3rd Qtr Newsletter- Oct. 2019
Who do you trust for information these days? It’s tough to know who’s bending the truth, or steering you to a point of view, right? Seemingly half the country believes nothing that comes from our president’s mouth (or twitter account), but buys into everything dished out by the mainstream media. The other half seems to believe only what the president says; everything else is Fake News. Facebook is easily manipulated; Amazon wants to seduce you into their web of everything, and who knows about Google? I mean, we enjoy having the encyclopedia of the internet at our fingertips, but they probably already know everything about you, including your thoughts.
Surely, your faithful hometown investment advisor is trustworthy, right? You probably have a long list of queries you’ve been yearning to ask Monarch, and you’ve dreamt of marrying that with the convenience of Google. Your wait is over. Yes, it’s time to take the wraps off our latest endeavor. You are witness to the worldwide unveiling of the Monarch search engine. No longer do you need to Google it, rather you Monarch it.
While we understand the limitations of the media of this newsletter (paper), let us nonetheless move forward undeterred with beta testing. How? Because you’re reading a Monarch newsletter, odds are good that you’re not expecting to hear about needlepoint, cooking, or travel. We could easily talk about all of these, but we figure you are here with your full attention paid to the world of high finance, markets, the economy and investments.
So without further ado, we christen the Monarch search engine.
Whoa, weighty subject for the first salvo. No softballs to start the session here. Can we talk about the yield curve instead? Ah but seriously, capitalism seems to be on trial as the Democratic campaigning ramps up. While the skepticism regarding capitalism has been growing steadily throughout this economic expansion which began in 2009, it is now a deafening roar. Capitalism isn’t perfect, and needs to be managed to some degree. But history has shown that capitalism works and socialism fails in the long-term. On what grounds would someone disagree?
Well, if capitalism hasn’t treated you well, the siren song of “free stuff” sounds like a better alternative. Politicians know this, and they know that Economics can be bent in many ways…why would anything need to change if income tax rates rise to 70% and the government takes 8% of your wealth away each year? It frightens those of us who invest professionally that anyone would want to double down on the economic policies of Europe, namely a welfare system that is generous enough to reduce the incentive to work and paid for by taxes that also reduce the incentive to work, invest and generate profits. That’s a viable system, but the problem is that other countries have much lower tax rates. Capital flows where it is treated best. Europe is often called “the dead continent” for its economy. (Later, we predict you will Monarch a query about negative interest rates – stay tuned.).
Maybe we are too idealistic, but we think that capitalism is too entwined into the fabric of America to give up on it. Our historic identity is as a nation of opportunity, where the sky is the limit, of hard work and individualism, and of property rights. The government exists to serve the people, not to limit, burden, or expropriate from us. We need the government to fund common causes, and to step in to care for the least of these when the private sector is unable or unwilling. People need to be able to see a path to a better life before they start walking it, and work that gives them dignity and hope should be at the center of that better life. Our system needs improving, but at the end of the day, we have faith that Americans are still American enough to share these American values.
You have probably heard of a “bank run,” when depositors at a bank are nervous about the safety of their bank. They don’t want to lose their deposits if the bank folds, so they cash out their deposits. If lots of folks do it, it becomes a bank run, and the failure of the bank becomes self-fulfilling. Given that U.S. bank deposits are protected by FDIC insurance up to $250,000 per depositor, bank runs don’t really happen anymore in the U.S. They do still happen in emerging markets where there is no insurance.
The term “bond run” is not in Wall Street lexicon yet, but it should be. We apply the term to the flight INTO bonds, because investors have sought safety. While we generally trust that the bond market is a good predictor for the economy, we wonder if too much speculative money has been thrust into long bonds. TLT is a widely held ETF that holds 20+ year treasuries; it is +26% year-to-date. Up 26%!! It has attracted hundreds of billions of new investor money. Money always follows performance. Investors pulled money out of TLT in 2018 (as interest rates rose). In 2019, the narrative has changed. Apparently, inflation is dead forever and our economy isn’t going to see a resurgence of growth for many years, so the “threats” to owning long bonds have vanished.
This flight to safety has been corroborated by the strong performance of many safe “bond substitute” stocks this year, such as consumer staples (P&G, Coke, Kimberly-Clark, Pepsi), utilities, telecoms and REIT’s. But investors have also crowded into other high quality “ruler stocks” such as Abbott, ADP, Microsoft, NextEra, and Stryker.
However, starting on September 5, the 10-year yield rose from 1.46% to 1.90% in just 6 trading days. At the same time, safety stocks fell and value stocks (banks, energy, retailers) arose from the dead. The 10-year has since settled back to 1.69%. We can never claim it’s the start of a trend, but the violence of the move up in yields suggests that a ton of money was crowding into treasuries looking for a quick payoff, and possibly, distorting the yield curve.
The European Central Bank began its experiment with negative interest rates in 2014, when it lowered the rate it “pays” to banks to -0.1%. Rather than paying banks who deposit funds at the ECB, the ECB now charges banks to do so (-0.4% currently). This was intended to stimulate European economies, but it has not. In fact, Germany is probably in a recession already, a victim of the China-led slowdown in global capital spending. Remember that Germany operates with a trade surplus, meaning they export more than import, which hurts them when global trade slows down. The U.S. is much less exposed to trade. The German 10-year “bund” now trades at -0.61%, one of 14 countries where investors literally pay out-of-pocket to buy their 10-year bonds. Some corporate bonds now even have negative yields. Yes, you can pay governments AND companies to own their bonds! That said, if you were hoping to buy a house in Germany and snag a negative-yield mortgage, you’ll need to wait; rates are 1.8% currently, which is still pretty darn low.
Never mind, and no.
There is no greater soap opera on Wall Street (as we write this) than the attempted IPO (initial public offering) of WeWork. If you haven’t been following it, it’s almost not worth catching you up, but we will anyway. The company was founded in 2010 by Adam Neumann, a visionary young guy who saw dreams of dollars by snatching up cheap office space in big markets, redesigning the space to be hip and appealing to startups and entrepreneurs, and subleasing it out to them.
The company quickly became successful, attracted a much broader leasing clientele, and (more to the point) attracted a lot of venture capital, which is good because the company requires a lot of capital to expand into more office space, fund buildouts, and operate at Billion $ annual losses. Like so many venture capital-backed startups, its valuation rose consistently and quickly, to a high water mark of $45 billion last November, the last time it raised capital.
Despite the strong stock market since then, it appears the best valuation WeWork might be able to achieve in an IPO is $20 billion. Partly this is a result of the usual dog’s breakfast of corporate governance issues that are common in startups. The founder is known to throw lavish, tequila-doused parties for employees and tenants, as well as regularly smoking pot on the corporate jet. He has taken numerous liberties with the financials, and is prone to sounding flaky: the corporate objective is to “elevate the world’s consciousness.” These are typical for startups, even those worth $20 billion.
But the real reason for the lower valuation is that private valuations are just too high. It’s amazing how, when a company opens itself up to hundreds of millions of potential new investors, its value can drop by half.
Venture capital fund managers have so much money they need to put to work that they will fund nearly anything at nearly any valuation and will look the other way at the shenanigans of the founders. Not so the public markets, and that should give investors comfort. Sadly for investors hoping to cash out of WeWork, though, they will need to wait awhile, as the IPO has been postponed. The founder fared worse; his own board fired him as CEO.
Taking these in reverse order, Tariff Man is not a Superhero, but rather the self-given nickname of our president as he perennially bucks not only common sense, but hundreds of years of economic theory, in being proud to support tariffs on our trading partners. His meandering path of picking fights with virtually every entity on the planet (most countries, multi-governmental organizations such as the UN, WTO, IMF, EU, et. al., corporations, and individuals who are in his way) seems to beg for a strategy. The best explanation is that he enjoys negotiating, and the endgame is not so much a grand scheme as it is a checklist of conquests. Supporters believe there is a grand scheme.
Trump is going after the right villain in China, and going after the right remedies (technology sharing requirements, intellectual property rights, unfettered access to the Chinese consumer). Unfortunately, he isn’t making it easy for American multinational companies, who are wondering where they are supposed to operate, so they delay spending on expansion. Pending a resolution, business spending is falling, which will eventually lead to lower corporate profits, a softer labor market, reduced consumer spending, and ultimately our economy will be in a recession.
We are all losers in a trade war in the short-term. Manufacturers pay more for Chinese components. They can either pass the higher costs onto customers or their profits will drop. Retailers pay higher costs on imported goods, and can either raise prices to consumers or see their profits drop. Exporters, notably farmers, face retaliatory tariffs from China. Protected industries like steel have enjoyed higher prices because they have faced fewer cheap imports, which get passed through to the consumer for anything that uses steel. While American steel (and coal) jobs have increased, the jobs added have only been in the thousands and a recession would see those jobs and more disappear. Winners in a trade war are few. Companies have moved some production out of China and into other countries such as Vietnam. This is workable if there is a simple supply chain, but if a manufacturer’s suppliers are all in China, it’s logistically much more challenging and costly to get components out. We all hope the U.S. is a winner in the long-term, but that will require the Chinese to cave into our demands.
Damage has been done to the economy, and it will start showing up over the next year in hard economic data—a slowdown in business spending, profits, and hiring. That said, if the trade war is resolved, businesses will resume spending and layoffs (a result of the slowing growth) could be staved off. There might be a couple quarters of an ugly GDP number (like, GDP falls), but we have seen that already 3 times in this cycle, twice in 2011 and once in 2014. The stock market tends to look ahead, and if they see a path to higher GDP growth eventually, a slow quarter in the interim is forgivable.
Kind of. The purest gauge of profits that we look at is the “NIPA” profits reported as part of the quarterly GDP reports. It is pure because it is what companies report to the government for tax purposes. It is pretax (so, not affected by the corporate tax rate cut), and it is in dollars, not per share. Plus, it is for ALL American businesses and their U.S. operations alone. The more widely-used S&P 500 profits are after-tax, per-share, and often exclude “one-time” charges that tend to recur every quarter. NIPA profits peaked in 2014, believe it or not, and were then set back by the commodity crash in 2015. It is surprising that they have not regained the old peak yet, but after a good report in 2nd Quarter 2019, they are only 4% away from the old 2014 peak.
S&P 500 “adjusted” profits, meanwhile, are 36% higher than their 2014 level. While much of this growth is from lower taxes and lower shares outstanding, EBIT is still +18% in those 5 years. EBIT is earnings before interest and taxes, so its growth should be comparable to that of NIPA profits. Why are these profits +18% versus -4%? Partly because large companies have done better than small businesses, and partly because multinationals have growing overseas profits that get counted in S&P profits.
Going forward, it’s difficult to see a good path forward for profits, with tougher business conditions outside the U.S., tariffs into China, higher costs on imports, and higher labor costs. Consumer spending is still carrying the load for the economy and profits, and we hasten to point out that the consumer is still healthy—the savings rate is still high and household debt burden is much lower than in the past 2 cycles.
We continue to watch our “Bull Market Top Checklist” like a hawk, and still only 2 out of 10 conditions are indicating we are at the top of the bull market. Nevertheless the trade war looms.
–Written by John Meyer
Save-the-Date! Our first “winter lunch” of the season will take place December 10 at Fort Wayne Country Club. Invitations will go out in November.
Next time you call Monarch, the person answering the phone with a slight Southern accent could be Debbie Meyer, our new Client Services Administrator. Debbie is Dave’s sister-in-law and is moving to Fort Wayne from Bradenton, Florida. She starts October 7. She says she is looking forward to winter – we shall see. Debbie has many years’ experience as an administrative assistant. She enjoys being outdoors, taking long walks, photography (sunsets, wildlife and landscapes), kayaking, relaxing with a good book, volunteering, and helping others in her spare time. Debbie replaces Melyssa Stock who decided to take a full-time teaching position and left Monarch over the summer. We wish Melyssa well in her new endeavor and are excited to welcome Debbie as our newest Monarchian!