Hope everyone had an excellent summer. We did, even though the season moves faster with each passing year I admit to enjoying the summer break from blog writing but, like a new school year, I’m eager to get back to blogging. The task helps keep me focused on all the wealth management stuff happening outside of our office.
I am an unredeemable Seinfeld fan. I still stop to watch this timeless sitcom whenever I find it while channel surfing.
A favorite episode is when George Castanza, the worst employee in New York Yankee’s front office, finally gets terminated with three-months of severance pay. While flummoxed at first by the news, he comes to terms with the benefits of his short-term financial freedom and exults “It’s the summer of George”. He even proclaims that he’s going to read a book, from beginning to end.
Alas, George’s ambitious summer plans do not materialize and he reverts back to his lazy tendencies, rarely leaving his apartment or even changing out of his pajamas. After taking a fall down a flight of stairs and injuring his back, he decries from the ambulance stretcher “This was supposed to be the summer of George!”.
Unlike George Castanza, US capital markets experienced a relatively pleasant summer and are enjoying a festive 2019 through Labor Day. US stocks, as measured by the S&P500 Index, rose a solid 4.1% from Memorial Day until Labor Day. US bonds returned an astonishing 9.1% over the summer, more on why below (all data per Wall Street Journal).
Much like George, the US stock market started the summer with a bang and then faded with the Dog Days of August. The advance was, once again, led by US growth stocks. Value, mid-cap and small-cap stocks have “stayed in their pajamas” over the summer. Value stocks continue to grossly trail the performance of its growth counterpart by wide margins. This underperformance is Castanza-esque, but don’t expect it to persist forever.
In August, the dreaded inversion of the US Treasury yield curve finally happened when the yield on the ten-year Treasury note dropped lower than the two-year Treasury note. That unusual event in the US Treasury debt market, which in the past has often presaged a future US recession, dinged US stocks and sent bond prices soaring last month.
The yield curve inversion is yet another signal that US economy is showing signs of a recession, likely in 2020. While other factors are driving down long-term US interest rates – especially capital flows from foreign investors suffering from negative interest rates in Europe and Japan - other leading US economic indicators are now flashing caution as well.
The catalyst for both the US economic deceleration in 2020 has been the bad attitude by big business. The positive economic benefits from the 2017 tax act have been negated by the US-China trade brinkmanship. Think about it, if you are the CEO of a major US corporation and POTUS just ordered you to exit a country in which you have many clients and a major capital investment, that’s not a real confidence builder.
When, not if, we get the next recession, it will be championed by falling business profits and lower capital investment, not Fed Reserve monetary policy, the government or the US consumer. The federal government and consumers are still spending like sailors on leave.
The last time we had a business-led recession was 2000-2003 and it proved to be a doozy for US stocks. Geo-political events will ultimately determine the timing and depth of a future recession, which, by definition, is unpredictable. Watch POTUS as he tries to shore up his tenuous re-election chances by striking a China trade deal before November ’20. The timing and details of a China trade deal will factor into the recession equation.
I saw a chart in my summer reading that gave me pause: Total US corporate profits since 2012 are flat, but earnings per share have grown like a rocket ship over the same time. Hazard to take a guess as to why? Stock buybacks is the correct answer. US corporations have borrowed massive amounts to buy back their stock to goose earnings-per-share to placate investor growth expectations.
The total US corporate debt is so large some analysts are using the “bubble” word to describe the corporate debt market and worry that it could be the tripwire for the next recession. That seems plausible to me.
Longer term, there’s been growing talk since the yield curve inversion last month about the US eventually entering the negative interest rate frontier as well. I’m concerned that negative interest rates and high national debt are a precipice from which there’s no return.
One of the lessons learned from the Fed Reserve’s recent monetary policy tightening exercise is that the “neutral” short-term interest rate to maintain favorable economic conditions appears to be in the 2% - 2.5% range. Historically, the neutral Fed Funds rate has been between 4% and 5%.
The Fed Reserve was forced to hit the brakes early in 2019 on their plans to raise the Fed Funds Rate meaningfully higher due to the economic headwind it has caused. If the neutral Fed Funds rate is now only 2.5%, it doesn’t leave the Fed much dry powder during the next recession to stoke economic growth via monetary policy, hence the worry about negative US interest rates and even QE4 money printing.
Look at Japan and the Europe Union as test tubes for the unpleasant impact of negative interest rates and excessive debt. Their government and bankers have been thus far unable to escape the vortex of negative interest rates and debt via economic growth and manufactured inflation.
The specter of negative US interest rates has major implications for portfolio construction and it’s a strange subject to fold into our investment management process.
By the way, I did find time to read a couple non-financial books over the summer, from beginning to end.
Until next time, be well…Tim