Here in Milwaukee, the Fourth of July is kicked off every July 3 with a large-scale fireworks show held on the lakefront. The panoramic backdrop makes for quite a show in the night sky. Looking through the fireworks induced haze marking the celebration of another Fourth of July, I was struck by the parallels between staging a successful fireworks show and managing the current economic cycle. Both depend on sponsorship, signaling their audience and good timing if they are to be successful. Lack of any of these and you are likely to have less boom and more fizzle.
Both the fireworks display and the economic cycle need sponsorship. For the Milwaukee July 3 Fireworks, the legacy sponsor for over 40 years has been U.S. Bank, but not surprisingly as many banks are feeling a financial pinch and engaging in cost-cutting, this long-running sponsorship was canceled. Luckily other sponsors were found and the show went on. Similarly, in Washington, we are witnessing a change in the sponsorship of the economy. Whereas the federal government was the traditional sponsor through the use of fiscal stimulus, it has passed the baton to the Federal Reserve. The heavy debt burden of the federal government limits their ability to underwrite the risk to the economic cycle. Although, even the Federal Reserve is realizing its limits to ensure prosperity without pain.
With a single boom to start the show and the dramatic pause to reload prior to the finale, a successful fireworks show lets the audience know what’s coming. A good fireworks show through signals and choreograph can anticipate and orchestrate the crowds’ appreciative “oohs” and “aahs.” Hence, timing and pacing are critical to the fireworks show operator. A good pyrotechnician will keep their powder dry, rationing and saving the best for last, rather than risk too short of a show or misfires. There must be a steady build-up of sound, light and color to maintain viewer interest. The grand finale must be spectacular. It must end in exhaustion.
So too economic policymakers must send proper signals to markets and gauge the pace of the economy. Confidence is the main risk to promotors of the economic cycle. Interest rate policy and unconventional tools are their blunt instruments that are ineffective if investor confidence wanes. Communications from policymakers must ensure investors that risk-taking is underwritten. Early signals of interest rate policy accommodation can excite animal spirits. Accommodation must be maintained throughout the cycle. Any attempt to reign in speculation must be short-lived. Pausing or patience before the finale can be quite effective. The grand finale must be euphoric. It must end with a blow-off.
Late economic cycles are known for asset volatility. During the fourth quarter of 2018, there was a 20% drawdown in US equity prices followed by a record run-up in equity prices in the first quarter of 2019. The rally continued in April until it was disrupted by a 6% drawdown in May. July is on its way to record highs. Any doubt it is late-cycle behavior? The rare positive correlation of stocks, bonds and gold this cycle ensures a spectacular blow up at some point.
Last year’s volatility related to a gradual tightening bias on the part of the Federal Reserve. This year’s euphoria relates to their admission of a mistake and a quick turnabout to rate accommodation. The end of economic cycles often is defined by policy errors. Either the Fed erred in tightening late last year or is about to err in switching course. Time will tell which.
The Fed appears to be held hostage by financial markets. They are increasingly unwilling to disappoint investors and that sets a dangerous precedent for future cycles. Political pressure from the Trump administration further undermines their credibility. Risks abound from the uncertainty swirling around the global trading system to slowing global growth and non-existent inflation pressure. With US employment at a secular peak and domestic economic data relatively well-behaved, the Fed is hard-pressed for a justification to act.
Global pressures from the European Central Bank (ECB) and the Bank of Japan (BOJ) to lower interest rates could potentially lead to an unwanted appreciation in the value of the US dollar. With over $13 billion in negative interest rate foreign bonds outstanding, the U.S. stands as a relatively attractive place to invest. The outperformance and high valuation of US stocks relative to foreign equities is one indication of investor flows. The relative high interest rate on domestic debt relative to foreign debt is another. There is a risk that the U.S. may be attracting too much foreign capital.
The about-face by the Fed has repriced markets worldwide. The Fed must now deliver rate cuts or the reaction from the markets will necessitate even more rate cuts. They are about to succumb to the markets by surrendering to market pricing and political pressure. They have lost their independence and joined the expanding cast of market shills. The dual mandate of managing inflation and employment has been replaced by supporting the S&P 500. Market dependence has replaced data dependence in terms of developing policy. A break from market dependence will require the courage to disappoint markets. The courage to disappoint is not in the DNA of this particular Federal Reserve Board or its Chair, especially in a coming election year.
So, things will run hot until they don’t. It may take a lot to reach escape velocity in inflation with deflationary pressure so high. The Fed’s intent is clear. They feel the necessity of generating inflation to slowly reduce the debt burden. Ironically, by forcing real rates lower they are increasing the creation of debt making matters worse. Like their counterparts at the BOJ and ECB, a failure to generate inflation in the intermediate time horizon will reduce their policies to pushing on a string. In the short-term, there are some opportunities.
Shifts in Fed policy proved positive for emerging market debt in the second quarter as evidenced by several indicators:
- Over the past several months, performance for the emerging market fixed-income asset class has continued to be very strong, with spread tightening accelerating in recent weeks as risk assets rallied in response to expectations of Fed cuts;
- Emerging market investment-grade bonds continued their strong performance as the Bloomberg Barclays Emerging Markets USD Aggregate: Investment Grade Index returned +2.08% in June, +3.88% in the second quarter and is up +8.98% year-to-date as of June 30, 2019;
- Emerging market junk bonds performed well in June and have closed their performance gap with investment-grade emerging market bonds for the year. The Bloomberg Barclays Emerging Markets USD Aggregate: High Yield Bond Index returned +3.81% in June, +3.54% in the second quarter and +10.03% year to date as of June 30, 2019. Essentially, all emerging market high-yield bond performance for the second quarter occurred over the last four weeks;
- At 154 basis points (bps) as of June 30, 2019, the average option-adjusted spread (OAS) on the Bloomberg Barclays Emerging Markets USD Aggregate: Investment Grade Bond Index is 14 bps above the recent 10-year low of 120 bps observed in early 2018, and 47 bps above the all-time low of 87 bps observed in early 2006. Nevertheless, investment-grade emerging market bond spreads have fallen about 50 bps this year from a high of 196 bps in January. The index currently offers a spread pickup of 32 bps over the Bloomberg Barclays US Corporate Bond Index, slightly below the long-term average of 40-50 bps but well above post-crisis lows of +10 bps and a pre-crisis record low of -57 bps;
- Emerging market junk bonds continue to offer attractive absolute and relative value versus US high-yield corporates, with the Bloomberg Barclays Emerging Markets USD Aggregate: High Yield Bond Index currently offering an OAS of 533 bps as of June 30, 2019, near the highs of the year and 176 bps above the low of 340 bps seen in early 2018. The Bloomberg Barclays Emerging Markets USD Aggregate: High Yield Bond Index OAS was 156 bps over the Bloomberg Barclays US Corporate High Yield Bond Index at end of the second quarter, well above the post-crisis average emerging market risk premium of approximately 50 bps in the high-yield space as of June 30, 2019;
- Although emerging market bond issuance has been light for most of 2019, lower absolute yields have led to a recent pickup in activity, with sovereign and quasi-sovereign issues from Indonesia, Peru, Colombia, Panama, Qatar, Turkey and others appearing over the past month or two;
- In the investment-grade bond space, some of the best sovereign credit performers year-to-date has been Colombia, Malaysia, Indonesia, Uruguay and Russia. Mexico has underperformed the rest of Latin America, and state-owned Pemex (Petróleos Mexicanos) has dramatically underperformed the rest of the investment-grade market in spread terms;
- Pemex continues to present a significant fallen angel risk in our opinion, as the Mexican government’s rescue plans have been underwhelming and the recent resignation of its Finance Minister suggests significant dysfunction within the Obrador administration over economic and fiscal policymaking; and lastly,
- Although Turkey and Argentina remain among the worst sovereign performers year-to- date, the momentum for both has turned in a positive direction, with the two countries leading sovereign spread tightening during June. Argentina credit has responded to improved pre-election polling for Mauricio Macri, while Turkish credit has recovered on the decisive defeat of the ruling AKP party in Istanbul mayoral election.
What should we make of this ongoing show? Has the Fed kept enough of its powder dry to ensure the finale is a boom and not a bust? We appear to be witnessing the failure of central bank policies to promote a broader economic good. We seem headed to a disappointing fizzle if the Fed continues to follow the path of Japan and Europe by attempting to socialize the risk of debt default and democratize the process of choosing winners and losers.
The current bull market in stocks, like Independence Day, is a uniquely American phenomenon. It is born less from the free markets that we celebrate and more from our attempt to manage them. It may take until the smoke clears to know where exactly we end up.
To download the PDF version, click here: 2019-07 The Rockets Red Glare
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