Weekly Relative Value

Transcription

1 Puppies and Rainbows The broad consensus is to own stocks and to sell bonds. The broad consensus of investors is often wrong. Due to massive monetary stimulus (ZIRP and QE), financial assets have been inflated at or near the most expensive levels in history. Yet, the equity rally that has taken place since the election of Donald Trump comes at a time when the Fed is (slowly, so far) reversing the zero-interest rate policy of the past eight years. The market is betting the Trump promises of tax cuts, deregulation, repatriation and fiscal stimulus across defense and infrastructure related industries will outweigh the potential negatives of possible trade wars and tariffs, a stronger dollar, inflation, and further rising debt and deficits. Let s run through Trump s proposals quickly. 1) Tax Reform: Trump wants to simplify the tax code, lower the corporate tax rate and offer multinationals the ability to repatriate their offshore cash with a one-time tax charge of 10%. Yes, a lower tax rate opens the door to greater corporate profits, but any benefits from tax reform would take at a minimum six months and possibly a year to really begin trickling into corporate results. More importantly, most large corporations are already paying little if any taxes due to various gimmicks and loopholes. The Government Accountability Office found that in 2012 more than 43% of large corporations (those with $10 million in assets or more) paid no corporate income tax. 2) Deregulation/Infrastructure Spending/ etc.: None of these will likely be implemented until late A large-scale stimulus is a controversial measure that might not get through Congress. Even if it did, we already know such policies have minimal effect on GDP particularly late in an economic cycle (Bush s Stimulus act of 2008 and Obama s Stimulus of 2009).

2 Trump won t take office until January 20, He will likely not be able to engage in any of his proposed reforms until this time next year (it s possible he might be able to ram through a few bills via reconciliation in Congress, but the odds are likely that any major reforms will take a year). And yet, the financial media are abuzz with the idea that somehow GDP growth of 5% is going to hit in January. And investors are acting as if they believe this! My point is that any policies Trump implements, CERTAINLY does not warrant the absolute mania we are currently experiencing in the stock market. Burn it with Fire Turns out that former Treasury Secretary Lawrence Summers has read up on the Trump economic plan and his opinion can best be summarized as burn it with FIRE! Summers was quite critical of a paper jointly written by economist Peter Navarro, who will lead a newly formed White House National Trade Council, and Commerce Department head Wilbur Ross. Voodoo Economics The Navarro-Ross paper is well beyond voodoo economics, Summers said of the September report on Trump s growth plans. The logic of it, the arguments made, are so far out of the mainstream of any kind of responsible economic thinking that they are the economic equivalent of creationism. Larry went on to say: The vast majority of the companies who have large overseas cash also have substantial amounts of domestic cash, he said. The reality is that cash that is brought home will be used to pay dividends, to buy back shares, to engage in mergers and acquisitions, to rearrange the financial chessboard, not to invest in large amounts of new capital. It is a chimera to suppose that there will be large increases in capital investment as a consequence of that repatriation.

3 Adding to the criticism of Trumponomics, last week Bond King Bill Gross said that there s a lot of voodoo in terms of the economics of Trump s tax policies around cutting rates and repatriation of money by companies to generate revenue and investment. More on Trumponomics When you delve into the finer details of Trump`s economic plan, its effects for spurring true economic growth is severally lacking. In fact, it is only going to exacerbate the out of control National Debt and Budget Deficit Issues. Since President Obama took office in 2008, Federal Debt has more than doubled in eight years. As I have highlighted numerous times, we now have a federal debt load of $20 trillion and a total annual deficit of over $1 trillion. There is nearly $49 trillion of public and private sector debt in the U.S. Every increase of 100 basis points in rates boosts debt service by $470 billion annually (that's 2.5% of GDP). This money that can't be spent growing the economy because it is paid to holders of U.S. debt. We Don t Need More Debt As a reminder, despite adding almost $10 trillion of debt since 2008, Obama's recovery has officially been the worst recovery in U.S. history.

4 Source: JPMorgan So, why did 51 Senate Republicans vote this week to consider a measure that says the appropriate levels of the public debt would rise from the current $20 trillion to $29.1 trillion in 10 years? And predict deficits of $1 trillion by the end of that period? Senator Rand Paul (R-KY), for one, took to the Senate floor to slam his fellow Republicans for the $9.7 trillion of debt that a newly introduced budget resolution will add. Is that really what we campaigned on? Paul asked on. Is that really what the Republican party represents? That s not why I ran for office. That s not why I m here. That s not why I spend time away from my family and from my medical practice. It s because debt is consuming our country. I will continue to bring up to the American people that it is important not to add more debt, Paul said. I agree with Senator Paul. From my vantage point, we need major spending cuts and a reallocation of budgetary resources, a complete budget overhaul, and that means less government to start with. Government needs to be downsized, the military industrial complex needs to be downsized, and healthcare needs major structural reform as an industry. For the meantime, the market disagrees with Summer, Gross and Paul and instead has soared after having wholeheartedly accepted that anything Trump does will be beneficial, if not for the economy then certainly for risk assets.

5 That may change. All honeymoons come to an end! Are We Heading for a Currency War? The U.S and China the two biggest economies face off with the new Trump administration. China, of course, is central to Trump s strategy to reduce the U.S. trade deficit, which includes three actions: naming China a currency manipulator; bringing trade cases against it under the World Trade Organization and U.S. rules; and using every lawful presidential power to remedy trade disputes if China does not stop its illegal activities, including its theft of American trade secrets. In addition, last week the president-elect named Robert Lighthizer as U.S. trade representative, adding him to the hawkish team of Peter Navarro, director of the new National Trade Council, and Commerce Secretary-designate Wilbur Ross. The risk is that this will escalate into a currency war, with both sides attempting to gain a trade advantage, and that it ultimately ends up disrupting global trade and financial markets. As with any war, this one should be avoided at all costs. But the events of the past year suggest never say never. This would come at a time when U.S.-Asia relations, notably those between America and China, have become the main source of risk to growth around the world. The major risk now is if global supply chains that have been linked together in recent years are disrupted. What Will be the Surprise of 2017? The biggest surprise in 2017 could be the rapidity in which the bloom comes off the Trump flower. Donald Trump's reflation rally short-circuits. Rising borrowing costs will blow fuses across the world before fiscal stimulus arrives, if it in fact arrives. The Republican Party becomes divided and Trump's policy support loosens. The Trump administration's popularity quickly wanes as the trade-off from a slower growth world to a late-cycle policy experiment to stimulate growth fails.

6 By the end of 2017, it will be clear that nothing has changed for the better. Powerful deflationary forces retain an invisible grip over the global economy. Bond yields will ratchet up further and then come clattering down again ultimately driving 10-year U.S. yields to the lowest ever in the next few years. Jobs Update The Bureau of Labor Statistics (BLS), which is charged with calculating monthly jobs gains, released labor market report showing 156,000 new jobs were added in the month of December. Below is a friendly updated reminder from the BLS on the standard error in the NFP estimate: The employment number is an estimate based on a monthly sample survey rather than a complete count of jobs each month. As a result, the sampling error (variance) can be quite large. How large? The BLS assigns a 90-percent confidence interval of their estimate because, if they were to choose 100 different samples of employers, the nonfarm employment change could be between 42,000 and 270,000. Say what? So, the Bureau of Labor Statistics is 90% sure that the U.S. economy added somewhere between 42,000 and 270,000 jobs in the month of December. With such a wide range of plus or minus 114,000 jobs for a given month, economists could just as easily pull their nonfarm payroll estimate out of thin air. Most media outlets suggested that jobs growth has been chugging along. Never mind that the 156,000- number missed Wall Street consensus' estimate of 180,000.

7 Interestingly, and more importantly, year-over-year jobs growth continued to slow. To be precise, jobs growth has slowed from 2.3% (year-over-year) in February 2015 to today's rate of 1.51%. The year-overyear growth rate captures the big picture better than blindly staring at these uncertain monthly oscillations. The long-term trend is that jobs growth continues to slow. One UGLY Bond Market Forecast If you thought you had already read the gloomiest possible prognosis for bonds, wait until you read this one. Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, said if the latest bond market bubble bursts, it will be worse than in 1994 when global government bonds suffered the biggest annual loss on record. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded history suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 bond massacre. Market Outlook and Portfolio Strategy As stated at the beginning of this article, the consensus is stocks are the place to be. As shown below, Russell 2000 speculative positioning has never... ever... been longer. Volatility (or risk) has never been lower.

8 In bond land, Treasury futures speculative positioning has never... ever... been shorter. What could possibly go wrong? Remember: The broad consensus is to own stocks and to sell bonds. The broad consensus of investors is often wrong. In terms of relative value, please click here for the Relative Value Analysis More Information For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at or (800) , ext Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments. At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level. Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.