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.


Scaling and the Treasury's Tariff Take

The Treasury’s monthly statement for May hit the wires Thursday, driving about a bazillion headlines about the surging budget deficit, which jumped 39% in fiscal 2019’s first eight months versus the same period in fiscal 2018 (the Treasury’s fiscal year runs October 1 – September 30). Most coverage was sure to note that customs duties collected also soared, up 80.9% year to date from fiscal 2018’s first eight months. Sounds huge! Yet this factoid doesn’t give one a real sense of how big a bite tariffs are taking out of economic activity. As always, to assess this, we must scale.

The numbers here aren’t astronomical. Exhibit 1 shows cumulative monthly year-to-date customs duties for the past five years. May’s year-to-date take is $44.9 billion, versus $24.8 billion in October 2017 – May 2018. But US GDP clocked in at $20.5 trillion in 2018. Trillion, with a T. Even if you pencil in another $20 billion of tariff revenues over the rest of this fiscal year, which is straight-line back-of-the-envelope math with no scientific basis other than being a rough average of the past four months, the tariff take amounts to 0.3% of GDP.

Exhibit 1: A Brief History of Tariff Revenues

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Risk, Due Diligence and Higher-Yield Alternatives

With 10-year Treasurys yielding just 2.13%—near their lowest level since September 2017—and CDs and savings accounts mostly offering ultra-low rates, interest in higher-yielding bond alternatives is rising.[i] Financial news and advertisements frequently feature such options, likely tempting many investors eager to spruce up their fixed income holdings with securities that aren’t struggling to outpace inflation. We sympathize—but also urge caution. As with any investment, it pays to know what you are buying—how it functions and what risks it carries—and resist the “low-risk, high-returning” siren song. As investors in the three examples we explore here show, the alternative could be painful.

First up: Municipal (or “muni”) bonds, which are debt issued by state, county or local governments. These have enjoyed a recent run of popularity: In 2019 through May, investors added $37 billion to muni bond funds—$8 billion of which went to high-yielding muni debt, dwarfing last January – May’s $1.5 billion.[ii] In our view, munis are overall a-ok as fixed income investments, especially in taxable accounts. They typically offer attractive yields relative to Treasurys and get preferential tax treatment. Moreover, muni defaults are rare. Per Moody’s, the average annual default rate between 1970 and 2016 on five-year muni bonds was just 0.07%.[iii] Even in the event of default, bondholders typically get some money back. The same Moody’s report noted the average recovery rate on defaulted munis is 66%.[iv]

However, some recent court cases highlight a muni risk investors may not have considered. Contrary to the common belief cities are legally obligated to service debt as long as they have the funds to do so—and if they don’t, courts will force partial payment—honoring claims can be a political decision as much as a fiscal one. An excellent Bloomberg article documented Platte County, Missouri’s recent decision to stop setting aside sales tax revenues for interest payments on bonds backing a struggling retail development. The county wasn’t out of money and didn’t declare bankruptcy. They just determined the pros of default outweighed the cons. A district judge ruled on June 3 there was “no promise or requirement” for Platte County to make payments—the bond’s contractual obligations were rather flimsy.[v]

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Deep Thoughts on Rome's Successful 20-Year Bond Auction

Amid another round of political upheaval—not to mention a global freakout over a potential Quitaly—Italy sold a 20-year bond Wednesday. This, in and of itself, should not be news. Countries sell bonds all the time. But demand for this bond was four times the amount on offer, which is huge. Some headlines couched this as a dangerous sign of yield-starved investors voluntarily overlooking risk. Yet we see this as a sign markets, always forward-looking and efficient, are quite good at separating news from noise.

Italy’s Treasury offered €6 billion worth of this new bond, which matures in 2040 and has an annual coupon of 3.1%.[i] When banks shopped it, investors put in bids totaling around €24 billion, for an average yield of 3.15%. This tells us a couple things: One, Italy’s government is more than capable of funding itself, despite the debt sirens’ warnings. Two, investors are able to see through said warnings, assess the likelihood that Italy will be a fully functional eurozone member-state capable of servicing its debt in 2040, and calculate how much compensation they require for the risk of a 20-year loan. In this case, it was only five basis points more annually than the government initially offered.

We guess it is possible this is a case of investors ignoring obvious risks—in the sense that anything is possible. But some recent historical context suggests this is unlikely. As last year showed, investors weren’t shy about demanding more compensation from Italy’s government when they sniffed higher long-term risks. The entire eurozone crisis is a testament to this as well. Even German bond auctions were undersubscribed then. Are we really to believe extreme pessimism has spiraled into unwarranted euphoria today? Particularly when headlines remain mired in doom? Even broad complacency towards eurozone “risks” looks highly unlikely considering surveys routinely show investors are pessimistic toward the region’s stocks. Inflation may be a big bond yield driver globally, but default risk matters country to country. If Italian default risk were legitimate, yields would almost surely show it.

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No, the Fed Doesn't Need to Cut Rates, but ...

Stocks had another nice day Wednesday, with the S&P 500 gaining 0.8% in price terms on the heels of Tuesday’s 2.1% rise.[i] Headlines near universally credited the Fed, citing Chair Jerome Powell’s jawboning about rate cuts and pledging not to sit idle if tariffs start taking a toll. On the whole, this strikes us as an overreaction and another example of investors having far too much faith in the Fed's ability to manipulate US growth rates. If policymakers could control the economy by pushing this button or pulling that lever, the Fed probably wouldn’t be struggling to hit its self-imposed inflation target amid the slowest economic expansion in history. Moreover, as we wrote last week, there is scant (if any) evidence the economy needs Fed intervention. Yet it could be a salve for sentiment, perhaps helping investors move on from 2019’s false fears.

A Wall Street Journal op-ed by economic researcher Donald Luskin highlights why:

Last July, in his first semiannual testimony before Congress, Mr. Powell was asked by Sen. Patrick Toomey (R., Pa.) what he thought of the narrowing yield curve. Mr. Powell answered: “If you raise short-term rates higher than long-term rates, then maybe your policy’s tighter than you think, or it’s tight anyway.”

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Italy's Unspoken Lesson: Tune Out the Political Noise

Editors’ Note: Our political commentary is non-ideological by design. We favor no political party, politician or elected official in any country and assess political developments solely for their potential economic and market impact.

One week ago, Italian co-Deputy Prime Minister Matteo Salvini was flying high after his party, the far-right The League, trounced its competition (and coalition partner Five Star Movement, or M5S) in European Parliamentary elections. In short order, he claimed a new mandate for wide-ranging tax cuts and taunted Brussels over its deficit limits, while his government passed a motion to explore a parallel currency known as the “mini-BOT,” which is a play on the Italian acronym for short-term Treasury bills. Eurozone leaders responded with a letter threatening sanctions if Italy broke its deficit reduction commitments, rekindling fear that the long-awaited Quitaly was at hand. Yet since then, the pendulum has swung in the opposite direction: The Treasury all but disavowed mini-BOTs last Friday, and on Monday, Prime Minister Giuseppe Conte threatened to walk and force a snap election because he couldn’t abide Salvini and M5S leader Luigi Di Maio’s constant bickering. Let this be a lesson in the danger of reacting to short-term fear: The story can flip fast, leaving investors chasing their tails.

What happens next in Italy, we have no idea. After Conte threw down the gauntlet Monday evening, Salvini and Di Maio at first played nice. The Guardian reports they had a cordial phone call and pledged to support Conte and their coalition. But harmony apparently reverted to discord Tuesday, with Salvini reportedly accusing Di Maio of plotting against him and issuing his own ultimatum. They could very well kiss and make up again, or Italy could be heading to a snap election. A lot will probably depend on what the polls show over the next couple of weeks and what party leaders think is in their interest. A politician’s mind is a terrible place to navigate, so we won’t hazard a guess on how this all shakes out.

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Potential New Retirement Legislation on the Horizon

Last month, the US House passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in a rare bipartisan 417 – 3 vote. The bill offers Americans more incentives to save and invest through tax-advantaged retirement accounts like 401(k)s and IRAs. With similar bills receiving broad Senate support—the Retirement Enhancement Savings Act (RESA) and the Retirement Security and Savings Act (RSSA)—many expect some version to become law before too long, changing America’s retirement system significantly. Predictably, there are good and some not-so-good provisions, in our view. Here we provide a rundown, focusing on the SECURE Act since it is furthest along in the legislative process but noting where the RESA and RSSA potentially differ.

The Good

Perhaps the biggest benefit from a retiree’s perspective: provisions raising the required minimum distribution (RMD) age to 72 from 70 ½ and allowing traditional IRA contributions after age 70 ½. This would help folks living and working longer by enabling more tax-deferred growth in their traditional IRAs (funded with pre-tax income), which could mean greater assets later in life, when medical care costs loom large. Note: The RESA doesn’t change the current RMD age, but the RSSA would up it to 75.

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More on America's (Small) Yield Curve Inversion

The US’s yield curve inverted again this week, reigniting fears of a looming recession. Our view, discussed at length in March and early April, remains unchanged: Such a shallow inversion (12 basis points between the 3-month and 10-year US Treasury yields, as of market close on Thursday) is largely indistinguishable from a flat or slightly positive curve, and overall, the global yield curve matters most. We live in a world where big banks can borrow in one country, hedge for currency risk if they like, and lend in another—seizing arbitrage opportunities from different countries’ different interest rates. Today’s global yield curve is positively sloped, helped both by negative short-term rates across Europe and Japan as well as relatively high US long rates. So we see plenty of potential for positive surprise, rendering yield curve dread—which sets expectations low and bakes fear into the marketplace—a rather bullish helper for stocks.

Here is another reason we don’t buy into today’s fears: While the yield curve influences banks’ profits, which drive lending, it isn’t a perfect proxy. Banks do indeed borrow at short rates, lend at long rates and profit off the spread. But they do so at market-set rates, not Fed-set overnight rates or long-term government bond rates. Government yields are reference rates only. So to gauge whether bank lending is still profitable, you must look at actual bank rates. As the next several charts show, these remain favorable for lending even as the yield curve flounders.

Presently, the effective fed-funds rate is 2.39%, while 3-month US Treasury yields are 2.37%.[i] But banks are not paying anywhere near that much to borrow money. Exhibit 1 shows a smattering of short-term interest rates, including checking accounts, savings accounts, money market funds and 3-month CDs. All are well below 1%.

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On China, Rare Earths and Adaptive Markets

As the US/China trade spat lumbers on and both sides run out of new imports to threaten with tariffs, many pundits speculate China will soon seek non-tariff retaliation methods. One oft-touted tool: exploiting its alleged stranglehold on the supply of “rare earth elements”[i] to hurt US companies reliant on them to produce goods ranging from memory chips and batteries to lasers and satellites. While the prospect of America’s high-tech engine sputtering without them sounds scary, we think this is a far-fetched scenario. In our view, rare earth metals are a case study in markets’ problem-solving power, not a potent economic weapon for countries (supposedly) controlling their supply.

First, a high school chemistry throwback: “Rare earths” refers to a group of 17 elements with similar chemical properties and many electronics applications. Contrary to what the name implies, they aren’t all that rare—some are as abundant as copper and lead. Nor are they difficult to find: In a single discovery last April, a team of Japanese scientists located offshore deposits with “the potential to supply these materials on a semi-infinite basis to the world.”[ii] However, extracting rare earth minerals and transforming them into usable materials can be expensive, environmentally risky and physically dangerous.

Partly thanks to lower production costs and less concern about environmental dangers, China became the rare earths mining and refining leader in the 1990s—a position it has kept since. Last year, China accounted for about 70% of the world’s rare earths output—supposedly positioning it to hamstring US industry by blocking shipments.[iii] Chinese officials seem happy to foster this impression. Last week, President Xi Jinping visited a rare earths facility in southern China—a move many interpreted as a shot across the bow. The National Development and Reform Commission—China’s economic planning agency—offered this cryptic musing on Tuesday: “Will rare earths become China’s counter-weapon against the US’s unwarranted suppression? What I can tell you is that if anyone wants to use products made from rare earth to curb the development of China, then the people of the revolutionary soviet base and the whole Chinese people will not be happy.”[iv] On Wednesday, the state-owned paper People’s Daily issued a similar warning.[v] This drumbeat helped fuel fears of a rare earths export ban.

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Europe Has a Parliament—and Gridlock

Editors’ Note: Our political commentary is nonpartisan by design. We favor no party, politician or elected official in any country and assess political developments solely for their potential economic or market impact.

The results are in, and we now know the winners from last week’s European Parliamentary elections: everyone and no one! Ok, perhaps that is juuuuuuuust a bit oversimplified. But pro-European parties combined for more than 50% of available seats—a victory of sorts.[i] Then again, the two biggest centrist groupings lost their combined majority for the first time since the European Parliament launched in 1979. Populist and euroskeptic parties combined for a largest-ever total of 25% of seats. But those populists aren’t unified, and no faction is anywhere big enough to get a meaningful seat at the table. Meanwhile, both pro- and anti-Brexit parties in the UK are claiming victory, while one of Italy’s ruling populist parties seemingly has a newfound mandate. For investors, the outcome is much simpler: entrenched gridlock, which should relieve European stocks.

Exhibit 1 shows the latest tally. The two traditional groups—the center-right European People’s Party (EPP) and center-left Progressive Alliance of Socialists and Democrats (S&D)—took first and second place, respectively, but combined for only 44.1% of seats.[ii] But a third centrist group, the Alliance of Liberals and Democrats for Europe (ALDE), took third place with 14% of seats, giving a three-way centrist coalition an easy majority if that is the road party leaders decide to take. Political analysts worldwide seem to think this is the likeliest outcome, perhaps with the Green Party joining. We guess a left-leaning coalition of S&D, ALDE, Greens, leftists and the populist Europe of Freedom and Direct Democracy (EFDD) is also possible, as is some other fractured hodgepodge. But whatever coalition ultimately emerges, it will have at least three main parties—a recipe for internal disagreements and next to nothing happening. Populist parties will probably spend most of their time making rousing speeches from the back benches, not writing radical legislation.

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As the Global Economy Goes, So Goes Japan

With most major developed world economies already reporting Q1 GDP, Japan finally joined the fun last week—and the numbers were better than expected. Q1 GDP grew 2.1% annualized, besting estimates of flattish growth or even contraction.[i] Yet the stronger-than-expected Q1 number isn’t reason to be wildly bullish, in our view. Japan faces several economic and political headwinds for the foreseeable future, and in our view, better opportunities lie outside domestically focused Japanese firms.

While the headline number grabbed attention—Japan’s growth rate topped both the eurozone’s and the UK’s—a look under the hood revealed a less rosy picture. On the domestic front, growth was weak. Household consumption slipped -0.4% annualized, while business investment fell -1.2%.[ii] Trade numbers indicated flagging domestic and external demand: Imports plummeted -17.2% and exports dropped -9.4%.[iii] Since GDP accounts for net trade (exports minus imports), imports’ falling faster than exports actually boosted the headline number—even though contractionary imports and exports aren’t economic positives. The other main positive contributor: public investment (6.2% annualized), tied to the government’s infrastructure improvement efforts prompted by last summer’s natural disasters.[iv]

More recent data were also mixed. Japan’s core machinery orders, which some treat as a proxy for future business capital spending, rose 3.8% m/m in March.[v] However, this is a volatile gauge, and the positive March reflected some big orders from nonmanufacturers. Perhaps more tellingly, April exports values fell -2.4% y/y—the fifth straight contraction.[vi] Even that figure was boosted somewhat by currency translation, as export volumes fell -4.3% y/y, the sixth straight slide.[vii] Weak external demand isn’t good news for an economy whose swing factor tends to be trade. But it also isn’t new news. The culprit, in our view, is China’s shadow banking crackdown last year. That roiled Chinese domestic demand and had global ramifications, creating headwinds for eurozone and other Asian exporters, too.

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