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Last month, an unusual thing happened in the overnight credit markets. Overnight repurchase agreement (repo) rates surged, departing from their typically tight relationship with the fed-funds target rate to hit a high near 6% intraday, before the Fed eventually intervened. Headlines went wild, calling the intervention the first since the financial crisis and offering jargon-laden explainers of this dry subject, many tinged with more than a little fear. But as we wrote at the time, this was benign—more a return to normal monetary policy that existed pre-2008 than a sign of impending doom. Now, to address volatility in short-term funding markets, the Fed has resumed expanding its holdings of Treasurys—a move some see as resuming quantitative easing (QE). Folks, in our view, it isn’t anything of the sort. Here is why.
As we noted last month, the overnight repo market is one way banks that temporarily find themselves short of required reserves can access quick funding. If daily transactions tip them below required levels (a normal thing!), they can post Treasurys they own as collateral for a loan from a big investor (think: money market fund) or bank. When the loan’s term is up, they repay and get their bonds back.
Because these loans are super short term, rates tend to track the fed-funds target rate pretty closely, except when liquidity runs tight. That happened last month due a confluence of factors: corporate tax payments draining money markets of liquidity, a Japanese bank holiday and big issuance of Treasurys. The Fed was initially slow to respond, but when they eventually did, rates fell back towards fed-funds. (Exhibit 1)
Ladies and gentlemen, we have a deal! A Brexit deal, that is. Again. As with the last deal, the prime minister is gung-ho. European Union leadership is, too. Yet many UK Members of Parliament (MPs) are less so. They might approve it. They might not. The UK might leave the EU on Halloween. It might not. There might be a general election next month. There might not. Read on to see what is in the deal, what Parliamentary math says about its chances of passing, and our three hundredth (give or take) assertion that whatever Brexit looks like, whenever it happens, just getting on with it and ending this uncertainty should be a tonic for the UK economy and markets (and, to a lesser extent, the remaining EU nations).
For those who haven’t followed along[i] or get their news from the new Brexit-free British news channel, here is your catch-up summary: In the spring, MPs rejected former Prime Minister (PM) Theresa May’s deal, which would have kept the UK in the EU’s customs union until and unless negotiators solved the thorny Irish border issue. The Good Friday Agreement that resolved the conflict between the Irish Republican Army and UK government mandates an open border between Northern Ireland (the UK) and Ireland. Thus, May sought and received a Brexit delay from the original March 29 deadline until October 31. Then May stepped down. Boris Johnson won the Conservative Party’s leadership contest and became PM.
Unlike May, Johnson campaigned for Brexit and has since carved out a niche as champion of a “hard Brexit.” This means strong trade ties with the EU but no customs union membership. He pledged to negotiate such a deal. The EU said nah, no more negotiations, these are red lines, thanks for playing. Johnson, seemingly undaunted, promised he would take the UK out of the EU on Halloween. To that end, he aimed to limit Parliamentary debate by suspending the body, an unpopular move[ii] that, among other factors, resulted in his working majority going from a handful to -43. (That isn’t a typo.) Anyway, MPs passed a law mandating Johnson seek a three-month Brexit extension if Parliament didn’t approve a deal by October 19. At some point, EU leaders perked up and said ah ok we guess we can try negotiating again. Those negotiations happened last weekend. Now they have borne fruit.
When stocks have floundered directionlessly for a stretch, it usually doesn’t take long for investors to start pondering loading up on high-dividend payers. Then, the theory goes, they will at least earn something. We can see the theoretical allure. If stock prices are bouncing sideways, a large cash payout provides a near-term reward for sitting through the volatility. Yet in our view, this line of logic is too short-term and could lead investors into mistimed moves.
One curiosity about the dividends as solution to flat markets argument is that it commits a key error twice, in two different ways. Namely, it doesn’t consider stocks’ total return. Rather, it sets total return’s two components—price movement and dividends—against each other. To accurately consider whether high dividend paying stocks can offset flat returns, you must also look at high dividend payers’ price movements.
Full disclosure: In the very limited history of long bull market sideways streaks during the time when high dividend index daily total return data are available, high dividend payers beat the broad market. By limited history, we mean four data points excluding the present. Those are: 2/2/1994 – 2/14/1995, 2/11/2004 – 11/4/2004, 4/29/2011 – 2/24/2012 and 5/21/2015 – 7/11/2016. In all four, the S&P 500 Dividend Aristocrats beat the S&P 500 on a total return basis. Global high dividend data exist for the latter three. In each, the MSCI World Index High Dividend Payers beat the MSCI World Index.
With long-term sovereign bond yields sitting near rock-bottom lows after a sharp year-to-date decline, many wonder what lies ahead. Some speculate rates have even further to fall—hence, the steady demand for super-low and even negative-yielding bonds. Others, however, expect a reversal—with rates rebounding some as recession fears abate. The US yield curve’s return to a positive slope on Friday morning might spur that sentiment even more, which may raise the question of how to position today. With rising yields come falling bond prices, potentially making bonds appear unattractive: If bonds’ purpose in a portfolio incorporating a mix of bonds and stocks is to reduce expected short-term volatility, the prospect of declining prices may seem counterproductive. But we don’t think it should. Potentially rising long-term interest rates might be reason for bondholders to tweak the mix of bonds they own, but we don’t think it is reason to ditch them outright.
First, rising yields don’t necessarily mean sinking bond returns. The reason: Price movement is only part of a bond’s total return. The other is its yield. Since the two move in opposite directions, rising yields can help offset price declines. Consider a bond yielding 1%. If yields on equivalent bonds rise to 2%, its price would fall. But the interest payments may keep its total return from deteriorating much. Small increases in 10-year US Treasury yields in 2015 and 2016 didn’t bring negative bond total returns.[i] Neither did 2009’s 1.78 percentage point climb in Treasury yields.[ii] In a diversified bond portfolio in which maturing bonds are reinvested at the new higher rates, price declines’ effects can be even more muted.
Bonds can also still do their primary job—dampening portfolio volatility—even if total returns are muted or negative. Last year is a good example, as the S&P 500 fell -4.4% while bonds ticked down -0.8%.[iii] Importantly, volatility is about moves’ magnitude, not their direction. This means an investment whose value fluctuates 5% annually on average is more volatile than an investment that fluctuates 3% annually on average, even if the former’s returns are positive and the latter’s are negative. Hence, declining bond values in a blended portfolio doesn’t mean it is more volatile than an all-equity portfolio. In all likelihood, it will be less, since bond returns tend to be less bouncy over shorter time periods. For example, during the two sustained stretches of rising bond yields (and falling prices) during this expansion—August 2012 – August 2013 and July 2016 – October 2018—US stocks’ average monthly volatility was more than twice that of long-term bonds’.[iv] Those holding bonds to reduce short-term portfolio volatility were likely rewarded.
Is a leadership shift underway? Value stocks—those whose price is low relative to others’ using metrics comparing prices to things like earnings or sales—outperformed in September. This has some pundits proclaiming a new value leadership trend is at hand, arguing growth stocks’ supposed decade-long leadership is over. However, we believe this is premature and ignores actual leadership changes since this bull market began.
The relationship between value and growth stocks, overall and on average, is cyclical. Value stocks typically (but not always) perform best coming out of bear markets and recessions. They tend to be in economically sensitive sectors—moving with the business cycle. Hence, markets usually punish them disproportionately when recession hits. At the bear market’s bottom, pessimism overshoots by miles—depressing prices to irrationally low levels and loading a spring that launches them higher as recovery takes hold. Many value companies are also small, so this overlaps with small cap’s tendency to outperform early in a bull.
But value can also have short bursts of outperformance later in the cycle, too. While value led after 2008 – 2009’s recession, it also outperformed for months in 2012 – 2013 and 2016. Temporary deviations from the prevailing trend—so-called countertrends—happen often and tend to fool many investors. Rather than try to time them, ask if there is a valid reason for value to outperform for a meaningful length of time. Given where we are in the market cycle, we don’t think there is.
Reminiscent of August, this week markets turned rockier, with many pundits citing “weak data” and renewed US recession chatter. World and US stocks sold off on Tuesday and Wednesday, falling a total of -2.7% and -3.0%, respectively.[i] Headline reactions to the swings ranged from “Stocks Tumble, Bonds Climb as Slowdown Fears Mount” and “Stocks Are Off to Ominous Start in Fourth Quarter” to worrying that weak manufacturing is infecting the stronger services sector. While we agree there are weak spots in the global economy presently, we think the growing talk of a recession is going much too far. Here we will try to share some perspective on what is fueling the fears—and why we don’t think it is a call to action now.
The principal “weak spot” in the US economy is manufacturing—a global trend, and not a new one. In many corners of the world, manufacturing purchasing managers’ indexes (PMIs, surveys tallying the breadth of growth) aren’t looking great. So it was this week, when Tuesday’s Institute for Supply Management (ISM) US manufacturing PMI came in at 47.8, meaning more than half of businesses contracted—for the second straight month.[ii]
That isn’t so hot. But there are a couple of points to consider here: One, as we’ve written many times on these pages, manufacturing is a small slice of most major economies, including America’s. According to data from the Organization of Economic Cooperation and Development, it is 11.6% of US GDP. Services is nearly seven times bigger. ISM’s non-manufacturing PMI—which includes the services industry, mining and construction—slowed in September. But it remained in expansion at 52.6.[iii]
As folks enter or return to college this fall, the majority are seemingly paying for it on credit. According to the Fed, through the end of the last school year, 54% of college students took out some form of debt to finance their education.[i] This is part of a growing trend, which many view negatively—not only for the borrowers, but also for the economy. They see student debt triggering a financial crisis or a generation of debt-saddled graduates weighing on economic growth as they postpone marriage, kids and home buying. But as we have explored before, the evidence suggests reality remains rather benign.
Yes, student loans aren’t small potatoes. While student loans account for only 11% of total US household debt, they have grown from about $240 billion in Q1 2003 to $1.5 trillion in Q2 2019—the fastest-growing consumer debt category. (Exhibit 1)
Exhibit 1: Student Loans Are Only Part of Households’ Debt Picture
Source: Federal Reserve Bank of New York, as of 9/17/2019. Quarterly Report on Household Debt and Credit: Total Debt Balance and its Composition, Q1 2003 – Q2 2019.
Three years ago today, the IMF added China’s yuan to the basket of currencies underpinning its Special Drawing Rights (SDR)—its proprietary reserve accounting unit and means of extending credit to countries in need. At the time, the IMF touted it as “an important milestone in the integration of the Chinese economy into the global financial system.” Many investors took a less benign view, seeing the IMF’s move as threatening to end the dollar’s status as the world’s leading reserve currency—sending interest rates spiking and rendering US debt unaffordable. That was always a false fear, in our view, as the US gets next to nothing from having the world’s preferred reserve currency. Regardless, the yuan is still nowhere near unseating the dollar—and it isn’t likely to make a quantum leap anytime soon.
After World War II, the US used its newfound superpower status to help redesign aspects of international finance. The result was the World Bank, IMF and a standard that pinned the dollar to gold—and the world’s other currencies to the dollar. In the 1960s, then-French Finance Minister (later President) Valery Giscard d’Estaing referred to this dollar-centric system as an “exorbitant privilege.” He claimed it inflated demand for dollars and dollar-denominated assets—think Treasury bonds—affording the US government lower interest rates and more latitude to borrow. Even after the world ditched the gold standard in the 1970s, the dollar remained the principal reserve currency globally. Many folks have feared this status eroding over the years, thinking it would spell default on US debt. Earlier in this bull market, the yuan’s inclusion in the SDR was widely feared as a trigger event—after all, China’s economic clout has been rising. Many pundits thought adding the yuan to the SDR would drive central banks to add boodles of it to official reserves—at the dollar’s expense.
Yet the yuan has gained precious little market share since then. As Exhibit 1 shows, the yuan hardly rates in countries’ foreign exchange reserves.
Brexit and tariff fears have dominated financial headlines this year. Though shrill warnings make waves, reality isn’t quite as dire as pundits make it seem. Why? Government officials and business leaders alike have been adjusting and preparing for myriad scenarios, decreasing the likelihood of a negative surprise. In our view, Brexit and tariffs provide a timely illustration of why widely discussed events often don’t damage commerce as much as feared—important for investors to keep in mind.
Gearing Up for Brexit
Though Brexit’s exact timing and shape remain unknown, regulators and business executives alike have been preparing contingency plans in anticipation of post-Brexit day-to-day life. On the government’s side, the UK has continuity deals with countries representing 72% of goods trade previously covered by EU trade agreements—not huge relative to trade with the EU, but still progress. Public officials have also taken steps to mitigate potential disruptions in the event of a no-deal Brexit. For instance, the Department for Transport announced an extension of air traffic rights for EU airlines until October 2020, regardless of Brexit’s form. Logistically, the CEO of the Port of Dover—which handles a sixth of the UK’s trade in goods—believes they will sail through without major disruptions.
US stocks are a hair from all-time highs and over a decade has passed since the last global bear market. Yet amid the bounty, investors are glum. August’s volatility sent bearish sentiment spiking in the US.[i] European confidence tanked. One survey showed German investor expectations hit all-time lows in July—only to tick lower in August.[ii] Fund outflows accelerated worldwide, continuing even after stocks resumed climbing.[iii]
That a brief -5.4%[iv] slide in global stocks sparked such angst hints at the vast torment a bear market—a prolonged, fundamentally driven decline of -20% or more—might bring. It highlights a key point: Recalling some general bear market traits now can shed light on the mindset you’ll need to navigate future bears, regardless of portfolio positioning.
I know, thinking about bear markets is no fun. Who wants to relive 2008 – 2009’s terror or 2000 – 2002’s bursting Tech Bubble? But as they wear on, bear markets distort reality. They make even rational people believe in outcomes that might seem far-fetched today. So the time to think about what you’ll face in bear markets is during bull markets—like now, in my view. Regardless of whether you (or your financial professional) identify the next downturn early and mitigate the declines, thinking about what to expect from a bear ahead of time, while markets are comparatively calm, can be a big benefit later.
