonds for “as long as necessary.” That weakened the Euro.

Bonds were flat. Stocks liked the jobs number. The S&P 500 and European stocks were up around 3% to 3.5%. We're still 3% down from the market peak on January 26, but up 7% from the lows. The dollar took a round trip…down and then up.

1.     Blow-out job numbers. We've been cautious on the jobs market for a while. Yes, good headline numbers but low labor force participation, low wage growth and high growth in low wage and part-time jobs. This month was different.

The headline number was the best since November 2014 and the third biggest since 2000. The unemployment rate was flat because the participation rate ticked up to 63%, which is good, but the same as a year ago. And the types of jobs? Construction, specialty trades did well but there were still the same mix of temporary and low-level service jobs. No argument or change there.

The last set of job numbers set up a storm about Average Hourly Earnings, which showed a big jump and had all the “here comes wage inflation” experts humming. But it proved another false start. Earnings growth slowed to 0.1% from 0.4%. Hours worked increased.

What’s it all mean? There is more labor slack in the market than assumed. More sidelined workers are coming into work. This is good for activity and the economy. Wages are not growing. Which is good for stocks. Mind you, this is only one month of data. So, you know, lest we get carried away.

2.     How are the steel companies doing? Quite well, thank you. Steel production peaked in the early 1970s, halved in the next decade and has been flat since 1988. As stocks, you would think they’d be hammered as old industrials but they've actually done quite well. Here’s a composite of the 10 largest steel companies in the S&P 1500.

In the last three years, the top five steel stocks have outperformed the S&P 500 by a whopping 31% and by 5% in the last year. The long-term results of 20 and 30 years are equally impressive. Of course, they are highly cyclical stocks so an investor would have had to stomach a 70% loss in the 2008 recession.  But, basically, they're in good shape and for the 134,000 employees in the steel industry, wages are about 35% higher than the national average.

So what does all that mean? Well, the tariffs were not really about steel or aluminum. The U.S. did not accuse any country of dumping, which will get you a hearing at the WTO. Instead, the Department of Commerce used the national security argument (pretext?...hey, I’m not a lawyer). That opens up all sorts of retaliation opportunities because it's a spurious and hard-to-prove rationale.

Meanwhile the Fed’s Beige Book mentioned that “Four Districts saw a marked increase in steel prices, due in part to a decline in foreign competition.” And the survey was taken mid-February. So, you know, barn door…horses.

If the purpose of the tariff was to “stick it to the foreigners” and send a strongman message, then job done. But if this escalates into tit-for-tat, then we’re in serious trouble. As of midweek, the market was leaning to the former.

Bottom Line: The trade issues are going to be lurking for a while. We don't know what policy will come down the road. It's somewhere between speak softly…big stick and improv. We don't think this is a game changer yet. We hold Treasuries for a risk-off market. We'll increase our growth exposure in international and Emerging Markets. We're lightening up on real estate and looking at some downside protection on the S&P 500. It was a good week.

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Another take on share buybacks

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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.

 

Debt ceiling fears just got real

When do one month bills yield more than three month bills? When your'e afraid you may not get paid back. 

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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. 

All you need to know about today's inflation numbers

All you need to know about today's inflation numbers

Nothing on core...lowest since May 2015

Owners's Equivalent Rent (i.e. housing) at 3%.

And your cell phone just got cheaper

See BLS report

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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.