YTD 2019 Jul Commentary

US Markets and the Lawnmower Parent

As the US equity markets reach news highs last December’s deterioration feels very far away indeed. As 2019 began many investment professionals were secretly hoping that the excesses as a result of misguided monetary policy would finally be eradicated.  Quite the opposite has taken place as the Federal Reserve continued to act as a lawnmower parent to the capital markets. Rather than return to a sound monetary stance they began to dote and change their messaging to remove all obstacles in the way of their spoiled children. The equity markets have effectively been trending ever since. Unfortunately, the largest part of the capital markets has been trending as well. The ten-year Treasury yield is quickly returning to all-time lows and income has once again become extremely expensive. Investment grade corporate spreads have followed, leaving credit-based income expensive by any historical standard. So, we are back in our capital market paradox with fixed income offering extreme asymmetric risk. Equities have been the beneficiary of this profligate policy.

Monetary policy has perverted the capital market environment for over a decade to the extreme advantage of equities. Interest rate levels, both Treasury and corporate credit, have been teetering near all time lows thus offering very little reward to investors. The capital markets have thus become a single asset class market due to monetary policy. It is no wonder it has trended higher. The Fed has effectively created a situation where we have too much money chasing too few assets; the only result is for values to increase. The risk-return tradeoffs have become asymmetric and we have an equity market that is meaningfully overvalued by any historical metric. However, valuations are relative across asset classes and investment decisions are made cross-sectionally. If no other asset class offers a better tradeoff is it over valued? This is the quandary professional investors find themselves in. As long as the term structure of interest rates offers no competition, equity investors are confident that valuations have no where to go but up. This logic is bolstered by a Fed that offers insurance every time the equity market begins to incorporate risk into valuations. The danger is that this frenzy upward lasts only until it doesn’t. At that point risk management will suddenly become important again. We began to see this toward the end of last year only to see the Fed panic and assuage the equity markets while destroying the fixed income markets.

Equity markets, Monetary Policy, Freud, and Pavlov

Why do the markets still respond to monetary policy at all? The question is equally applicable across the Atlantic. Borrowing rates have been ridiculously low for over a decade. Some of us who have been around long enough to remember the 1980’s find the Pavlovian response bewildering and conceptually inconsistent. How can monetary policy be stimulating when rates are this low? It is more psychological than financial at this point. Moreover, given the level of unemployment it seems a dangerous policy to implement. It is also hard to square that increasing the debt burden further would be effective in increasing economic growth. Professional investors like us will do well to maintain perspective on inherent risks.

Economic Success due to Regulatory Rollback

We would argue that some of the equity market increases are due to regulatory changes. Reducing constraints on economic activity has been largely responsible for recent successes domestically. This is undeniable and we are hopeful it continues. However, these changes must be measured against the macroeconomic limits due to trade disputes and unemployment rates. Some argue that classic economic metrics are now anathema due to the onset of technology. This seems short-sighted to us given that no new conceptually defendable alternatives exist. It harkens back to the onset of this century when equity analysts were declaring that fundamental analysis is a waste of time and that one only needs to count the number of clicks on a website. These preposterously vacuous claims generally portend bad outcomes. Optimism is fleeting when risk begins to dominate the battle with return. Again, perspective and risk management can’t be abandoned.

Interestingly, global equity markets have followed a very similar pattern as the US markets including monetary policy that seems based in psychology. Our global strategist will have more on these issues below. Commodities, like always, have followed more of a non-cyclical sinusoidal path year to date. Overall, they are higher than at the beginning of the year but not at highs. Overall energy prices are up except for natural gas. Precious metals are split. Gold is up while silver is down year to date. Agriculture is somewhat a wash year to date. Energy as always has been impacted by geopolitics (Iran, OPEC, etc.) and the push for alternative energy (the Green New Deal being the latest). Agriculture has been impacted by the tariff harangue emanating from the White House. Because commodities exposure is obtained primarily using contingent claims it is generally an asset class that suffers from decretion. Gold might be the exception; it is a short-term placeholder at best.

What’s next for the rest of the year?

As the second half of 2019 begins, we continue to be mindful of the risks embedded throughout the capital markets. Trigger events are difficult to identify beforehand and reacting to them smartly with sound risk management will be critical. We are particularly mindful of the seemingly psychological fragility that monetary policy has created throughout the global capital markets. When true policy guidance and leadership is needed most central banks will be left watching as they will find that their toolbox is empty. This only adds to our anxiety. We do not believe that risk is a binary event and that the onset of any correction, even a recession, will allow for risk management strategies to be properly deployed.

Global Markets

The situation in Europe is like in the United States, if not more extreme. The European Central Bank (ECB) has lowered interest rates to extreme levels over the past few years and has even recently recommitted to this misguided policy. Since March 2016 the rate for deposits at the ECB has been -0.40% per year (that’s a minus .4%!). While economists used to rule out negative interest rates because people would just withdraw their money and store it elsewhere, negative rates have become a well-established reality. Market participants must deposit their money somewhere, either in risky securities like stocks or corporate bonds where the expected compensation for risk has arguably become lower and lower or in riskless deposits without interest or negative interest. Like the US then, investors have very few asset classes to realistically deploy capital.

In Germany, the yield on 5-year bonds issued by mortgage banks decreased to -0.2% per year compared to 5% ten years ago. In Denmark, some banks are offering borrowers negative-interest mortgages. Instead of obliging borrowers to pay interest, they receive interest when they take out a mortgage. They are being paid to take on debt and purchase a home! Yields in France and Sweden have fallen into negative territory, just like in Germany and Japan. All of these are nominal rates while inflation is still positive. So real yields (after subtracting inflation) are even more negative in these countries. This is worth pondering for a moment. Investors are being paid by institutions to take on debt or they are paying an institution to take their money. This defies all economic common sense, yet it is happening all over Europe. Despite this, growth in Europe remains anemic. When will policy makers wake up and realize that the only way forward is through fiscal and infrastructural change? Until then they will flounder.

Is it 1999?

Negative government bond yields and an inverted yield curve in the US are signaling that real trouble might lie ahead for global economies. Yet, global equity and credit markets seem to be partying as if no worries in the world existed. Prince is smiling somewhere.

Geographical Subsidies

The monetary bubble that has been building up in Europe over the last ten years mostly due to ECB easy money policies shows no signs of slowing. Some argue that the ECB’s unconventional measures of quantitative easing and lowering interest rates to record-low levels saved the Euro. If that is the case, the question is whether it was a price worth paying and for how long the Euro may have been saved? We would put forth that it merely has postponed the inevitable and destroyed any opportunity to save for everyday investors. Economies in Southern Europe (mostly Greece, Italy and Portugal) that have never been truly competitive have been artificially propped up by European Institutions (above all the ECB). Enormous wealth transfers have taken place from Northern Europe to Southern Europe in an attempt to rescue those governments and companies from bankruptcy. The north is subsidizing the south. This can’t last forever and is a dangerous dynamic. The cost to savers has already been astronomical and it keeps growing day by day.

The huge wealth transfers have increased government spending in the crisis countries and kept wages and salaries at record high levels synthetically. Simultaneously, companies’ productivity in these economies remains low. At current salary levels and operating costs, they are unable to compete in global competitive markets. The predictable result has been record unemployment which persists and a huge proportion of companies going out of business in the affected countries. This has happened despite the fact that the global economy has been relatively strong over the last 5-10 years. It raises the question how the crisis countries will fare once the global economy weakens.

How the ECB will be able to deal with a weakening economy requires a bit of skepticism. The monetary toolkit is close to exhausted – if not completely depleted. How much more negative can interest rates get? How can the extremely large quantitative easing policies be increased even further? How can the wealth transfers from Northern Europe to Southern Europe be increased even further given that they are already in the trillion-dollar range? Like the US, the ECB may have lost all effectiveness except for the psychological.

Brexit: An example of political dysfunction

Substantial UK political resources have been used in dealing with the looming Brexit. The lack of leadership in this regard makes the US Federal Government look downright functional. Most large global companies have moved substantial portions of their operations to mainland Europe as a result of the absolute leadership vacuum. Some argue this is to the advantage of Europe and thus the net economic impact will be zero. We find this difficult to believe since otherwise productive resources are now being allocated toward unproductive geographic transitioning. Additionally, the political opportunity costs have yet to be understood. Finally, trade between mainland Europe and the UK will certainly be negatively impacted as the Brexit forces take hold. Uncertainty always hampers economic growth. Brexit has certainly added meaningfully to the uncertain outlook for the whole of Europe.

Global Trade and Macbeth

Europe as well as any other region is affected by the prospect of a potential global trade war initiated by the Trump administration. Whether the threats regarding trade tariffs by the US government are for bargaining advantages is immaterial. The global trade bluster only increases economic uncertainty. This is always a negative force. In theory, tariffs will permeate through the global economy and simply add unnecessary costs to goods and services. At a time when global economic growth is struggling this could possibly be the final straw. We hope this is “a tale told by an idiot full of sound and fury signifying nothing.”

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