The financial press is replete with stories about what possible calamity awaits if the Federal Reserve (the Fed) does not cut the fed funds rate soon. Services that track the odds of a cut (at this writing) are calling with near certainty for one in July. We read every day about sinking optimism, non-existent inflation, declining corporate earnings estimates and how out of step the Fed’s interest rate policy is versus other central banks. We can see how bearish investors’ inflation expectations are with negative yielding debt now standing at a record $13 trillion. Trade tensions are certainly contributing to this angst, but also concern about the record amount of corporate debt globally is keeping the market Cassandras up at night.
At the same time, when we look at how much of this potential future wreckage is discounted in what we call “risk” assets, we find that very little is. The S&P 500 Index (S&P 500) is near record highs, and the ICE Bank of America Merrill Lynch U.S. High Yield (HY) Index yield has broached 6% yield to the downside. Returns year-to-date (as of 6/30/19) are over 18% for the S&P 500 and 10% for the HY market. “Risk-off” assets, such as Treasury bonds and gold, have also climbed sharply, buoyed by low inflation, accommodative interest rates, and slow, steady growth.
Call us crazy but there seems to be a disconnect here. How can the bond market and the equity market be sending such different signals? The situation is confounding, but it is not irrational. Recent economic data has been decidedly mixed, which has allowed investors to divide into different camps. In our view, the most likely outcome is an extension of the status quo. Although some leading indicators are softening, we feel that the slow-growth recovery should continue, albeit with ebbs, flows and potentially some volatility, primarily due to an accommodative Fed and historically low unemployment.
Earnings expectations are one of the data points that have fallen recently. Forecasts for the second quarter 2019, as measured by Bloomberg, have dropped since last September from estimated growth of ~8.5% to a decline of ~2.7%. For full year 2019 the estimates have dropped from ~7.5% growth to ~0.7% growth. Most of the damage is predicted to happen in the second quarter, with a large rebound in the fourth quarter. In our many years investing we have observed that the farther away the time period is, the more optimistic people are. Time will tell, but if we get no meaningful break in the incessant trade wars soon, sentiment will likely deteriorate further, and earnings may well ebb more.
On the plus side, first quarter U.S. Real Gross Domestic Product was 3.1% following a slight downward revision – evidence that the end of the cycle is not yet at hand. With Fed stimulus apparently imminent, equity investors may feel that ensuing economic growth and a potential rebound in earnings justify equity prices today.
Yield curves have inverted more recently as the Fed has pinned the fed funds rate at 2.25%-2.50%, while the longer rates have declined given the lowered earnings expectations. The 10-year Treasury yield recently broke 2% and the 30-year is a stone’s throw from 2.5%. Can the Fed remain credible if it keeps rates where they are? Unlikely without further economic growth. Additionally, there is not much room between interest rates today and zero, giving the Fed limited firepower. Therefore, if the Fed does start an easing campaign, one hopes that “animal spirits” take hold quickly and economic growth resumes or we risk entering a Japanese-like existential battle against impending deflation and near zero interest rates. We do note that the Japanese equity market, as measured by the Nikkei 225 Index, has also done fairly well over the past five years (as of 6/30/19), compounding at a 9.3% clip.
Negative rates continue to present a challenge. If doing the same thing and expecting different results is the definition of insanity, then the central banks around the world are the financial asylums of today. We have written before about negative interest rates not having the desired effect on consumption. In theory, if you’re paying people to borrow money, they should be borrowing as much as they can and spending it, since there is no cost to borrow. In practice however, this has not been the case. People save more as their savings go from being a source of income to a cost. Japan is the prime example of that; it has a persistently high savings rate. China, which has fewer safety nets than Europe or the U.S., also has a very high savings rate. This will be a continued source of frustration for central bankers for years as they continue to use the limited tools within their mandate. Fiscal policy must step in at some point to carry the day.
Why is inflation targeting such a fetish for central bankers? For the average person, inflation erodes buying power and is not welcome as a rule. However, if one carries a large debt load, whether it is a home mortgage, student loans, corporate or government debt, inflation is good. It allows you to repay interest and principal in future dollars, which are worth less than they are today. So, if people, corporations and governments curtailed their debt loads, inflation would be a terrible thing. Since that is not the case, some inflation is helpful. The governments of the U.S., Japan, China and Europe have engorged their balance sheets with debt due to excessive stimulus programs over the past 10 plus years in what some feel is a misguided attempt to stoke inflation. Corporations have used this virtually “free” money to buy back stock in record amounts, while piling on record amounts of debt, albeit at low carrying costs. How does this all end? While we do not know where the point of no return is, we do know that we are in uncharted waters. If inflation remains low for a long time, we may be able to kick the can down the road without adverse consequences. We would prefer a more thoughtful approach.
With a healthy labor market here and in Europe, economic growth above Treasury rates, and healthy consumer spending, why does inflation remain stubbornly subdued? While we’ve had a few spikes in some measures of inflation, such as the Fed Underlying Inflation Gauge (UIG), even those are pulling back from their peaks. Inflation appears to be virtually non-existent in Europe. Japan has been overmedicating its markets for decades trying to coax it out of hiding, with no success. We have thought about this dilemma for some time and one factor seems to crop up that may explain why most developed markets, no matter how much monetary stimulus is applied, cannot light the match of inflation: demographics, or more specifically, aging populations.
Most developed markets’ have a large bubble of aging people who are either past working age or rapidly approaching retirement, putting them squarely in their prime savings years. Demographers call this a top-heavy population pyramid. Simon Black, writing in “Sovereign Man,” points out that Japan has more people over the age of 80 than under the age of 10! World population growth is at its slowest since 1950, and most of the fastest growth is happening in the least developed countries, which collectively amount for a small percentage of the global economy. He adds that “…for the first time in recorded history, people aged 65 and older around the world outnumbered children under the age of 5.” TS Lombard adds that fully 30% of the German workforce is due to retire within 10 years. This means that the worker to retiree ratios are worsening in these countries. Typically, the threshold for “solvency” is between 2.8-3.2 workers per retiree. In the U.S., we are currently at 2.7 and Japan is at 1.7! Basic arithmetic will tell you this is not optimal.
Luckily for the U.S. and to some degree China, we have a very large cohort of millennials aged 25-34, which outnumbers the baby boomers. While most are just now starting their careers, as they age and hit their peak earnings years, they should be able to better shoulder some of the cost of supporting aging boomers, although the likely mechanism (higher taxes) will probably snub economic growth. Arbor Research recently showed that there is a correlation (inverse) between the median age of a country and its 30-year bond yield. As you might imagine, emerging markets, who have younger aged populations, have higher 30-year bond rates on average. There is also a disconnect between their inflation rates and those of the developed world. Arbor adds that the issue of demographics is now back on the Fed’s radar, although it is uncertain what they can do about it. There is no short-term fix for the demographic ills of developed economies. In the meantime, however, lower interest rates will likely persist and continue to exert pressure on retirement savings and on those in their prime saving years (those within 10 years of retirement). They will likely need to save more and spend less if they are to have enough to maintain their lifestyle in retirement. No amount of monetary stimulus can change that.
Low interest rates and easy money have typically spawned asset bubbles. One potential bubble that gets a fair amount of press is corporate debt. Corporate debt has risen to record levels and that has some investors worried. Should we expect that the next down cycle causes a reversal of that excess? If so, what would be the trigger? First, a sudden and sustainable rise in interest rates could cause a cascade of defaults in companies that have elevated levels of debt in their capital structures. Given the demographically induced deflation globally and high savings rates, this is a remote possibility, barring an exogenous event. Second, and more likely, if the global economic slowdown worsens dramatically, and the earnings support of highly indebted companies weakens, this too could force involuntary debt reduction. Since many companies have debt profiles with longer tenors and very low interest burdens, this scenario will likely be played out over years, so lasting damage may be minimized. Third, policy changes such as eliminating the deductibility of interest expenses entirely, may cause some companies to shift their capital structures to more equity or convertible structures, depending on after-tax economics of doing so. In this David vs. Goliath social and political environment, we wouldn’t rule this out. We do feel this would be short-sighted as it would create an impediment to borrowing for productive growth and may reset growth rates lower for the economy for years to come. In sum, without a severe economic contraction, we feel the interest burdens are manageable.
Economic cycles typically collapse when an area of excess investment collides with declining credit availability (read: higher interest rates). We’ve seen recessions following the excesses (bubbles) in energy (twice), mortgages, internet and technology, and Savings and Loans debt, with slowdowns in autos and airlines along the way over the past 40 years. Today’s cycle is very different in that credit is widely available at rates that are at historically low levels (especially in Europe and Japan, for example). While there is no shortage of corporate debt, growth continues, albeit at a more measured pace than in past cycles, and population pyramids have grown very top heavy. Since the fountain of youth has yet to be discovered, only interest rates and fiscal policy are within our control. Central banks will likely keep interest rates low because that is what has always worked for them in the past, so we don’t expect anything to change there. Corporate debt, however, while not directly under government control, can be vulnerable to policy changes.
So, where does all this leave investors?
Clearly there are some significant macroeconomic crosscurrents affecting the global economy. With aging demographics in developed markets likely keeping inflation low, central banks around the world are signaling easier monetary policy in an attempt to keep the slow-growth economy moving. The resulting rally in both “risk” and “risk-off” assets leaves us somewhat perplexed; the rally in Treasuries and the inversion of the yield curve suggest a recession is close at hand, while the rally in equities and credit seem to suggest the opposite. At this juncture, a compelling case can be made for either side of the argument. We remain cautiously optimistic, but we also feel that discipline and patience are warranted at present. We expect there will be ebbs and flows in the market, which should enable us to continue generating solid risk-adjusted returns by upgrading the quality of the portfolio and taking advantage of more opportunistic entry points – of which there have been few year-to-date. We also continue to keep our duration short.
Thank you for your continued support and we welcome any questions and comments you may have.
Sincerely,
Carl Kaufman Bradley Kane Craig Manchuck
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Earnings growth is not a measure of a fund’s future performance.
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The Federal Funds Rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The ICE Bank of America Merrill Lynch U.S. High Yield (HY) Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
Nikkei Index (Japan's Nikkei 225 Stock Average) is the leading and most-respected index of Japanese stocks. It is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average Index in the U.S.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
The UIG captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.
A basis point is a unit that is equal to 1/100th of 1%.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
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© Osterweis Capital Management
© Osterweis Capital Management
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