Last Week Today: President Trump again criticized the Fed for raising interest rates, which seemed to have some effect in pushing the US Dollar lower early in the week. | Perceived legal problems for the President resulted in a minor risk-off trade on Tuesday when his former attorney pleaded guilty (implicating the President in the process), and his former campaign chairman was convicted on eight criminal charges. | Minutes released from the recent Fed meeting show that certain members of the committee are concerned about the Fed’s ability to fight the next recession (more on this below). | Trade negotiations between a Chinese delegation and the U.S. went nowhere as reciprocal tariffs on $16 billion goods and services were implemented. | Fed Chair Jerome Powell’s speech at the annual Jackson Hole symposium was interpreted as long-term dovish giving equities a boost, even as the yield curve flattened further – the US Treasury 10/2-year spread ended the week at less than 20bps, moving ever closer to inversion. | Dallas Fed President Robert Kaplan appeared to push back on Trump’s tweets regarding interest rates, “The job of a central bank and my job is to make decisions on monetary policy without regard to political considerations or political influence. I’m very confident we’ll do that.” Speaking of which, two more rate hikes this year are a near certainty unless international trade or emerging market turmoil spreads SIGNIFICANTLY into domestic markets.
Equity markets pushed higher in a record-setting week for the S&P 500 (+0.9%), Nasdaq (+1.7%), and Russell 2000 (+1.9%) indexes. Global stocks, while not setting new highs, kept pace with their large-cap domestic counterparts, with developed market international stocks rising 1.1% (as measured by the EAFE Index) and the relentless selling of Emerging Market stocks abated, as would-be bottom fishers pushed the MXEF Index higher by 2.5% (though it remains down -3.4% MTD at -7.7% YTD). As mentioned above, the US Treasury curve flattened, as 2-year treasury yields rose 0.1%, while the yield on the 10-year UST dropped -0.05% to 2.81%. The yield on the 30-year UST fell -0.06%, crossing below the 3% threshold to end the week at 2.96%. The US Dollar declined on the week, releasing pressure on the commodity complex: gold +1.8%, copper +2.7%, and WTI Crude +4.3% ($68.72 per barrel).
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Questions: On Friday at the Jackson Hole symposium, Fed Chair Jerome Powell’s keynote speech described the dove/hawk divide in the Federal Open Market Committee and the path of future monetary policy. Powell used the following questions to summarize the views of the doves vs. the hawks.
Asketh the Dove: “With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion?” The dove contingent believes that if the Fed does not change the way it forms monetary policy by slowing the pace of rate hikes, they will once again be confronting the threat of deflation within the next ten years, forecasting the following:
- The fed funds rate will fall to the effective lower bound (i.e., a Fed Funds rate of 0%) and remain there for 3-4 years within the next decade.
- Inflation will average 1.2% over the 10-year period.
- Economic growth will average 1% below potential over the decade.
Asketh the Hawk: “With the unemployment rate well below estimates of its longer-term normal level, why isn’t the FOMC tightening monetary policy more sharply to head off overheating and inflation?” The hawks argue the Fed should raise rates at an accelerated pace when the unemployment rate falls to very low levels (i.e., below the estimated natural rate of unemployment) to avoid elevated inflation and asset bubbles.
Quoth the Fed Chair: “These questions strike me as representing the two errors that the Committee [the Fed] is always seeking to avoid as expansions continue – moving too fast and needlessly shortening the expansions, versus moving too slowly and risking a destabilizing overheating.” In other words, while the underlying data and analytical methodologies may change, this debate is nothing new, and the questions frame the Fed’s challenge in setting monetary policy.
Powell’s stated solution is to borrow from both the doves and the hawks by walking a middle path of monetary policy. This approach includes continuing to remove accommodation slowly and looking beyond the unemployment rate for signs of slack in the economy. Powell hopes to avoid the inflationary episode of the 1970’s and achieve the low-inflation growth of the 1990’s. We certainly wish him well, but we also appreciate that the 1970’s and the 1990’s do not serve as useful templates for monetary policy today. Neither of those periods followed a path in which a global recession caused the Fed to reduce interest rates to zero and employ aggressive, unconventional monetary stimulus. The Fed was indeed not alone in applying emergency stimulus. Negative interest rates crossed the Rubicon from theory to reality when the European Central Bank, Bank of Japan and others, began charging interest on deposits. As a result, Fed Chair Powell and his colleagues are facing the backend of the grand monetary policy experiment, trying to safely guide the economy through a high tide of liquidity precipitated by central banks around the world.
Food for Thought: While we (as in, the collective marketplace of investors) bask in the glow of second quarter’s 4.1% annualized GDP growth rate (noting that Q3 is off to a good start as well), it’s essential to keep our eye on the ball and not to allow ourselves to blindly accept that 4% growth is the “new normal”. Accelerating economic growth has been fueled by government debt (tax cuts and fiscal stimulus increase government borrowing to fund the gap between tax receipts and spending). Likewise, corporations have been binging on low-interest rate leverage. Although capital expenditures picked up recently, much of the proceeds from cheap corporate debt amassed since the Great Financial Crisis has been directed toward non-productive purposes such as stock buybacks and special dividends. The term “non-productive” is meant in the economic sense, in that stock buybacks do not increase the economic output of a corporation to offset interest payments on the debt. Now that the tide is changing, and the Fed is on a path to raise interest rates, it’s worth keeping an eye on the health of corporate balance sheets. On that point, corporate debt is at levels typically seen during recessions when measured as a percentage of GDP.
There are, of course, two inputs to this equation: total debt levels (numerator) and Gross Domestic Product (divisor). A decline in the numerator (i.e., corporations paying down debt) or a rise in the divisor (accelerating GDP growth) will cause this metric to decline. The recent downturn of the squiggly line in the chart above reflects the latter scenario. However, 4% annualized GDP growth is unlikely to continue for long, and the market is confirming as much through the flattening yield curve. The takeaway is that, in the aggregate, corporations are running bloated balance sheets that will inhibit flexibility to maneuver when growth inevitably slows. Although there does not appear to be imminent danger, at a time when domestic stocks look expensive by most generally accepted measures, don’t allow yourself to get carried away by looking in the rearview mirror. Instead, cast your eyes forward through the proverbial windshield, and remain disciplined in diversifying your portfolio by balancing equity risk with other types of investments.
P.S. Good morning Donna E.
Last Week Today. The crisis in Turkey combined with a local corruption scandal forced Argentina’s central bank to raise interest rates by 5% to 45% to arrest the decline in their peso. It was only last year that Argentina, a country that has defaulted on its debt six times in the previous 100 years, issued $2.75 billion of 7.75% U.S. dollar-denominated 100-year maturity bonds. A weak currency raises the chances of Argentina defaulting on its debt once again. | Turkey raised the cost of shorting the lira by 33%, and Qatar pledged a $15 billion investment in Turkey to help stabilize the currency. | The Wall Street Journal reported that a delegation from China would travel to the U.S. this week to lay the groundwork for a November meeting between President Trump and Chinese President Xi Jinping. | President Trump tweeted that public corporations should reduce financial reports to semi-annually from quarterly and asked the SEC to study the issue. While it would limit transparency, Trump is not alone in this crusade as JPMorgan CEO Jamie Dimon and Warren Buffet have made similar suggestions arguing that quarterly reporting promotes short-term thinking and limits innovation. Editorial Note: Transparency is a critical element of U.S. financial markets and is one reason U.S. stock markets are considered the bellwether of global finance – reduced transparency is hardly a good thing for investors who, via share purchases, are owners of public corporations.
Events surrounding Turkey and trade tariffs once again took center stage for investors last week and, in a near-mirror image of the previous week, equity markets got off to a shaky start but came back in the second half of the week. Domestic equity markets ended the week in positive territory, and the S&P 500 is only 0.8% below its January 26th record high. International equity markets, with the notable exception of Japan (+1.9%), were unable to get above water with the EAFE Index declining 1.4% and the Emerging Markets Index down 3.8%. Unsurprisingly, the situation in Turkey is having a more substantial impact on equity markets outside the U.S. – while the S&P 500 is up 1.4% month-to-date, the EAFE Index is down 3.9%, and the Emerging Markets Index is off by 5.9% month-to-date. Yields on traditional fixed-income investments ground modestly lower last week, resulting in a 10-year US Treasury yield of 2.86%. The commodity complex was down, led by Dr. Copper whose 4.1% decline brings year-to-date losses to -20.3% in this important leading indicator of global economic strength. Since June 1st crude oil has traded between $65 and $75 per barrel; following last week’s decline of 2.5%, crude is trading at the lower end of that range at $65.91 per barrel.
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Robots I. Extremely tight labor markets and elevated capacity utilization rates in several industries are finally triggering management teams to invest in productivity-enhancing technology. Not only is the unemployment level below 4%, but for the first time in 50 years, there are fewer available workers than job openings (0.993 unemployed workers to job openings, to be specific).
With regards to capacity utilization, although the aggregate rate stands at 78.1% through July, several key sectors are near peak capacity: mining 92%, computers and peripherals 92.4%, crude production 90.1%, and fabricated metals 81.1%. Generally speaking, capacity utilization levels above 80% signal that producers will a) raise prices to maximize profitability on remaining capacity stoking inflation, and b) make investments to expand capacity to increase future revenue, if they believe demand will continue.
The upshot of the tight labor market and increased demand is that business investment is finally moving higher, following an extended drought. Indeed, Morgan Stanley’s measure of capital expenditures hit an all-time high earlier this year, and spending on equipment, structures, and intellectual property remained strong in the second quarter. Moreover, capital expenditure forecasts are solid according to recent surveys by the National Federation of Independent Businesses (NFIB).
A big focus of capital expenditures is on automating simple, repetitive functions (e.g., point-to-point transfers of merchandise in warehouse distribution facilities). While this may seem like it would displace workers, thus far that is not the case. Instead, automation is freeing-up workers to apply themselves in more value-added activities at companies, further enhancing productivity.
Productivity has yet to accelerate – yes, productivity rose by a 2.9% annualized rate in the second quarter, but it is only up 1.3% on a year-over-year basis – yet continued business investment should ultimately change that trend and could help extend the business cycle. Higher productivity enables the economy to run faster without associated inflation. A lack of inflationary pressure would give the Fed cover to slow the pace of rate hikes, removing one of the most significant threats to the expansionary phase of this business cycle.
Robots II. Without a lot of fanfare, driverless cars are racking up the miles through experimental programs in select U.S. cities. Waymo, a subsidiary of Alphabet, Inc. (the company formerly known as Google), is leading the charge as its fleet of self-driving cars recently reached 8 million cumulative miles driven. While that may not sound significant (Americans drove a total of 3.2 trillion miles in 2016, according to the Federal Highway Administration), it is striking that the jump from 7 million miles to 8 million miles took only one month, when the first 1 million self-driving car miles required six years to complete.
The cost of self-driving vehicle service appears reasonable and will likely decline as competition in the space comes online. For Waymo’s test markets, the company is using an estimated charge of $1.70 per mile – approximately 30% cheaper than comparable taxi services. Industry experts foresee the rides dropping to less than $1.00 per mile, with one of the more aggressive forecasts coming in at $0.35 per mile by 2020 (Source: Bloomberg). As the father of a 13-year old girl who is quickly approaching the legal driving age, widespread adoption of self-driving technology is a welcome possibility. While there will always be reasons to worry about our children, at least concerns about her or her friends texting or being otherwise distracted while driving would be eliminated. Perhaps being trusted with a parent-funded driverless car hailing app will replace “my first car” as a teenage rite of passage.
We typically distribute this report at the time of the quarterly GDP release, but the delay worked to our advantage. In addition to reporting the fastest quarterly economic growth in four years, the Bureau of Economic Analysis revised several years of recent economic data and “found” $3 trillion of previously unreported income. The revision is a game-changer as it relates to perspectives on the status of the consumer, which is a critical input to future GDP growth.
Last Week Today: Tesla’s CEO and major shareholder Elon Musk Tweeted the possibility of taking Tesla private at $420 per share – TSLA’s price jumped 11%; the SEC is investigating Musk’s claims that financing for the privatization was “secured” and several shareholder lawsuits have been filed relating to the veracity of the tweet. | China announced 25% tariffs on $16 billion of U.S. imports. | U.S. introduced new sanctions on Russia for poisoning a former Russian spy in Britain – Russian Ruble declined to its lowest level in nearly two years. | Turkey’s currency (the Lira) fell 15% on Friday, and 23% for the week, following President Trump’s announcement of sanctions and increased tariffs to pressure the country to release an American pastor arrested two years ago by Turkish authorities. In addition to the Lira taking a beating, Emerging Market (-2.1%) and EAFE (-2.0%) stock indexes suffered on Friday.
What looked to be a promising week for risk assets fell apart on Friday as the situation in Turkey came to the fore and fears of financial market contagion sucked the wind out of generally positive investor sentiment. Domestic equity markets were pressured, but not nearly to the extent of international equity markets. Conversely, safe haven US Treasury bonds were bid, and the yield on the benchmark 10-year UST once again retreated from the 3% threshold, a level it is not reliably held since before 2011. Commodities, were caught in Turkish whirlwind on Friday as well, though the desynchronization of global growth has been a headwind since May. The US Dollar Index rose 1.2% (another safe haven trade) and the VIX Index jumped 13.1% for the week (though at a level of 13.2, it is hardly indicating market panic).
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Peak Growth? Second quarter growth in the U.S. economy was impressive as anticipated. The Bureau of Economic Analysis’s (BEA) first estimate of real, annualized growth for Q2 is 4.1%, representing the fastest quarterly rate of expansion since Q2 2014’s 5.1% annualized growth.
As impressive as the Q2 acceleration is, we believe extrapolating this growth into the future is a mistake. Sure, the economy can continue to expand at an above-trend rate for a few quarters, and while Q2 may not mark peak growth, we don’t believe this is the beginning of a new cycle of 4%+ growth. Indeed, 3%+ may be a challenge beginning in 2019 as fiscal stimulus wanes and the Fed continues to tighten its monetary policy screws. We cover these topics in more detail in our “Mid-Year Economic Review and Outlook,” which is scheduled for release late this week.
Leveraged Loans Ain’t What They Used To Be. Since the globally coordinated effort by central banks to reduce interest rates following the Great Financial Crisis, investors have been starved for yield. Low coupon payments from traditional fixed-income investments pushed institutional and retail investors alike to explore other sources of yield investments, including high yield bonds, preferred equity, and, increasingly, leveraged loans. Although leveraged loans are issued by non-investment grade companies, they have been a favored destination because of the perceived safety of the investments: the loans are typically senior in the capital structure of the borrower, and the interest rates on the loans are floating (meaning the rates move higher or lower with market rates, therein providing protection from rising interest rates). In a “virtuous” circle, high demand for these types of loans has also made them a favorite kind of debt for issuing companies. While the high yield bond market remains larger in overall size, leveraged loan issuance is on pace to reach $1.5 trillion in 2018, a more than 50% increase since 2016 (Source: Bloomberg).
The adjective “virtuous” is in quotations because high demand for leveraged loans has contributed to the negotiating power of corporate issuers and investors have acquiesced, accelerating growth in issuance of covenant-lite loans. In fact, covenant-lite loans have increased from 5% of the leveraged loan market before 2007, to nearly 80% of the leveraged loan market today.
Loan covenants stipulate what provisions a borrower must follow to preserve the interests of the lenders (i.e., whoever purchases the loans). Typical covenants include financial maintenance restrictions (e.g., minimum interest coverage and maximum leverage ratios) and ensuring the position of the lenders remain senior in the capital structure. However, torrid demand has spurred the growth of covenant-lite loans which have no financial maintenance restrictions. Incredibly, many of these covenant-lite loans give borrowers the flexibility to issue more debt, pay out dividends, and even remove collateral that was supporting the original loan issuance. According to Moody’s Investor Services, “We have never seen weaker loan covenants. That includes prior to the financial crisis”.
The message here, as usual, is caveat emptor. To earn a return on an investment, you must bear some type of risk. The question investors in leveraged loans must ask themselves is whether the risk of diminished controls on borrowers is worth the additional yield available over traditional fixed-income investments. While the data on default recoveries for recently issued covenant-lite loans is limited by the small number of defaults since 2010, early results are discouraging. Nevertheless, the low recovery rate thus far serves as a powerful reminder that return of capital is more important than return on capital.