In the third quarter, markets unfolded much as they had in the prior several months with a considerable level of calm prevailing in the major domestic investment asset categories. Beneath the surface, however, change was brewing and has broken out in the equity market in the beginning of the fourth quarter.
In late September, we were pleased to welcome clients and guests to our annual investment conference. As I try to do each year, I profiled the major forces that affected the markets and the economy in the prior year, and those likely to influence economic and investment activity in the period ahead. In this commentary, I will highlight the main points from the conference and will update market conditions, outlining risk and reward potential in each of the major asset categories.
Short-Term Cash Equivalents
As part of the bail-out of the major banks in 2008, the Federal Reserve brought interest rates effectively down to zero, where they stayed for seven years. Rates began a steady rise in late-2015 that continues through today. At its September meeting, the Fed raised its risk-free rate by another 25 basis points to the 2% to 2.25% range. They indicated their intention, subject, of course, to changing conditions, to raise rates by another 25 basis points in December, by three more quarter percent increments in 2019 and another in 2020. This increase in rates has been greatly beneficial for those unwilling to accept the risk of longer fixed income securities or equities. Many of those clients have asked us to manage assets exclusively in short-term, essentially risk-free securities. Using only government-guaranteed securities over the past ten years, Mission earned more than 1.6% per year above the risk-free rate. If the Fed stays on its intended path, short rates should continue to rise over the next two years. Short-term cash management will likely be more productive than investment in longer fixed income securities in the years just ahead, despite such longer securities having higher interest rate coupons today.
Longer Fixed Income Securities
With longer interest rates rising since mid-2016, the total return on US Treasury securities with maturities ranging from five to thirty years (combining interest payments and changes in bond prices) has been negative, with the loss on the longest bonds in double digits. Interestingly, junk bonds provided positive total returns over that rising interest rate period, and CCC-rated bonds, the lowest quality bonds just one step from default, provided the highest returns. That inverse relationship between quality and returns is indictive of the environment in which we have lived for several years. Investors accepting the highest risks, even risks that have typically been severely penalized, have reaped maximum rewards.
Many analysts are predicting that the next financial crisis will occur in the area of corporate debt. According to S&P Global, 37% of companies worldwide are carrying excessive debt. That compares with only 32% in 2007, just before the economy collapsed in a serious recession that Fed Chairman Ben Bernanke said would have turned into a depression without the government’s rescue. On top of the dangerous amount of debt on corporate balance sheets, the quality of that debt is declining. The median corporate credit rating has deteriorated to BBB-, just one notch above junk status. We now have the junkiest corporate bond market ever.
There is no way to know how long or how far interest rates may rise in this cycle. It is instructive to note, however, that in the last long rising interest rate cycle, risk-free cash equivalents outperformed any diversified longer fixed income portfolio for more than four decades from the early -1940s to the early -1980s. It could be a significant mistake to mandate a permanent portfolio allocation to longer fixed income securities in the years ahead, especially if inflation should begin to rise more virulently.
Although not uncommon, there are numerous conflicting bullish and bearish factors facing investors. By itself, each provides a rationale to be either excited by or fearful of equity ownership. I will profile bullish factors first.
• We are now experiencing the longest bull market ever.
• Domestic stock prices ended the quarter at or near all-time highs.
• In 2018, corporate profits are very strong, due largely to the substantially reduced corporate tax rate and the more generous depreciation allowance.
• Second quarter GDP growth was a strong 4.2%.
• The 3.9% unemployment rate is the lowest in years.
• Increased deficit spending has boosted economic growth.
• More infrastructure spending may be coming.
• Historically high levels of corporate stock buybacks are overwhelming stock issuance. This activity has provided a huge boost to stock prices, and 2018 is expected to be a record year for companies buying back their own stock.
• Some major central banks (European Central Bank and Bank of Japan) are still printing money. Money created anywhere easily crosses borders and helps to boost stock prices everywhere.
• Credit remains readily available.
• Interest rates are still historically low, although they are rising in many parts of the world.
• There will be lower taxes going forward for corporations and many individuals.
• Consumer and business optimism levels are extremely high.
• There is an abundance of corporate cash, although it is concentrated in a few huge corporations.
• Intermediate-term technical conditions are still positive. We have not yet seen the signs in supply and demand statistics and buying power and selling pressure patterns that normally appear a few months before a major market top.
• Central banks, like the Bank of Japan and Swiss National Bank, and sovereign wealth funds in oil rich countries like Norway, Kuwait and Saudi Arabia are large, powerful, non-price sensitive entities gobbling up equities around the world. They have staying power and are not accountable to stakeholders. There is no way to know how long they will continue to buy.
Wall Street analysts and strategists regularly point to many of these factors as justification for even higher prices in the months and quarters ahead. Needless to say, however, there are significant bearish factors as well.
• The current US economic expansion is already the second longest ever, nearly double the length of the average economic expansion. Some of history’s biggest stock market declines followed the longest economic expansions.
• The Fed continues to raise rates and reduce its balance sheet, which reduces the liquidity that has fueled the lengthy stock market expansion. A few weeks ago, Jeffrey Gundlach, the current “Bond King”, said: “We are doing something that almost seems like a suicide mission. We are increasing the size of the deficit while we are raising interest rates so late in an economic cycle.”
• Other major central banks are becoming more restrictive. The Bank of England has taken its first steps in raising short rates. The European Central Bank has said it will stop its quantitative easing at year-end and begin to raise rates some time in 2019.
• Longer-term interest rates are rising, which will make conditions tougher for the economically important housing industry.
• Higher interest rates will hurt corporate profits and possibly lead to bankruptcies for companies that are overleveraged.
• Geopolitical risks are extensive. J.P. Morgan Chase CEO Jaime Dimon recently warned about Brexit, flareups across Europe including Italy and Turkey, the Middle East and Latin America. The US has its own contentious interactions with longstanding European and North American allies, plus ongoing disputes with China, Russia, Iran, and North Korea — any of which could escalate to more troublesome levels.
• Equity valuations are near all-time extremes.
• Investor sentiment (a contrary indicator) is extremely optimistic.
• Domestic and global debt levels are at or near all-time highs. For centuries throughout the world, excessive debt has established the framework for some of the most severe economic and stock market declines.
• The quality of debt is deteriorating significantly.
• Trade disputes could become trade wars. Trade wars were a major contributing factor to the length and depth of the Great Depression of the 1930s. Many dozens of US companies have already complained of increased costs and reduced sales from US tariffs.
One major negative factor that we spent some time on at the conference was the diminishing likelihood of significant future economic growth, as measured by Gross Domestic Product (GDP). While there have been peaks and valleys, GDP growth has trended markedly lower for the past 70 years. And although the current economic expansion is the second longest in US history, it is the weakest in the post-World War II era. I have long argued that excess debt is the principal cause of declining economic growth. The record shows very clearly that as the ratio of US debt-to-GDP began to explode upward in the early 1980s, the rate of GDP growth began to plummet. That pattern has continued for almost 40 years. Ironically, in the financial crisis a decade ago, the Fed and other central banks around the world tried to solve a problem of excess debt by multiplying the amount of debt outstanding. Worldwide debt levels today are at all-time highs, which will likely penalize GDP growth for years to come.
While tax reductions have given a significant boost to 2018 economic and corporate profit growth, all well-recognized forecasters see this as the peak year with GDP falling off progressively in 2019 and beyond. The Congressional Budget Office (CBO), the Fed and the Wall Street Journal Survey of Private Economists see GDP growth this year coming in at 3.0% to 3.1%, then declining to 2.4% to 2.5% in 2019. The Fed’s estimate of the long-term US growth rate is a mere 1.9%. The European Central Bank’s growth estimate for the Eurozone is an even less lustrous 2.0% this year and 1.8% next. Notwithstanding strength in corporate earnings this year because of the tax reduction, it is important to recognize that corporate earnings on average do not grow much more than a couple of percent more than GDP growth.
It is hard to imagine stock prices remaining anywhere near current levels if GDP and corporate earnings growth fall off as forecasted. Stock valuations are priced for perfection with a composite of the most commonly used valuation measures just below the highest levels of all-time, the period around the dot.com mania at the turn of the century. That valuation extreme was penalized by a 50% decline in the S&P 500 index by 2002 and a total of 57% down from the 2000 peak by early 2009.
At the end of my conference presentation, I showed a graph of the Japanese Nikkei index from the mid-1980s to present. In the 1980’s, Japan’s economy was the envy of the world, thought to be the embodiment of the new industrial paradigm. Japan’s stock prices powered upward through the decade and, in 1989, its stock market was the world’s largest. I included this graph, not as a forecast, but rather as a caution. With the government standing strongly in support of its banking system and general economy, few thought that any significant harm could befall investors in Japan. That confidence turned out to be badly placed.
The Nikkei peaked on the last trading day of 1989. It declined by more than 60% in less than three years, eventually more than 80% to its ultimate bottom during the 2008 financial crisis. Even with the subsequent worldwide rally, the Nikkei today, nearly 29 years later, remains more than 40% below its 1989 high.
The purpose in showing this depressing precedent was to shake attendees from the complacency born of dramatic recoveries from the two traumatic bear markets so far in this still young century. The US barely escaped depression a decade ago because of an unprecedented government rescue, which has left the country massively indebted. Rescues from inevitable future recessions may be far more difficult to engineer.
The environment remains problematic for investors and investment managers alike. As indicated earlier, if the Fed’s forecasts prove even reasonably accurate, intermediate and long fixed income securities will have a difficult time providing even minimally positive total returns. High quality, short-term cash equivalents will provide a growing, but still not exciting positive return. Those willing to assume the serious risk attendant to common stocks at these levels of overvaluation in a late cycle economy laden with historically high levels of debt can still profit so long as sentiment holds up and central bankers signal a willingness to prevent equity prices from declining too significantly. As a deep discount value firm, Mission will always look for strategic opportunities. In the meantime, we will maximize safe returns while awaiting more attractive valuations before committing a substantial portion of assets to equity positions. The potential for a severe, long-lasting decline beginning in the next year or two is extremely real.