Several currencies in developing economies have been weakening against the US dollar and not surprisingly, volatility, depicted on the chart below, has been rising. Part of the fallout is related to US dollar strength against the Euro, Japanese Yen and British Pound but rising interest rates in the US are also a significant influence. External dollar-denominated debt issued by emerging economies in recent years has risen and repayment could be challenging if the dollar continues to strengthen. This warrants monitoring. We continue to have no emerging market debt exposure at this time.
The yield on the widely followed benchmark 10 Year US Treasury bond eclipsed 3.05% Tuesday morning May 15th and now stands at levels last seen in 2011. The rise in April’s retail sales report showing further expansion likely helped push rates higher. Stronger economic activity and the potential for inflation are forces potentially putting upward pressure on interest rates, but record Treasury bond issuance is also a highly influential factor in the other direction.
We believe interest rates will continue to rise as the US Federal Reserve pursues monetary policy normalization and the economy expands. As a result, our fixed income positions remain short duration. Bloomberg’s survey of 58 analysts projects the yield on the 10 Year US Treasury bond should reach 3.19% by the end of 2018 which would imply further price declines in longer duration fixed income.
Following through on a campaign commitment, President Trump announced that he is withdrawing the United States from the multilateral accord that halted Iran’s nuclear program development and opened it to international verification in exchange for the lifting of economic sanctions. We will leave the analysis and commentary on the reasoning as well as the implications for regional stability to others. Our specific concern is what the implications for global public markets might be.
The most obvious place market participants are looking for a signal is in the oil market. Our view is that there will be little direct impact on the global supply-demand equation since consumption patterns are unlikely to change and most of the world can still access Iran’s output.
Where we think there is underappreciated and largely unmeasured risk is in the asymmetrical application of a sanctions regime in global fixed income and equities. Continue reading
Last week’s unemployment figures released by the US Bureau of Labor Statistics were further signs that the labor market as well as the overall economy continue to improve. Headline unemployment is at the lowest level since the technology boom fueled 1999-2000 period. Unemployment including part time workers is approaching levels experienced during that same timeframe. While this is good news for the American worker, the market is concerned that labor scarcity could place upward pressure on wages, inflation and ultimately interest rates. Right now, nominal wage inflation is contained at 2.6%, a level the Federal Reserve has indicated to be tolerable.
US Dollar strength caught some investors off guard recently as Bloomberg’s DXY index, which measures the dollar versus a basket of major currencies, has risen some 3% over the past three months. Dollar strength could persist if interest rates continue to rise in the US as monetary policy continues to firm, as many including us expect. Meanwhile, central bankers abroad, notably the ECB and BOJ, will likely remain more accommodative given weaker economic conditions—ECB President Draghi indicated as much last week in his post-ECB meeting remarks. The result could be further widening of interest rate spreads across government bond markets.
The strength/weakness of the US dollar represented by DXY, the red line on the chart below, appears to be related to Global government bond spreads among US Treasuries, U.K. Gilts, ECB Bonds and JGBs. Spreads contracted from 2006 until the financial crisis during a period of dollar weakness. The dollar rebounded in the aftermath of the crisis, and over the past decade of extraordinary central bank intervention, the relationship between global spread differentials and the value of the dollar appears to be influential.
John Williams, current head of the Federal Reserve’s San Francisco branch, will soon be taking over as head of the influential New York branch. He was recently discussing a range of topics including the flattening of the US yield curve, which measures the spread between shorter and longer-term US Treasury rates. The risk is that as the yield curve inverts – when short term rates rise above long term rates – a recession usually follows (represented as shaded areas spanning back three decades).
It appears that we may have some time before the curve inverts, if it does at all. Every cycle is different and this one is unique due to the absolute low level of rates throughout the world. Interest rates in Europe and Japan may anchor US rates lower than they otherwise would be. That, in turn, may distort the shape of the curve in coming quarters and with it change the economic impact.
Investors have been focused on gyrations in the US equity market and rightfully so. It has been quite harrowing to witness the large intraday price swings in the major US indexes as market participants react or sometimes overreact to tariff and trade-related posturing among the Trump administration and trading partners. Our sense is that the market is attempting to establish a new equilibrium once a new global export/import balance is established. A new global balance of trade may not be bad for the world as long as the outcome is truly fairer and freer trade, but still, the uncertainty around this issue has caused painful volatility.
Meanwhile, the US bond market as measured by the Bloomberg Barclays US Aggregate Index depicted below, has offered a relative safe haven at least since mid-February. However, the index is about 1.5% lower year-to-date. We are concerned about rising interest rates in the US and the impact on bond prices and potentially the stock market. In the bond portion of our portfolios we have allocated to investments that are shorter duration and tend to perform better in rising interest rate environments. On the equity side of the equation we have more exposure to less rate sensitive sectors. We view the interest rate environment as a major risk and we believe that the US Federal Reserve will continue to be highly transparent and deliberate as it raises policy rates. Another anchor to interest rates in the US is accommodative central bank policy in the Eurozone and Japan where comparable interest rates are expected to remain low for longer.
There has been an increased level of volatility in US equities across several key larger capitalization indexes going back to the first week of February. Lately, investors have been attempting to identify what may lead to a market bottom and many have been drawing attention to S&P 500 price levels relative to its 200-day moving average — a key long-term trend measure. On April 2nd the S&P 500 price index closed below the 200-day moving average for the first time since late June 2016. Today, the index recovered and closed slightly above that trend line. The question for investors is whether the correction will deepen or did yesterday mark the resumption of the bull market.
On a total return basis (which we find more relevant as that is what people actually get by investing), the S&P 500 has yet to close below the 200-day moving average. That is critical in our view, although we do acknowledge that this measure is precariously close to turning negative. What appears to be escalating trade friction between the US and China among other trading partners, potentially developing into a much broader trade war, is the most likely reason US equities have entered a corrective phase. The market is now trading at valuations last seen in 2016 which could be a bargain since fundamentals in the US remain strong and earnings are expected to be robust in coming quarters.
Made you look. No, this is not about that. This is also not about tariffs and trade wars. This is a reminder that there are more forces at work in the market, more fundamental forces, than just headline news.
The Technology and Consumer spaces have been having a bit of a Waterloo moment. A steady drumbeat of information breaches from tech firms, consumer credit firms, major merchants, health insurers and others has shown that our digital lives are the new currency of commerce, and thieves will gladly take and then sell this information to the highest bidder.
To date, the response has been largely profiteering. Play on the concerns of the citizenry that companies cannot be trusted to care for their personal identifiable information and sell them identity protection and credit protection services, in some cases crassly by the very same companies that fumbled the information into the open in the first place.
Larry Kudlow was appointed by President Trump as Director of the National Economic Council, replacing the widely respected Gary Cohn. Kudlow, a former Federal Reserve and Wall Street economist and most recently a television host on financial news network CNBC, has raised some eyebrows with his comments regarding his support for a strong dollar. The dollar has been in a downward trend against a basket of major currencies since the beginning of 2017, although it has strengthened modestly over the past month or so. Weakness may have been more related to economic repair or the regaining of lost ground for the rest of the world versus the US. We view that as positive for the global economy and not necessarily a bad thing for the US. Corporate US fundamentals – most notably earnings growth – are robust and should support securities prices going forward. But, a stronger dollar could place downward pressure on earnings and serve as a headwind.