Q1 2020 Market Commentary
Change in Federal Reverse interest rate policy spur large gains in 2019
The equity markets had a robust 2019 spurred by changes in interest rate policy. At the end of 2018 the Federal Reserve Bank was predicting about four interest rate hikes in 2019, but by January of 2019 the Fed reversed course (after a 20% decline in the equity market at the end of 2018) and actually cut rates three times in 2019. In turn, this lead to a sharp rally in the equity and bond markets. Moreover, the Fed is now forecasting no rate hikes before the presidential election and modest inflation. European Central Bank president Christine Lagarde has also stated that monetary policy in Europe will also remain accommodative for growth. In this commentary we will discuss how the Federal Reserve actions rallied the market last year, why we believe the expansion will continue, as well as review some of the geo-political risk and negative debt trends we see on the horizon.
The turnaround in stocks last year was driven primarily by a shift in monetary policy. The change in monetary policy was a lowering of interest rates and a return to expanding the Federal Reserve’s balance sheet. Remember that the value of any income stream is determined by the value of the risk free rate (short term U.S. interest rates). As interest rates decline, the value of stocks and existing bonds goes up, and vice versa. Thus, we believe lower interest rates caused last years’ double digit higher equity prices, even though RBC Capital Markets reports that the S&P 500 earnings growth was up only 2% year over year. However, because prices have moved higher while corporate earnings have only moved modestly means that valuations have become more expensive which puts a greater degree of risk into the financial markets. Indeed, the most common valuation on equities such as price/earnings and price/book value ratios are both running higher than historical averages. According to Standard and Poor’s, the forward price to earnings ratio on the S&P 500 is now 18.18 as of December 31, 2019, versus the 16.26 historical 25 year average. That does not mean prices have to go lower this year. James Paulsen, of Leuthold Group Research, has pointed out that when the interest rate on the ten-year U.S. government bond is trading below three percent (the current rate is 1.92%), that future 12- month returns were negative only 18% of the time.
To keep the current stock market rally going without equity valuations expanding even further, earnings growth will have to pick up, and interest rates will have to remain low. Fortunately, both things seem likely. Wall Street analysts see stronger earnings growth this year, driven by secular trends and stock buy-backs. FactSet Research is estimating 9.6% earnings growth for the S&P 500 this year. Over the long term, UBS points out that over the next ten years major demographic trends will drive earnings growth primarily because 790 million people worldwide are expected to move from rural areas to cities (which will create demand for consumer goods). Further the number of internet users are expected to expand to 7.5 billion from 4.3 billion, and connected devices will number 46 billion up from 10 billion last year. These fundamental changes will continue to drive earnings growth in a number of industries particularly in the technology sector.
The lower interest rates that helped drive equity valuations higher last year are also starting to benefit the interest sensitive areas of the economy like housing. U.S. homebuilding and permits for future home construction jumped to a more than 12-year high in November, pointing to strength in the housing market amid lower mortgage rates. Housing starts increased 3.8% to an annual rate of 1.314 million units, with single-family construction rising for a fifth straight month. Building permits surged 5.0% to a rate of 1.461 million units in November, the highest level since May 2007 (CNBC, Commerce Dept.). The improving housing sector should help U.S. manufacturing because a higher percentage of manufactured items used in homes are actually made in the U.S.A. (roofing, insulation, drywall, wood, glass, plumbing, carpets, paint etc.).
Reducing share capitalization will also drive earnings growth. According to DataTreck research, U.S. companies have been able to issue bonds to repurchase shares of stock, arbitraging the cheaper cost on debt versus equity capital. Many companies now actually pay higher dividend yields on their stock than they pay on interest cost for their debt. This makes buying back stock an easy way to boost earnings. Last year 334 of the S&P 500 companies shrank their shares outstanding last year, with 115 of them cutting their share count by at least 4%.
Corporate stock buybacks not only increase future earnings, but also continue to be a major driver behind the stock market rally. Before the 1980s, corporations rarely repurchased shares of their own stock. When they started to, it was typically a defensive move intended to fend off corporate raiders, who were drawn to cash piles on a company’s balance sheet. By contrast, according to Federal Reserve data compiled by Goldman Sachs, over the past nine years, corporations have put more money into their own stocks—an astonishing $5.04 trillion— than every other type of investor (individuals, mutual funds, pension funds, foreign investors).
We believe the growth of domestic and international debt is and will remain the biggest long term fear for both the U.S. in equity and debt markets. While low rates will make corporate equities look more attractive in the short term; the low interest rates are masking a bigger and growing problem of debt. The International Monetary Fund reports that global debt has reached an all-time high of $184 trillion. On average, the worldwide debt now exceeds $86,000 in per capita terms, which is more than 2.5 times the average income per-capita. The Federal Reverse now reports the U.S. has close to $22 trillion in debt (debt held by the public was $16.1 trillion and intra-governmental holdings were $5.87 trillion) so in the U.S. even a 1% rise in interest rates would add $220 billion in annual interest costs to our budget. This amount of forced spending would quickly crowd out other budget items. To put this in perspective, The Congressional Budget Office indicates that by this year, the cost of paying interest on the national U.S. debt will have roughly doubled in the last three years due to rising interest rates in 2017 and 2018 and large budget deficits. At the current rate, interest expense will exceed the level of discretionary defense spending within five years.
Due to these high debt levels, we believe interest rates will remain low both in the U.S. and internationally as governments around the world pressure their central banks to keep rates low in order to service their growing balances. In the U.S., interest rates are low, but still significantly higher than other developed economies, which gives the U.S. more options. In fact, Barron’s reports that there are currently over $11 trillion of bonds around the world with a negative yield. Most of the negative yielding bonds are sovereign debt in Europe and Japan. These are investments that are designed to return less than nothing. Such policies that were once considered highly unconventional have now become normalized as governments become increasingly reliant on central banks to cover gaps in fiscal and economic policy.
The Dallas Fed research highlights the problems with high debt. First, a rising debt trajectory is associated with slower economic growth. The Dallas Fed research found that “growth was about 1 percentage point per year lower” when government debt exceeded 90% of GDP. The United States, most of Europe, Japan, and China (most of China’s debt is on the municipal level, not the national level) are already at this threshold. In the U.S., when expected GDP growth is forecast at only 2%, this is a big number.
Next, the low interest rates needed to service debt come at the expense of investors. As early as the mid 1990’s investors could get over 7% ($70,000 of income per 1 million invested) on a ten year U.S. government risk free bond. At the end of last year, that same ten year U.S. bond yield just 1.92% ($19,200 in income per 1 million invested). Thus, investors are forced to accept less income or take on more risk to get income even though prices have increased sustainably since the mid 1990’s.
In addition to debt, geopolitical risk (Iran, North Korea, Russia, and China) remain an ongoing issue for the market as does market uncertainty and political risk. We believe the uncertainty of the up-coming presidential elections will weigh on investors’ minds as the economic policies of the candidates are far apart. We will comment more on this as the elections get closer. Fortunately, some other uncertainties have also been cleared up; Brexit is happening, and the trade war phase one has been concluded. The trade deal should aid U.S. farmers and at least make the terms of trade a little bit more favorable to U.S. companies doing business in China, although huge trade deficits with China are likely to continue. Strategas Research Partners estimates that the proposed deal will save $62 billion in tariff cost which includes $45 billion in new tariffs that will not happen and a $17 billion dollar reduction in existing tariffs, which in aggregate is about 0.3% of U.S. GDP. That might not sound like much, but it is important to the U.S. manufacturing sector of the economy which is much more dependent on trade for sales and parts and it removes some uncertainty for that sector. Manufacturing was the weakest overall sector last year in the economy with flattish to negative growth.
On another positive note, in regards to the Middle East, the threat of oil disruption has been reduced significantly. According to the Washington Post, the EIA (Energy Information Administration) reported that the U.S.A. last month exported more oil and oil products than it imported for the first time since 1949. We thought this is important to mention for two reasons. First, since oil has traditionally accounted for half of our trade deficit, and since the trade deficit has continued to grow even though we are now a net energy exporter, the number of American manufacturing jobs that have been lost over the last two decades is even more severe than the gradually rising trade deficit suggest (EIA). Second, the fact that the U.S.A. is now the world’s largest oil and natural gas producer, and a net energy exporter means the U.S. will be less interested in keeping stability in the Middle East and ensuring access to the regions energy supplies (EIA). It is unlikely that the U.S. would have killed general Qasseem Suleimani, Iran’s top general and second most powerful person if we were still importing 13 million barrels of oil a day as we were at our peak imports. In the past, the possible shortages of oil, the disruption to the economy and spike in prices at the pump would have likely caused a recession. Today, the U.S.A. is producing 12.9 million barrels of oil and oil liquids a day, compared to Iran’s current oil production of 2.1 million barrels of oil a day (down from 3.5 million barrels a day before the sanctions) (OPEC). Indeed, the Federal Reserve Bank issued a report to Congress in late 2018 that stated the U.S. is now a net beneficiary from higher oil prices (Market Watch). This is important for stock investors because it means the U.S. may act more unilaterally in the future in the Middle East and be less concerned about regional stability since it gets little oil from the region. This is especially true since about 80% of the oil that leaves the Persian Gulf now goes to Asia (mainly China, Japan, India, and South Korea) and most of the balance goes to Europe, according to Neil Mellor who is the senior strategist at BNY Mellon. However, this willingness to act will create more uncertainty for stock investors, and more volatility in prices.
In conclusion, last year was a good year in the markets which we believe was driven by monetary policy and aided by a growing economy. With the ten year interest rate on U.S. T-Bill’s near historic lows of only 2%, this set off a rush into equities which for most of 2019 created a situation where stocks paid a higher interest rate than bonds. This pushed investors to grab income producing assets of all types in 2019 pushing up valuations despite relatively anemic earnings growth. Moreover, given the massive debt loads both domestically and internationally, we believe interest rates around the world will stay low in order to service these debts. Furthermore, earnings are expected to pick up this year, which when combined with low interest rates should bode well for stocks. While we don’t expect 2020 to be as strong as 2019, we do expect returns to be positive, but we also expect more volatility this year due to the presidential election and geopolitical risk. However, we believe that low rates and positive earnings growth are masking tomorrow’s problem of overly elevated debt levels that need to be addressed. As a result, we plan to continue to focus on brand name, large capitalization companies which provide goods and services that consumers use on a daily basis and who are returning cash back to investors from both dividends and share buy-backs.
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