Quote of the Week
“The most important single ingredient in the formula of success is knowing how to get along with people.” – Theodore Roosevelt
Earnings season is starting to pick up this week. With the exception of a few negative surprises in the industrial space, early indications point to strong sales and earnings growth in the aggregate. Even though earnings growth should remain positive, some companies in the industrial sector are adjusting forward earnings estimates due to the tariff issue. From a fundamental standpoint, a flashing yellow sign is indicated because it appears that Mr. Trump and the Chinese are playing a game of chicken. Some projections are that the trade war could last a long time.
Last week the Dow was up 0.4%, the S&P 500 was flat, the Nasdaq was down 0.6%, and the MSCI EAFE was down 0.1%. For the year the Dow is up 2.9%, the S&P 500 is up 3.5%, the Nasdaq is up 7.9%, and the MSCI EAFE is down 9.8%.
Last week in Larry’s Thoughts we gave you some year-end tax planning tips. I received an email from Tom Herz, one of our clients, suggesting another valuable tax tip. Because of the increase in the Standard Deduction for 2018 to $12,000 for single taxpayers, and $24,000 for married taxpayers, more people will not be itemizing their tax deductions. If you wish to make a charitable contribution and are over 70½ and you are not going to exceed the standard itemized deduction amount, you should consider sending some or all of your required minimum distribution (RMD) directly to the charity from your IRA. Remember you must itemize to get the charitable deduction. By sending the donation directly from your IRA, you don’t have to pay taxes on the distribution, and you still don’t have to itemize deductions on your tax return.
We have done this for our clients in past years, and we will be doing it going forward. If you want to take advantage of this idea, please let us know, and we can make the arrangements. Please let us know before December 1st this year. Because this is a little more complicated, we will need more time to accomplish the process.
In last week’s Tech Corner, I discussed the coming crisis of the US growing debt situation. This week I was fortunate in receiving the best explanation of that crisis that I have ever read. If you read nothing else from me again, I strongly encourage you to read this. It is important to understand the dire situation our politicians have put us in.
One of my good friends in our business forwarded me this great explanation of the problem. Rather than creating my take on the debt situation, I couldn’t have explained it any better than Michael Drury. I totally agree with his analysis. If you want to discuss this problem further with me, just give me a call. I love talking about finance and economics with anyone who will listen.
By Michael Drury, Chief Economist, McVean Trading & Investments, LLC
The big news this week was that the US budget deficit for FY2018 had grown by 170/0 to $779 billion. The anticipated deficit for FY2019 pushes $1 trillion. This should not come as a surprise to anyone given that Congress passed a huge corporate tax cut at the start of the year and immediately followed with a hefty spending package, particularly for defense. The concern was much more muted back then as interest rates were still languishing at low levels — but after four rounds of Federal Reserve tightening and a commensurate rise in long rates to 3.20% on a ten year note, investors are becoming concerned about who will finance these swelling deficits. The increased government borrowing was supposed to pay for itself by stimulating stronger growth and growth is running at least a full percentage point stronger than before its passage. We will get a clearer reading next Friday when the first estimate of third-quarter growth is released, with estimates running between 3% and 4%.
In our view, stimulating an economy which was already operating near full capacity was never a good idea. The strength it has generated is raising operating costs and sowing the seeds of the next slowdown — which we expect will begin in 2019, well ahead of the consensus which sees sustained growth driven by continued fiscal stimulus. With the President now calling for 5% budget reductions from all his cabinet members, it is clear that spending — including military — will be restrained. This makes for a testy FY2019 if the Democrats take the House and the payoff for no impeachment was to be increased infrastructure spending or other pet projects.
Our biggest concern is that Treasury rates form the basis for all other rates in the increasingly risky debt structure of not only the US, but the entire world. Who is going to finance the additional burden of $220 billion in FY2019 — a 27% increase in fresh Treasury offerings compared to FY2018? But wait, there’s more —as the Federal Reserve moves to runoff its balance sheet, it has promised to increase its sales of Treasuries to $50 billion a month — increasing the pace another $300 billion annually from the current rate. We have worried for some time what would happen when it became clear that the Fed is issuing Treasuries in competition with — well, the Treasury. The world constantly worries about what would happen if the Chinese sold their Treasury horde. And, the fact that the Russians may have offloaded $100 billion in Treasuries in March through May explains some of this year’s rate rise. Will the President, who is already railing against the Fed, threaten their independence?
The federal debt doubled in relation to GDP in the 1980s on the Reagan tax cuts and defense increases. That increase was palatable only because interest rates were falling sharply after the Volker squeeze and because the Social Security surplus was swelling providing a ready buyer of Treasuries. A different Republican Revolution, led by Newt Gingrich and accepted by lame duck President Clinton, cut spending from 220/0 of GDP to 18% while taxes rose from 17% to 20% of GDP. This produced a brief surplus when businesses were investing like crazy in the late 1990s to preserve their viability on Y2K. The Bush 42 tax cuts of 2001 and 2003, renewed modest deficits — but until the Lehman crisis debt was relatively steady as a share of GDP. However, that crisis pushed Treasury debt above 100% of GDP — and the new deficit binge promises another surge from an already elevated base.
As noted above, the Social Security surplus has been a steady offset to the Federal deficit, as it bought roughly 2% of GDP worth of nonmarketable bonds every year from the 1981 Greenspan reforms through 2008. Since then their contribution has dropped to less than 1% of GDP and will continue to shrink as the Baby Boom retires. Pre-Lehman, foreign purchases of US debt by mercantilists in Japan and China led to $1 trillion plus holdings in both nations. Since Lehman, though they have maintained their holdings, neither has added to the pot. Despite ongoing trade surpluses with the US, both nations are now current account neutral as they spend their accumulated US dollars on oil and other goods elsewhere. In the immediate post Lehman period, it was the Federal Reserve who purchased the lion’s share of newly issued Treasuries — but now it is not only not buying, it is selling. Even the repatriation of foreign profits, which has returned $470 billion to date to the US, is likely a drawdown on Treasury purchases — as much of these funds were actually held in Treasuries or at US banks, where they created excess reserves backed by Fed held Treasuries. These funds have now been largely redistributed as stock buybacks and dividends. Are the recipients of those disbursements now holding Treasuries? We doubt it. Hence, risk free rates are rising.
We started working on Wall Street in 1982 just as interest rates began to fall. During our business career virtually every new high in the S&P500 has come with a lower ten year note rate. That trend lifted all riskier asset values as comparative safe returns declined. Unfortunately, that cycle hit bottom in 2013 as the Baby Boom began to retire and pull money out of savings rather than piling it in. Bottom line, the shift in Baby Boomers around the world from savers to consumers puts greater strain on interest rates for at least a decade ahead. If larger US deficits compound that trend by lifting the interest rate to fund what are still the safest of safe assets, than all riskier assets suffer in comparison.
As Danielle DiMartino Booth so eloquently espoused back in her July 10th epistle — “The Corporate Bond Market is Getting Junkier”. True investment grade debt is just one third of the market. Part of the reason debt has been rising relative to GDP, while the number of companies and equity shares available has been falling, is because debt is no longer safe and equity risky. The market has developed a huge spectrum in between satisfying all customers at their particular level of risk. Like in other parts of the economy, this is better than having just three car companies or three TV stations. However, it means the debt of today is not the debt of yesteryear — particularly as much more of globally available fixed incomes are in riskier EM nations or countries with significant currency risks.
Debt holders don’t get any of the upside if the underlying company underperforms, but they definitely lose out of it doesn’t. Thus, proper risk analysis is critical to pricing increasingly risky debt assets properly. At the top of the last cycle, investors were convinced that home values could never fall. They came to believe that repackaging the riskier parts of a repayment strip into separate tranches could produce higher quality returns as CDOs became CDO squareds. At the top of an economic cycle, investors will often believe six impossible things before breakfast. Anecdotal evidence convinces us that we are at that point in the cycle. As in boxing, the number one rule for investors should be “protect yourself at all times”. No one else will! Caveat Emptor.
Drury, Michael. “Weekly Economic Update Volume 87, Number 2 October 19, 2018” McVean Trading & Investments, LLC, http://www.mcvean.com/sites/426/uploaded/files/EU10192018.pdf. Accessed October 22, 2018.
By the Numbers
“JUST FIVE SURPLUS YEARS – The budget deficit for the United States in fiscal year 2018 (i.e., the 12 months that ended 9/30/18) was $779 billion. The USA has run a budget deficit in 53 of the last 58 fiscal years, i.e., 1961-2018. The only surplus years were 1969, 1998, 1999, 2000 and 2001 (source: Treasury Department).” – Michael A. Higley, BTN 10-22-2018
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These are the opinions of Larry Lof and Stephanie Mayoral and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is not indicative of future results. Due to our compliance review process, delayed dissemination of this commentary occurs.
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