why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

three steps and a stumble?

That’s the conventional wisdom (read: old wives tale) about Fed rate hikes and the stock market.  The idea is that the market absorbs the first two hikes in any rate rise series as if nothing were going on   …but reacts negatively on the third.

The third in this series of rate hikes will almost certainly come tomorrow.

The problem with this particular old saw is that there’s very little evidence from the past to support it.  Yes, there may be an immediate knee-jerk reaction downward.  But in almost all cases the S&P 500 is higher a year after a third hike than it was on the day of the rate rise.  Sometimes, the S&P has been a lot higher, once in a while a percent or two lower, but there’s no third-hike disaster on record.

Generally speaking, the reason is that rate rises occur as a policy offset to the threat of the runaway inflation that can happen during a too-rapid acceleration in economic growth.  As financial instruments, stocks face downward pressure as higher rates make cash a more attractive investment option.  On the other hand, strong earnings growth exerts contervailing upward pressure on stock prices.  In most cases, the two effects more or less offset one another.  (Bonds are a different story.  With the possible exception of junk bonds, all the pressure is downward.)

Of course, nothing having to do with economics is that simple.  There are always other forces at work.  Usually they don’t matter, however.

In this case, for example:

–I think of a neutral position for the Fed Funds rate as one where holding cash gives protection against inflation and little, if anything, more.  If so, the neutral Fed Funds rate in today’s world should be between 2.5% and 3.0%.  Let’s say 2.75%.  Three-month T-bills yield 0.75% at present.  To get back to neutral, then, we need the Fed Funds rate to be 200 basis points higher than it is now.

I was stunned when an economist explained this to me when I was a starting out portfolio manager.  I simply didn’t believe what she told me, until I went through the past data and verified what she said.  Back then, I was the odd man out.  Given the wholesale layoffs of experienced talent on Wall Street over the past ten years, however, I wonder how many more budding PMs are in the position I was in the mid-1980s.

–the bigger issue, I think, is Washington.  I read the post-election rally as being based on the belief that Mr. Trump has, and will carry out, a mandate to reform corporate taxes and markedly increase infrastructure spending.  The Fed decision to move at faster than a glacial pace in raising interest rates is based to a considerable degree, I think, on the premise that Mr. Trump will get a substantial amount of that done.  If that assumption is incorrect, then future earnings growth will be weaker than the market now imagines and the Fed will revert to its original snail’s pace plan.  That’s probably a negative for stocks …and a positive for bonds.

 

 

 

Employment Situation, February 2017

This morning at 8:30 est, the Bureau of Labor Statistics of the Labor Department issued its Employment Situation report for February 2017.

The Bureau estimates the economy added 235,000 new jobs last month.  This is a very strong result.  However,it is most likely influenced by unseasonable warm temperatures in February, which typically allow outdoor construction work to get started earlier than  usual.  So maybe the “real” figure should be 200,000–which would still signal significant economic strength.

Revisions to the prior two months’ data were +9,000 positions.  Most other data–like the labor participation rate, the number of long-term unemployed…–were relatively unchanged.

The unemployment rate fell to 4.7%, a level that twenty years ago would have set off alarm bells warning of incipient wage inflation.  Nevertheless, wages grew at the same steady yearly rate of +2.8% we have been seeing for a while, and are showing none of the acceleration that labor economists fear.

We know from the BLS’s Job Opening and Labor Turnover (JOLT) survey that the number of current job openings is more than 20% higher than at the pre-recession economic peak in 2007.  This makes the lack of wage acceleration look even more peculiar (more about this on Monday).

Nevertheless, the Fed has made it clear that it thinks there’s nothing further that maintaining emergency-room low interest rates can do to stimulate the economy.  That ball in in the court of fiscal policy, the province of Congress and the administration, where it has resided unmoved for several years.

Especially given Mr. Trump’s promises of corporate income tax reform and renewed infrastructure spending, the biggest economic hazards lie in not continuing to normalize interest rates.

So I think we can pencil in three hikes of 25 basis points each in the Fed Funds rate both this year and next.

 

 

Warren Buffett’s bid for Unilever (ULVR)

(Note:  ULVR is an Anglo-Dutch conglomerate with what is for Americans a very unusual corporate structure.  I’m using the London ticker.)

Late last week word leaked of a takeover offer Kraft Heinz (KHZ)–controlled by Warren Buffett and private equity investor 3G Capital–made for Unilever.  Within a day, KHZ withdrew its offer, supposedly because of a frosty reception from the UK government.  Not much further information is available.  In fact, when I checked on Monday evening as I was writing this, there’s no mention of the offer or its retraction among the investor releases on the KHZ website.  Press reports don’t even seem to acknowledge that Unilever is one set of assets controlled by two publicly traded companies.

In any event, two aspects of this situation seem clear to me:

–Buffett’s initial foray with 3G was Heinz, where the Brazilian private equity group quickly established that something like one out of every four people on the Heinz payroll did absolutely no productive work.  Profits rose enormously as the workforce was trimmed to fit the actual needs of the company.

Buffett subsequently joined with 3G in the same rationalization process with Kraft.

For some time, achieving stock market outperformance through portfolio investing has proved difficult for Berkshire Hathaway.  Tech companies are basically excluded from the investment universe; everyone nowadays understands the value of intangibles, the area where Buffett made his reputation.

The bid for ULVR shows, I think, the Sage of Omaha’s new strategy–acquire and rationalize long-established, now-bloated firms in the food and consumer products industries.

Expect a lot more of this, with any needed extra financing likely coming from Berkshire Hathaway.

–the sitting pro-Brexit UK government is showing itself to be extremely sensitive to evidence that contradicts its (questionable) narrative that Brexit is good for the UK.  That seems to me to not be true in the case of UVLR.

Sterling has fallen by 15% or so since the Brexit vote, creating problems for firms, like UVLR, which have revenues in sterling + euros but costs in dollars.  Since the Brexit vote, and before the revelation of the bid, UVLR ADRs in the US had underperformed the S&P 500 since last June by about 20 percentage points.  Yes, UVLR has been a serial laggard, but most of the recent stock price decline can be attributed, I think, to the currency decline brought about by Brexit.

The idea that a venerable British firm would fall into American hands, with layoffs following close behind, appears to have been more than #10 Downing Street could tolerate.

That attitude is probably also going to remain, meaning that weak management teams in the UK need not fear being replaced–and that Buffett will likely have to look elsewhere for his next conquest.

 

 

the French election?

French elections

As I mentioned yesterday, there’s at least some chance that control of the French government will fall in the Spring to a party that vows to:

–leave the euro,

–engineer a depreciation of the newly-resurrected French franc and

–repudiate euro-denominated French national debt.

This is not just like Brexit, since Brexit didn’t involve government refusal to repay previously incurred financial obligations.  It’s way worse.  This is more like Argentina or Cuba.

Sounds crazy, but so did Brexit and so did Trump.

What to do?

…particularly since it’s hard for me to figure the chances of any of this happening, and I no longer know that much about French stocks.

Two lines of thought:

–avoiding being hurt, and

–trying to make money.

Both will be brief, since I don’t know enough to say any more.

avoiding being hurt

Currency depreciation would have effects much like what’s happened in Japan during the Abe administration.  National wealth and the standard of living of ordinary citizens could take a substantial beating.  Export-oriented industries would thrive.

It’s likely that French companies would have a more difficult time raising money in global capital markets, if France refuses to honor its existing euro-denominated debt.  Companys’ repayment of debt not denominated in francs would become more costly.

Knock-on effects:  my guess is that Italy wouldn’t be far behind France in leaving the euro.  The currency union would likely end up being Germany plus bells and whistles.

The way bond investors are now taking defensive measures is by selling their French government-issued euro bonds for German issues, giving up 0.4% in annual yield to avoid a potential currency loss.

We, as equity investors, can do something similar now, by avoiding non-French multinationals with large exposure to the French economy.  If we want to/need to have some French exposure, it should be in companies that will benefit from possible devaluation–that is, firms with costs in France but revenues elsewhere.  Here the performance of Japanese stocks should be a good guide, except that I’d avoid French companies with a lot of foreign debt.

trying to make money

I consider betting on future political developments to be a dubious enterprise.  If Marine Le Pen makes an unusually good showing in the first round (of two) in French voting in April, and if the French market sells off sharply on that result, I’d be tempted to look for beaten down French multinationals, on the thought that Le Pen would lose in the second round.  I’m not sure I’d actually do anything, but I’d be willing to think about it.  This would imply beginning to study potential purchase candidates, or a suitable ETF, now.

 

 

 

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.

 

 

 

 

 

 

 

should the US dollar be strong or weak?

This is the question President Trump purportedly called his adviser, Michael Flynn, to ask at 3am one recent morning.  Flynn, to his credit, said he didn’t know.

Perhaps the genesis of the inquiry is the odd position Mr. Trump has put himself in of criticizing Germany (and by implication the EU as a whole) for damaging the US by having a currency that’s too strong while berating China for damaging us by doing the opposite.

It may also be economists’ comments that the Republican Congressional proposal to introduce a value added tax on imports could trigger a sharp appreciation in the dollar, thereby making exports from the US that much less attractive.

What is the best strategy for the US?

First of all, we should recognize that there’s no generally accepted economic framework that deals with currency.  There are lots of theories for particular aspects of currency relationships, but no one go-to theory.

Also, the US is in the unusual position of being the only universally accepted reserve currency, making the US is in effect the banker to the world.  So rules that apply rigorously to others may not, for good or ill, hold so firmly for us.

 

In 30+ years of dealing with foreign currencies as an equity investor, I think the issue can be summed up in practical terms to the question:  “If this country were a person, would I feel comfortable lending money to him?”

The factors that have meant the most to me are:  political stability, the rule of law, growth-oriented government policies, no excessive government debt, prudent government spending, and no restrictions on being able to repatriate my funds.  All other things being equal, mild appreciation of the foreign currency would be nice.  But I would trade that away in a nanosecond for assurance I wouldn’t have a currency loss.

All this implies that the value of a country’s currency isn’t determined by a deliberate currency policy.  Instead, it’s the result of overall conditions for doing business in that place, and of the effectiveness of government in providing a backdrop conducive for corporations to locate there.

One instructive recent example of what not to do:  massive government-engineered currency depreciation has been the cornerstone of Abenomics in Japan.  The main results so far have been to revive the fortunes of near-obsolete manufacturers, while retarding innovation and inducing an epic fall in the standard of living of ordinary citizens.

My advice for Mr. Trump?   Press forward on tax reform and infrastructure spending.  Establish meaningful vocational training to replace the VA-like stuff we have now.  Don’t try to weaken the dollar; that’s a recipe for disaster.