a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.

 

 

 

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

the amazing shrinking dollar

So far this year, the US$ has fallen by about 14% against the €, and around 8% against the ¥ and £.

A substantial portion of this movement is giveback of the sharp dollar appreciation which happened last year after the surprise election of Donald Trump as president.  That was sparked by belief that a non-establishment chief executive would be able to get things done in Washington.  Reform of the income tax system and repair of aging infrastructure were supposed to be high on the agenda, with the resulting fiscal stimulus allowing the Fed to raise interest rates much more aggressively than the consensus had imagined.  Hence, continuing dollar strength on a booming economy and increasing interest rate differentials.

To date, none of that has happened.   So it makes sense that currency traders would begin to reverse their bets on.  However, last year’s move up in the dollar has been more than completely erased and the clear consensus is now on continuing dollar weakness.

 

Dollar weakness has caused stock market investors to shift their portfolios away from domestic-oriented firms toward multinationals and exporters.  This is the standard tactic.  It also makes sense:  a firm with costs in dollars and revenues in euros is in an ideal position at present.

It’s interesting to note, though, that over the weekend China lifted some restrictions imposed last year that limited the ability of its citizens to sell renminbi to buy dollars.

To my mind, this is the first sign that dollar weakness may have gone too far.

It’s too soon, in my view, to react to this possibility.  In particular, the appointment of a new head of the Federal Reserve could play a key role in the currency’s future path, given persistent Republican calls to curtail its independence.  Gary Cohn, the establishment choice, is rumored to have fallen out of favor with Mr. Trump after protesting the latter’s support of neo-Nazis in Charlottesville.

Still, it’s not too early to plot out a potential strategy to benefit from a dollar reversal.

 

 

the Trump rally and its aftermath (so far)

the Trump rally

From the surprise election of Donald Trump as president through late December 2016, the S&P 500 rose by 7.3%.  What was, to my mind, much more impressive, though less remarked on, was the 14% gain of the US$ vs the ¥ over that period and its 7% rise against the €.

the aftermath

Since the beginning of 2017, the S&P 500 has tacked on another +4.9%.  However, as the charts on my Keeping Score page show, Trump-related sectors (Materials, Industrials, Financials, Energy) have lagged badly.  The dollar has reversed course as well, losing about half its late-2016 gains against both the yen and euro.

How so?

Where to from here?

the S&P

The happy picture of late 2016 was that having one party control both Congress and the administration, and with a maverick president unwilling to tolerate government dysfunction, gridlock in Washington would end.  Tax reform and infrastructure spending would top the agenda.

The reality so far, however, is that discord within the Republican Party plus the President’s surprisingly limited grasp of the relevant economic and political issues have resulted in continuing inaction.  The latest pothole is Mr. Trump’s refusal to release his tax returns–that would reveal what he personally has to gain from the tax changes he is proposing.

On the other hand, disappointment about the potential for US profit advances generated by constructive fiscal policy has been offset by surprisingly strong growth indications from Continental Europe and, to a lesser extent, from China.

This is why equity investors in the US have shifted their interest away from Trump stocks and toward multinationals, world-leading tech stocks and beneficiaries of demographic change.

the dollar

The case for dollar strength has been based on the idea that new fiscal stimulus emanating from Washington would allow the Fed to raise interest rates at a faster clip this year than previously anticipated.  Washington’s continuing ineptness, however, is giving fixed income and currency investors second thoughts.  Hence, the dollar’s reversal of form.

tactics

Absent a reversal of form in Washington that permits substantial corporate tax reform, it’s hard for me to argue that the S&P is going up.  Yes, we probably get some support from a slower interest rate increase program by the Fed, as well as from continuing grass-roots political action that threatens recalcitrant legislators with replacement in the next election.  The dollar probably slides a bit, as well–a plus for the 50% or so of S&P earnings sourced abroad.  But sideways is both the most likely and the best I think ws can hope for.  Secular growth themes probably continue to predominate, with beneficiaries of fiscal stimulation lagging.

Having written that, I still think shale oil is interesting   …and the contrarian in me says that at some point there will be a valuation case for things like shipping and basic materials.  On the latter, I don’t think there’s any need to do more than nibble right now, though.

 

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

Brexit, sterling and InterContinental Hotels Group (LN:IHG)

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession.  Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG.  The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked.  But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note    that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency.  This is an unexpected boon for British-based multinationals.

As Richard Solomons, the CEO of IHG, put it in yesterday’s report to shareholders:

“Note that whilst the UK comprises around 5% of our group revenues,

approximately 50% of our gross central overhead and

40% of Europe regional overhead are in sterling.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit.  Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been.  But overheads will be down by much more.  In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive.  This means that it can act as a way for British residents to preserve the purchasing power of their savings.

 

internal and external economic adjustment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.

 

imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.

imbalances

In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:

internal

–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.

external

–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.

 

More tomorrow.