Although equity markets continued to rally on the week, fixed income investors are singing a different tune. Domestic stocks led the way, highlighted by Friday’s eleventh consecutive positive session for the Dow Jones Industrial Average – its longest winning streak since 1987. The S&P 500 ended the week with a 0.7% gain, while global equities (as measured by the MSCI All Country World Index) notched a more modest increase of 0.3%. Meanwhile, U.S. Treasury instruments were also bid, resulting in a decline in the 10-year Treasury yield to a multi-month low of 2.3% (note equity prices and bond prices typically move in different directions, that is they are negatively correlated over long time horizons). The fact that both bond and equity prices moved higher demonstrates a certain dissonance between equity and fixed income investors, as equity bulls see the Trump Administration driving an acceleration in economic (and corporate earnings) growth, while those in the fixed income camp are more circumspect about those prospects. Precious metals, perhaps reflecting some of this uncertainty, increased by about 2% on the week. Meanwhile, WTI Crude moved higher by a little more than 1% to $54.04 per barrel. All in all, it was a good week for just about every asset class as (to varying degrees) prices rose across the board.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Consumer Confidence – A Great Divide: The February 2017 University of Michigan Consumer Confidence index data was released on Friday. The good news is consumer confidence remains elevated, and, though off the January peak of 98.5, at 96.3 it is still 5.5% higher than this time last year. High levels of consumer confidence are associated with higher consumption levels, ergo better economic growth as consumption equates to roughly 70% of US GDP.
Sources: University of Michigan and Covenant Investment Research
All good news indeed, but here’s what is interesting about this month’s survey….the divergence of consumer sentiment between self-identified Republicans and Democrats is “unprecedented”, according to Richard Curtin (Surveys of Consumers Chief Economist at the University of Michigan). The Republicans expect robust growth, while the Democrats expect a recession. Within the survey, these views largely offset each other and it is the self-identified Independents that are keeping the survey reading high. This divergence can also be seen in the Expectations Index, which gauges consumer sentiment further into the future:
- Democrats Expectations survey score: 55.1
- Republicans Expectations survey score: 120.1
- Independents Expectations survey score: 89.2
Within the United States, there are about 200 million registered voters, with party affiliations breaking down along the following lines: 25% Democrat, 44% Independent, and 28% Republican (Source: Gallup).
It’s not all that surprising to learn that Democrats (who likely didn’t vote for Trump) are nervous about the future, but who would have thought that Independents would be so bullish about the economy? Given the relative size of the political party bases it appears that Independents not only have the ability to swing the popular vote in national elections, but they also have a huge influence on consumption patterns. Fortunately, at least for the time being, Independents’ confidence in the economy are closer to the optimistic views of Republicans than the skeptical views of the Democrats.
Whatever the root cause of the variant views on the future, as Curtin surmises “…we can expect greater volatility and discretionary spending differences across subgroups [i.e. political party affiliations]”. For those of you in a sales role, now would be a good time to contact your Republican and Independent prospects, while spending less time on Democrats (that’s not a political statement, just a reflection of their various levels of confidence and propensity to spend).
Weekly Economic Data Summary: There was a dearth of data releases this week. Existing Home Sales in January beat expectations by 140,000, reaching the highest level since early 2007. Of course in 2007 new home sales were in free fall as the Financial Crisis began to take hold. Nevertheless, at 5.69mm Existing Home Sales are near the average level experienced prior to the peak of the Housing Bubble, so all in all a very solid report. By contrast, New Home Sales were a little below expectations in January, but at 555,000 are up more than 5.5% compared to this time last year. The primary constraint to new home sales appears to be developers’ conservatism. New home inventory remains tight as developers learned a valuable lesson in balance sheet management following the Housing Bust.
Domestic economic data releases were generally upbeat this week while a flock of Fed speeches (seven in all) did little to impede the stampeding bull market. Global equity markets rose about 1.5%, pushing MTD gains north of 3% and domestic indices to new highs. Yields on longer-dated U.S. Treasuries ticked higher (though remain lower than at the beginning of the month). Precious metals managed to eke out a small gain, while WTI Crude declined by just under 1% to $53.88 per barrel. It’s worth noting that OPEC countries exceeded their commitment to reduce oil production by a million barrels in January (the reported reduction was 1.1mm barrels), however, domestic production has been ramping up. According to the widely cited Baker Hughes Rig Count, through last week the number of rigs operating in the U.S. increased by 237 rigs from this time last year. Increasing domestic oil production (aided by improved technology enabling economic oil extraction at lower market prices) will stymie OPEC’s efforts to push oil prices meaningfully higher.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Corporate Tax Reform – Consistent with President Trump’s campaign commitment to overhaul the corporate tax code, Republicans in Congress are developing a plan to do just that. Their plan consists of:
- Reducing the federal corporate tax from a top rate of 35% to 20%;
- Allowing businesses to depreciate capital expenditures immediately, rather than over a multi-year schedule;
- Eliminating interest expense tax deductions;
- Implementing a “destination-based cash flow tax”, also known as a “border adjustment tax (BAT)”.
It is this last element of the Republican’s proposal that is generating the most confusion and hence bears further explanation. Under current U.S. tax law, domestic corporations are taxed on the difference between worldwide revenues and worldwide costs. Under the new proposal, taxes would be calculated only on the difference between revenue generated in the U.S. minus costs incurred in the U.S. The following simplified example highlights the impact of a BAT by comparing three types of companies:
1) A purely domestic company who produces and sells product only in the U.S.
2) An exporter who produces product domestically, but sells internationally (“Pure Exporter”)
3) An importer who manufactures overseas, but only sells product in the U.S. (“Pure Importer”)
The impact of the BAT (which provides a credit for exporters, a tax on importers, and no impact to domestic manufacturers selling domestically) is illustrated in the “Border Adjustment Rebate / Tax” line item and is assumed to be 20%. In this simplified example, the BAT dramatically increases exporter’s margins, while decimating the margins for importers.
Of course, this example ignores currency effects and a BAT would prompt upward pressure on the US Dollar. If one assumes that the dollar appreciates by 25% [the inverse of the BAT Rate calculated as 1/(1-BAT), or 1/(1-20%)], the stronger dollar would perfectly offset the subsidy to exports (less demand for relatively expensive US-produced products) and reduce import costs (the stronger dollar makes overseas production cheaper). In theory, the stronger dollar would restore importers’ and exporters’ profit margins back to their original level. However, economies (especially ones as complicated as the global economy) do not operate on a theoretical basis, and implementation of a BAT will have broad implications on global commerce… some intended and some unintended. For example, if the USD were to appreciate by 25%, it would reduce the value of assets Americans own abroad, while domestic liabilities would be unchanged. BCA Research estimates this scenario would result in a paper loss on the U.S. of about 13% of GDP. Yikes!
Given the known impacts and potential for unintended consequences of a BAT, why are Congressional Republicans considering it? The answer is to generate tax revenue to help pay for the proposed Federal corporate tax rate cut (from today’s 35% level to 20%). Under the current system, corporations have the ability to “play games” with overseas costs and revenues that can reduce tax revenue for the U.S. government. Imposing a BAT provides the IRS with improved transparency into taxable transactions, while disincentivizing exporters from “fudging” overseas sales levels since it would reduce the amount of the subsidy they would receive. With an annual trade deficit of approximately $500 billion (i.e. the U.S. imports $500 billion more than it exports annually), it is estimated that the 20% BAT would raise an additional $100 billion in tax revenue. The extra tax revenue would allow for a reduction in the corporate tax rate, without causing a massive spike in the Federal deficit. That is to say, the corporate tax rate reduction could be subsidized by proceeds from the BAT.
Corporations want tax reform; individuals want tax reform. However, absent throwing fiscal discipline to the wind and allowing the country to become even more indebted, Congress and the President will have to make some very tough decisions. Some companies will be hurt and some will benefit; it will be the same for individuals if the government addresses personal tax reform. The point is that there is a wide and deep canyon between talking about tax reform and delivering it. The complexity and the political ramifications are key reasons why the thorny issue of tax reform has remained unaddressed by previous administrations. It will be fascinating to watch how President Trump and Congress attempt to thread the needle with their approach. (Data and commentary was sourced from BCA Research’s article, “U.S. Border Adjustment Tax: A Potential Monster Issue for 2017”).
Weekly Economic Data Summary: Data released this week supports our “Good, but not great” growth theme, suggesting a continuation of positive real GDP growth trending around 2.5%. Inflation data for January, per the Producer Price Index (+0.6% month-over-month) and Consumer Price Index (+0.6% m/m) confirmed forecasts that a rise in energy prices (based on year-over-year comparisons) would boost inflationary readings. Note, we expect this energy-induced tailwind to fade by March or April. Retail Sales exceeded expectations, rising 0.4% in January on top of an upward revision to December sales. Note, that January’s Retail Sales gains marks the first time since 2014 to see five consecutive months of sales gains – the consumer is alive and well, yet we’ll find out in a few weeks if consumption is being driven by a rise in discretionary income (sustainable) or is being financed by increased borrowing or a drawdown in savings (both unsustainable). Industrial Production missed expectations, declining 0.3% in January while Capacity Utilization declined from 75.6% to 75.3% (80% is considered the threshold that begins to generate inflationary pressure). Meanwhile, Housing continues to exhibit strength with Housing Starts 10.5% higher than January 2016 and an unanticipated 4.6% rise in Building Permits.
It was a “phenomenal” week for risk assets… well at least for the final two days following President Trump’s meeting with airline executives in which he said an announcement would be made within 2-3 weeks that would be “…phenomenal in terms of tax”. Although no details were offered about the plan (will it involve a border-adjustment tax, limits on interest expense deductions, caps on individual exemptions, or abolishing the estate tax (please!)), investors/traders embraced the President’s pro-growth mojo. Indeed, the Big 3 stock indices (S&P 500, Dow Jones Industrial Average, and Nasdaq) all tacked on approximately 1% in gains reaching new records and, in so doing, added $225 billion in total market capitalization for the week (source: Barron’s). International equities drafted on their domestic counterparts, rising by a similar amount, while emerging markets continue to outpace gaining 1.2% on the week and 7.1% year-to-date. Interestingly, in spite of the risk-on sentiment, yields on US Treasuries declined (i.e. bond prices increased), as perhaps the “smart money” is waiting for details on the tax plan to assess its likely impact on the real economy. In the commodity complex, the results were mixed as precious metals gained, while crude prices declined slightly (WTI Crude closed the week down 0.1% at $53.79 per barrel).
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Great Expectations: Paraphrasing from our most recent quarterly Economic Review and Outlook (available here) the Presidential election has created the greatest divergence between sentiment and economic data we have witnessed in recent memory. In sum, the new administration’s pro-growth campaign promises struck a chord that resonates strongly with consumers, business owners, CEOs and investors. And while the economy is expanding at around 2.5% per annum, the sentiment indicators imply dramatically accelerating growth. The chart below, which compares Consumer Confidence to the Chicago Fed National Activity Index (a forward-looking composite of 85 subcomponents of overall economic activity that provides an indication of what the economy may look like in the coming months), underscores that statement.
Source: Real Investment Advice
Optimistic sentiment is not a bad thing. In fact, this nation was born out of an optimistic view of how a democratic society could enable citizens the rights to life, liberty and the pursuit of happiness. Optimism also propelled the United States to develop into the most innovative country on the planet as entrepreneurs, each pursuing a specific better vision of the future optimistically pursued progressive innovations. Studies have indicated that optimistic people are more successful…. and happier. Optimism, generally speaking, is a powerful state of mind.
Yet, too much optimism or positive sentiment predicated on a series of interconnected events that is each subject to unique variables (such as timing and magnitude) can result in short-term disappointment as hope meets reality. This is as true for entrepreneurs as it is for the markets. In this regard, sentiment indicators such as Consumer Confidence (shown above) and the Small Business Optimism Index shown below seem exaggerated, or in trading parlance they appear “priced-to-perfection”.
This optimism has been mainlined into the financial markets as equities have advanced more than 10% since the election, while there has been little change in corporate earnings (other than the typical beginning-of-year rosy earnings growth forecasts). Equity gains based on hope are vulnerable to pullbacks if investors become disappointed with the timing and/or magnitude of market-friendly policies. In fact, while equities appear attractive relative to bonds from a historical perspective, both asset classes are richly priced compared to almost any other metric. That’s not to say that stocks won’t keep moving higher, but to do so will require improved earnings or even greater optimism. Although both catalysts are possible, long-term investors would prefer the former to backfill the already high levels of optimism.
Weekly Economic Data Summary: It was a light week for economic data releases. On the labor front, the December Job Opening and Labor Turnover (JOLT) survey revealed a stable, yet mature labor market. The number of Job Openings remains elevated at 5.5 million, although that is a decline of 300,000 openings from the peak in April 2016. Moreover, confidence amongst the workforce (i.e. their belief they can find a better job) is strong as indicated by a Quits rate of 2%. For reference, the Quits rate was 2.6% just prior to the recession in 2001 and only 1.3% at the depths of the Financial Crisis. The February Michigan Consumer Confidence Survey came in below expectations at 95.7. Looking deeper in the survey, consumers’ assessment of Current Conditions was relatively unchanged from the prior month at 111.2. However, the forward-looking Consumer Expectations survey declined from 90.3 to 85.7, perhaps due to the perception that the new administration may fall short of achieving their aggressive agenda for the first 200 days.
One of the many adages on Wall Street is that as goes January, so goes the year. If that old saw holds true, then 2017 should be a decent year as developed market equity indices gained between 2% – 3% and emerging markets jumped 5.5% in January. Yields on US Treasuries were relatively stable on the front end and middle portions of the curve (2-year and 10-year maturities), while yields on the back end of the curve (30-year maturity) declined 0.38% as the long-bond sees neither accelerating economic growth nor inflation on the horizon. Precious metals (gold +6.3% / silver +9.7%) outperformed developed market equities, although crude oil prices were essentially flat (WTI Crude closed the month at $53.84/barrel). The US Dollar declined by 2.4% in January, which is a welcome change for US manufacturers and export driven companies. Meanwhile, the VIX Index (a forward looking metric of S&P 500 volatility one month out) declined 22.9% to 10.82 (vs. a post-Crisis average of approx. 18.0), signaling a high level of market calm/investor complacency at month end.
P2P Lending: The Movement – Attended a conference last week that included the entire ecosystem of Peer-to-Peer lending which goes by several names: P2P, market-based lending, alternative lending, non-bank lending, etc. Across various presentations and panels consisting of representatives from electronic origination platforms, portfolio managers, legal teams, audit firms, and fund administrators, the mood was bright. And why not? The industry is positioned at the favorable nexus of high loan demand and high capital supply. On the demand side, online lending is becoming an accepted, if not preferred, mode for consumers to efficiently gain access to small dollar loans. Billed by one presenter as “Democratization of Access to Capital”, online platforms provide capital where banks can no longer economically do so as a result of regulations and high cost infrastructure. In addition to consumer debt, P2P lending has expanded to include refinancing of student loans, short-term real estate loans, small business loans, and receivables factoring. It is also worth noting that P2P lending is not just a domestic phenomenon, but rather it is a global movement.
In terms of capital supply, P2P platforms don’t lend their own funds like traditional banks. Rather the P2P platforms serve as a marketplace in which borrowers are underwritten and then matched with investors who purchase the notes. These investors include Ivy League endowments, financial institutions, traditional banks and high-net worth individuals. For the many investors scurrying around the event, financing P2P loans offer a higher yielding (6% – 15%+ per annum) investment alternative to traditional fixed income investments (where yields are near historic lows and a rise in interest rates would eviscerate future returns). Just as the number of platforms has been increasing, so have the access points and investment options for investors which now include direct purchases, investment funds, and securitizations. Demand for loans is so high, that many managers are forced to slow investment inflows as they simply cannot effectively put all of the new money to work.
Traditional banks, for the most part, are not ignoring this trend. After all, they do not want to be “Uberized” a la the taxicab industry (see below). As such, banks are becoming increasingly involved in P2P Lending through one or more of the following strategies:
- Buy loans directly from the platforms
- Partnering with the platforms (the bank connects borrowers that don’t qualify for a bank loan to marketplace lenders)
- White labeling of platforms
- Buying equity stakes in P2P lending platforms
- Acquiring an online lender
Although P2P Lending has experienced some growing pains, and the loans originated by the various platforms are not without risk, the optimism expressed at the event appears warranted. Indeed, major institutions such as PriceWaterhouseCoopers, The Harvard Business School, Goldman Sachs, and Morgan Stanley have all issued research reports suggesting the global P2P Lending market is set to continue grow at a blistering pace (some estimate as much as 50% growth per annum) both by taking market share from traditional banking institutions and from other specialty finance lenders.
Taxi Blues: Just as technology is displacing banks in the supply of credit, Uber and its competitors have done a number on the taxicab industry. This is not new news in a theoretical sense, but the practical impact of on-demand private driving services on traditional taxicabs is unmistakable. In fact, in Capital One Financial Corporation’s (NYSE: COF) recent Q4 quarterly report, their NYC taxi loan program showed that the rate of non-performing loans has increased to more than 50% as taxicab drivers are providing fewer rides and generating less revenue in New York.
Commensurate with declining market share, the price of NYC Medallions (which basically give someone the right to operate a yellow cab in NY) is plummeting. According to Business Insider, the value of medallions has declined from $1.3 million in 2014 to $250,000 – $500,000 in 2016.
Weekly Economic Data Summary: At their first meeting of 2017, the Fed elected not to move interest rates higher and gave few clues about what might happen at their next meeting in March. They appear to be taking a patient view of the economy and perhaps waiting to learn more about the Trump Administration’s fiscal stimulus plans. The January ISM Manufacturing Index reached 56.0 (highest since Nov. 2014), while the ISM Non-Manufacturing Index held steady at 56.5 (a reading above 50 implies expansionary conditions). Core inflation (as measured by the Personal Consumption Expenditures Index) remained in the 1.6% – 1.7% range it has been in for the past 12 months (another reason the Fed is in no rush to move rates higher). All-in-all, the January economic data thus far suggests the economy is reasonably stable, but not in a breakout growth mode.