Is this another taper tantrum? Our thesis is for economic growth and rising interest rates. Let’s look at the reasons for, reasons against and where to go from here with respect to our thesis. The reasons that support economic growth and a higher stock market are the following:
- Consumer credit increased
- ISM figures mostly up except for the most recent New York ISM
- US Jobs data and Canadian too, but to a lesser extent
- German retail sales up 1.6% year over year
- US Federal Reserve seeing strength and comfortable slowly but steadily increasing interest rates
- US/Mexico/Canada trade deal completed
Overall this is an environment for growth with inflation not showing in the headlines. There are many bright spots and the fed has indicated an increasing rate environment. We would be ill advised to fight the fed and should be mindful of their actions. As consumer credit increases, transactions increase. An increase in transactions creates growth. US unemployment came in on October 5, 2018 at 3.7% which was the lowest since 1969. Trade deals are making progress however more countries may have to wait until after the November US mid-term elections as China is likely looking for a less hostile environment as Democrats may take control of one or both houses. Gridlock in Washington politics may slow down any momentum that Trump has and create some stability for the markets. Alternatively Trump could try to deploy more leverage against people and countries in order to push his agenda through and that could create more uncertainty. The key will be to look through the noise and focus on long term probabilities. Having said that, politics which have an impact on the markets, the affects are yet to be seen and much has not been finalized. The news is mainly headlines and the main focus should be on the economic data until the structural environment changes.
- German retail sales down 0.1% month over month but better than the previous month of -1.1%
- ISM Manufacturing Prices and New Orders are less than the previous month but remain expansionary
- ISM New York Index at 72.5 from 76.5 but is still good.
- US housing starts, building permits and existing home sales look to be in a down trend
- Copper is down over 10% since it’s most recent peak in June 2018
There are some concerns out there as there are with any environment. There are always bulls and bears regardless of what the market is doing. I’m in the bull camp at the moment but remain alert to risks out there. My primary concerns are the decrease in US housing activity as it seems that existing home sales have broken below recent floors in 2016 & 2017. Another concern is corporate debt as interest rates on the US 10 year closed the week at 3.233% which is the highest since mid 2011. It appears that summer 2016 was the bottom of US interest rates.
Copper is down for the year and is thought to be an indicator of industrial production. It is off it’s August and September lows and seems to be in recovery mode. China has debt fears and the US and China seem to be patient on finding trade agreement solutions which will bring uncertainty. Will China have a soft landing and will they be able to wait out the trade tensions? Given that China is fairly government controlled, they have more ability to stick handle the situation than a completely open capitalist environment.
Italy budget negotiations are being worked out but slowly. There were initial tensions from the big deviation from the last government’s return to budgetary conservativeness when the new government proposed a steady deficit of projected spending over the next three years. Brussels wasn’t going to have it and they seem to have come to an understanding for the time being. This calmed the markets and the Euro strengthened on the news. Since the Euro is a common currency we believe this creates an unnatural valuation for some countries. We believe this undervalues the Euro for Germany which is beneficial to Germany. It also overvalues the Euro for Italy which is punitive to Italy.
One benefit to being commonly tied is the oddly low Italian bond yields. The 10 year bond yield on a government of Italy bond is at 3.435% while the 10 year US treasury is at 3.233%. Just over 20 basis points is nothing for the economic differences. However Germany’s 10 year stands at 0.576% which is being kept artificially low by the European Central Bank. This is suppressing Italian yields and lowers the cost of funding that if the currency was floating for Italy then it would be remarkably lower and it’s bond yields higher.
Keep in mind that German government 1-5 year bond yields are all negative. That’s right. The total return on buying a 5 year German government bond will get you a loss of 0.0695% per year. German 1 year yields will cost you -0.60% per year for their safety. This has a limiting affect on US bond yields as European investors will buy US bonds with the higher yield and this will keep buying pressure on US bonds to some extent. We feel that rates will still rise in the US and also in Europe as the ECB eases their bond buying programs.
Overall the growth of the world is still positive and it is particularly bright in the US with the exception of the US housing. At this point we believe that the housing market is taking a breather rather than going through a contraction. As oil prices continue to stay higher we believe this will flow through to a higher read on inflation and give further reason for the US fed to increase interest rates. These increased interest rates will eventually put tensions on US corporations as there are some companies out there that have taken on too much debt. As those companies refinance their maturing debt at higher interest rates, we will likely see stress come out in the markets. This is expected in 2019 or 2020.
Given the bright spots in the US economy we continue to be focused there for equity exposure. Industrials and financials are the preferred sectors however we are happy to settle with a core holding of currency hedged S&P 500 or Dow Jones Industrial Average Indices. For international equities we focus on Germany as they Euro is soft and they are an export focused country and an economic powerhouse. Many ETF’s have 40% in the UK however the GDP in Germany is actually larger than that of the UK as of the last reads. Further, Germany is the benefactor of a brexit as many financial companies are moving operations to Germany so we will see a migration in workers and productivity from the England to Germany. As we look for trade deals come to conclusion, the senate or congress is likely to turn more democrat and we think economic growth continues. This will continue to be our focus until there is a change in tide.
We believe the sell off in US equities this week is a taper tantrum of sorts and will be a buying opportunity for equities as we head in to year end.
On the bond side we still prefer to hold 1-3 year bonds and hold them until maturity. Higher the quality, the better, as we prefer the equities to do the heavy lifting and let the bonds be a stable force that matches cash flows in a portfolio.
As the fed expects short term interest rates up from today by 0.85% and 1.15% by the ends of 2019 and 2020 respectively. This will be troublesome for most bond portfolios. Keeping short term rollovers of bonds will allow us to buy bonds in the future that have an expected higher yield.
Our call is for: Overweight equities, overweight US economy, currency neutral, short term bonds.
Until next week.
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