Same ol’, same ol’ equity markets…another week and more record closes for the DJIA, S&P 500 and Nasdaq stock indices. Although stocks didn’t close the week on their highs, the S&P managed to move ahead by 0.1%. Beneath the tranquil surface there were some less obvious short-term (thus far) changes to the market’s texture:
- Small capitalization stocks caught a bid and jumped 1.3% for the week (small cap stocks were one of the best performers following President Trump’s election, but year-to-date have only advanced 7.9% vs. their large cap cousins’ gain of 13.4%).
- Value stocks, which are significantly underperforming Growth stocks thus far this year (7.1% vs. 19.9%), rose 0.5% vs. Growth stocks declining by 0.2%. The primary beneficiary were bank stocks, which counterintuitively rose even as the yield curve flattened. (Note: banks benefit from a steeper yield curve because they borrow money at short-term rates and lend at long-term rates; the flatter the curve, the smaller the spread which reduces bank profits, all else being equal).
Among international stocks, Japan was the standout adding 1.9%, Europe tacked on 0.7%, and Emerging Markets were flat. The real action last week was in interest rates, which saw the yield on the 10-year US Treasury bounce off a low of 2.1% to close the week at 2.25%. The yield on the 30-year UST also moved higher, but only by 0.05% resulting in a continued flattening of the yield curve. Precious metals were negative for the week (gold -1.7%; silver -3.4%). Crude gained 1.5% to pierce the psychologically important $50 level and at Friday’s close was trading at $50.66 per barrel. Also of note, the lack of volatility in the market is reflected in the VIX Index, which declined 5.7% on the week to an almost implausible level of 9.59.
For more detail on weekly, month-to-date and year-to-date asset class performance please click here.
The Fed’s Hint on the Business Cycle – Last week’s Federal Open Market Committee (FOMC) meeting was not as much of a “nothingburger” as many expected it to be. Yes, the FOMC announced they would begin reducing the size of their balance sheet at both the pace and magnitude as previously discussed. But, the FOMC caught the market offside relative to their future targets for the Fed funds rate. Rather than reduce the number of rate hikes through 2018 (as some expected given relatively weak economic data releases of late), the FOMC stuck to their rate guns and forecast a rate increase this December followed by three more hikes in 2018. The chart below shows the shift in implied probabilities for a December hike from approximately 54% before the meeting to above 65% following the meeting.
Source: FTN Financial
The combination of these hikes would result in a 1% increase in the Fed Funds rate over 12 months, slightly faster than the pace of rate hikes over the last 12 months. Notably, irrespective of the move in implied probabilities for a rate hike in December, the market is not buying what Chair Yellen and the FOMC are selling longer term – currently, the market is pricing in only one rate hike in 2018.
It remains to be seen if the economic data will support the FOMC’s target rate moving from today’s level of 1.25% to 2.25% by the end of 2018. However, in an apparent acknowledgement of lower overall economic growth potential, the FOMC’s new median forecast for the “terminal” Fed Funds rate unexpectedly fell from 3% to 2.75%. It may not seem like much, but the move reflects reduced forecasts from several FOMC members that had been holding on to the 3% forecast for a year or more. It is called the “terminal” rate because it is the highest rate the FOMC believes they will reach before the business cycle turns and they begin reducing rates to stimulate the economy.
Comparing the FOMC’s planned rate hike schedule to their estimated terminal rate provides perspective on the FOMC members’ beliefs about where we are in the business cycle. Consider the following:
- The Fed intends to raise rates to 2.25% by the end of 2018 (four rate hikes in the next year).
- The Fed’s median forecast is for rates to reach 2.75% in 2019.
- The Fed’s estimate of the terminal rate is 2.75%.
- Thus, two rate hikes in 2019 will mark the end of rate tightening and the beginning of the end of the economic expansion for this cycle.
According to this calculus, the FOMC believes the economy will continue to expand for another two years, which is good news (to the extent you trust their forecasts). Just keep in mind that financial markets typically begin sniffing out a recession about one year before it occurs.
Hurricane Irma’s fortuitous last minute turn to the west and general fatigue with Lil’ Kim’s shenanigans touched off a strong week for equities. Although Irma caused severe damage in Florida and other areas of the southeast, realized damages were far lower than originally forecast when meteorologists expected Irma to take a more easterly path. While the total economic impact of the hurricane was lower than expected, that means little to those directly affected by the hurricane and our thoughts and prayers are with them. As for Kim Jong Un… he remains a thorn in U.S. foreign policy, but for now his bellicose antics (which include 15 missile launches and 1 nuclear bomb test thus far this year) are being discounted by financial markets.
Domestic stocks jumped more than 1.5%, with the Dow Jones Index and S&P 500 reaching another all-time high (best week of the year for the Dow). International equities followed suit, making it a truly global equity rally with European and Japanese equities putting in the strongest performance amongst the major financial markets. As equity markets rallied, U.S. Treasuries prices fell and the yield on the 10-year Treasury jumped 0.09% to a still-low level of only 2.2%. The paradox of high equity valuations implying improved economic growth and low yields suggesting the opposite remains intact. Perhaps the forthcoming Quantitative Tightening (discussed below) will help resolve this enigmatic puzzle. Precious metals were down 2% on the week, but WTI Crude jumped 5.1% to $49.89 per barrel on lower domestic rig counts and forecasts of stronger demand.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
From QE to QT – The Federal Open Market Committee (FOMC aka the “Fed”) will hold their 6th meeting of the year this Tuesday/Wednesday. The FOMC is not expected to raise interest rates at this meeting, but is likely to announce the start of its balance sheet reduction…. which should surprise exactly no one. Indeed, the Fed learned their lesson from the 2013 episode in which former Fed Chair Bernanke mentioned the idea of scaling back the pace of Quantitative Easing (QE). Investors did not appreciate the un-telegraphed announcement and the yield on the 10-year Treasury rose 1% in less than 2 months giving rise to the “Taper Tantrum”. This time around members of the FOMC have been very public about their intent for the balance sheet.
Fed Chair Yellen hopes that Quantitative Tightening (QT) will occur quietly in the background and will be as boring as “watching paint dry”. The FOMC’s plan calls for allowing $6 billion in U.S. Treasuries and $4 billion in mortgage-backed securities (MBS) to roll-off per month (i.e. the FOMC will reduce their reinvestment of interest and principal payments by $10 billion per month). Every three months the amount that is held back from reinvestment will increase by $6 billion and $4 billion, respectively, until the amount held back from reinvestment on a monthly basis maxes out at $30 billion for Treasuries and $20 billion for MBS.
Functionally, QT is expected to reduce the Fed’s balance sheet from roughly $4.5 trillion today to somewhere between $2.5 – $3 trillion by 2023. When viewing the graphic below, keep in mind that on a balance sheet, Assets = Liabilities + Equities. As the Assets (USTs and MBS) mature and an increasing portion of those maturities is not reinvested, the Excess Reserves will decline dollar-for dollar, resulting in a smaller balance sheet overall.
Sources: Federal Reserve and FTN Financial.
Note: Excess Reserves are cash deposits at the Fed from commercial banks. These deposits represent cash that is in excess of the regulatory level of capital that the Fed requires commercial banks maintain. Excess Reserves are a liability to the Fed as the Fed owes the commercial banks this cash. Essentially, the Fed has used the Excess Reserves to purchase USTs and MBS.
Economists have different views on how QT will impact markets. Some believe it will have little impact. While others are more skeptical, believing it will serve as a headwind to financial assets whose price appreciated in lockstep with the Fed’s QE-induced balance sheet expansion. If not accompanied by some type of fiscal stimulus, color me a skeptic.
Despite concerns about manmade weapons of mass destruction (Korea), natural weapons of mass destruction (Irma), and debt levels of mass proportion (the debt ceiling), global equities were relatively unchanged last week. Domestic stocks declined by 0.6%, while International stocks gained 0.6%. Squinting hard enough, one could see a subtle hint of a risk-off trade, even if it was not reflected in equities. Prices of precious metals (gold and silver) appreciated by more than 1% on the week as yields on US Treasuries grinded lower. The 10-year bond finished the week yielding only 2.05%. While not currently in danger of inverting (short-term yields higher than long-term yields), the yield curve continues to flatten. A flattening yield curves implies slower economic growth and inflation ahead versus a steepening yield curve. If the curve were to flatten and then invert, look out as an inverted yield curve is a well-known signal of an impending recession. Thus, investors and economists pay close attention to the shape of “the curve”. The US dollar fell another 1.6% during the week (bringing the year-to-date decline to 10.6%) and WTI Crude recorded a weekly gain for the first time in 6 weeks, rising 0.5% to $47.48 per barrel. Notwithstanding the relatively low price of oil, gasoline prices remain elevated as a result of hurricane Harvey’s disruption to oil refineries and transportation pipelines. The national average price of gasoline is 13% higher since Harvey according to the U.S. Energy Information Administration (and in San Antonio, we are just now getting back to the point where most stations have gasoline to sell, though fuel grade options remain limited).
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Natural Disasters, Insurance & Opportunity – The one-two punch of hurricanes Harvey and Irma may be a once-in-a-lifetime event. While weather models can predict the probability of two Category 4 storms hitting the U.S. in a single season, up until this weekend it had never occurred in recorded history. That is how rare, from a meteorological perspective, the last three weeks have been. Insured losses from Harvey are still being tallied, but are currently estimated at between $5 billion to $20 billion. Total economic losses will be larger, but unfortunately only about 20% of flooded homes were insured against water damage. The story on Irma is still being written. As of Friday afternoon, the forecasted path of Irma had the potential to create $60B – $100B in insured losses in addition to the estimated $10B of insured losses in the Caribbean. Irma ultimately took a different path, so hopefully total losses (economic and human) will be lower. Nonetheless, these twin natural disasters will generate significant losses for insurance companies and reinsurance providers. Like most of you, I have multiple insurance policies covering a variety of outcomes and insurance companies have rightly earned the reputation of being a pain-in-the-rear to deal with. So, I doubt many people feel sorry for the insurance companies… I feel deeply sorry for the people impacted by the hurricanes, but the insurance companies? Meh.
On the other hand, expected insurance industry losses may create a good investment opportunity if historical precedent holds – specifically in reinsurance. Reinsurance is insurance that is purchased by insurance companies to reduce risk exposure. Each year insurance companies write billions of dollars in insurance policies on a variety of perils (e.g. wind, fire, business interruption, etc.). The insurance companies then transfer a portion of that risk by purchasing insurance from reinsurers. The reinsurance contracts specify a level at which the reinsurance policy pays out (technically these are “attachment points”, but can be thought of as deductibles for the insurance company). Insurance companies are willing to purchase reinsurance as it creates a more predictable income stream as they can better model maximum risk to a variety of likely disaster scenarios.
Issuers of reinsurance earn a premium for selling the reinsurance contracts. Reinsurers typically sell these contracts on a variety of perils to create a diversified portfolio and a relatively stable income source until there is a significant event or a series of events. Reinsurance has grown into a nearly $600B a year industry attracting capital from traditional specialty reinsurance providers and, more recently, private investors. While traditional sources of capital have grown steadily, “alternative” capital (i.e. non-insurance company capital) has nearly tripled since 2011 to $78 billion as of the end of 2016 (see chart below).
Source: Aon Benfield, “Reinsurance Market Outlook”, January 2017.
The increased capital flows into the industry have coincided with a relatively quiescent 10-year period in which no natural disasters have resulted in the types of insured losses expected from hurricanes Harvey and Irma. The combination of large capital flows and low insurance claims have compressed returns as premiums have been driven lower. For example, one large investor in the reinsurance space has experienced annual returns steadily decline from 11% in 2014 to 7.9% in 2015 and 6.4% in 2016.
That’s all changed in the last three weeks. As is typical following a major natural disaster, insurance and reinsurance rates will increase. Indeed, a large reinsurance contract issued on July 3rd of this year sold for 50-cents on the dollar last week, implying a doubling of rates on that contract as Irma bore down on Florida. The combined insured losses from two Cat-4 hurricanes hitting the U.S. in a single year may upend the insurance industry. One reinsurance expert estimates that the rates on Florida risks could increase by 40% in 2018, depending on the severity of the insured losses. The dislocation could create an opportunity for investors to earn double digit returns once again on reinsurance investments. With low correlation to equity and fixed income investments (and below-average expected returns from these traditional asset classes), potential mid-teens returns from reinsurance investments may prove to be a valuable addition to one’s portfolio in the months and years ahead.
Investors looked past the increasingly belligerent North Korean dictator’s latest provocation (launching missiles over Japan) and the awful human and economic damage wrought by Hurricane Harvey. The S&P 500 gained 1.4% and the tech-heavy NASDAQ Index jumped 2.7% (it’s best weekly performance since December 2016 and a new, all-time high). International equities notched gains as well, though they lagged domestic equities. If one believes the economy is on solid footing and corporate earnings will increase at a healthy pace over the next several years, the threat of war and a large storm shouldn’t derail that view. In fact, the annualized Q2 GDP growth rate was revised upwards to 3% (from 2.6%), supporting the “goldilocks” narrative (low interest rates and slow growth are “just right” for equities). Others aren’t so sure… in fact, a lot of people are voicing a less sanguine view of equity markets and the economy, including investment guru Warren Buffet. Last week Warren remarked that the expansion doesn’t feel like 3%, but more of the same old 2%. He’s also sitting on about $100 billion in cash, underscoring his struggle to find opportunities in a richly valued market.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Corporate Cash, Debt and Tax Reform – This is the week that Congress gets back to work. They have an ambitious agenda ahead of them that includes passing a budget, raising the debt ceiling, securing funding for addressing the damage from Hurricane Harvey, and tax reform. All of this will be happening as Kim Jong Un continues to show-off his new toys to the international community. Though odds are long that Congress will complete everything on their list, our representatives possess a real opportunity to lay the groundwork for a stronger economy going forward.
Headlines regarding corporate cash levels indicate companies are flush with cash and thus in a strong position to withstand an economic slowdown. Indeed, the amount of cash held by corporations is at record highs so the statement in and of itself is not inaccurate. Yet, it only tells half the story. The other half of the story is that corporations have taken advantage of low interest rates and borrowed $7.8 trillion since 2010 (source: International Monetary Fund). Combined with sluggish earnings growth, median net debt across S&P 500 firms is also close to a historic high of more than 1.5x earnings (see chart below). When expanded to a broader set of 4,000 firms that comprise about half of the economy-wide corporate balance sheet, the story is similar.
Source: International Monetary Fund
What have corporations done with proceeds from the debt? For the most part it has been directed toward financial risk taking (defined as either purchases of financial assets or mergers/acquisitions and dividend payments/stock repurchases). The preference for financial risk taking over economic risk taking (e.g. investment in capital equipment and R&D) is highlighted in the chart below which illustrates the step function decline in capital expenditures beginning at the turn of the century. The reduction in capital expenditures is a key contributor to reduced productivity (researchers at the Brookings Institution estimate that this could explain about half of the productivity slowdown) and a headwind to an acceleration in economic growth.
What impact might tax reform have on the types of risk management teams take? Unfortunately, if past is prologue, tax reform that simply reduces the corporate tax rate is unlikely to turn the tide from financial risk taking to economic risk taking. Tax cuts in the 1980’s and a tax holiday for offshore profits in 2004 both coincided with a surge in financial risk taking (M&A, dividends and stock buybacks) and had little impact on economic risk taking. Said differently, increased free cash flow from corporations was directed not toward productivity-boosting capital investment or R&D, but rather to financial engineering. Coincidentally, both of those periods were characterized by a rollback of financial and business regulations, similar to the deregulatory environment today. The chart below provides a historical perspective of the impact that tax reform has had on the types of risk that businesses pursue. Notably, this chart also highlights the decline in capital expenditures since 2000.
The concern is that high levels of financial risk taking are associated with obvious increases in leverage. In the past, leverage cycles that have built up gradually, have ended abruptly in recessions, as was the case in both 2001 and 2008.
So what can be done? One idea is to implement tax reform in a manner that specifically stimulates economic risk taking. For example, Congress could pass tax reform that eliminates the tax deductibility of interest payments while simultaneously allowing for the immediate expensing of capital expenditures (currently capital expenditures are depreciated (i.e. deducted) over a multi-year schedule). This type of tax reform would:
- Place equity financing on more even footing with debt financing. Since interest on debt would not offer a tax benefit, management teams would have reduced incentives to favor debt over equity. Over time, this could lead to lower overall corporate leverage and more stable balance sheets.
- Encourage management teams to invest in productivity stimulating equipment and R&D since those expenses would immediately reduce tax obligations.
This approach is not a panacea. Some industries will be hurt, while others will thrive under a new corporate tax plan. However, if phased-in over a multi-year period, the negative impacts can be minimized. Congress has an opportunity to set a new course for American businesses going forward. A course that could lead to a more stable economy and encourage investment in new technologies. A well-crafted tax plan has the potential to position the U.S. to continue in its role as the most innovative country in the world. It would be disappointing to let this opportunity slip away because of political infighting.