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A slip of the Fed

The Days Ahead: ECB meeting…will probably announce a cut

One-Minute Summary Stocks were off less than 0.6% over the week. They were down 1.5% mid-week but good results from index heavyweights like Microsoft, JP Morgan and Phillip Morris all reported good numbers.

The economic data was mostly in line with expectations. Retail sales ahead, consumer confidence fine, housing starts and industrial production slightly below. No great dramas. But the Fed governors kept up the dovish talk with three leading voters implying rates could go lower than the 25bp cut already baked into prices. There was an unusual gaff from Governor Williams who said:

“If inflation gets stuck too low — below the 2% goal — people may start to expect it to stay that way, creating a feedback loop, pushing inflation further down over the longer term and it pays to act quickly to lower rates at the first sign of economic distress.”

Ok clear enough. Jump on rate cuts if inflation is running low. The 10-Year Treasuries dropped 4bps and the expectations for a 50bp cut went from 39% to 51% immediately. But then the New York Fed said, er, no, he didn't mean that.

“This was an academic speech on 20 years of research. It was not about potential policy actions at the upcoming FOMC meeting."

And bonds gave up their gain and the probability promptly fell to 20%.

Now we know the problems of reigning in the opinions of 17 regional governors and board members. But can we please get this straight? The market is reacting to every comment as if it was guidance and they are not all on the same page. Thankfully, there’s a blackout period next week pending the July 30th meeting.

All that Williams stuff meant gold had a run of 3.5%…it tends to do well if rates go to zero for the simple fact that a zero yielding asset looks better. But it didn't last.

1.     How’s small cap doing?  Could be better. We like to use the S&P 600 as our small cap benchmark, not the Russell 2000. It’s less well known but has a quality bias, which we like. The main differences are that the S&P 600 i) is slower to include IPOs ii) company must have four quarters of net income (so no tech companies selling $1 bills for 80 cents) and iii) no multiple share classes (so no companies where founders retain control with minority positions). The S&P 600 has comfortably outperformed the Russell 2000 over long terms but the Russell is easier to trade and gets most of the headlines.

Which brings us to this.

Small caps have underperformed since mid 2018

This shows the Russell 2000 compared to the S&P 500 over the last five years. An up line means small cap has done better. A down line means large cap has done better. Even if you’re not into charts (h/t Cameron Crise) you’d notice small caps have had a rough time recently, trading at the bottom of their 5-year range. They're still up around 15% this year but not as much as the S&P 500 at 19%.

Why?

  1. Small companies aren't cheap. The S&P 500 trades at around 17 times earnings. Small companies at 48 times.

  2. They've been harder hit with tariffs. Though they only have around 16% of sales overseas compared to the S&P 500 at 40%, they have less room to work around or avoid tariffs.

  3. They also don't make as much money. In the list we scrubbed, 614 out of 1861, or 32%, were loss making, compared to 5% for the S&P 500.

  4. The tax cuts were kind to small companies last year but that effect has worn off

We'd say that the small company sell off is overdone. These are fiendishly difficult timing calls but we’d look for some relative outperformance if the macro data improves.

2.     How’s business dealing with the trade issues?  Not well. We came across this report from the U.S.-China Economic and Security Review Commission about how some companies are trying to work around tariffs. Basically, it's hard to do without very deep pockets. Currently, more than 90% of Apple’s products are produced in China. It probably has the most entrenched supply chain in China of any manufacturing company, and it's going to take them 18 months to move 20% of production to India and China.

So, if it’s hard for Apple, it was no real surprise that in the latest Beige Book, a survey of companies in each of the 12 Fed districts, that uncertainty, tariffs and trade were cited 37 times. We'll admit this is not the most scientific method to measure concern but this compared to 31 times a year ago. So companies have had this looming over their heads for quite some time.

The overall message is “modest” growth and widespread concerns. Which is the same story coming out of the earnings reports.

3.     How’s the recession watch? Close but not there. We've talked about the Dow Transportation index as an indicator of goods moving around the country. One of the measures is “inter-modal” traffic, which simply means a container moving from ship, to rail to truck without any handling of the freight inside.

So, anything going on?

Freight volumes falling

This shows the one-year change in freight ton-miles (the weight of a good multiplied by how many miles it’s moved) and a broad freight index. Both are down, by 14% and 0.2%. That's more than normal for a pre-recession period.

Last week CSX, one of the four pure-play railroads in the S&P 500, reported. It runs freight rail up and down the East Coast and over to the Mid-West. Their CEO had some interesting points on the earnings call and this caught our eye:

 “The present economic backdrop is one of the most puzzling I have experienced in my career…many of our industrial customers’ volumes continuing to show weakness with no concrete signs of these trends changing…[and we] are seeing a range of conflicting data points and economic indicators…”

We looked at FedEx a few weeks ago and that’s shown weakness in volumes and revenues. We also looked at the Los Angeles port traffic where the basic story is that volumes have fallen steadily since last October.

None of this is a surprise. It’s linked to uncertainty, manufacturing and trade. The concern is that the slowdown might spread. But meanwhile, jobless claims are around the 200,000 to 220,000 range, down from recent highs in the January government shutdowns. So nothing to see or worry about.

Maybe the Fed is on to something with this “insurance” cut?

Bottom Line: Full blown earnings reports coming up. ECB meeting will probably confirm the easy stance. The U.K. will get a new Prime Minister and more Brexit purgatory. Oil may come under renewed pressure but it will be short lived. Stay invested. We're quite defensive already so no major changes to portfolios.

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“In all honesty, profitability is not one of our metrics”

 --Christian Thwaites, Brouwer & Janachowski, LLC

Art work is Burghers of Amsterdam Avenue 1963, by Elaine de Kooning

 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.

 Maconi Union - Weightless 

Powell delivers

The Days Ahead: Retail sales and manufacturing numbers

One-Minute Summary Market at record highs. It’s all down to that curious mix of a slowing (not recessionary) economy and lower rates, both here and in the major economies in Europe. Recent numbers on CPI and employment, the two biggest market moving data points, have come in above estimates. The yield curve steepened especially in the 5s/10s, so that takes some heat off recession fears.

Nothing remarkable in the details. Energy did well but that reflects a bounce in the oil price not some big global-growth-demand story. Stocks that did well were health care related and all to do with the ups and downs of the Medicare for All story.

1.     What will the Fed do?  Cut but not by much. We're writing this just as Chair Powell is wrapping up two days of Congressional testimony and the latest Fed minutes from June are out. We'd summarize the Fed’s position as i) the economy is fine ii) but we can't see inflation anywhere iii) we hear about some bad stuff especially trade iv) an “insurance” cut seems like a good idea and v) that will get the President off our backs. Ok, we made that last one up. But the direction is for easier money.

One interesting note was that Powell’s written piece (here), felt the need to stress the Fed’s independence. Then there was this:  

“I urge Chairman Powell and other Federal Reserve Board governors not to submit to the high pressure tactics of this President who continues to push reckless and harmful economic and social policies,” House Financial Services Committee Chair Maxine Waters, a Democrat, told Powell.

She asked Powell what he would do if Trump asked him to resign.

“Of course I would not do that,” Powell said, and repeated that he fully intends to serve his four-year term.

We cannot recall anytime where the Fed has had to state its own independence. I mean it’s one of those things, right? Most economies run independent central banks, no?

We felt it was Chair Powell laying down a marker. Not daring Trump to fire him. He seems too sensible for that. But calmly stating he’s holding his own and not intimidated. Of course, Trump could force the Fed’s hand by going all out on tariffs, inducing a slow-down and recession. The Fed would then cut rates, restoring the economy to health around, oh, say mid-2020. But he wouldn't do that.

We don't feel the Fed will cave nor do we think Trump will force a resignation. We don't think the rate cut is necessary. Employment is fine, inflation low but not heading into dangerous or negative territory. When we look for trouble, we look for depth, duration and dispersion. We see no material, widespread slowdown in any major leading indicator.

The Fed did not surprise the market, so full marks for communicating well. Here’s the 10-Year Treasury:

Yields rose which means the market expected a little more from the Fed and gave up some recent gains. But here’s the 2-Year Treasury:

Yes, it moved in the opposite direction. What’s happening is that i) the long end of the curve was overbought and ii) the front end could move down on the confirmation that a rate cut is coming.

Here’s how the yield curve moved with the blue line as of writing on Friday, compared to a week ago (yellow) and for grins, 18 months ago (black):

What does it all mean? Rates dropping. Long end looking cooked. The 30-Year Treasury popped up. It’s very inflation sensitive. Keep the floaters because we’re getting more coupon than the Ten-Year and stay in the middle of the curve.

2.     Top of the market. Should I buy? Yes. One of our favorite analysts, John Kemp, over at Reuters, had some interesting stats as we sail/crawl by the 3,000 mark on the S&P 500.

Here we go, with the S&P 500 going all the way back to 1929.

There’s an upward bias to the stock market. It reflects nominal GDP, inflation and productivity. Even if U.S. industry stopped making any productivity growth, the market would probably rise by 2% just to track inflation. Add in another 2% for dividends and 2% for share buybacks and you're in the 5% range without too much effort.

So, the long-term trend is up and the short-term trend is about the cycle, greed, fear and the thousand natural shocks we’re all heir to.

The S&P 500 has traded at record highs eight times in 2019. In 2018 it was 19 times, 2017 62 times and 2016 18 times. On average, the S&P 500 trades at a record level 13 times a year.

The current trend is not concerning. It’s come on a little fast in 2019, but it was oversold in late 2018. The average return for the last 5 years is 8%, which is slightly more than we use in our plans and projections.

So, yes, you can buy at these levels.

 3.     How’s the budget deficit going?  Ha, not well. The deficit is up 23% from last year and at this rate will hit $1tr, around 5% of GDP by year-end. Receipts are up 2.6% and spending up 6.6%. Interest payments on debt are up 16%... although some of that is due to the Fed running down its QE balance sheet.

The bond market seems not to mind but then the volume of new Treasury securities don’t drive rates much. Inflation and growth do.

We bring this point up because the debt runaway seems not to bother many people in Washington. In the week that Ross Perot died, we recall his charts and warnings when we ran deficits of around $300bn. Now it’s three times that and you don't hear about it. Or as Mr. Perot said:

“The debt is like a crazy aunt we keep down in the basement. All the neighbors know she’s there, but nobody wants to talk about her.”

We also bring it up because the debt ceiling runs out in September and, guess what, there is no agreement on raising it. So, we’ll put a pin in that.

Bottom Line: Earnings season starts in earnest with the big banks all reporting next week. Equities have come a long way. We'd like to see some consolidation.

Please check out our 119 Years of the Dow chart  

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Last of the beetles

 --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.

 Discovering India

Another day, another record

The Days Ahead: Payrolls and CPI

One-Minute Summary Market volume was down. It was a short week and we’re writing this on Wednesday. We have the jobs numbers on Friday but we expect a return to the 150,000 level from May’s 75,000. Not enough to tip the Fed’s hand into a July cut.

It was a case of another day, another record. The S&P 500 has now returned 19% this year. So did the Dow. We won't repeat our “don’t follow the Dow” lesson but it’s also up 14% this year. Since January 2018, however, it’s flat, which just goes to show much disruption the market has had to deal with in the last 18 months. The 10-Year Treasury continues to drop. It’s now at 1.95%, which is the lowest it’s been since November 2016.

We see no conflict between a strong bond and equity market. There are plenty of comments around that a low Treasury yield means a rate cut, which means a slowdown, which can't be good for equities. But that is to misread the equity market. Yes, growth is slowing and the Fed may well cut this year but stocks adjusted for slower growth a year ago. Stocks are at record highs but not record valuations. And in the last 18 months have only risen 8%. Small caps and international are still way off their record highs.

That’s hardly the stuff of exuberance.

1.     Has this been the longest expansion? Like ever?  Yes, but. But it’s also been the lowest rate of growth of any expansion in the last 70 years. Here’s the quick graph:

Since the 2009 crisis, we've seen average growth of 2.3%. In prior years it was much higher, even after the 2001 tech bubble. And we've had three negative, although not consecutive, quarters of growth. As we've said for a while: very bad recession and not-so-great recovery. This is how this recovery compares according to the NBER’s data going back to 1858.

So there, it is. It’s one month older than the prior record. But there are a few things to note:

  1.  This expansion has been slow from the start. Even today, anything to do with housing has yet to recover pre-recession peaks. Housing starts are at around 45% below the crisis. It’s the same with commercial construction, mortgage applications, refinances, existing home sales and new home sales.

  2. Unemployment used to take around 36 months to reach back to pre-recession lows. This time it took 10 years. For the underemployed it took 12 years.

  3. Household net worth never declined in prior recessions. This time it took five years to recover.

  4. Personal income never fell in absolute terms…growth would slow, sure, but it would not decline. This time it fell more than 5%.

  5. The first reaction to the recession back in 2009 was austerity. It seems a long time ago but it took nearly 11 months for QE to start.

You get the picture. A very scared and scarred consumer and a slow return to confidence.

Can it continue? Sure. There is no evidence that the “probability of recession increases with the length of the recovery.” There are no signs that we see right now. We look at housing, claims and unemployment and they're all stable. We think it would take some outside event (yeah, I know that could be anything any day) or an asset price inflation to really bring on a recession.

But outside of that, keep calm and carry on.

2.     Another round of tariffs. We saw some respite at last week’s G-20 meeting where both sides (China and America) agreed to keep talking. That was enough to send stocks moving up on Monday and at least postpones the worst. It may even lead to a break through. Meanwhile:

  • The Commerce Department slapped 450% tariffs on steel coming from Vietnam. The U.S. imports about $30bn of steel and Vietnam’s total exports to the U.S. are about $48bn or about 20% of their economy. So this will hurt Vietnam.

  • The U.S. Trade Representative added another $4bn of EU goods for additional taxes as a response to European aircraft subsidies (it's the decades old Airbus thing). The total up for tariffs is now $21bn. 

This could go on indefinitely, of course. For what it’s worth, we think the U.S. tactics used on China, Japan, Mexico and Canada will fall flat when dealing with the EU. It's not a bi-lateral discussion. It’s one vs. 27. The EU will close ranks very quickly if the U.S. pushes too hard.

Meanwhile, the “uncertainties” the Fed referred to are still front and center.

Bottom Line: Interest-sensitive stocks have done much of the running recently. That’s probably temporary. We'd look for strength in international.

Please check out our 119 Years of the Dow chart  

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Bottle cap challenge

 --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.

Over to you G-20

The Days Ahead: G-20 meeting.

Listen to the Podcast: iTunes | Soundcloud | Google Play

One-Minute Summary. Markets had two things on their mind. One, the G-20 meeting and, two, quarter end rebalancing. What? Yes, rebalancing is a big deal given how many funds (think of all those target dates funds, pension accounts, risk-parity funds) have to maintain their Equity/Fixed Income allocations. After a barn-storming start to the year, with Treasuries up 7%, equities up 14% and similar recoveries in international and emerging markets, many portfolios will have rebalanced in the last week or so.

Outside the technical side, markets are running on low rates, the expectation of lower rates and the hope of a trade deal. Fair enough, but those have been the headlines for months now. We need a new narrative to keep things moving. While 2019 has been good (see below for our mid-year scorecard), we've only advanced some 4% since January 2018 with two corrections of 10% and one of 20%.

Now sit back and enjoy the G-20 meeting.

1.     How are Emerging Markets doing?  Better than 2018 (down 16%), which was worse than 2017 (up 37%) and much better than 2016 (up 11%). So far this year, we’re up 9%. The reasons why Emerging Markets took a hit in 2018 are pretty straightforward: trade tariffs, a strong dollar and interest rates.

What about all that growth, the richer middle class, the emergence of the, well, emerging markets? Well, all that's true but, one, these are countries that rely on exports for growth. For China and India, it’s 20% of GDP. For other SE Asian countries it ranges from 40% (Korea) to over 100% (Vietnam and Hong Kong). Compare that to the U.S. at 12% and you can see why the headline “trade wars hurts them more than us” holds true. And it's a general principle in capital markets that it’s not the level of change that matters as much as the rapidity of change. So a quick 10% fall in exports to some emerging markets is very dangerous indeed.

And, two, many Emerging Markets countries carry dollar denominated debt. China and India are at 14% and 20%. Some are more than double that, such as Turkey, Mexico and Indonesia. So when the dollar strengthens, debt-servicing costs rise.

Last year the Fed raised rates four times and the dollar strengthened by 8%. That was the average. Against the Renminbi, it strengthened 9.7% from 2017 lows. Against the Korean Won, it was 10% and against Turkey and Argentina (both in the news for economic crisis) it was 25% and 55%. That all meant higher debt service costs. And a lot of that debt is private so it hits companies and households.

Now, with U.S. rates on hold, a slower U.S. economy and lower short-term rates, we've seen some dollar weakness and that is good news for Emerging Markets.

We've shown the dollar (in blue) against the Emerging Markets index. The shaded areas show that when there's dollar weakness (blue line up), Emerging Markets do very well. And vice versa. While the dollar has not weakened materially this year, we think it’s likely to. The rationale is simple enough starting with the President calling for it, lower interest rates, the possibility of some, any, trade deal, the U.S.’ twin deficits, the rise of gold and the attraction of the Euro.

The last few weeks have seen a weaker dollar and, if this persists, it will undoubtedly be a very good signal for Emerging Markets equities.

2.     We said some things would happen in 2019, how did we do? Fair enough. The year’s not over but this is an appropriate time to pull out the scorecard. This is what we said:

1. Will the U.S. economy roll into recession? No. What we’re seeing is a slow down from peak performance.

Score: We'll stay with that. We’ve seen some slowdown. Every week comes with a slowing indicator. Last week it was consumer confidence but we think that was tied to the Mexico tariffs-that-never-were. Not enough to see a recession coming.

2. Will the Fed raise rates? Not in the first quarter and probably not in the first half of the year.

Score: Not only was there no rate rise but the whole talk shifted to cuts. We still think they’ll hold for a while. A July rate cut looks too soon.

3. Will there be a trade deal? Probably. We know that both sides have an incentive to close a deal.

Score: Not yet but we've had postponements of the extra tariffs with China. We still think something will break to the upside.

4. Will U.S. Equities start to recover? Yes, but it may be a rocky road. In 2018, U.S. stocks had their first down year since 2008.

Score: Wow, yes but we didn't expect the takeoff we saw since January. We’ve had a pause since May and we’re only recovered from September levels. We're cautious given the run up.

5. And how about international and Emerging Markets? Nearly 100% of global markets were either in correction (down 10%) or bear (down 20%) markets in 2018. But the markets are selling at a substantial discount to the U.S. and that looks like an opportunity.

Score: Right but for the wrong reasons. International stocks still look cheap but the trade and general slowdown has meant they've underperformed…but by a lot less than 2018.

6. Where will the U.S. 10-Year Treasury end?  About where it is now. We think U.S. treasuries will be a valuable “risk off” asset class especially as corporate credit spreads look vulnerable.

Score: Another one where we got the direction right but magnitude wrong. Treasuries at the end of 2018 were 2.7% and had rallied from 3.2% . Today we’re knocking on the door of a 10-Year Treasury with a “one handle” at 2.0%. They’re expensive but good insurance.

The year’s not over, we know, but so far we’d characterize 2019 as a lot of fire and brimstone but solid returns. And it will probably stay that way.

3.     Inflation, not a problem is it? No, it isn't but the Fed acts as if it’s non-existent. There has been plenty of talk over the last week that the Fed needs to get inflation moving. Here’s Neel Kashkari of the Minneapolis Fed arguing that inflation needs to grow and a 50bp cut in the Fed Funds rate will do the trick. The President should love this guy. And here's Jay Powell saying inflation is stuck at less than 2%.

But inflation is not absent, as we’ve described with the whole hedonic thing and here’s the latest Dallas Fed trimmed PCE.

The “trimmed” part is to adjust for outliers that tend to have a) small weightings and b) short term volatility. So out go eggs (0.09% of the index and down 23% in the last month) and car rentals (0.1% and up 26%). You're left with about 50% of the index and some big items, like home rents and meals. And that, as seen from the above, is sailing along at a pretty consistent 2% for the last year.

So what? Well, there may be reasons to cut (trade worries, a lower dollar) but collapsing inflation ain’t one (h/t Pantheon Economics).

Bottom Line: It still looks like defensive stocks are the way to go. We'd notice that dividend-paying stocks are having a day in the sun. Hold the Treasuries.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

How many squirrels live in Central Park?

--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.

Peter Green - Live

4th Time Around

The Days Ahead: Fed meeting.

One-Minute Summary Markets seem quite unperturbed these days. U.K. leadership battles, no trade news, except the Mexico “soya beans for immigration” deal, tech in the sights of regulators, oil tankers shot at, Hong Kong riots. But equities have their eye on a rate cut and ended up 0.5% after a four week losing streak. Still some 2.5% behind the all-time high but retracing much of the May correction.

Hardly a day goes by when the 10-Year Treasury doesn't seem to rally. We're at 2.09% on Friday. They rallied when the not-so-great NFIB and low CPI numbers came out mid-week, gave some back with the OK retail sales on Friday…only to rally again going into the weekend. No one wants to be short Treasuries over a weekend in these markets.

We still have differing messages from equities and bonds. Bonds are saying slower economy, rate cuts, low inflation. Stocks are saying earnings are cheaper to buy and a slowdown will be temporary. They can both be right and so far this year, investors have been rewarded with a 15% gain in equities and 11% gain in long Treasuries.

We're comfortable with both markets right now. Some caution in order on the equity side but not enough to sell.

 1.     Are we about to hit a recession?  No. Oh, come on, you know where we are with this. There are many recession indicators. Some so early as to be unhelpful (yield curve inversion). Others too late to do anything (credit spreads) and plenty in the middle (consumer confidence).

The common definition of recession is two consecutive quarters of declining real GDP. Fair enough. That’s enough to worry about. But it tells you little about depth or duration. The 1990 recession, for example, lasted 8 months peak to trough and unemployment went from 5.1% to 7.0%. The 2008 recession lasted 18 months and unemployment shot from 4.5% to over 10%.

The folk who determine if we’re in a recession are at the National Bureau of Economic Research and their definition of recession is quite long and complicated (see here). And it turns out, the two quarters of GDP measure is woefully inaccurate. The 2001 recession never had two quarters of declining GDP but many of the other measures (sales, employment, real income etc.) were turning south quickly. The 2008 recession was halfway done when it first showed two quarters of declining GDP.

And the NBER doesn't try to predict. Far from it. They announced the 1980 recession one month before it ended. And the 2008 recession 11 months after it started.

So we’re always looking for a good recession indicator. And we found one courtesy of Brookings, which says if the 3-month moving average unemployment rate is 0.5% above its recent 12-month low, then you're in a recession. That makes sense. It doesn't really matter if unemployment is 3% or 5%. If it starts to move quickly upwards, the chances are employers are getting nervous and laying people off. We've headed into recessions with 6% unemployment and we’ve had recoveries with 9% unemployment. It’s the rate of change that matters. The moving average just removes one-offs like, oh I dunno, government shutdowns, tariffs.

There’s a whole book on it and we’re probably doing a disservice in our summary but the 0.5% rule has a very high success rate. And it makes intuitive sense as well.

So where are we now?

The recent 12-month low in unemployment is 3.6% and the recent 3-month moving average is 3.67%. Add 0.5% to the low and we get 4.1%, the black dotted line. So if we see unemployment increase closer 4.1% in the next few months, we’re in trouble.

But not yet.

2.     Any sign of inflation? No. In fact it’s heading down. The latest CPI showed broad inflation falling to 1.8% from 2.0%. Core inflation was at 2.0% but has been running at an annualized rate of 1.2% since February. The PCE inflation, the one the Fed follows, is below even those at 1.57% and has also been trending down for the last 3 months.

Now you would be quite forgiven if you said to yourself that the official CPI doesn’t resemble anything like what you pay. And that’s down to some adjustments that the BLS makes when calculating inflation. Here's a graph of TV prices over the last 20 years.

They've fallen 97% in the last 20 years. And it’s true that it's never been cheaper to buy a good 40” high end TV loaded for $229.. Back in the mid-1990s a top of the line 32” TV would have cost around $1,000. But according to that graph it would have been around $7,700. That’s where the folk from the BLS say,

 “Yes, we know it’s not a 97% price decline but today’s TV has better sound, a 4K display, is internet ready, built-in Wi-Fi, HDMI ports, is lighter, flatter, bigger and just overall awesome, so we’re going to make a price adjustment for that”.

And that’s fine. It’s called hedonic adjustment and no one thinks it’s a government plot to suppress inflation (well some do but they’re fringe). But it's one reason why there is a downward bias to inflation reporting. Think of all the things that are cheaper or the same price than a few years ago but of much higher quality. Autos, phones, houses….all big-ticket items.

It’s one of the reasons that we’re looking at lower inflation for a while and although the Fed claimed back in April that

 “At least part of the recent softness in inflation could be attributed to idiosyncratic factors that seemed likely to have only transitory effects on inflation…”

 …it’s very possible they're not transitory at all. We'll know more with the Fed meeting next week where they might signal a rate cut for the July meeting (h/t Tim Duy).

Either way, things are slowing down and the Fed will probably act in the face of weak inflation.

3.     How’s the budget deficit going? Oh, you know….bad. Depending on your point of view tax cuts i) pay for themselves ii) increase capex and iii) employment and wages or iv) are a decidedly dodgy way to play with the country’s finances.

Anyway, the latest Treasury Statement shows that a year ago, the deficit was at $532bn for eight months of the fiscal year (government years run from October) and is now $738bn…or, wait for it, the same as the total for fiscal 2018.

Tax receipts are flat while expenditures are up 9%. Corporate taxes are way down, which was the plan, but interestingly custom duties, which are around 1% of tax revenue, are up…a lot.

That's a 66% increase and the government is pulling in around $100bn (annualized) from custom duties…which we all know as tariffs. It’s not enough to choke off consumer confidence yet but it cancels out the personal tax cuts. So, well done everybody.

Bottom Line: Plenty of concerns in the market right now but prospect of a Fed cut is front and center. Oil is not moving because of high inventories and low demand.  

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I met the Prince of Whales

 --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.

 4th Time Around 

Equity Bounce Back

The Days Ahead: Fed black out. G7 Central Bankers meet.

Listen to the Podcast: iTunes Soundcloud Google Play

One-Minute Summary: Sometimes you wait for some, any news to come around. Sometimes, it comes fast and understandable. Sometimes it comes so fast, you just have to wait to see how the air clears.

So last week, we had i) weaker manufacturing numbers but ii) okay services numbers iii) weak employment but iv) okay vehicle sales. Tech companies are under regulatory review. The Mexico tariffs took their toll. But by Friday, there was talk that there was a deal going through if Mexico agreed to buy more agricultural products (I know, I thought it was about immigration too).

Bonds rallied again, equities came back 4.5% and we’re now back to where we were in the beginning of May. Fed speak was mostly dovish ahead of the blackout period for the FOMC meeting on June 18.

The Fed has a tough task. They have to weigh up:

Signals that Fed should cut: trade, stock weakness, manufacturing, slower Q2 growth and low inflation

Against

Signals to stay put: employment, claims, service industries, consumer and housing.

If there is a cut (we’d give it a more than 50% chance in the next three months) then we’ll see asset classes perform in this order of best to worse:

  1. Treasuries

  2. U.S. Equities

  3. Emerging Markets

  4. Credit

  5. Mortgages

  6. U.S. Dollar

Good news! A sign that the Trade Wars may be behind us arrived in a new ETF called “The Innovation α® Trade War ETF”. It buys companies that are insulated from trade wars. Companies like GE, MasterCard, IBM and Xerox, most of which sell a ton overseas and have been bad investments because, well, they’re not great businesses. Of course, it’s back tested and looks terrific. So, whew.

But when these types of ETFs hit the market, they’re a decent contrarian indicator

1.     Demographics as destiny. The fun part about demographics is that you can predict changes years ahead with some accuracy. After all, if you're alive today, you’ll probably be alive tomorrow and a year from now. So a birth cohort moves through the years pretty much unchanged.

Unless… unless, immigration increases, fecundity takes off or people start dying later than planned. In the U.S., immigration has slowed, birth rates are lower and later and life expectancy has dropped.

Put all these numbers together and U.S. population growth is around 0.6% a year, compared to 1.3% two decades ago. So instead of the population growing 3.3m a year it’s down to 1.9m a year.  Labor force growth is around 0.9% compared to 1.8%. So that’s down from 2.3m to 1.4m.

So what? Why should we care? Well we should care very much because while the U.S. has an impressive GDP record, it has a decidedly less impressive GDP per capita growth record. Here it is for the last 30 years.  

The GDP number (blue column) is always above the GDP per capita number (line), which means we’re getting about 30% of our growth through population increases. Or to put it crudely, we get growth through more people on the job rather than better productivity. It’s the reverse in Japan:

There, GDP per capita has tended to exceed GDP growth. It’s mostly down to labor productivity and increased labor force participation, especially for women which is 57% in the U.S. and 70% in Japan (using slightly different methodology).

So, ok, what next? U.S. growth is very population dependent. Slow that growth and GDP will slow. And that is precisely what has happened in recent years.

 2.     Great job numbers? Er, not this time. Before we dive in, following on from the last topic, the U.S. has to grow employment by about 187,000 per month to keep up with civilian Noninstitutional Population growth…yeah that’s a weird title but it's  basically the U.S. population over 16 and not in the military, prison or nursing homes.

So any time you see a new jobs numbers below 187,000, then you can roughly say that it’s not keeping up with population growth and the difference will show up as “not in the labor force” or “unemployed”.

 So this month it was 75,000 with no change in the already low unemployment rate.  

It was also flattered by 1,000 Census workers. We bring this up because over the next year, the Census Bureau will hire and fire over half a million people for the 2020 census. Last time that happened in 2009 and 2010, a certain administration got a little carried away about job growth on their watch…and it’s possible, just possible that it might happen again.

The biggest hit came in the private sector where there was a decline of about 90,000 over the prior two months. State and local government jobs also were down. Hourly wage growth slowed.

It’s difficult to pinpoint “why?” But the China tariffs (the Mexico one wasn't known on the survey date) and general uncertainty must have played their part.

So, job growth has slowed and it gives the Fed a reason to cut rates. The bond market seems already there and the 10-Year Treasury dropped 3bps on the news.

3.     What’s up with the yield curve? There’s more talk about the yield curve especially now the Fed Funds at 2.5% is above almost every Treasury bond out there until you get to around 25 years. One of the most cited spreads is the 10-Year and 2-Year Treasury, which are now separated by 24bps, up from 15bps two months ago.

As we've said before, yes, the inverted curve is a decent forward indicator of a recession but its timing is unreliable. In some years, it inverted and there was no recession, in some the recession came two years later and for some it came six months later.

And as we also like to say, being early and right is the same as being wrong.

We do know with some certainty that the Fed stops raising rates when the curve inverts. Sometimes they go on to cut but, again, with some delay. So, right now we'd say (and it's not a great insight but, hey, we’ll take certainty when we can get it) the Fed will not raise rates this year.

Bottom Line: Full pricing in Treasuries but still the best place to be in a risk-off market. Perhaps some tariff rate relief with Mexico but who wants to make an outsize bet on a tweet.

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Facebook shareholders don't count

 --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.

 June Bustin’ Out…

A strange game…the only winning move is not to play

The Days Ahead: Jobs next Friday. G7 Central Bankers meet.

So, it was a normal week up until Thursday. Weaker economic numbers, Fed on hold, yield curve inverting, more on China and Huawei. The revised GDP numbers and new low of PCE inflation all seemed important.

Then bam, Tweet time. This was the 5%, climbing to 25%, tariffs on Mexico. For the record, Mexico displaced China as the U.S.’  largest trading partner last month. Total goods trade between the two was $149bn in Q1 2019. China was $137bn.

U.S. companies may silently cheer from the sidelines on the Get Tough with China talks. But it is a very different story with Mexico. People make avocado jokes but Mexico trade is heavily into car parts, vehicles, medical instruments and computers. There is also the added problem that a finished good may pass back and forth over the border before completion (certainly not the case with China). So, does that mean a 5% hit every trip? Companies with big Mexico dependence took a hit on Friday. Constellation Brands (Corona beer among others) was down 15%. Levi down 9%. GM down 11%. And so on.

And that 5% tariff. The Mexican Peso dropped 4% on Friday. So that price increase is down to 1%. Funny how markets react. Perhaps the trade guys should follow this advice:

On that yield curve. We were bulls on Treasuries at the end of 2018. With a slowing economy and the Fed seemingly done with rate increases, the 3.2% on the 10-Year Treasury looked enticing. Now it’s 2.16% so that’s a 10% return if you bought something like ITE (a Treasury ETF) or the then new issue Treasury 2.87% of 2028. The curve is now inverted all the way to 20 years and every bond out to 30 years is below the Fed Funds rate. Even the 2-Year note is at 1.97% down from 2.6% in January.

At this point, Treasuries look rich. Corporate bond too. Equities aren't so cheap that they’re an obvious buy. Emerging Markets look more vulnerable by the day. What could reverse it all? A trade settlement of course. But for now, protection, safety assets and sidelining are our best strategies.   

1. Gettin’ Defensive.

In times of economic or market uncertainty there are a few pretty reliable defensive trades.  

  1. Full on fear: head for Treasuries (now 2.16%)

  2. Hedge your fear: Yen (+3% MTD) or Swiss Franc (+2%), although the Swiss Central Bank gets a bit twitchy if their currency rises too much. They clocked FX traders back in 2015 with a 30% rise in the Euro/Franc rates.

  3. Fearful but greedy: Gold (+3% but if you feel a need to buy gold, don’t)

  4. Fear of missing out: Defensive sectors of the stock market

It’s the last one that gets interesting. Over the last year, there’s been plenty to fret about. Heck a Tweet can move the market and we’ve had wars, embargoes, trade and politics to think about. So where’s a good place to hang out until things feel better?

Defensive sectors have done well

Treasuries have done fine but squint at the above and you can see Real Estate, Utilities and Consumer Staples have done very well against the S&P 500 in the last year (h/t Mike Mackenzie). The first two are interest-rate plays. Real Estate especially is very highly leveraged. Staples usually fail to excite investors much. The largest stocks are Coca Cola, Wal-Mart, P&G, Pepsi and they've been on a tear. They’re seen as safe (people gotta buy toothpaste, right?) and even with low single digit growth, that’s better than negative sales.

But we’d also put the run-up in defensive stocks in the context of a major sector change. Here’s another chart:

Not many defensive stocks left

The top line is the value or market cap of the S&P 500. We use this because share buy-backs mess up the numbers. The lines below show the proportion of the market considered defensive before and after last year’s changes, when Telecoms was merged into a new sector.

Apart from a brief period in the early March 2000, the defensive sectors have never been a lower proportion of the S&P 500, even after their recent run-up.

What does this tell us? There are fewer safe places in the S&P 500 and those trades can get pretty crowded pretty quickly.  

2. The changing U.S. economy.

Forget about tech for a while. We get that. But one of the most successful stories in recent years is U.S. production of oil. In 2011, 60% of the trade deficit was due to oil and oil products (diesel and petrol). But in the last two years, U.S. oil production jumped 31% (blue line), while oil imports fell 25% since 2010. The oil deficit is now very close to surplus.

US oil production is now world’s third largest

What does this mean? 1) The U.S. is rapidly becoming self sufficient in oil 2) higher oil prices used to put a dent in the economy but now higher output and prices will show in up in oil producing companies and 3) even with sanctions on Iran, oil prices are likely to remain low and remain a tailwind for the economy.

3. How much has the trade war cost?

Hard to say. At one level, just take the $500bn and throw 25% at it and call it a day. That’s $120bn or 0.5% of GDP. But the hidden costs are higher. Here’s an article about Huewei planning in case their executives end up in U.S. jails. That must put a stress on your executive decisions if you’re worried about your staff being arrested. Or you may be thinking of moving your plants to Mexico. But that takes time and then this comes out Thursday:

Or you run a company in China and want to move to Vietnam or Cambodia. But takes time to figure out regulations, labor and environmental laws. Or you stockpile as much as you can.

It’s a truism that businesses hate uncertainty (mind you, unless you’re a bookie, most of us do). And if the rules aren't clear, then it makes sense to just wait it out.

The indirect costs are high but difficult to calculate. Stocks can help. Since the beginning of 2018, when the trade wars kicked into high gear, the MSCI World Stock Market Capitalization has lost $7.7 trillion. U.S. stocks have been in a sideways pattern since then but managed to lose $723bn in value.

So there you have it. Bookkeeping costs low. Intangible cost high.

Bottom Line; More on the trade front. There aren't enough obvious bargains out there and Fixed Income markets look like the i) deflation ii) Fed won’t hike iii) low growth and iv) fear are fully priced. We may trim Pacific related stocks on a bounce.

Other
Wealthfront’s risk parity fund is a dud

--Christian Thwaites, Brouwer & Janachowski, LLC

Please check out our 119 Years of the Dow chart  

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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.

 Cate Brothers - Union Man 

"Thank you driver for getting me here" *

Listen on Apple Podcasts | Soundcloud | Google Play

Short week. Second estimate at Q1 GDP.

Stocks opened lower seven out of the last 10 trading days. That means stocks sold off overnight in Asia and Europe but then picked up in the U.S. trading day. That shows high-risk avoidance. No one wants to be long overnight and find there’s no volume. Who can blame them? Stocks were down for the week amid trade tensions, weak manufacturing orders and lower oil prices (down 13% this year).

The deflation forces are showing up in a strong dollar and another rally in 10-Year Treasuries. The yield hit an inter-day low of 2.39%  (it was as high as 3.2% in October). A 10-Year note trading at $96 back then is now at $104 and that excludes coupon payments. If the slow down continues, trade talks deteriorate and inflation keeps slipping, we would not be surprised to see the 10-Year trade with a 1 handle.

1. Trade talks improving?

Ha, no. The Administration placed severe restrictions on Huawei, which is China’s trophy tech company with a huge lead in 5G technologies. They make Android phones, among other things, and so won't be able to use Google’s software. The restrictions essentially reduce a Huawei phone to the status of a brick. It’s not a public company but some of its suppliers are and they're down 15% to 50% this year.

The Chinese authorities did not take kindly to this, of course, and promised to play the long game which could mean anything from tit-for-tat tariffs, to selling down Treasuries, to withholding exports of rare earth minerals, which are vital to electric vehicle components, guidance systems etc. China accounts for seven out of every 10 tonnes of rare earth elements.

What is one to do while this all goes on? The obvious would be to stay away from U.S. stocks with China exposure. So that’s Hollywood, Apple, Starbucks, Qualcomm, Boeing, Wal-Mart and Intel. But that doesn't capture companies who depend on Chinese suppliers, like Nike, 3M and many others. Then you would stay away from European car and luxury goods on the basis that Chinese consumers will have less spending money. We’ve done most of that already. Next we’d look at Emerging Markets which are obvious casualties in the U.S. /China wars. But they've sold off already and don't yet look like bargains. So we wait. And keep the Treasuries as insurance.

Meanwhile, the latest Durable Goods orders were disappointing. If one of the claimed benefits of the tax changes was that capex would soar, then there are some disappointed supply siders around.

Here are the latest durable goods orders with the black line showing orders excluding defense. They're down 11% since last year.

Nondefense capital goods orders down

2. Does the Transportation index tell us anything?

Yes. Not many people use this index any more. Heck, there’s not even an ETF for it and there are some dopey ETFs around as we’ve discussed before. It’s made up of distinctly unglamorous businesses. Kirby (barges), JD Hunt (trucks), Expeditors International (ships), CSX (rail). All companies that move either people or stuff around. They're cyclical because costs are fixed and volumes and prices fluctuate so profits are volatile.

Expeditors is a good example. It’s up 38% in the last two years but has had many corrections of 15% or more. And that's in a good economy. In recession time, it gets ugly. The stock has massively underperformed the S&P 500 in the last 12 years.

So, if there is a slowdown in the economy it’s going to show up in transportation stocks' earnings.

What’s happening with Transportation? It’s underperformed the S&P 500 by 10%. We recently looked at tonnage coming in and out of the Los Angeles ports. Outbound containers are down every month this year. Airfreight through Memphis (through which all the iPhones are shipped) is also down. Memphis is the base for FedEx. It’s share price has fallen 40% since January 2018 and by 36% in the last year. Here’s the running annual stock price change since it went public in 1980 (h/t John Kemp).

One of the worst declines in FedEx share price

What does all this mean? Well, early signs of a slow down are everywhere. Freight, activity, volumes are all weaker. These are not recession triggers yet. But more evidence that the U.S. economy is slowing.

3. How’s Brexit going?

You had to ask? Terrible. Look, there are so many permutations here that we’re not going to say we have much insight other than the U.K. seems to:

  1. believe going it alone is better than cooperation

  2. dreams back to a glorious imperial past and

  3. think trade will work better using tools ditched 30 years ago.

If that sounds familiar to another great country, then that's on you.

Brexit has now claimed its second Prime Minister and the next one appears to be Boris Johnson. Although if we had a vote it would be for Rory Stewart but that’s a long shot. Johnson is a shameless self-promoter, with changing positions and values and opportunistic to the core. He should do well on the world stage. Yes, this guy.

Britain’s future Prime Minister?

So, these are the Brexit choices

  1. Leave with no deal

  2. Leave with negotiated deal

  3. Don't leave

  4. Have another referendum.

We only care about the markets at this stage. Stocks are down 11% since last October but for U.S. investors, they’re down 17%. We’ve been out of the U.K. for two years now and can't see any reason to change our minds.

Bottom Line: The Fed is probably the most predictable player in the markets right now. The minutes were all about “patience” and they're not going to make any big changes to the SOMA balances (i.e. the QE assets). Meanwhile, expect political headlines to rule the day.

Other

* Because it all seems Magic Bussy now.

All the Game of Thrones memes so we don't have to talk about it anymore

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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.

 Link Wray - Fire & Brimstone

There may be a winner in the trade talks

The Days Ahead: Geopolitics a wild card. Europe elections

One-Minute Summary Stocks marginally down and Treasuries up for the week. You’d think with that, the Fed must have cut rates or something. But no it’s another week of trade, slower economic numbers and the expectations of lower rates for a while. Every economic number that comes in low…and there were plenty this week with industrial production, capacity, retail sales, import prices…reinforces the lower rates for longer story. Confidence remains fragile. We see companies holding off on big decisions and playing it safe. It's not enough for a recession but definitely slower.

Markets are just taking this all on board. We track four “fear” trades: gold, yen, 10-Year Treasuries and the VIX. All trades which turn sharply up when things are bad. The only one with a sustained rally is the 10-Year Treasury, now at 2.4%. The other three have all calmed down.

1.     Trade talks, war, progress, and retaliation.  Yes, something for everyone. China responded with tariffs on $60bn of goods from June 1st and the U.S. went ahead with 25% tariffs on $200bn of imports (bad). Goods which are on board ships now (it’s a 4 week journey from China) aren't affected but they will be from then on (good). The U.S. agreed to remove steel tariffs on Canada and Mexico (good). The U.S. claimed military superiority depends on the automobile industry so is looking at imposing tariffs on auto imports from Japan and Europe (bad).

Auto tariffs are complicated. The U.S. imposes a 25% import tariffs on trucks. Trucks include SUVs….even small ones like RAVs and CRVs. So they're made in the U.S. They also outsell cars 2.5:1.

Here’s a rough guess on how much other countries charge.

So that’s as high as 60% if you want an American car in India and 25% in China. Even places like Australia at 0% , can have luxury car taxes, which hit U.S. manufacturers. The Administration’s goal, we think, is to have that entire map the same color as Canada.

With all that going on, why are stocks so calm? Well part of the reason is that the tariffs a) hurt the Chinese economy a lot more than the U.S. and b) tariffs are not necessarily paid for by U.S. consumers. There’s much debate on this ranging from “it's a straight up consumer tax” to “it won't cost them anything”.

Recent import prices were down year on year for the fifth straight month and we think consumers will barely notice the tariffs. We realize this is not the mainstream opinion. But we’re interested in stocks, investing and the economy not polemics. And so far, we’re okay with the U.S. outlook.

We discussed last week how tariffs may not hit consumers but skipped over the foreign exchange point. The Renminbi has weakened by about 3.5% in the last week and by 10% over the last year.

Weakening Yuan

That's not enough to cancel out the tariffs entirely but shows major risk aversion by currency and Emerging Markets traders.

What's next? Sit this out. We already reduced Emerging Market exposure and we could do that again if the tariffs stick or there’s a bad deal.

2.     Recession Watch Housing is a leading indicator of recession. One only has to think back to the carnage in 2008 to remind ourselves how overstretched borrowers, bad lending and a housing oversupply can crash the economy very quickly. There are numerous housing indicators: new sales completed sales, pending sales, mortgage applications, starts, permits etc. Existing home sales are important for homeowners. We all feel good when the house down the road goes for 20% more than we paid for ours. But existing home sales don't generate much economic activity other than some commissions and the occasional kitchen rebuild. New home sales are more important to the economy because they require some entrepreneurial activity, building materials and labor.

So new housing starts is the one to look at and it’s good news. Interest rates and consumer confidence drive starts. Last year, as rates increased, starts fell by 7%. This year, as rates eased back after the Fed’s “patient” stance, they've come back, especially with multi-family units, which are up 13% from 2018 lows.

This is quite a turn from last year when we (and others) called the top of the housing market.  So all better on the housing front? Yes from an immediate recession concern. Nothing to see.

But on the broader side, there are some important changes to the housing market. We've discussed many times the increase in student debt, local housing markets that have squeezed out borrowers and the delay in household formation.

This has meant mortgage levels have flattened and mortgage debt as a percent of GDP has fallen... a lot. Foreclosures (the lower line) are at 25-year lows. But as the New York Fed points out, people using a mortgage have fallen steadily and now (h/t BMO):

“At the end of 2018, about 26 percent of Americans between 20 and 69 had a mortgage, the lowest point reached in the twenty years of available data.”

Mortgage participation is way down

So, it seems more and more people are opting out of parts of the economy that made baby boomers so wealthy.

Bottom Line: Emerging Markets are our chief concern. They're going to be hurt most with trade problems. 

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Alice Rivlin died

Marin County has the wrong jobs

 --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.

 Peter Green - Fool no more

The Tweet heard round the world

The Days Ahead: Brace for another week of trade stuff.  

One-Minute Summary Trade and new IPOs. That was pretty much all we needed to know about the week. We discuss both below but would just point out that stocks were up 17% year-to-date a week ago and they're now up 15%. We'd had a straight four months of gains. When you get your expected return for the year in one third of the time, some people are going to take profits.  

One of the things we’re reminded of, is that getting tough on China is a bi-partisan deal. Even corporate America is quietly cheering this on. We think one of three things can happen:  

  1. It all gets worse and confidence evaporates

  2. There is a deal and tariffs are reset

  3. There are more negotiations and something gets done

 We think #3 is the most likely but it will be a heck of a bumpy road.

Meanwhile Treasuries continue to rally. The soft CPI numbers on Friday capped a week of so-so economic reports. The whole yield curve out to 11 years is now below the Fed Funds rate, which suggests the Fed will stay put.

1.     Trade Tariff Tweets: was pretty much all you need to know about markets early last week. We saw some, frankly irresponsible, headlines from people like Bloomberg, who should know better. “Swoon…precipice…soaring volatility”. Gimme a break. The market was down 2% from Friday’s close to its low point on Tuesday. The worst performing stocks (those down 7% or more) had nothing to do with trade but were companies with their own set of problems. Mylan, a generic pharma company, for example, was down 22% but that was due to a big revenue miss. Companies with big China exposure (e.g. Apple, Yum) were down no more than average.

The tweets were quite straightforward.

Donald_J__Trump___realDonaldTrump____Twitter.jpg

We might also add that the tweets were two of 71 tweets sent out in 48 hours. That’s three per waking hour. So it’s unlikely they're the product of thoughtful deliberation.  And we certainly have no insight into the strategy.

But it's worth breaking down.

The tweet says simply that there will be 25% tariffs on $575bn worth of imports. The current tariff schedules would raise around $32bn. The new tweeted schedule would raise $143bn. That’s around 0.6% of GDP and a little less than the amount the U.S. economy grew in Q1 (see Table 3).

The U.S. imported around $539bn (not $575bn) worth of goods from China last year and ran a total trade and services deficit of $378bn. That’s made up of a services surplus of $40bn and a goods deficit of $419bn.

The actual imports of goods from China is around 15% lower this year (yes, tariffs tend to do that) so the more likely number for China imports in 2019 is probably $490bn, again, not $575bn. Plug 25% into that and we’re looking at $120bn. Still a big number but the same as about 6 weeks of U.S. GDP growth.

Now, there are a number of ways to pay that $120bn (ignoring FX changes):

  1. Chinese companies can lower their prices

  2. U.S. importers can face a margin squeeze

  3. U.S. consumers end up with higher prices

Of course, it’ll probably be all three. Governments may also make it easier on all three parties. Both China and the U.S. have provided aid to the most affected parties, as when U.S. farmers received $12bn in compensation for the collapse in soybean exports.

So far, import tariffs have not hit the consumer much. Some 35% of U.S. imports from China are cell phones, computers, telecom and computer accessories. Just looking at my desk, the phone, screens, laptop, desktop, keyboard, router and something else with many wires….all made in China. It's possible that they will all be 25% more expensive a year from now. But very unlikely. 

The bottom line is that the tariffs are really no big deal for the U.S. The worst case we can come up with is a 0.6% reduction in GDP. If the threat to growth was real, we would have seen the Australian Dollar weaken (a reasonable proxy for the Chinese Renminbi) or Mexican stocks rally. Mexico is a net beneficiary of U.S.-China trade tensions. But no. Neither moved.

China stocks were down a lot more than the U.S., some 6%. But that makes sense. Chinese export to the U.S. account for 3.5% of GDP. For the U.S., it's 0.6%. So there’s some truth that all this hurts China more than the U.S.

The biggest effect of the trade wars is on confidence and financial markets. Markets were due for a sell-off and some overdue profit taking. We think the overall effect is fleeting. 

2.     Recession Watch: Consumer Debt One interesting feature of the post-crash landscape is that households have become reluctant borrowers. Here's the growth of personal income and revolving (i.e. credit card) debt and fixed debt (i.e. vehicles).

Prior to 2009, consumers borrowed freely. Since then, income (top line) has grown 45% but both types of debt have grown 30%. Yes, there’s a lot more student debt around but that kind of debt is deflationary…it holds back household formation. The above tells us that there’s very little inflationary pressure coming from consumers and so any recession is likely to be mild.

Last week, new numbers came out on credit showing total outstanding credit rose only $10bn. For most of 2018, it was growing at $20bn a month. Consumers just don't seem ready to increase debt.

3.     When risk goes up…Treasuries do well. That's not always so but it has certainly been the case this time round. There are other risk-off trades such as gold, the Swiss Franc, Yen and German Bunds but U.S. Treasuries have the liquidity and depth those lack. Last week, there was plenty to worry the market and there was even a hint that Chinese buyers stayed away from Treasury auctions in retaliation for the trade threats.

The 30-Year Treasury is now around the same level as it was in January 2018 and the 10-Year Treasury is at 2.46%. Three-month bills, from which FRN price, are at 2.44%. We think the Treasury market strength signals an easy Fed, slowing growth, a trade stand off and a place to hedge against rising volatility, as measured by the VIX index. With that, we’re happy to keep our position.

4.     Top of the market? No. We've learned that if you play that game, it ends up badly. But here are a few indicators that make us go…really?

 Lyft reported its first quarterly earnings and lost $1.1bn on revenues of $776m and gave out $859m in stock-based compensation.

 Uber…enough has been said but companies selling a dollar for 95cents tend not to do well.

 Softbank, a Japanese investment trust that owns a bunch of tech stocks, including Uber and Sprint, tried to convince investors that it should not trade at a 50% discount to NAV and ended up with this slide.

So that's rainbow unicorns flying into AI traffic with the share price tagging along. We think. (h/t FT Alphaville).

Bottom Line: Earnings season winds down. Probably some short-term upticks as trade news comes and goes. As one of our long term lessons goes, “Never trade on headlines.” We feel we've set portfolios up to withstand the next few months of headlines.

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Other:

People who swear are honest.

 --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.

 

 

Keep growing and carry on

The Days Ahead: Light economic calendar so focus on earnings

One-Minute Summary We had a ton of economic data with a Fed meeting right in the middle of the week. The economic data was generally good.

Positive

Productivity numbers

Employment costs

Employment

 Not so good

Personal consumption

ISM manufacturing

ISM Services

Trade

Stocks finished April with a fourth consecutive month of growth. That doesn’t happen often. The S&P 500 and the S&P 600 (small cap) are both up 17% this year. Tech has led again, up 27%. Last week, Apple beat and Google missed. But Apple, Facebook, Microsoft, Amazon and Google, are up between 15% and 50%. They're the five largest companies in the world and around 13% of the index. That’s a heck of a good run.

1.     What did the Fed say? That they’re going to stay patient, that inflation was too low but that most of it was transitory (see below). The market expected most of what was said so there were no big market moves.

The Fed finds itself in an interesting position. Employment is going gangbusters, Q1 growth was fine but inflation remains well below target. For now, the inflation number rules and they’re going to keep watching and doing nothing.

Richard Clarida, a very fine Governor, made a speech on Friday, which emphasized the market and pragmatic approach to inflation, rather than a model based approach, and concluded “the federal funds rate is now in the range of estimates of its longer-run neutral level.” Which seems right. So don't expect a cut this year unless something very bad happens.

And this is good. Steve Moore: “My biggest ally is the president. He’s full speed ahead.” Ninety minutes later, he withdrew the nomination.  

2.     Why is inflation so low? Is a question the Fed keeps asking and comes up with “it’s transitory”. But is it? Despite many years of warnings that inflation was just around the corner (the Fed’s QE bought out a lot of the crazies on this)…well, it’s not.

It’s probably the most important question for markets right now. If inflation rises, bond yields will rise to compensate investors for a lower real rate of return. Same for stocks. Equities are a great inflation hedge because, in theory, they can raise prices. But their costs rise as well and investors need higher returns to compensate for the loss of purchasing power. Inflation was the bane of the 1970s. Eventually, we saw Treasury yields at 16% and stocks trading at 8x earnings and yields of 8%.

Since then, however, inflation has steadily declined. Here’s the headline CPI and the Fed’s preferred PCE inflation, showing the broad number and the “core” numbers, which exclude food and energy.

Inflation had barely broken 2% for decades

The latest numbers show 1.5% for the PCE and 2% for the CPI, with the former well below the Fed’s 2% target.

The two measures of inflation differ quite a bit. Here’s a full explanation but basically the CPI measures out-of-pocket expenses and the PCE measures those and other expenses which people pay for indirectly, like medical insurance. Housing is very big in the CPI at 42% but only 23% in the PCE. Medical costs are only 8% in the CPI but 22% in the PCE.  

Anyway, here are some of the reasons why inflation is so low:

  1. Strong dollar: decreases import costs

  2. Lower medical inflation: yes surprisingly but you won't know it because deductibles are through the roof

  3. Services: transportation (all those subsidized Uber rides), professional and personal services are all lower mainly because unit labor costs are down

  4. Substitution: it’s a lot easier to substitute products these days, so if TV prices are down 20%, people may just buy a tablet and hook it up to a screen. The same goes for foods. Lettuce fans (prices up 18%) can switch to lentils (down 5%). No comments, please, on our food choices.

  5. Productivity: showed a recent climb, which allows companies to reduce price without a margin hit

  6. Underreporting: there’s probably a downward bias in inflation reporting because of things like hedonic adjustments. This tries to adjust for things that cost more but are a heck of a lot better than a few years ago. Compare your car or computer now to a decade ago and chances are they’re about the same price but do a lot more.

    These adjustments are fiendishly difficult and I don't envy the pros at BLS but the sum effect, we think, is to understate costs.

 Will it continue? Yes probably. If the above chart is anything to go by, apart from momentary blips, inflation has anchored at 2% for the best part of three decades.

3.     Jobs numbers blow out. Well not quite but very good. You’ll have read about the best numbers since 1969 etc. and we’re not about to take the shine off the numbers.

What, wait, of course we are! First, we’ll not restate points about lower labor force participation, which fell again, or the low increase in Average Hourly Earnings, or the still high underemployment rate. No, not going to.

 Instead, we’ll point to lower average hours worked and a fourth straight month decline in the labor force. This time it fell 500,000. This doesn't take away from the fact that the numbers were strong but we’re not sure it means things like wage pressure or that these sorts of gains can continue.

Here’s the chart:

Nice recovery in new jobs

Treasuries rallied on the news. Normally (what’s that these days, I know) a report like this would mean a Fed ≠hike, inflation corner and blooming consumer confidence. But the Fed has said it’s on pause so it means that the curve steepened a bit (i.e. good for short Treasuries like FRNs).

Bottom Line: Earnings season continues. We've seen mostly positive comments from companies about the U.S. and with continuing caution on trade/China/Brexit/Europe. We expect that to continue.

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Whale is a Russian spy

 --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.

 Just the smile

100 Year of Inflation and Real Rates - Updated May, 2019

We looked at 100 years of inflation. This chart shows: 

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

Our takeaway is that inflation remains low by historical standards and that it has not been much of a problem for nearly 30 years. The level of real rates looks very low and suggests more deflationary than inflationary forces.  

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.

Coming up to May. Now what?

The Days Ahead: Jobs numbers, Fed meeting, more big earnings

One-Minute Summary We mentioned last week that it was going to be a bottoms-up sort of market, trading on stock stories rather than macro. And so it was. Boeing (biggest stock in Dow, which is one reason that index didn't reach record highs), suspended guidance. Facebook did its thing of record sales and fines. Anadarko, a $35bn oil E&P company, was put in play. SAP, Germany’s largest company by far, up 18%. Microsoft, at record highs and, as of writing, back on top as America’s biggest company and sole member of the $1tr club. And so on. All good solid stuff, which is what we wanted to see as we start hitting a tougher time for year-over-year comparisons.

Stocks hit a record high. They've now fully retraced the near 20% correction, which started last February and reached bottom in December. Those who look at the S&P 500 total return index (the one that includes dividends) or used a 60/40 portfolio, reached all-time highs a few weeks ago…yes, dividends are important. The Dow Jones Industrials and Dow Jones Transportation indices, neither of which should be used for portfolio measurement, are about 1% and 3% off their record highs.

What's holding stocks up? A very favorable yield environment.  The Fed won't do anything next week. After that, the market will look for a more definite trend. We're in an abnormally low volatility phase right now. You would think with trade, Washington, embargoes, Brexit and all, we’d all be nervous. But for now investors are taking the Fed’s lead.

Breaking news on GDP: we wrote most of this on Thursday night thinking the Q1 GDP sneak peek would be a “hold the back page” story.

So, doncha know, it came in at 3.2% when everyone, including us, thought it would be a 1% affair. You would think if it was the “blockbuster report [showing that] policies are unleashing the vitality of the American economy” (yes, the Commerce Department said that), the 10-Year Treasuries would plummet. But they rallied.

Why? Well one reason is that the report is not all that it appears. Trade and inventory growth accounted for half the growth. We see inventory builds as essentially borrowing growth from the future. It’s unlikely that companies will be happy to keep high inventory on hand. Housing, personal consumption and the core PCE inflation were all weak. So, we’ll have to see if this can continue.

1.     Housing on recession watch. No. This is a bit of an ongoing theme because a few months ago, the warning lights were on for a recession. We've covered some of the early signs of a recession here, with claims, and here with some other major indicators.

Housing is always a prominent recession indicator. The way we think about it is to separate housing sales from housing starts and new sales. That’s because while home sales are a very big number, the most recent was 5.2m, down 5% on the month and 5.5% from a year ago, sales don't create much economic activity. Yes, people redecorate and earn commissions but that pales against the economic output from building, fitting and equipping a new house.

So, it’s housing starts and new home sales that interest us.

After some concerns back in December, it looks like housing is firming up again. Here are the new home sales from early in the week.

New home sales on the rise

The level of 692,000 (it’s an annualized rate) is a near peak from the recession lows and was well above forecast. We'd also note that the median price is down nearly 10% from a year ago. But i) prices are volatile and may rebound and ii) the SALT limits hit high-price areas like the Northeast and overstate the national trends.

This is good news. Sure, low rental vacancies are helping but normally people don't buy a new house unless they feel pretty secure about jobs and pay. We also like the fact that new home sales are still catching up with existing home sales. After the crash, distressed sales were everywhere, which meant home builders focused on higher priced units. But now, there is more affordable housing especially in the Southeast, which accounts for 58% of all new sales (h/t  Calculated Risk).

So, housing is one area of our recession watch that is on solid ground.

2.     How’s that inverted yield curve going? Well, as the song says, I just looked around and it was gone. Back in December there were real concerns the curve was inverting and that suggested a recession. Our point was that, yes, inverted curves preceded recessions but the timing was way off and, as we like to say, “being early and right is the same as being wrong”. So we didn't think it meant much. But now look at it:

Yield curve not inverting any more

Yield curve not inverting any more

The spread has more than doubled since its 8bp low back in December, when markets were pricing in a full recession. It’s the 2-Year Treasury, which has fallen in yield, from around 2.6% to 2.3%. That suggests there is i) more deflation in the air (certainly possible given recent dollar strength) or ii) the Fed will cut later this year (unlikely) or iii) the recent economic data has been poor (it hasn't) or iv) the 2-year is pricing off German bunds, which are back below 0% (possibly).

You can see we’re not exuding unqualified confidence on this one. We'd say some of it might be seasonal (always a good copout) or that the market is just pricing in a prolonged Fed-on-hold and doesn't expect much move in long-term rates. But for sure, it shows a fast fading of recession fears.

Bottom Line: Despite the recent rise in stocks, valuations remain solid. Some 204 of the S&P 500 companies trade 20% or more below their all-time highs and despite a stock market average valuation of 17x, there are 160 companies trading below 14x. The top 10 companies, with a heavy tech weighting and 22% of the market, trade at an average of 22x. That's a good indicator for the next year.

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Other:

Man sailed around the world with a chicken

 --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.

 Time of the Season

Earnings one day at a time

The Days Ahead: More earnings; first sight of Q1 GDP.

One Minute Summary The market definitely had other things on its mind last week. It was a short one to begin with and by Thursday, most eyes were on The Report or the long weekend. We're reminded that financial markets tend to ignore political events unless they’re really going to disrupt things. But the bar is high these days and a divided Congress and polarized opinions is really nothing new.

Healthcare stocks were down around 5% especially the big insurers who stand to lose most from any move to universal access. Somehow, we think they'll still be standing post any reforms. Economic data was better than expected including the consumer sensitive retail sales. Growth in China seemed to stabilize. Companies continue to report decent earnings but there were mostly modest beats and no big moves. The market liked the Apple/Qualcomm patent deal resolution. Qualcomm was up 42%. Not bad for a $96bn company but only back to where it was in 2014.

1.     Recession Watch. As we've mentioned several times, we don't think a recession is around the corner. But Wall Street economists, academics and the Fed all have pretty dismal records when it comes to recession predictions so we’ll not claim special insight. Our thinking is that we've seen modest, slow growth since the Great Recession with no big consumer-led credit bubbles. That kind of pattern is more in line with a slowdown than outright recession. Of course there are a ton of variables that can change things quickly. Trade, budgets, China growth, tariffs. Name it and there’s some chance that it could happen.

But we do know that the Fed looks at the big ones like GDP, change in nonfarm payrolls, PCE inflation and the unemployment rate. These are all lagging or coincident indicators. So they also look at forward-looking indicators including retail sales, industrial production, durable goods and the ISM surveys. We'll look at these in coming weeks but the short version is that none are critical right now.

We view initial claims as important, simply because if you're laid off, you have every incentive to file an unemployment claim. They also come out weekly and tend not to have revisions unless there are things like natural disasters. The recent claims numbers are around 192,000, which are the lowest for 50 years even when not adjusting for population growth. And if we adjust for workforce growth, we see claims are 0.14% of all workers, which is the lowest it’s ever been. Recession peaks for claims and claims as a percent of workforce were 680,000 and 0.4%. So, yes, we've come a long way.

But two things make us cautious. One, the number of people eligible for unemployment benefits plummeted. Put another way, the insured unemployment rate, here in the green line, is only 1.2%. That means two thirds of all unemployed receive no benefits at all.

Very low rate of insured unemployed

That may be because of i) the gig economy or ii) people have not built up enough time in the workforce or iii) workers have reached their limits.

And two, (h/t Capital Economics), is that states have changed eligibility rules drastically in recent years. Some states simply exclude certain professions from unemployment benefits. So hard luck if you’re a real estate or insurance agent, student nurse, intern or part time in some states. You're not covered. Also, some reduced the duration and eligibility of benefits. In the case of NC, for example, claims fell 80% following benefit reductions compared to a national average of 50%.

So what? Well, claims may not be the reliable indicators it was. We feel that the labor market is weaker than it looks, hence our position that wage and price inflation will remain low.

2.     Germany. Any news? Germany is very important in the global economy, where it’s number four in the world, but less in stock market terms, where it's not even in the top 10. In fact, the top three companies in the U.S. have a higher market cap than the entire German stock market, with some change to spare.

But the market is important not least because it serves as a bellwether for the EU block. Last year was rough for German stocks. U.S. trade tariffs, Brexit, low interest and new EU auto emissions all hit the auto companies and banks, together over 40% of the index, hard.

This year, it’s been a much better story. The market is up around 16% for U.S. investor, outperforming the U.S., and is one of the strongest in Europe. It’s not because all has turned around. More that things stopped getting worse. Major indicators like industrial production, capital investment and exports bottomed out in the last few months and that’s after the economy narrowly missed a technical recession in 2018.

The market has always traded at a discount to the U.S. That’s more to do with the sector make-up of the index. The U.S. market has around a 30% weighting to tech. With Germany it’s less than 2%.

German stock market cheap

Current valuations of German stocks are 74% of the U.S., less than the long-term average of 80%. At these levels, we think they’re worth holding.

Bottom Line: It’s a micro, not macro market right now. And we wouldn't have it any other way. It's clear the economy is slowing but not halted, the Fed is hands-off and Treasuries low and stable. We'd like to see solid earnings with stable margins and no surprises.

Please check out our 119 Years of the Dow chart  

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 Other:

Dog swims 130 miles out to sea 

 --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.

LP - Lost on you 

Uber: Market Top or Big Nothing

The Days Ahead: More earnings, some Fed speak and a short week

 One-Minute Summary There were lots of tradable events last week: claims, inflation, producer inflation, Fed minutes, the ECB meeting, job openings. But bonds moved only 5bp up and the yield curve didn’t send out any more recession signals. All quiet. Stocks had a good week. Up around 0.5% and now, wait for it, up 16% this year. Riskier assets like small cap, tech and growth are up even more. It seems strange that stocks would rip when the economy is slowing but it’s all to do with dovish language from the main central banks. The Fed confirmed its “patient for longer” decision with the publication of the March minutes. No real dissent and expectations that the Fed balance sheet will soon be a source of demand for Treasuries.

Earnings season is just getting started but JP Morgan (JPM) posted some good numbers on Friday, which helped. JPM is the biggest bank in the financial sector part of the S&P 500. It’s all been a good run on stocks. Disney announced a new subscription service which sent the stock up 13%. So good news from 2 of the 20 largest companies in the S&P 500. Stuff that did badly last year is coming back and we have a different type of leadership than the tech giants. Volatility is very low. We're not saying that things will roll over but some caution is due.

1.     Where’s the inflation?  Not in the headlines that's for sure. The Fed has a model that says low unemployment means wage pressures means higher prices. Nothing wrong with that, it’s an easy-to-understand sequence. Unemployment is way down and last week’s claims numbers reached the lowest level since 1969 when the population was around 35% smaller. But inflation? Not there. Here’s the latest:

Inflation low everywhere except rents

There’s the headline in blue columns at 1.8%. Gas prices rose in the last few months, so that pushes the core CPI up to 2%.This all makes it unlikely inflation will reach the Fed’s 2% target, which in turn makes it unlikely they’ll hike rates. The Fed also tracks real rates so we now have a curious position where real rates as measured by Fed Funds are at their highest point in 10 years and against the 10-Year Treasury, their highest since mid-2016. That’s a de facto tightening which was not in the script. Whoops.

There are those who feel that earnings must start to increase but we haven’t seen it yet. Real earnings are up just 1.3% over the year which, sure, is better than a year ago but still pretty modest given how wonderful the tax cuts were going to be for wages.

One concern is rents.

Rental vacancies at 30 year low

This shows rental vacancy rates at 30-year lows and, in the bottom chart, the relentless growth in rents. Since 1988, they've grown 50% faster than standard inflation. They account for 33% of the CPI and 42% of the Core CPI. So put together higher living costs, low unemployment, low wages and you either get a break in one of those series or just low 2% growth. Which is what we have now and what we see happening.

2.     Uber? Sure, why not? Here’s the prospectus. It’s 395 pages long and the “risk factors” start on page 25 and go on…and on….for 48 pages. There’s the usual stuff about competitors, expenses and acquisitions but then it goes into a weird world of deaths, criminal activities and incarcerations. And that tricky one where courts say their employees are employees and not contractors. And that they may never make money. We'd say on that last point, they're world class because on $11bn of revenue they lose $3bn and they say 25 times that they may “never achieve profitability”. It must have been a blast as an investment banker coming up with all that risk stuff.

So no complaining if your investment goes to zero because the lawyers will point to the document and say, “see, we told you it was dodgy”.

Uber has a bit of a reputational challenge but no worries, the Chairman is a serious bloke who ran Northrop Grumman, is Canadian and says “world class governance will be our north star”, which is a bit tricky if you live in the Southern Hemisphere but full marks for trying. The price tag for all this great technology which allows you to, er, call a cab and have it take you where you want to go is…well, to be determined, but most think it’s around $100bn which would make it #54 in the S&P 500 and #499 in profitability. GE holds the wooden spoon for that because it’s busy writing down bad insurance policies from 20 years ago.

The bigger point, well made by Matt Levine over at Bloomberg, is that Uber is one of the unicorns emerging from the enchanted forest where profits don't matter and first-to-scale wins. There are more to come like Slack, Palantir, Airbnb and Pinterest. Some could be the next Facebook or the next Snap (-45%), Blue Apron (-88%), GoPro (-92%) or Dropbox (-34%). If they go well, put it down to top of the market exuberance (a bad thing). If they go badly, put it down to healthy investor caution (a good thing).

Anyway, "Uber is the defining tech start-up of its generation" which may be true if you're measuring it in dog generations (h/t FT) and they have a picture of a bloke to reassure us that they're nice guys.

And a killer slogan.

So, yeah, no profits, no growth, regulatory difficulties and increasingly intense competition. Awesome. Sign me up.

Bottom Line: We're reminded that last time the market was this high was in August and the 10-Year Treasury was 3.25% not 2.5%. We've swapped high rates and high stocks for low rates and, well, still high stocks.  Markets tend to overreach themselves in each direction so we’re still sticking with our call to have some Treasuries around in case it all comes undone.  

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San Francisco most expensive city in world

 --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.

 Pinball

The Fed and Politics

The Days Ahead: U.S. inflation and start to earnings

 One-Minute Summary Stocks were up 2% in the week after a barnstorming first quarter of 13.6%. With all the ballyhoo about record markets, if you compared your portfolio six months ago to now, not much changed. If you got your timing wrong, then it was a very different story. Last year, nearly all asset classes moved down together, except for Treasuries later in the year. This year, it’s been up across the board. This is what a humble 60% Equity/40% bonds looked like in the first quarter, the best level since 1998 and the third best quarter in 30 years.

The market liked the latest on trade talks (“any day now, going well’) which makes us a little wary about how many times the market can rally on the rumor. Most of the economic news was better than expected (U.S. manufacturing) or seems to be touching lows from which they’ll rebound (German manufacturing). European stocks climbed to a seven-month high on expectations trade will improve.

 U.S. Treasuries lost some ground but ended the week at 2.5% or just 6bps up on the week. We don't think anything changed that would cause Treasuries to break out of their 2.4% to 2.7% range.

 1.  How exciting were the jobs numbers?   Not very. New jobs came in at 196,000 after February’s weak 20,000 number. The unemployment and underemployment (those who would like to work more but can't) were unchanged. Service jobs (71% of the workforce) increased by 170,000 and 61,000 of those were in healthcare. Now, when the BLS says healthcare, please don't think of nurses, technicians, doctors and EMTs. Most of the jobs are home and community care and office service workers and the point about those jobs are they’re i) part time and ii) pay very little. The average home care worker earns $11 an hour, or 40% of the average, and works 20% less.

Look, we get it. Jobs are jobs. But many jobs just aren't that well paid and pay rises stalled again. The Average Hourly Earnings, which popped by 3% in January, is now down at a 0.1% growth and 3.2% over the year (white line below).

The curious thing about wages is that the NFIB consistently talks about the difficulty of finding workers. If that's the case then you would expect wage increases to start coming through. But they haven’t. If they do start to rise then we’ll see margins compressed and a feed through into inflation. If we don't, then we’ll continue to see the economy eke out 2% growth rate with low productivity.

Either way, these numbers won't have changed the Fed’s mind about holding off on rates.

2.     Is the Fed becoming politicized? Not yet. The Fed enjoys a well-earned reputation for independence. A couple of things happened last week, which caused concern. One, the President upped the pressure on the Fed to drop rates and let the “rocket ship” run. The Fed can ignore this. Two, Herman Cain and, two weeks ago, Stephen Moore, were nominated to fill the two vacant spots on the Fed’s Board of Governors. You can read about it here and here but the summary is that both are hacks, ignorant of monetary policy and run an overt political agenda with a history of disastrous calls on the economy, inflation and markets. And they’re not economists.

All of which is true. But taking this one step at a time, we don't think it’s quite as dire. First, there are five permanent members of the FOMC, and only two are economists. The other three are lawyers. Rotating groups of Regional Fed Presidents make up the rest of the ten members for a total of six economists and four non-economists. So the non-economist is not a problem. And there’s an army of highly qualified economists at the Fed if you're a Governor who’s intellectually curious.

Second, not all nominees make it through the process. Two very good nominees, here and here, were just dinged for no particular reason.

Third, just because they're on the board doesn't mean anyone pays attention to them. The Fed statements back in 2008-2009 regularly had two policy dissenters and no one gave them a second thought. Sure, they can take to the airways right after the meetings but that won't change things.

So at this point we’d say the possible outcomes are:

  1. They’re voted down by the Senate (like Nellie Liang and Marvin Goodfriend)

  2. They’re voted in and cause havoc

  3. They’re voted in and marginalized

  4. They're voted in and grow up

  5. The regional governors run the show

People are rightly worried about #2 but we’d put it at less than a 20% probability. 

3.     What can we expect in earnings season? There is a bit of a ritual in forecasting earnings that goes like this:

Analyst (shows number on paper): I’m putting you down for this.

CFO (sucks teeth): Er, bit high, we had that recall thing.

Analyst (scribbles down a number): Gotcha. This?

CFO (looks out the window)

Analyst: This?

CFO: That does not look unreasonable.

Three months later:

CFO: We beat estimates

Analyst: Good quarter guys. Solid beat. Trebles all round.

That’s why 75% of companies “beat” earnings because everyone lowballed them to begin with. Anyway this quarter, analysts are busy revising down earnings. According to Factset, they revised them down 7% during the quarter, which means as the quarter progressed, they slowly pushed estimates down. Earnings will still be up year over year but far short of the 20% levels we saw throughout 2018.

That 7% is a big number. Normally it’s more like 4%. It makes us a bit nervous what businesses will say about sales and the rest of the year. And it will probably reduce the number of times we hear “beats”.

Bottom Line: Inflation numbers next week. This is the one measure the Fed has consistently overestimated and got wrong. We're looking closely at the earnings announcements with the big banks all due next week.

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Oreo Game of Thrones

--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.

 David McWilliams

Does the yield curve really predict recession?

The Days Ahead: Jobs numbers and durable goods

One-Minute Summary We're writing this Wednesday mid-week so either something big will happen that will render all below irrelevant or it may have a two-day staying power.

We had a week where the broad economic numbers were still weak: housing, trade and consumer confidence. Markets traded off but much of the news was anticipated so there were no grand meltdowns.

1.     You're not going to talk inversion again, are you?  Afraid so. So, let’s be clear. The yield curve has not inverted. Parts of the yield curve have inverted. The most cited curve is the 10-Year Treasury and 2-Year Treasury (or 2s/10s because bond types love shorthand) and that has not inverted. The 10-Year Treasury yields 2.37% and the 2-Year Treasury yields 2.25%. Next we go to the 2s/30s, so now we’re at the 30-Year Treasury, which yields 2.82%. So that's not inverted either.

Where’s the inversion? In the belly of the curve, so-called because if you hold it vertically it looks like, well, a belly (here take a look, section 1, blue line). Ok, so where we have inversion is in the 90-day bill, yielding 2.45% and the 5-Year Treasury at 2.19%. And at the Fed Funds Rate of 2.5% and the 90-day bill.

We’re unlikely to see the entire yield curve invert because

a) the 30-Year Treasury is very popular with pension funds with long-term liabilities and no-one issues bonds that long with that quality, so if you have ‘em, hold ‘em and

b) post-2008, banks must hold safe assets and the long Treasuries don't tend to be sold much.

And that means? Now that's where the long knives come out. Some say “harbinger of recession, tin hat and New Zealand time” , others, meh. We're in the middle and take the view that a) tax cuts brought forward growth b) the tax cut effect has faded c) growth everywhere is slow and d) that the bond and stock markets saw this coming six months ago. So, will everyone please calm down.

Yield curves in developed markets started to flatten a few months ago.

All those lines sloping down measure the difference between 10-Year and 2-Year sovereign bonds in Germany, Japan and the U.S. The U.S. one is still above zero, just. The others are at their lowest levels in two years, although note that in the case of Germany and Japan all four bonds (so two at 10-Years and two at 2-years) are at negative rates.

As we’ve noted before, a yield curve inversion does precede a recession but not all the time and even when it does, it can lead by 9 to 23 months. And, as we’ve also said, being early and right is the same as being wrong.

Where does this lead us? That economies are weak, growth is slower and that any upturn, here or overseas looks far from certain. So with that we're fine with our Treasury allocation and focus on the front-end of the curve.

2.     Recession Watch So having relegated the yield curve as the recession signal, what works? What's the single best, sure fire, back tested to the nth and reliable recession indicator? Well, no surprise, there isn't one. Here are some ones we look at and recent trends:

Looking at the list, there are no resounding, ding-dong highs or sepulchral lows. Nor we would expect them at this stage of a very long cycle. Slowdown it is then. Will the Fed cut rates? Perhaps but they've never cut rates with claims this low:

The absolute level is around 220,000 and as a percent of the labor force, it's never been lower. So, we’ll change that “perhaps” for “no” and watch the claims numbers.

3.     Are earnings slowing? Yes. First, it’s down to lower growth of the economy. Second, wage pressures, while very low, do affect margins. Third, year over year comparisons are hit hard by the base effects of a year ago, when U.S. companies had 20% earnings growth, half of which was courtesy of the tax cut. The earnings slow down is worldwide:

The S&P 500 is still ahead, showing around 7% annual growth in earnings. Europe is the worst hit because of banks, which are not only badly managed but have bad loans and assets and low rates to contend with. Japan is suffering from trade problems and low growth.

So, there is the earnings growth: weaker and probably due for some downgrades but probably priced in.

Bottom Line: We're probably done with the low rates news and its immediate effects on the market. We'd like to see equities trade sideways but we don't always get what we want and would expect some correction unless earnings surprise to the upside. Treasuries seem like a continued good allocation.

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Double your revenue double your losses

--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.

Magic Bus

Fed still rules the game

The Days Ahead: PCE inflation and housing. Slow corporate calendar.  

 One-Minute Summary The surprise was the Fed’s very dovish move to lower growth forecasts and to say they're done for the year (see below). That sent the 10-Year Treasury down to 2.44% and below the 3-month bill. That’s the “inversion” we and others discussed before (here and here). We’re not sure it’s the recession indicator people say it is but it’s definitely corroborating the slowdown in the economy. For good measure, German and Japanese 10-Year government bonds traded below zero.

Low rates are all well and good but they’re a disaster for financials. No bank can make money borrowing at the Fed Funds window for 2.4% and make a five year commercial loan at 2.3% with a traditional 200bps spread. In Europe, bank depositors get 0% but it costs the bank -0.4% to borrow from the central bank. The worse outcome, here and overseas, is that low rates push up financial assets but kill risk taking by banks (h/t Cameron Crise).

Major indexes were down on the week. We hope it’s all part of a healthy consolidation but when markets make their targeted annual gain in 10 weeks, expect some profit taking.

1.     Has the Fed turned dove?  Yes, in a very big way. Most expected the Fed to confirm its “patient” stance from January. After all the slowdown in January was expected (it was there in the trade and housing numbers back in December) and the seasonal problems with January are well known (they tend to understate growth). So most investors expected “halt until June then one, possibly two hikes”.

No more. The Fed sounded very cautious on growth, spending and investment and noted no change in inflation. Then with the “dot plots” they effectively forecasted that there would be no rate increases for the rest of 2019. Here are the dot plots:

We'll save you squinting and head to the bottom line. In December, the Fed thought the Fed Funds rate would be 2.72% in 2019 and 2.94% in 2020. Those are now down to 2.37% and 2.54%. That implies no more increases in this year and maybe one in 2020.

What's also noteworthy is that they're also saying they're not going to raise Fed Funds, currently at 2.5%, above their long-term neutral rate of 2.79%. That's curious because that's what a central bank would have to do to deliberately slow the economy. We don't have an answer to that.

They also made some changes to the “balance sheet”, which is the stock of Treasuries and Agency (i.e. mortgage) securities from years of QE. These peaked at around $4.3tr in 2016 and dropped by an average of $24bn a month from 2018 to reach $3.7trt this month. You would think the Fed would want to keep running the balance sheet down, after all it was less than $1tr in 2009. But no, they're going to keep reinvesting coupons on Treasuries and Agencies into Treasuries. So the Fed will become a net buyer of Treasuries again this fall.

This whole meeting is a bit of puzzle if only because the Fed seems to have boxed itself in. We see the following possible outcomes

  1. Economy continues to weaken. Rates drift lower. The Fed looks like they're ahead of the game.

  2. Economy bounces back later in the year. Rates steady. Fed has given the cycle a second wind.

  3. Economy comes back strongly. Rates drift upwards. The Fed will have to reverse quickly.

We think the biggest issues around right now, China, Brexit and global growth, will all improve later this year. But for now the Fed is very dovish indeed.

Market reactions were fairly predictable.

  1. 10-Year Treasuries dropped to 2.52%

  2. 2-Year Treasuries to 2.38% (six month ago it was 2.96%)

  3. 3-month bills increased a bit to 2.46%

  4. The front end of the curve inverted more…the 3-month bill now yields more than the 10-Year Treasury

  5. Dollar weaker

  6. Emerging Markets up

  7. U.S. stocks sold off in a classic case of “buy the rumor, sell the news”

  8. Financials were hit (they don't like low rates)

 We had put many of these investments in place a few months ago so we don't feel the need to adjust portfolios.

And because today’s yield curve is one for the grandkids (yes, it's that unusual), here it is: 

The blue one is from Fed day, with a big sinkhole in the middle and well below the yellow line from January. The black line is from a year ago. That’s a normalish yield curve. Since then all the action and gains have been at the front end of the curve.

2.     How’s the German stock market doing? Not well. From mid-2015 to January 2018, it was up 42% in local terms and 60% for a U.S. investor and handily beat the S&P 500 by 7% in 2017. It was all driven by the global synchronized growth and higher rates story. Since its peak, it’s down 21% but has rallied 8% this year.

Why? Germany was caught in the U.S. and China trade, er, talks. The German stock market derives 72% of its sales from outside Germany (S&P 500 around 40%) and exports are 35% of GDP (U.S. is around 12%). The stock market is also very dependent on financial, industrials and autos, which are 52% of the market, compared to 30% for the U.S. The top 10 companies in the German stock market are 40% of the index and the big three autos are 11%. You get the picture, big companies, no tech and very dependent on overseas demand.

The result is Germany is very much unloved right now, which means it’s very cheap

The blue line below is a rough measure of valuation. For the last 15 years, the German market has traded at about a 20% discount to the S&P 500. Today that number is around 28%. The market also yields around 2.7% compared to the S&P 500 at 1.8%. None of these are sure things. We know markets can get cheaper, dividends cut and more bad news can come out. But Germany seems very unloved right now and on a two to three-year horizon, that might not be a bad entry point.  

3.     Unicorns are coming to town. Yes, it’s time for the Lyft, Uber, Pinterest, Slack, Palantir, WeWork, RobinHood (your kids use it), AirBNB and Peloton to enter adulthood and the big bad world of the public company.

  1. There are a few things different from the last time a bunch of IPOs came along.

  2. There are more dual classes of share, which means they won't be in some leading indexes.

  3. They lose money. A lot.

  4. Pricing may be very aggressive. See companies like SNAP (down 60%) and Blue Apron (down 88%).

  5. Some of these companies are already owned by mutual funds and the like as private companies (yes, ‘40 Act funds can own private companies, just not very much) so there may not be a big queue of buyers on day 2.

Still, they'll get some attention.

Bottom Line: So the market got what it was looking for, lower rates, and…sold off. We know the economy is slowing right back to its 2% normal and inflation is slipping lower. We're almost back to the 2-2-2 world we talked about a few years ago. Inflation, growth at around 2% and the 10-Year Treasury  with a 2 handle.  

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Surprising nominee for the Fed. And not a good one.

 --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.

 Days of Pearly Spencer 

A shot across the Dow

The Days Ahead: Fed meeting.

One-Minute Summary A steady drip of lower but not catastrophic economic numbers helped push the S&P 500 up every day this week. Yes, it’s one of those “bad news is good” things because the Fed is on hold and lower rates make stocks look better. The S&P 500 seems reluctant to broach its September highs but we’re only 4% off the record and up 14% from December.

To us it looks like an asset and technical trade. The asset side is just the relative attraction of equities. To oversimplify, lower rates allow equity discount models to throw off higher valuations. The technicals are just resistance lines for moving averages. We'll leave both to those who know what they’re talking about.

But what we don't see is bullish, confident, “great quarter guys” talk coming from the corporate sector. It’s all a bit wait-and-see if the cycle can keep going. We think it can and see this as the pause that refreshes.

And in an update on the tenth anniversary of the market low, we’d remind investors that the S&P 500 rolling 10-Year return is 16.5%. It hasn't been above 15% since 2001 so the 10-Year numbers are about as good as they get. What can we expect? Somewhere between the rolling 20-year number of 6% and 5-year of 11%.

 1.     How low can rates go? Don’t know. They’re already way below what we thought they would hit in 2019. This week we had a run of weak data, starting with retail sales, lower new home sales and Friday’s industrial production. The 10-Year Treasury tracked lower every day and hit 2.58% on Friday morning.

The yield curve is fully inverted in the belly of the curve with 10-Year Treasuries yielding only 7bp more than 1-Year Treasuries and 15bp more than a Treasury FRN. The latter has no duration risk. The 10-Year Treasury has a duration of around 8. The curve isn't yet the alarming shape it was back in 2007 but here, in the blue line, you can see the kinks in the curve.

We think the following dynamics are at play:

  1. Fed is on hold and there’s talk of only one rise this year. A few weeks ago it was a pause until June and then two.

  2. The ECB talked a grim book last week and announced a new LTRO (a sort of bank lending subsidy). No chance of rate changes there either.

  3. The German and Japanese 3-month bills are at -0.5% and -0.1. The U.S. is at 2.43%. On a relative basis with global money movements, the U.S. trade is a no-brainer.

  4. Brexit and Venezuela creates a fear trade. The U.S. retains haven status

For what it’s worth, rates have declined steadily since the December FOMC meeting. There is much discussion about the level of the  R* rate (the neutral rate where the economy neither expands or contracts). What is clear is that it’s lower than thought a few months ago. And we’ll probably see confirmation of that at next week’s FOMC meeting.

2.     Is there any sign of inflation?  No. The Fed talks about inflation all the time. It’s one of their two mandates: promote maximum employment and stable prices. They do not provide more specifics. Maximum employment could be unemployment of 2% (it’s never 0%) or 4% depending on the cycle and circumstances. The inflation target is usually held to be 2%. It’s relatively easy for the Fed to kill inflation but very hard for them to increase it. But, my, how they have tried. Years of QE, forward guidance and low rates should have stoked the inflation fires. But they haven’t. Not in the U.S. or in any other leading economy. Here’s the long-term trend in U.S. inflation.  

Inflation tends to rise going into a recession. No surprise there as the Fed chokes off any inflation uptick very quickly. But you can see that inflation has barely stayed above 2% since the recession or indeed going back to the 1990s.

The latest inflation measure looks like this:

That’s shows housing at 3.2%, core inflation at 2.1% and, because of soft gas prices, headline inflation at 1.5%. There are still deflationary forces at work…the bottom graph shows things like TVs and cell phone prices falling.

What’s next for inflation? Banks and investments houses pushed TIPS earlier this year on the basis that the Fed would allow higher inflation. That hasn't worked out. Expected inflation was as high as 2.1% in October but slipped to 1.9%. We think there is some risk of wage inflation coming though in the back end of the year. But there’s also the force of a strong dollar and lower import prices if a trade deal comes through. On balance, we don't see much inflationary pressure. Neither does the bond market.

3.     We're not alone in rubbishing the Dow as a lousy indicator of market sentiment, direction or performance. It's price weighted which means that the higher the stock price, the more that stock moves the Dow.

The five most valuable stocks (MSFT, AAPL, JPM, JNJ, XOM) in the Dow are 38% of the index. But the five highest prices are Boeing, United Health, 3M, Goldman Sachs and Home Depot. They’re 12% of the value but 32% of the prices. So, when Boeing tumbled on Tuesday from $450 to $358, it had an oversized influence on the Dow and greatly overstated stock market weakness.

So what does the Dow have going for it? Longevity and the sound bite value of “the Dow fell 400 points” rather than “the S&P 500 rose 0.8%”. But as a market measure? Nothing.

Bottom Line: Expect the news and macro events to keep stocks going. We think one of the big catalysts will be for news out of Europe to stop worsening. Expectations are beaten down. A small respite could help European stocks a lot.

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Lyft’s IPO filing. Yes, it loses gobs of money

 --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.

 

 

China? What return would you like?

The Days Ahead: Inflation and headline risk on trade and tech 

One-Minute Summary:  Ouch! Those payroll numbers were 20,000, down from back to back months of 300,000 new jobs. If you're Chair Powell, your call on staying patient back in January looks like mighty fine timing.

So is this the economy weakening? Yes. Are the recession bears right? No. There’s a lot of noise in any one-month print and the new jobs number has an over/under deviation of 75,000…so this number may be 95,000 or a loss of 55,000. What we’re looking for is are people worried about job security and will that cycle into declining spending? There is no sign of either. Hey, look, there is no doubt the economy is slower. You can see it in housing, manufacturing and trade. But a full tip into recession? No.

As for wage gains, yes, average hourly earnings increased 0.4% over the month and 3.4% over the year. But if your employer gives you an hourly wage increase at the same time as fewer hours, you're not ahead (although the BLS says you are). And that’s what happened. The average workweek fell.

So there’s something in the numbers for the bears (low numbers) and the bulls (wages) but we’d stay our hand until there are clearer trends. Treasuries rallied. The 10-Year Treasury is at 2.63% compared to 3.2% in November. It’s likely to stay at these lower bands. At the start of the year, we expected the Fed to postpone any further rate hikes until June. But if we get another few months of this, the Fed’s next move may be to cut, not raise.

Stocks were down every day this week. It was mostly a global growth story. Slower in U.S., China and Germany and a very accommodative (bearish) statement from the ECB. This is fine. We think the market was oversold last December and over bought up until a few weeks ago. I mean how many times can the market rally on “hopes for a China trade deal” headline?

1.     Did the trade policy backfire? Well, it ain’t over but if you're looking at the halftime score, then, yes. Here’s the full report. A quick way to look at it is with 2018 and (2017) numbers:

  1. The U.S. ran a $891bn ($807) goods deficit. 

  2. It ran a $271bn ($255bn) service surplus (things like transport, travel and financial services)

  3. And an overall trade deficit of $620bn ($552bn)

 The big changes were:

  1. A much narrower petroleum deficit of $53bn ($61bn) but that used to run over $300bn as recently as 2012

  2. A much bigger deficit of $129bn ($110bn) in technology parts

  3. A deteriorating trade deficit with China at $419bn ($375bn)

There's no real mystery to this. One, last year’s tax cut was equivalent to a fiscal stimulus while at full employment. You do this and demand leaks into imports almost straight away. Two, dollar strength. Three, trade tariffs. We'd argue that the third was probably the least important but it did lead to a big drop in food exports. Anyway, here's the goods part. A rising blue column means the deficit is worsening.

The U.S. started to talk tough on trade in early 2018. There was an immediate improvement as importers of U.S. goods brought forward purchases to avoid tariffs. But since the low in mid-May, the monthly deficit has grown 23%.

We don't know where it’s all going to end. But the U.S. cannot simultaneously enjoy tax cuts + low unemployment + low inflation AND a smaller trade deficit + dollar strength. Something has to give and for now, it’s the trade deficit.

 2.     Are China stocks up and away?   What answer would you like? The headline indexes are up 25% to 30% this year but are still down 10% to 15% from last year. The main reasons are a feeling that the trade talks will go China’s way, that the worst is over and a rally from very low valuations…the China market traded at 10x earnings in December or 35% cheaper than the U.S.

Another reason was the power of the index. MSCI, a leading index provider, announced it would start to increase the weighting of China shares in its Emerging Market Index, which is the benchmark for $1.6tr of assets. It will increase China weight in the index from 7% to 10% and the greater China weight (so include Hong Kong and Taiwan) from 42% to 46%. That means around 40% of all Emerging Markets investors must increase their buying of China stocks. They have no choice in the matter.

This matters very much, because, as we've said many times, while we’re big fans of indexing, it really matters what index you use. Here’s the performance of leading China equity indexes over the last two years.

The returns range from -14% for the Shenzhen Index to +23% for the China 100 index. Why the difference? Well the indexes range from Hong Kong listed but China domiciled Blue Chips, Nasdaq type stocks, small caps, all cap stocks and stocks registered only in China with limited foreign ownership rules. The S&P 500 is towards the top at +16%. But you’ll also note how volatile China stocks can be. The peak to trough drop in most of the China indexes was 47% compared to 20% for the S&P 500.

But the biggest lesson? Choose your index carefully.

Meanwhile, we think some of the rally in China is overdone and so like to have downside protection on our Emerging Markets positions.

3.     Did the equity melt down in December hurt households? Yes. By about $4 trillion.

That's the first decline since 2015 and meant that growth in net worth fell to 0.8% from around 5%. But we’re not concerned.

  1. It’s probably temporary. High net worth households holds a large part of the equity holdings. Their propensity to spend is less than the average household.

  2. We'd note from the same report, that net corporate borrowing was flat for most of 2018. Many commentators only cite the gross number. U.S. corporations are not heavily indebted.

  3. Consumer borrowing (so credit cards and mortgages) is around 130% of compensation, down 1% from last year and from a peak of 170%. U.S. households de-levered post 2008 and stayed that way.

  4. Overall debt grew 4.5% but household debt grew 3% and the Federal Government debt grew at 7.6%. Nominal GDP grew 5.2% and as long as debt grows slower than income, we don't have a problem in the household sector.

The Household Financial Accounts report rarely generates market-moving news. But we like it because it confirms that we’re looking at modest debt growth in the corporate, household, state and local government sectors. The Federal Government is another story.

Bottom Line: Some 442 of the S&P 500 companies are up this year and 305 have outperformed the S&P 500. But, in contrast to 2018, performance of the 10 largest companies accounting for 22% of the index has been way below the S&P 500. We'd wait on the sidelines for now.

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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.

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