Dear Clients and Friends,
April was a month which saw most global markets continue to rebound off their February lows. It was also a very newsworthy month where the Doha meeting failed to agree to terms on oil production cuts mainly due to Saudi Arabia’s fixation on Iran, Brazil started the impeachment process of Dilma Rouseff and the Fed maintained it’s current interest rate policy while leaving the door open for a June increase.
As you can see from the images below, P/E ratios for the S&P are still climbing, mainly as a result from falling profits. The Atlanta Federal Reserve maintains a forecasting model for GDP which they update regularly. The most recent forecast expected GDP for Q1 to be barely positive around .30%. They were close. On April 28th, Q1 GDP came out at +.50%, the weakest reading in 2 years. Shaky global markets and oil’s tumble resulted in the biggest business-investment slump in almost seven years, and household purchases climbed the least since early 2015, the data showed.
While Federal Reserve officials on Wednesday acknowledged the softness, they also indicated strong hiring and income gains have the potential to reignite consumer spending and propel economic growth. While labor markets and wage growth has been up slightly recently, there have been times when this resulted in higher inflation but muted growth. With growth expected to be anemic in the US and globally, we could see a period of inflation and stagnant growth (AKA stagflation). In fact, the IMF recently raised the warning signs of stagflation.
We still believe we’re in a cyclical bull market within a longer term secular bear market which started in 2000. In our belief, in order for a new secular bull market to begin, we’d need valuations closer to where they began in past secular bull markets such as in 1981. For that to occur, P/E ratios would need to drop to at least 11 as they have in past cycles. As you can see on the last chart, Q1 earnings releases (which are not yet complete as of the time of my writing this update) have shown an overall decrease of over 8% in the S&P 500. And while most will point to energy as the main culprit, energy companies only represent 38 companies in the S&P 500 and only 3 companies releases are included in these statistics.
Negative Interest Rates
As of the time of my writing this, there are around $8 Trillion worth of bonds that are negatively yielding and approximately $17 Trillion that yield under 1% in the world. While many economies have embarqed on a negative interest rate policy (NIRP), there are many people who believe this policy causes more harm than good. Joseph Stiglitz, recipient of the Nobel Memorial Prize in Economic Sciences in 2001 had this to say recently on NIRPs:
A decrease in the real interest rate on government bonds to -3% or even -4% will make little or no difference. Negative interest rates hurt banks’ balance sheets, with the “wealth effect” on banks overwhelming the small increase in incentives to lend. Unless policymakers are careful, lending rates could increase and credit availability decline.
There are three further problems. First, low interest rates encourage firms to invest in more capital-intensive technologies, resulting in demand for labor falling in the longer term, even as unemployment declines in the short term. Second, older people who depend on interest income, hurt further, cut their consumption more deeply than those who benefit – rich owners of equity – increase theirs, undermining aggregate demand today. Third, the perhaps irrational but widely document search for yield implies that many investors will shift their portfolios toward riskier assets, exposing the economy to greater financial instability.
Pension and Retirement Issues
The current Pension crisis is ever-evolving and nobody seems to be discussing it all that much. Members of the International Brotherhood of Teamsters requested to cut benefits to pensioners by 23%. Without the cuts, the pension argues it will be insolvent within 10 years. With them, it has a 50% chance of surviving another 30 years.
Private Corporate Defined Benefit Pensions look better, but are they really? Based on data from Milliman, one of the largest providers of actuarial products and services in the world, the picture isn’t pretty. Milliman maintains an index that tracks the top 100 corporate US pension funds. Here’s where the index stood on 3/31/16: $1.37 trillion in assets and $1.76 trillion in liabilities producing a shortfall of $390 billion and a funded ratio of 78%. It iss that the $390 billion funding deficit is close to its all-time high even though the S&P 500 is just inside of its all-time high.
Equally surprising are the assumptions embedded in future returns. In order to reach 100% funded status, the funds will need to earn returns of +11.2% per annum going forward. The base case, just to stay at the current ~80% funding level, would require +7.2% returns per annum, while their bear case assumes positive returns of +3.2% and would result in funding levels declining to 65%.
Clean Technology
While there are many things to be cautious about, it’s not all doom and gloom in the world. There are amazing advances in technology and medicine that are occurring as we speak. A company named Oscilla Power is trying to create an aqua-mill that can harness power from waves. They estimate this technology could supply clean energy to 1/3 of the U.S. Click here to watch their technology in action.
Lorax Redux
Lastly, I’ll leave you with a poem from Dr. Seuss’ The Lorax which has been cleverly adjusted for today’s central bankers.
“Look”, said the Ease-ler, “There’s no cause for alarm
I bought just one bond. I am doing no harm
I’m being quite useful. This thing is called Easing.
An Easing’s a Fine-Something-The-1%-Finds-Pleasing.
It’s a Bill. It’s a Bond. It drives global flows.
But it has other uses. Yes, far beyond those.
It can boost inequality and the suppression of risk
Or financial repression and bear markets in VIX ….
… I meant no harm. I most truly did not
But it had to grow bigger. So bigger it got.
I biggered my balance sheet, I biggered my ZIRP
I biggered my QE, I biggered my NIRP.
I biggered the yield chase, I biggered the needTo bigger the belief system on which it all feeds.”
I hope you enjoyed this month’s update. If you have any questions, please contact me directly.
Regards,
Jared Toren
CEO & Founder
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