Client Note June 2020

As we close June and the first half of 2020, financial markets continue their rebound from the first quarter’s corona-crash.  In very volatile markets there will be many “best/worst X since Y”.  The close at 3100 on the SP500 reflects the best quarter in the sp500 since 1987, with a gain of 19.9%.  After a 36% decline off the all-time high and subsequent 40% gain, puts the SP500 at -4% year to date and -9% below the all-time highs.  Our average moderate portfolio gained almost 15% for the quarter and is up 4% on the year.  While further upside is possible but in the short term, US equity markets are in a downtrend since June 23.  On a larger time, frame, we have downtrends since June 8 and off the highs on February 19thGetting over 3200 should open the door towards 3400+, but if we lose the 3000 level, my medium-term outlook will change.  Our individual stocks continue to do very well.

International equities continue to sorely lag US equities.  European shares gained 2.5% on the month, and currently sit at -14% year to date.  Japan gained 1% and China ebbed 1.6% on the month and both fall well short of the SP500 at -7% and -9%, respectively, year to date.  Emerging markets were the winner on the month at +6% but also have made far less progress recovering post-crash, coming in at     -11% year to date. We sold the last bits of emerging and international equities towards the end of the month.

In credit markets, treasuries have dominated over all other areas of the bond markets.  The long bond/20-yr treasury ebbed by 2.25% during the month, is flat for the quarter and up a massive 20% for 2020.  Even with equivalent maturities, treasuries are outpacing investment grade and junk bonds by 5% and 17%(!) respectively.  The investment grade corporate bond etf, LQD is up 5.1% ytd, while junk bond etf, JNK is -7.7% ytd.   This disparity is due to the rapid credit deterioration seen during this severe recession.  Given this, and spike in covid19 cases, its unlikely rates will rise appreciably in the near term.  Our long treasury position was reduced late March at slightly higher prices.

Economic data released in June continue to show improvement over the April/May shutdown (naturally).    The pace at which the economy would rebound after reopening is a hot topic.  We are seeing rapid improvement in some areas but the estimates versus data are showing extremely poor forecasting ability by economists in the short term.  I am watching year over year data to see how much rebound we are getting.  If July and August data show similar growth as May and June, we could see 90% of more of the economy back by Labor Day.  The trend of economic recovery is far more important than the level.  Ideally, we will trend higher and higher until full recovery.   At the end of July, we will get the first read on GDP for the second quarter.  The Atlanta Fed current estimate has risen to   -36%. 

Looking forward, the recent spike in virus cases has opened the door to the risk that the re-opening of the economy will be slowed, as we are more likely to see county or regional shutdowns.  Continued support from the Fed and continuation of stimulus programs are critical.  A bit higher in equities may provide some momentum to get to 3400 and Fed intervention can keep rates low.

Adam Waszkowski, CFA

Client Note May 2020

June 1, 2020

Like April, equity markets started the month of May off slowly, but over the past 10 days, the S&P500 has gained roughly 4.5% on the month putting it at -5.7% year to date.    International equity indices gained a bit more for the month but continue to lag the U.S. by a wide margin.     Bonds were generally flat, with junk bonds moving up alongside stocks, while a small move up in interest rates pushed the long bond (TLT) down slightly on the month.   Gold moved up almost 3% on the month, after being up almost 4% mid-month.  And our individual stocks continue to do well, enabling our average moderate portfolio to add just over 3.5% for May and for year to date returns approaching 4%.

Looking ahead, it appears investors are pricing the market in expectation of a solid second half recovery and near full economic recovery into 2021.  While investors have bid up prices in anticipation, there is a loooong way to go to recover from the sinkhole we are in.   Current earnings estimates for second quarter are expected to drop 35%, reflecting a full year estimate of around $100/share of the SP500. If that occurs and the expected earnings bounce in Q3 and Q4, we have a forward Price to Earnings ratio of 30x, which is extremely expensive.  We will see earnings in mid-July; first read on GDP at the end of July; and all the while we will see employment numbers each week.   On going jobless claims have now exceeded 20 million, reflecting an unemployment rate a bit under 15%.   Economic data will remain dire.  The hope is that employment and spending figures rebound rapidly in the coming weeks. 

As mentioned last month, the expectations and sentiment that direct short term prices are well ahead of actual improvements in employment or spending (declining).  We have made significant progress in flattening the curve with the virus.  We have seen stock prices climb dramatically alongside the hope of a rapid economic recovery. However, we are seeing an even more stretched disparity between current prices and reality on the ground.  This does keep markets at risk of wide price vacillations.

Attaining and holding 3000 on the SP500 does allow for further upside in the markets and while I rotate out of individual stocks that have lost their ‘mojo’ (or take profits), there is another handful I am tracking and may show up in portfolios in the coming days.  In my April Observations and Outlook, with tongue firmly in cheek, I outlined a path for stocks to 4000 if the Fed continues to add liquidity/monetize debt. Since that writing, the Fed has covered a quarter of that quantity.  The rise in the Fed balance sheet has paralleled a rise in equity prices. The Fed continues to plan for and express willingness to continue its balance sheet expansion in pursuit of its stated mandates: full employment and stable prices.

Prices across virtually all asset classes remain constructive considering Fed actions and optimism towards renewed economic vigor.  State re-openings have occurred, and the expectations are for rapid improvement in employment and spending.  There is a nascent uptick in the outperformance of equal-weighted and value indexes versus the general market.  This market characteristic often shows up at the beginning of economic expansions and longer bull markets.  June’s economic data and market price action should give us a great deal of insight into the remainder of the year.

Adam Waszkowski, CFA

Honoring Sacrifice

Brendan 1941.JPG

Since the earliest ceremonies in small American towns following the Civil War, we have gathered on Memorial Day to honor and remember those who made the ultimate sacrifice in service to our nation. As in those early days of laying wreaths and placing flags, our national day of remembrance is often felt most deeply among the families and communities who have personally lost friends and loved ones.

Uncle Hubert 1943Since World War I, more than 645,000 men and women have given their lives in defense of our freedom here at home and around the world. 

This national holiday may also be the unofficial start of the summer season, but all Americans must take a moment to remember the sacrifice of our valiant military service members, first responders and their families. Memorial Day is a day of both celebration and grief, accounting for the honor of our heroes and reflecting on their tragic loss.

This Memorial Day, join us in remembering those who bravely sacrificed their lives for our country, including the many first responders of COVID. 

At NAMCOA we pay tribute to Honor, Duty and Sacrifice.  

Client Note April 2020

Equity markets moved up strongly in April.  The S&P500 moved up 12%, and currently off 3% from the April 29th intraday high.  Gold jumped early in the month, then flat for a gain of 7% in April.  Long treasury bonds moved up in price by 1% but have been on the wane since April 21st.   Most asset classes have been rangebound (+/-3%) since early to mid-April, reflecting a decrease in market momentum.  The average moderate portfolio gained approximately 9% vs the SP500 gains of 12% in April.  Year to date, through April 30, SP500 is off 9.9% while most portfolios are very close to 0% year to date. 

Economic data continues to come in at extremely negative levels.  Auto sales fell by 45% April 2020 vs April 2019.  China, in February saw a 90% drop.  Current market sentiment is bearish and consumer confidence declined from 101 in February to 71 in April.  This is similar to the decline from February 2007 to June 2008 (the month Fannie and Freddie’s first attempted bailout, after losing 50% of their value that month), which saw a decline of 35%.  This could be another reflection on how this recession is being ‘front-loaded’.   We have seen already how GDP and employment has fallen as much as the entire 2008 Great Financial Crisis, but now expect robust rebound by year end.

In light of all this, equity markets have remained buoyant, after the March decline.  This may further indicate the front-loaded- ‘ness’ of this economic period.  And at the root of it all is the expectation that the economy will rebound strongly in the second half and especially in the 4th quarter of 2020.  While GDP estimates for Q2, which will come out at the end of July, range from -10% to -30% (annualized basis), some estimates for Q4 are as high as +20%.    I believe that we are again priced for perfection.  The past few years saw valuations (price to earnings, price to sales, etc.) elevated with expectations of an acceleration in earnings and wages to justify the then-current prices.  Today a significant economic rebound is priced into the market.   If the economy in late May and June isn’t picking up quickly enough it could put pressure on equity prices.  It depends on re-opening the economy and that depends on subduing the pandemic.

We have seen momentum decline recently and thus increases the potential for volatility in equity markets.  If the S&P500 cannot breakout above 3000 in the near term, we’re likely to remain rangebound vacillating +/- 6%.  Bonds and gold are at a point where they are testing support and have the potential to move several percent as well.  If we are to remain rangebound, my preference would be to reduce risk until there is more confidence in further upside.

On a side note, I have significantly reduced the amount of cable and national news I watch on TV.  It’s the same sad and fearful story we’ve heard the past 6 weeks.  I have noticed I feel better doing this.  A client went back north recently and was surprised/disheartened at the difference in the local news in Naples vs the local news in the tri-state area.  Avoiding the bad news TV and enjoying the good news of spending time with family/projects/hobbies/exercise can be an important factor in getting through this time and being ready to embrace the other side of this crisis.

Stay safe and thank you,

Adam Waszkowski, CFA

Observations and Outlook April 2020

Current State of the Markets

After the most precipitous fall in market history and now a 50% bounce-back, investors are trying to figure which way the wind blows.   The NFIB (Natl Federation of Independent Businesses) estimates that half of all small businesses cannot survive the shutdown through June.  Small businesses make up half of all employment.   We are already seeing massively negative numbers in unemployment claims and PMI surveys.  This is expected given our current situation.   IF unemployment is going to 25%, has the market priced this in already, albeit briefly?  Will the several trillion dollars in stimulus and liquidity overpower economic gravity and keep asset prices elevated?  Valuations for stocks had been in the top 2% most expensive of all time, for a couple of years.  If prices stay or climb higher without commensurate wage/economic activity, valuations could surpass recent levels—inflation in assets, deflation in wages.  In the past, these two generally have not gone together, except in the post 2008 era.

In addition, past recessions have seen job losses increase over several periods.  This time, a lot of the economic impact is happening in a short period of time.  Much of the impact is being front-loaded AND is expected to be short-lived.  Estimates are that GDP has contracted as much as all the previous recession.  As we contract further, the risk that we have not done enough stimulus becomes greater, extending the timeframe for recovery which in turn will lower sentiment and expectations for asset prices.

Which is it? Bull or Bear Market?

The terms bull and bear have a long history, dating back to the 18th century during the South Seas Bubble.   Some attribute the attacking postures each animal takes, the bull goring and lifting upward; the bear, swiping its claws downward.  The definitions we use today though are very new, dating only to the 1970’s.  The arbitrary 20% measurement to label a market as a bull market or bear market can be misleading.   We say today that the recent fall was greater than 20%, thus a ‘bear’ market; and now we have seen prices rise more than 20% from the bottom, a ‘bull’ market.  Do these labels help us in determining whether to be invested in stock markets? Do these labels provide any clarity to the nature or outlook for the markets? No, on both questions.   For a far longer time the terms bearish and bullish have been used to describe the nature of the market.  Bear-ish and bull-ish can better describe the character of the market one is in.  A trend can be described with these terms, also the behavior can be better characterized with these terms.  In bearish markets, large daily movements can be seen in the context of a downtrend.  Bearish markets move fast.  Bullish markets are a slower daily grind in an uptrend with a rare day showing more than 1% or 2% move.   Its certainly a subjective interpretation, but the change from a bearish market to a bullish market, in addition to a visible trend change, should also see smaller intraday percentage moves.   While the daily trend has turned up, the daily percentage moves remain elevated.

A Visual of Fed Interventions

Recently, some famous names from the 2008 crash reflected on that period and concluded they should have acted faster and with larger amounts of stimulus.   The Fed certainly has taken that to heart this time around and indeed has acted with vigor.  The first chart below tracks the Fed’s actions overlaid with the S&P500.  Even after the bottom, the Fed continued with QE 1, 2, Operation Twist, and QE 3.

fed actions vs sp500 2008

All the Fed actions, in real time, did nothing to stem the decline in prices.  The S&P 500 Price to Earnings ratio in early 2009 exceeded 100 (trailing 12 months earnings).  In late 2008, we saw 50+, prior to banks recognition of their losses.  Here is another chart, with recent Fed actions overlaid against the S&P 500.

fed actions vs sp500 2020 resized

Looking at these, an honest question is whether the Fed has any influence over equity markets in the short term.

Covid-19 or Global Dollar Funding Issues?

Few remember way back in September 2019 when the US overnight interbank lending rate increased by a factor of 5, rising from the targeted 2.2% to almost 10% (annual rate, intraday) on September 16th.  This caused the Fed to intervene, putting $53billion into interbank lending on an overnight basis.  The overnight lending quickly morphed into multi-day and multi-week repurchases agreements totaling more than $300B in a few weeks.  Previously banks had been lending to each other, overnight, secured with collateral (red line).  The Fed went from no participation in the $1 trillion+ overnight market to more than $350 billion, and then moved from repurchase agreement to outright permanent purchases and began the massive balance sheet expansion we are seeing today.  The Fed balance sheet rose from $3.76T in mid-September 2019, to $4.3 by March 11, and now is $6.4 trillion. Another $1 trillion and the recent expansion will be larger than QE 1, 2 and 3 combined.

The red line secured overnight lending began spring 2018, right after the February 2018 market correction, AND foreign dollar-funding costs (TED spread- orange line) jumped to the highest level since 2009.  The volume of funding increased for several months until banks ran short on capital to use as security, as dictated by liquidity rules in the Volcker Rule.   While demand (red line) had been growing for liquid cash dollars, the amount of collateral used to secure this lending was not enough, and when demand outpaces supply, the price (overnight funding rate—green line) goes up.  But that price was too high, and the Fed intervened, and the total volume of dollar funding continued to increase (red and blue lines together) at an increasing rate.

repos global dollar

We can see how due to the demand for US dollars began to increase in early 2018 (orange line), funding for dollars increased to a point where major banks could not meet demand for dollar liquidity, and the Fed stepped in and took over funding.  There was balance in the supply and demand from November 2019 to the end of February 2020.  From February 26 to March 4, the TED spread (a measure of stress in markets) began to grow rapidly.  The economic contraction stemming from Covid-19 exacerbated the serious issue of dollar funding (less activity means less trade/less dollar flow).  Today the Fed is fighting the dollar crisis AND the loss of over $2trillion in US output/GDP.

Monetary Base and the case for S&P 500 to 4000

For most of the post WW2 era, the growth of the monetary base (all currency and bank reserves) tracked the growth in GDP.  Historically, growth in GDP lined up very well to growth in the S&P 500 over a full business cycle.  During the Great Financial Crisis (GFC) with hundreds of billions of mortgage loans going bad, there was a risk that if all the loans were marked to their true worth that the monetary base would contract, resulting in a deflationary debt spiral.  In our current system all money is created by new credit.  If too many loans go bad, the monetary base declines as money that was lent/created disappears as collateral prices decline, and loans are not paid back.

The solution was for the Fed, for the first time in its history to accept as collateral (and purchase outright) mortgage-backed securities.  As the Fed accepted these securities, it provided cash to banks. Without the burden of non- or poor- performing loan, banks were freed up to lend again.  As this new cash was put into the system it also flowed into risk assets like the stock market.

The chart below clearly shows the relationship between QE and the S&P 500.  New cash found its way into stocks and pushed prices up.  The period after QE3 and the brief ‘balance sheet normalization’ saw the most significant corrections post GFC.  A minor 15% correction after the base stopped expanding in early 2016 followed by a 19% decline late 2018 and now the 30% decline most recently.  Other banks, namely China did keep expanding their monetary base in late 2015 and into 2016.  Then as China’s credit impulse wore off and as mentioned earlier, demand for US dollars kept increasing while the Fed lowered supply, we had the late 2018 market sell off.  The Fed backed off its plan to raise interest rates and cut rates summer 2019.  These actions aided liquidity and stock moved up after both actions.

With each QE period we saw the monetary base and the S&P 500 market capitalization increase.

Change in S&P 500             Change Monetary Base

QE 1              +37%                   +33%                                                                                   QE 2              +12%                  +33%                                                                           QE3/Twist    +53%                  +52%                                                                               2019 Cuts    +34%                 -20%  needed rate cuts were due to MB decline  2020             -15%                       +43%

monetary base

Currently the Fed is trying to increase the monetary base to keep asset prices and liquidity up.  We do not know yet to what degree the current recession will lead to loan losses and other credit destruction.  In addition to loans going south there is the general decline in output as we are locked down.

Through April 8th, the Fed has increased the monetary base by $1.2T, or 35% over late 2019 levels.  $1.2T may be the approximate output lost during the lockdown.  The Fed has expanded its collateral and purchases from treasuries and mortgage backed securities to now include junk bonds, corporate bonds, and other collateralized loans.   Over the past week and going forward the Fed will likely continue to monetize these securities, further expanding the monetary base.  If we see another $2T to the monetary base (Fed balance sheet expansion) that would approximate a 100% change in the MB and potentially impact the S&P500 similarly, going from 2100 in late March to 4000 by end of the year.   In this scenario, one would have to accept a reality of 12% unemployment concurrent with S&P500 at 3500+, and a $2 trillion annual deficit.  The wealth disparity would be substantially more extreme than in recent past.

We are entering a period in US history like no other.  The reaction to the Covid19 virus has put the economy into a self-induced coma.   Current expectations are that monetary and fiscal stimulus will pave over/fill in lost income and liquidity setting the stage for a return to economic growth.  The problem with this thesis is that we do not know how long the shutdown will last and after many small businesses run out of cash and close, how many people will get hired back.   There is substantial risk of extremely poor economic data to persist for several months.   The knock-on effects of a prolonged shutdown are difficult to estimate.  The more unknowns, the longer the shutdown, the worse the global dollar shortage, the more extreme market movements we are likely to see.

 

Adam Waszkowski, CFA

 

 

March Client Note

The collapse in prices is the fastest decline of 20%, off the market highs, ever.   Looking into the immediate future, the economic/unemployment/earnings data will be horrible.  GDP for Q1 will come in at -15%, Q2 may see -20%.  These should be expected given we’ve shut 1/3 of the economy down.  In a ‘normal’ recession, this data accumulates over several weeks and months, not all at once.  Most of the bad data were going to see is going to be front-loaded, and we will see this throughout April and into May.   Over the same 8 weeks, sentiment will change much more rapidly as the light at the end of the tunnel becomes more/less apparent.   Prices of financial assets will react even more quickly.  Those 3 elements (econ data, sentiment, market prices)  work together but at different paces, and appear to contradict at times (like the day the Fed announced all the backstop measures, markets fell—not because stimulus is bad but probably due to the increasing alarm over the virus).

As of March 31st, the SP500 is down 20%; the Dow is off 23%; US small cap stocks -31%; Nasdaq -14%; eurozone stocks -25%; long treasury bond (TLT) +21% and gold +4%.    The average moderate portfolio is down about 9% year to date.

During the quarter, we hedged the equity side of portfolios during the early decline (not changing actual positioning, just owning the hedge then removing it).   The idea is always to buy low/sell high and removing the hedge was akin to buying/gaining exposure at lower prices.   Long treasury bonds have done very well, and we have sold some into strength, locking in some gains.  Technology has been one of the stronger areas and have increased this area substantially.    In addition, we’ve added equity exposure via SP500 etf, IVV, at the 2550 SP500 level.  I plan to add more, once the pullback eases and prices are constructive again.

As it stands now, most portfolios have increased equities compared to the beginning of the quarter, with less exposure to bonds.  Gold still has some potential, but as I’ve mentioned before gains will be more gradual and believe $1700+ is attainable.  The near-term market movements will likely be tied to the general expectations of when the US can get back to work.   The past couple of days’ weakness, I believe, is tied to the extension from April 12 to April 30 of guidelines established to slow the spread of covid19.

My expectations (given the truly massive and quick stimulus) are that we are now in the pullback from the initial bounce in stock prices.  I believe it is likely to see another leg up over the next couple of weeks.   Staying over 2400 on the SP500 is very important.  The combination of several trillion dollars of stimulus, both fiscal and monetary, combined with the concept that the covid19 crisis will end, does set the stage for possibly, a very substantial rally in stocks in the coming months.  Very generally, if there is now (or soon will be) $2-5 trillion (new money) in the financial system and we get back 90% of GDP that has been lost,  prices could go much higher even if fundamentals don’t recover–that’s post-2009 in a nutshell.   Before that we need to turn the corner on the virus.

The past couple months has been a lesson in which is more difficult:  to sell high or buy low?   Buying high and selling low are easy choices.   “Everyone” is doing it and it feels better to be a part of the crowd, ‘getting a piece of the action’ when in bull market; and conversely ‘stopping the pain’ in a bear market.   Believe me, it is much more difficult to lean into the market in early stages than to jump on the bandwagon once most of a move has already occurred.   This is weighed against market outlook and risk tolerance.       The other lesson is basic financial planning:  do you have 2-6 months of living expenses on hand in case of financial disruption?  And is your at-risk money truly a multi-year holding period.    It’s no fun to be forced to sell into a weak market to raise cash for living expenses.

Adam Waszkowski, CFA

Client Note December 2019

December was another strong month for US (+2.8%) and global equity markets (1.8%). Junk bonds gained 1.1% in price while treasury bonds were off, giving the Aggregate Bond Index a slight decline.   Federal Reserve intervention, beginning early September, as a result of the overnight inter-bank lending drying up, has totaled some $400billion.   The rate of additions to the Fed balance sheet, is faster than in QE 2 (Nov 2010-June 2011) which took 8 months to add a similar amount.  QE 3 was larger, adding $1.7 trillion, over 2 years.   Central bank liquidity is the primary driver of 4th quarter equity market gains.  Economic data and earnings growth remain slow and near zero.

Portfolios gained across the board in December averaging approximately 2%; owing largely to our individual stock holdings and exposure to gold and miners.  Bonds were muted and were a drag.  Bonds look best posed to gain in the near term. Gold can extend further, and stocks have hit a speed bump with the turmoil in Iraq/Iran and may be slightly choppy in the immediate term.

Gold and gold miners gained 3.6% and 8%, respectively, in December.  Both bottomed November 26th and earned most gains in the last week of December, prior to the assassination of the Iranian general.  International stock markets have outpaced US stock markets since 10/15 (as forecast in October’s Note).  Commodities, ex-US equities and gold have gained significantly since the US Dollar peaked October 1, and its most recent lower high, on 11/27.    The dollar has broken down and may find support another 1% lower, matching its level in late June, which would be 3% decline off its high on October 1.  A small change in the value and direction of the US $ can have large impacts on metals and other natural resources.

The decline in the US Dollar corresponds well to the Feds telegraphing its intentions to refrain from raising rates in 2020.  The dollar can fall/rise relative to other currencies for a variety of reasons.   The current decline is not getting much attention.  Most finance headlines are full of talk about “reflation”.  Given the SP500 is off its all time high by a mere .75%, its not a reference to stock prices.

Reflation, is the topic du jour.  This term refers to economic data.  Federal reserve interventions impact the markets first with a much longer lag to the general economy.  China’s recent modest liquidity injections are: 1) much smaller than in 2017 and 2014 and take about 6-9 months to impact the US/global economy. Positive economic data from central bank actions will take at least one quarter to begin to show up.  Easing amongst central banks is as significant today as during QE 2.  CBs have completely discarded the concept of ‘normalization’ over the next year.

The biggest risk I see in the immediate term is the start to earnings season.  Earnings estimates for the 4th quarter, as usual, have declined substantially over the past year.  IF stocks can ‘beat by a penny’ reduced earnings estimates, we should get through with only minor stock market fluctuations.  Conversely, if companies’ lower guidance and/or miss low estimates, we could see a more general ‘correction’.  Bonds appear to have completed a 4-month consolidation and any more gain will give it some momentum, while stocks consolidate 4th quarter gains.

Slow economic growth, questionable earnings growth and the ever present geo-political risk are risks to the stock market.  With bonds and gold looking up for a variety of reasons, diversifying across asset classes (into areas not correlated with the stock market) is always a prudent approach.

Adam Waszkowski, CFA

The Yield Curve Un-Inverting Is Not Your Friend

I have talked about this phenomenon before and must do it again today.  All over the news recently is how the previously inverted yield curve is now no longer inverted.

Yield curve inversion is when short term Federal Funds Rate, set by the Federal Reserve, has a higher yield than longer term rates.   The most common curve-inversion metric is the Fed Funds rate versus the 10-year Treasury bond.  One can also make comparisons between the 30yr, 10yr, 5yr, 2yr and 1yr Treasury yields.  Inversion is regarded as an indicator of a higher risk of recession in the near future.

The chart below shows, in blue, the spread between the US 10 year Treasury yield and the Fed Funds Rate.  The orange is the Fed Funds rate, set by the Federal Reserve.  Red is the 10-year Treasury.

We can see without a doubt that the past 3 recessions (grey bars) were preceded by a decline in the 10-year yield to BELOW the Fed Funds Rate.  Longer term bonds carry higher rates of interest primarily due to inflation expectations.  The natural state is to have the longest-term bonds pay more than shorter term bonds.

When the 10-year is below the Fed Funds rate, the curve is said to be inverted, as its expected longer-term rates are normally higher than short term rates (the Fed Funds rate is an overnight rate).  The curve un-inverts when the 10-year yield goes back above the Fed Funds rate.

The financial media have spilled a lot of digital ink on this topic.  When it first inverted, reports were based on a recession indicator.  Now that it has normalized slightly, I’m seeing reports that the recession risk has passed.

The chart below clearly indicates that the past 3 recessions began as the curve un-inverted. Recessions are the grey vertical bars.

resteepening 11 2019

The process the last 3 times this has occurred was that; 1) market-driven yield on the 10-year bond went down, generally due to deteriorating economic conditions. 2) the 10-year gets below the Fed Funds rate (blue line under the 0% level), inversion. 3) The Fed begins to lower rates to stimulate the economy. It continues to lower rates basically until the recession is over (orange line).  4) The 10-year Treasury bond yield remains flat or vacillates some as the Fed lowers its Fed Funds rate below the Fed Funds rate, un-inverting.

The problem lays in that the Fed is doing the ‘un-inverting’, not market forces.  Had the Fed left rates alone at 2.5% and the 10-year market-driven rate had gone up (due to increasing economic activity)—THAT would be healthy and a good sign for earnings and the economy. 

It is important to remember that stock prices and the economy are only loosely tied together in the short term, stock prices can rise and remain elevated in the early stages of a recession.  Also, it is possible that the curve inversion is falsely predicting a recession, however this indicator has a very high success rate.

Adam Waszkowski, CFA

Client Note October 2019

November 3, 2019

After a week September, equity markets came back to life in October with the S&P 500 gaining about 2.2%, Euro Stoxx 600 up almost 6% (equal now to April ’19, but still 11% below all-time high from Jan 2018), emerging market stocks gained 4% (remain under April ’19 level, and about 20% below Jan 2018). Aggregate bond index was flat on the month, gold gained 2.5% but remains sideways over the past couple of months.    Portfolios gained across the board, .75% to about 2% on the month.   Our recently added individual stocks continue to do well supporting our core ETF holdings.

Stocks appear to be moving up out of the range we have seen the past several months on the hopes of a trade deal with China and that the current earnings recession is about to end.

Open Interest in gold futures has declined by about 20% as prices have gone sideways and media attention has waned.   At the same time prices have gone sideways and appear to have consolidated enough to provide another base from which to stage another modest rally.

Market driven interest rates have climbed, fallen and climbed again, since August and are consolidating.  With economic numbers (showing the recent past month) have begun to slow their decline (still contracting in durable good, manufacturing) the Fed is indicating less willingness to commit to additional rate cuts.  If data remains ‘less-bad’ I don’t expect a rate cut in December.

Recently we’ve seen very low expectations in employment, earnings and economic data come in ‘less-bad’.  Employment gains were expected at 75k (very weak) to 128k (middling, barely keeping pace with population growth); earnings decline for Q3 year over year at -1% (expected at -3%) and manufacturing PMI slip to 48.3, but greater than expected 47.8 (both indicate contraction).   So, with data not being worse than feared appears to have given market participants confidence that this year may be similar to 2015/2016 and that this bout of weakness will pass.

Western economies grow with credit growth.  In my October Observations, we see how China’s credit impulse impacts US economic data. China’s credit impulse has gone from declining to flat which I believe is the source of our no-longer-falling-but-still-weak economic data.  The Fed restarted a form of QE in September putting in substantial liquidity (comparted to the drain previously) and should give rise to good data in December and January.  If this is temporary remains to be seen.

The US dollar has broken down and may signal an end to its climb (and some decline) which should bode well for commodities which have been added to portfolios.  Oil is on the sidelines still as its in the middle of its 12-, 6-, and 3-month ranges!   We may also see (as mentioned previously) outperformance in ex-US equities (affirmative past 90 days).

 

Adam Waszkowski, CFA

Observations and Outlook October 2019

October 8, 2019

Perspective

 Over the past 3, 12 and 18 months there has been a wide dispersion in the returns of various asset classes.  US equites remain range-bound while ex-US, stocks continue to ebb.  Risk-off assets like bonds and gold have done very well over the past year, while stocks vacillate.  Interest rates continue to fall, and inflation expectations are subdued.  Earnings growth for the third quarter are expected to be negative year over year, and likely zero growth for full year 2019. US economic data continues to be weak while Eurozone and Asia may be entering a recession.  Below are the approximate returns over the 3-month, 12-month and 18-month time frames.

 

3 mos.            12 mos.                 18 mos.

S&P500                                          1.7%                 4.25%                      13.5%

Russell 2000 (US small cap)      -2.4%                  -8.9%                         .5%

Euro Stoxx 600                                .8%                    -.5%                      -2.4%

Emerging stocks                            -4.2%                  -2%                       -14%

Gold                                                    4%                 23.1%                     10.4%

Long-bond price (TLT)                 8.1%                 25.2%                     21.8%

Aggregate Bond Index                 2.3%                   7.5%                        9.6%

 

Economic data in the US continues to roll over.  The chart below shows the top three inputs into the LEI (Leading Economic Indicator) as published by the Conference Board.  Data continued to slow and is now in contraction in some areas like manufacturing.  Payroll growth has declined significantly during 2019.  These data points must reverse very soon otherwise we will undercut the 2015 slowdown and increase chances of a recession in the coming months.

econ rolling over 10 2019

 

We’ve been seeing risk-off assets outperform substantially in recent quarters under the pressure of slowing global economic data and lack of growth in earnings.   More recently there are been reports of large-scale rotation from growth stocks (like Consumer Discretionary sector; XLY) to more value-oriented stocks (like Consumer Staples; XLP).  Value has begun to outperform growth.   While not completely uncommon, it is uncommon to see this while Consumer Confidence is very high.  Recently I came across the chart below from Sentimenttrader.com which shows how rare this is.

discretionary vs stpales vs consumer confidence

Discretionary items are what people buy with ‘extra’ money, while Staples are what people need for everyday life.  Defensive areas usually outperform only when consumers and investors are less confidence about the future.  Only just after the market peak in 1969 (far left side) and the 2000 peak (center) confidence was high (survey results) while defensives were beginning to outperform cyclical stocks.  If this rotation continues it may portend tough times for the general stock market.

Why might consumers be confident while investors are buying more defensive stocks over more cyclical stocks is a difficult question.  Sentiment is often a lagging indicator.  People feel good and optimistic after good things happen.  The long string of employment growth and a long bull market has buoyed sentiment, perhaps so much that any contrary information is being discounted.  A poor job report or two may change this outlook.  But again, we are faced with an imminent need for very good economic data points to counteract current downtrends.

Credit Expansion (aka QE/liquidity/debt)

china credit impulse pmi

 

us pmi 10 2019

 

These two charts show how China’s credit impulse (QE/liquidity/Reserve Rate reductions etc.) have a lagged impact on US manufacturing.   Coming out of the 2009 recession, China had the spigot wide open and we can see US PMI hit a high mark in early 2011. The Impulse was removed during 2010 which resulted in a decline in US PMI.  The renewed impulses in mid-2012 and late 2015 helped create the rise in US PMI in 2013 and 2016.  There is about a 6-9 month lag between an expansion in credit and its impact on the real economy.

Today we are seeing the impact of a lack of significant credit expansion which should continue   Global economies appear to be completely reliant upon increasingly larger credit impulses to maintain growth.   China has eased during calendar year 2019, but not as much in the past.  Hopefully we will soon see better US PMI numbers to avoid outright recession in the very near term.

Update on the Yield Curve

fed funds vs 2 year inversion 10 2018

We’re not hearing much on the Yield Curve lately.  It remains inverted with the 10-year Treasury yield being lower than the 90-day T-bill rate.  The 90-day bill and Fed Funds rate (set by the Federal Reserve) follow each other hand in glove.  We can see market rates, the 10-year Treasury yield began to decline in earnest about a year ago.  We can also see how the 90-day rate moved lower prior to the Fed lowering rates.  It is clear that the Fed follows the market.

Current market expectations are that the Fed will lower its rate again in October by another 25 bps (.25%).  I have showed in previous writings how the last two recessions began (the official dating) as the yield curve regained normalcy with the 10-year yield rising above the 90-day/Fed Funds rate by .33%.

If the Fed Funds rate decreases by .25%, from 1.75% to 1.5%, and the 10-year yield remains constant at 1.56%, the yield curve will un-invert and become positive.  Further decreases will cause the spread to go above .33%.   In 2007 the Fed lowered its rate enough (following the 90-day T-Bill) to get below the 10-year yield, resteepening/normalizing the curve again.  This occurred August-October 2007, and the official dating (which was given to us November 28, 2008(!) that it started December 2007.   Waiting for economic data regarding a recession, before reallocating one’s investments will always result in very poor returns

 

Adam Waszkowski, CFA

awaszkowski@namcoa.com

239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.