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After the FOMC adjourned its March meeting, financial media immediately drew conclusions about US monetary policy’s direction for the rest of the year, cheering the prospect of zero rate hikes—with some even speculating about a rate cut. When the yield curve inverted slightly on Friday morning, we suspect the prospect of a Fed rate cut became even more attractive to some. Mind you, we don’t think it is necessary or that this inversion is anything to lose sleep over. A surprise inversion that no one paid attention to would potentially be a negative, as it could signal euphoric investors were ignoring the risk of a weakening economy—that is what happened in March 2000, when the 1990s bull ended. Today, however, we have the opposite: Everyone fearing slow growth and all eyeballs from here to kingdom come watching the slight inversion and tying themselves in knots over it. Its surprise power is sapped, and abundant fear merely extends the bull market’s wall of worry. Stocks should keep climbing that wall, helped in part by the widely ignored—but nicely positive—global yield curve.
Still, because the Fed is on everyone’s mind, let us explore the history of Fed rate cuts and whether investors should put much stock in the legend of the “Fed put.” Investors’ new short-term interest rate expectations stem from the FOMC’s updated economic projections, including the widely watched “dot plot”—which shows 17 officials’ forecasts of the fed-funds target rate over the next three years “and beyond.” In December 2018, the median forecast was two 2019 rate hikes. Now, the median is for none. This isn’t terribly shocking, given the odd optics associated with tightening into widespread economic slowdown fears. However, it also isn’t a blueprint. Nevertheless, fed-funds futures markets imply investors see a better than 50% chance of rate cuts by yearend—up significantly from Monday.
Four years ago this week, MarketMinder’s Senior Editor Elisabeth Dellinger wrote about why folks shouldn’t put too much stock in the dot plot in her column, “Fed People Write Words, Draw Dots”—and those lessons still hold true today. As March 2015’s dot plot showed, the vast majority of Fed folks thought fed funds would be above 2.5% starting in 2017 and at least at 3% in the “longer run.” Yet here we are in “the longer run” of March 2019, and the fed-funds target range was just set to 2.25% — 2.50% in December 2018. In our view, this is a keen reminder the Fed doesn’t possess a crystal ball that allows them to see years into the future.
Aaaaaaaaaaaah, the Fed.[i] You may have heard the US yield curve inverted Friday morning, with the 10-year US Treasury yield crossing a shade below the 3-month rate. Media is making a big deal of this, although it seems hard to call it bad news. Surprises move markets most, and people have been eyeing inversion for months. Heaping media attention today basically vaporizes any negative surprise power, making this priced in, and making expectations easy for reality to beat.
This is a big, global world. The yield curve indeed influences banks’ loan profits—banks borrow at short rates, lend at long rates and profit off the spread—yet government bond rates don’t translate directly to banks’ rates. Banks’ funding costs have trailed US government rates since the Fed began raising overnight rates, thanks to a glut of deposits relieving banks of the need to compete for funding by offering higher rates. Meanwhile, business and mortgage loan rates are above government rates. So, banks’ business models likely remain profitable. This is doubly true considering far lower—even negative—rates abroad, which allow banks to fund lending cheaply elsewhere. (Why we often say the global yield curve trumps any individual nation’s.) So this is a time to own stocks. But it is worth considering how we got here.
Wednesday, the FOMC announced its long-awaited blueprint for winding down the winding down of their balance sheet. Come October, instead of letting up to $50 billion worth of Treasury bonds and mortgage-backed securities roll off the Fed’s balance sheet, the Fed will keep the total value of its portfolio static. But there is a twist. In addition to resuming reinvestment of all maturing Treasury bonds, it will reinvest the proceeds of up to $20 billion worth of mortgage-backed securities into Treasurys. So, not only will the Fed stop shrinking its balance sheet, it will resume increasing its holdings of Treasury bonds. Though this move is too small to move the needle, it is curious and seems counterproductive.
1,000 days ago, Brits went to the polls, with 52% of voters electing to leave the EU, kicking off the long-running saga known as “Brexit.” In the last episode of this political soap opera, UK Members of Parliament (MPs) had once again rejected Prime Minister Theresa May’s Brexit deal, teeing up two additional votes: one to reject a “no-deal” Brexit and one to delay the departure date past March 29. Both passed last week, leading to May’s Plan C: get Parliament to pass the deal this week, then get a short delay to give her government a bit more breathing room to implement said deal. But House of Commons Speaker John Bercow threw cold water on that plan Monday, invoking a Parliamentary procedure that resembles US “double jeopardy” laws to declare a revote illegal unless the legislation were significantly modified. Now May is launching Plan D: requesting a three-month Brexit delay to buy more time to modify and pass a deal. As we write, the ball is in Brussels’ court, and with Brexit still scheduled to take effect at 11:00 PM GMT March 29, this could still go any number of ways—including a no-deal Brexit. Uncertainty is high, the pound is yo-yoing as sentiment gyrates, and we still think markets will be happiest once they just get on with it, whatever that looks like.
Preliminary rumblings from Brussels suggest this could go down to the wire. Accepting the UK’s requested delay requires unanimous consent from all other 27 EU member-states. At the moment, that consensus doesn’t exist. They can’t even agree on whether delaying Brexit to June 30 would disrupt the upcoming European Parliament elections by requiring Brits to field candidates and vote. Some say it would be fine, as Parliament isn’t seated until July 1. Others call it a no-go, citing the late-May election date as a hard deadline. As for the mere notion of an extension, Poland seems ok with it, but France has suggested it doesn’t see the point and would rather just get on with a no-deal endgame. European Council President Donald Tusk, who chairs discussions among the EU’s heads of state and government, says they’ll likely grant an extension only if May’s deal passes. The very deal Bercow says can’t return to Parliament—which is nonetheless expected to return to Parliament Monday. Circular logic if we have ever seen it.
While MPs rejected a no-deal Brexit last week, that doesn’t rule out a no-deal Brexit actually happening. It’s all rather like when George tried to break up with Maura on Seinfeld and they both had to “turn their keys.” Parliament turned its key. But if the EU doesn’t turn its key and grant a delay, then a no-deal Brexit happens by default on March 29.
After Japanese Q4 GDP rebounded from Q3’s one-off, natural disaster-driven contraction, January data suggest the economy got off to a subpar start in 2019. The primary culprit? Softer Chinese demand. While this headwind should pass, in our view, other economic woes—especially weak domestic demand—likely linger, hindering Japanese growth and hampering domestically focused Japanese firms.
Up first: some not-so-pretty numbers. Japanese firms’ machinery orders—which many consider a harbinger of broader business investment—fell -7.9% m/m in January.[i] Core orders—which exclude the volatile categories of ships and electric utility orders—also contracted (-5.4% m/m).[ii] January was the third straight contractionary month for both. Elsewhere, in a sign of tepid external demand, core machinery orders from overseas fell -18.1% m/m—the same pace as December.[iii] Exports also struggled, falling -8.4% y/y in January after December’s -3.9% drop.[iv] Exports to China fell more, plunging -17.1%.[v] While February exports held up better (as we will discuss), they still fell and missed estimates.
In sum—a poor showing! The usual suspect is Lunar New Year’s shifting timing, which typically distorts first-quarter economic data across Asia. But the common perception goes beyond this, arguing a US/China trade war is sapping Chinese demand and crimping global growth. As its key export destinations flag, the logic goes, Japan suffers. While we think trade war fears are overblown, this explanation has some merit. Tariffs probably partially explain recent weakness, especially if fear of getting caught in the crossfire is leading Japanese businesses to delay spending.
Since 2016’s presidential campaign, political rhetoric fanning fears of major drug price regulation has weighed on sentiment toward Pharmaceuticals stocks. Those fears weren’t fulfilled during President Trump’s first two years, but many now argue the Democrats’ House victory in last year’s midterms changes the calculus, paving the way for Trump to push bipartisan prescription drug pricing reform. While small measures are possible, we think the big, sweeping drug price caps investors fear most are unlikely to pass. Limited reform tied to the Pharmacy Benefit Manager (PBM) rebate system seems more probably, and it likely lacks the scale to dent Pharmaceuticals’ earnings.
For those unfamiliar with the prescription drug supply chain, PBMs are essentially middlemen between drug companies and health plans. PBMs serve the health plans and, indirectly, patients the plans represent by negotiating drug prices on their behalf. The result is a list of covered drugs for the health plans they represent, known as the formulary list. In turn, drugmakers pay PBMs rebates in order to get included, which the PBM then returns to the health plan. This rebate system is key, as PBMs generate their revenue based partly on the volume of rebates and discounts they get for health plans, which they can retain, reinvest or use to lower patient costs. While terms vary among health plans, the standard industry presumption is that PBMs return approximately 90% of total rebate dollars to health plans and employers.[i] However, the system isn’t very transparent, and patients often don’t benefit directly from PBM rebates—surveys show health plans most often use the rebates to reduce their own costs rather than offset patient premiums or their out-of-pocket costs for prescriptions. (Exhibit 1)
Exhibit 1: How Health Plans Use PBM Rebates
In this podcast, Client Communications Group Vice President Naj Srinivas speaks with Fisher Investments’ founder, Executive Chairman and Co-Chief Investment Officer Ken Fisher about the past 10 years of this bull market—including how it started, how it has progressed and whether there is still more room to run. Recorded March 14, 2019.
00:57 – Bull market length
01:45 – Sentiment curve
02:35 – Bull market depressants
02:50 – QE misunderstandings
03:40 – Effects of money supply, PIIGS and Trump
05:03 – Biggest surprise of this bull market
06:30 – Media and investor sentiment
08:45 – How much longer can the bull market go?
10:45 – Volatility and investor sentiment
12:00 – 2019 forecast
14:00 – Presidential 3rd years
16:10 – 2018’s effect on 2019
On March 9, 2009, a global bull market began. A decade—and multitudinous predictions of its demise—later, the bull still seems on solid footing. Its 10-year anniversary, though an arbitrary marker, is a timely reminder of how powerful and resilient bull markets are.
This “bulliversary” milestone does come with a caveat: Both global and US stocks remain below the record highs set before last year’s correction. The MSCI World last registered an all-time high on January 26, 2018, while the S&P 500’s most recent record was September 20.[i] Though stocks have rebounded significantly, the S&P 500 and MSCI World remain -3.1% and -4.7% below their last highs, respectively.[ii] We suspect last year’s drop was a correction, which ended around Christmastime, and think it is only a matter of time before both gauges register new highs. Short-term negative volatility could always knock markets again, dragging this out. But we see little fundamental reason to think the bull is over now.
Presuming that holds true, this bull’s 120-month run is the longest on record—eclipsing the 1990s bull’s 113 months. It is a trivial milestone, but inevitably rekindles the long-running debate: Is the bull long in the tooth and on its last legs, or can it keep on trucking? But in our view, bull markets don’t die from old age. Based on our research and understanding of the stock market, bulls die in one of two ways: what we refer to as “the wall” or “the wallop.” We don’t see either as likely in the here and now, suggesting this old bull should keep running.
The ECB is stimulating! Or at least that is how it and the media are portraying President Mario Draghi’s recent decision to renew the central bank’s “targeted long-term refinancing operations” (TLTROs). Media have speculated for weeks this would happen, describing it as a “major policy reversal” and a “U-turn.” We think this gives the ECB too much credit. Thursday’s announcement largely extends the status quo—an unnecessary move, in our view. While couched as stimulus, we think it was really designed to defang a false fear: maturing TLTRO loans.
First, understand: TLTROs are not quantitative easing (QE). Under QE, the ECB bought long-term bonds to reduce longer-term interest rates. By doing so while fixing short rates just below zero, they reduced the difference between short- and long-term interest rates. Because banks borrow short term to fund long-term loans, this reduces profits on future lending. By contrast, TLTROs let banks borrow funds for a fixed period directly from the ECB at discounted rates, providing they use them to underpin loans to businesses and consumers.
This isn’t the first time the ECB tried extending cheap funding to banks. TLTROs’ predecessor was 2011’s longer-term refinancing operation (LTRO), sans the first T, which didn’t require banks to lend the funds. Amid a debt crisis and recession, banks scrambling for liquidity took out over €1 trillion in three-year LTRO funds. When LTRO repayment approached in 2014, the ECB introduced the first TLTRO with four-year maturities, allowing banks to roll over their LTRO funds if they put them to work. Banks took €430 billion. In 2016, rather than wait four years, the ECB launched TLTRO-II—another four-year facility—which permitted greater borrowing at lower rates for new private sector loans. Banks not only rolled over most of their TLTRO-I funding, but they increased it to €739 billion. Repayments for TLTRO-II are now poised to start coming due in the next 12 – 18 months. The ECB’s announcement it will offer two-year funding should allow banks to roll over funding once again.
The UK’s Parliament conducted its latest “meaningful vote” on Brexit Tuesday. On the bright side for Prime Minister Theresa May, who won a few concessions from Brussels overnight in hopes of rallying lawmakers to her side, more members of Parliament (MPs) voted for her deal than in the last vote. On the not-so-bright side, the No votes dropped from 432 to 391—still far exceeding the 242 Yes votes. For markets, this widely expected defeat merely extends the status quo of Brexit uncertainty. We remain of the opinion that the sooner this all ends, the better—regardless of the actual outcome—so that investors and businesses can get on with life. But the road there could go a number of ways.
On paper, the next steps are as follows:
Exhibit 1: Your Handy Brexit Vote Flowchart
Lately, economic worries have most seeing trouble in almost every data release. Last week was no exception. Yet two data points published last week—which, at first blush, seemingly support slowdown fears—actually have some interesting twists when you take a closer look. Here is a quick rundown.
Eurozone GDP Slowing Has a Silver Lining Most Missed
While most media focused on the ECB’s new “stimulus” (which is nothing of the sort, in our view), they seemingly overlooked the revised Q4 GDP data, published the same day. This report didn’t change headline growth—it was still a slow 0.2% q/q (0.9% annualized)—but it added detail lacking in the preliminary release.[i] The upshot: Consumer spending, business investment and trade all added to growth. Sum them up and you get 0.4% q/q GDP growth. Adding in government spending bumps it to 0.5%. So what dragged growth down?