How did markets fare this week?
We closed September and ended up Monday as markets continued their shake-off of impeachment news and political drama. However, Tuesday markets dropped over 300 points as manufacturing activity hit its lowest level since March 2009. The trade war has taken its toll both on sentiment but also on activity. The largest drop in the survey came from the collapse in - you guessed it - export orders. The sell-off accelerated on Wednesday (another 500 points down in the Dow). Thursday, markets were marginally up at the open, but then when even the ISM services data came in far below expectations, markets quickly reversed course to the downside. By press time markets were marginally up again (Thursday).
The basic narrative is that shorter term, the impact of the trade war is indeed working its way through the economy. Markets don't like that. Longer-term, do markets start to see other cracks in the armor? Earnings season is really quite important to shine a light on the state of corporate profits.
I understand the temptation to see the market sell-off as the fear that Elizabeth Warren is now more likely to be elected President in a little over a year. And indeed many market actors and market forces fear that outcome a great deal. But markets have a lot to digest right now around contracting manufacturing and capex, and Occam's razor tells me that is the best explanation.
What impeachment inquiry? "It's the economy, stupid ..."
Those who want to see President Trump re-elected, but are concerned about the impeachment inquiry, may want to change the focus of their concern ... While there is ample political reason that a House impeachment followed by a Senate refusal to conflict could be dangerous for House Democrats, the risk of losing the "calling card message" of a strong economy would be fatal to a Trump re-election. And yet the manufacturing data this month, the employment picture in Rust Belt states...
The good, the bad, and the quarterly
Q3 ended up +1.7% in the S&P 500 (dividend growth did much better), with Utilities, REIT's, and Consumer Staples (so-called "defensive sectors" leading the way), and Energy and Health Care being the big detractors.
Yields dropped 26 basis points in the 3-month T-Bill, 33 basis points in the 10-year treasury, and 41 basis points in the 30-year treasury, leading to the largest performance gain in bond prices in a long time.
Did your Value over Growth story come to fruition in Q3?
It is true that so-called "Value" stocks trounced so-called "Growth" stocks in the third quarter, but it is not true that our forecast of Value as more compelling than Growth was ever intended to be a transitory or cyclical call. It is a timeless call. It is etched in our souls. It is programmed in our DNA. We do not believe that long-term investors do as well buying over-priced stocks as they do buying under-priced stocks. If someone means something different by these silly terms, we'll hear them out. But truth be told, some "value" stocks are not at a great "value" themselves right now. My advice: Avoid style boxes. Avoid indices. Avoid generic labels. Invest bottom-up around fundamental opportunity.
Shorter version: Invest in companies growing the cash flow they return to you year-over-year.
Do failed IPO's and lackluster results from high profile overpriced unprofitable companies mean we are in trouble?
No. Failed IPO's and collapsing stock prices from companies who went public and sold shares in their cash-draining unprofitable companies at excessive prices to gullible investors who love brand names and fads mean that those people who bought them are in trouble, they do not mean that we are in trouble. The market tiring of permanent unprofitability is an entirely predictable reality. The broader market does not struggle from excessive valuation - just certain pockets do. My hope is that the lesson of companies failing in getting an IPO out the door will be a real reminder for those of the permanent realities of markets. There is no free lunch. Profits matter. And capital markets have changed as it pertains to companies coming into public equity markets. More on that last part later!
Did someone say Europe?
I tout the merits of contrarianism for investors as much as I can, and surely very few investment themes could be more contrarian right now than the idea that Europe represents an attractive investment opportunity. But even a contrarian like me struggles to see the opportunity there with the massive distortion of price discovery caused by the bazooka of their central bank, the fiscal disaster that is the state of their sovereign countries, and the total dependence on global trade they are exposed to in a period of growing skepticism about globalization. Political turmoil persists. And frankly, the risk/reward calculus continues to leave Europe a mostly unattractive domicile in our analysis.
Did someone say Fed?
Yes, the President did. But now the market is saying it too, as in the fed futures market, where there is back to a 90%+ chance of another rate cut - this time for October, not December. There is a 50/50 probability of a further rate cut in December as well.
So what are the advantages in the economy?
Many conventional economists point to captain obvious stuff like consumer spending and low unemployment to make the case for a strong economy, and they are not wrong, per se. The problem is that it is the business investment of today that makes for low unemployment or growing wages tomorrow. One leads, the other lags. This is not rocket science. The idea that we can have a weakening business sector yet not see it come into the employment and consumer space eventually is just ridiculous. The question is whether or not the business sector merely bends, or actually breaks.
Corporate tax reform and supply-side incentives for repatriation and business investment is still at play. The problem is that those dynamics are fighting against the uncertainty of the trade war, and the actual reality of collapsing trade. This invites a negative feedback loop with confidence, investment, and productivity. The incentives are still there, combined with a low cost of capital, if the uncertainty of the trade war were not fighting against it. Credit is still healthy, where that permanent issue of "return on invested capital vs. cost of capital" is at play (and right now, favorable).
The advantages are that we have a competitive corporate economy with healthy credit markets and a desirable place for global dollars to be invested. The disadvantage is uncertainty around trade. This isn't a new explanation, and it won't be the last time I offer it.
About that bull market?
A periodic update of our friends at Strategas Research continued monitoring of the "bull market checklist" ...
Repo Fun All Over Again
I don't think last week's section on the Federal reserve interventions in the repo market to ensure proper liquidity in our nation's financial system was quite boring enough, so I thought you may want a part deux to spice things up ...
Why do I not believe this activity has been remotely suggestive of something more inherently unstable in the financial system? Because it is being caused by all that policymakers did to create more inherent stability in the system! There are ample excess reserves on the balance sheets of banks. The problem is that the post-2008 regulatory environment does not merely burden banks (appropriately, I might add) with certain capital ratio requirements, but also with liquidity coverage requirements. Very healthy banks with proper capital reserves and even excess reserves are limited by the liquidity ratios. The technical supply-demand issues that created this situation are overly technical and complicated, but at the end of the day, it comes down to reduced demand for U.S. Treasuries happening in concert with increased demand for overnight funding by primary dealers. The Fed has said they will increase the size of its balance sheet to increase the size of reserves in the banking system, but the reality is that loosening the liquidity ratio would be a more sensible way to get there.
I like what my friend, Jason Trennert, CEO of Strategas Research, said here ... The Fed has done a fine job as 'firefighters' with this repo market mess recently; but they did not do a good job as 'architects' with the system that is now showing vulnerabilities.
Politics & Money: Beltway Bulls and Bears
- The impeachment issues are so out of control politically and rhetorically now (non-partisan comment) that all I can say is the betting odds still show ~60% chance of the House voting to impeach and a less than 20% chance of the Senate voting to convict. The shocker to me is not in any part of the facts of the case (which have predictively separated Americans according to party lines, primarily around their support or lack thereof for the President). Rather, I am somewhat surprised to hear that NAFTA 2.0 is still on the discussion block. The basis for optimism many on both sides have that the deal will still get done is not totally clear to me, but it is the primary thread circulating around the beltway.
- I can't recommend this podcast to you enough in terms of flushing out the implications of the present political environment on your portfolio. Our entire investment committee walks through where political issues matter, and where they don't, and suggests four categories for evaluating Presidential implications on investment markets (legislative, executive, rhetorical, and popularity).
- A major argument against a progressive-leftist President doing significant damage to the economy is the notion that a GOP-majority Senate would not let the damage get done. Some are concerned that the GOP holding the Senate would be in jeopardy if President Trump's popularity drops further. It is fascinating to see that there are only two states that Trump won where he out-performed the GOP Senator (either in 2016 or 2018) - Missouri and Indiana (neither of which are at GOP risk for 2020 Senate). And there are two states Trump won (Alabama and Michigan) that have a Democrat Senator, and in at least Alabama there is a big chance that seat reverts to the Republican. The two states that Trump lost with a Republican running for re-election in the Senate? Susan Collins in Maine, and Cory Gardner in Colorado - both of which have a great (but not assured) chance of re-election.
- Elizabeth Warren's new tax proposal this week? A 75% tax on the money companies spend on lobbying. No comment on the Constitutionality of that ...
Chart of the Week
One of the most important questions for those on "recession watch" is whether or not history is playing out or a set of different circumstances are playing out around the Fed launching rate cut measures late into a cycle. The historical trend has been that a recession follows (and this is more because the recession was going to happen anyways, and the Fed's actions were too late to stop it; not because the Fed's actions caused it). However, you will note there are some cases (mid to late 90's most notably) where the cuts proved to be "mid cycle," not "late cycle," and a recession did not come for a long time. This is, of course, a tautology. We don't know if the cuts were mid-cycle or late-cycle until we know, well, what happened to the cycle.
Quote of the Week
"On Wall Street experience is the teacher. She is a harsh taskmaster. The test comes first, and the lesson comes afterwards."
-- Mark Grant