3rd Quarter, 2019
The persistence of negative rates leads to the destruction of capital.
THE MARKETS
In the last quarter, markets have been subjected to a variable risk scenario, which back in June focused on the classic factors of earnings growth, jobs growth, consumer spending and interest rates. By the end of the quarter, a confluence of known and previously unknown geopolitical events appeared to have taken the lead in influencing current investor sentiment. As we move into the final quarter of 2019, we can expect to experience bouts of market volatility related to both factors.
Having achieved a domestic GDP growth rate of 3.1% in the first quarter, markets began the quarter with a spate of news reports focusing on a declining rate of domestic growth, with forecasts suggesting a return to trend of 2% and a peaking of the employment rate. Interest rates continued to trend lower, with a flirtation towards an inverted yield curve and increasing likelihood of a follow-on recession. As the quarter moved along, the dollar continued to strike new highs and the politics of global tariff and trade policies began to generate market volatility. At the same time, the bond markets were fed a diet of news that focused on the Federal Reserve’s policy of mid-cycle adjustments, followed by concerns about the global pressure of negative interest rates and latterly, reflation of the FED’S balance sheet. In this interim, a number of geopolitical events began to unfold, culminating in the rebel attack on Saudi Aramco’s oil fields, again reinforcing dollar strength as a flight to safety, not as a reflection of strong U.S. growth.
Media focus on the latest flurry of market data tends to have an overkill bias, whereas earlier in the quarter numerous trends indicating softness were largely ignored as the focus remained positive on job growth and earnings reports. It is the sudden shift that has an unsettling effect on investor sentiment.
THE ECONOMY
The domestic economy saw recent growth peak at just over 3.1% in the first quarter, followed by 2.1% in the second quarter. We expect third quarter growth to approximate 2%, which represents a reasonable trend level. Fourth quarter estimates are likely to be marginally below trend due largely to active and confusing trade and tariff issues which are blunting business confidence. The recent PMI numbers bear this out, as do the past three months’ tepid employment numbers.
We are now in a situation where monetary policy options offer the prospect of diminishing returns as the economy grapples with the vagaries of a trade war on two fronts. The recent Fed action of a two-step rate reduction should enable the current business cycle to continue on-trend through 2020, assuming there is no major external economic shock to the financial system. However, the caveats of a business confidence double down and a consumer swing from spending to saving could bring a recession forward.
The situation in Europe appears to be one of numerous self-inflicted wounds, which have added downside to an otherwise dour set of economic expectations due to contractions in global trade. The politics of the EU and Brexit are on a course to become mutually disruptive, as there are many obstacles that simply cannot be prepared for a timely resolution. There is also the issue that if one country finds an exit from a union that has no exit proviso, others may follow.
Notwithstanding the previous political conundrum, Europe has a major weakness in that while the ECB controls monetary policy, fiscal policy continues to rest with the member states; thus, there exists a growth disparity within the membership of the EU. Nonetheless, renewed stimulus efforts should benefit from the cheap Euro as Asian growth continues in the 5% GDP range.
The recent flare-ups of geopolitical risks have propelled the U.S. dollar to new highs at a time when our growth rate is under pressure. In turn, this makes U.S. manufactured goods and services very expensive overseas and curtails our GDP at home. At present, although some look to gold as a store of constant value, there is no alternative to the U.S. dollar as global reserve currency, and we are subject to the costs as well as the benefits that involves.
As we look forward, a balanced view of expectations suggests the U.S. can push the growth card out and along for another twelve to fifteen months before a confrontation of financial excesses created by cheap money will bring a recession on. Thus, the aging bull still has some pasture left to roam, albeit with reduced expectations.
INVESTMENT POLICY
Our current policy of reducing risk from both equity valuations and volatility remains intact. Fixed income policy is in step with equity policy as regards risk quality and short duration. Where appropriate, we have reduced equity risk further by moving assets into U.S. treasury bills. While we do not like the continued monetary support that pushes out the economic day of reckoning, we continue to buy and hold high-quality U.S. and International stocks of companies that have consistently managed well in periods of changing economic circumstances, while at the same time safeguarding their balance sheets for future growth. We remain vigilant in our search for opportunistic purchase of new stocks. Current valuations are not stretched as they were some 18 months ago; however, we do not expect double-digit equity gains as we approach a cyclical transition. We remain focused on stocks that will continue to grow their dividends under most economic conditions. In the meantime, the all-important question to think about is how close will we get to a recession in the next several quarters if sentiment really stalls in the geopolitical trade war and tariff conundrum.
A FEW COMMENTS ON NEGATIVE INTEREST RATES
Interest rates in the U.S. are low, but remain in positive territory. However, outside the U.S., there is negative yielding debt of roughly $15 Trillion. Negative interest rates are a condition that arises when there is a significant surplus of savings over and above the demand for borrowing. The pre-conditions for the current imbalance were fostered by central banks’ creation of liquidity to counteract effects of the financial crisis that began in 2008. The demographic curve also plays an important role, as the lifetime accumulation of wealth by older populations is out of balance with weak demand for investment capital to fund future growth. In Europe, the situation is made more difficult by the continuous injections of bond buying stimulus by the ECB. The problem is further compounded by the fact that Germany, the largest economy in the EU, has a constitutional mandate against deficit financing and stimulus; thus savers have lost their income stream from real interest rates and are paying a levy of 1% or more to keep their nest eggs. As an example, the Swiss National Bank estimates that 80% of SF 1,000 Franc notes are being hoarded.
A persistent condition of negative rates leads to the destruction of capital available for investment and is indicative of a period of declining economic growth. One must then ask what therefore is the real cost of extending the growth cycle?
Who are the major victims of persistent negative rates? To begin, one must look at the pension and insurance benefit plans and the shortfalls in cash flow to fund mandated payments and maintain requisite levels of solvency. The situation is grim and consultants are beginning to recommend significant shifts from fixed income to equities for many of the European plans. This in turn is causing more demand for dollars to positive yield dollar debt, thus adding to the strength of the dollar. This trend puts further pressure on consumers to reduce their spending and cling to their savings with the hope of seeing positive rates again.
The present European situation requires a new approach before the trend of capital destruction threatens the stability of financial institutions. Although the U.S. dollar is affected by negative rates elsewhere, we do not expect U.S. policy to go down the path of negative rates. Roughly 70% of our GDP is consumer driven, a significantly higher percentage than is the case in the EU. As a result, the U.S. has a much more substantial internal source of demand for credit, whereas Europe must look for demand externally. With fiscal policy residing among the individual member countries in the EU, there is little or no chance of a policy response to bolster growth through fiscal policy. This leaves them with monetary policy as their only viable tool, leading to the questionable policy of negative rates. Despite intense political pressure for lower rates in the U.S., the Federal Reserve clearly appreciates the desirability of a positive rate structure for the long-term health of the economy.
As always, your comments and questions are welcome.