Third Quarter 2016

 In Market Commentary

Equities rebounded strongly in July and stayed in a fairly narrow range throughout August and September. US Treasury yields rose over the quarter as the Fed slowly became more hawkish and long term bonds priced in higher breakeven inflation. Equities and bonds are simultaneously trying to digest increasing noise from the world’s most important central banks and disparate election polls. While both presidential candidates’ policies include major infrastructure spending bills, which could boost both growth and inflation, differing candidate views on global trade, healthcare and taxes have made predicting the economic direction post-election a coin flip.

Investors are starting to realize that US monetary policy may not continue to provide the same tailwind it did in the past. One of the few bright spots (or at least non-dark spots) in the world continues to be the US economy. Although growth has been slow, the US consumer remains resilient and unemployment continues to be fairly low by historical standards. In fact, firms are finding it more difficult to find workers and are thus increasing wages to retain key staff, according to Fed Beige Book surveys. This wage pressure is seeping into the Fed’s outlook for when to raise the rates. With domestic conditions strong, but international conditions weak, the Fed is walking a tightrope. Concurrently, headline consumer prices are forecasted to rise above the Fed’s stated 2% target, as last year’s oil price drop fallsout of the base effect. Breakeven inflation rates in the TIPS market seem to be predicting this, as 10 year breakeven inflation rates have risen from 1.4% in June to 1.64% today. Still, this rate seems too low compared to the Federal Reserve’s target of 2%. It remains to be seen how sternly the Federal Reserve will stick to its target.

We have often written that US regulatory policy continues to dampen economic and job growth. While it is often hard to point to one culprit for slow growth, we think regulation in the financial sector is a great example of the heavy hand of government doing real harm. For example, since the passage of Dodd-Frank and the Volker Rule, regulations have limited credit available to small businesses. Small businesses in the US employ 49% of the population and provide 64% of net new private sector jobs, according to the Small Business Administration. US regulations effectively cut off banks from doing anything but the most vanilla lending to good corporate customers and basic consumer (autos and real estate) lending. These regulations are increasing the cost of running small banks while at the same time low interest rates are shrinking net interest margins, crippling overall bank profitability. The industry’s response has been consolidation. Many small banks are getting gobbled up by their larger regional and national brethren, where it’s easy to consolidate regulatory costs and realize quick synergies. However, this strips the banking system of their local expertise and favors lending to larger customers at the hindrance of smaller local companies.

Consequently, the lack of credit supplied by banks allows the less regulated markets for lending such as peer-to-peer business models, to fill in the gaps. Here, margins are much higher, but these new “Fintech” business models have yet to be tested by a credit cycle. Further, the cost of capital to businesses through these non-bank credit providers is much higher than what banks would normally charge. Large corporations who can issue bonds in financial markets pay very little in terms of interest rates, but small businesses must pay at least 15% or more to private credit providers, such as Ondeck, Lending Club, Fundera, and SoFi, who are backed by both private and public markets. Furthermore, these models don’t have nearly the amount of capital that US banks can provide. Any new administration would do well to tackle this heavy handed regulation of banks to improve the prospects for small business.

Five years after the PIGS threatened Europe, very little has been resolved. The European Central Bank and the Bank of Japan recently became more skeptical of the positive impacts of negative rates in their economies. They too are realizing the pain low net interest margins create for banks. When banks lend money at low interest rates, their ability to withstand a credit hit is lower, as they don’t make enough money on assets to increase their book value. Normally, these profits would serve as a capital cushion against future losses in a full credit cycle. Thus, in light of the higher risk, banks have slowed lending to only the most credit worthy of borrowers. Given that much of the European and Japanese markets are still financed by loans rather than bond markets, this has limited the transmission of capital to the real economy. In addition, concerns of thin capital cushions at Deutsche Bank and Banca Monte Dei Paschi Seina continue to negatively impact investor sentiment. The coming impact of Brexit on credit quality has further reduced banks willingness to lend. This continues to be a major concern for financial markets.

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