The noisy themes for the 4th quarter were centered on concerns of a global economic slowdown, uncertainty related to trade negotiations, and manufacturing weakness in the US and abroad. These themes were countered by strong domestic employment numbers , real wage growth, and robust housing activity in parts of the country. The real change that defined the quarter was the market’s change in mindset. The mood of the market changed from concerns of “can this economic expansion really last” to a belief that “the Fed has our back.” In response, equity markets made record highs and 10-year Treasury yields moved from the September low of 1.45% to 1.92% at year end. Interestingly, the jump in the 10-year Treasury yield at the end of the year was 32% above the September low yield, but 31% below the peak 2019 yield for the 10-year Treasury of 2.78% on January 18th. The fact that we are back to a “risk on” environment, combined with a positively sloped yield curve and higher interest rates has us interpreting that the market believes that we are back to the “good old days” where the Fed insulates the markets from nearly all sources of pain.
So much time and headline space was dedicated over the quarter to the gyrations of the trade negotiations between the US and China. Both sides want to communicate a win in a negotiation that likely can’t be concluded anytime soon. The deadlock could be resolved if one economy or the other ends up “on the ropes” and must sacrifice long-term growth for near-term relief. The Chinese have been told to prepare for a long march. Since this is the battle for the position as the largest economy on planet earth, we expect this tension will be a global influence for decades. A stroke of genius was the introduction of the “phased approach” to the negotiations. It certainly offers political leaders the opportunity to show progress and perhaps several small “wins” help us move in a directionally positive way, which in the end may be more achievable than an “all or none” trade deal. While both economies are at acceptable levels of growth, we should all be prepared for the long march and that progress (and setbacks) will come in small steps. Since we are told that phase one will be signed any day, for now, we see the negotiations as directionally positive.
Beyond China, we are developing a concern that if slapping tariffs on our trading partners, followed by productive discussions becomes the normal operating procedure, at a point does the US lose the valuable position of being assumed to be a fair and good global actor? Clearly there is room to move some negotiations toward both freer and more fair trade. At a point, this strategy may fail, not because someone is “calling our bluff” but rather because they are making decisions based on non-economic factors. A sense of fairness (even if through a flawed and skewed lens), pride, and overconfidence are frequent behavioral flaws that impede sound decision-making from an economic perspective. Some have called this tactic a “weaponization” of trade. We can see a need to create or defend jobs that require modest skill sets to support middle class families. Our concern is that if (insert subject) is applied to the wrong counterparty, it could result in a surprise response (think bad surprise, not a good one) that could chill the markets.
"Clearly there is room to move some negotiations toward both freer and more fair trade."
Ten-year municipal bond yields began the quarter at 1.47% and closed the year at 1.48%. Most municipal bond indexes saw returns for 2019 of between 5.45% and 7.70%. Ten-year Treasury yields began the quarter at 1.64% and ended at 1.92%. Many taxable bond indexes saw returns of 6.70% to 8.70% for the year.
Observations and Outlook – Is It Time to Do This Without Water Wings?
Our primary outlook last quarter was that the consumer has had real wage growth, jobs are plentiful in several industries with good wages, and consumer sentiment/comfort numbers remain solid. As a result, we were confident that the start of a recession is several quarters away. Nothing has changed there and in fact, that is our driving investment theme for most of 2020 (5/6ths qualifies as “most”). There will be more political distraction, a dash of geopolitical tensions, trade tiffs, and the occasional economic release that causes angst, but the consumer will carry this economy in 2020. The most important influence to track over the next year will be the confidence and expectations of the consumer. Their exuberance may be tested by challenges and developments both at home and abroad.
Europe is in a manufacturing recession. The December release of the IHS Market’s Gage of Factory Activity fell to 46.3 (a number below 50 represents contractions). It is the 11th consecutive month below 50. Although Germany was the worst performing country, the contractions in both the Netherlands and Italy were the worst in more than six years. For added context, manufacturing in Germany is nearly twice as important to GDP as is the case in the US. Also, of note, the rate of job losses was the worst since early 2013. Slow factories are one thing, but job losses get into the psyche of the market. The International Monetary Fund (IMF) has yet again lowered global growth forecasts. 2019 is expected to come in at just 3.00% growth and the 2020 outlook is for 3.40% growth (down from an expectation of 3.60%). Europe, and more specifically, the European Central Bank (ECB), is in a tough position. Their negative rate experiment (or reality) has resulted in INCREASED German savings rates. So, whereas negative rates were likely designed to stimulate spending over saving, it may have been a rationale outcome for savers to save more in the face of their cash slowly eroding away, rather than earning interest on surplus assets. Now the ECB is in the unenviable position where it seems that raising rates would stifle growth (from those using credit so they can consume more) and if they make rates more negative, savers may consume less so they can save more. It seems that some other pro-growth policies are needed such as increased immigration, government spending, or incenting business investment.
Domestically, we expect that at times consumer confidence will be shaken at times by signs of weakness in the manufacturing sector, increasing personal debt burdens, volatility in the market appetite for corporate credit exposure and diminished long-term growth expectations. In the 3rd quarter of 2019 the ISM Manufacturing Purchasing Managers Index, a measure of the manufacturing sector in the US, started showing signs of contraction. In December the contraction deepened to a reading of 47.2 (a number below 50 suggests contraction). Not surprisingly, in response US manufacturers expect to reduce capital spending by 2.10% in 2020, which would be the first decline in 11 years. If you aren’t making as much as was in the case in the past, you aren’t transporting as much either. In the 3rd quarter, US railroad carloads declined by 5.5%, the largest drop in three years. The point being that although manufacturing is a smaller segment of the US economy, a slowdown has contagion impacts.
The consumer may, themselves, be on shaky ground (and not yet know it). A study by UBS recently showed that 44% of consumers are not meeting their expenses. In the three-month period that ended in June of 2019, auto loans that were 90 or more days late made up 4.6% of total balances, the highest number since 2011. The same measure for credit cards showed 5.17% of total balances were seriously delinquent, the highest reading since 2012. According to the New York Federal Reserve, over the past 10 years US households have amassed $803 billion in student loan debt (compared to $576 billion for autos, $493 billion for mortgages and $69 billon in credit card debt). There is obviously a student loan crisis brewing (as is there a cost of college and a college education value proposition crisis). The government solutions currently discussed range from unequitable and moral hazard creating to downright gross. Specifically, there is a solution called an Income Share Agreement where either individuals, corporations, or the government get a piece of a person’s incremental wage growth in exchange for funding a portion of the student’s education. Let the bidding begin!
"A study by UBS recently showed that 44% of consumers are not meeting their expenses."
Last year (2019) saw the most credit rating downgrades for US corporate debt since 2009 yet the extra yield you earn (the spread) over a comparable term Treasury for both investment grade and “junk” rated issuers is very stingy by historical standards. Whereas “junk” spreads began 2019 around 525 basis points over Treasuries, they closed the year offering roughly 325 basis points over the Treasury. If this relationship normalizes, we can expect some companies to have a tough time managing the increased cost of their debt and the willingness to extend credit could dry up. Decreasing creditworthiness and stingy yields for extending credit does not seem like it can end well.
We have said before that the key to a strong economy is confidence. In that regard, the only thing we have to fear is fear itself. The Fed Chairman has made comments that suggest keeping an eye on consumer expectations and the data are starting to reflect a slide in future expected economic strength. Chairman Powell said in testimony before the US Congress that persistently low inflation readings could lead to an “unwelcome” downward move in consumers’ inflation expectations. In December, the University of Michigan consumer sentiment survey showed a drop in long-term inflation expectations to the lowest reading on record. While that sounds quite dire, it is important to remember that we have been in a low inflation environment for more than a decade. People anchor expectations based on past experience (economists call that “hysteresis” and in the field of behavioral finance it is called “decision anchoring”). For some market participants, all they have known during their adult life is low inflation and this too will likely be an economic influence for many years. Our interpretation is that the weak long-term expectations may be hardwired into many of the Millennials and that it further diminishes the risk that run-away inflation expectations may have on fixed-income investments.
We have established that Europe and the ECB are in tough shape, the consumer is showing some signs of stress and long-term pessimism, corporate leverage and the cost of borrowing may be a source of turbulence and domestic manufacturing may be in the start of a recession, how is it that it may be time to “remove the water wings” and let our economy swim on its own? We believe the Fed may be watching the challenges of the ECB and the Bank of Japan (BOJ) and have brilliantly realized that they may have a small window to get the US economy back to being one where the markets act more on a stand-alone basis and less of being a ward of the State. Recent comments from both the Cleveland Fed President (Loretta Mester) and the Chicago Fed President (Charles Evans) have suggested that geopolitical uncertainty is, to a degree, noise, and that the US economy is fundamentally sound. The Dallas Fed President (Robert Kaplan) has said that the disappointing December manufacturing numbers and the tensions between the US and Iran don’t impact his outlook for 2020 (he expects growth of 2% to 2.25% for 2020). Fed officials have signaled that policy is expected to stay on hold through 2020. Chairman Powell has also said that he believes “monetary policy is in a good place.” Kaplan has said that geopolitical tensions could result in a “repricing of risk assets” that could be healthy, but that the development that would be worrisome to growth prospects would be a “severe tightening in financial conditions, particularly the availability and cost of money.” The translation of the quotes above is that 1) the economy is sound, 2) the Fed would like to become less of a factor in the proper functioning of the economy and 3) they are going to try to let markets “work.” That said, if corporate spreads/borrowing costs dramatically increase and credit dries up, they will jump back in to stabilize price expectations and the employment environment. If the Fed can pull this off, and it all hinges on the durability of the consumer, it would be masterful. If they must step in, we are headed the way of Europe and Japan.
Where exactly do we think a masterful outcome would place domestic interest rates at the end of 2020? The answer sadly is that we would see yields close to where they are at currently, with a bias toward rates being lower. If the Fed is in a position where they must step in, our expectation is that we are dealing with rates lower and the yield curve steepness that we currently enjoy is being wiped out. Last quarter we dove deep into the impact and challenges of negative rates (sloppy risk allocation, misallocation of resources, valuation models being thrown out the window, and complex consumer behavior patterns represent just a handful of the related headaches). Let’s hope they pull it off and we have the luxury of dealing with positive yet low interest rates. A new paper by Yale professor, Paul Schmelzing, has us thinking that perhaps where we are at is not so bad after all. The study looked at real interest rates of developed markets over the past 600 years. The deduction seems to be that although interest rates demonstrate a reversion to the mean, the mean is declining over time (roughly 1% every 60 years). His observation is that developed markets should see negative real rates of interest about a quarter of the time. The result seems reasonable to us because as technology and governance “improves,” the friction to moving capital should seemingly reduce the cost (or value) of capital. Also, as sources of capital are disbursed among more people, cost/value could decline as well. The world is awash in liquidity right now and moving/lending/investing funds is as easy as it has ever been, so it seems reasonable to us that the value of capital will remain low for the near future. Longer term, we see some imminent technological changes that should be disinflationary and that could result in more capital being concentrated. Such technologies include quantum computing, 5G data transmission, genetic modification (you can buy a CRISPR kit online right now), and nuclear fusion.
From an interest rate outlook, we are in the camp of “buy on the dips.” The Fed has indicated that they want to be hands off for the foreseeable future and we are only a strong economic release or two away from market participants coming to the usual conclusion that the Fed is behind the curve. If that happens while the curve has some steepness and interest rates are driven higher, we suggest jumping in with both feet. In fact, that environment may offer another opportunity to sell short bonds and extend portfolio maturity to pick up some meaningful additional yield. The credit spread environment is such that we would continue to focus on quality exposures. We would start averaging into the market if the 10-year Treasury yield is above 1.95% and we would have a tough time seeing yields climb much past 2.20%. Municipal bond yields, relative to Treasuries, are a bit underwhelming as of late and we would be a buyer as “AA” rated bond yields reach a level that is 100% of the comparable Treasury. Municipal Bond Market Developments – The State of the States is Good
Moody’s Investor Service estimates that state tax revenues will rise 4% in 2020, after a very robust 4.90% growth in 2019. Among other influences, rising stock markets resulted in capital gains related revenues. According to a report from the National Association of State Budget Officers, the median balance of state rainy day funds is enough to cover 7.60% of their general budgets in 2019, the strongest level of reserves ever. They anticipate the level could rise as high as 8% in 2020. The state of the states seems as if it is well-positioned to weather a modest recession, should one hit the US. The level of reserves was a bit of an accomplishment as state spending increases jumped by 5.90% in 2019, the largest increase since the Great Recession. Although it sounds like the level may be irresponsible, in truth, the ability to pass referendum was so difficult for so long there may be a significant amount of catching up with addressing deferred maintenance and infrastructure issues. From a policy and economic growth perspective, infrastructure spending may be about the only thing both major political parties can jointly support.
"The state of the states seems as if it is well-positioned to weather a modest recession, should one hit the US."
Adding a splash of reality to the strength of many of the states is the reality [JW1] that municipal defaults and distress are on the rise. According to Municipal Market Advisors, the number of municipal defaults has increased to 45 in 2019 (up from something approaching 30 in 2018) and the number of municipalities experiencing financial distress, through October of 2019, has risen to 117, the most since 2015 and 22% higher than was the case in 2018. The most challenged areas of the market were focused in the areas of land-secured bonds, specifically senior living facilities. Depending on the outcome of the 2020 Presidential election, we expect that the hospital and private college sectors could be in a serious state of flux, so we would suggest selling those credits into the current market euphoria (in the form of tight risk spreads) or to only hold the dominant players in a given market. Pension pressures continue to be an anchor to both the creditworthiness and budget flexibility of many municipal issuers. For the 4th straight year, New Jersey, Kentucky, Illinois and Connecticut have claimed the top spots for the worst funded state pensions. Illinois’ pension plans are only 40% funded, leaving them with an unfunded liability of $137 billion. So, while there is general health throughout much of the municipal market, there are pockets where the end result will be like watching a belly-flop from 30 feet.
There are two niche areas of concern that are worth watching. First, municipals are being sold swaps contracts again. Three Pennsylvania school districts have entered into swap agreements to bet that rates will rise between now and when they plan to issue debt. According to the Philadelphia Inquirer, the swaps are already “out of the money” and the districts will owe millions if rates stay where they are at currently (or if they wanted to terminate the agreements). We have seen municipalities engage in speculative derivate agreements, often sold using the pitch that “80% of the time over the past several years this would have made you money.” It ended catastrophically for some school districts and we are disappointed to see municipalities wading back into the waters of the leveraged speculation game. The other development worth watching has to do with municipal pooled products. In California, a court ruled that interest on tax-exempt bonds paid as dividends to investors may be taxable income. The California state constitution seems to require that 50% of income must be from California municipal obligations to be passed through as tax-exempt income. The Blackrock fund that was the focus of the case only had 12.41% in California munis so the dividend income from the closed-end fund was determined to be taxable. We imagine that the fund companies will work quickly to shield investors from negative impacts of this situation and similar scenarios in other states, but it reinforces the benefits of holding individual munis in a separately managed account (where you control the composition).
Strategy and Summary
Since we touched on our current “buy on the dips” strategy earlier, we will offer a summary. If the consumer carries the economy through most of 2020 and what we believe to be the Fed’s plan, works, expect turbulence of market expectations and modestly lower yields at the end of the year. If we experience moments when the market believes the Fed is behind the inflation curve, especially if the yield curve is steep, consider selling shorter bonds and extending your exposure with call-protected bonds (to lock in palatable yields). Taxable municipal bond spreads are attractive from an historical perspective but if the yield is a “push” on an “apples to apples” comparison with tax exempts, the edge should go to the tax-exempt security. We expect the value of the tax exemption will increase over time as tax rates are more likely to be higher, rather than lower, in the future.
We continue to expect 10-year munis will be stuck in a range where yields may fall as low as 1.40% and we may see them reach as high as 2.10% - for AAA rated bonds). “A” rated bonds that ACG deems to be of “AA” quality in the 13-to 15-year area can be found with yields of 2.00% to 2.20%. The noise of the markets and the extrapolation of the expected outcome of the Presidential election will cause many waves over the course of 2020. Use the overreactions to posture the portfolio for long-term success and stability.
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