Daily Commentary

Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.

An Update on Global Oil Markets

While recent declines in Iranian and Venezuelan oil production have spurred worries of a supply crunch driving up oil prices, energy market fundamentals don’t appear much changed since last year. Underappreciated supply growth from other OPEC countries plus still-strong US output suggest global oil markets remain roughly balanced, rendering sharp price moves in either direction unlikely at present. Thus, fears of big oil price hikes choking off economic growth likely remain misplaced. As for Energy stocks, if prices stay stable near current levels as we expect, some larger oil producers could benefit by picking up some slack from lost output in Venezuela and Iran.

Before the US and Europe imposed sanctions in 2012, Iran was producing 3.7 million barrels of oil per day (bpd).[i] After sanctions cut Iran off from US banking services and most European countries ceased buying Iranian crude, production sank to 2.8 million bpd by November 2013.[ii] In 2015, the Iran nuclear deal—also known by its more cumbersome and vague title, the Joint Comprehensive Plan of Action (JCPOA)—alleviated this pressure. Iran’s exports rebounded fast, reaching 3.8 million bpd in early 2016.[iii]

Since the US withdrew from the JCPOA in May, US sanctions will return—but with big question marks surrounding other countries’ participation. In the lead-up to withdrawal, estimates of Iran’s likely oil output decline varied widely—from as low as a 200,000 bpd to as high as a million.[iv] Reaching the latter figure would probably require US allies to meaningfully curtail their buying and could conceivably lift global oil prices. The US State Department has sent mixed signals about how hard it will push allies to reduce their purchases, initially saying it wanted zero exports from Iran but later promising to grant some waivers.

Although sanctions on Iran’s oil sector don’t officially take effect until November, the country’s crude production has already started to slide, tied to the summertime implementation of sanctions on its Financials sector. (Exhibit 1) In August, it dropped 150,000 bpd from July to 3.63 million bpd.[v] 

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American Banks’ Strength Doesn’t Make Them Great Investments

As financial crisis retrospectives make the rounds, a refreshingly large sample note the US banking system’s current strength. Failures are way down, profits are way up, and lending is rising—all good things. Yet, none of this necessarily means US banks are a great opportunity for investors right now. Markets look forward, not backward, and US banks likely face some headwinds in the foreseeable future.

By all means, take a minute to celebrate how far banks have come since the crisis. Regulatory capital was just 2.5% of the eight largest banks’ total assets in 2007.[i] Now, the top eight banks’ capital-to-asset ratios average 6.6%.[ii] Problem banks exist, but their numbers are dwindling. As of Q2, the Federal Deposit Insurance Corporation (FDIC) lists 82 banks as “problem institutions.”[iii] In 2010, there were 884.[iv] Meanwhile, no banks have failed so far this year—down from 157 in 2010.[v] If the stretch continues, 2018 will be the first year since 2006 without a bank failure—not surprising with 96% of all banks profitable.[vi]

In Q2, US banks enjoyed record-high profits and soaring net interest income. Profits rose 25.1% y/y to $60.2 billion—not a bad haul.[vii] According to the FDIC, about half the gains were from last year’s corporate tax reform (a one-off), but the other half came from higher net interest income—profits from lending. Banks’ profits stem from the yield curve—namely, the gap between interest rates on their short-term funding and the long-term loans they extend to households and businesses. Because banks borrow short and lend long, the difference between short- and long-term rates—the yield curve—closely approximates their profit margins (aka “net interest margins”).

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Market Insights: Corporate Debt Fears in Perspective

While some fear companies could be over-indebted, corporate debt levels look a lot less scary when properly scaled.

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Lessons From Lehman, 10 Years Later

10 years ago, on September 15, 2008, Lehman Brothers filed for bankruptcy, sparking the worst financial panic since the 1930s. It was a defining moment in the seminal market event of most investors’ lives. Financial media are full of retrospectives, from interviews with former employees to analyses of what has—and hasn’t—changed since. In our view, Lehman’s failure serves as a reminder of crises’ silver linings: They offer learning opportunities for investors.

The popular narrative of what happened then hasn’t much changed since we were all in the thick of it 10 years ago. Many experts continue blaming the same characters: “too big to fail” financial institutions; a housing bubble; subprime loans; banks that were houses of cards built on sand. Very little coverage has dwelled on what we (and others) believe were the true culprits. The first: a widely overlooked accounting rule change that decimated financial institutions’ balance sheets. The second: the government’s haphazard response to the resulting crisis.   

While our view is in the minority, evidence supports it. In November 2007—weeks after the last bull market’s peak—the Financial Accounting Standards Board (FASB) started enforcing FAS 157, the mark-to-market accounting rule. This required banks to mark assets on their balance sheet to their current market value. This makes sense for liquid, widely traded assets whose market value is up-to-the-minute—like stocks. But not for everything. Financial institutions also hold illiquid assets like mortgage-backed securities (MBS) and collateralized debt obligations (CDO) with no intention of selling. Rather, they hold these assets to maturity and collect the interest. Their market value is more difficult to determine since they trade rarely and aren’t trackable on a daily basis. The only reference point is the last sale price of something comparable. Booking these assets at face value seems more sensible, lest one institution’s hasty sale force healthier banks to book a loss—or lest one institution’s ability to sell these assets far above face value forces other banks to inflate the assets on their own balance sheets, artificially juicing capital. Yet FAS 157 forced financial institutions to treat all assets on their balance sheets as if they would have to sell on a day’s notice. This created a destructive feedback loop that destroyed trillions of dollars of bank capital.

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Random Musings on Markets XI: Museraker

This week, we are sad to report we did not run into Kanye West as he roamed through Hillsdale Mall in San Mateo. We did, however, overcome our sadness to bring you another non-weekly smorgasbord. Read on for the tales of a bizarre way people are investing in FANG stocks, the latest Bank of England hiring news, iffy income calculators and more!

Annuities and Incentives

People respond to incentives. Reduce taxes, and avoidance typically falls. Pay people to install solar panels, voila, solar panels! Raise sales taxes on cigarettes, and cigarette consumption falls. So it will be unsurprising—yet still noteworthy to us—if selling annuities to IRA owners becomes less common now that one major firm that rhymes with Cheryl Pinch has banned commissions on the practice.

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Are Leveraged Loans Really 'The Next Lehman'?

A lot of things have happened since Lehman Brothers went bankrupt 10 years ago Saturday. The stock market and economy have recovered, and then some. America has had two new presidents. The Fed and Treasury have profited on all the toxic assets they took over from Bear Stearns and AIG. Your friendly senior MarketMinder editors have noticed more grey hairs and crows’ feet. But one thing has held fairly constant: Investors still search around every corner for “The Next Lehman.” First it was Dubai. Then Greece, Ireland and Portugal. Spain and Italy each took their turn, then Greece again (and again). More recently, we have seen eurozone banks, US subprime auto loans, student debt and Chinese shadow banks get “The Next Lehman” treatment. This summer, another joined the ranks: leveraged loans, which are bank loans to companies, backed by illiquid assets, usually with floating interest rates. Like subprime loans in the 2000s, many leveraged loans have been repackaged into securities called collateralized loan obligations (CLOs), creating fears that we are in for a near-perfect repeat. However, we think this thesis misunderstands securitization and—crucially—ignores how mark-to-market accounting transformed a couple hundred billion dollars’ worth of eventual loan losses into a few trillion in immediate paper losses for banks.

Leveraged loans are in the spotlight today largely due to a recent Moody’s report, which projected high default rates if rising interest rates and an economic downturn coincide. Ordinarily, it wouldn’t be huge news that loan defaults would rise under such conditions, but leveraged loans get special treatment. For one, investors supposedly see them as safer than typical junk bonds, as they are higher in the creditor pecking order in the event of bankruptcy since they are backed by collateral. Plus, because many have floating rates tied to the three-month Libor rate, returns have improved alongside rising rates this year, presumably creating a false sense of security. And then there is the securitization angle, combined with the fact many of these loans are now owned by mutual funds or ETFs that market them as high-yield alternatives for investors.

At face value, this is a very large market. Bloomberg tallies total issuance from 2009 – 2018 at $8.7 trillion, while The Wall Street Journal estimates about $1.4 trillion of this is below investment-grade. According to Moody’s analysis, the average recovery for investors in firms that go bankrupt would fall from 77% in past downturns to just 61% in a hypothetical next downturn, thanks to the weakening of covenants (aka legal protections in the loan contract) in recent years. Recovery rates in the market’s riskier segment would drop from 43% to just 14%. As the Journal sums up: “That means that in the next default cycle there will be more loanholders making claims on companies with fewer assets to recover than the historical norm. There will also be less left over for unsecured bondholders, who stand to recover about 32% in the next default cycle compared with a historical average of about 40%, according to Moody’s.”

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RMDs May Get a Bit More Minimal

If you are presently saving for retirement in a 401(k) or IRA—or wish the small business you work for offered a 401(k)—we have some potentially good news! A recent executive order instructed the Labor Department and Treasury to consider tweaking regulations to make 401(k)s less costly to administer, make it easier for small businesses to join forces in a single 401(k) plan, and make IRAs’ required minimum distributions (RMDs) less burdensome. As with most news surrounding the Trump administration, media reaction was largely sociological, with many speculating about potential pros and cons of more widespread adoption of defined contribution retirement plans. However, we think all investors ought to be aware of the potential changes, especially on the RMD front.

IRA RMDs began in 1987 as part of the Reagan Administration’s tax reform. Until then, there wasn’t any way to ensure the IRS would eventually get its cut of Americans’ tax-deferred retirement savings. When the Employee Retirement Income Security Act of 1974 (ERISA) introduced IRAs, it established that workers would fund them with pre-tax income and pay income taxes on eventual withdrawals. But without mandated distributions, savers could theoretically sock away money forever, letting it grow tax deferred into perpetuity. Hence, the RMD, whose sole purpose is making retirees pay taxes. Once you hit age 70 ½, you take your IRA’s prior year-end balance, divide it by a number provided by the IRS, and withdraw that amount. And you do this every year until you die[i] (or your IRA reaches $0), withdrawing a steadily larger percentage of your account.

The executive order suggests examining and perhaps updating “the life expectancy and distribution period tables.” That is quite nebulous, but one potential outcome is increasing the RMD starting age. It hasn’t changed since 1987. But life expectancies have. In 1987, the typical 65-year-old man could expect to live 15.7 more years. The typical 65-year-old woman had 19.1 years. Today, the average life expectancy at age 65 is 19.1 years for men and 21.2 years for women. For some, delayed RMDs could enable them to use other accounts to meet cash flow needs for longer while racking up more tax-deferred growth in their IRAs. It could also mean more assets in retirement accounts later in life, when health care expenses are typically far higher.

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Lessons From Lots and Lots of Wage Metrics

A Council of Economic Advisers (CEA) report released last week[i] argues US wages are rising faster than Labor Department measures indicate. Are they riiiiiiiiiiight?[ii] We aren’t here to settle the debate—rather, we believe it highlights the fact there is more than one way to measure any segment of economic activity, and pretty much all metrics have their merits (and shortcomings). Hence, we believe investors trying to get the lay of the land should look at all available data, not just one measurement of a given category.

The comparison point for the CEA report is the Bureau of Labor Statistics’ (BLS)[iii] Current Employment Statistics (CES) survey. This survey includes one of the most commonly cited wage figures in financial media: average hourly and weekly earnings figures based on a survey of about 149,000 businesses and government agencies. The calculation is simple and easy to understand —divide total hours worked by total reported payrolls (excluding bonuses and other forms of nonwage compensation). Per July’s CES survey, average hourly earnings grew 2.7% y/y (compared to 3.0% y/y for average weekly earnings).[iv] This number drove fears American workers’ wages are falling behind their cost of living after the BLS’ July Consumer Price Index (CPI) was up 2.9% y/y. (August’s CES, released late last week, showed wage growth accelerating to 2.9% y/y.) However, besides some high-level reasons why these concerns are off, excluding bonuses and the like from earnings figures is kind of a big omission! These accounted for 30% of employer payroll costs as of June 2018 and have been slowly rising as a percentage of the total for decades.[v] Seems like important information to be aware of.

The CEA report takes a different tack. First, it adjusts for workforce demographic changes stemming from the trend of experienced, high-earning baby boomers retiring while younger, less experienced, lower-paid workers take their place. Conventional wage growth metrics don’t reflect this ongoing shift. Second, the CEA’s method uses the Bureau of Economic Analysis’s (BEA) Personal Consumption Expenditures (PCE) inflation gauge rather than the BLS’s CPI. PCE, the authors argue, better accounts for consumers’ tendency to buy cheaper substitutes when certain goods get more expensive. Third, it incorporates non-wage benefits, such as bonuses, medical insurance, vacation time and parental leave. With these adjustments, it shows inflation-adjusted worker compensation rose 1.0% y/y in Q2—well above the BLS’s 0.1% y/y measurement.[vi] Including the effects of last year’s tax reform bill, the CEA estimated real take-home pay rose a whopping 1.4% y/y in Q2.[vii]

Both approaches are useful, depending on what you are looking for. If you are interested in pure wages, the Labor Department mostly has you covered, though its broad measure doesn’t necessarily reflect individual earners. For a more expansive view, something like the CEA’s figures may be more helpful. Plus, tracking the differences between them can highlight trends in compensation and labor markets. Having two different options/perspectives is good!

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17 Years Ago Today …

Beams from the steel façade on floors 96-99 of the North Tower—at the point of impact—loom over the building’s footprint at the 9/11 Memorial in Manhattan. Photo by Elisabeth Dellinger.

Today marks 17 years since terrorists struck America on the deadly day that would come to be known as 9/11, killing thousands of souls and shaking us all to the core. Yet most anniversary retrospectives throughout financial media today don’t look back at the World Trade Center attacks. Rather, headlines are preoccupied with another pending date: The 10-year anniversary of Lehman Brothers’ bankruptcy this Saturday. Perhaps it is because of people’s fascination with round numbers, or perhaps it is another sign of society’s (and markets’) ability to recover and move on from even the most terrible tragedies. You can also see this in The Wall Street Journal’s article on the rebuilt World Trade Center and its occupancy rates. We will get to Lehman later this week, but for now, let us pause to remember the lives lost, the families and friends left behind, and the heroes from all walks of life—and celebrate the resilience of not just America, but all the nations where terrorists struck before and since that day.

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Global PMIs Counter Trade Gloom

September is off and running, which means one thing: We now have the full range of purchasing managers’ indexes (PMIs) for August! Overall and on average, these business surveys show broad-based growth globally—great! Even better: They also reflect widespread trade concerns. We believe this illustrates a wide gap between uneasy sentiment and a fine reality—ideal bullish conditions.

For those unaware, PMIs ask representative firms how their business fared. Did production expand or contract? What about new orders, employment, inventories and backlogs? Surveyors then compile these responses into an overall business activity index. By convention, readings above 50 denote expansion and below 50 contraction. Because PMIs measure only growth’s breadth—how many firms expanded (or contracted)—they don’t say anything about its magnitude (by how much). But while PMIs don’t move in lockstep with GDP, they provide a timely look at economic activity.

In America, the Institute for Supply Management (ISM) August manufacturing PMI rose 3.2 points to 61.3—a 14-year high—while forward-looking new orders surged 4.8 points to 63.3.[i] ISM’s non-manufacturing PMI—including services, the bulk of US output—rose 2.8 points to 58.5, with new orders up 3.4 points to 60.4, signaling further growth.[ii] Yet when questioned, respondents overwhelmingly said they dread tariffs. While understandable, considering manufacturers would get hit hard in a trade war, their wide-ranging advance demonstrates tariffs enacted thus far aren’t a huge headwind. This isn’t surprising, considering the tariffs’ small scope. Those enacted and threatened are a tiny fraction of global GDP, and they are relatively easy to work around, undercutting the popular view that they could soon derail the expansion. Rejiggering supply chains and rerouting trade may not be fun, but for many firms in America’s vast private sector, tariffs aren’t holding back expansion.

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