October 2018 Commentary

  • Bank Shares Underperforming: Recently, the banking sector has begun to significantly underperform the broader market. Despite maintaining a relatively high correlation throughout the past year, as the Fed has begun to increase the short term interest rate target, banks (particularly smaller, regional banks) have slid in value. Areas that have been raised as particular concern, and thus explanations for the recent declines, include slowing loan origination growth due to higher rates and soft property markets. However, this underperformance has remained moderate compared to that of other sectors since the financial sector as a whole (while declining through the relevant time periods) has remained in the middle of the pack compared to the other constituent sectors in the S&P over 1 year, 6 month, 3 month, and 1 month time periods.

    • Our Takeaways: Typical wisdom would dictate that higher rates would be a net benefit for banks. Specifically, a rising rate environment where its average cost of capital (rates it has to deliver on deposits) will lag its price of capital (interest rates given on new loans). Additionally, as rates rise, the spread between deposit rates and loan rates will rise, or at least there will be more room for the spread to rise, which is akin to increasing gross margins for a bank. However, in this cycle there is one big reason why the typical wisdom may not hold. Since the 2008 financial crisis, there has been a large shift away from homeownership in the United States. Peak homeownership was in the fourth quarter of 2004 when 69.2% of Americans owned their home. The most recent reading in the second quarter of 2018 has homeownership at 64.3% which is up from an all-time low reading in the second quarter of 2015 which sat at 62.9%. The 2004 high to current represents a 7.08% decline in homeownership which could prove to have substantial longer term implications on new loan growth prospects if this trend of lower homeownership continues. The two biggest supporting factors that would cause this trend to continue are decreasing home affordability and flat wages. Houses have now become less affordable than were prior to the financial crisis and this trend does not seem to be showing any indication of abating. Lower home affordability is driven in part by higher prices (most major MSAs have seen home values return to pre-recession highs) and higher costs of construction. Higher prices have been fueled by low inventories (which are in art caused by higher costs of new construction) and the industries overall disinterest in single family homes recently with construction since the financial crisis favoring multifamily apartments. Rising costs of construction have been driven by higher input costs both from materials (due to tariffs) and labor (due to shortages in the labor market). With mortgage rates rising as affordability declines and wages remain flat, this indicates a reinforcing cycle continuing the trend away from homeownership unless one of the underlying factors can begin to move in a different direction.

  • German Industrial Production Slowdown & Economic Outlook: German industrial production has been declining and a recent reading showed production posted a negative year over year decline after failing to gain some traction. This, combined with reports that inventory levels are rising, points to even more weakness in the production areas of the German economy. In a political signaling of this weakness, German Chancellor Angela Merkel proposed a new model for the European Union to use when evaluating corporate organization and antitrust regulation of EU companies. Europe has favored the U.S. model of encouraging a competitiveness of firms in as many major industries as possible, with the government intervening when one or a handful of powerful players begin to dominate (and thus decrease competitiveness) an industry. Merkel’s proposal would encourage mergers between European companies in order to promote their competitiveness on a global scale at the expense of the competitiveness in the regional (in this case, European) market. This shift would be more in line with the Asian model where a few, sometimes only one, often state-sponsored company dominates a given industry.

    • Our Takeaways: What Merkel is proposing is so clearly bad economic policy, it is difficult to not see the underlying reason - the struggling German economy. Relative to the rest of the EU, Germany is still doing exceptionally well, so it is likely that German companies will benefit the most from a shift to this kind of policy. Having the strength and resources, German companies would be able to roll up smaller, less powerful competitors within Europe, thus creating a more powerful, but inexplicably German company. While, in theory, this approach could prove to be the tailwind the German economy needs to start moving in the right direction again, it is very telling as to the state of European cohesion (or lack thereof) that Merkel would propose a policy shift that could prove to be so detrimental to the rest of the EU and so openly self-serving to Germany. Germany seems to have woken up to the idea that the EU arrangement is losing its benefit for Germans, and has started exploring options to maintain its global economic standing. Germany is the world's 4th largest economy, but almost 50% of its GDP is export based. The German home market, while prosperous, cannot come anywhere close to meeting the demand that Germany finds in the global market for its goods. The German economy has been geared for a very long time to protect its firms from competition, so this has bred large, slow moving, 1950s style corporations that are poorly equipped to address rapidly changing global markets. Unlike the U.S. which, through a combination of a highly competitive, innovative business community and a large domestic market, has been geared for decades to produce disruptive firms such as Apple, Amazon, and Google that are capable of growing to a global scale, German firms by contrast are not set up for that kind of success. Now, it is too late for Germany to feasibly make a shift to this kind of economy without having to first experience decades of international irrelevance. The negative consequences of Germany retooling its entire economy alone might prove to be more than the collective European market could bare since so much of Europe’s recent stability is due to Germany. Even if a shift to a more innovative German economy was well received by the rest of Europe, this would be a huge gamble on the stability of the already fracturing EU. Without a cohesive market for German start-up firms to grow in the size of the EU (which is comparable to the U.S. market) it would be very difficult for those companies to grow to a global scale solely on the back of the German domestic economy. How German handles the weakening of their economy will be a huge determinate in future European growth, and to a certain degree global growth, so it will remain area to watch closely for the next several quarters.

  • U.S. Jobs & Wages: Headlines recently have been filed with the recent consecutive records that have been set in U.S. job openings, hires-to-openings, unemployment, voluntary quit rate, and a handful of other job related indicators. There has undoubtedly been real strength in both the demand for labor and the response by both firms and individuals of getting people in the workforce, off of unemployment, and back into the working world. However, wages are still flat (which we have already addressed and we will go into further detail on in other section) and despite what seems like a significant uptick in a willingness to work, firms are still complaining they are unable to fully meet their staffing needs with qualified workers.

    • Our Takeaways: Given the aforementioned job related economic data, mainstream economists and economic commentators are continuing to push the narrative that the labor market is tight and continuing to tighten, and as a result, there is an expectation that wages will increase. This narrative fails to incorporate two factors. One, there are a significant number of able bodied Americans that are not in the workforce. The labor force participation rate is low, currently sitting at 62.7%, which means there is a large portion of the population that could potentially enter the workforce. Second, firms, particularly public companies, are highly incentivized to lower hiring standards rather than increase wages. Corporate profits have been enjoying a nice run since the 2008 financial crisis, but looking forward they face several significant potential headwinds, not the least of which may be higher labor costs. Certainly when weighing the prospects of protecting profitability versus lowering hiring standards, it seems increasingly likely firms would chose the latter over the former.

  • Update on Coffee Prices & the Larger Picture in Brazil: Last month we talked a little about the rout in coffee prices that had been happening the last few months. However, recently there has been a significant turnaround both the coffee bean and sugar markets propelled by a strengthening Brazilian real. This remarkable turnaround seems to be the result of the current polling in Brazil’s presidential election which has the ultra- conservative candidate, Jair Bolsonaro, pulling away with a commanding lead. This would mark a big political shift for Brazil which has had a socialist, workers party in power for some time now. The Dollar has remained strong, particularly compared to other emerging market currencies, so this weakening against the real does point to a specific factor (such as the elections) as a driver. As of 10/28, Jair Bolsonaro was elected as the next President of Brazil. This will likely solidify the trends we are analyzing in this section.

    • Our Takeaways: Jair Bolsonaro is a very far right, ultra-conservative candidate who has been preaching an alarming message of law and order during his campaign. His running mate, a former Army General, has openly commented to the press that he believes a military coup of the government may be an appropriate response to the corruption and disorder that has prevailed in recent years. While on their face, these types of facts may seem odd or even concerning coming from a leading presidential candidate, the fact they are so well received by the Brazilian people just goes to show how poorly things have been going in the country. Crime is a very pervasive issue in Brazil, particularly due to its proximity to the world’s top cocaine producing nations of Columbia, Peru and Bolivia. Drug and gang related violence has spilled over into Brazil causing it have a homicide rate nearly 6 times higher than that of the United States - 29.9 per 100,000 compared to 5.3 per 100,000. Given this chaos, it is a little less surprising the Brazilian people would turn to such an extreme leader, but his rhetoric proved to be comforting to enough people that it won him the election. Now, if the trends we have already seen develop continue, we will see an oddity in economics where market participants will react positively to events that may not always be politically, ethically, or even morally favorable. This particular geopolitical event is a nice reminder that any thorough analysis of economics or markets must be conducted through a lens of objectivity with a focus on the underlying fundamentals and psychology, and a temporary suspension of some larger, philosophical lines of inquiry.

  • U.S. Household Net Worth & Looking Ahead to Consumer Spending: United States household net worth as measured by a percentage of disposable income has increased dramatically since the end of the 2008 financial crisis as housing markets and the stock market have recovered, and in some cases increased, substantially. Currently, household net worth as a percentage of disposable income sits just over 690% percent, which is up from the low reading of 533% in 2009. Convention (and history) would hold that such an increase in household net worth should spur further consumption (and thus lower savings), but this time around it has failed to do so. In fact, the savings rate, after having risen substantially during the most recent recession, has on net continued to rise in the post-recession period. The savings rate rose from a pre-recession low of around 3% to a post-recession high of almost 10%, and has recently settled around 7%. Many economists are using this as an example of how consumer behavior was changed during the last recession arguing that many people were encouraged to save more for when economic times are not as good after seeing so many people lose their jobs and homes.

    • Our Takeaways: This will be an interesting point to watch going forward. While we would tend to agree this is strong evidence that overall consumer behavior was changed in the wake of the last recession, it does not necessarily follow that people are doing as much to protect themselves in other aspects of their financial lives. While a higher savings rate is good, these are not substantially high measures by any stretch of the imagination. Take for example the median US household in 2016 which the Census reported brought in $61,372. Even with a 7% savings rate PRE TAX, this household would only be tucking away $4,296.04 annually which would likely not go very far in the event of a medical emergency, layoff, or other significant life event. On the net worth side of the conversation, it should come as no surprise that a large portion of the increases from many households net worth have some from gains made in the stock market. Unfortunately, since these gains are exposed to downturns which at this point in the market cycle are likely to be significant, consumers may see their net worth decline rapidly which further discourage consumption which would in turn put further downward pressure on the economy.


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