That was a Friday to remember. The day was supposed to be dominated by Jay Powell’s much-anticipated talk in Jackson Hole. Investors were looking for clues on the timing and direction of the next Fed policy move. Powell’s speech ended up satisfying markets, but not the President. Trump wants a 100 bp ease, and he wants it now (not over the next year as the futures markets predict).
It turns out that Jackson Hole was not the news epicenter. It was Twitter. China snuck in a tariff on $75 billion of US goods before Powell’s presentation, which was later met by a vicious tweet-storm from the President. In just a few hundred characters, he declared Powell an enemy of the state, banned American companies from doing business in China, imposed mandatory inspections on all goods entering China, and increased tariffs on Chinese imports. (I think I just used more characters describing his tweets than he used inside them…you have to admit, he gets straight to the point.)
In case you missed them, the tweets that rocked the market are provided below. Note to self: don’t anger President Trump.
Precious Metals Reach 2019 Highs
When you combine low/negative real rates to geopolitical uncertainty, you have a recipe for a rally in gold and other precious metals. With the outlook for global trade taking a turn for the worse last week, the Bloomberg Precious Metals Index hit a new 2019 high and now sits with a 15% gain for the year. Silver has also started to awaken from years of stagnation. Upside option skew, measured via 25-delta risk reversals, is at elevated levels, and demand for option calls is at a 10-year high.
A Stronger US Dollar Complicates Matters
Why does the current administration care so much about the US dollar? It has to do with the way the President defines economic “success”. If reducing the trade deficit is the measure, then a strong trade-weighted dollar makes US goods more expensive on global markets. The problem is it is sitting near a 20-year high. A weaker currency relative to our trading partners would make US companies more competitive internationally. It would also provide a tailwind to corporate profits when foreign earnings are brought back to the US. Lower policy rates could trigger a correction in the dollar, and that is why the President is so harsh on the FOMC chair, Jay Powell.
Low Rate Insurance is Getting Expensive!
Another market with extreme option skew is the Eurodollar market. The market continues to bid up low-strike Eurodollar calls in anticipation of further easing by the Fed. With futures contracts already pricing 3-month LIBOR rates at 1.4% over the next year, the current skew (at more than four standard deviations rich) appears excessive. Remember how hard it was to buy protection against higher rates in 2018? Protection for higher rates is now very inexpensive…but the likelihood for a rate increase is also much lower.
Relative Value in Agency MBS
Most investment-grade fixed income markets appear expensive in absolute terms, but some markets look cheap in relative terms. For instance, consider Agency MBS spreads which have widened to Treasuries. 30-year MBS have an effective duration of 4.6 years, similar to a 5-year government bond, but offer an additional 40 bps of yield. With a yield of 1.4%, 5-year notes are the low point on the Treasury yield curve. A 40 bp pickup for MBS may not seem like a lot given the extension risk, but if investors have the view that rates will stabilize as volatility subsides, then a move into MBS could provide a better total return over the next six months.
Asset Allocation: The Rotation Continues
Trends in asset allocation can be summarized as follows: money is flowing into money market funds, bond funds and safe-haven sectors while flowing out of Japan, bank loans as well as the energy and financial sectors. Given the performance in fixed income in August, anticipate at least some rebalancing at the end of the month toward equities.
CEO Confidence Sours
Each month, Chief Executive Magazine surveys CEOs across corporate America, at organizations of all types and sizes. At 6.2 out of 10 on a 1-10 scale, confidence in future business conditions fell 6% in August and is at its lowest level since mid-2016. CEOs in the financial services, retail and mining industries showed the largest monthly drop. Transportation and technology CEOs grew in confidence. 62% of CEOs say the trade war is becoming highly detrimental to their outlook and strategy…and that was BEFORE the latest round of increases from both China and the US.
Market Sentiment Sours, Too
Weak and volatile markets hurt investor sentiment. That should be no surprise. According to BOA’s “Bull/Bear” suite of indicators, investors are pretty darn bearish. Equity flows and positioning indicate “very bearish” sentiment. Note these indicators were measured BEFORE Friday’s market tumble.
European Credit Spreads Hover at the Tights
In a world growing ever more fearful of a recession, the investment-grade credit market in Europe appears to be a safe harbor. Spreads in the cash market have dwindled down to 41 bps, and the 10-year debt of some EUR corporate issuers, such as Walmart and Nestle, is even trading with negative yields. One would think that stock buybacks must pick up in the Eurozone. The sector is also benefiting from a potential revival of the ECB corporate bond purchase program.
Rates Lower. Bond Proxies Higher.
Low long-term interest rates in the US have caused investors to look for “bond proxies”. One example is the utilities sector. Its dividend yield is currently 1.63% higher than that of the 10-year note. However, demand for such proxies has caused a significant richening in valuation. The utilities sector trades at a forward P/E ratio of 20x, higher than the broader S&P 500 and at the richest level over the last five years. The consumer staples and real estate sectors are also near record highs. These proxies are still “cheap” to bonds, but rich relative to their own histories.
Fiscal Policy to the Rescue in Germany?
Last week, Germany sold EUR 824 million of a zero-coupon 30-year bond above par. Yes, that implies a negative yield. Germany has signaled a willingness to ramp up issuance to fund various infrastructure programs in the event the country slips into a recession. That time may come sooner rather than later. Fortunately, Germany is in good fiscal shape to accomplish such a stimulus. It is running a budget surplus, and its Debt to GDP ratio is just above 60%. This is 25% lower than the Eurozone average. They have discussed the potential for a EUR 50 billion spending package, similar in size to the one deployed after the financial crisis in 2009.
Ed Yardeni penned a great article in Barrons this weekend on stock buybacks. His conclusion is that most stock buyback programs are designed to avoid share dilution arising from the vesting of employee compensation plans.
In our recent study on buybacks, we calculated that over the same period, S&P 500 companies repurchased 72 billion shares and issued 50 billion, resulting in net repurchases of 22 billion shares. Net issuance (actually, net buybacks in this case) has fluctuated at about a third of gross buybacks over this period. That explains why the amount that gross buybacks have contributed to the growth of earnings per share has been relatively small.Barrons- Aug 23, 2019
In any case, a slowdown in share buybacks would reduce what is roughly $700 billion annual flow into the market. The WSJ also had a story on dwindling stock repurchases.
Companies in the S&P 500 repurchased about $166 billion of their own stock in the second quarter, S&P Dow Jones Indices projects, down from $205.8 billion in the first quarter and $190.6 billion in the same period a year ago. That marks the lowest total since the fourth quarter of 2017 and the second consecutive quarter of contraction.WSJ- Aug 21, 2019