June 2019: Market Viewpoints


Manish Singh - 六月 30, 2019

Summary:

Last week, in an extraordinary interview US President Donald Trump embarked on a vicious and personal attack on the US Federal Reserve Chairman Jerome Powell. Trump ranted – “Here’s a guy – nobody ever heard of him before. And now, I made him, and he wants to show how tough he is, okay. Let him show how tough he is.” In recent times, Trump’s attack on the Fed has intensified. Meanwhile, Powell has the challenge of navigating three distinct challenges – setting a policy to prolong the 10-year-old economic expansion, explaining clearly why the Fed adopts the policy it does and ignoring the most consistent badgering of a Fed Chair by a US President in the recent memory. I do not expect the Fed to yield to political pressure and any interest rate cut will be in response to weakening economic conditions and not due to name-calling and bullying by Trump. While Trump started on the right track by promising to change the way the US is governed, I now believe it may have just been lip service and he will do whatever it takes to get himself re-elected.

The market is pricing in significantly lower interest rates to come and this should be seen as an early indication of a growth slowdown in the US economy. The Fed raised rates in 2018 by a full 100 basis points, yet the 10-year yield curve didn’t steepen, but flattened instead. The yield curve fell sharply in Q4 2018 and continues to fall. It reminds me of the 2005-06 rate hike cycle, when the Fed raised rates and kept raising, even as the yield curve was flattening fast and financial conditions were tightening. By the time the Fed started cutting rates, it was too late, the US economy had tipped into a recession. I expect the Fed has learned from its past mistakes, and it appears that the Fed is listening this time around. The Fed paused interest rate hikes in December last year, adapted its communication significantly to make it more dovish and is now getting ready to cut rates. This bodes well for risk assets and will help keep the recession shallow when it eventually comes.

Trump at 15,000 roentgen

If you haven’t yet seen Chernobyl – the Sky/HBO series retelling the catastrophic 1986 explosion at the nuclear reactor in Chernobyl, Ukraine – then I strongly recommend you do so. The mini-series has proven such a compelling watch, that over a quarter million users of the influential entertainment website Internet Movie Database (IMDb) have rated the show, as the best television series of all time. The series is visually pleasing as it recreates the daily life in the Union of Soviet Socialist Republics (USSR) in the 1980s and stars, amongst others, Jared Harris as flawlessly cynical nuclear physicist Valery legasov and Emily Watson as the clinical and committed nuclear physicist Ulana Khomyuk, trying to discover the cause of the explosion. It is so well made and so detailed that you leave thinking you’ve just earned a PhD in nuclear physics.

Chernobyl isn’t just an account of a nuclear catastrophe. It illustrates what happens to societies when lies become mainstream and people stop questioning them. In scene after scene, Communist party officials decreed that the incident is not serious. In one particular scene, an engineer who oversaw the safety test that led to the disaster says to the scientist trying to find out what happened the night of the accident – “Do you think the right question will get you the truth? There is no truth. Ask the bosses whatever you want and you will get the lie. And I will get the bullet.” The lie travelled up the Party’s chain of command and the truth was lost with disastrous consequences. The Communist party retained monopoly on power and thus, by extension, a monopoly on “information” and “truth.” Chernobyl helped destroy the Soviet Union. Mikhail Gorbachev, Soviet Union’s last General Secretary described the explosion as a “turning point” that “opened the possibility of much greater freedom of expression, to the point that the system as we knew it could no longer continue. Gorbachev’s attempted to re-inject life into the moribund Soviet system by introducing reforms such as Glasnost (listen) and Perestroika (openness), but to no avail, and the Union ultimately collapsed in 1991. The dosimeters at Chernobyl were calibrated to register a maximum reading of 3.6 roentgen (400 chest X-rays every second). We later learn the real levels were as high as 15,000 roentgen.

Scene from HBO’s critically acclaimed mini-series Chernobyl

Source: Liam Daniel/HBO

This brings me to the main topic of my newsletter this month. It will not surprise you that US President Donald Trump continues to play fast and smooth with facts. However, of late, he is hitting 15,000 roentgen (if not more) on the outrage dosimeter. Last week, in an extraordinary interview with FOX Business anchor Maria Bartiromo, Trump embarked on a vicious and personal attack on the US Federal Reserve (Fed) Chairman Jerome Powell, Trump ranted – “Here’s a guy — nobody ever heard of him before. And now, I made him, and he wants to show how tough he is, okay. Let him show how tough he is. He’s a– he’s a– he’s not doing a good job.”

Trump went on to say that he has “the right” to demote or fire the Fed chair – which is not true. The US President may choose not to reappoint the Fed chair for a new four-year term, but the President can’t fire him mid-term. Trump also went on to say “we should have Draghi instead of our Fed person. Draghi, as you know, last week he said lower interest rates and we’re going to stimulate the economy…and with us we have a Fed that keeps raising interest rates.”

This attack follows from another attack last week when Trump called into a CNBC news program and complained about the Fed’s policy under Powell. Trump said – “They made a big mistake. They raised interest rates far too fast. It’s more than just Jay [Jerome] Powell. We have people on the Fed that really weren’t—you know, they’re not my people.”

In recent times, Trump’s attack on the Fed has intensified. If I were to list them all I would run out of pages. Below are some of the most recent ones.

  • “If the Fed had done its job properly, which it has not, the Stock Market would have been up 5000 to 10,000 additional points, and GDP would have been well over 4% instead of 3%.” – Trump on Twitter, April 14
  • “Despite the unnecessary and destructive actions taken by the Fed, the Economy is looking very strong” – Trump on Twitter, April 4
  • “The only problem our economy has is the Fed. They don’t have a feel for the market….. The Fed is like a powerful golfer who can’t score because he has no touch–he can’t putt!” – Trump on Twitter, December 24, 2018
  • “I’m doing deals, and I’m not being accommodated by the Fed. They’re making a mistake because I have a gut, and my gut tells me more sometimes than anybody else’s brain can ever tell me.” – President Trump in a Washington Post interview, November 27, 2018
  • “The Fed is going wild. I mean, I don’t know what their problem is, but they’re raising interest rates and it’s ridiculous. The Fed is going loco and there’s no reason for them to do it.” – Trump in a Fox News interview, October 10, 2018

In 2016 when Trump was running for President, he accused then Fed Chair Janet Yellen of not being “independent” and “cutting rates” because US President Barrack Obama told her to do so. He accused the Fed of having created a “false stock market.” The Dow Jones Index was at the 18,000 level then. It is at 26,500 now. That was the false stock market, and this isn’t?

The world is no stranger to Trump’s cantankerous tweets, interviews and extemporaneous remarks criticising his political opponents and adversaries in the media. He is of course entitled to hold an opinion on where interest rates should be. However, to make the attacks on the Fed Chair is most astounding. I am by no means saying that the Fed is right and Trump is wrong, and that economists are better than politicians when it comes to monetary policy. In fact, the growing number of economists with PhDs in economics at the Federal Reserve should be a sign of concern. The Harvard Business Review (HBR) published an article on it – “How Economics PhDs Took Over the Federal Reserve.” During the term of President Harry Truman, the Federal Reserve employed three economists with doctorates in economics. Today, there are more than 700 economists with doctorates employed there. The Fed should never lose sight of real business and the real world and should be careful of not getting too academic with so many PhDs around with “ivory tower” mind-sets and theoretical thinking. All said and done, I’d still chose Powell’s economics over the “Gut Economics” of stable genius Trump. Trump obviously fancies his chances of winning the Nobel Prize, not just for peace but the economics as well.

Meanwhile, Powell has the difficulty of navigating three distinct challenges – setting a policy to prolong the 10-year-old economic expansion, explaining clearly why the Fed adopts the policy it does and ignoring the most consistent badgering of a Fed Chair by a US President in the recent memory.

Before Trump, the last President to publicly call for lower interest rates1 was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.”

I do not expect Powell to yield to political pressure and any rate cut will be in response to weakening economic conditions and not due to name-calling and bullying by Trump.

On the US-China trade deal, there have been so many claims and counter-claims by Trump’s White House, that nobody knows anymore where the deal is or what’s going to be made of it. Last week, CNBC reported that the – “White House says Trump and Chinese President Xi Jinping are going to meet at the G20.” However, they qualified it by saying that they are not going to take the White House’s word for it and would believe it when they hear it from the Chinese. Now, depending on which side of the Trump debate you are on, you could say that the CNBC is no fan of Trump or you could say that they are tired of Trump’s lies and don’t trust anything coming out of the White House. Either way, it’s extraordinary to think that the Chinese news service is trusted more to confirm the news of a meeting between the US President and the Chinese President. The destruction of truth is a wound that doesn’t heal quickly.

Trump’s popularity however among his base is still high. The Trump base believes he is doing a great job. That tariffs are working, that the US economy is on a strong footing and that the US is winning the trade war. While Trump started on the right track by promising to change the way the US is governed, I now think he will do whatever it takes to get himself re-elected i.e. his term will not put the US back on the right track and that the lies will damage America a great deal. It reminds me of Hannah Arendt’s famous observation – “If everybody always lies to you, the consequence is not that you believe the lies, but rather that nobody believes anything any longer.” Trump may be just a symptom of a society gone very tribal and unwilling to consider troubling truths.

In my opinion, sadly, the US (and much of the Western world) is in midst of its own Chernobyl and is suffering from a collapse of the traditional family unit and its effect on demographics, civic and interpersonal engagement – giving way to life in a virtual world, crippling and rising inequality, monetary policy of artificially low rates that benefit small section of the society at the expense of the rest, a breakdown in political consensus which has been so vital in ensuring growth and progress in the post-war period, and the media’s complete abrogation of its duty of objective reporting or semblance of it.

Markets and the Economy:

The S&P 500 Index (SPX) saw another V-Shaped recovery this month, as the -6.5% sell-off witnessed during May, is on course to be recouped. Talk of an interest rate cut by the Fed has intensified. The recent escalation of US-China trade tensions has fuelled worries about a sharper growth slowdown in the US. A weak May jobs report in the US has further added to the concerns. At the recent Federal Open Market Committee (FOMC) meeting, the Fed left interest rates unchanged, but raised expectations for a rate cut – or two – in the near future.

The word “patient” was removed from the FOMC statement in favour of language promising to “closely monitor the implications of incoming information for the economic outlook.” The text of “closely monitor” in the statement has preceded rate cuts in 2007 and 2000. The market is, therefore, pricing in a 100% probability of a rate cut at the July 31 meeting of the FOMC. I believe that we will see a +0.25% rate cut at the next FOMC meeting irrespective of the outcome of the US-China meeting at the G-20 in Japan.

Benchmark Equity Index Performance (Year-to-Date)

Source: Bloomberg

Parts of the US yield curve have been inverted since last November and now the key 10 year – 3 month Treasury yield curve is inverted. While not all US yield curve inversions have led to a recession, a yield curve inversion has preceded every US recession since World War II and slowing economic data in the US should not be ignored. The Fed, therefore, will not be complacent and will cut rates to smoothen the economic slowdown that will inevitably follow after a decade of economic expansion. A rate cut, or a series of rate cuts, might just prolong the expansion by a few more quarters. The Eurozone, the UK, Switzerland, and Canada also all have inverted yield curves, at shorter maturities.

The market is pricing in significantly lower interest rates to come and this should be seen as an early indicator of the growth slowdown in the economy. The Fed raised rates in 2018 by a full, 100 basis points, yet the 10-year yield curve (USGG10YR) didn’t steepen but flattened instead. The yield curve fell sharply in Q4 2018 and continues to fall (chart below).

US 10-Year Treasury Yield and Fed Funds Rate

Source: Bloomberg

It reminds me of the 2005-06 rate hike cycle, when the Fed raised rates and kept raising even as the yield curve was flattening fast (chart below) and financial conditions were tightening. The Fed kept the rates at +5.25% level all through June 2006 to September 2007, even as the yield curve inverted in August 2006. By the time the Fed started cutting rates, it was too late, the US economy had tipped into a recession. The US entered a recession is December 2007 with the Fed Funds Rate still at +4.25%. Sensing that it was lagging behind, the Fed embarked on a set of very aggressive rate cuts and in the next 3 months, cut rates by a whopping 225 basis points.

US 10-Year Treasury Yield, Fed Funds Rate and S&P 500 Index

Source: Bloomberg

I expect the Fed has learned from its past mistakes, and the need for it to act pre-emptively. It appears that the Fed is listening this time. The Fed paused interest rate hikes in December last year, adapted its communication significantly to make it more dovish and is now getting ready to cut rates. This bodes well for risk assets and will help keep the recession shallow when it eventually comes.

Source: Bespoke Premium

Meanwhile, in Europe last week, European Central Bank (ECB) President Mario Draghi signalled the bank could embark on a new round of stimulus as soon as next month, sending the EUR/USD lower and prompting an unusual rebuke from Trump.

Trump tweeted: “Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA.”

Draghi said that in the coming weeks the ECB would consider how to adapt their policy tools “commensurate to the severity of the risk” to the economic outlook. He added: “We have our remit, we have our mandate. We are ready to use all instruments that are necessary to fulfil the mandate.” The instruments being – extending the time frame before the next interest rate increase, a reduction in the already negative policy rate or restarting bond purchases.

The Eurozone has long had a trade surplus with the US and that surplus now stands at a record high of €139 billion (up from €119 billion in 2017). Trump has long disliked this surplus and repeated his scathing attack on Europe ahead of the G20 meeting in Japan saying “it [Europe] treats us worse than China.”

Trump also added that the “European nations were set up to take advantage of the United States. They have worse trade barriers than China,” and expect Trump to turn his ire on the Eurozone in a not so distant future and respond with his favourite tool – tariffs – on auto exports.

Given the Fed is getting ready to cut rates, equities will remain well bid, but I do not see the SPX moving beyond the 3,000 level on a sustained basis. What the Fed rate cut expectation does is put a floor under the SPX. I expect the SPX to trade in a narrow range of 2800-2950 for the next few weeks. There will not be a sustained sell-off in US equities as the “Powell Put” and “Trump Put” are still in place. The opportunity, therefore, lies more in sector rotation and buying the sectors that have been lagging this year – Financials (XLF), Energy (XLE) and Industrials (XLI) in particular. Individual stocks in the Technology (XLK), Communication Services (XLC) and Consumer Discretionary (XLP) sectors also offer good upside.

Source: Bespoke Premium

With the ECB in the easing mode, European stocks and the Eurostoxx 50 Index (SX5E) offer a good short term buying opportunity. Emerging Markets should also perform well given the scenario of a US rate cut that will have a dampening effect on the US Dollar vis-à-vis Emerging Market currencies. I would wait for the outcome of US-China meeting at the G-20 before adding risk. If this relationship deteriorates further, then markets would see a sharp sell-off and would offer a good buying opportunity into what would most certainly lead to a rate cut by the Fed at its July 31 meeting.

For specific stock recommendations, please do not hesitate to get in touch.

1 Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html

Best wishes,

Manish Singh, CFA