The latest in the market
Consider this for market volatility, and consider it for where things actually are in terms of market levels. Last Monday we were down 400 points. Last Tuesday we were up 400 points. So we enter Wednesday even on the week, right? Then we go down a stunning 800 points on Wednesday. Thursday we go up 100, Friday up 300, and then Monday this week we are up another 250. We drop 150 on Tuesday but then go up 250 on Wednesday. As I type this on Thursday, we are reasonably flat in the markets. So when all is said and done, from the beginning of last week to right now, the Dow is in the exact same place it started, yet with eight consecutive days of triple-digit movement up or down, averaging about 350 points of intra-day swing per day ... All to be at the exact same place as when last week started ... (of course, I am typing this on a Thursday morning, so by the time you read this, who knows ...)
The latest in the trade war
The President continued "tough talk" about China this week, but at the same time, China's Yuan reached an 11-year low to the dollar as they export the impact of the trade war to others (mainly those transacting in dollars). From the U.S. side, the latest in action was suspending the increase of 10% tariffs on $160 billion of product until December, and backing down on restrictions with Huawei. But many tariffs on consumer products are set to rise in September, and the total tariff cost will now equal the amount of corporate tax relief passed in late 2017.
One note: Elizabeth Warren is surging in the Democratic primary polls. She is much closer to Donald Trump on China than she is Joe Biden. So does the possibility of a tough China deal with either Trump or Warren expedite China's motive to reach an agreement? Food for thought for those watching the political landscape ...
The latest in the rate war
The fed funds futures market is presently pricing in a 100% chance of one rate cut in the September meeting (quarter-point), and there is roughly a 40% implied probability for one more cut in December, and a 40% implied probability for two more rate cuts in December. So what the market is telling us is that one (not zero, and not two) cuts will happen in the next meeting, and that December is wide open for either zero, one, or two cuts.
The latest in the yield curve
A lot calmer and measure surfaced in this discussion as some of the very legitimate reasons to at least consider if "this time it is different" received more air time. Very sober-minded economists and analysts (including yours truly) are willing to look at the somewhat indisputable reality that there are some very relevant facts that are different here. Does this mean the inversion of the yield curve is not forecasting an eventual recession? No, it does not. It just means there is a compelling reason to conclude that we cannot draw a hard and fast conclusion at all.
As I have talked about at great length, including in this brief podcast last weekend, the phenomena of negative interest rates around the world has caused extraordinary demand in U.S. treasuries, as investors (and nations) do what they can to find some positive yield. The slow growth around the world has caused investors to seek principal protection with yield, and even at just 1.5% in our ten-year, it trumps the -0.5% in Germany. This global demand and buying pressure pushes bond prices up/bond yields down, even as the Fed has kept the fed funds rate over 2% (hence the inversion).
Summarizing our viewpoint
Do we expect the market to make new highs any time soon? No.
Do we expect the market to reach the lows of December any time soon? No.
Do we expect perpetual volatility until there is clarity on the China trade tensions? Yes.
Do we expect the Fed to cut an additional 50 basis points between now and the end of the year? Yes.
Do we favor a balanced, even-weight approach to equities for the foreseeable future, with emphasis on under-valued securities and sectors, and more defensive, quality names? Yes.
Yield curve inversion - past is not prologue
The yield curve has inverted five times in the last thirty years, and four of those times it led to a recession. But please note the following:
In 1981 the 2/10 yield curve was inverted for 36 days before it hit its maximum level of inversion
In 1988 the 2/10 yield curve was inverted for 71 days before it hit its maximum level of inversion
In 1998 the 2/10 yield curve was inverted for 22 days before it hit its maximum level of inversion (and we did not have a recession)
In 2000 the 2/10 yield curve was inverted for 46 days before it hit its maximum level of inversion
In 2006 the 2/10 yield curve was inverted for 224 days before it hit its maximum level of inversion
In all of the above periods besides 1981, by the way, while the curve was inverted, the S&P was up between 3% and 11% ...
I do not know if the yield curve will invert again or not, but last week's inversion lasted about five minutes. Drawing parallels to these particular past events strikes me as unreliable.
How bout' them credit spreads?
I will never, ever, ever stop talking about the importance of the spread between various credit instruments as safe-rate assets as the key signification for understanding various things in the market. Spreads have nudged somewhat higher this quarter, and yet overall borrowing costs have decreased (because of the absolute drop in bond yields). Liquidity in the bond market has actually increased, and so while the credit spreads certainly could blow out at any time, right now the spread widening in both high yield and investment-grade has been contained, and the absolute level of borrowing costs has actually dropped.
How to hedge equity risk?
A simple rule of thumb that has been long forgotten for reasons I will make clear in a moment ... First, why do people want to "hedge" equity risk? It is NOT for standard 3-10% equity volatility, but rather for more lasting, significant, deep draw-down that can happen in either an inflationary debacle, or a deflationary debacle. To "hedge" against a 5% drop will cost someone enough to miss out on far too high of the expected return of equities - in other words, it is unhedgeable.
But what do we do in the asset allocation process to "hedge" against significant deflationary drops, or inflationary drops? The latter one could argue is hedged with commodities. It has been so long since we had an inflation-driven bull market, and we are so far from experiencing inflationary issues that this has been easily forgotten. But with deflationary drops in the stock market, nothing in human history has been more effective than long-dated treasury bonds. Indeed, even short-dated and medium-maturity bonds have provided a lot of defense in both the August 2019 and Q4 2018 market distress.
And yet here is the irony: Why did most investors not experience a greater hedge effect from their bond portfolio in the last few deflationary market disruptions? Because they have sat around in the consensus view that rising interest rates were the big risk, and therefore insisted that their bond portfolios have excessively short durations. The long-dated bonds that everyone was so afraid of provided double-digit relief to equities lately.
One has to examine why they own bonds. If the reason is to diversify against equity deflationary risk, the hugging of short duration bonds (now paying about the amount you will find in loose change in your couch cushions) is counter-productive. Bonds are not a surrogate money market or cash fund. The last ten years have been humbling to those who have tried to develop a consensus or conventional view on bonds. The effective asset allocator sees the asset class for what it is - a zig to the deflationary zags that stocks sometimes experience.
Some disastrous rationality in the irrationality
Germany attempted to sell a 30-year German bond in the market (two billion euros worth) with a negative yield, what would have been the longest maturity debt instrument ever with a negative yield. The auction failed spectacularly with only 824 million euros worth being sold.
A quick debriefs on the state of the global and domestic energy market ... It is pretty amazing that oil prices are up well over 20% on the year, because all we hear is how weak oil prices are. Oil sits right now at $55, up 22% from the beginning of the year. Granted, a move from $45 to $65 and back to $55 covers a lot of ground. Our perspective has been that oil in the '40s has been short-lived the last few years, and is unlikely to happen, or last if it does happen. $50-75 has been the range where prices are affordable to consumers and profitable to producers, though even that range covers a lot of ground.
Shale production is likely to tail down a bit, simply because it has been so incredibly high. Incredibly weak producers (financially) were forced out a few years ago. Marginally weak producers have been shown religion ever since, though some adopted the lessons more fervently than others. There is likely to be more consolidation in the space because balance sheets matter in this cyclical, challenging business.
Ultimately, demand remains high - very high. Demand growth in natural gas is even higher. Supply keeps gas prices down, which bodes well for volumes but not for prices. We remain focused on export opportunities, infrastructure, financial strength and discipline, integrated and diversified companies, and where there are sustainable and growing cash flows regardless. Color us energized.
What else is out there?
The Fed will provide both some action (or inaction) next month, along with language to accompany it. U.S. tariffs in European auto imports are not completely off the table (though no one is rooting for them more than Democratic Presidential contenders). Japan's VAT tax increase kicks on October 1. The Brexit deadline sits on October 31. Hong Kong's tensions are not resolved. The trade war and issues around the yield curve will dominate financial media, but the entire news cycle and calendar is positioned for enhanced volatility in the months ahead.
Politics & Money: Beltway Bulls and Bears
- It was a disappointing week for those looking for stimulus in capital gain relief. After significant signals that indexing of capital gains to inflation was imminent from Mark Meadows in the Freedom Caucus, Larry Kudlow from the National Economic Council, and even the President himself, the President reversed course in 24 hours and indicated he was against the idea, believing it would "have the appearance of being elitist." I spoke about this a bit on Charles Payne's Fox Business show Wednesday.
- The President also indicated he was interested in a payroll tax cut, something that may very well sound good politically, but of course, has absolutely no chance of being passed by the House (whereas the capital gain relief could be). But beyond the political infeasibility of the idea, a payroll tax cut has not been stimulative to growth the last five times it has been enacted.
Chart of the Week
I am sure this week's Chart requires some explanation, but each week the chart ought to require a little color ... Here we are looking at a distribution of daily returns in the market (courtesy of my friends at Invesco). We see that over the last ten years, there were about 450 days where the market was up or down right at 0%. There are a few outliers of big up % days and a few outliers of big down % days. And there are more down very small days then up very small days ... Certainly, the vast majority of days (~1,200 market days) are between -0.25% and +0.25%, and when you expand to -1% to +1% it captures ~77% of market days. But why is this interesting at all?
Because the market is up 400% in this time period. Four. Hundred. Percent. And yet in that time period, the market was down basically half of all market days (not quite). Going back to 1926, only 54% of days have been positive. The concept that individual daily moves should drive our investment thinking, let alone actions, is not just false; it is counter-true. It is destructive. It is cannibalistic to returns. It is foolish. Other than that ...
Quote of the Week
"Think like a man of action, act like a man of thought."
-- Henri Bergson