Trade Jabs & Big Tech Snafus

2018 has turned out to be a completely different investing environment from 2017. I have been reminded of debt market issues I thought I would not to have to address until 2019-20, beginning with interest rates.

We remain in a low interest rate environment, well below levels we saw before both recessions we experienced earlier this century. Short-term interest rates have started to move higher, primarily as a function of the Fed normalizing interest rates, but the yield curve for maturities between 7-30 years show only a slight increase over short-term rates. Overall, interest rates remain well below levels that have historically marked the start of a recession. We are reminded, however, that interest rates can rise swiftly and for reasons other than Fed policy.

Here’s a look at the current yield curve for U.S. Treasury Bonds which represents the rate of interest for different bond maturities.

April 2018 (Stockchart.com)

The current Treasury yield curve shows short-term rates just over 2% for two-year maturities and just over 3% for a 30-year bond!

Here is what the Treasury yield curve looked like prior to the 2000-2003 recession, where short-term rates were above long-term rates which created what is referred to as an “inverted yield curve”.

August 2000 (Stockcharts.com)

Prior to the Great Recession of 2008-09, the Treasury yield curve was flat and at much higher rates across maturities, compared to today’s levels.

July 2007 (Stockcharts.com)

The question investors should ask is, what besides the Fed could cause interest rates to rise in the current environment?

Ongoing deficits in the U.S. require the federal government to issue new debt to keep the government running. Have you noticed the increase in potential government shutdown warnings? It is not as though the economy stops if a shutdown materializes, but it is a reminder the federal government is chronically broke, which could eventually create a bigger problem.

In addition, existing government debt must be refinanced as it matures. As interest rates rise, the interest expense to the U.S. government increases requiring a larger amount of the federal budget (which may have something to do with why President Trump pushed some infrastructure spending to states and private partnerships). As of 2017, it was estimated that 70% of Treasury debt held by private investors will need to be refinanced in the next five years. (The Fiscal Times, June 7th, 2017, Lawrence Goodman) Much of the current U.S. debt was issued when short-term interest rates were near zero due to quantitative easing (QE). It wasn’t until 2016 they started to creep higher; the biggest move in short-term interest rates has happened in the past 12 months.

There are other potential challenges, recently highlighted by JP Morgan CEO, Jamie Dimon. He reminded investors in his annual letter to shareholders that rates may move higher than expected, as the Fed and other holders (China) move to sell more Treasuries (QE unwind, Trade War Retaliation), at a time when market structure (a reduction in market makers – broker/dealers making a market for specific stocks or bonds due to financial reform and other factors) may not be able to provide the needed liquidity. As asset prices adjust to a not so positive environment (swift moving interest rates), declining stock AND bond prices could lead to a market panic (which may end up being a terrific buying opportunity).

There is risk too in the Trump tax plan.  A reduction in federal government revenues would be a disaster further aggravating our already enormous deficit.  The administration is counting on tax cuts to stimulate economic activity, increase employment and wages, to make up the difference and then sum.

Other aspects of the current environment remain attractive. Throughout the 20th & 21stcenturies the stock market has moved to higher levels after severe market events. We may not see the Dow hit 30,000 before the next bear market (which is a shift from my previous view) but if long-term trends continue we are very likely to see it within the next decade.

The current selling in the stock market has been a typical correction. The combination of interest rates on the rise, big tech snafus (Facebook, Uber, Tesla) on high valuations, trade jabs between President Trump and Prime Minister Xi, it’s not surprising stocks have struggled. There are plenty of positive trends that even if the correction deepens, should help stocks find their footing.

We are about to enter Q1 earnings season which could be a positive diversion. Analyst expect strong sales and earnings growth which could provide the cover needed for current company valuations to push higher, especially if guidance remains strong. A record number of S&P 500 companies are issuing positive earnings per share guidance for Q1 (according to FactSet), on the back of steady and/or improving economic numbers. Combined with a renaissance in technology and consumer services, there are a lot of reasons this market has more upside.

Trade Negotiations & LIBOR Spike

Another round of volatility hit stocks this week, but current support levels remain, and volume has been tamer. The Nasdaq 100’s outperformance YTD remains intact suggesting tech investors are still committed to the sector.

It’s one thing to see stocks under pressure but the recent spike in LIBOR (the rate banks lend to each other overnight) was my focus this week. Fortunately, the banking system remains stable and the rise in LIBOR appears to be the result of an increase in demand from short-term U.S. government funding needs for deficit spending and U.S. corporations pulling offshore money from corporate bonds and putting it into cash for spending. While the spike in LIBOR signals caution, banks impacted by the higher rate are not flashing other warning signs.

For those familiar with the TED Spread, the difference between interest rates on Eurodollar Contracts and T-bills, we are still well below levels that signaled problems in the banking sector back in 2008.

On balance the market is evaluating several concurrent events; higher interest rates, chronic deficit spending and trade policy adjustments are center stage. The economy and corporate sales/earnings are in good shape, so the bias remains to the upside. If a nasty trade war does break out, then we could see more downside pressure on stocks and the economy; we are a long way from that environment and it will be interesting to see how far President Trump will push the Chinese. They have far more to lose then we do in a trade war, but I don’t think the president wants to derail the overall growth environment in the U.S.

There is no such thing as “free trade”. What President Trump is trying to do with trade overall is reduce the concessions we provide our global partners (and reduce outright theft). The goal of spreading wealth via trade rules is a noble one, but the principles that make our country the success it is are free for the adopting too.

You may have heard, today the Dropbox IPO started trading and delivered a gained of 35%. An active IPO market is a sign this market may have more upside. Leading stocks are also holding up well, which is promising.

So far markets are correcting for trade uncertainties following interest rate concerns earlier this year. As uncomfortable as it can be, it’s a healthy process and should allow stocks to resume their uptrend once trade matters are resolved.

Stock Market Anxious & Vulnerable

This was one of the most fascinating weeks in my career as a portfolio manager. Stocks were under aggressive selling pressure most of the week but ended the session on Friday recovering most of the days’ declines. Especially encouraging was the impressive advance Friday from the tech sector and small caps. Overall trading on Friday was supportive but action for the week is another reminder to investors, we have entered a new phase of increased market volatility.

Here is how the S&P 500 traded on Thursday and Friday.

The biggest issue at hand is not President Trump’s steel and aluminum tariff announcement. Time will tell how the policy unfolds. The biggest challenge has more do to with the new Fed Chair, Jerome Powell, providing both houses of congress his first testimony. Unlike prior Fed chairs, Chair Powell appears less concerned about what Wall Street thinks and more focused on executing his monetary policy. Here is what one of my Wall Street trading contacts had to say about the Donny & Jay Team…

“If you think Donny is going to pull back on this major announcement just because the mkt sells off a bit – think again……Like Jay Powell – Donny will not be led around by the nose when traders on Wall St. throw a hissy fit.” Kenny Polcari, Oneil Securities

The market was already anxious and vulnerable so testimony from Chairman Powell on interest rates, which are headed higher, and import tariff policy by President Trump, is bound to rattle markets. From elevated levels in a prolonged bull market, stocks are vulnerable to steep corrections.

I would suggest the interest rate and inflation dynamic is what is driving markets today. My ongoing research has caused me to change my view of whether an increase in rates from current levels can negatively impact the economy and stock market. I have suggested that interest rates rising from such low levels are not likely to have a negative impact our economy or the stock market until they move past normal levels. Most rate hikes in the past that have slowed the economy have occurred at much higher levels. However, a closer look at three different factors facing most central banks in the world has changed my thinking.

Those factors are:

1- Refinancing costs by treasuries (issuing new debt to retire maturing debt)
2- Treasuries issuing new debt to fund budget deficits
3- Central banks selling bonds from their balance sheets

Collectively these three factors represent a massive impact on the bond market. Central bankers and treasury officials do have options for managing these challenges. The Fed will increase their available tools after a few more hikes in the Fed Funds Rate. The playbook seems pretty clear for 2018, the Fed lifts the Fed Fund Rate to around 2% while the economy strengthens on Trump’s economic policies. 2019 is where it will get interesting and the stock and bond markets are already anticipating the environment 6-9 months in the future.

For reference, here is a quick look at the Prime Lending Rate, Consumer Price Index and the S&P 500 over the last 20 years.

Much of the recovery from 2008 involved bond buying by central banks: Bank of Japan, European Central Bank and the Federal Reserve. The Federal Reserve was the first to start selling bonds from their balance sheet last fall. Keep in mind, the bonds on a central bank balance sheet are in addition to bonds a treasury department may issue to fund government operations. Central bank balance sheet bonds are already issued bonds, treasury bonds are newly issued bonds. As I have communicated many times, the world is swimming in debt from decisions made during the last financial crisis and a consumption driven economy.

Japan has even hinted they may stop purchasing government bonds soon. Once a central banks shift to selling bonds from their balance sheets, while government treasuries continue to issue new bonds to fund operations, the supply of bonds very well may push prices down further and interest rates higher. Some traders are expecting the U.S. Treasury to issue substantially more 30-year bonds around this time next year. Combined with ongoing sales from The Fed (which holds several trillion dollars’ worth), some traders believe bond prices will have to be much lower to get new bonds sold, driving interest rates higher. Higher interest rates mean government debt servicing costs are going to rise which will increase the deficit (which shows no end in sight). As I have said before, I would not be surprised if the next crisis comes once again from the bond market. What policy makers are dealing with now is the other side of Quantitative Easing, the strategy used to address the last financial crisis.

The White House is hoping economic growth accelerates and tax revenues increase to cover costs and reduce the deficit. If the economy grows too fast The Fed will be under pressure to raise short-term interest rates, where most of government debt is financed. This will cause debt servicing costs to shoot up. This is another concern I have mentioned in prior commentary. Debt servicing costs as a percent of the Federal Government expenditures is a risk to the economy. Unfortunately there are not many good options for policy makers.

Markets have pretty much priced in 3-4 increases in the Fed Funds rate for 2018. Now the attention is focused on 2019. It should be clear President Trump and Fed Chair Powell have a very delicate balance to maintain but their style of communicating their policy is decidedly different than previous administrations. They can’t really afford to let markets dictate their moves (many analysis and commentators believe The Fed waited to long to raise rates). They have to take actions based on what they believe will be the best path for navigating the U.S. economy through the current challenges.

The key appears to be maintaining a steadily improving economy of moderate GDP growth around 3%. Here is where Economic Cheerleader Trump may run into problems. The harder he pushes for 4% growth the more trouble he may create in debt markets. The good news here is innovation is alive and well at a time where money is plentiful, financing relatively cheap and government policy is generally favorable.

From a portfolio management perspective, there are clearly better areas of the stock market to be invested in right now and even some undervalued assets to consider bringing into portfolios to reduce risk levels. 2018 appears to be delivering a market where investors may be rewarded for making the right changes to their portfolio. Let me know if you are interested in discussing how I handled the 2008 bear market and how I am addressing the current set of challenges and opportunities.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

Tax Cuts and Jobs Act Overview

There are many changes to our current tax system with the recently signed, Tax Cuts and Jobs Act.  It is going to take more time for tax advisers to fully comprehend how the new act applies to individual situations.  In the meantime, the following Tax Cuts and Jobs Act Alert does a nice job of summarizing parts of the old and new law, as well as highlighting other changes.

 

 

Fed Rate Hikes & Bond Prices

After several interest-rate hikes this year, U.S. bond prices are looking for support and so far they have found it.

The iShares 7-10 Year Treasury ETF (IEF) closed today at $105.40.  Since June, $104.75 has provided price support.  Looking back to the start of 2016, a price of $101.50 has held ground.  The average yield* for this bond ETF is currently reported to be 2.36%.

Looking at interest rate sensitivity, the effective duration on IEF is 7.5.  This tells us it might only take a 50-basis point rate hike to move the price of IEF below $101, a real possibility next year.  Durations change and the surprising bond rally, along with stocks during most of 2017, may mean bond investors will be giving up a bit more if rates continue to rise.

With the Fed Funds rate already at 1.5%, the Fed may come up against the rate they are reluctant to cross, 2%.  It will be interesting to see how new Fed Chair, Jerome Powell, approaches rates next year.  It is highly likely the Fed is concerned bond price sensitivity (duration) may go up in 2018; something bond investors should keep in mind.  If you want to adjust your bond portfolio interest-rate sensitivity, now may be the time to do it.

There are a multitude of reason why the Fed needs to be more careful raising rates going forward; government-debt funding is at the top of the list.  And let’s not forget, the Fed has just started unwinding a balance sheet with billions in bonds.  There is no doubt Mr. Powell will have his hands full trying to appease the inflation hawks while selling bonds if the economy continues to grow.  It looks like next year could be very different for the bond market.

Here’s a quick look at where other bond ETF prices are trading.  As the charts below show, most of the bond market has taken this years’ rate hikes in stride.

Aggregate U.S. Bond, Average Yield* 2.68%

Corporate Bonds, Average Yield* 3.39%

High-Yield (Junk Bonds), Average Yield*  5.54%

Municipal Bonds, Average Yield* 2.16% (Tax Equivalent of 3.32% at 35% Rate)

* Average yield data provided by Blackrock at www.ishares.com.

Cryptocurrency Resources & Tools

I have received a lot of inquiries about Bitcoin and other “cryptocurrencies” recently.  As a finance related subject, I believe it is important to help individuals educate themselves so I offer the following learning resources.

I am not acting as an investment adviser in ANY capacity regarding information in this communication about  cryptocurrencies (CC).  As a finance topic, I am willing to pass along information to help people educate themselves further.  The information contained herein and referenced externally is not enough information for anyone  to enter the market for cryptocurrencies.  Anyone that does their own research and gets involved with CC will need to stay engaged in the subject as future developments may require their attention.  I am not offering any ongoing assistance in this area at this time.

THE FOLLOWING INFORMATION IS FOR EDUCATIONAL PURPOSES ONLY.

 

Warning, the cryptocurrency market is ripe for scams and there are likely many underway as I type these words.  Proceed with caution and consider working with friends, family members, colleagues, etc. to explore this area together.

Individuals interested in understanding Bitcoin and related CC might want to begin by watching the movie, Banking on Bitcoin.  It it also available on some on-demand networks.  The documentary may help an individual determine their interest level in this subject.  Another important video for understanding the ebbs and flows of the U.S. credit based economy can be found on YouTube, How The Economy Works, by Ray Dalio.

Phone App/Information Sources

A phone app, like HODL, can also be a great resource  where fundamentals, news, charts and posts for different CC can be reviewed.  A good app on your phone that tracks cryptocurrencies is a critical tool and next step for anyone interested in this market but you have to be careful, not all information is the same.  Here are the names of a few respected thought leaders on the subject of CC.

  • Andreas Antonopoulos (Mastering Bitcoin book)
  • Trace Mayer (Bitcoin knowledge podcast)
  • Jimmy Song (Twitter)

Read posts on Reddit/Medium for information and support on many CC subjects ( currencies, exchanges, and wallets).  There are also support forums for technical issues.  There have been many different types of technical issues in the past and they should be expected in the future.

There are also blogs and newsletters dedicated to this topic, some better than others; you should be able to find several dedicated information sources on CC to explore and compare.

Also, when comparing the different CC, you are well served to dig into detail around factors that may have a big impact on the future of a CC.  Here are a few additional topics to become familiar with overtime.

  • Governance – How are decisions made about the future of the CC?
  • Programmability – How easy it is to add features to the blockchain of the CC?
  • Development Funding – How is the CC funding future development, upgrades, marketing, research, etc?
  • Merchant/Payment Tools – How robust are their services and tools for merchants/ecommerce developers?

There are many other subjects to consider (Encryption Type, Hashing Power, Mining Reward, Transaction Validation, etc.) with cryptocurrency and the underlying blockchain supporting it.  This is a very fragmented and rapidly developing technology; the list of subjects above is incomplete but will help you dig into details you will want to understand if you are serious about CC.

Exchanges

A U.S. based exchange is most likely the best choice for U.S. residents although there appear to be some good exchanges in foreign countries.  Exchanges connect with a bank account or credit card and provide the ability to make a CC purchase.  Exchanges offer other features as well, like conversion to other CC.   Beware, transaction fees, trading costs and wide-price spreads can be costly.  Also, exchanges are not connected so the price listed at one exchange can vary dramatically from the price at another exchange, especially during periods of high volatility which have occurred frequently.

Reporting transactions is an important element of the CC market.  The Internal Revenue Service has already come out with notices on the subject referred to as “virtual currency”.  Participants in this market will want to keep good records and work with service providers that include accurate record keeping.

A quick internet search on U.S. cryptocurrency exchanges will provide more resources.  Some exchanges are more sophisticated than others.  One exchange that may be a good starting point for learning more about this service is Coinbase/GDAX but a full review of the competition should be completed before taking any action.

The website of some exchanges will operate on your phone.  Others are better from a tablet or computer.  Some exchanges offer a wallet but a different wallet provider from your exchange may be preferred.

Wallet

A wallet lets you take possession of the keys to your CC on a computer, phone or other personal device.  LOST OR STOLEN KEYS IS A BIG RISK FACTOR WITH CRYPTOCURRENCIES.  Some wallets may also allow you to convert to other types of CC inexpensively by using a feature like Shapeshift.  You don’t need a wallet right away or even at all but it can be nice to have for the reasons mentioned.

THE FOLLOWING INFORMATION IS INTENDED FOR EDUCATIONAL PURPOSES ONLY.  NO INVESTMENT RECOMMENDATIONS ARE BEING MADE.  CRYPTOCURRENCIES ARE HIGHLY SPECULATIVE.  INVESTING INVOLVES RISK, INCLUDING THE TOTAL LOSS OF CAPITAL INVESTED.

Cryptocurrencies

There are a lot of CC and the market is likely to change dramatically over time.  Below is a list of some of the more successful CC at this time and may be worth watching.  To keep track of CC winners and losers, individuals may want to pay attention to market cap, trading volume and price movements in addition to the subjects mentioned above.  The list below will likely change dramatically overtime but here are some of the leading CC at present.

  • BTC – BITCOIN
  • ETH – ETHEREUM
  • XRP – RIPPLE
  • BCH – BITCOIN CASH
  • LTC – LITECOIN
  • IOT – MIOTA
  • DASH – DASH
  • XMR – MONERO

It will be interesting to see how this market evolves.  There is a high likelihood CC will be with us for the foreseeable future; perhaps not in the present form.  The current environment is a little like the “DotCom” era of the 1990’s; the potential for massive change from the current market is high.

The Fallacy of Weak Productivity Growth

Models of the economy are pretty useful tools.  And simple models are some of he most useful.  They help people envision how the world works.  They help organize thinking.

For Example, the model that says the potential U.S. economic growth is determined by “population (labor force) growth” plus “productivity” is an elegant model that shows how adding workers, or having them become more productive, leads to more economic growth.

But, event an elegant model can lead people astray when the inputs are misunderstood.  As they say, [Click To Continue]

Why Inflation Has Stayed So Low

Globalization, demographics, technology have helped to keep inflation low

Key takeaways:

  • Globalization, demographics, technology have been helping to keep a lid on inflation.
  • Continued low inflation could be a headwind for the performance of Treasury Inflation-Protected Securities (TIPS).
  • Low inflation helps to justify above-average valuations for stocks.

In the wake of the financial crisis, the Federal Reserve kept rates low, waiting for unemployment to fall and inflation to rise to the Central Bank’s long-term target.  Several years ago, the unemployment rate passed the Fed’s target, but despite some [Click To Continue]