By: Alan Lewis
Since my last writing in September much has happened, and therefore I would like to bring several subjects to everyone’s attention. I will begin with what happened to the repo market and why it’s important. Then, I will also touch on demographics and their importance for the economy and financial markets. Finally, we’ll revisit the topic at the end of my last article on the consequences if rates stay very low for longer? This is a question I have been pondering for some time now. What is the impact on savings, pension funds and the banking system? What does this mean when valuing equities and private market investments?
On the 16th of September in the repo market rates were briefly blown out to 10% until the Fed intervened. Since then over $320 billion has been released due to the ongoing issues of liquidity in that market. This has effectively reversed the entire QE 2 unwinding of the past 18 months. The Fed has just announced the addition of $500 billion for the repo market going into year-end. The Fed has been very careful not to call this QE 3, but rather a repo adjustment…hmmm. In fact, the result is the same, the Fed has been injecting massive amounts of capital into the system. We should all be alarmed by this as it clearly shows there is a liquidity issue in the market. However, I would argue in the short term with all this added liquidity it has served as fuel to lift markets artificially.
In just a short 12 months the Fed posture had gone from tightening (Q 4 2018), with statements indicating further tightening would occur well into 2019, to an easing cycle by the end of Q1 2019. Why did this happen? Did the Fed not see that since Q3 of 2018 the global economy was slowing? By Q4 of 2018 the evidence was very clear not just in Europe but in the U.S. as well. Here, what is most important to watch is the “rate of change” not the absolute top line number, to determine the direction of the economy. This slowdown has continued for all of this year when looking at the rate of change across all economic indicators, including employment. Employment and wages remain the bright spot as they are holding up better, but this should be expected as these are lagging indicators, usually not rolling completely over until a recession becomes a reality. Now I am not predicting a recession. The most recent PMI data points to a continued slowdown with forecasts for GDP growth in the coming twelve months of around 1.5%.
Earnings forecasts continue to point to ending up with a small negative, however more importantly visibility for the future is low. The latest monthly CEO survey point to a slowdown. This is 9 months in a row of negative sentiment from CEOs. I believe we are still not out of the woods and should not expect any significant rebound in economic activity.
Links to the CEO Survey:
The chart below compares U.S. to OECD
With over 60% of government rated interest rates globally in negative territory and others not far away, how does this impact economic activity? Negative rates are a real sign of economic breakdowns. What are the consequences of this? To begin with, the banking sector has been negatively affected and it is the fuel that drives economic growth. But with interest margins being negligible in the banking sector how can they improve profitability and more important, continue their role in fueling the economy? There are also signs of stress in Japan and Europe with negative rates on their financial system. Low rates are supposed to incentivize corporations and individuals to take on loans to expand businesses and for individuals to borrow for a house or a car. However, if the corporation has a negative outlook on the coming 18 months, what incentive do they have to borrow? If a business sees less demand for what they produce and have excess capacity, why should they invest? On a slight positive note, we have just seen announced a phase one, deal on trade talks with China. While it’s a relief to have some sort of deal, is it any reason to celebrate? China agrees to buy $50 Billion of ag products, +$29 Billion from before tariffs, BUT, tariffs have cost U.S. farmers $11Bil and U.S. taxpayers have spent $28Bil on emergency payouts to farmers. It looks like a net loss to me. I guess the most important part of this agreement is that it provides some clarity and removes some noise.
This brings me to the importance of the consumer. It is the consumer that drives the U.S. and other developed economies. Here I must begin with demographics which are a sleeping giant when one considers the long cycles of economic activity. Its effect is not seen until one is smack in the middle of a change. Much has been written about the baby boomers, the largest generation ever seen. Baby boomers are now reaching the age of 65 at a rate of 10,000 per day. This will continue until 2030 before slowing down. Why is this important? Seniors have very different spending habits than young families. They don’t need a new home. They don’t change their car every 2/3 years; the list goes on and on. Quite simply they become much smaller consumers. On top of this they are no longer the big savers. In fact, they now start withdrawing the saving they spent years accumulating for retirement. From a financial market point of view, they have become liquidity seekers, not liquidity providers. We should not underestimate the impact of this, as we have seen the effect of this on Japan and developed Europe as well.
Just as Boomers propelled the growth of the mutual fund industry in the 80’s & 90’s, they are now beginning to withdraw their accumulated savings. Can this potentially cause shocks to the system? They certainly will have an impact, and perhaps even in conjunction with other events, it could create a shock. The baby boomers were the consumption generation. Compare baby boomers to millennials and you will see very different spending habits. Millennials are often more conservative. In sum, I believe that we are in the beginnings of a secular decline in demand for large ticket consumer goods in the U.S. This does not necessarily infer a massive slowdown, only that demographics as they are will be a drag on the economy until at least 2030. Both, in absolute economic and financial market terms. The difficulty is how to quantify demographic changes. This is usually not clearly seen until after the fact. It is not a reason to be defensive in asset allocation by itself, but it will present a certain headwind for some sectors and should be looked at more closely before investing.
At the same time, with the globalization of the world over the past 25 years much has changed. A positive point is the number of people that have moved out of extreme poverty. In 1990 for example, 37% of the world population lived in extreme poverty. In 2016 the number has decreased to 10%! There are many factors that have caused this. A brief example on how this happened, very simply, is that instead of making TVs in the U.S. we now make them in Korea and other emerging markets. The same is true for so many other consumer goods which has improved the standard of living globally for the poor. It has also made goods for consumers in the western nations much cheaper. I believe the big win for developed and emerging economies that gave us all the ability to obtain goods produced at far cheaper prices than before is now in the rear view mirror. Hence, we have seen the globalization of the consumer. One should look carefully at what areas (globally) are seeing the most growth on a secular basis. A question, are we at the end of the deflationary forces that were behind this?
In considering the very low rates we have today and the likelihood that rates will stay low, how does this impact the valuation process for equities and other investments? What does this mean for the pension and retirement accounts? The chase for yield has been massive for several years now. It has created bubbles everywhere, from bonds to equities and as followed through to PE and VC valuations. With capital being essentially free today how does one value any given investment? Corporate bond issuance is above the level seen in 2007. Equity valuations are at levels not seen since 2000. Does this make sense considering where we are in economic terms with corporate earnings still falling? Does it make sense considering what is happening structurally with demographics as they are? Perhaps it does if one was to assume rates at zero forever, but I am not sure I would bet on that. How one makes adjustments to their portfolio very much depends on their client. Pension funds for example, are facing very difficult choices as most pension funds cannot meet their 7% targeted return without going further out on the risk curve. Very simply, the classic 60/40 equity/bond allocation no longer works. We have seen pension funds increase their allocations to real estate and private equity in hopes of making up the performance difference. Certainly, accepting more risk is necessary if one is going to reach a targeted return with the U.S. 10 year at 1.82%.
Below is my current asset allocation:
Equities: Modestly overweight, with a preference for outside U.S.. Value underperformance is at an extreme, so I would have an allocation here.
Credit: Underweight, Credit has had a great year, however the level of corporate debt has me concerned. Credit issuance is now above 2007 levels, and the chase for yields has made prices too high.
Govt Bonds: Neutral with a preference for the shorter end of the curve and inflation protected bonds.
HFs/Real estate, Private Equity/VC: Neutral, I would avoid VC in the shorter term. I am positive long term on the space just make sure your managers are disciplined and not over-paying for investments.
Commodities: Gold, a new position early this year. With global central bank posture as it stands, gold will benefit and it’s a good hedge.
USD:I believe we have seen the highs in the US Dollar.
I wish I could give you a definitive answer to the current market dilemma, but I can’t. This is the one thing that keeps me awake at night. I do believe we are living in unprecedented times, seeing things in markets that no one has seen before. It is easy to say, “well the Fed will bail us out”, after all they always have done so. But, can we reach a point in which the consequences of free money will bring a great deal of pain? I have always been taught that there is no such thing as a free lunch, and I can’t help but believe that the world has been living on free lunches for a while now. How one positions their portfolio in this environment is difficult to answer. As I stated above, it very much depends on the individual investor and their requirements. I think that we have to accept more risk in order to have a chance of achieving better returns. To do this we have to accept more volatility. We also need to consider broadening our exposure to different asset classes rather than the classic stock & bond portfolio. Real estate and private equity are certainly areas to look. But I would also look at precious metals, gold in particular. With all the liquidity being added to the system globally the possibility of currency devaluation is certainly there. Should this happen gold will shine. In addition, gold is without a doubt the most under-owned asset you can find. Obtain exposure either through the metal itself or a basket of gold equities. An area I would definitely avoid is corporate credit. I believe the next real downturn will have the most negative impact in corporate credit. Another suggestion is to take a careful look at the liquidity of your portfolio. Here, stress tests can be very beneficial. Assume a high stress environment in your testing and see how your portfolio holds up. If you don’t like the result, do not dismiss it, study it and make adjustments as needed.
I have only touched the surface on several topics here. I firmly believe that we all need to carefully study and determine what the impact of demographics and zero interest rates could have on the financial markets as well as on the economy. A recent meeting reported by Bloomberg that had economic notables such as Janet Yellen and many other concluded that there is still no consensus on why global inflation stays lame or what comes next in the economic cycle. I don’t have a crystal ball, so I would both enjoy and very much appreciate the ability to discuss these thoughts with readers, so please do contact me to discuss.
Finally, I want to wish everyone a very Happy Holiday Season! Peace and goodwill to all.