The financial markets saw a substantial sell-off in risk assets today as all major US stock market indices closed down over 7%. Current market levels are roughly 1-2% away from levels that would signal a bear market (20% down from recent highs). The decline was so steep, market circuit breakers kicked in this morning, halting trading for 15 minutes. Market wide trading halts have not been triggered since 1997. Currency and commodities markets have also seen extreme moves.
The moves in the bond market can only be described as unprecedented. The yield on the entire US Treasury bond curve is now below 1%. Investors are demanding less than 1% annual interest to lend to the US government for 30 years. These levels have never been seen before, and are indicative of a flight to low-risk assets by investors. Gold, another safe haven asset popular during volatile times, also reached a 7 year high today.
In our view, there are two precipitating factors for these moves:
We are at the end of an 11 year bull market where US equities have returned over 400%. Valuations were, and continue to be at high levels.
As we discussed in our note last week, the measures being taken to contain the Corona virus outbreak have an impact on economic activity and could lead much of the world into recession.
Our view on the first is not a surprise. to our readers. We have expressed our valuation concerns for several quarters and are not taken aback that the broader market has begun to share them.
On the second, we believe the measures required to contain this dangerous virus may easily have a significant impact on the economy. Several regions across the world, including all of Italy, have mandated quarantines and closed schools. Such steps can curtail economic activity for weeks. Major employers in the north-western US have mandated employees work from home. Many large US employers have curtailed non-essential travel. The impact on the airlines, hospitality and oil industries is already significant, with airline executives comparing the environment to the period after 9/11.
We believe there are significant risks that remain to be expressed. We have repeatedly asked ourselves where the good news is, and cannot come up with a good answer. The market is already pricing in zero interest rates for the next 30 years. Interest rate policy has effectively been neutered. The Federal Reserve has lost substantial credibility under this administration. The market seems skeptical of both fiscal and monetary stimulus, unconvinced either or both can prevent further drops.
We continue to advocate a defensive position and do not see a quick recovery to previous levels for risky assets like stocks. That said, with steep sell-offs come opportunities and we are looking closely at where to deploy capital when valuations become more favorable. We don’t think valuations are there yet, but at some point there will be an opportunity to buy high quality companies at discounted prices.
Please contact us if you would like to discuss your portfolio or investment allocation.
Regards,
Subir Grewal, CFA, CFP Louis Berger
What would a Bernie Sanders administration mean for the economy and markets?
With the Iowa, New Hampshire and Nevada largely behind us, and South Carolina tomorrow, the likelihood that Bernie Sanders will be the Democratic nominee for president has grown. 538 now places this probability at 40%. We believe it is time to meaningfully engage with this possibility and consider what it would mean for the US economy and the markets.
In our view, Sanders’ agenda is a robust response to rising income inequality and market failures in the 21st century. His biggest proposals, Medicare for All and College for All, enjoy majority support among voters. There is evidence to suggest US voters (particularly younger ones) are not as ideologically fixed as many assume. Lastly, since his initially quixotic 2016 campaign, Senator Sanders has succeeded in expanding the overton window, i.e. what is considered possible in US politics. We take his agenda seriously.
A full consideration of Sanders’ program will require more than a single blog post. We choose to begin with a look at Senator Sanders’ signature policy proposal, his Medicare For All plan. Other major policy proposals and stances will be considered in later installments. We should however, make some general thematic remarks on Senator Sanders policy platform.
Senator Sanders’ proposals are often presented as “radical”. In truth, they match the social democratic policies in place across much of Europe and the rest of the industrialized world. Proposals such as College for All align well with past US policy. College tuition at most public colleges in the 60s/70s was either very low or free.
Some of Sanders’ more ambitious policies attempt to tackle systemic risks related to market failures. His proposals to address climate change, extreme inequality and breaking up the largest banks are pretty conventional prescriptions to address the market’s inability to price externalities, protect the rule of law, and prevent speculative credit crises respectively. There is a case to be made that such measures would make our economic system more resilient and lay a lasting architecture for prosperity.
Many of Sanders’ policies have been enacted in other parts of the world so we have a benchmark to compare against. The United Kingdom, France, Italy and Canada have single-payer healthcare systems, few would claim this has impacted their long-term growth negatively. If anything, there is some evidence that the unpredictability of health care costs in the US has driven industrial production towards Canada, where a single payer system equalizes costs among employers.
We should also note that improving the health, well-being and longevity of the human population is a valuable and laudable goal. Even when using the narrow criteria of economic/GDP growth, healthcare and public health are critical. Our economy depends on human ingenuity to add value to material resources. Health and well-being are necessary to make this possible. The public health crisis that is the COVID-19 virus outbreak brings this into sharp relief. The rapid spread of this virus has already impacted economies and markets on multiple continents. Healthcare systems that are free at the point of service, with a strong primary care network lead to early diagnosis and response to such outbreaks. Imagine a healthcare system where people who are sick do not visit the doctor because they cannot shoulder the costs, or worse yet, continue to work because they do not have paid sick leave. Both have deleterious effects on short-term economic activity and long-term potential, by impacting human capital.
We assume most readers are familiar with the contours of Senator Sanders’ Medicare For All proposal. The highlights:
creates a “public option” in the first year
expands Medicare services to cover dental, vision, long-term care and all necessary medical procedures
eliminates co-pays and deductibles, making healthcare free at point of service
covers the cost of all prescribed medications
expands eligibility to cover all US residents over four years, creating a single-payer healthcare system
private insurance is prohibited from covering services covered by Medicare For All
eliminates all past-due medical debt
Medical service providers (hospitals, doctors, laboratories) continue to operate independently and bill Medicare for services.
If enacted, this proposal would make health insurance companies largely obsolete. Some rump services (elective surgery, health insurance for foreign travelers, etc.) would survive. Most health insurers would shrink to other insurance lines (P&C, life, liability etc.). Service providers that refuse to accept Medicare and its reimbursement rates would be left with a small pool of US patients who can afford to pay for medical services entirely out of pocket.
This is clearly negative for the health insurance industry. The proposal includes funding to retrain workers and help them find work, but there is no such provision for businesses. The US spends an outsized amount on healthcare, Senator Sanders claims his proposals would reduce this fraction while expanding coverage. This is only possible if the system reduces costs significantly.
US healthcare expenditures are an outlier among OECD countries. World Bank data.
If a single-payer system is implemented in the US, it would almost certainly reduce costs. Some of this would come from lower overhead. Health insurance companies typically expend 20% of their revenues on costs other than reimbursement for medical services. In contrast, the current Medicare system operates at a much lower 3% overhead. Most observers also believe additional savings would be realized by delivering timely primary and preventative care to all, rather than expensive emergency care when maladies have become worse.
A detailed study published in The Lancet arrives at similar conclusions:
Taking into account both the costs of coverage expansion and the savings that would be achieved through the Medicare for All Act, we calculate that a single-payer, universal health-care system is likely to lead to a 13% savings in national health-care expenditure, equivalent to more than US$450 billion annually (based on the value of the US$ in 2017). The entire system could be funded with less financial outlay than is incurred by employers and households paying for health-care premiums combined with existing government allocations. This shift to single-payer health care would provide the greatest relief to lower-income households. Furthermore, we estimate that ensuring health-care access for all Americans would save more than 68,000 lives and 1.73 million life-years every year compared with the status quo.
Under Medicare for All, medical service providers would also face restructuring. Medicare’s reimbursement rates are generally lower than those offered by private plans. This may be partially offset by eliminating the complexity involved in billing thousands of health insurers and millions of individual patients. Since Medicare is a reliable payer, the effort and expense involved in managing unpaid bills would disappear for most health practices. These assumptions are validated by a survey of academic literature in the academic journal PLOS Medicine:
We found that 19 (86%) of the analyses predicted net savings (median net result was a savings of 3.46% of total costs) in the first year of program operation and 20 (91%) predicted savings over several years; anticipated growth rates would result in long-term net savings for all plans. The largest source of savings was simplified payment administration (median 8.8%), and the best predictors of net savings were the magnitude of utilization increase, and savings on administration and drug costs (R2 of 0.035, 0.43, and 0.62, respectively).
The benefits of Medicare for All would accrue to a broad cross-section of individuals and employers:
Health-care costs should begin to trend downward over time, from roughly 16% of GDP currently, to the 8-10% average across OECD countries.
Individuals would be guaranteed health-care free at the point of service. Our expectation is that this will quickly lead to better health outcomes across the US, eventually matching other developed countries.
US life expectancy should rise over time from the current 79 years to approach Canada’s 82 years.
US infant mortality rates should also fall from 6.5 per 1,000 live births to Canada’s 5.0.
By removing all cost-related barriers to health care, Medicare For All should result in increased use of preventative healthcare. This in turn should lead to a healthier work-force, increasing productivity.
Employers would no longer have to expend significant resources to evaluate, choose and maintain health insurance plans for employees.
Individuals would no longer have to expend time and effort on choosing plans and battling for reimbursement when they have medical expenses. By our estimate, this should result in a time savings of 2 days for every person in the US.
Almost 79 million US residents have medical debt. Academic research suggests such overhangs reduce economic activity and consumer spending. Medical debt also leads to hundreds of thousands of bankruptcies each year. Wiping out such debt should have a positive effect on growth.
Labor mobility should be improved by instituting universal healthcare that is free at point of service. The academic literature is quite clear that employer-linked health insurance reduces labor mobility and locks employees to jobs that may not be a desirable. COBRA does alleviate some of these concerns, but not entirely.
With such varied effects, it is difficult to estimate the overall short and medium term impact on US economic activity overall. From the experience of other industrialized economies, it seems clear that investments in public health improve long-term economic prospects. Taken together, these effects could add up to several points in additional GDP growth over 10 years.
We generally assume that the market reaction to a Sanders’ Medicare For All enactment will be negative to flat. Health markets in most jurisdictions do have some sort of price control and there is a case to be made for them in a market with the sort of information disparities and local monopolies that health care has. Yet many market participants instinctively recoil from price controls and our assumption is that the general market reaction to a single payer plan will be negative. Any longer-term impacts will take a while to materialize. Sanders’ proposals to raise capital gains rates, implement wealth taxes and a capital markets transaction tax are all more likely to affect market sentiment.
We will evaluate Senator Sanders’ College for All proposal in a later post, for now, we will note that home-ownership and head-of-household rates for adults in their 20s, 30s and 40s have been declining since 2007 and never recovered. That is a very strong indicator of lasting debt overhangs.
forgiving student debt would allow deeply indebted graduates an opportunity to embark on household formation without the burden of a debt overhang.
Each of these claims should be evaluated on its merits. We are skeptical of arguments relying on conventionally accepted political principles that dismiss this reasoning out of hand (eg. “it would never work”, “it is too costly”, “it’s insane”). There are several industrialized economies where higher education is free or very low-cost, these can serve as a model for analysis.
We hope you’ve had a restful holiday season with family and a pleasant start to the New Year.
The fourth quarter of 2018 saw steep declines in US stocks, with certain indices entering bear markets (20% below their highs). Amid these moves, the Federal Reserve followed through on broadly held expectations and raised its benchmark Fed Funds rate to 2.5%. Taking a longer view, it’s clear the post 2000 era has been unusual. From 1962 to 2000, the Federal Reserve had never lowered rates below 2.5%. Since 2000, rates have remained below 2.5% for 15 of the last 18 years. Extremely low interest rates were made feasible by the near disappearance of inflationary pressure in the US. Prices for most manufactured goods have been kept low for over two decades as manufacturing was outsourced and large Asian populations were integrated into global industrial production. This multi-decade trend has allowed US and European central banks keep interest rates at historic lows without triggering inflation. Absent a dramatic reversal in global trade policy, we do believe this long-term trend will continue. In the near term, the Fed chairman has signaled two more interest rate hikes are expected in 2019 which would take the benchmark rate to 3%. We believe the Fed is more likely than not to follow through on these hikes, for two reasons:
1. Q4 saw unprecedented pressure from the White House on the Federal Reserve to avoid a rate hike. This included rumors that the president had sought to dismiss chairman Powell in an attempt to influence interest policy. The White House does not have the authority to dismiss the chairman except for cause, and we believe the Fed will be keen to demonstrate its independence by following through on its previously broadcast intentions.
2. Fed governors are well aware that recessionary risks are high in 2019. If the Fed Funds peaked at 3%, the Fed would have more room to respond to a downturn using rate cuts alone. We believe Fed governors would prefer to use interest rates to respond to the next recession, rather than a revival of the unprecedented Quantitative Easing (QE) program put in place in 2008.
Normalized rates, trade disputes, a faltering Chinese economy, and concerns about asset valuations in a long-running US bull market combined to deliver a very volatile stock market in December. Stepping back to get a wider perspective, we are nearly ten years into an exceptionally long bull market. Several risks to economic growth materialized over 2018. Central banks globally have pulled back from the exceptional liquidity programs adopted after the financial crisis. These factors combine to create a less forgiving investment environment and makes a so-called soft-landing less likely. In our view, the underlying risks to the US and global economy advocate for continued caution on the part of investors. As always, long-term opportunities will present themselves in choppy markets and we intend to capitalize on them when they do.
We have enclosed our 2019 investment themes as well as a review of our 2018 themes. We hope to have an opportunity to discuss them with you in the near future.
Regards,
Subir Grewal, CFA, CFP Louis Berger
2019 Economic Themes: Return of the Bear
Bear Market Comes out of Hibernation. 2018 saw a major speed bump in the nearly 10 year global bull market run in stocks. We contend this reversal gains steam this year as stocks globally will finish 2019 in firmly negative territory. Trade wars, rising interest rates, inflated asset valuations, and a general slowdown in economic activity will contribute to a “risk-off” environment where investors prefer protection over speculation.
Peak Interest Rates. In December of 2015, after seven years of 0% interest rate policy, the Federal Reserve shifted course and slowly began to raise interest rates in 0.25% increments. At the start of 2019, the effective target rate stands at 2.25%-2.50%. While the Fed has signaled a continuation of rate hikes this year and into 2020, we think rates will peak in 2019 and the Fed will pause before potentially cutting rates if/when a recession materializes. We do not think the Fed will raise past 3% in this year.
Unemployment Rises. 2018 saw the US unemployment rate reach a 49-year low of 3.7%. The US economy has come a long way since unemployment peaked at 10% in October 2009. That said, this expansion cycle looks due for a reversal and we expect the unemployment rate will climb back over 4% in 2019.
Investors Want Value. Since 2009, US growth stocks have outperformed US value stocks in seven of those ten years (including three of the last four). We believe value will outperform growth this year as economic expansion slows and investors shift investment capital into more defensive sectors.
The Unwinnable War. Despite rhetoric from president Trump that trade wars are “easy to win” and a March 1 deadline to resolve the US/China trade dispute, we see no quick and easy resolution to this fiasco. We see 2019 ending with some measure of tariffs still in place, continued global hostility towards the Trump administration and ongoing damage to the US reputation and economy.
Real Estate Reckoning. 2018 saw residential real estate prices finally eclipse the peak reached before the credit crisis. The S&P/Case-Shiller 20 City Composite Home Price index peaked in April 2006 and didn’t reach a bottom until March 2012. Since then, it has seen a nearly 7 year uninterrupted run-up of higher prices. We think this streak comes to an end in 2019 and the index will finish the year lower.
Oil Prices Flounder. After peaking at $86.07 on 10/4/18, Brent Crude oil prices tanked in Q4, finishing the year at $51.49 per barrel. While there may be a short term bounce in prices to start the year, we believe Brent Crude will dip below $50 per barrel and finish the year under that level as global trade slows and energy consumption slackens.
High Times for the Cannabis Industry. In recent years, marijuana has made a steady push into the mainstream as several US states and a few countries have passed legislation to legalize recreational consumption. A nascent industry has emerged to service this growing demand. Many of these companies are small, regional operators, but recently, larger and better-financed corporations have entered the space with many becoming publicly traded entities. While the road has been rocky and the sector has seen large price swings, we think this is an industry poised for long term growth. We expect 2019 will bring more legislation to expand the recreational market and more investments from multinational conglomerates (2018 saw Altria and Constellation Brands invest in the space). We expect publicly traded marijuana stocks will outperform consumer discretionary stocks in 2019.
China Stumbles. Over the course of 2018, we saw several worrying signs that the Chinese economy is slowing. Property prices, which have propped up all other assets for years have slowed, and there are numerous reports that several non-bank lenders have halted redemptions. The trade war with the US has also been a major drag on the economy. 2018 was a terrible year for Chinese stocks — the S&P China Composite index returned -27.82% — and while some investors expect a bounce-back year, we believe 2019 will continue to be a flat to negative market for Chinese equities. The Shanghai Composite remains around 2,500. This is less than half the 5,178 level reached in 2015, which was lower than its all time high of 5,800 in 2007.
Battery Power. A long-term trend we are highlighting in our thinking for 2019 is the growth of plug-in electric vehicles. Roughly 2 million four wheel electric vehicles were sold in 2018. US sales of EVs represented over 1% of total vehicle sales. In California, the largest passenger vehicle market, EV were 4% of all vehicles sold spurred by tax incentives and emissions targets. When we include plug-in hybrid electric vehicles, EV sales account for over 7% of all vehicle sales in California. These figures portend a long-term shift in the transportation industry, of the same degree as driverless cars. 10 years from now, we expect 25% of the world’s vehicle fleet to be battery powered. Over the long-term, this implies a very difficult environment for the oil and gas industry. We expect EV sales to continue to grow in 2019, and global liquid fuels growth to be below 1.3%.
2018 was an uneven year for our market predictions. We were right on six calls and wrong on four calls. While we were right about the general market direction, a few of our sector specific calls were off the mark.
Slow But Steady Rate Rise: 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. The Fed started 2018 with a target interest rate of 1.25%-1.50%, raised rates four times by 0.25% to finish the year with a target rate of 2.25%-2.50%. This was precisely in the range we expected.
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. The 2018 midterm elections resulted in a sharp rebuke to the Republican agenda. Democrats won the House popular vote by a whopping 8.6% and had a net gain of 40 House seats, taking back control of the House of Representatives. They also had a net gain of seven governorships and six state legislative chambers.
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. After a fast start in January, 2018 turned into a down year globally for stocks. In the US, large caps fared best as the S&P 500 index finished the year at -4.38%. Mid caps were hit harder as the S&P MidCap 400 index returned -11.08%. Small Cap value stocks brought up the rear in the US as the S&P 600 Value index returned -12.64%. International stocks lagged the US as the FTSE All World (Ex-US) index returned -14.13%.
Rise of the Machines: As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks. While we strongly believe Artificial Intelligence and Automation companies will be integral to the global economy in years to come, 2018 saw stocks in this sector hit a speed bump as investors sold off more speculative technology names. The Global Robotics and Automation index finished the year at -20.92% while the S&P Global Consumer Discretionary index returned -6.24%.
International Beats Domestic: We expect international stocks, especially European markets, to outperform the US in 2018. We were flat out wrong on this call. International stocks fared worse than US stocks in 2018, with European stocks performing particularly poorly. The S&P 500 index posted a return of -4.38%, the FTSE All World (Ex-US) index returned -14.13% while the MSCI EMU index returned -16.90%.
Bitcoin Bust: Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018. Bitcoin’s meteroic rise in 2017 saw a sharp reversal in 2018 as speculators fled en masse. Bitcoin opened 2018 at $13,444.88 per coin, but finished the year at $3,880.15 per coin, a drop of 73.70%.
Renewables Redux: 2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities. We expect this trend to continue through 2018. While we strongly believe in the long term prospects of renewable power, YieldCo stocks trailed conventional utilities for a variety of reasons: energy prices fell (because of higher up-front costs, YieldCos tend to be more attractive when energy prices are high) and a flight to safety from investors (conventional utilities are a popular safe haven in times of market volatility). The INDXX Global YieldCo index finished the year -4.98% while the S&P Global 1200 Utilities Sector index was up 1.69%.
Organics Go Mainstream: We think organic food stocks will outperform conventional food stocks this year. 2018 was a tough year for packaged food stocks across the board. That said, organic companies performed notably worse than conventional food companies. The MSCI World Food Products index returned -12.99% while the Solactive Organic Food index returned -26.61%.
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. 2018 saw several space related milestones. The highest profile was a successful test launch for SpaceX’s Falcon Heavy rocket, which placed a car in a helio-centric orbit that takes it past Mars. Virgin Galactic completed testing a craft designed for sub-orbital space tourism flights. The most interesting project is the Japanese Hayabusa2 mission. Hayabusa2 successfully rendezvoused with the asteroid Ryugu and placed multiple rovers on the surface. The spacecraft will return a sample from the asteroid to Earth. This mission provides a viable template for future space based mining endeavors. These technological advances will take a decade or more to reach industrial scale, but once they do we believe they will significantly alter the nature of the mining industry.
Net Neutrality Fallout: 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. 2018 did see a backlash against the major telecom companies and the net neutrality ruling certainly didn’t help to reverse the cord-cutting trend. Telecoms underperformed the broader market in 2018 as the S&P 500 Telecom Services Index returned -7.20% while the S&P 500 index returned -4.38%.
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.
2017 was an uneven year for our market predictions. We were right on five calls, half right on one call and wrong on four calls. Continued bullishness and investor support for the Trump administration (despite abysmal poll numbers) torpedoed three of our calls.
? Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017. The Fed started 2017 with a target interest rate of 0.50%-0.75% and finished the year with a target rate of 1.25%-1.50%. While the Fed raised rates, they met but did not exceed 1.50%, so we’re giving ourselves half a point on this one.
× Equities Caution: We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year. We were dead wrong on this call as US equities continued their bull market run through year eight.
? Artificial Intelligence: We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call. Artificial Intelligence-related companies had a very strong 2017 as the Global Robotics and Artificial Intelligence Index was up 57.62%. Comparatively, the S&P 600 Consumer Discretionary Index was up 17.13%.
? Continental shifts: Over the next several years, we expect Indian markets to outperform those in China and the developed world. We were right on year one of this call. The S&P BMI India Index was up 29.56% in 2017. This compares to 26.67% return for the S&P Greater China Index and 21.83% return for the S&P 500 Index.
× European upheavals: We believe European stocks to be more attractively priced than US equities…we expect European stocks to outperform US equities. While European stocks performed in-line with our expectations — S&P 350 Europe Index was up 10.75% on the year — the unexpectedly strong performance of US stocks (21.83% return for the S&P 500 Index) easily outperformed this total.
× Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. Despite rising interest rates, the USD weakened against a basket of international currencies in 2017.
? Drones are going to be delivering much more than bombs: We expect companies building these technologies to outperform the freight and shipping transportation companies. While we view this as a long term trend, 2017 saw drone-related companies outperform. The Solactive Robotics and Drones Index was up 38.7% while the S&P 500 Transportation Index was up 23.52%.
? Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. YieldCos saw a strong rebound in 2017 and handily outperformed traditional utilities. The Global YieldCo Index saw returns of 22.87% while the S&P 1500 Utilities Index returned 12.16%.
? Retail Real-Estate: We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments. This prediction came to fruition as brick and mortar stores, and particularly malls, continued to see a decline in foot traffic and a loss of market share to online shopping in 2017. The FTSE NAREIT Regional Malls Index was -2.68% and the FTSE NAREIT Shopping Centers Index was -11.37%. Meanwhile, the FTSE NAREIT Composite was up 9.29%.
× Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises. As we expected, President Trump has been unable to follow through on his campaign promises, and his approval ratings are among the lowest ever recorded for a first year presidency. However, a strong economy, robust corporate profits and the prospect of a tax cut allowed investors to shrug off his policy failures, chaotic management style and a criminal investigation to send equity markets to all-time highs.
We trust you’ve had a restful and enjoyable summer.
This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.
This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.
Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.
The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.
Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.
The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.
Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.
The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.
The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.
Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.
From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.
Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.
As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.
Data source: Robert Shiller – Yale University
We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.
For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.
Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.
At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.
Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.
Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.
As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.
There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.
Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.
The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.
It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.
All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.
Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.
The first quarter of 2017 was full of eventful news for markets. We saw a Fed rate hike, record low unemployment rates, all time highs for US equity markets and a new administration sworn in, with Republicans now in full control of Congress. In our view, this likely marks an inflection point for the current business cycle and market levels.
Since the election, we have received several queries from our socially responsible investors about the fate of environmental and climate change regulation under the Trump administration. We understand and share many of their concerns. We hasten to add, however, that infrastructure spending and projects are usually undertaken with long time frames in mind. Enterprises making decisions about what kind of power plants to build will consider the costs over a long term. They are well aware that the current administration and its policies are not set in stone.
We do not expect a raft of coal plants to be built over the next four years — in fact, 2017 has seen an acceleration of the closure of several legacy coal plants. Large plants typically take 3-5 years to build and operators have to factor in the possibility that they will face a changed regulatory environment just as the plants come online. Natural gas prices are likely to play a much larger role in determining what resource mix generates our electricity. The cost of utility scale renewable solar power continues to fall, and though it is not yet competitive with cheap gas, it is not far off either. The IEA estimated the average capital costs of photovoltaic solar plants under construction to be 35-45% higher than natural gas plants per unit of energy produced. An array of tax credits make solar competitive with gas. though the precise economics are driven by regional factors and weather. Wind and hydroelectric power are already competitive with natural gas.
At the risk of appearing sanguine, we think that technological advances, consumer preferences, and the economics of scale have brought us to the point where renewable energy will be competitive with conventional electricity generation going forward. Installed renewable capacity will continue to increase, with or without incentives. If fuel costs move higher, renewables will be become very attractive.
In our view, purchasing certain sectors based on the administration’s stated policy preferences is unlikely to lead to consistent gains. Our reasoning is based on the Trump administration’s penchant for changing direction at the drop of a hat, and secondly on the opposition to various aspects of their policy agenda from either side of the aisle in Congress. In the medium and long-term, valuations and the business cycle will determine investor success. Neither looks particularly fortuitous at the moment for risk assets (equities, or long-term/lower-quality bonds). We continue to recommend a defensive shift for clients based on these factors.
Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017.
Equities Caution: We continue to be cautious on US equities, as we have been for the past several years. S&P 500 is priced at over 25 times last-year’s earnings. Even if we use projections that forecast a recovery in energy sector prices, P/E ratios are over 20. Rising rates erode support for outsized price-earnings ratios. We are also in the eighth year of a long bull market with a number of credit related issues in markets across the world. We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year.
Artificial Intelligence: Technology continues to come at us hard and fast, but the groundwork has been around for decades. We recall using voice-recognition software to dictate texts almost 20 years ago. It was slow and cumbersome. Modern voice recognition is vastly improved by faster hardware and refined software. When coupled with the ability to search for information and issue instructions to connected devices, this technology can seem very much like science fiction, evoking both fears and dreams. Yet, asking Alexa to lower your blinds is in essence no different than using “the clapper” to turn on the lights. We expect this to be the year that voice activated instructions come to various devices, including cars and household appliances. Companies with effective voice activated solutions will find themselves partnering with manufacturers of all sorts of devices, not simply computer and phone makers. The revenue and earnings implications are less clear. Licensing fees may not amount to much and a large part of the value for technology companies may derive from sales of media and in Amazon’s case, all sorts of goods. We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call.
Continental shifts: For much of human history Asia has been the center of the global economy. That changed in the centuries following the European industrial revolution and colonial expansion. Over the past thirty years, rapid growth in China has brought gross East/South Asian annual GDP (ex-Russia) to roughly 25 Trillion USD. This exceeds both that of North America and Europe/Central Asia, both around 20 Trillion USD. The big laggard in Asia has been India, where per capita GDP is 20% that of China. We expect India’s growth rate to exceed that of China’s for the next several years, with the relative difference in per capita GDP falling. Despite the numerous hurdles to doing business in India, we expect investors will begin to pay more attention to companies with exposure to India and an India related strategy. Over the next several years, we expect Indian markets to outperform those in China and the developed world.
European upheavals: This will be a busy year of European politics, there are major elections in France and Germany. Looming over it all is last year’s British decision to exit the Europe zone. Any or all of these have the capacity to inject more policy uncertainty and create market upheavals. Though we believe European stocks to be more attractively priced than US equities, these concerns give us pause. Nevertheless, we expect European stocks to outperform US equities.
Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. This impacts the returns dollar-based investors can expect to realize from foreign investments.
Drones are going to be delivering much more than bombs: Many of us have been concerned about the impact of automated weapons on conflicts across the world. This technology raises numerous difficult ethical questions, alongside legal dilemmas. Less attention has been paid to the revolution soon to overtake transport and delivery services of every form. Remote operations and autonomous guiding systems are approaching the point where not just driverless cars, but pilot-less planes, captain-less ships and person-less food delivery are about to become a reality. These technologies are going to create immense disruptions for various work-forces across the aviation, shipping and transport sectors. As with so many other technologies, the armaments industry has led the way. But the long-term impacts on our economy, politics and lives will be driven by the commercial applications of these technologies. We expect companies building these technologies to outperform the freight and shipping transportation companies.
Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. Despite a high likelihood of loosening EPA standards, we think YieldCos benefit from a newer fleet of power plants and stock prices that haven’t recovered much from the energy crash of 2014/15.
Retail Real-Estate: We believe the retail real estate sector will come under pressure from rising interest rates and a secular shift towards online purchases. We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments.
Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises.
First, we think a Trump victory is quite unlikely. That said, the probability is not zero, it’s likely to be around 15-25%. We routinely analyze even less likely events and their impact on markets, so we have considered the reaction of markets if Mr. Trump were to win the general election.
There will be almost no place to hide from the initial volatility after an unexpected Trump victory. We expect significant turmoil in the financial markets and we believe that in the short-term (days/weeks) there will be few safe havens. Mr. Trump’s economic policies are so unconventional, and his temperament so mercurial, that we expect almost all sectors and asset classes to be somewhat affected by negative uncertainty. Precious metals may be the only asset that benefits from a flight to safety.
Bonds have traditionally served as a safe haven in times of turmoil. We believe bond investors should not remain sanguine if Mr. Trump does win the presidency. As a leveraged developer, Mr. Trump has had a colorful and combative history with lenders. His natural bluster has been intermittently aimed at bond markets during this campaign and the prospect of a Trump administration in control of the US Treasury is bound to spook bond investors. He has suggested he would unilaterally default on US sovereign debt (arguably not a novel position since the Republican congress toyed with a similar position in 2011) and seek to renegotiate principal amounts.
Mr. Trump has made combative comments about the Federal Reserve and its current policies. He has also expressed dissatisfaction with the current low interest rate regime. Taken together, these sharp, unusual policy views create immense uncertainty about how Mr. Trump would manage the credit and repayment of US debt, the government’s relationship with the Fed, and other issues of concern to the broader credit markets. We expect FX markets to exhibit a flight to perceived safety which historically has benefited the Swiss Franc and Japanese Yen. Uncertainty about bonds and rates will also hit real assets heavily dependent on credit markets. We do not expect real-estate to do well.
When it comes to stocks, we expect broad declines in the short term, but some sectors will be harder hit than others. The banking and financial sector is likely to see a steep decline in market sentiment and levels. Mr. Trump has made several negative statements about banks and their business models. Banks are also naturally leveraged and very sensitive to market sentiment. None of this augurs well for the banking or financial sectors.
Given Mr. Trump’s combative stance on trade and trade agreements, we would expect sectors dependent on imports/exports in their global supply chain to be battered. This includes consumer discretionary, technology, heavy industry, materials, and depending on precise global footprint, energy companies. In contrast, consumer staples should play their standard defensive role.
The immediate sentiment towards the defense industry is somewhat more uncertain. Mr. Trump has, at times, advocated a combative posture on national security and war matters. In almost direct contradiction, he has also proclaimed he would reduce the defense budget and the number of military bases overseas in line with his “America First” pledge. Defense contractors dependent on Pentagon contracts for services to troops overseas are likely to see sentiment and stock prices decline. Large defense manufacturers should decline as well since Mr. Trump has expressed skepticism about some expensive weapons programs (the F-35 in particular). The foreign policy and defense team Mr. Trump puts in place will determine how this plays out in the longer-term.
Beyond the initial few weeks and months, we expect much will depend on the composition of Mr. Trump’s administration and his demeanor during the transition. A prospective Trump administration caught up in balancing spending, debt, legislative priorities and political considerations would normally be constrained. However, Mr. Trump is likely to have a compliant Congress, with Republican legislative majorities and both Senators and Representatives eager to please the new force in American politics. It is impossible to make longer-range forecasts of what a Trump administration’s policies would look like, simply because we do not know his true priorities. We would advise investors to be extremely cautious about bargain-shopping in the immediate aftermath of a Trump victory.
Mr. Trump is unlikely to win the election, but in the event he did, we believe markets will react very poorly, at least initially. He is in many ways, the opposite of a traditional conservative politician, disdaining societal norms and conventional politics. Mr. Trump’s election would engender policy uncertainty on a scale not seen for decades, upending long-range business plans and reducing risk-appetites across the board. We would advise investors to exercise caution in the event Mr. Trump wins.
If a presidential candidate berates the Fed and no one pays attention, do markets still react?
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.
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.
Overall, we did well on our call for 2015. We were right on six, half right on three others and had one wrong. In general, the year lived up to our expectations of a low return environment with the anticipated Fed rate hike being the biggest influence.
~ If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. We were right on this call, but the Fed chose to wait till December to raise rates to 0.50%.Though the Fed has signaled rates will be raised to 1.25-1.50%, we are calling this one half-right.
~ No one rings a bell at the top of the market: […] we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory. We were mostly right here, two out of the three indices ended down. The S&P500 ended 2014 at 2,059 and 2015 at 2,044; the Dow Jones dropped from 17,823 to 17,425; but the Nasdaq rose from 4,736 to 5,007.
+ Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. […] We expect emerging market stocks and bonds to underperform developed markets this year. The MSCI Emerging Markets Index ended the year down 17%. The Chinese markets ended the year down over 10%, Brazil was down almost 16%, Russia down over 6%, and India down over 2%.
+ Commodities weighed down: […] We see commodities finishing the year flat to negative. The Goldman-Sachs Commodities Index ended 2015 down over 30%.
+ The trouble with oil: We do not expect oil prices to substantially recover in 2015. […] We expect brent crude prices to remain under $60 by year’s end. Brent crude started the year around $57 and ended 2015 around $37.
+ Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view. We were half right on this call as healthcare outperformed the S&P 500 Index in 2015 (S&P Healthcare Index +5.8%) while utilities lagged (S&P Utilities Index -7.9%).
+ Euro Crisis, back to the future: […] Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro. Over the course of the year, we saw another round of concerns about Greece that led to weeks of tense negotiation. The Euro ended the year down about 10% against USD (from 1.20 to 1.07) partly s a result of continued concern about the longer-term prospects for the Euro-zone. Though economic issues have faded from view as a continuing refugee crisis absorbs headlines, we do not believe the Euro-zones strategic challenges have been dealt with.
+ Junk bonds get kicked to the curb. […] With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk. We were correct on this call as high yield bonds suffered their first down year since 2008. The Barclays High Yield Bond Index was -6.77% for 2015.
×Growth in Renewables: […] With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors. We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place. We believe we’re a bit early on this call, but for year-end list-scoring purposes we were wrong. Renewable energy stocks had a negative return for 2015 impacted by falling prices for conventional energy. Renewables did however, outperform traditional fossil fuel energy stocks. The Nasdaq Clean Edge Green Energy Index was -6.21% while the S&P 500 Energy Index finished -21.12%.
+ The Russian question: […] We are bearish on Russia and expect the Russian market to underperform in 2015. The Russian market ended the year down 6%.
Dear Friends,
Fed stays the course