Third Quarter 2017

 In Market Commentary

The third quarter proved to be profitable for global equities. Continued growth across Asia, Europe and the US lifted confidence in equities, bringing valuations higher and keeping volatility subdued. In addition, the market seems to have confidence that Congress and President Trump can get a meaningful tax reform accomplished, despite their inability to repeal the Affordable Care Act, presumably their number one goal when Republicans took control of Congress and the White House. We witnessed this in the third quarter as US small-cap companies and financials outperformed broad market benchmarks. Both groups source a large amount of profits domestically, so they would be most positively affected by lower corporate tax rates. While Republicans have pledged to make any tax reform revenue neutral, this most likely won’t be the case. It’s easy to cut taxes, but it’s hard to take away tax breaks. The proposals we’ve seen seek to eliminate the deduction of state and local taxes. This tax subsidy essentially lowers the tax burden for those in high income tax states like California, New Jersey, and New York, traditionally Democrat leaning states. History tells us once you give people a benefit like Social Security, Health Care, or a generous tax break, it is politically hard, if not impossible, to take them away. We suspect this will be the case with the tax subsidies and loopholes the administration would need to close to make tax reform revenue neutral.

With volatility at an all-time low and the market’s persistent bid, one would think all is well in the world, but the headlines tell a much different story. North Korea tested an ICBM, flying one over Japan, and may have successfully tested a Hydrogen bomb. Hydrogen bombs are much more powerful than previous nuclear bombs tested by North Korea. The US is trying to “decertify” the Iran nuclear deal, which would allow Congress to place tougher sanctions on the regime. Theresa May, the prime minister of the UK, is struggling to maintain power, hampering efforts to negotiate an orderly exit from the EU. Catalonia, a region that encompasses Barcelona, seems intent on leaving Spain. Spain attempted to stop their votes to do so by using police and military intervention. German elections this quarter saw Angela Merkel keep her position, but the far-right party, Alternative for Germany (AfD), won seats. No far right, anti-immigration party has held seats in German Parliament for 60 years. Russia continues to aggressively pursue its agenda, both in Eastern Europe and through social media, as we found out recently through Congressional inquiry. If you want to read the news, I suggest paying for high quality journalism from the Wall Street Journal, the Financial Times, the New York Times, or the Washington Post, but avoid your Facebook and Twitter feed unless you are sure of the source.

Chart 1: UK Fiscal and Current Account Deficits as a % of GDP and GBP/USD Exchange Rate

Chart 1: UK Fiscal and Current Account Deficits as a % of GDP and GBP/USD Exchange Rate

I think it’s helpful to take headlines like these and determine how geopolitical events can impact the economy, interest rates, and corporate profits. Right now, while rhetoric is high, no real action has happened to affect the global economy. However, this could change rapidly. One central fear we have is a collapse in the British Pound (GBP) and potentially a severe recession in the UK. Why you may ask? The UK runs both a current account and fiscal deficit. This means the country depends upon the kindness of foreigners to finance their spending. If this confidence were to erode, GBP could drop in value relative to their trading partners. Due to their dependence on imports, this could trigger inflation, pushing interest rates higher, with a real effect on asset price valuations, especially government bonds and real estate. With very high consumer debt levels in the country, higher borrowing costs could push the UK into recession and significantly impact bank profitability. With already low rates, the country would have very few resources to stimulate the economy. Several of our fund managers are looking to short the GBP via options that limit their losses but have high payouts if the currency were to depreciate.

Chart 2: Global Central Bank Balance Sheets Rates of Change

Chart 2: Global Central Bank Balance Sheets Rates of Change

Weather did have a real impact on the economy and financial assets this quarter. Hurricanes Harvey, Irma and Maria brought devastation to Houston, Florida and Puerto Rico. Recent nonfarm payroll data showed a sizeable impact from the storms. Maria brought about a humanitarian crisis within Puerto Rico. Already suffering from aging and underinvested infrastructure, Maria delivered a knockout punch to the territory. The storm, along with unscripted remarks from the President, wiped billions off the value of the territory’s already defaulted debt and most likely significantly reduced investors’ expected recoveries. Puerto Rico’s largest General Obligation Bond moved from trading at 60 cents to 38 cents per dollar owed. We suspect many of the people who are trying to leave the island will likely never return, quickening the pace of emigration already taking place. This will decrease economic activity in the territory and make the sustainable level of debt even lower than it is today. Puerto Rico was probably the worst offender of using a passive bond market and low yields to finance pension promises that could never hope to be fulfilled, but they won’t be the last. Connecticut, Illinois, and New Jersey must now pay spreads (i.e. higher yields) over higher quality state issuers, and the US has no real resolution mechanism to allow a state to reorganize their debts. We know people can vote with their feet, so if the states try to tax their way out of the problem, or decrease public education and infrastructure investments, people will likely leave, eroding the tax base even further. To say the least, we would advise our clients to avoid municipal debt from these states, as the pick-up in yield for these riskier issuers is not worth the risk.

While we talk about things that may happen, we are more certain that the Federal Reserve and other central bank balance sheets will start shrinking in 2018 and 2019, and that could affect asset prices. The Institute of International Finance (IIF) just published a beautiful chart (above) on the change in size of central bank balance sheets both historically and currently forecasted by central bank policy makers. While the Federal Reserve is the only one that is forecasted to begin shrinking, the rate of change for the ECB will go to zero, and Japan is more or less still increasing. However, net-net, by spring of 2019, the global central bank balance sheets will be shrinking for the first time. This, of course, could change. The ECB could decide to start selling assets before then as could the Bank of Japan. Or, in the event of very weak inflationary data, these could start growing again. However, the status quo is that the balance sheets will be in retreat and this could provide a head wind to continued asset price appreciation and lead to higher yields in government and corporate bonds.

Recent Posts

Leave a Comment

Contact Us

We're not around right now. But you can send us an email and we'll get back to you, asap.

Not readable? Change text. captcha txt