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
Economy continues to weaken. Rates drift lower. The Fed looks like they're ahead of the game.
Economy bounces back later in the year. Rates steady. Fed has given the cycle a second wind.
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.
10-Year Treasuries dropped to 2.52%
2-Year Treasuries to 2.38% (six month ago it was 2.96%)
3-month bills increased a bit to 2.46%
The front end of the curve inverted more…the 3-month bill now yields more than the 10-Year Treasury
Emerging Markets up
U.S. stocks sold off in a classic case of “buy the rumor, sell the news”
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.
There are a few things different from the last time a bunch of IPOs came along.
There are more dual classes of share, which means they won't be in some leading indexes.
They lose money. A lot.
Pricing may be very aggressive. See companies like SNAP (down 60%) and Blue Apron (down 88%).
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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--Christian Thwaites, Brouwer & Janachowski, LLC
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Days of Pearly Spencer