Is volatility back? You tell me - here was the market action this week: Down 400 points Monday, Up 400 points Tuesday. Down 800 points Wednesday. And as I submit this for the week, Thursday (late morning) we are up a little over 100 points (but saw the pre-market futures up and down hundreds of points at a time). There is always one reason for "up & down" volatility (is there any other kind?), and it is uncertainty. In the Dividend Cafe this week we are going to look at the sources of the uncertainty and seek to enhance your understanding of the world affairs that are driving capital markets at present. This has been the most volatile week of the year in the market, with last week being the second most. In other words, since July 31 we really been sitting at non-stop market drama. I don't recommend a quick skim of this Dividend Cafe - the underlying issues of "yield curve," recession fears, interest rates, and the trade war warrant a cup of coffee, and a committed read. Let's jump into the Dividend Cafe ...
What is going on???
At the heart of everything is the U.S.-China trade saga (see below), and yet the underlying global economic environment is front and center now, as the U.S. 2-year treasury yield went higher than the 10-year treasury yield this week (official yield curve inversion), and the 30-year treasury yield hit it's all-time low this week (going below 2% for the first time ever). Let me repeat that: Investors can now loan their money to the United States government for thirty years and receive for their trouble less than 2% per year. Markets are struggling to find a footing. Uncertainty is ruling the day around policy, around economic direction, and around pretty much everything else.
Updating the U.S.-China Trade Saga
For those keeping score ... The U.S. has announced a new 10% tariff on $300 billion of imports from China. China allowed the Yuan to drop last week ... The U.S. designated China a currency manipulator ... China suspended purchases of U.S. agricultural products ... The U.S. prohibited any federal agency from buying product from Huawei and other Chinese tech companies ... The September talks are rumored to be not happening, but that is unclear ... And on Tuesday this week the White House announced that the 10% tariffs on cell phones, laptops, and toys would go into effect in December instead of September (the President specifically said it was to avoid impacting consumers with their Christmas shopping, which is odd since we were told that America is not paying these tariffs).
Worth noting in the zigs and zags
The stock market may be zigging and zagging around the tosses and turns of the trade war, but it is worth noting that as the stock market goes up and down, bond yields have only gone down, and stayed there. Meaning, bond prices have gone higher - way higher.
Volatility needs no excuse
For those wondering about the present state of volatility in the market, allow me to say the following:
(1) As of press time, the VIX was not even above $20. The VIX level is actually down 22% from where it started the year. It was higher in May when we last had a trade tantrum, and much higher in December when markets were in freefall, and don't even compare to February of 2018 when the trade war started.
(2) There are plenty of other events that very well elevate uncertainty in the weeks and months ahead. The Brexit deadline contains all kinds of unanswered questions. Japan is raising taxes. We don't know what the Fed will do, and even worse, what they will say. Oil prices look vulnerable. Trumpian tariffs can always be assigned on other products outside of China. The Hong Kong situation is a mess. You get the idea.
So does this mean to leave markets? Of course not. That would make you the sucker selling shares to the real investor.
And the yield curve?
No investment professional should ever use the phrase “this time it’s different” without being able to really, seriously, profoundly defend their case. I have no such case to offer here – the inversion of the 2/10 yield curve has foreshadowed a recession way too many times (nine of the last twelve) to not believe that, once again, a recession will follow this inversion (generally a year or two later). I have written before that this inversion does not tell us if a recession is coming in six months or two years, but I do believe the policy framework and economic conditions that have caused the yield curve to invert should be taken at face value.
That said, I do want readers to understand the following:
- Had it not been for three rounds of quantitative easing totaling nearly $4 trillion of federal reserve bond buying post-crisis, we would surely have had higher long-dated bond yields, and it is not as clear to me that the effects we now endure would have created an inversion.
- This is a big deal: The cost of capital is still much below the return on invested capital, meaning credit use is not declining. The yield curve inverting has traditionally created this effect, causing the economic inversion that is itself recessionary. But in this case, for any number of distortive reasons, the conditions are different. This at the very least bears watching.
So is it different this time? Well, the smart and safe answer is, “it never is!” But did the most aggressive monetary policy we have ever seen in our nation’s history post-crisis change some factors in a way that requires nuance and analysis? Of course it did. Caution and balance are the need of the hour.
Why do we see $15 trillion of bonds trading at negative yields around the world?
Because central banks create the bonds ex nihilo, which affords governments the ability to borrow money at virtually no cost (or literally no cost), which keeps them solvent in the face of unsustainable debt and spending levels they can’t afford.
Honestly, no other sentence is necessary to understand what is going on. As complicated and bizarre of a topic as it is, that above sentence truly does capture the entire story of what the global economy is currently dealing with.
Hurt Trade, Hurt Manufacturing
Here are the manufacturing levels of the major countries of the world in the final month before the trade war began (including the United States), and the manufacturing levels of all the same countries now.
Did I say the "R" word ?
The concerns I feel about the impact of this trade war and their contractionary effect on business investment are not a call for an imminent recession, but nor are they a forecast that a recession will not come. Rather, the escalation in trade distress and its inevitable depletion of business confidence creates added uncertainty, and an economy can "muddle thru" in uncertainty for longer than many believe. But "muddle thru" is not good enough, and whether the economy tips into recession in 2020 or 2022 or somewhere in between is not as important as this: Reduced capex in the worst case quickens the time that the U.S. economy faces its next recession; and in the best case it stunts growth and leaves us with unimpressive economic productivity.
So now I will say the "D" word ...
What is the problem with "muddle thru" growth if we can avoid a recession? I'll give you two words - "Debt" (cumulative amount owed by the United States government) and "Deficits" (the amount being added to the total debt annually due to higher amount of government spending than revenue). Spending cuts have not shown themselves to be politically feasible with either political party, so only an increase in revenue is likely to keep the debt problem from spiraling. Muddle-thru growth does not increase revenue. Above-trendline growth is the great need of the U.S. economy, and we are missing it both in a cyclical and secular sense.
What is the debt that we are trying to manage around?
Hint: It is a global phenomena ... The United States has just over 100% government debt-to-GDP, and another 75% (each) of household debt and corporate debt (relative to the size of the economy). This is 250% total debt-to-GDP, and that puts us in the middle of the pack (but with a higher growth rate than the countries that are worse off than us, like Japan and various European constituencies.
In the weeds of Chinese debt and currency
Why do Americans care that China’s debt level has ramped up as it has in recent years? Because so much of it is denominated in dollars that they would have to draw down their foreign-exchange reserves to pay back dollar debts (not going to happen), or they have to buy dollars to pay back in dollars. At the levels we are talking about, this automatically pushes the Yuan lower and the dollar higher. Gone are the days of China having low debt and large foreign exchange reserves. The external debt levels have tripled since the financial crisis, and while foreign exchange reserves have stayed level for over two years, they declined $1 trillion from 2014 to 2016.
Let's talk more about corporate debt and less about government debt
The market is always obsessed with corporate debt, liquidity, and health, and rarely very concerned about government debt. Markets understand how much of economic health is reliant upon countries being able to grow leverage. Since the financial crisis we have seen a huge process of companies replacing equity for debt on their balance sheets. I have been heavily influenced by Michael Milken's writings on capital structure over the years, and Michael is famous for articulating why healthy economic growth depends on corporate treasurers getting this right. Milken taught me that "capital structure risk should vary inversely with business risk." This means that some companies should have no debt at all, because their operating business itself has enough risk that it can't handle more.
What do you think the odds are that every company which has levered up since the financial crisis has done so responsibly and wisely? What are the odds that the business risk of companies has stayed inversely proportionate to their capital structure risk?
We are living through a period where policy is overwhelmingly asking companies to put more debt on their balance sheet and maintain less equity. We are also living through a period where the best and brightest corporate financiers are looking to replace debt with equity, not vice versa (sadly, there are not many). We are living in a period where stewardship of a company's cap-stack will be a massive determinant of health (if not survival) in the next economic downturn.
History must get tired of teaching us the same lessons over and over again. But the moral of this paragraph is: Fundamental analysis of a company's debt management, equity ratios, use of cash flow, and relationship between business risk and capital structure risk, are all the most significant things an investor can hope for in the years that lie ahead.
Bond yields - one of these things is just like the other
Why do we not celebrate low bond yields, even though they theoretically mean lower borrowing costs, an increase in the price of our bonds, and more liquidity in the economy? Because we evaluate bond yields not merely for what they produce, but for what they signify. A sudden and dramatic lowering of bond yields is indicative of fear, panic, low growth expectations, and a number of other things that create concern. And as I have written about extensively this year, they follow intense increase in government spending because government spending suppresses demand, ergo, suppresses growth.
Enough about stocks, let’s talk about bonds
I will say two things about bonds in the environment we have been in … Interest rates dropping and credit spreads tightening – a double whammy of goodness for the bond market whether duration-driven or credit-driven – have been the clear lay of the land this year. It would be nearly impossible to not make money as a bond investor in such a period. The question, of course, is what’s next? Do rates go down further? If not, what is one’s plan for yield curve positioning. Are credit spreads going to tighten, widen, or stay where they are? What is one’s outlook on that question based on, and what are the implications for the credit exposures in one’s portfolio? Look, we manage hundreds of millions of dollars of bonds on behalf of our clients – we want fixed income inside our client’s asset allocations. But the burden of having really thoughtful answers around the questions I ask above is more important than ever. This is a time for your investment managers to actually have a point of view, and bond managers do not get a hall pass from such!
Asset prices - this includes stocks (and real estate, and everything else)
The issue so many take for granted these days is the way risk assets are priced, and that pricing has been heavily influenced by the low risk-free rate and heavy liquidity provisions of the Fed for quite some time. Should an investor who recognizes the risk in asset-pricing become bearish, just because they recognize that there is vulnerability there? Frankly, that makes no sense, as (a) Asset pricing and valuations are always vulnerable to any number of conditions, and (b) It is just as likely right now that the Fed's interventions will boost asset pricing as they will deteriorate them.
The right lesson is to be aware of this risk, and position one's portfolio around the reality it represents. Fundamentally solid and heavily cash flow-generative investments are less vulnerable to the volatility of asset pricing. Risk is there. It always is. And the Fed is doing the opposite of "backing off" the impact they have on all of this.
Want to hear something contrarian and opportunistic?
Global trade war and currency unrest do not exactly go with “opportunities in the emerging markets,” right? Wrong. Two things drive secular growth: Population growth, and Productivity growth. Both of these elements shine bright in the emerging markets, and create long-term profits opportunity for those with a long-term investment horizon.
The equity risk premium is the earnings yield of the S&P 500 less than the 10-year Treasury yield. The lower that premium, the less attractive equities look on a risk-reward basis. The lower the premium, the less companies are earning in profits, and the more one can make by holding bonds. The higher the premium, the higher the spread between the two. Led by the combination of a healthy earnings level in the stock market and collapsing bond yields, the equity risk premium is wide right now – the widest it has been since the end of the financial crisis!
Is this the pain point?
I have written throughout the trade war that it would end when one or more sides reach a point of pain that they had to find a deal to end it. In more recent times it has become clearer to me that China is more willing to endure economic pain for the sake of waiting out American political realities than previously imagined.
But why might we be near the pain point necessary for the United States? (1) Market reaction, which the President has been sensitive to, forces a practical limit; and (2) Currency reality, namely that China’s currency depreciation enables them to offset the effects of the trade war for themselves, all the while hurting everyone else. Now, as I wrote last week, the U.S. can choose to fight back on the currency front, too, but that simply opens up that pandora’s box of risk and instability as well. Logically, and based on normal political assumptions, it would be a reasonable analysis that the U.S. is likely to find an off-ramp, preserve economic stability going into an election year, and keep the strongest card for President Trump’s re-election (up until now, the strong economy) fresh and ready. But logic and normalcy are not hallmarks of the times in which we live, so a bold prediction that “this is the pain point we have been waiting for” strikes me as imprudent.
The conditions China has insisted upon are (1) Reasonable expectations in what China is to import from the U.S.; (2) Elimination of existing tariffs; and (3) “Respect for China’s dignity” in the text of the agreement (I assume this last point is tonal and not substantive). In all three of these cases I see room for the U.S. to appease China, all the while saving face. The prospect of that happening is what market bulls must be assuming or hoping for (it is more likely than capitulation from China pre-election).
Manic about Midstream
The oil and gas pipeline space concluded its fourth consecutive down week last week (after six consecutive up weeks before that). Though not down as much as oil prices, the correlation with oil seems to have picked back up after what had been a very constructive earnings season for the pipeline sector. Demand remains insanely high for natural gas. We find it is easier to go through periods of broad market distress when one is getting paid handsomely to do so, and this sector is doing that.
Do those stocks seem expensive?
The "average price" of a stock in the S&P 500 has never been higher, which of course has nothing to do with valuation, index level, or performance. It simply means less stocks are doing stock splits than ever (thank God). By the way, the highest priced stocks in the index have outperformed the lowest priced stocks in the index by 10% on the year - 10% !!! What does that tell us? Well, we know retail investors tend to favor lower priced stocks out of the childish notion that low priced stocks go up in price more than high priced stocks. But it also tells us that companies are more focused on seeking mature investors, those with an institutional mindset, and shaking out trading types who do not make good owners.
Politics & Money: Beltway Bulls and Bears
- I continue to hear that the conversations in the White House about indexing capital gains to inflation are substantially heating up, and that this is becoming a more likely fiscal policy tool by the end of the year. Its impact on the "unlocking" of capital and improved capital allocation and re-deployment would be significant. We are watching this very, very closely, and I will be meeting with administration officials this weekend to hopefully get a better feel of how viable this is at this time.
Chart of the Week
Should the Fed be targeting a 2% annual inflation rate? Those upset about it fall into one of two camps: (1) Those frustrated by the fact that they are not succeeding in doing it, and want them to try harder, and (2) The camp I am in, which finds targeting any inflation to be outside the idea of sound money, a central mandate of the Federal Reserve.
Quote of the Week
"He who refuses to study history has no past and no future."
-- Robert Heinlein