Keeping an eye on what matters for the economy, Trade.

posted in: Bonds, Economics, Quarterly Letters, Stocks | 0

Dear Friends,

Over the past year and a half, trying to absorb news has felt a bit like drinking water from a fire hose. Like many of you, we have steadily become more concerned and simultaneously more accustomed to the chaos being created by the current US administration. While the actions of our government have deviated from the values of the American people in the past, this disconnect is especially evident today. The government’s high disapproval ratings reinforce the fact that its actions represent a minority of American society. A large majority of Americans are not beguiled by the administration’s base appeals to fear.

Amid all the animosity directed at weaker members of our society, the administration has also undertaken ill-considered actions on trade that we believe will impact investors.

In many industrial fields, US protections for workers and the environment outpace those in developing parts of the world. This, coupled with our relative wealth, creates a situation where set-up costs tend to be higher in the US than they are in less wealthy nations. The international trade norms which have been adopted by much of the world over the past several decades acknowledge this fact. They establish basic labor and environmental protection standards which most nations adhere to. The expectation is that as industries in other countries mature, they face natural pressures to improve labor and environment practices. We can see this dynamic in effect in China, India and much of the developing world as a more assertive labor force organizes itself and citizens demand safer, cleaner, healthier environments. Previous US administrations have largely stuck with this bargain and helped cement it. This administration’s response is markedly different. It has worked relentlessly to demolish protections for workers and the environment, engaging in a race to the bottom. Such an effort will have a long-term impact on our human and ecological capital.

US workers, citizens and enterprises have legitimate concerns about our trade policies. Much of what our country exports is ethereal: movies, software, music, designs and technology are simple to reproduce if the original source is available. American technology companies fend off numerous attempts each day to steal valuable designs or content. Some of these attempts are successful. In several cases, the perpetrators and beneficiaries of such thefts are politically connected businesses.

Prior administrations have worked to slow down and deter such anti-competitive trade practices, opting for targeted action that sought to limit the impact on other industries. The current administration has repeatedly shown a penchant for using a sledgehammer when a scalpel is more appropriate, and this matter is no different. It has embarked on a series of wide-ranging punitive tariffs on a range of goods, from a number of different countries, including China and close allies like the EU and Canada. These countries have begun to respond, slapping tariffs on American exports.

As the cycle of tit-for-tat increases in import duties gathers steam, markets have begun to wobble. Global trade and supply chains rely on orders placed months ahead of time. For the system to function, some degree of price stability has to exist. When prices, or in this case, duties are changing rapidly, traders are apt to overcompensate, not knowing whether the worst of the increases are baked in. An increase in duties can force companies to modify supply chains, moving production to different areas in an effort to avoid tariffs. Newer centers of production take time to ramp up and build expertise. When enough of this happens, supplies become constrained, prices rise, and quality suffers. None of these are good outcomes for enterprise or consumers.

As the administration’s trade war intensifies, driven by a president whose instinct is to always double down, we are not complacent about the risks.

A decline in trade levels will impact a wide swath of American industry, which is deeply interwoven into a global network of production. When trade levels fall, we will see this ripple through corporate expectations and outlook, eventually reducing valuations, earnings and prices.

Based on this outlook, we recommend investors maintain caution and adopt defensive positions. Reducing risk assets and holding a portion of portfolios in low risk securities such as short-term government bonds, fixed deposits or cash remains our priority.

 

Regards,

 

Subir Grewal, CFA, CFP                                                                     Louis Berger

2018 Q1 letter: Why the roller-coaster market is back.

As we noted in our 2017 year-end review, we expect 2018 to be a tough year for the domestic stock market. Rising interest rates and valuation concerns are going to be the major story for investors this year. Stock market valuations remain elevated, with the S&P 500 currently priced at 24 times last year’s earnings. This is far higher than the post-war average of 17 times earnings.

The primary justification for high P/E ratios is the extremely low interest rate environment we’ve experienced in this century. For much of the 80s and 90s, interest rates remained above 5% (see chart below). In contrast, since April 2001, US interest rates have kept well below 5%, apart from 13 months spread between 2006-07.

This unusually low interest-rate environment has support stock prices throughout the 21st century. Low interest rates spur higher stock prices for a variety of reasons:

  • Income oriented investors are driven to the stock market since bonds and bank deposits offer very little return.

  • Future corporate earnings are valued more highly since the discount rate is lower.

  • Consumers and companies take advantage of low interest rates to finance projects and purchases cheaply. This spurs sales.

  • Leverage becomes cheap for speculators, amplifying the amount of money invested the market.

When rates begin to rise, all these supportive factors are reversed, acting as a head-wind for stocks. The Fed has signaled that it intends to continue raising interest rates since unemployment is low and the overall health of the economy remains strong. In our view, rate hikes are the crucial factor driving the recent stock market drops, and we believe this volatility will continue.

There’s no denying the market has been more volatile since January. Over the past three years, the S&P 500 has seen 20 days when it was down more than 2%. Seven of those days have occurred in 2018 (and we’re only in early April). As of this writing, the S&P 500 is now 10% below the peak reached on January 26th. Technology stocks, which had seemed relatively immune to the downturn have also begun to sell-off. Over the long-term, we continue to believe technology will become a larger part of consumer’s lives and our economy. However, just as with every industry, business models can change and seemingly unassailable companies can falter. The current, sky-high valuations for many technology companies leave little room for error.

In our view, conditions remain challenging for the stock market, and investors should adopt or maintain defensive positions. This can be accomplished in multiple ways: holding short-term and floating rate bonds, reducing overall allocations to stocks and shifting into more stable stock-market sectors (such as consumer staples).

As we do on a continuing basis, we have been evaluating client allocations and adjusting investments as warranted. Please let us know if you have questions about your portfolio or holdings.

PS. If there is a friend or relative you believe would benefit from a conversation with us, as always, we would appreciate the introduction.

Regards,

 

 

Subir Grewal, CFA, CFP Louis Berger

Income inequality is rising in America, and corporate boards are to blame.

That’s what I read into the comprehensive analysis of individual income tax returns by Bakija, Cole and Heim. The Washington Post has coverage of their work. The work is a damning indictment of the manner in which corporate boards have abdicated their responsibility towards shareholders to rein in excess corporate compensation. The compensation process is run entirely by alpha-CEOs and compensation consultants who understand which side their bread is buttered. The board is a rubber stamp.

The paper also throws cold water at the various excuses presented to justify sky-high executive compensation. High-paid sports professionals, doctors or lawyers are not nearly as numerous as high-paid executives.

What should investors make of the big drops in the stock market.

posted in: Bonds, Markets, Stocks | 0

Dear Friends,

We rarely deliver a mid-quarter email, but the last two days of large drops in the equities markets and recent conversations with clients have prompted us to provide this update.

On Friday, the Dow Jones Industrial Average dropped 666 points (2.6%), which was followed by a 1,175 point drop (4.6%) today.

The S&P500 (a far broader index of stocks) dropped 60 points (2.1%) on Friday, followed by a 113 point drop (4.1%) today.

Intra-day action was even more extreme, with the market down over 6% mid-day today (almost 1600 points on the Dow).

These drops have brought us 1% below where the market was at the beginning of the year and below where broad markets traded when the tax bill was passed in December.

Though these are large point drops, they are not particularly extreme when seen in percentage terms. 4% one-day drops are relatively frequent, occurring every several years, the last one was in 2011. The Dow has dropped by over 7% on 20 separate occasion, four of those drops occurred in 2008 alone.

In its 95 year history, the S&P 500 (which includes a far larger group of stocks) has dropped by more than 5% on at least 20 separate days. Today’s drop, though severe, did not make it into that list.

Viewed in a broader perspective, these drops are severe, but not extreme.

That said, as we cautioned in our annual outlook, stocks remain at historically high levels with various indicators suggesting headwinds for businesses and stock market investors. Stock market valuations are at cyclical peaks. The US economy has been expanding for 9 years, making this one of the longest booms in history. Job growth has slowed over the past year, signalling some economic cooling, though unemployment remains very low and corporate earnings are strong. Underlying economic conditions are still robust, but elevated valuations remain a concern.

In our view, the recent skittishness in equities markets is driven mostly by interest rates. Interest rates on long dated bonds (10-30Y) have continued to climb. The 10Y treasury yield in particular has risen sharply this year. These long-term rates drive key economic decisions and are one of the indicators we watch closely. The 10Y rate is used to price most mortgages, and many companies use 5-10 year rates to evaluate the costs/benefits of projects and investments. Rising rates increase costs for home-buyers and all long-term investments, reducing activity in these sectors. Rising rates also impact disposable income for investors who carry credit card balances (which are at an all time high), and for investors who trade on margin (margin balances are also at an all time high). Most importantly, rising rates impact corporate earnings. US corporate debt stands at almost $9 Trillion. Not all of it is held by public companies, and  rates on most corporate debt is pre-set for a period of years. Still, every 1% rise in interest rates translates into tens of billions in additional interest expense for corporations, reducing corporate profits.

Though today saw a large drop in longer-term rates as investors rushed to the safety of Treasuries, we believe this is temporary and rates will continue to rise in the near term. The Fed will continue to unwind its bloated balance sheet to the tune of $30 billion a month, providing a source of supply for skittish equities investors retreating to bonds.

Overall, higher interest rates act as a brake on economic activity. It is this anticipation of higher interest rates and an end to the Fed’s unprecedented policy of quantitative easing that is driving the stock market declines.

We reiterate our year-end advice. Investors should adopt a cautious allocation and be aware of the headwinds we face.

Please give us a call at 646-450-9772 if you would like to discuss your specific circumstances.
Regards,

 

Subir Grewal, CFA, CFP                   Louis Berger

2018 Economic Themes: Machines, Bitcoins, Space and Technology.

posted in: Markets | 0

Dear Friends,

We trust you’ve had a wonderful holiday season and a good start to the New Year.

As we dig ourselves out from one of the first winter storms and a biting cold front, we have been considering the year ahead and what it may bring for investors. 2017 ended with a remarkable rally in December. This was fueled by the passage of a tax bill that generally favors investors and corporations. Though this tax-bill may have provided some short-term boost to the markets, we believe it’s long term impact will be quite mixed. The bill is estimated to create an unfunded deficit of approximately $1.5 Trillion. This amount of deficit spending would generally give rise to fears of inflation, which seem to have been largely ignored. We are also skeptical about the claim that the bill simplifies the tax code significantly. It is true that a larger proportion of individual filers will now claim the standard deduction, but there are several other complexities introduced by the bill for both individual and business filers which will be argued over by tax accountants for years.

In many other countries, the tax authorities prepare a return/statement at the end of the year for tax-filers which can then be contested/corrected. No such mechanism for low/middle-income Americans is anticipated in this bill. We are also skeptical about claims that the corporate tax cuts embedded in this bill will spur investment or boost anemic wage growth. Corporations are already holding record cash reserves, and wage growth in the US has been slow for decades, largely due to the legislature’s failure to increase the minimum wage. As such, we believe the tax bill will have a limited impact on medium-term prospects. Given our view on the 2018 mid-terms, there is a good chance many provisions will be reversed within a year.

A list of the top 10 economic themes we expect to see this year follows. A graded ranking of our themes from last year is also available.

Regards,

 

Subir Grewal, CFA, CFP                   Louis Berger


 

2018 Economic Themes: Machines, Bitcoins, Space and Technology.

 

  1. Slow But Steady Rate Rise.  The Fed has signaled no intention to halt its program of bond sales and interest rate hikes. Over $400 billion worth of the Fed’s Treasury bond holdings will come due in 2018. The normalization program announced in 2015 suggests the Fed will not reinvest most of the principal. Many billions in principal repayments on the Fed’s MBS (mortgage-backed securities) holdings will also not be reinvested. In aggregate, we expect the Fed’s normalization actions will withdraw $300-$400 Billion from money supply in 2018. We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% range. Both these actions will place additional pressure on stocks.
  2. Year of the Donkey.  We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal government. We expect the Democratic party to win a majority in the House of Representatives and we suspect there is a real possibility (40%) they will take the Senate as well. Such a result would stall or reverse the Trump administration’s legislative agenda. We expect congressional investigations of the administration to intensify as a result.
  3. The Bull Runs Out of Steam.  We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two years. Margin debt is now at all time highs, at 1.6 times the peak reached in 2007. We have been advising caution for the past few years while the market has continued to rise. However, we see no reason to change our short/medium term forecast given stretched valuations and the age of this bull market (now entering its 9th year).
  4. Rise of the Machines.  2017 saw various automation/AI technologies gain a firm foothold among consumers. Siri, Alexa, Google Home and several voice activated car-technologies have become second nature to millions of people. We believe this trend will continue in 2018 and we will see the initial emergence of voice-activated AI/automation being married with robots/machinery. This has already begun in cars, but we expect intelligent home devices to begin controlling autonomous vacuum cleaners, window washing drones and other small devices. As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.
  5. International Beats Domestic.  We expect international stocks, especially European markets, to outperform the US in 2018. Emerging market fundamentals remain broadly positive, and we expect these markets to perform reasonably well while we are expecting a negative year in the US.
  6. Bitcoin Bust.  2017 saw immense interest in crypto-currencies, particularly Bitcoin. Prices were driven up by sky-high demand and fixed supply (the total amount of Bitcoins in circulation increases only by a very small percentage each year). The sharp rise was partially fueled by speculation around new ETFs that seek to track Bitcoin prices and open up the market to more traditional investors. We believe some of the technologies embedded in Bitcoin, especially the peer-to-peer transactions and public ledger/blockchain, are innovative and do have a future. That said, Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018.
  7. Renewables Redux.  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities. We expect this trend to continue through 2018 as YieldCos will benefit from robust demand for renewably sourced electricity (by both the public and private sectors), increased efficiency from solar and wind power, newer fleets that require less maintenance and a smaller scale that allow them to operate more nimbly compared to their conventional peers.
  8. Organics Go Mainstream.  Organic food products are the fastest growing segment of the US food industry. Sales have increased by high single digits in recent years while the overall food market has remained stagnant. Though some of the major food behemoths have launched their own organic food lines or acquired smaller start-ups, they continue to play catch-up in this arena. We think organic food stocks will outperform conventional food stocks this year.
  9. New Dawn of Space Race.  2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission. As commercial space missions become routine and the prospect of mining asteroids and the moon becomes a reality, we expect a secular rethinking of the prospects for natural resource mining enterprises that are earth-bound. The trend itself will take a couple of decades to reach fruition, but we expect earth-side mining for certain materials to decline over time in favor of extraction in space. We realize this sounds far-fetched, but technological changes over 20 year cycles can be immense (for example, compare internet ubiquity with where we were in 1997). The technology to permit the creation of largely automated mines on the moon or an asteroid are largely available today.
  10. Net Neutrality Fallout.  Though the revision of net neutrality rules was overshadowed by the tax bill negotiations, it was a landmark change. We expect to see tangible impact to the way consumers experience the internet as a result of the FCC’s contentious decision to remove net neutrality.  This reversal tilts the playing field towards telecommunications companies and away from content providers. We expect telecommunications firms will seek to exploit the ability to meter bandwidth and extract rents from content providers. ISPs will start to create fast lanes and we may see some of the large content firms seek to create their own networks. Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.