Collateral Damage

I have become aware of new information about what may be preventing the REPO market from operating properly.  Despite emergency Fed intervention, the REPO market continues to have trouble meeting cash demands.  It may not be a liquidity problem after all, it appears to be a problem with collateral.

The following example from Fed Governor Jeremy C. Stein, back in 2013, is a helpful illustration.

“Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be “pristine”–that is, it has to be in the form of Treasury securities. However, the insurance company doesn’t have any unencumbered Treasury securities available–all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.

Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does–say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.”

This illustration helps us understand the complexity associated with lending.  How multiple parties can be associated with one transaction and the importance of the collateral backing the transaction.  Concerns by REPO market lenders about who has title to collateral and/or the underlying quality of the collateral itself, appears to be causing securities lenders to step away from the market.  The REPO market deals in “Pristine” collateral.

It is important to understand banks participating in REPO transactions have visibility to the underlying conditions of our financial system.  Problems emanating from this market should be taken seriously.

It is entirely possible this episode will pass without a serious market impact.  But if a market surprise were to arrive, a problem emanating from debt markets is a likely candidate.  There is no need to panic but it is a good time to consider your mix of investment holdings and eliminate unnecessary debt.

The global economy requires credit growth to continue and expand.  As the end of a cycle is approached lending standards have been known to be loosened to meet credit issuance targets.  Think of “No Credit, Bad Credit, No Problem” loan commercials.  Eventually lower quality borrowers can have difficulty servicing their loan obligations.  Get enough of them in a market and pop, a debt bubble deflates.  It is not clear we’re are at this point.  Employment is strong and wages have been rising but something has spooked REPO lenders.

To put some of this in visual context, I offer the following charts from the FRED database managed by The Federal Reserve of St. Louis.

Student loans are growing at approximately a rate of $100 Billion per year.  The balance outstanding is currently $1.6 Trillion.  Up over $1 Trillion in he last 10 years.

Our debt to GDP ratio has not climbed much the last several years, but it remains stubbornly high relative to the last 50+ years.  There are other countries with even higher ratios.

On the plus side, Federal tax revenues through April of 2019 remain near all-time highs, despite tax cuts in 2017.

What you see in the above charts is also present in many states, counties and cities in the U.S.  An accumulation of more debt, a high debt to output ratio, and rising revenues.  It is a delicate balance.

Dightman Capital – Q4 Outlook

U.S. stocks have experienced a strong recovery in 2019 but the increase in volatility the last several months is a concern.  If stock indexes can hold current gains, they will deliver solid double-digit returns for the year despite sputtering trade progress with China and political turmoil in Washington DC.  While political developments can lead to uncertainty, such as the current impeachment inquiry, the market does not appear to have been impacted by developments at this point.

You would think stocks would be under massive selling pressure based on the daily reporting by many financial news outlets.  The current environment is one of the better examples of why it is important to pay attention to what stocks are doing versus what commentators think they are going to do.  Right now, stocks are telling investors the economy can handle the trade war process and any weakness in the economy is temporary.

One of the primary reasons stocks have rallied in 2019 is the Federal Reserve’s reversal (from raising to lowering) on interest rates.  Monetary policy is always one of the most important factors driving the direction of stocks.  What makes the U.S. different from other countries (Japan, Europe) with accommodative monetary policy is that we have also implemented Fiscal policy (tax and regulatory reform).  Lower corporate-tax rates have provided U.S. companies more financial flexibility; regulatory reform lowers costs and has helped stimulate new business formations.  Growing new businesses is an important element that has been slow to develop out of the 2008 recession, as shown in the following graphic

United States Census Bureau, Business Formation Statistics, Second Quarter 2019

Small businesses are an important element in our economy and the increase in business formations is a strong driver for ongoing economic growth.

The global economy remains challenging.  Germany is on the brink of a recession and Japan’s economy only grew 0.8% in 2018.  Over the summer Mario Draghi, the outgoing head of the European Central Bank, reminded government policy heads of the importance of fiscal measures in spurring economic growth.  European Union officials are dealing with a lot of skepticism over their mandates and controls for member countries on immigration, labor, tax, etc.  Brexit is a real-time example of the frustration voters have with the European Union.

Back in the U.S. there are several additional factors driving our economy.  First, our move to oil independence has significantly lowered energy costs and eliminated our dependence on foreign oil.  Fiscal policy, in the form of reduced taxes and regulation, is another boost to the U.S. economy.  An innovation renaissance is also spurring new business formations and impacting our quality of life.  As an example, the incredible improvements in medical devices and genetics has delivered a measurable impact on the survivability of certain cancers and researchers are hard at work to try and cure more diseases.

Regarding news in September of a shortage of cash in overnight lending markets between banks.  The run on cash appears to have been the result of corporations pulling cash from money market funds to make quarterly tax payments on the same day banks had to settle trades from a $78 billion U.S. Treasury bond auction.  The jump in rates was at the “tail” of the market. Most trades only experienced slightly higher rates.  On balance, there was not a serious system-wide shortage of reserves.  There remains approximately $1.4 trillion of “excess reserves” in the banking system.  It is also believed the increased reserve requirements by banks as a result of Dodd Frank may have played a roll.  Specifically, the Liquidity Coverage Ratio (LCR), which forces banks to hold enough liquidity to last a month in a significant financial/economic crisis.  The Fed has responded by cutting the size of its bond portfolio and is actively considering additional policy action to make sure this critical part of our financial system works smoothly.

On the topic of the constant calls for a recession I suggest economies don’t fall into recession because they have been expanding for longer than usual.  They usually contract because the Federal Reserve raised interest rates to high, which chokes off the economy, or a black swan shock, which is an event that cannot be predicted in the future but disrupts financial markets.  We know the Fed is in an easing mode, lowering rates and buying bonds, like other central banks around the world, which will likely support a continued stock market rally.

Still, many leading stocks have experienced significant corrections over the summer and into the fall.  Further weakness would signal the likelihood of additional stock market declines.  We may not have to wait long for a near-term signal regarding the direction of stocks.  Earnings season has officially kicked-off and if the report from JP Morgan is any indication, it may surprise to the upside.  I’ll be keeping an eye on the recovery from leading stocks during the Q3 earnings season.

A Divided Market

There are clearly opposite views on the market right now.  After a fabulous day for all three indexes yesterday, not to mention the performance of many leading stocks, some commentators remain committed to the idea we are headed for a recession.

A week ago, recession fears were plastered on the front pages of all the major financial news services.  This week we witness a string of outstanding earnings from consumer-based retailers like Home Depot, Walmart, Lowes and Target.  Target hit the ball out of the park sending the stock up 20% on better than expected sales and earnings.

So which view is right?  The one where we are teetering on the verge of a recession or one with a robust consumer and generally constructive economic news?   If you have been following the recession fear story, it is based on the bond market yield curve inversion where interest rates for short-term bonds rise above long-term bonds.  When this takes place a recession often follows.  It is important to note that during ALL of the prior recessions following a yield curve inversion in the last 50 years, The Fed was in an interest rate tightening mode. Today they are easing.  Another important point regarding yield curve inversions and recessions, it can take up to two years from the inversion to materialize.  A yield curve inversion is a noteworthy development, but like many aspects of the bond market, you have to put it into the context of this ultra-low rate environment.

The global economy is slowing, in part due to the trade war with China.  The president has decided the short-term pain is worth the long-term benefit of bringing manufacturing jobs back to the U.S., protecting American intellectual property and preventing China from spying on American citizens.  So far the U.S. economy has been resilient.

The doom and gloom crowd seem to have a reasonable argument.  The rest of the word is having a tough time, The Fed appears confused about what to do with interest rates and tariffs are hurting global trade.

In the U.S. interest rates are on the decline, innovation is alive and well, labor markets are healthy and we had a fairly good Q2 earnings season.

Investors know the likelihood is high we will enter a recession at some point.  Right now, there is simply very little evidence a recession is pending.  Of course, if one happens in the next two years, which is always a possibility, some will gleefully point back to August of 2019 as evidence of the pending event.  The real take away, the timing of a yield curve inversion and a recession is unhelpful in the current environment, in my opinion.

The two biggest factors holding back the U.S. is interest rates and the trade war with China.  So far tariffs have had little effect broadly but that could change as an agreement is delayed.  Interest rates are hopefully headed down, so we are more in line with the rest of the world, which should be good for U.S. investors.  We will know more this week as the Kansas City Federal Reserve host their annual meeting in Jackson Hole, Wyoming.

One more factor about interest rates.  Investors know the Fed controls short-term rates.  But what about long-term rates, why are they so low?  Simply put, demand from foreign investors.  Negative interest rates in other parts of the world is causing money to flow into the U.S. bond market.  That demand causes prices to rise (see chart below) and yields to fall.  This dynamic also causes the Dollar to rise as foreigners have to exchange their Yen, Yuan, or Euros into Dollars to purchase U.S. bonds.

We could explore more about what may be holding back Europe (high taxation, high regulation, liberal social programs) and Japan (immigration policy) in more detail.  In the meantime, we are fortunate to have many investment opportunities to choose from in the U.S.

Stock Market Struggles, Recession Threat Minimal

Yesterday the market experienced a follow-through day according to Investor’s Business Daily, only to open sharply lower today and continue lower most of the day.  Overall, the action today increases the odds this correction is going to continue but there is little evidence, if any, we are going into a sustained bear market or recession.

The issue of the day revolves around the yield curve, which is a measure of interest rates at different maturities.  The difference between a 2-year rate and a 10-year rate is essentially zero and is close to inverting (short-term rates higher than long-term rates), which has historically been an early recession indicator.  That may not be the case in the current environment due to the pervasive and continuing low-interest rates here and around the world.  There is even talk of the U.S. eventually moving to a negative-interest rate environment like European and Japanese investors are experiencing.

The Federal Reserve can fix the yield curve inversion by lowering short term rates, which is why the recession warning may be misplaced.  Other parts of the U.S. economy are doing fine.

The more interesting development over the last several weeks is the upward price movement of assets that benefit from inflation.  Gold has move higher and so have some real estate assets.  This may be an indication that if a recession does materialize, investors believe it will be met with a massive round of money creation through both monetary (The Fed) and fiscal (president/congress) policies.

My favorite indicator for the health of the stock market is the behavior of leading stocks.  Below is a chart of 12 top performing stock in 2019, several of them are younger companies or even recent IPOs.  There are many others I could have included.  Generally this type of company is the first to see massive declines when risk leaves the market.  Even after recent selling these stocks are holding up.

Leading Stocks Remain at the top of their trading range.

When the price action for leading stocks I follow start to deteriorate in unexpected ways, I become more concerned about future market action.  That is not how I feel today.

The conversations I have with business leaders and investors suggest there are a lot of opportunities to go after right now and government tax and regulatory policy in the U.S. is favorable.  Overall their outlook is positive.  I think this market will turn positive too, once this correction has run its course.

The Fed Is A Hostage

The Fed is on the verge of a new cycle of cutting interest rates.  This free Macro Watch video, from Richard Duncan Economics, explains what has forced this important shift in Monetary Policy and what lower interest rates could mean for the stock market and the price of gold.

Dightman Capital subscribes to Richard Duncan’s economic service.  We highly recommend his introductory videos and his periodic updates to those individuals that want to develop a better understanding of the current global economic system.  This has provided Dightman Capital with a concrete understanding of money flows via global trade and its impact on trade deficits or surpluses, the relationships and impact on currency demand, and many other important global economic variables.

If you are interested in modern global economics and want to better understand the subject, consider subscribing to his service.  If you read his blog he often provides a discount code.

 

Q2 2019 Market & Economic Review

Volatility returned to the U.S. stock market during the second quarter of 2019.  By the end of May, broad U.S. stock indexes were below levels from the start of April.  The S&P 500 actually traded below its 200 day moving average before a rally kicked off in June which ultimately delivered gains for the quarter.

During the period The Fed moved to a more dovish position, even hinting a rate cut may be needed to keep the economy growing.  Data since The Fed raised rates has shown economic growth moderating and corporate earnings have slowing.  We have not seen data suggesting inflation is on the rise which has helped the The Fed back off the need to raise rates.  On the contrary, policy makers appear concerned about being the cause of an unnecessary slowdown, or even a recession, by raising rates too far too fast.

In terms of fiscal policy, there is little happening in congress regarding an infrastructure bill, or other spending programs, and there is little chance that will change before the 2020 elections.  As long as interest rates remain attractive, lower taxes and regulatory reform seem to be working.  In terms of the impact from tariffs, so far they appear muted but that could change.  Eventually consumers can expect producers and distributors to start passing on the costs they are reportedly absorbing.

As we move into Q3 it appears we have stable and moderate economic growth combined with moderate inflation, an ideal condition for stocks and bonds.  As a result, we have started Q3 strong and look poised to move further into new high territory.

Will A Trade War Take Down The U.S. Stock Market?

What is the biggest risk?

The U.S. stock market is under pressure on concerns over US/China trade talks.  Last week stocks attempted a recovery, but a breakdown in trade talks has increased selling pressure this week.

Given the circumstances, U.S. stocks have held up well.  The topic is not new; the market has had time to consider various scenarios.  Overall, a restriction in trade is bad for the U.S. and China.  Interestingly, so far, the stock market seems to be taking it in stride.  In terms of the major U.S. stock indexes, the selling has been less volatile and on lower volume than we saw last fall when the Q4 correction began.

After a strong rally through April, the stock market is due for a rest.

More importantly, perhaps, is the action of many leading stocks.  They remain in constructive price patterns and are not showing evidence of widespread panic selling.  When leading stocks start to crumble the likelihood of a deeper and prolonged correction increases.

In terms of the stock market performance for the balance of 2019, it may come down to how well U.S. companies have prepared for an extended trade war.  We have already heard from companies like CISCO who has become less reliant on manufacturing in China.  Other manufactures have been reported to be making adjustments to their supply chain out of China as well.

With the push to bring manufacturing back to the U.S. through reduced regulations and tax incentives, U.S. manufacturers in China have more flexibility to deal with the current trade challenges.  For some companies, however, the investment made in China is a long-term commitment.  For those companies and the global economy in general, we can hope for a speedy resolution.

The big worry is whether U.S. companies will suffer an earnings recession due to restricted trade with China.  This is the biggest risk to the U.S. stock market and if one is expected to develop, expect a deeper correction.

China’s move to devalue the Yuan may turn out to be a net positive for the U.S. by reducing import costs, potentially taking some of the sting out higher prices from tariffs.

We should prepare for economic pain.  China is a leading supplier of some rare earth minerals used in high-tech components and materials; expect China to restrict access by U.S.companies in China as well as exports to the U.S.

If there was a time for the U.S. to address our concerns with China trade, it is now.  With tax incentives to onshore corporate money and the healthiest developed economy in the world, the U.S. is in a strong position.  Our economy is on a mild acceleration path whereas China remains on a decelerating path.

The following charts are examples of leading stocks from my Watch List Indicator that are holding up well given current market concerns.  Interested in learning more about my Watch List Indicator? Email me at info@dightmancapital.com.

No specific investment recommendations have been made to any person or entity in this article. Investing involves risk including the loss of capital. Conduct your own research before making any investment decision, or work with an adviser like me.  Call Kelly at 877-874-1133 to schedule a phone call.

Q1 2019 Market & Economic Review

U.S. stocks experienced a strong rally in the first quarter of 2019.  The biggest performance driver came from the Federal Reserve pausing their interest hikes.  Between 2017 and 2018 the Fed raised the Fed Funds rate approximately 8 times and until recently expected to continue raising rates into 2019.  The sell-off in Q4 was largely attributed to the Fed moving too fast with interest rates combined with lofty stock valuations and a mild slowdown in economic activity.  The Fed is also in the process of reducing their balance sheet by selling back the bonds they purchased during their QE program.  They reached a level of $50 billion per month but have since slowed the program dramatically and expect to put it on hold soon.  The Fed actions suggest that while the U.S. economy continues to improve, it remains in a fragile state.

Economically we are experiencing a mild slow-down as reported by Doug Short of Advisor Perspectives in his “The Big Four Economic Indicators”.  For example, January Real Income experienced a sizable decline, but that was after 8 months of growth and followed December’s increase of 1.06%.  Real Sales in February also dipped and 4 out of the last 11 reports have shown declines.  Industrial Production appears to be pausing, with a combination of 2 shallow declines and one small increase during the last three months.  Employment remains the shining star, but February almost reported a decline.  Here’s a look at recent numbers (several reports for March and one for February still need to be updated).

In a report by State Street Global Advisors, they reported confidence of North American investors shows a slight improvement while confidence for European investors declined further.  In the U.S. investors appear skeptical.  In Europe they are faced with BREXIT and a host of other challenges, including violent protest in Paris.

Regarding all the talk about the Yield Curve inversion, we remain in an extremely low interest-rate environment which may reduce the predictability of a future recession a yield curve inversion has had in the past.  The other factor to note is the long lead time between the inversion and the start of a recession (16 months since 1976).

We are at the beginning of Q1 corporate earnings season.  As of last Friday, 25 companies have already reported quarterly earnings.  Overall the market expects a decline in earnings compared to a year ago.  However, as of April 5th industry analysts project a 8% price increase for the S&P 500 over the next 12 months according to FactSet.  During the last 5 years analysts have overestimated their 1-year price target by 1.5%.  The more constructive takeaway here may be the directional move versus the magnitude of the move, especially give the gains produces in Q1.

There are two developments currently working their way through the political process that could have a positive impact on the market.  A favorable resolution to trade negotiations with China and talk of an infrastructure bill, potentially ready for a vote this summer.  Positive developments in these two areas would go a long way toward helping the economy get back onto a stronger growth trajectory.

Overall, I feel pretty good about the economy and markets.

Spare Us the GDP Agony – Brian Wesbury, First Trust

Real GDP grew at a 2.6% annual rate in the fourth quarter, and while some analysts are overly occupied with this “slowdown” from the second and third quarter, we think time will prove it statistical noise.  Even at 2.6%, the pace is a step up from the Plow Horse 2.2% annual rate from mid-2009 (when the recovery started) through early 2017.

Fourth quarter real GDP growth happened in spite of a huge decline in retail sales for December (itself suspicious and likely to be revised higher, as job growth and retailer reports painted a different picture).  Moreover, business investment grew at a 6.2% rate in Q4 and was up 7.2% in 2018, the fastest calendar growth for any year since 2011.

In 2018 as a whole, real GDP grew at the fastest pace for any calendar year since 2005.  And what’s even more impressive is that year-over-year real GDP growth has accelerated in every quarter since the beginning of 2017.  The first quarter of 2017 was up just 1.9% from a year earlier while subsequent quarters showed four-quarter growth of 2.1%, 2.3%, 2.5%, 2.6%, 2.9%, 3.0% and now 3.1%. We expect Q1-2019 GDP to slow like many other Q1s in recent years, meaning this impressive streak may come to an end.  But this too is just statistical noise, and the YOY trend should remain around 3%+ over coming quarters.

“Potential growth,” a measure of how fast the economy can grow when the unemployment rate is stable, has also improved. It’s calculated using “Okun’s Law,” which says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.

Working backward from the unemployment declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, potential real GDP grew at just a 0.6% annual rate.  But in 2018, with real GDP growth of 3.1% while the jobless rate dropped only 0.3 points, potential growth was 2.5%.

The worst part of the GDP story is the political gamesmanship of those who say real GDP only grew 2.9% in 2018.  These data distorters are not looking at the size of the economy in the fourth quarter of 2018 compared to the fourth quarter of 2017; instead, they are comparing production through all of 2018 to production in all of 2017.

Here’s why their method is misleading.  Let’s say that in the first quarter of Year 1 a company earns $100 per share then earnings slip to $99 in Q2, $98 in Q3 and $97 in Q4.  Then, in Year 2, earnings start at $97 per share in Q1, go to $98 in Q2, $99 in Q3 and finally back to $100 in Q4.  Overall, for two years earnings per share were flat.  But that’s because earnings growth was bad in Year 1 and good in Year 2.  But the misleading method used by those saying the economy only grew 2.9% in 2018 would compare total earnings in Year 2 ($394) to total earnings in Year 1 ($394) and say the company had zero growth in Year 2!  But that’s nonsense.  What matters in measuring Year 2 is how much earnings grew during the year, and in our example, that was 3.1% in Year 2.

More commentary from Brian Wesbury can be found on his blog.

Inspiring Podcast by Great Investing Minds

Check out this podcast by one of our top investment providers, ARK Investment Management.  In Episode 9 of FYI (For Your Innovation) you are going to hear from three people.  The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist).  During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer.  A truly inspiring, power packed podcast, on investing in disruptive innovation.