To My Clients, Friends, & Observers
A Tale of Two Markets
Consider the stock market. Clients are nervous. Fear is percolating and market psychology is important. There is a steady news feed of a slowing economy, the protracted expansion that must end, the impending doom of an amorphous recession. I suppose I'd rather be electrocuted than sandpapered to death. I'm old enough to have lived through many recessions and many bear markets. To the best of my knowledge my clients and I are all well equipped to ride out either.
Unfortunately, our president regularly baits the media with remarks that exacerbate uncertainty, confusion and fear. Presidents can cause short-term market reactions but the market discounts things pretty quickly. Administrations have a lot less influence on the stock market than the bond market and even there the Federal Reserve Chairman is more influential.
The trade war with China is weighing on economic growth. A confrontation with China over its trade practices - and its labor, environmental, and human rights abuses - was inevitable and long overdue. China should not have been granted membership in the World Trade Organization in 2001. But the exclusive use of tariffs to correct our trade imbalances is ineffective. Jason Furman wrote in the wall Street Journal this week that a multilateral approach - utilizing the WTO, joining the Trans-Pacific Partnership (which does not include China) and enjoining other natural allies East and West - would likely be more effective and less chaotic. I'm reminded of the aphorism "when the only tool you have is a hammer, every problem looks like a nail."
Here are some observations. The economy is slower in 2019 than it was in 2018. Leading indicators have dropped below 50% but they did that a few months ago and recovered. The Cass Freight Index (domestic freight traffic) is lower than a year ago but well ahead of 2017. The Baltic Dry Index (global shipping) is actually up 65% for the year despite slow growth worldwide. Second quarter corporate earnings exceeded expectations. The housing market is improving. Unemployment is still at a record low.
Bank of America CEO Brian Moynihan predicted yesterday that the U.S. will avoid a recession citing healthy consumer spending, which accounts for 68% of the economy. He dismissed the "yield curve inversion" as a result of the influx of foreign money due to negative yields elsewhere. I concur. Every recession has been preceded by an inverted yield curve but not every inversion has resulted in a recession. Correlation is not causation. The significance of the yield curve is that typically banks borrow short-term and lend long-term. When short-term rates exceed long-term rates banks have difficulty lending, thus slowing the economy.
The Congressional Budget Office reports that the economy will slow over the next four years due to trade policies, cutbacks in government purchasing and declines in consumer spending. They estimate GDP growth of 2.3% this year and an average of 1.8% annually for the next ten years, I would add that as the baby boomers age their economic activity will slow. Millennials and Gen-Xers are too indebted and too few to pick up the slack.
A Goldman Sachs study released this week surveyed 835 hedge funds holdings which showed a preference for cyclical stocks which normally perform well in good economic conditions. The study revealed a dearth of defensive stocks. The conclusion is that hedge funds are not investing for a recession.
Rest assured that the business cycle is not extinct. There will be a recession someday, somehow, to some degree. But to the extent the U.S. has become more of a service economy, with less cyclical inventory bloating and better technology to manage supply chains, the business cycle has become smoother. Asset bubbles like overvalued tech stocks in '99 or overvalued housing in 2009 are just not apparent at this time. Two successive quarters of negative GDP (the definition of recession) do not loom in the near future.
The Bond Market
A client asked me last week, "Shouldn't I be in bonds?" The answer is no. The most suitable fixed income instrument a client should be buying at current levels are 3-month Treasury bills, presently yielding 1.8%. Anything else would truly be speculation that rates are going to stay very low for a very long time. But how low and for how long? We will extend durations when rates rise and not before. There is not enough yield to justify the risk for any length of time.
The world is piling into U.S. Treasuries because the currency is safe and the rates are relatively high. There are over $15 trillion globally in securities with negative yields. Demand for Treasuries has pushed prices up and yields lower. It's also made the dollar exceptionally strong. Currently the Euro is worth $1.10 down from $1.40 ten years ago. This hurts U.S. exports which is why the president keeps hectoring the Fed chairman to lower rates.
The Fed Funds rate at 2.25% is an arbitrary rate set by the Fed. To reflect the global market more accurately it should be 1.5% or lower. I wouldn't be surprised to see that before year-end. Voila, inverted yield curve corrected. The Federal Reserve Bank is a private bank, owned by the largest American money-center banks. Its purpose is to maintain an orderly, stable and profitable national banking system. Its owners will not tolerate unprofitability for long. The president and the chairman of the Fed are on the same side, despite the public twitter spat.
Perhaps there is some lingering antipathy between the president and the banking industry. Recall the Atlantic City bankruptcies. If you owe the bank $100,000, they own you. If you owe the banks $100 million, you own them.
What would be alarming is any dramatic increase in inflation that would cause rates to rise. If the stock market loves low rates it abhors high rates. There were three days in September 1987 when the 30-year U.S. Treasury yielded over 10%. I was a big buyer for the few clients I had at the time. It was the bargain of the century and the result of a bond market crash. Less than a month later the stock market crashed. Today a sudden bond market decline could accelerate into a crash as bond ETF's would be forced to liquidate. Prices would plummet; there would be no market. When there's no buyer there's no bottom. What the government would do is anybody's guess. Equity ETF's would have the same effect on the stock market. I have a strong conviction that ETFs will be a big factor in the next investment calamity.
U.S. federal government debt is 106% of GDP and growing. That debt does not include all the state and municipal debt with their unfunded pension obligations. Debt service is a growing problem even at today's low rates. Increases in rates could crowd out all other public expenditures. Most pension funds are using actuarial assumptions of investment returns that are unrealistically ambitious. So there is pressure, big pressure, to keep rates low and support the stock market. Nobody in government, regardless of party or ideology, is immune to this.
By way of conclusion, why would an average investor buy a Treasury yielding 1.5% fixed for ten years or 2% for 30 years with all the uncertainty about rates and government debt and currency exchange rates? A better alternative, by way of example, is J.P. Morgan stock which
has averaged a 3% yield long-term and paid a dividend every year since 1892. And it's increased its dividend every year that I can remember with the exception of 2009 and 2010 when it cut its dividend to $.20/share during the financial crisis. In 2011 the company resumed its annual dividend increases, to $1.00/shr, increasing to $1.52/shr by 2013. In 2016 JPM paid $1.92 dividend. In 2019 the dividend is $3.20. I've held JPM stock since 1992, choosing to own the bank and share in its profits rather than lend to it (in CD's and deposits). It's become a core holding. With stock splits and dividend increases JP Morgan stock pays a 17.6% dividend on what I paid for it in 1992.
There are hundreds of great companies that earn money and pay increasing dividends, year after year, good times and bad. They are worth owning. Instead of fretting about market conditions, consider the conditions of the companies you own. Any questions? Call me.
Dennis M. O’Connor