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Where Are the Safe Havens?

publication date: Aug 29, 2019
author/source: Valuentum Analysts

"We believe that staying diversified as in holding a broad swath of ideas as in either the Best Ideas Newsletter portfolio or Dividend Growth Newsletter portfolio as the equity portion of one’s allocation makes a lot of sense in any environment...High yield dividend investing may become more and more popular in coming years as rates across the globe approach 0%, and the amount of negative-yielding debt proliferates." -- Brian Nelson, CFA

By The Valuentum Team

The Federal Reserve is weighing all its options as it assesses how to balance global economic weakness and strong performance in the US, pressure from the White House to aggressively cut rates, and a 30-year yield that puts the federal funds rate at the highest point along the curve, something that even many voting Fed members say makes little sense.

We sat down with the Valuentum team to learn about some of the new developments and where some safe havens may be in the market for more-conservative investors. To get started, let’s get the team’s thoughts on a tool that is being considered, but not yet put to work, called the countercyclical capital buffer (CCyB), introduced during Basel III following the Financial Crisis. Here is the point of the CCyB:

Many economists argue that the rapid growth of credit, especially in the household sector, contributed to the global Financial Crisis of 2007-09 and the subsequent Great Recession. By forcing banks to hold more capital when their assets grow rapidly (i.e., when they make a lot of loans), regulators can ensure that a larger buffer protects bank solvency should the value of those assets drop. In other words, the CCyB is designed to be activated during good times, when banks are lending a lot. During a recession, bank assets are likely to lose value; the extra capital buffer can then help ensure that banks have sufficient capital to absorb those losses.

Let’s open it up to the team.

Brian Nelson: The more capital the banks (XLF) hold, the stronger their balance sheets and ability to withstand economic storms, but it does come with a cost in the form of generally lower returns on equity through the course of the cycle. That said, these lower economic returns driven mostly by a higher required capital base may be offset by reduced firm-specific and systemic risk, which may make such a policy a net positive on bank equity values. One thing is certain, however, it is much easier to build an outsize capital base after years of economic expansion (near economic peaks) than at the depths of economic troughs, so the cost of holding excess capital when times are good may be a very practical solution to smooth out the ups and downs of the banking cycle.

Callum Turcan: My question on the CCyB as it relates to America is whether the Fed could pursue such a move, politically speaking, given how the banking lobby is likely to push back aggressively if the CCyB were ever to truly be used? While the banking lobby couldn't directly influence whether the CCyB rate is raised from 0% (the Fed has chosen not to raise the CCyB rate since the rule’s implementation), it could put pressure on members of the US Congress and President Trump himself to act to stymie the move. Using the CCyB to engineer soft landings could be viewed as regulators continuing to encroach (for better or worse) on banking business decisions.

Assuming those concerns are unfounded, I can see why the CCyB could look like an appealing tool during boom times to manage any eventual bust, but I wonder how often the rate would change. It seems like the CCyB would be best if used very rarely to allow for banks to adjust for longer periods of time to the “new normal,” instead of a rate that changes on a continuous basis. Adjusting to the new capital buffer rules is significantly tougher task than adjusting to changes in interest rates. What are your thoughts Matt?

Matthew Warren: Interesting. I think there is some merit to the argument. If there is rapid growth in bank loans in a mature economy, it suggests something risky might be afoot. Looking back at the growth in loans and asset books before the Great Financial Crisis (GFC), the warning signs were there across most banks. Bank of America (BAC) and Citigroup (C), for example, were growing their balance sheets like mad in the run up to the GFC. Subprime home loan specialists like New Century, Novastar, Indy Mac, and the like were growing even more rapidly. In the latter cases, extra capital probably wouldn’t have saved the riskiest of lenders. However, if the 15 biggest banks in the country had been carrying extra capital, that certainly would have been helpful. It might even have prevented the need for the TARP (Troubled Asset Relief Program) capital raise. 

So really, the only question is: how much growth should attract how much of an additional capital cushion, if the goal is to reduce systemic risk from the banks. That said, however, the rule itself, might well scare banks from growing too quickly so as to avoid the penalty of a counter-cyclical capital buffer. The stress tests are also a very useful way of monitoring what the banks are doing and how much losses they can absorb. I think the banks, as a whole, are much safer as a result, and of course bank balance-sheet growth has been very muted over the last 10 years.

I agree there would be pushback from the banking lobby on any additional regulations. The banks are quite highly capitalized already if you ask me. I don’t see the need for more capital at this point. My opinion might change if the big banks were growing near double-digit rates however, so I do think there is some merit for curbing stupid loan growth. I think the stress test already does that to some extent. In somewhat related news, former vice chairman of the Fed Bill Dudley recently wrote an interesting op-ed titled, “The Fed Shouldn’t Enable Donald Trump.”

Callum: On the issue of enabling trade wars, I agree with Dudley's point that when the US Fed opted to cut rates to offset the negative impact of tariffs, that hasn't been a stabilizing factor as hoped. Quite the opposite. Now the Trump Administration can continue ramping things up knowing that growth tailwinds created by monetary easing will help his reelection chances in 2020. I don't agree with Dudley's assertion that the Fed should try to game the 2020 election cycle away from President Trump either; that sets a dangerous precedent and almost certainly would see the end of the Fed's independence forever. At the end of the day, the ultimate goal of the Fed is to maintain stability as best it can come what may. When it comes to attempting to force Trump's hand on trade, it's anyone's guess as it whether that's even possible, given his unconventional nature.

Matthew: Yeah, the last paragraph was astonishing to me. That anyone associated with the Fed would go that far. The goal should be to not effect elections one way or the other, in my opinion.

Callum: Perhaps the most interesting thing is the universal disapproval of Trump's trade wars by those in the finance profession (both the private and public sectors), yet the GOP is standing behind him on this crusade while the leading Democratic candidates for president haven't really come out against tariffs per se (they are against turbulence, but not the actual tariffs) at least from what I've seen. Meaning there is no other way for those like former Fed officials to have a seat at the table other than to encourage unilateral action by certain government bodies.

Brian: I’m very much in favor of an independent Fed. I think it is a staple of the American economic system, and I think it should be preserved as a “balance of power.” While I do think the Fed may be indirectly “enabling” Trump’s trade war in working to prevent any US recession--and the trade war may be causing unrest in the bond markets, driving the long-end of the curve lower (as money flocks to the US)--I don’t think it is fair to put all of blame on Trump for non-US economic weakness and the current stance in Fed policy.

For example, we were still operating in an environment of ultra-low interest rates when President Trump took office. While there was somewhat of an about-face with Fed policy in late 2018, even if Trump wasn’t in office and without a trade war, the Fed probably would have been in a similar situation, having to potentially cut rates aggressively. Roughly $15 trillion of debt is now negative yielding across the globe, so market pressure on US rates across the entire curve may have happened regardless; capital is going to seek the highest risk-adjusted return. When it comes to the sovereign debt markets, that may very well be US Treasuries (lots of global debt has negative yields). 

I think the long end of the curve is telling the real story. The 30-year bond yield is now trading at about 1.9%, below that of the federal funds rate. It doesn’t make much sense for Fed policy to set near-term rates as the highest point on the curve. I think we will see a 50 basis-point cut at the next Fed meeting to avoid the behavioral implications of a prolonged inversion (which may cause the recession); it’s possible, however, that this situation might have happened with or without Trump or the trade war. Yields on trillions of dollars of debt are negative, and money is simply flocking to the US. Trump’s foreign trade policies may not be entirely to blame for this.

The bond markets are suggesting the global economy may be ill, but the US economy may be strong. The real concern is if the trade war with China (FXI, MCHI) is the straw that breaks the global economy’s back that drives China into deflationary bust and the weakness across the globe ensues, bringing the US economy down with it. If the US “wins” this trade war in a big way, it may actually lose. Many members have been asking about what we think are some “safe havens” in today’s market, if anything can truly be called as such.

Matthew: It seems like the “safer havens” are bid up. That said, apartment REITs (VNQ), utilities (XLU), cash and/or short duration treasuries and/or bank CDs, and consumer inelastic staples (XLP) are worth considering. It’s worth noting that consumer staples have high PEs (price-to-earnings ratios) so there is risk of downside with this group.

Callum: Some of the less conventional safe havens could include very net cash rich tech firms with sizable free cash flows and promising growth runways. In many ways, Apple (AAPL) is a great example of an unconventional safe haven. Sure, the company is exposed to the US-China trade war but many have noted that Apple is better positioned to shift production away from China while still meeting US demand, particularly for iPhones, than some investors might give the tech giant credit for.

Additionally, Apple is very net cash rich and its free cash flows are enormous. The firm's growth runway is supported by a promising high-margin services growth story built around its top tier ecosystem, supplemented by its R&D powerhouse that's investing in things like AI and machine learning (Apple recently placed a greater emphasis on these subjects after scaling back its self-driving car ambitions). Acquiring Intel's (INTC) smartphone modem business in 2019 is Apple's way of ensuring greater control over the iPhone's future, which we like (~$1 billion seems like a relatively small down payment on the future of semiconductor and communications technology, which is what Apple reportedly paid Intel).

Brian: Members can probably guess my answer. We believe that staying diversified as in holding a broad swath of ideas as in either the Best Ideas Newsletter portfolio or Dividend Growth Newsletter portfolio as the equity portion of one’s allocation makes a lot of sense in any environment. Either of these respective portfolios coupled with some high-yield corporate bonds, dry powder in the form of cash, and real assets or private businesses would round out a very strong portfolio of assets.

Though we’ve yet to pull the trigger on gold (GLD) in the newsletter portfolios, I’m warming up to the idea, as the potential for NIRP (negative interest rate policy) in the US becomes more and more likely in the coming years. We’re still staying far away from cryptocurrency, as in Bitcoin, for example. We don’t view cryptocurrencies as “diversifiers.”

High yield dividend investing may become more and more popular in coming years as rates across the globe approach 0%, and the amount of negative-yielding debt proliferates. Investors want to have some income stream, so high yield and dividend-paying equities as in dividend growth ideas (SDY) have tremendous merit. We like ideas in the Best Ideas Newsletter portfolio, Dividend Growth Newsletter portfolio, and High Yield Dividend Newsletter portfolio.

Callum: Another “safe haven” we really like is the self-storage REIT industry, particularly with respect to firms with strong traditional free cash flow generation (as measured by cash flow from operations less all capital spending). The High Yield Dividend Newsletter portfolio includes two self-storage REITs that we see as best of breed within that space.

Brian: Per our previous Economic Roundtable discussion, when we discussed how unusual it was for President Trump to continue to say China wants a deal “very badly” the week after it issued retaliatory tariffs, and something he’s been saying for many months, Bloomberg reported that “perhaps nobody was more surprised to hear that China had called President Donald Trump’s administration than the government in Beijing itself.” It is becoming more and more difficult to believe the updates coming from the White House.

Callum: Simply put, China is being realistic. Given China's political makeup, there isn't as much pressure in the short term for Beijing to make a deal with the US, which would likely involve concessions to Washington. China likely wants to wait until after the 2020 election to make a deal, which could possibly be with a Democratic president if exogenous shocks materially weaken the US economy.

On that note, there's a lot of pressure on President Trump to make a deal to shore up the economic outlook of rural America (net farm incomes are expected by the USDA to be around three quarters of their historical average in 2019, likely less now that trade tensions have increased significantly) after China halted agricultural imports to the US. There's also pressure from the domestic oil & gas (XLE) industry to get a deal done, as Chinese tariffs on energy products prices the US out of the second largest economy in the world (the outlook for US oil and LNG exports to China looks dire in the medium-term).

When it comes to suburban voters, a weakening stock market and possibly weakening jobs outlook represents a big reason why President Trump would likely want to get a deal done with China before 2020. In summary, while China's economy is clearly taking the brunt of the negative trade war impacts (at least for starters), Beijing may have a stronger hand to play than Washington given each nation's very different political realities.

Matthew: I would push back a bit on China having the upper hand altogether. Some things being manufactured in China right now could easily be made in Vietnam (VNM), Malaysia (EWM), or Bangladesh. Some things could be moved over easily, and some things would require a very concerted effort and building up an ecosystem out of thin air. The longer the tariffs go on, the more-inclined corporate multinationals wills be to source elsewhere. Once gone, a lot of this will never go back to China. 

Given China’s tenuous debt and over-investment problems the country has had for years, China is a bit fragile, in my opinion. An investment and banking bust combined with offshoring of manufacturing is an ugly picture.

I also think a completely Balkanized global economy is an ugly scenario too--China insourcing high value-added goods instead of buying from the US. If the US forces China to come up with its own solutions instead of buying from the US, we might well regret it in the long run.

Callum: To your first point Matt, I would break my thesis down into two categories. On the medium-term political side heading into the 2020 election, I think China has the stronger hand politically relative to President Trump (I differentiate Trump from America at-large given how many Americans aren't sold on the trade war) but over the long term, the US at-large has the strongest hand by far (and I agree with several of the points you made on that topic in this thread and others covering the space).

A lot of goods currently made in mass in China can be manufactured elsewhere, sometimes even at a lower cost, once scale is achieved due to cheaper labor costs. That includes leveraging existing and future manufacturing bases in Southeast Asia (like Vietnam), East Africa (where manufacturing hubs are emerging), India (INDA), etc. The low-cost supply chain story has changed considerably from 2000 to 2019.

Given that China has taken out an enormous amount of debt to finance its stellar industrialization story since the late 1970s, a prolonged slowdown in its economy would get rid of the main way Beijing was going to pay that burden off (namely through continued economic growth into near-perpetuity). China's main way of staving off a recession involves allowing local governments, which are already up to their ears in debt, to borrow even more to finance massive infrastructure investments.

However, those infrastructure investments support the export side of China's economy that's slowly losing relevance, as consumer spending and services start to make up more of its economy. More broadly, unnecessary infrastructure spending won't yield the kind of dynamic returns for China that (much needed) infrastructure spending in the US or elsewhere might yield, as the future of China's economy rests on its consumer. Propping up China's consumer spending and services spending would be tough to do when millions that used to be employed in the export space are being laid off.

For high-tech goods, while America is currently dominant in that category, the industry needs to accept rising competition from Chinese firms that will eventually come into play down the road. However, seeing as America has largely kept its high-tech edge over Japan (EWJ) and the EU over the past few decades (based on most large tech firms being primarily based in the US, including Apple, Qualcomm (QCOM), Facebook (FB), Intel, Nvidia (NVDA), Cisco (CSCO), Alphabet (GOOG, GOOGL), numerous high-flying SaaS names like Crowdstrike (CRWD), the list goes on), I'm optimistic that America could continue to maintain its lead in the decades to come (noting that competitive pressures in an already competitive industry are set to kick it up another notch).

Industrial tech is a different matter (such as automobile and elevator-related tech), but America still reigns supreme in the high-tech world (autonomous driving, cloud computing, digital advertising, video stream services, ride hailing, SaaS, healthcare tech, and more).

Matthew: I agree with what you are saying. I think it comes down to a timing and magnitude question, which is so hard to predict given Trump’s inherent “unpredictability.” He might well try to force things to come to a head prior the elections by raising tariffs further by example. The higher the tariff, the more likely a multinational will throw in the towel and go elsewhere.

If this happens fairly-rapidly, the pressure on China could mount quite quickly. Granted that the markets would also probably go into a tailspin, pressuring Trump right back. With Mexico (EWW), he simply cut a quick deal and declared victory. Ultimately, I think that is what will happen here. But the odds of a bad outcome are not small, and I think it is quite ominous from where we stand right now.

Brian: It’s no doubt an interesting time in the markets and global economy. The Valuentum team continues to pay attention to the myriad risks, but we think it’s important readers don’t overreact to any negative headlines. We like to pay attention to what can go “wrong” in the markets because the good things tend to take care of themselves. We very much expect strong long-term performance from our newsletter portfolios, and if you haven’t yet considered the Exclusive, please do so.

Join the conversation below. Where are you looking when it comes to “safe havens?”

6 Comments Posted Leave a comment

Thomas Judge (Annapolis)

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