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Happy Friday! While many folks see the summer as the “doldrums”—an idle period featuring beaches, umbrella drinks and air conditioning—this summer is off to quite a newsy start. This week was no exception. Here is our attempt to round up some biggies—US inflation data, the Supreme Court nominee, UK political hijinks and more tariff talk.
‘Flation!
US CPI inflation hit 2.9% y/y in June, notching another six-year high and creating a bit of fear because June’s wage growth didn’t keep up. Keeping with the human tendency to extrapolate all recent moves forward, media coverage warned more price rises could be in store, bringing consumers great pain.
Over a month after Italy’s populist government took office, debt fears are still commonplace as investors grapple with a potential for tax cuts and big spending. We think the likelihood of such sweeping changes to fiscal policy is low, considering how gridlocked the coalition appears to be, but that isn’t the only reason we think debt fears are probably unnecessary. A quick look at a recent bond auction and a measured analysis of Italian government finances reveal a landscape far different from common media portrayals. Italian debt is just one of many areas where Italy’s economic and political reality exceeds expectations. We think this is a bullish disconnect that bodes well for Italian and eurozone stocks.
At June 28’s bond auction, Italy’s Treasury sold €2.5 billion in 10-year debt and €2.0 billion in 5-year debt. Some coverage sounded a skeptical note because the bid-to-cover ratio, which tallies the number of bids per bond sold, fell to 1.26 for the 10-year Italian Treasury’s Buoni del Tesoro Poliannuali (BTP) auction, down from 1.48 a month ago and its lowest since January. The 5-year BTP auction’s bid-to-cover ratio was 1.34, the lowest in a year. That is one way to look at it, we guess. But here is another: A surplus of investors were willing to lend to a shaky, populist government widely feared to blow debt through the roof—and to do so at lower rates than they did a month prior. Plus, these issues refinanced maturing debt at lower rates. The 10-year notes auctioned on June 27, 2008 carried an interest rate of 5.1%. The 10-year notes issued two weeks ago, some of which replaced those maturing notes, cost just 2.8%. Similarly, on June 27, 2013, the Treasury sold 5-year notes at 3.5%. June 28’s replacement notes carried an interest rate of just 1.8%. In other words, a piece of Italy’s debt stock just got a bit cheaper.
Exhibit 1: Italian Bond Yields Near Their Lowest in Decades
Are Chinese markets the first domino to fall in what will become a global bear market? That question seems to be on many pundits’ minds lately, with tariff fears swirling, the yuan tumbling and mainland Chinese markets dropping -24.4% since January 26.[i] Many suspect China’s “bear market” is an advance warning of huge problems for the world’s second-largest economy—with major implications for the global economy. However, we believe history and current economic fundamentals suggest otherwise.
First, consider: Is China’s market downturn really a bear market, or is it part of the ongoing global stock market correction that began in late January? At the risk of seeming pedantic, during corrections, not every country or index falls the same amount. While a correction is technically a sharp, sentiment-driven drop of about -10% to -20%, that general parameter refers to a broad index like the MSCI World, MSCI All-Country World (ACWI) or S&P 500 (for those more US-focused). In a global correction, it isn’t unusual for individual countries to fall more than -20%. In the correction from May 21, 2015 to February 11, 2016, the MSCI World Index fell -17.9%.[ii] Yet 14 of 23 constituent country indexes fell more than -20%.[iii] In 2012’s April 2 – June 4 correction, the MSCI World dipped -12.5%.[iv] However, 7 of 23 nations breached -20%, led by Finland’s -26.4% swoon.[v] Often, this is due to country-specific quirks. Many national indexes aren’t diversified. In China’s case, the Shanghai Index (the media’s main reference point) represents A-shares, which are traded on mainland exchanges and therefore largely inaccessible to foreign investors. As a result, mainland Chinese markets tend to be less efficient and often suffer big swings tied to speculation, as many domestic investors prefer property as a long-term investment vehicle. Sentiment, therefore, can have an outsized impact, making the Shanghai Index’s swings much more akin to corrections than bears. This is why whether an individual country’s index breaches a -20% decline—a somewhat arbitrary bear market qualifier—is much less significant than whether a major, multi-trillion dollar economic negative few see accompanies it.
No matter what you call the downturn in Chinese stocks, we believe it is unlikely to prove a prelude to deeper problems in the rest of the world. Consider recent history. From the global bull market’s birth on March 9, 2009 through this year’s start, there have been four Shanghai Index “bear markets.” Not even five months after this bull began, Chinese stocks fell -23.2% August 4 — 31, 2009.[vi] The MSCI World Index didn’t even suffer a correction. Yet another Chinese “bear” started on November 23—less than three months later!—and ran through July 1, 2010. Global markets experienced a correction in early 2010, but not a bear. In November 2010, yet another Chinese “bear” started, with the Shanghai Index falling -33.5% through December 2012.[vii] While broader markets endured three corrections over that span, the MSCI World rose 4%.[viii] Similarly, the Shanghai Index fell -51.5% from June 12, 2015 – January 28, 2016—a period largely coinciding with the aforementioned world stock market correction.[ix] But there was no global bear.
If you have at all glanced at financial media in recent weeks, you have likely read (or heard) the yield curve is in imminent danger of inverting, bringing recession to the US economy and havoc to stock markets. Some coverage points out that the curve is at its flattest in 11 years, with that reference point being the eve of the last bear market, which began in October 2007. Public Service Announcement: These warnings are based on a flawed version of the yield curve that doesn’t have much bearing on the real world. Moreover, they ignore the global yield curve and its increasing relevance to the world’s capital markets. When viewed in proper perspective, we don’t believe the yield curve is flashing warning signs today.
We aren’t pooh-poohing the yield curve as a leading economic indicator—indeed, it is one of the best! An inverted yield curve—with short-term interest rates higher than long-term interest rates—has preceded all US recessions since World War II, which is around the time quality national economic data begin. This isn’t just coincidence—it makes logical sense, since the yield curve drives bank lending. Banks borrow at short-term rates, either from each other or from business and household deposits. They lend at long-term rates. The spread between short and long rates is their potential profit on the next loan made. When the yield curve is steep, the spread is big and positive, and banks lend plentifully. The flatter it gets, the smaller potential profits are, and banks become more judicious when making lending decisions. They aren’t charities, after all, so if profits are small, they will likely determine there isn’t enough potential reward to make the risk of lending to less creditworthy borrowers worthwhile. At these times, as a tired joke says, you can get a loan only if you don’t need one (see: 2010, 2011, 2012). When the spread is negative and stays that way for a while, lending is a money-losing proposition, and banks curtail it. Credit locks up, capital-starved businesses can’t invest, and markets and the economy generally go kaput.
So from a philosophical standpoint, we tip our hat to all the financial commentary that is watching the yield curve like a hawk. And we concede that as they present it, things don’t look so good. The yield spread isn’t yet negative, but to the untrained eye it appears headed that way on a straight shot.
This holiday-shortened week had no shortage of financial news. Here is an attempt to round up a few for your Friday reading pleasure.
Implementation Day
It seems no one can pen a financial news column these days without discussing something about tariffs. So here is your obligatory tariff discussion for today: $34 billion in Chinese imports are now subject to new US tariffs—and an equivalent amount of US goods are subject to new Chinese tariffs in response. In the run up, media treated tariff implementation like it was make-or-break for markets. Huge news. But, in my view, that misunderstands how markets work.
With the first half of 2018 in the books, the state of the US economy is up for debate. Growth seems to have accelerated in Q2, so should we cheer it—and expect more of where that came from? Or is the optimism unwarranted, with a slowdown looming? In our view, debating over the pace of growth misses the more important point for investors: The US economy is on sound footing and the expansion looks likely to continue for the foreseeable future.
Ask a number of experts for their thoughts on the US expansion, and you will likely get a number of different prognoses. Bulls might argue tax reform and the overall friendlier business environment are paying dividends and will continue doing so. Bears may suggest growth will slow for a number of reasons: The Fed is raising interest rates and tightening monetary policy; tariffs raise uncertainty and implementation potentially discourage business activity; tax reform provides only a one-time boost unlikely to repeat, especially if tariffs offset its benefits. This camp sees the current uptick as a “temporary blip in growth.”
Even different Federal Reserve Banks have seemingly conflicting opinions. The Atlanta Fed’s most recent “GDPNow” estimate puts Q2 2018 GDP at a 4.1% annualized rate. If that estimate holds, it would be a big acceleration from Q1’s 2.0% and the fastest since Q3 2014’s 5.2%. In contrast to “Hotlanta,” the New York Fed’s “Nowcast” report projects a less spicy 2.8% growth (which would still be a pickup from Q1). So who is right? The different interpretations each carry their own biases, so when in doubt, look at the data.
In this podcast, Client Communications Group Vice President Naj Srinivas speaks with Research Analyst Scott Botterman about recent developments in Emerging Markets.
Time Stamps:
US home prices are now well above pre-crisis highs, and concerns about affordability now stretch beyond the major coastal metropolises. Yet there is little to no chatter about a new housing bubble threatening to pop and derail stocks’ bull market—and for good reason. Despite elevated prices, today’s US housing market shows few similarities to the 2005 – 2007 period that preceded the big housing market downturn. As the following charts show, true bubbles require more than just sky-high prices—a timeless lesson for investors in all asset classes.
On the demand side, Exhibit 1 shows mortgage debt-servicing costs are currently at multi-decade lows due to the combination of low interest rates and low levels of mortgage lending over the past decade. By comparison, mortgage-servicing costs were at multi-decade highs prior to the housing bust, making it much more difficult for many households to continue meeting payment obligations.
Exhibit 1: US Mortgage Debt Service Costs Are Low
June 23 marked the two-year anniversary of the UK’s narrow—52% to 48%—vote to leave the EU. For some, it also marks the two-year anniversary of waking up in a cold sweat, paralyzed by bear market and EU collapse fears. Two years later, Brexit hasn’t proven disastrous for markets. Actually, not much has changed—nor does it appear likely to in the near term. Parliament remains gridlocked, and despite some recent choppy data, UK economic fundamentals are sound. While it is always possible Brexit negotiations deteriorate, we continue to believe any catastrophic breakdown in talks remains unlikely. Instead, as slow-moving public negotiations continue reducing Brexit uncertainty, we expect overly dour sentiment to improve.
Where Do Negotiations Stand Today?
Despite initial fears of a rushed breakup, the multi-phase Brexit negotiations are plodding along. (Exhibit 1) In Phase 1, politicians drafted the “divorce bill,” determined post-Brexit EU/UK citizens’ rights and debated options for keeping the Irish border physically free and open once it becomes an EU border. While many aspects of these issues (notably, the Irish border) remain unresolved, late last year the two parties agreed to move into Phase 2’s trade relationship and transition-period talks anyway. Thus far, trade negotiations are proceeding glacially. However, the UK and EU agreed to a transition period, granting Brits access to the EU’s single market through December 31, 2020—well beyond the scheduled Brexit date of March 29, 2019. This date could even be extended—EU officials hinted at extending the two-year negotiation period recently. Negotiation progress is possible at this week’s EU summit, but sweeping change is unlikely, especially considering leaders remain preoccupied with the issue of migration. Some EU leaders—most notably Spanish Foreign Minister Josep Borrell—have signaled they will reject UK Prime Minister Theresa May’s proposal to keep the UK in the EU’s single market for trade in goods while revoking the free movement of people. As we have long argued, this process will likely be slow and grinding and play out very publicly. The chance of a shocking surprise from Brexit proceedings is, therefore, very low.
Ladies and gentlemen, Greek Prime Minister Alexis Tsipras has worn a tie, which means spring will start early next year! Kidding! Actually, the firebrand-turned-compliant-reformist pledged he would don a necktie only when Greece received some debt relief. Greece and its creditors are saying this is the case after reaching a “historic” agreement in Luxembourg last week. The debt-relief deal is the latest in Greece’s long road back from the abyss and a reminder that markets can and do move on from a crisis well before the turnaround appears complete to the naked eye.
The deal gives the Hellenic Republic an extra 10 years to pay back about €96 billion of loans, or about 40% of what Greece owes the eurozone. Additionally, the agreement defers interest payments and amortizations another 10 years, pushing the earliest repayment deadline to 2033. Creditors will also lend the country €15 billion to pay its IMF loans and add to its cash reserves, leaving Athens with about €24 billion to meet its financing needs for the next two years.
Both parties are applauding the accord. Greece gets a short-term cash buffer ahead of its bailout program exit in August—a relief for its weary citizens. Creditors didn’t provide an explicit debt write-off, assuaging concerns (particularly from Germany) of being too soft. Meanwhile, some observers pointed out that Tsipras committed to decades’ worth of austerity, basically ceding sovereignty over economic policy. This is far from what many expected when the radical leftist populist took power nearly three and a half years ago. In our view, it is a timely reminder that populists moderate like all other politicians, so watch what they do, not what they say.
