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Whiff of Contagion

The Days Ahead: Jackson Hole Symposium, which is often a good source of Central Bank think. Very thin economic reports and corporate earnings season is all but done.

One-Minute Summary: Consumer confidence fell. That surprised some but we think it’s not tied to claims and employment, which are running well. But to wages. I know we bang on about this a lot and there are plenty of others following the same story. Here are the latest wage increases:

Wage increases are barely positive and we believe even those numbers are inflated by supervisory pay. In other words, non-supervisory employees are seeing negative growth in real wages. There are many more workers than bosses so we think the average number is misleading. And it’s been happening all year. There are plenty of plausible and conflicting reasons why this is happening but none are important to markets right here right now. We'll just leave it that consumer spending cannot sustain a 4% growth rate. Wages aren't strong enough.

Gold was down (it usually drops if the dollar strengthens). The S&P 500 finished mostly higher with defensive sectors (telecomm and staples) ahead. The 10-Year Treasury was up. Economic news was mixed. Slow housing starts. Strong retail sales. Productivity growth stayed around its recent, not-so-great trend. Tesla dropped and Elon Musk apologised.

1.     How’s Turkey doing? Not well. If you're an Emerging Market with an inflation and budget deficit problem, you're meant to:

  1. Increase your domestic interest rates…it helps to defend the currency
  2. Tighten fiscal and credit markets…anything, like raise the pension age, curb bank borrowing, but, you know, something
  3. Get some external funding, which usually means calling the IMF

It’s a pretty well-trodden road and see, passim, Argentina, Thailand, Mexico and even Turkey in 2002. What you're not meant to do is:

  1. Pick a fight with your allies
  2. Openly seek assistance from countries with sanctions against them
  3. Not increase bank rates and keep your son-in-law as head of Finance.

So Emerging Market bears continued to sell Turkish stocks, bonds and currency. The bonds alone widened out by 200bps in the last few weeks, which means they had a capital loss of around 22%. Here’s the chart:

One might reasonably ask why Turkey, with its 1% weighting in the Emerging Markets stock index brings everything else down? It’s mostly because of contagion fear.

First there are European banks with outstanding loans to Turkey. Those loans will be impaired. Banco Bilbao, in Spain, is down 13% in the last few weeks and down 25% over the year.

Second, investors start to look at countries that share the same problems as Turkey, and number one on that list is South Africa.

Third, there’s a problem with covariance in Emerging Markets. If a developed market runs into a recession, stocks fall and interest rates fall. So, there is some portfolio diversification benefit. But in Emerging Markets, currencies need protection so interest rates rise and stocks fall. There is no diversification benefit.

Emerging Markets are also caught up in the Sino-U.S. trade war. News of renewed trade talks later in August helped markets recover on Friday but China is still slowing…the trade talks may help but signs in the currency (it’s down) and commodities (way down) suggest the Asian correction isn't over. Again, we’re using protection for what might be a troubled few months.

2.     Fidelity launched a 0% ETF. Isn't that great? Perhaps. So, yes, Fidelity launched a zero cost ETF and even stuck “zero” in the name, so they would be taken seriously.  What could possibly go wrong? Well, not much, perhaps, but there are other things to think about when we get to near zero fees. For every $10,000 you have in the Fidelity account, you would pay $4 in a similar Vanguard fund and $3 in a Blackrock iShares fund. Fidelity is a fine company. But we’d also look at:

1.     Securities Lending: Many ETFs lend out their securities to custodian banks. We could not find how much of the securities lending proceeds Fidelity will credit to the fund and how much to the investment company. The split should be around 80/20. Our guess is that the investment company will take a larger share.

2.     Index: Fidelity came up with its own index to track the U.S. market. Again, nothing wrong with that but others like Blackrock, Schwab and Vanguard use external, independent indices. Which, we sort of prefer.

3.     Returns: not all indexes are created equal. We've written about the performance of the small cap S&P 600 (up 213% in 10 years) over the better-known Russell 2000 index (up 162%). While not quite as big a difference, here are the 10-year returns of five big, U.S. multi-cap stock funds and ETFs:

They’re all bunched together but squint at the end lines and the extra returns for a $100,000 portfolio over 10 years for an investment in the top and bottom funds turn out to be $17,530. The best fund was not the cheapest. Nor was the worst (we’re talking relative here) the most expensive. It all came down to which index the fund tracked. Some indexes are better than others.

So, pick your index, then the cost. Cheapest does not mean the best (h/t Dan Wiener).

 Bottom Line: Treasuries will remain bid, mainly because of the expensing of pension contributions we discussed last week. We'll be testing Emerging Markets contagion again.

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Pastafarianism is not a thing

--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.

Closing note: Aretha and Chains