The US fixed income market has had a tremendous run so far in 2019. The Bloomberg Barclays US Aggregate has risen 8.4% through August 22nd. That performance is not surprising given that the 10-year US Treasury yield has fallen by roughly 50% from November 2018 to current levels. The overall fixed income market is overextended based on several fundamental metrics and it is overbought relative to its long-term trend. This week’s chart shows the aggregate index plotted with the 50 and 200-day moving averages in the top panel while the lower panel shows the ratio of the index to its long-term 200-day moving average. The arrow on the top chart highlights the significant spread between the current level of the benchmark and the long-term trend. Usually, when the index reaches elevated levels versus long-term trends, a consolidation or even modest correction follows. What concerns us is the ratio of this relationship (bottom panel) currently registers 1.057, the highest reading we have seen in the past five years. Forward 6- and 12-month total returns were mostly positive over the past 20 years when this ratio reached or even surpassed the current level largely because interest rates were higher than they are now. With current interest rates so low, the ability of yield to overcome principle loss if or when rates rise is nonexistent in our view. This is the main reason why we continue to allocate towards shorter duration instruments with the fixed income portion of portfolios.
It will take some time to unpack both the intent and the implications of the Business Roundtable’s redefinition of the purpose of a corporation, but a quick meditation on their announcement on August 19th leads to a very confusing place for a sustainability-minded stakeholder.
On the surface, the “Statement on the Purpose of a Corporation”, co-signed by 181 CEOs, seems like a tectonic shift in the alignment of stakeholder values. At long last, corporations are committing to prioritize something beyond unadulterated capitalism. The points they made and the rhetoric they used could have been taken right off the vision boards of a thousand responsible and sustainable investors. The five central principles they outlined are (direct quote from the Business Roundtable, August 19, 2019):
Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.
That all business ought to be conducted as if people and place mattered.
That, through their products, practices, and profits, businesses should aspire to do no harm and benefit all.
To do so requires that we act with the understanding that we are each dependent upon another and thus responsible for each other and future generations.
So where’s the fly swimming in the punchbowl? The sub-heading for the Roundtable’s press release said the following – “Updated Statement Moves Away from Shareholder Primacy, Includes Commitment to All Stakeholders”. Again, at face value this is a good thing putting aside profit and shareholder value as the priority above all others. But, this announcement lands almost contemporaneously with an announcement that the SEC would be holding meetings to discuss a plan on the table to reign in proxy advisory firms (a prior discussion of this move from Cydney Posner, Cooley LLP on the Harvard Law School Forum on Corporate Governance and Financial Regulation can be found here), and during a period where the SEC has been increasingly lining up with companies to brush back shareholder resolutions and keep them off the proxy ballots. This move to limit the shareholder franchise has taken the form of questioning the materiality of the resolution to the overall business, as well as inching toward requiring a minimum percentage of ownership in order to sponsor a resolution.
The danger here is that the confluence of disenfranchising shareholders with this new announcement from the Business Roundtable could actually mean a net setback if sustainable business behavior is defined almost exclusively by what management says it is without the input from and the natural corrective of the shareholder. That fifth principle is the linchpin to whether this will work or not – being “…committed to transparency and effective engagement with shareholders.” If the SEC defangs the shareholder, what does that actually mean in practice? We have seen repeated examples from aerospace to pharmaceuticals where self-supervision and fast-track regulation lead to bad outcomes for all stakeholders.
The Roundtable is on the right track if these principles are pursued in a regulatory environment that preserves an appropriate level of governance and accountability for shareholders, who are ultimately the only ones that have the ability to hold managements fully responsible in a free market. Employees can quit, customers can boycott and suppliers can freeze their pipelines, but boards and C-suite executives work for the shareholders.
The US Yield Curve inverted this week for the first time since 2005 as the yield on the 10-year US Treasury fell below the 2-year. Stock markets around the world fell with the Dow Jones Industrials suffering its worst point drop of 2019 — over 800 points alone on August 14th. Investors are concerned because an inverted yield curve has preceded the three most recent recessions, highlighted in the shaded areas on this week’s chart. This time may be different because a case can be made that longer-term interest rates in the US are being suppressed due to negative interest rates in several developed countries, which is likely distorting the US yield curve. Another observation from the chart is that, while an inverted yield curve causes equity market volatility, it does not necessarily derail stock prices in the intermediate term. US equities continued to rise in the early and late nineties as well as from 2005-2007, all instances that occurred with curve inversions.
There has been little doubt in investors’ minds that monetary policy has played a critical role in supporting the global economy and capital markets for several decades. Lately, the focus has been on how many times (and for how long) the US Federal Reserve will cut its Target Rate this cycle. The current US economic expansion is the longest on record, and the question is whether late cycle rate cuts can sustain growth and the upward trajectory in the US stock market. The most recent prior period we had a mid-to-late cycle reduction in the Fed Funds Target Rate was during the Alan Greenspan era when easy monetary policy fueled the Technology-driven bull market during the 1990s. In the aftermath of the Tech bubble bursting, Greenspan was criticized for being too accommodative and ultimately producing a deeper rout than otherwise could have been. Many forget that the rationale for easy monetary policy at the time was in part a response to the Asian currency crisis that spread from Thailand throughout South East Asia in 1997. The current US Fed actions are a response to global economic weakness and should ultimately provide support for stock markets around the world. A critical difference this time around is that fundamentals and valuations in the US stock market are far stronger than we experienced during the late 1990s. [chart courtesy Bloomberg LP (c) 2019]
The Hong Kong equity market, and in particular its world-class financial sector, has been a critical gateway for foreign investors to participate in and fund Mainland China’s economic resurgence over the past several decades. Lately, the Hang Seng Index, Hong Kong’s most recognized stock market gauge, has been selling off in response to pro-democracy and anti-extradition protests throughout the territory. Our concern is that the Chinese President, Xi Jinping, will lose patience with the uprisings and respond in a manner consistent with the 1989 Tiananmen Square Massacre when military assaults resulted in the loss of life for hundreds if not thousands of protesters. This is a risk that could derail the upward trend in global stock since the beginning of the year.
It was worth waiting a couple days to post our chart to see how markets would handicap the new occupant of 10 Downing Street. The British Pound, currently trading at 1.24 US Dollars, is approaching the lows reached after the Brexit referendum vote of June 23, 2016. Britain’s formal deadline to exit from the European Union has been extended to October 31, 2019, and with the newly appointed Prime Minister Boris Johnson that deadline could turn out to be firmer than it was perceived to be under May. If Johnson pushes through with a “hard” Brexit, it would likely lead to trade and supply chain disruption, uncertainty regarding the residency status of both UK and EU citizens, and the potential return of a physical border in Northern Ireland. The potential fallout is another headwind facing the struggling UK and EU economies. Given all this uncertainty we would not be surprised to see the Pound head to even lower levels.
The total amount of negative yielding debt has been steadily climbing (in fact doubling) since last September, and now stands at a staggering $12.7 trillion dollars according the Bloomberg Global Aggregate Negative-Yielding Debt Index. Negative yielding debt now represents over 23% of the Bloomberg Global Aggregate Index and consists of both investment grade corporate and sovereign bonds, predominantly in Continental Europe and Japan, areas of the capital markets we have avoided. Hyper-accommodative monetary policy throughout the world in the form of quantitative easing, and negative interest rate policy in particular, is the main impetus producing this upside-down phenomenon of forcing investors to pay to hold bonds. The risk is that this negative income stream situation will be adversely compounded as interest rates ultimately rise, risking principal, in our view. We are concerned how long these conditions can persist and the ultimate fallout on the real economy and capital markets.
Welcome back from holiday. GDP growth in the Middle Kingdom has been slowing over the past several years and, as the world’s second largest economy, it has a significant influence on global capital markets. Our concern is that, while recent fiscal and monetary stimulus may have had initial positive effects, the impact may not be sustainable longer term. The country needs robust economic growth in order to support job growth and placate social unrest. Stronger growth would also help avoid a potential debt crisis as the pace of bankruptcies is accelerating – one indication that growth may not be as strong as it appears.
The official government figures for GDP growth – which we view with some doubt – stands at 6.4%, a level consistent with the Bloomberg Li Keqiang Index. The index itself has its limitations but measures the growth in bank lending, freight shipments and electricity consumption. It tends to over and undershoot the official figures and may provide a more realistic view on economic conditions in China. This indicator nonetheless bears monitoring as we await the June reading that will be out in days. [Chart courtesy Bloomberg LP (c)2019]
The dollar has weakened considerably over the course of the past few weeks after having strengthened for much of the year. It has fallen below its long term trend (the 200-day moving average) which in the past has led to further weakness. The decline in US interest rates and expectations for further reductions in policy rates by the Fed are likely behind the dollar’s fall yet it is difficult to make the case for the dollar’s value to decline further against major currencies. Economic activity in the US is stronger than all other major economies (with the exception of China, which is slowing) and the yield on the 10-year US Treasury is positive while comparable rates in much of the developed world are negative. Currency movements are notoriously challenging to predict, but the dollar could decline more despite US economic strength as the other major currency values normalize to levels seen earlier in the decade. [chart courtesy Bloomberg LP (c) 2019]
With many investors pining for the US Federal Reserve to begin lowering the Fed funds rate at the conclusion of its’ policy meeting today, the aftermath of late cycle rate declines can serve as an ominous reality check. Few question that the US economy’s advance is in its latter stages with the current expansion lasting over a decade. Yet lower policy rates may not be a panacea. The past three recessions have been preceded by late cycle rate declines orchestrated by the Fed. US equities have not fared well during those lower rate regimes collapsing 15.3% in 1990, 22.1% in 2000-02 and 25.9% 2007-09. The key for investors is if the Fed can re-kindle activity in areas of the economy that have weakened lately, avoiding recession and an adverse reaction in the stock market. Another factor is Fed credibility give its policy U-turn to this year’s more dovish stance after hawkish comments made towards the end of 2018. This cycle could be different. We could see modest downward rate adjustments like we experienced in the mid-to-late 1990s which helped fuel the Tech-driven bull market.