Snoozefest or a Seismic Shift?
Looking at the beginning and ending levels for equities and fixed income during the third quarter, one might erroneously conclude that it was another summer snoozefest. However, there was volatility during the quarter as the equity markets shrugged off a sloppy August awash in second quarter earnings disappointments and staged a solid comeback rally through September. The S&P 500 Index finished the quarter up 1.70%, the Nasdaq 100 Index increased 1.29% and the ICE BAML U.S. High Yield Index rose 1.22%.
Beneath the surface there were seismic shifts in market leadership that suggest investors are becoming increasingly cautious in their positioning. This is corroborated by the fall in the 10-Year U.S. Treasury yield from 2.00% at the end of the second quarter to 1.68% at the end of the third, as investors sought the safety of government bonds. We think a little skepticism in the investment community and some rotation out of expensive, high-growth tech stocks into more defensive names is the sign of a rational market, which we prefer to a market that overpays for pie-in-the-sky growth expectations.
As we examine the factors that encourage us and weigh them against those which concern us, we continue to be cautiously optimistic about the economy and the investment climate. While we haven’t seen too many fat pitches in this low rate environment, we believe there are still plenty of opportunities to earn a solid return above cash without taking imprudent risks as we wait for greener pastures.
Since we tend to be cautious by nature, let’s first examine some of the topics and recent events that concern us – namely, the hegemonic battle between the U.S. and China, the effectiveness, or lack thereof, of central bank monetary policy in an unnaturally low global interest rate environment and the recent turbulence in the repo market.
Much of what has been written in the press about the struggle between the U.S. and China refers to it as merely a “trade war.” That’s akin to calling the Super Bowl just another football game. It is in fact an all-out battle for global leadership on many fronts — technological, social, religious, ideological, political and economic. Trade is just the most visible (for now) battle in a much larger struggle.
The U.S. has enjoyed the benefit of having the largest and arguably the most successful economy the modern world has ever seen, which, along with our role as the world’s policeman, has allowed us to remain in the global leadership seat for the better part of a century. The globalization of the world economy, which has been accelerating for the past 30 years, set us down a path for this conflict. The overzealousness of both foreign countries and multinational companies to court China as a trading partner, given their large and upwardly mobile population, was bound to result in lopsided deals favoring China.
Fighting to regain a better trade balance is probably an appropriate long-term goal, but it has created an uncomfortable and uncertain environment for the many industries affected by increased tariffs. The population in China is over three times that of the U.S., so we think it’s likely just a matter of time before they overtake us as the largest economy in the world, which would continue to afford them leverage and economic negotiating power. There is a possibility that any resolution, or even a partial trade deal, could cause an “exuberance” rally. In our view, that may provide a salve to the wounded ahead of the 2020 election, but it will not truly end the war, which we expect will play out slowly over our lifetime. Companies and investors will need to adjust and adapt to the new reality of U.S./China relations that are more guarded, and possibly more adversarial.
What, if any, impact will another cut in the federal funds rate have on our economy? That is the $64 trillion question. Many believe that attempting to apply monetary policy independently of fiscal policy in an environment where rates are already very low is folly. By cutting rates twice from 2.5% down to 2%, the Federal Reserve (the Fed) is currently signaling that our economic growth in the U.S. is not just slowing, but may actually already be weak. This doesn’t yet appear to be the case to us. While the most recent Purchasing Managers’ Index (PMI), which has been falling for a while now, took a surprisingly large step lower in September, coming in at 47.8 (possibly skewed by the GM strike), the consumer appears to be in good shape as evidenced by the improving retail sales numbers over the last nine months.
We hope that persisting on a path of cutting rates further does not turn out to be a self-fulfilling prophecy for the broader economy. CEOs and other corporate decision-makers take their cues from macroeconomic data, and, to the extent that they are listening to the Fed, may decide to hold off on major expansion or capital expenditure plans. We saw a similar episode in the fourth quarter of last year, as corporate spending plans contracted rapidly when the stock market fell sharply from October through December. CEOs, after all, are people too! They are affected by the emotions of the marketplace around them, so it’s only natural that they would err on the side of caution before implementing major spending programs in the face of uncertain economic times. We will be carefully monitoring corporate hiring and budgeting plans for 2020 as companies report their third quarter earnings over the next four to six weeks.
The recent volatility in overnight interest rates on repurchase agreements (repos) also bears watching. Banks and other investors use repos to borrow short-term money in exchange for depositing Treasuries or some investment grade bonds to meet overnight cash needs. We’ve seen it referred to as the pawn shop for banks, which is a good analogy.
Rates in this market have usually been fairly stable; however, they can become volatile during periods of peak liquidity needs, typically at quarter-end when banks and financial institutions want to show more cash on the balance sheet. In mid-September rates spiked from about 1.8% to briefly touch 10%! Typically, the large excess reserves in the banking system provide ample liquidity for the repo market to function smoothly. On September 17, however, repo rates spiked as a confluence of events quickly sucked reserves out of the system and caused those with short-term funding needs to pay up significantly for the overnight capital they needed to settle trades and meet margin requirements. Exactly what caused this run on reserves is not yet fully known, but a combination of a heavy Treasury issuance along with about $90 billion of corporate tax payments due on September 15 is thought to have tipped the supply-demand balance into shortage. Ultimately, the Fed stepped in for the first time since the financial crisis to provide the liquidity needed by the repo market.
The fact that they had to intervene at all has raised plenty of eyebrows in the market and raised questions about the adequacy of excess reserves in the banking system. The Fed had been reducing its balance sheet over the last 18 months, reversing the bloat caused by QE (Quantitative Easing) and QEII. This removed some of the excess liquidity that those programs pumped in during and following the 2008 financial crisis. What is troubling is how reliant the markets have become on the easy availability of those excess reserves to keep the money flow functioning smoothly. Fortunately, no lasting monetary impact resulted from this recent incident. The smooth functioning of the U.S. repo market is a cornerstone of the global capital markets, and investors need to feel comfortable that they can access the repo market when needed. If they are unable to do so, they could be forced to sell securities quickly to meet their cash needs, causing a veritable run on the bank. We are comfortable with the recent Fed actions to stabilize that market.
Balancing these concerns, on the positive side of the ledger, we are encouraged by the resilience in the housing market and the semblance of rationality that has seeped into the capital markets. After stalling in the third and fourth quarters of 2018, the housing market in the U.S. has roared back in 2019, likely spurred by a shortage in the housing stock and the 100 basis point (1%) fall in the yield on the 10-Year Treasury from this year. The rally in homebuilding shares has corresponded to the strength in new housing starts and the strong rebound in existing home sales, demonstrating that a little rate relief can have a big impact. After falling 25.57% in 2018 while the Fed was hiking rates, the S&P Homebuilders Select Industry Index has rallied 36.90% in 2019 as rates have declined.
As our friends at Cornerstone Macro point out, although housing is just 4% of Gross Domestic Product (GDP), it is a key economic signal because it generally spurs job growth, given its high multiplier, which suggests that the odds of a recession in the near term are low. In fact, if a housing resurgence means that economic growth does in fact pick up, or at least stabilize, we could see the Fed pause cutting rates further. On the other hand, if the Fed insists on pushing rates lower in the face of a stable or strengthening economy, it could lead to further capital misallocation (read: higher asset prices). For now, however, we are optimistic that the knock-on effects of overall housing firmness will be supportive of broad economic strength.
While the index performance for both the equity and high yield markets in the third quarter was not great, we are encouraged by the signs of rational investor behavior in both markets. After a tremendous amount of enthusiasm from the media and the investment banks in an attempt to whip investors into a speculative frenzy, the performance of several high profile, overpriced and overhyped initial public offerings (IPOs) was notably painful in the quarter. After touching an all-time closing high in June, Uber’s stock price plummeted over 34% in the quarter. Lyft performed even worse, falling nearly 38%. Other high profile 2019 IPOs like Slack (WORK), RealReal (REAL), Zoom (ZM), Chewy (CHWY) and Crowdstrike (CRWD) were also down significantly in the quarter. Peloton (PTON), the well-known home-fitness company, priced their IPO on September 26 and saw it plummet over 13% three days later! Finally, WeWork’s IPO was put on hold and its CEO was forced out after the market balked at its extreme valuation, questionable corporate governance and an unfriendly corporate structure, which would have further enriched its founder while requiring investors to value the real estate company as an otherworldly lifestyle brand. Clearly any hint of irrational exuberance toward these young growth companies that might have existed earlier in the year is being wrung out. Equity investors have woken up and smelled the coffee.
In the high yield market, $31 billion of new issues priced in September, the highest monthly total of the year, but it was the fifth smallest September in the last 10 years. Additionally, we saw several deals that were announced but cancelled due to cool investor interest. Either leverage was too high, structures were too weak or investor comfort with sector fundamentals failed to meet the underwriters’ expectations. This is certainly not the behavior of a frothy market where capital flows blindly to all manner of undeserving companies. On the contrary, we see it as rational investor behavior where capital is being withdrawn from overpriced investments and deployed, more logically, into higher quality and more reasonably priced securities or cash.
As we have said frequently over the last two years, we think we are in the late innings of a long, slow-growth economic expansion. While we have seen several industries impacted by the U.S./China trade war, we believe that the longer it goes on, the more time companies have to rationalize their costs and supply chains. We don’t know how this dispute will resolve itself in the short run, but we are seeing and hearing from our companies that they are right-sizing their balance sheets to adjust to the new realities in the marketplace.
The PMI has been telling us that manufacturing has been slowing in the U.S. for several months — a lot of that slowdown has been caused by a widespread inventory destocking following the buildup earlier this year when the tariff war heated up. Since manufacturing represents about 30% of GDP, it seems very reasonable that the economy would slow as we struggle through these “negotiations” with China — and seemingly every other U.S. trading partner. However, manufacturing only represents 8.5% of the U.S. employment base, so a large swath of the country’s workforce is not seeing their paycheck impacted by the manufacturing slowdown. The Fed’s decision to reverse course and cut rates this year seems well timed. It has alleviated some economic stress and has spurred a resurgence in the housing market, which is helping to balance out some of this manufacturing softness. The Fed also seems to be handling the turbulence in the repo market well. Lastly, it appears that more rational investor behavior is systematically wringing out some of the more egregious speculative excesses that had built up in the equity and debt markets.
Putting it all together, we are encouraged and optimistic that we will continue to have a stable, but slow-growing economic environment. Low interest rates are likely staying with us for a while. Hopefully, increased volatility will enable us to find investment opportunities in both the convertible and high yield bond markets that do not require us to stretch for yield by either extending our maturities or compromising our quality standards. We are beginning to see more opportunities that are attractively priced and appropriately structured to afford us the protections that we require. If the markets should sell off more sharply than we anticipate, we are holding a comfortable level of cash and liquid short-term investments that can be quickly re-deployed into any fat pitches that might emerge.
Thank you for your continued support and we welcome any questions and comments you may have.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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The Federal Funds Rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting. The purpose of the PMI is to provide information about current and future business conditions to company decision makers, analysts and investors.
The ICE Bank of America Merrill Lynch U.S. High Yield (HY) Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
The Nasdaq 100 Index is a basket of the 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. The index includes companies from various industries except for the financial industry.
The ISM Manufacturing Index monitors employment, production, inventories, new orders and supplier deliveries. The Index is based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM).
The S&P Homebuilders Select Industry Index represents the homebuilding sub-industry portion of the S&P Total Markets Index.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
A basis point is a unit that is equal to 1/100th of 1%.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.