cutting the fed funds rate

The main value you and me in Mohamed El-Erian’s observations on financial markets is that he has a knack for framing accurately, if longwindedly, the consensus view of financial professionals on topics of the day.  Nothing profound, but a solid base for figuring out how to fashion contrary bets.

In a piece for Yahoo Finance this week, however, Mr. El-Erian has neatly made a number of points about the fed funds rate cut that seems to be on the cards for later this month:

–there’s little justification for the cut on traditional economic grounds

–the reduction will likely have little impact on the real economy

–the cut won’t weaken the dollar, because other nations will reduce their equivalent rates

–at a time when financial speculation is already running hot, a rate cut risks adding accelerant to the fire

–cuts reduce the scope for the Fed to act in case of a real financial emergency

–the Fed will lose at least some credibility as an independent body whose signals should be followed by financial markets (my note: in fact, the parallels are already being drawn between Trump and Nixon, whose meddling with the Fed for political reasons in the early 1970s led to financial disaster later in that decade).

no good reason to cut, so why?

If everything’s going so well, why bully the Fed into easing?

I think it has to do with stock market earnings growth.  Last year overall eps for the S&P 500 grew by about 18%.  My back-of-the-envelope estimation is that operating earnings grew by 8% and the other 10% was a one-time upward adjustment for lower US taxes.  A reasonable guess for 2019–without including the negative effect of tariffs–would have been another 8% growth for the US portion of S&P earnings and, say, 6% for the foreign component.  Figuring that both are roughly equal in size, that would imply +7% for 2019 eps.

So far, though, eps are coming in about flat. And analyst predictions, always on the sunny side, are now for slight year-on-year dips for the June and September quarters.  Yes, Europe is weaker than one might have thought.  So that’s a (small) part of the disappointment.  But it seems to me the Trump tariffs + retaliation to them must be biting much deeper into the domestic economy than Wall Street (or I) had been expecting.   …and that’s without considering the longer-term structural harm I think they are likely to do.

If so, the solution is to find a face-saving way to reduce or eliminate tariffs.  it is certainly not to introduce further distortions into fixed income markets.

PS:  it seems to me that the best way to compete with China is to strengthen the education system and to support government-assisted scientific research.   Both are non-starters in today’s domestic politics.

 

 

 

shrinking global bond yields

valuing bonds   …and stocks

Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken.  For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.

If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.

Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.

last Friday

the 10-year

Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!

Austria

Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%.  Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since.  Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.

Trumponomics

Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates.  I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration.  If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection.  One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year.  In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly.  More forethought is likely out of the question for the administration   …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.

???

I’ll happily confess that I’m not a bond expert.  For what it’s worth, I don’t like bonds, either.  But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation.  The last thing we need is higher taxation through tariffs and even more distortion of yields.

 

What would make someone want to buy the proposed Austrian century bonds anyway?

…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?

…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?

…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?

…I’m shorting negative yield bonds against this long position?

 

global/demographic/government influences on yields

aging populations…

Another general principle:  as people get older and as they get wealthier they become more risk averse.  Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.

The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years.  The remainder goes into stocks.  For example, for a 65-year old, 65% of the portfolio should be in fixed income.  (I don’t think this is a particularly good rule, but it’s simple and it is used.)

What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force.  In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds.  At the end of last year, the total was $681 billion, of which 40% was in equities.  Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.

national economic policy

For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy   …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.

The chief characteristic of expansive monetary policy is the suppression of interest rates.  The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.

 

More tomorrow.

 

 

 

 

 

 

Trumponomics and Huawei

Effective May 16th, the Trump administration placed Chinese tech company Huawei on the entity list, meaning no American company can sell products, hardware or software, to Huawei without government permission.  In addition, the presumption of the administrators of the list is that permission will be denied.

Being on the entity list seems to mean no Intel or ARM-based microprocessors for Huawei-built computers and telecom equipment, and no Android software for its cellphones.

The US  had already been putting pressure on US telecoms, big and small, as well as allies around the world not to purchase Huawei offerings, especially of next-generation telecom infrastructure equipment–a difficult sell, given that Huawei products are better and cheaper than EU or US alternatives.  But the entity list move is a huge escalation.  It seems to pretty much put Huawei out of business unless/until it develops alternate sources of supply.

It seems to me that this decision is qualitatively different from taxing Chinese products entering the US.  The near-term effects are likely to be strongly negative for Hauwei; long-term consequences, in contrast, are likely to be strongly negative for the US, in a number of ways:

–by saying the US will not tolerate significant Chinese competition in tech industries, Mr. Trump is reframing a dispute about terms of trade into a struggle for cultural/economic dominance.  Arguably, this is what is really going on anyway, but making it explicit gives China a cause to rally around

–Beijing’s response to the Huawei decision will presumably be to try to jump start its domestic chip business, an area that is (oddly, to my mind) totally unimpressive despite having been a national priority for decades.  The obvious course for the US today, it seems to me, is to retrain workers and improve our education system, with emphasis on STEM subjects.  That, of course, is a non-starter for both major political parties

–US tech companies must now begin to think about whether they are American enterprises (meaning: willing to forgo Chinese business as/when Washington dictates) or multinationals based in the US.  This may not be a burning issue for mature US firms like Microsoft or Google, although Washington’s white supremacism and nativism are already compelling companies like this to locate research centers outside the US (either because the US will not admit accomplished foreign scientists or they fear for their safety).  For startups, however, Mr. Trump is making a compelling case that, say, Canada is a better place to establish themselves

–tech companies of all stripes will have to think long and hard before building new manufacturing capacity in the US

 

Pre-Huawei, one main consequence of the Trump trade strategy has been to substantially weaken the Chinese status quo’s resistance to shifting that economy away from low value-added exports.  With developing economies, such resistance is, in my experience, an almost insurmountable obstacle to progress.  Huawei gives Beijing a clear mandate to create a high-tech component industry, however.  Making it a victim of malign foreign influences only increases its power, given China’s century of humiliation (at foreign hands) historical narrative.

Taking Huawei off the entity list, which the administration now seems to be in the process of doing, does not, I think, return us to the status quo ante.  The barn door has already been opened.

 

So far as I can see, the US stock market has not reacted negatively to what I consider to be a collosal blunder.  Wall Street does continue to deal with the possibility of more tariffs principally, I think, by focusing on firms it sees to be the most immune–software, especially cloud-based, and potentially industry-transformative new market entrants in a variety of fields.

 

 

 

 

 

Trumponomics and tariffs

Note:  I’ve been writing this in fits and starts over the past couple of weeks.  It doesn’t reflect whatever agreement the US and China made over the past weekend.  (More on that as/when details become available.)  But I’m realizing that it’s better to write something that’s less than perfect instead of nothing at all..  I think the administration’s economic plan, if that’s the right word for a string of ad hoc actions revealed by tweet, will have crucial impacts–mostly negative–for the US and for multinational corporations located here.  I’ll post about that in a day or two.

 

On the plus side, Mr. Trump has been able to get the corporate income tax rate in the US reduced from 35% to 21%, stemming the outflow of US industry to lower tax-rate jurisdictions (meaning just about anyplace else in the world).  Even that has a minus attached, though, since he failed to make good on his campaign pledge to eliminate the carried interest tax dodge that private equity uses.  The tax bill also contained new tax reductions for the ultra-wealthy and left pork-barrel tax relief for politically powerful businesses untouched.

 

At its core, international Trumponomics revolves around the imposition of import duties on other countries in the name of “national security,” on the dubious rationale that anything that increases GDP is a national security matter and that tariffs are an effective mechanism to force other countries to do what we want.  (Oddly, if this is correct, one of Mr. Trump’s first moves was to withdraw the US from the Trans-Pacific Partnership, thereby triggering an escalating series of new tariffs on farm exports to Japan by  our “Patriot Farmers,” many of whom voted for Mr. Trump.  I assume he didn’t know.)

If the Trump tariff policy has a coherent purpose, it seems to me to be:

–to encourage primary industry (like smelting) and manual labor-intensive manufacturing now being done in developing countries to relocate to the US (fat chance, except for strip mining and factories run by robots)

–to encourage advanced manufacturing businesses abroad that serve US customers to build new operations in the US, and

–to retard the development of Chinese tech manufacturing by denying those companies access to US-made components.

 

The results so far:

–the portion of tariffs on imported goods (paid by US importers to the US customs authorities) passed on to consumers has offset (for all but the ultra-wealthy) the extra income from the 2017 tax cuts

–the arbitrary timing and nature of the tariffs Trump is imposing seems to be doing the expected —discouraging industry, foreign and domestic, from building new plants in the US.  BMW, for example, had been planning on building all its luxury cars for export to China here, because US labor costs less than EU labor.  The threat of retaliatory tariffs by China for those imposed by the US made this a non-starter.

–Huawei.  This story is just beginning.  It has a chance of turning really ugly.  For the moment, inferior US snd EU products become more attractive.  Typically, such protection also slows new product development rather than accelerating it.  (Look at the US auto industry of the mid-1970s, a tragic example of this phenomenon.)   US-based tech component suppliers are doing what companies always do in this situation:  they’re  finding ways around the ban:  selling to foreign middlemen who resell to Huawei, or supplying from their non-US factories.  Even if such loopholes remain open, Mr. Trump is establishing that the US can’t be relied on as a tech supplier. Two consequences:  much greater urgency for China to create local substitutes for US products; greater motivation for US-based multinationals to locate intellectual property and manufacturing outside the US.

 

 

 

 

 

 

the Fed’s dilemma

history

From almost my first day in the stock market, domestic macroeconomic policy has been implemented by and large by the Federal Reserve.  Two reasons:  a theoretical argument that fiscal policy is subject to long lead times–that by the time Congress acts to stimulate the economy through increased spending, circumstances will have changed enough to warrant the opposite; and ( my view), until very recently neither Democrats nor Republicans have had coherent or relevant macroeconomic platforms.

If pressed, Wall Streeters would likely say that Washington has historically represented a net drag on the country’s economic performance of, say, 1% yearly, but that it was ok with financial markets if politicians didn’t do anything crazily negative–the Smoot-Hawley tariffs of 1930, for example.

During the Volcker years (1979-87), money policy was severely restrictive because the country was struggling to control runaway inflation spawned by misguided policy decisions of the 1970s (Mr. Nixon pressuring the Fed to keep policy too loose).  Since then, the stock market has operated under the belief that the Fed’s mandate also includes mitigating stock market losses by loosening policy, the so-called Greenspan, Bernanke and Yellen “puts.”

recent past

We’ve learned that monetary policy is not the miracle cure-all that we once thought.  We could have figured this out from Japan’s experience in the 1980s.  But the message came home in spectacular fashion domestically during the financial crisis last decade.  As rates go lower and policy loosens, lots of “extra” money starts sloshing around.   Fixed income managers gravitate toward increasingly arcane and illiquid markets.  In their eagerness to not be left out of the latest fad product, they begin to take on risks they really don’t understand as  well as to forego standard protective covenants.

We could almost hear the sigh of relief from the Fed as the tax bill of 2017, which reduced payments for the ultra-rich and brought the corporate tax rate down to about the world average, passed.  Because the bill was so stimulative, it gave the Fed the chance to raise rates as an offset, meaning it could tamp down the speculative fires.

today

Enter the Trump tariffs.

Two preliminaries:

–tariffs are taxes.  Strictly speaking, importers, not foreign suppliers (as the president maintains (could it be he actually believes this?)) pay them to customs officials.  But the importer tries to ease his pain by asking for price reductions from suppliers and for selling price increases from customers.  How this all settles out depends on who has market power.  In this case,it looks like virtually all the cost will be borne by domestic parties.  Domestic economic growth will slow.  The relevant stock market question is how much of the pain consumers will bear and how much will be concentrated in a reduction of import business profits.

–I think Mr. Trump is correct that the US subsidy of NATO is excessive.  It represents the situation at the end of WWII, when the US left standing–or at best the time when the USSR began to disintegrate into today’s Russia (whose GDP = Pennsylvania + Ohio, or California/2).  I also think that China, with a population five times ours and an economy 1.25x as big as the US (using PPP), is a more serious economic rival than we have seen in decades.  It doesn’t have the post-WWII sense of obligation to us that we have seen elsewhere.  So we have to rethink our relationship.

Having written that, I don’t see that Mr. Trump has even the vaguest clue about how the country should proceed, given these insights.

To my mind, tariffs + retaliation mean both domestic and foreign companies will be reluctant to locate new operations in the US.  Tariffs on Chinese handicrafts may bring industries of the past back to the US, at the same time they force China to increase emphasis on industries of the future.  I don’t get how either of these moves should be a US strategic goal….

the dilemma

The question for the Fed:  should it enable the president’s spate of shoot-yourself-in-the-foot tariff policies by lowering rates?  …or should it let the economy slide into recession, hoping this will jar Congress into action?

 

more tariffs?

Wall Street woke up today to an announcement from Mr. Trump that he intends to place a tariff on all goods coming into the US from Mexico.  The levy will be in effect until that country prevents immigrants/asylum seekers from reaching its border with the US.  The initial rate will be 5%, escalating to 25% by October.

As an American, I think I can understand the issues the administration wants to address.  But I find it more than a little unsettling that there seems to be no coherent, well-reasoned plan being implemented.  I’m pretty sure tariffs are not the way to go.  Also, both sides of the aisle in Congress appear to be eerily content to watch from the sidelines, rather than make it clear that Mr. Trump does not have authority to levy tariffs without legislative consent (my personal view, for what it’s worth) or limit/revoke that authority if the president does have it now.

 

As an investor, however, my main concern is the much narrower question of how Washington will affect my portfolio.

As to Mexico:  let’s say the US sells $300 billion yearly to Mexico and buys $350 billion.  Most of that is food and car parts.  Even if we sell less to Mexico because of retaliatory tariffs and if imported goods are 15% more expensive–to pluck a figure out of the air–the total direct negative impact on the US + Mexican economies would probably be a loss of around $100 billion in GDP.  How that would be split between the two isn’t clear, but the aggregate figure is 8% of Mexican GDP and 0.5% of US GDP.  So, potentially much worse for Mexico than for the US.

Given the nature of US-Mexico trade, the negative economic impact in the US will be concentrated on lower-income Americans.  If earnings reports from Walmart and the dollar stores are to be believed (I think they are), these are people whose fortunes have finally, and only recently, begun to turn up post-recession.

From a US stock market point of view, neither autos nor food has large index representation.  My guess is the negative impact will be roughly equally divided between negative pressure on directly-affected stocks, including names that cater to the less affluent, and mild downward pressure on stocks in general from slower domestic growth.  Because small caps are more domestically focused than the S&P 500, only half of whose earnings come from the US, the Russell 2000 will likely suffer more than large caps.

 

There are deeper, long-term questions that Washington is raising–about whether the US is an attractive place to establish manufacturing businesses and whether it can be relied on as a supplier to buy from.  In addition, it’s hard to figure out what government policy today is–for example, how new tariffs on Mexican imports square with just-reworked NAFTA, or how imposing tariffs that hurt domestic car manufacturers square with the threat of tariffs on imported vehicles, which do the opposite.

Neither of these concerns are likely to have a significant impact on near-term trading.  But heightened Washington dysfunction must even now be becoming a red flag in multinationals’ planning.

 

 

the Huawei questions

Huawei is a Chinese telecom company.  It makes niftier smartphones than Apple and has 5G technology that’s better than anything US companies can offer.  The company is certainly a competitive threat to US cellphone makers, as well as to manufacturers of telephone equipment worldwide.

The question that arises with a firm like Huawei, also the perennial question raised about dominant US tech companies since WWII, is the degree to which Huawei will act in the national interest of China.  That is, can/will Beijing eavesdrop on conversations or collect/alter data being carried on Huawei networks–maybe even stop them operating, if Beijing so chooses.

The Trump response to Huawei’s technological edge has been two-fold:  to blacklist Huawei, and to aid its US rival, Qualcomm.

Two questions:

1.is this the proper response?   …or is it like Mr. Trump’s invoking national security to price better-performing Asian and European cars to unaffordable levels, forcing citizens to buy US automobiles that three-quarters of the population now shun?

I’m guessing the former.

 

2. does Mr. Trump have a strategy?   Has he thought out the consequences of what he’s doing?

Here my guess is no.  Otherwise, he would have been promoting science education and welcoming skilled foreign scientists, rather than compelling tech firms to relocate their tech hubs to Canada and elsewhere.

(An aside, sort of:  I was recently listening to a podcast which dealt with Mr. Trump’s weak record in real estate by saying that he was rich before he started in the family business and he remained rich after negotiating treacherous waters during the 1980s.  Really?

My read of the president’s career:  he ended (prior to licensing his name and performing in a reality show) with about as much money in real terms as he started with.  So in that highly technical sense what the podcast said is right.  Over the same period, however, a run-of-the-mill real estate developer made, adjusting for risk, four times what Trump did.  A really competent real estate person might have made 10x.  In achieving his result, Mr. Trump was also aided by the public listing, debt refinancing and subsequent bankruptcy declaration of his Atlantic City casinos.  Although Mr. Trump prevailed in the litigation that ensued, as a professional investor I find this an eyebrow-raising episode.

Mr. Trump was “successful” in running a business in the sense that he went fishing during a time when tons of fish were jumping into the boat and he came back with the boat.  Nothing in it …though he was in the area where the most fish were to be had   …and he was soaking wet in a way that suggested he fell out at some point.

I’m also extrapolating from that.)

investment implications?

Throughout my investing career, politics has never made much of a difference.  In fact, to my mind professional investors who based their decisions on reading Washington’s runes simply revealed the poverty of their thought.  I think now is different.  Mr. Trump has exposed the surprising weakness of Congress.  The reality of China as a rival superpower to the US has been made clear.

Unfortunately, Mr. Trump is executing an early twentieth-century strategy to solve a twenty-first century dilemma.  Arguably, but not necessarily, this is a drama where the US is playing the role of post-WWI Britain and China is the 1920s US.  We all know how that worked out. By simultaneously discouraging innovation at home and forcing China to up the pace of its own tech progress, I think the administration is auditioning for the UK part, and thereby potentially doing significant long-term harm to the economy.  Ironically, those hurt most badly will likely be Mr. Trump’s most rabid supporters.  Withdrawal from the Trans Pacific Partnership, for example, is already putting US farms at a disadvantage vs. Australian, Canadian and New Zealand rivals.

What to do?

I’m taking a two-pronged strategy in the US.  I’m looking for companies with worldwide reach and innovative products.  For domestically-oriented companies, I’m taking an approach that might be called, for lack of a better term, “value with a catalyst” (regular readers will likely know that I don’t believe traditional value works any more in the US).  This term usually means a value stock where a turnaround has progressed far enough that the path for the firm to return to health can be identified.  E.g., the stock is trading at 20% of book value in an environment where healthy firms are trading at book.  Only “deep” value investors might be interested.  Then the company recruits a CEO who’s a turnaround expert and the stock begins to trade at 30% of book–this is value with a catalyst.  I’m not so interested in book, though.  I’m looking at price/cash flow.

I’m also looking harder in the Pacific Basin.  I’m even thinking about the EU, although that’s an area where market participants have a thorough value orientation and where lots of local market lore is needed to be successful.  So I find it a bit scary–better said, the rewards not worth the effort.