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).


    Debt

    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.


    We thank you for your continued support.


    Sincerely,


    This newsletter is distributed for general informational purposes and does not constitute investment advice nor is it intended to constitute legal, tax, or accounting advice. No part of this newsletter nor any links contained therein is a solicitation or offer to sell investment advisory services except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. Information throughout this newsletter is obtained from sources which we believe reliable, but we do not warrant or guarantee the timeliness, accuracy or completeness of this information and the information presented should not be relied upon as such. All investments involve risk of loss, including the possible loss of all amounts invested, and nothing within this newsletter should be construed as a guarantee of any specific outcome or profit. This newsletter is confidential and is intended solely for the information of the person to whom it was delivered and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person under any circumstances. The information contained in this document is believed to be accurate as of the date hereof and is subject to change without notice. Schnieders Capital Management is not affiliated with any of the companies or indexes mentioned in this newsletter

    © 2019 by Schnieders Capital Management, LLC

    Schnieders Capital Management, LLC is a Registered Investment Advisor. Schnieders Capital Management, LLC may only transact business or render personalized investment advice in those states and international jurisdictions where we are registered/filed notice or otherwise excluded or exempted from registration requirements. The purpose of this website is information distribution.
    Any communications with prospective clients residing in states or international jurisdictions where Schnieders Capital Management, LLC and its advisory affiliates or registered representatives are not registered or licensed shall be limited so as not to trigger registration or licensing requirements.

    The information on this website is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. Information throughout this site, whether stock quotes, charts, articles, or any other statement or statements regarding market or other financial information, is obtained from sources which we, and our suppliers, believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.

     

    USE OF LINKS TO OTHER WEBSITES: This website may contain links to third-party websites. These links are provided solely as a convenience to you and does not imply an affiliation, sponsorship, endorsement, approval, investigation, verification, or monitoring by SCM of the contents on such third-party websites. SCM is not responsible for the content of any website owned by a third party that may be linked to this website regardless of whether the link is provided by SCM or a third party. SCM does not prepare or maintain, has not and will not review or update, and does not guarantee the accuracy, timeliness, completeness, suitability, reliability, or usefulness of any information contained on a linked third-party website. If you decide to access linked third-party websites, you do so at your own risk. Furthermore, no representation or warranty is provided for any software that you may download from a link from this website.

     

    THIRD PARTY CONTENT: Through this website, you may have access to information relating to securities, indexes or the securities markets ("Market Data"). SCM may compile or obtain this Market Data from third parties who are independent of SCM. Even though the sources of the Market Data provided on this website are believed to be reliable, SCM is not responsible for, and makes no warranty with respect to the contents, accuracy, completeness, timeliness, suitability, or reliability of the Market Data. The Market Data that may be provided is not a complete summary or statement of all available information or data. SCM makes no express or implied representations or warranties, including but not limited to warranties of merchantability or fitness for a particular purpose, with respect to Market Data.”