If a presidential candidate berates the Fed and no one pays attention, do markets still react?

posted in: Bonds, Markets, Stocks, USA, World | 0

The Federal Reserve chose not to raise rates in September, despite speculation by many participants that they would. The decision went as we expected since the Fed is generally unwilling to move rates this close to a presidential election. As an institution, the Fed is very reluctant to take actions that could be interpreted as favoring one or another party. Absent a genuine crisis (as in 2008), Fed governors will heavily favor inaction in a presidential election year. Inaction in this instance means an expansionary monetary policy with very low rates, and this does indeed benefit the incumbent party. In our view, this is more accidental than deliberate.

For a number of decades, central bankers have walked a fine line. They are political appointees, but their decisions are supposed to be apolitical, and they enjoy a degree of independence not afforded to the heads of other government agencies. Like all senior government officials, Fed governors are politically attuned and they undoubtedly have personal political preferences. In a normal election year, with a more typical slate of candidates, Fed inaction might lead to quiet grumblings within DC circles. But this is not a normal election year.

We have seen Mr. Trump repeatedly attack the Federal Reserve chair, Janet Yellen, in very personal terms for keeping rates low. This has received very little attention among all the other political news and outrageous statements by Mr. Trump in this cycle. As with so many things this year, we cannot say whether or not berating Fed officials will become the political norm.

What we do know is that in most countries, the slightest hint of overt political “interference” in central banking decisions can spook markets. The enormous volatility of the South African Rand over the past year is a case in point. European markets saw similar gyrations during the months leading up to Mario Draghi’s succession of Jean-Claude Trichet.

Though berating the Fed is a small part of Mr. Trump’s political plank, we had to go back to Williams Jennings Bryant’s candidacies of 1896 or 1900 to find an instance where central bankers and monetary policy was dragged into an American political contest in such a way. And that was back when US dollars were backed by gold in a fixed amount. Neither the Nixon administration’s abrogation of the gold standard nor Mr. Volcker’s unremitting steps to control inflation elicited such personal invective. As long as Mr. Trump’s chances of winning the presidency remain slim, the market will remain sanguine. If the prospect of a Trump presidency were to become more likely, we expect the future monetary policy of the US to become an area of immense concern for the markets.

We have discussed interest rates extensively in our previous letters, and would like to briefly turn our attention to debt levels. Extremely high levels of debt were the primary cause of the 2006-2009 financial crisis and generally make for a riskier financial system. Though US households and enterprises continue to reduce debt (deleverage), global debt levels have continued to rise. Looking at World Bank and IMF data, we can see that global private sector credit now exceeds 2008 levels (measured as a percentage of GDP). US private sector debt, at almost two times GDP, remains higher than the global average. Much of the growth in global debt levels has come from China where debt to GDP levels have risen significantly. In 2008, the World Bank pegged Chinese domestic credit at 100% of GDP. By 2015, this had risen to 150%.

Chinese debt has not yet reached extreme levels, but the rate of growth is more extreme than it was in the US between 1994 (when debt was 120% of GDP) and 2008 (when it reached a peak of 206%). Economies linked to China in the Asia-Pacific region (Australia in particular) have seen increases of similar magnitude. Latin America and the Middle East round out the regions where debt loads have increased, but levels remain relatively low, around 60-70% of GDP. China remains the biggest risk, since it has a relatively immature credit market which has seen enormous growth in the past decade.

In the US, equities markets have remained in a tight range for the past three years as consumers chose to reduce debt and forgo spending. The S&P 500 has continued trading between 1800 and 2200 since 2014. This can also be partly attributed to the tail end of the business cycle, with no immediate catalyst for either further growth or a retraction. At this stage, we would expect inflationary concerns to force interest rate hikes, but inflation is low to non-existent as consumers continue to reduce leverage and remain price-conscious. For the Fed, this remains a challenging period, with few answers available in textbooks. That said, we expect the Fed will raise interest rates in December, after the election is safely settled, likely by 0.25%.

Investors face similar uncertainties and we continue to advocate for cautious asset allocation and a focus on defensive companies and sectors.

United For Action SRI Presentation

Louis will be speaking about Socially Responsible Investing at the monthly United For Action meeting this Thursday, September 8th from 6:30-7:30.  United For Action is Non-Profit organization comprised of volunteers who shape public policy decisions by organizing and mobilizing groups of like-minded citizens to promote public health and sustainability.  The meeting is open to the public and will be held at the New York Society for Ethical Culture.  Further details about the event can be found here.

Brexit and the rise of Populist Isolationism

posted in: Markets | 1


The second quarter of 2016 saw some stabilization in global equities after a very volatile Q1. But this calm was short-lived as the surprise results of the Brexit vote roiled markets in the last weeks of the quarter.

We do not believe the Brexit referendum in itself will have a significant impact on the global investment climate or opportunities for investors. Whether the UK remains within the EU, or exits and reaches an alternate trade agreement with the EU, is of marginal significance to investors, especially those outside of Europe. The initial impact is almost certainly restricted to the UK itself, which may see a political disintegration if Scotland dissolves the union with England and Wales. Peripheral EU countries with significant deficits/debt (Greece, Spain, Portugal, Italy) would see a further erosion in confidence as a large, economically vibrant member leaves the EU. The financial industry in the UK is bound to see some contraction if Britain exits. The large London-based banks employ tens of thousands of workers, many carrying European passports. If the pool of available recruits narrows, banks are likely to expand offices in other cities. Dublin, Frankfurt and Paris are obvious alternatives, Switzerland is another continental (though non-EU) option. An exit will also mean personal data that pertains to EU nationals can no longer be stored or retained in the UK. This will impact technology companies and data-centers, where, as a result, the UK will find its market in those industries contracting as well.

An exit would permit the UK to enter into trade agreements with third (non-EU) countries, including former colonies such as India, with far more freedom than it would enjoy within the EU. After a period of adjustment, we would expect the UK economy to resume whatever long-term trajectory it would otherwise have had given demographic trends. The costs of adjustment if Britain does exit will be extensive. Regulations will need to be re-written, border procedures modified, passports re-issued, and undoubtedly the political costs will be enormous. Bickering over the result is bound to continue for years and indeed decades. But these costs will not continue into perpetuity.

This is not to say Brexit is insignificant. From a political perspective, it is extremely significant. It is yet another important signal that the enormous economic, demographic, environmental and political changes of the past few decades have left large segments of many populations with a sense of discontent and loss. Since the collapse of the Soviet Union, we have seen enormous changes in rapid succession. Technology has disrupted many industries, expanded markets and brought new competitors to formerly isolated corners of the world. Online marketplaces allow distributors to reach virtually every person in an increasingly connected world with ubiquitous network access. It has also led to an increasing concentration of wealth in many parts of the world. Environmental and political upheavals have created a historically high number of refugees fleeing war or lack of opportunity. Urbanization is on the rise virtually everywhere with populations moving to cities in record numbers. Large cities across the world, and their surrounding areas, have become ever more diverse and globally inter-connected. Asia, with its enormous population, has historically been the center of global trade and economic activity. After almost two centuries of relative decline, Asian economies are seeing rapid, sustained growth.

Brexit reminds us that these changes are unwelcome to many. Rural areas across the world, industrial areas in the western world, those with nationalist sentiments, and older populations everywhere see an erosion of all that is familiar and comforting. Every crisis is seen as an indictment of an global elite forcing such changes on a reluctant population. In many ways these political forces are not new. They have always been with us and have simply gathered force as the impact of changes has risen. Every era of change and migration has encountered some degree of resistance; this includes prior periods of urbanization and industrialization across the world. Yet, even in the recent UK referendum, 48% of voters, and large majorities of younger voters, opted for remain.

The broader question for us as investors is whether or not political systems will be able to manage these changes peacefully and with as little disruption to daily activity as possible. Quite clearly, this is not the case in many parts of the world. Our view is that democracies have a better chance of managing such change peacefully. Yet, even in the US, the remarkable strength of an openly nativist and populist candidate such as Trump should serve as a warning. Enormous changes such as those we have seen over the past three decades have to be managed with care lest they alienate large portions of the population. That alienation, if allowed to fester, can create a window of opportunity for disruptive forces to attain power. This would pose a real risk to continued stability and the prosperity and well-being that accrue from it.

Quite apart from the significant political risks ahead, equities markets are at cyclically-high valuations. Bond prices too are at high valuations with interest rates at low levels. In our view, as value oriented investors, we see limited rewards for taking excess risk. Accordingly, we continue to advise clients to maintain a relatively conservative portfolio allocation, keeping in mind their long-term objectives and recommended allocation.




Subir Grewal, CFA                                    Louis Berger

2016 Q1 letter: Negative interest rates cap a rocky quarter


The first quarter of 2016 saw market gyrations far rockier than many prognosticators had expected. A sharp drop in commodities prices and oil in particular sparked fears of a global slow-down and impacted all asset classes. Increased oil production in North America and the prospect of renewed imports from Iran led to expectations of a supply glut. Slowing economies in China, Brazil and Russia along with concern about potential slumps in the EU and US drove demand expectations down. Together, they combined to drive oil below $30 a barrel, causing great distress among the highest cost operators. Producers relying on deep sea projects (Brazil) and hydraulic fracturing (or fracking, in North America) have been among the most severely affected. Many small to mid-sized servicers and production companies are facing possible bankruptcy and have been liquidating assets. This has impacted the high-yield bond market (where many of these companies raised capital) and led to job losses in states where fracking had created small oil booms.

The commodity decline also caused steep retrenchment in various equity markets and drove the Federal Reserve to signal a pause in its plan to raise interest rates to 1% this year. The S&P 500 dropped as much 13% during the quarter and the MSCI Global stock index fell 11%. The S&P 500 has since recovered for the year, along with oil prices. In our view, the concerns that drove the asset market declines have not abated. Global growth continues to be weak and numerous markets are showing the signs of a waning seven year bull market. We would continue to urge caution when investing in risk assets across most markets.

Policy makers in several countries seem to have reached the end of their imagination when it comes to additional market stimulus. About 25% of the global economy now has negative interest rates. That includes the Euro-zone, Japan, Switzerland and Sweden. Banks are now being charged to maintain balances at the central bank. In a number of cases, banks have begun to pass these negative rates on to customers. This is bound to create great consternation. Depositors are not accustomed to being charged interest to maintain deposits. They may be used to seeing fees deducted from checking accounts, but most will be shocked to see savings accounts charged interest. In an environment where banks are already suspect in the eyes of many, this will lead to even more discontent.

From anecdotal evidence, customers have already begun to protest negative rates. We believe there is little sense in keeping rates negative for extended periods of time. In theory, it sounds reasonable to say there should be no zero-bound for rates. But humans are not theoretical creatures. We find being charged to keep our money in a bank rather strange, and customers will develop all sorts of behaviors to avoid this. These include keeping large sums of cash at home and purchasing safe haven non-financial assets (real-estate, precious metals etc.). Such behavior undermines the stated aims of negative rates, i.e. increasing the level of bank lending. The longer we maintain negative rates, the more distortions we introduce into the savings/money markets. In our view, this is not a policy that regulators should maintain for any period of time. It would be far more effective to apply fiscal stimulus in the form of government spending.

While markets have seemingly stabilized after a very volatile start to the year, we expect 2016 will see continued ups and downs with high risk assets remaining vulnerable to a price correction. We think this will present buying opportunities and we will continue to look for good entry points to buy equities we see as undervalued. We expect the market for bonds to remain very challenging for investors since rates are extremely low and corporate credit is deteriorating alongside the dip in global growth.


Subir Grewal                                                                                                 Louis Berger

2016 Investment Themes: An Uphill Battle

posted in: Markets | 0
  1. Fed stays the course: We expect short term rates to rise by 1% over 2016, and believe long-term rate rises will be roughly commensurate. We believe the Fed’s board will stick with their stated intentions, it would require dramatic events to make them change course during an election year.


  1. A return to risk: We believe risk concerns will weigh on markets all year, primarily driven by rate hikes, stagnant/declining earnings and a slowdown in demand in China and other markets. Continued war and turmoil in the Middle-East and uncertainty in US presidential election could add to the negative sentiment. US equities markets will be down for the year, with a strong possibility that we see a decline of 20% or more over the course of the year.


  1. Oil is red: We expect oil prices to continue to be weak in 2016, oil is likely to see the $20-25 range. We expect oil companies (particularly E&P) to face continued stress and expect defaults on high-yield issues in the sector. Oil price declines continue to be driven by softer demand in Asia (particularly China). Expanding supply has also played a role, for the first time in over 40 years, the US will export oil in 2016 (this had been prevented by law since the 70s oil crisis).


  1. Emerging markets comeback: We believe smaller emerging market equities will outperform developed markets in North America and Europe which we expect to be stuck in the doldrums during 2016. This opens up opportunities for smaller Asian (ex-China/Russia) and African markets to outperform.


  1. A Tech-wreck redux: Technology companies have been among the strongest performers over the past few years. This has been true for both listed and privately traded companies. Some of the outperformance is driven by actual changes in consumer and business behavior; more leisure and work activity is moving online, and that creates opportunities for technology companies that did not exist earlier. However, extremely optimistic valuations for unproven business models have become the norm and we believe the inevitable reckoning is quite likely to occur this year.


  1. Commodity economies fumble: Australia and Canada were both spared the worst of the global financial crisis thanks to their resource driven economies and the determination by some governments to support heavy industries that consume them. Neither country suffered a significant real-estate correction for example. We believe both will be among the worst performing markets in 2016.


  1. The greenback still rules: We expect upheaval in a number of markets to drive a flight to safety and support USD through 2016. We believe the dollar continues to remain strong in 2016 against Euro and other major currencies.


  1. Renewables: We are long-term believers in the prospects of the renewable energy industry and the recently concluded Paris accords should support prices in the sector. The extension of solar credits should also boost the domestic market. We expect renewables to continue outperforming their conventional energy counterparts.


  1. Presidential election: 2016 is a US presidential election year and an unusual one to boot. We believe the sentiment favors non-traditional candidates who reject the status-quo. There is a strong possibility one or both major party nominees will be from outside the establishment mainstream. In part this reflects a broad decline in deference to the governing class after the financial crisis of 2008 and the decade that preceded it. Recent European elections in France, Hungary and Greece have reflected similar sentiments. If as we suspect, a candidate opposed to the status-quo ends up on a major party ticket, this will create additional uncertainty weighing on markets in 2016.


  1. Unemployment Rises: We expect headline unemployment in the US to end the year above 5%. The softening in global demand, rising rates (however slight) and lackluster earnings we expect will also impact employment within the US. This is in keeping with our expectations of an economic downturn during 2016.