Join the Conversation on the Market Plunge
publication date: Aug 7, 2019
author/source: Valuentum Analysts
The Valuentum team shares its thoughts on the recent surge in volatility and collapse in interest rates amid a trade and currency war between two of the largest economies in the world, the US and China.
No changes to the newsletter portfolios at this time.
During the past few days, the US (SPY, DIA) and China (FXI, MCHI) have escalated a trade war, turning it into a currency war, the latter allowing its yuan to drop to lower levels against the U.S. dollar. The US has now labeled China a “currency manipulator,” and China has responded by suspending U.S. agricultural purchases. China is one of the largest buyers of U.S. agricultural goods. The Valuentum team builds on its previous conversation on the economy, which can be found at Valuentum’s Economic Roundtable.
Callum Turcan: It will be interesting to see how the rest of this week plays out. On the flip side, this in many ways ensures there will (likely) be additional rate cuts by the US Fed, probably by the ECB as well, and actions will be taken by China to offset the negative headwinds from reduced exports to the US (such as greater infrastructure spending, boosting loans and reducing bank's reserve rate requirements (RRR) to stimulate demand and investment, and cutting tariffs on non-US imports).
Brian Nelson: I wonder if this is the scenario, the one that the market just wasn’t expecting, that tilts the global economy over. Not something like the Great Financial Crisis, but I wonder how many hedge funds or counterparties might get swept up by developments. Not saying this will turn into a currency crisis like that of the late 1990s either, but things seem like they are escalating too quickly to handicap. One tweet by the President could move the market 400 points in any direction, it seems.
One thing I keep in mind though is that the US and China are multi-trillion-dollar economies and we’re looking at tariffs in the tens of billions. But currency tends to change things quite a bit (the currency markets are huge), and that China seems to have the resolve to stand its ground in the wake of US tariffs shows that the White House is walking a fine line in an election cycle. I get the sense that this bull market aged very quickly in the past 24 hours. We might see a test of the December 2018 lows.
Callum: The markets got some good traction Tuesday. It’s possible if Wednesday is another green day, investors might start to begin to price in the positive impact a cycle of interest rate cuts will have on the US economy and equity valuations (particularly in America). That's on top of the US Congress reaching a big debt ceiling/budget deal that was recently signed into law by President Trump, allowing for additional spending increases in FY2020 and FY2021.
The trade/currency war is ramping up, and that's a big concern as investors price in the impact of a prolonged period of US-China protectionism/nationalism, but America does have powerful short-term measures to offset exogenous pressures (lower interest rates, additional federal government spending, potentially higher spending by U.S. states as well, low electricity and petroleum product prices, etc.) which may provide support to US equities for the time being.
Matthew Warren: Callum, I think you are right with some of the puts and takes. Lots of cross currents.
Something I’ve been thinking about regarding the U.S. Fed: I’m not sure they can justify a series of cuts (more than an insurance cut or two), unless the market goes into a serious tailspin or economic data actually prints quite weak (market under pressure in that scenario, too). I just can’t wrap my mind around the U.S. Fed cutting 3, 4, or more times, while the market hangs around all-time highs and the economic prints remain decent. Watch for them to start talking a lot about inflation being too low, and then I might be wrong.
Callum: China also has numerous tools at its disposal to prop up its economy in the short term including cutting the RRR, boosting lending, increasing infrastructure spending, increasing Belt & Road spending/loans, reducing tariffs on non-US imports, regulatory reforms, and additional national spending on big priorities (whether that's infrastructure, the military, additional resource development, bolstering Tier 2 - 3 cities to alleviate congestion in Tier 1 cities, etc.), on top of letting the yuan slide lower against the US dollar.
Combined, it's possible that while the bull market has aged considerably in just a few days, there is also a "floor" here somewhere that's built on the ability of the US, China, and other nations to use short-term levers to manage economic growth at a time when low interest rates will push investors into equities. We need to see how trading action pans out over the next few days still to see if that's the case.
Matthew: I am more nervous about China’s ability to hold things together, but I have felt that way for a long time, so maybe take my concern with a grain of salt. If the China debt and investment bubble were to blow, they will export deflation. It could easily worsen the trade war, and the knock-on effect on Europe (VGK) could be really bad for their banks.
Callum: Fair points Matt, part of my "floor" thesis rests in part on US equities getting their cake (interest rate cuts) and eating it too (US economic activity continues to grow at 2+% heading into cycle of US Fed cutting interest rates). If US economic activity (or global economic activity) were to drop off a cliff before then, interest rate cuts start to mean a lot less.
Brian: The context of this now-currency war between the US-China and what looks to be expectations for aggressive action by the Fed comes amid a 10-year bull market in the US and some $15 trillion in negative-yielding debt around the globe. As valuation practitioners think about the implications of negative-yielding debt on equity valuations, the challenge becomes more and more how to value those long-duration cash flows on some of the lowest-quality companies.
This, coupled with the proliferation of price-agnostic trading, sets the stage for what I believe will be a sustained period of heightened volatility. We saw a volatility spike when short-vol products blew up in February of 2018, and the collapse in the markets in December 2018 was rather aggressive. Many investors got comfortable with a steady climb in the markets during 2016-2017, but I believe the coming decades may present some of the biggest volatility swings we have ever witnessed, with implications on savers and retirees.
As it relates to the newsletter portfolios, we are considering lightening up on some ideas, namely some of the broader ETFs, including the Energy Select Sector SPDR (XLE) and Financial Select SPDR (XLF), holdings in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio, rather than looking to allocate more capital. We are “fully-invested” in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio and have a modest 10% cash weighting in the High Yield Dividend Newsletter portfolio. In December 2018, we called for a melt-up, and we think the conditions of the past few days suggest we could be in for a meltdown.
I don’t think investors should panic (this is always a bad idea), but I do think that investors that have bolstered their retirement savings during this 10-year bull market and retirees that are counting on large returns should really start thinking about their portfolio allocations in the context of their goals and risk tolerances. Bear markers are swift and cut deep. Many are expecting future annual equity returns in the high-single-digit range and some even higher over the next decade or so, and I just can’t see that being the case for a broad market index such as the S&P 500 on a go-forward basis at current lofty levels.
Callum: As it relates to the newsletter portfolio, I think we need to tread very lightly going forward, but it's a good thing we didn't make any panic decisions on Monday (as many others did) as markets recovered a bit Tuesday. The collapse in 10-year yields will likely push a lot of investors into REITs (VNQ), utilities (XLU), and other high-yielding areas (relatively high-yielding). That's the impetus behind why we’re seeking to “fully invest” the remainder of the HYDN simulated portfolio, but also, we could increase the “cash holdings” of the Dividend Growth Newsletter portfolio and the Best Ideas Newsletter simulated portfolios.
We may also consider reducing both newsletter portfolios’ allocation to Intel (INTC) and Apple (AAPL) considering how we have a lot of tech exposure and given the very integrated nature of tech supply chains. There's also room to reduce exposure to Digital Realty (DLR) and/or Microsoft (MSFT) in the Dividend Growth Newsletter portfolio as both are trading at the upper end of the fair value estimate range. Oracle (ORCL) has also had a solid run, but it is now showing signs of weakness (stock price movement wise); that’s another one we’re watching closely in the Dividend Growth Newsletter portfolio.
Matthew: The collapse in world-wide interest rates seems to be suggesting a complete lack of inflation for the foreseeable future and even some probability of deflation. This is concerning for banks broadly as they make more money on zero-yielding deposits when short rates are higher, but the markets are now predicting more Fed cuts this year.
A lot of bank lending is also tied or roughly linked to prime, LIBOR, or the ten-year bond (as with mortgages). That said, the banking ecosystem is also a competitive one, so you can expect the banks to collectively move borrowing and lending rates to the extent possible so as to maintain cost of capital returns for the overall banking system. I think this pressure-release valve would help in all but the most extreme scenarios such as the US ten-year bond switching to negative rates like we have in Japan and Europe. That kind of pressure is extremely difficult to offset with competitive dynamics.
One other thought on the risk of deflation. If China's economy rolls over into a deflationary bust, that would add to the deflationary impulses that are already present in Japan (EWJ) and Europe. This would worsen the situation for the banks in both those geographies and could even lead to domino bank failures. While this is a scary tail risk as opposed to a base case, the consequences are so severe that it bears close watching and consideration in my opinion.
Keep the conversation going. Post your thoughts below!
<Discussion also tickerized for banks and insurance entities.>
Banks - Regional and Asset Management: AB, AINV, AMP, ARCC, BCH, BEN, BGCP, BKU, BLK, BMO, BNS, CM, FSIC, ISBC, KKR, LAZ, LM, MAIN, MTB, NABZY, NYB, OCN, PBCT, PFG, PSEC, RY, SBNY, SBSI, STT, TD, VLY, WBK
Banks & Money Centers: AXP, BAC, BBT, BK, C, DFS, FITB, GS, HBC, JPM, KEY, MS, NTRS, PNC, RF, STI, TCF, USB, WFC
Insurance: ACE, AFL, AIG, AJG, Y, AFG, ACGL, AIZ, AXS, BRK.B, LFC, CINF, CNA, CNO, RE, ERIE, FAF, GNW, HCC, LNC, L, MFC, MBI, MCY, MET, MKL, NAVG, PRE, PRA, PL, PRU, RGA, RLI, RNR, SIGI, SFG, STFC, SLF, ALL, CB, HIG, PGR, TRV, TMK, UNM, WTM
Related: KRE, KBE, TLT, TBT, VXX, UVXY, TVIX, UUP, UDN
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