December 2018 Commentary

  • December Fed Meeting: In the final meeting of 2018, the U.S. Federal Reserve elected to raise its target range for the federal funds rate another 0.25% to between 2.25% and 2.50%. This caps off a year which saw 3 such quarter point increases. After the steep stock market declines in October and November, many market participants began to speculate that the Fed would hold off on a final increase for the year. The White House (mostly the President via Twitter) expressed high levels of disapproval over this and potential further rate increases by the Fed. Some notable investors (such as Stanley Druckenmiller) also joined the fray, stating their disapproval over the prospect the Fed may raise rates further prior to the December 19th decision.

    • Our Takeaways: From a high level, further increases, while likely to slow an already tepid economy, are the sensible course to ensure there are enough options available to policymakers in the next downturn. There should be little, if any doubt, the ultra low interest rate environment we have enjoyed in the last several years has led to an increase in inefficient allocation of capital and abundant instances of malinvestment. These will need to burn off, through a significant correction, to ultimately improve the overall health of the economy and provide a strong base from which the next bull market can run.

  • Holiday Retail Sales: As mentioned in our previous note, headlines touted a strong start to the holiday shopping season. We dug into this claim further and found that things were not as exceptional as reported, and we stated that we would maintain a close watch on this indicator of consumer strength. Now, fully through the holiday shopping season, it appears the early predictions by industry experts proved to be true. November sales were up overall 4.2% year-over-year and non-store (online) sales were up a double-digit 10.8% year-over-year. Final count for the whole holiday shopping season saw overall sales up 5.1% year-over-year with between 4.3% and 4.8% expected, and huge double digit increase for online coming in at 19.1%. However, changes in sales were uneven across categories. Home Improvement and Clothing were the big winners, up 9% and 7.9% respectively from the last holiday season. Home furniture and furnishings were up 2.3%. Electronics and Appliances were the only major category to fall posting a 0.7% decline year-over-year. Despite a volatile stock market and a threatened (which turned into an actual) government shutdown during the season, these shopping numbers are a good indicator that American consumers at least believe they had plenty of dollars to spend. Also noteworthy during the season were several strong consumer confidence readings, however, things soured on that front in the post Christmas reading which saw levels fall back to where they were in July of this year after they had steadily increased this fall.

    • Our Takeaways: The takeaway from these numbers is exactly what was stated above - that U.S. consumers believe they had plenty of dollars to spend this holiday season. The big dip in the consumer confidence number right after Christmas is a bit worrisome, so that definitely leaves something of a cliffhanger going into 2019. Put another way, the question now becomes whether the recent declines in the stock market, trade tensions, and political uncertainty in Washington (just to name a few) will cause American consumers to shift away from consumption and focus more on saving as we enter 2019. We think a major theme in 2019 will be liquidity in the global system, so at least and so far as U.S. companies are concerned, it may not take some kind of negative shock to their consumer base to have a significant negative impact on profits. U.S. consumers simply choosing to allocate more of their income to savings may be enough to take enough liquidity out of the system to harm some of the less healthy companies. The opposite may also very well become the case. Coming off the recent tax stimulus and seeing stock portfolios, home equity at very robust values, and employment rates at historic lows certainly could be enough to keep consumers encouraged to maintain or even increase spending going into next year, thus continuing to bolster profits.

  • U.S. Home Mortgage Debt: Equity levels for U.S. homeowners continue to climb as U.S. home prices peak (in most markets substantially above pre-2008 levels) and mortgage debt stays below the 2008 high. Mortgage debt measured as a percentage of disposable income and GDP is also going notable lower despite the two denominators not increasing substantially. The 30-year fixed mortgage rate has also pulled back slightly after increasing from 2017 lows of around 3.7% to a 2018 high of a little over 4.8%.

    • Our Takeaways: This points to a good position/trend in overall household leverage - at least as mortgage debt is concerned. We have noted previously the U.S. housing market, despite spectacularly high prices, seems to be on much more solid ground than what we saw in the run up to the housing crisis. That is not to say that shocks from some other corner of the market could not make their way into housing, but at least in terms of available mortgage data, the average household appears to be in a better place. Affordability has been a big headwind this cycle for the housing market, and higher interest rates have been pricing more and more would be buyers out of the market. What the FED moving forward with 3 rate hikes this year, while simultaneously tightening their balance sheet at a rate of $50 billion per month, the downward turn in the 30-year mortgage market comes as a bit of a surprise.

  • U.S./China Trade Deal: Coming out of a meeting at this year’s G20 summit, the U.S. and China have agreed to “pause” further aggression in their trade dispute to work towards a set of yet-to-be-defined mutually beneficial goals. In the weeks since, it does not appear there has been much, if any, definitive progress towards putting more substance to what a further deal between the two countries could/would look like. The U.S. was set to increase tariffs on approximately $200 billion worth of Chinese goods on January 1st from the current 10% levels to 25%.

    • Our Takeaways: The first test of this “pause” will be to see if it lasts the full 90 days that it is slated to last. The second test will be if either side takes any substantive steps during the 90 day period to reach a broader agreement, or if things will just come to a head in the final hours when the truce is set to expire. Stepping back and looking at the big picture, China is likely to search for some deal whereby they can keep their economy moving long enough to retool so they no longer are as dependent on the U.S. (i.e. Made in China 2025, Belt and Road, etc.) and the U.S. is likely to seek a deal that involves protecting the intellectual property of U.S. companies who try to enter the Chinese market. Of course, it is unlikely that either side will get everything they want, but it is probably less likely the Chinese will agree to a deal that resembles what the U.S. wants closely enough to really consider it a win. The Chinese economy (and by extension its growth in recent years) has largely been predicated on its ability to, at a government supported level, copy or outright steal foreign intellectual property and reproduce it cheaper with domestic labor. It is unlikely they will ever verily give up this strategy considering how well it has worked for them, but for the Chinese economy to really surpass those of more developed nations, such as the U.S., they will need to actually develop goods and technologies that are truly novel. We suspect, however, the Chinese government has come to this conclusion as well which is way they are making significant investments in a variety of different areas such as AI and infrastructure.

  • Brexit Update / U.K. No Confidence Vote: In early December, the United Kingdom parliament held a vote of no confidence for Prime Minister Teresa May which failed by what many considered a very narrow margin - 117 to 200. This narrower than expected (although, expected is probably not even the best word seeing as the only reason the vote was held in the first place was because there were enough of those in the government who wanted to vote her out to have the vote in the first place) victory for May casts her leadership into an even more precarious position just months away from the Brexit deadline on March 29th, 2019. Currently, May has worked out a deal with the EU whereby the U.K. could have a somewhat orderly separation from the Union. Yet, this plan has been met by nothing short of contempt from many members of parliament, and so is likely to never come to fruition. For now, May is still trying to work out a solution for the U.K. that will be acceptable for both the EU and her government, but there have been few, if any, encouraging indications that a suitable deal will be reached.

    • Our Takeaways: The bottom line, as things currently stand, is that there are no great outcomes on the table for the United Kingdom. Even an orderly break up plan will likely prove to be detrimental to the U.K. economy to some degree, with the less orderly options increasing the damage by orders of magnitude. Already, the U.K. housing market is showing near 2008 levels of instability with supply, demand, and prices all falling. Market based inflation measures have been persistently higher which is a likely signal that participants are going increasingly uneasy about the economic uncertainty. Employment has remained somewhat of a bright spot for the time being, but early estimates put job losses around 750,000 in the “No Deal,” hard Brexit scenario. Another point to note is that if there is no deal in place by March 29th, the music won’t just stop economically speaking. Built in to the process is an almost two-year “transition period” that essentially maintains the status quo until December 31st, 2020. This is not a ton of time (especially given how far reaching the economic shocks will be in a “No Deal” scenario), and market are sure to look very disapprovingly on the uncertainty during this period, but at least it's not as if the U.K. will be driving off an economic cliff.

  • Gold v. Palladium: In December, spot prices for palladium surpassed those of gold after gold has enjoyed a 16 year run as the most expensive commodity. Each metal is currently trading for around $1,200 per ounce. Palladium has been getting a lot of attention in the media because of this, but its rise really started several decades ago. With emission standards on motor vehicles becoming pervasive since the 1970s, palladium has seen a steady increase in its demand since 80% of the global supply of the metal is used for catalytic converters. Additionally, as Europe has largely shifted away from diesel vehicles in recent years, global demand for the metal has increased at an even faster rate. However, the recent price increases have more likely been due to supply side constraints. South Africa and Russia are the two largest producers of the metal since it is typically a derivative of other precious metal mining operations such as those for platinum and nickel. There have been a string of political and labor related issues at some of the largest mines in both of these countries, so this has caused, at times, extraordinary constraints on the market.

    • Our Takeaways: This has been an interesting economic story to watch unfold over the last several years. Platinum, a metal commonly thought of with palladium, spent the better part of the first decade of the 2000s tracking the price movements of palladium in near perfect lockstep. The relationship broke down towards the beginning of the decade prompting many to believe there would be some kind of mean reversion in one of the markets to bring the two back together. Moreover, the relationship really began to breakdown around 2015 and the divergence seems to have accelerated since then. Palladium’s comparison to gold is equally as interesting. Gold typically is not used as frequently in commercial applications and certainly the demand for gold is not so heavily skewed towards commercial need as palladium. Gold, at least nowadays, is thought more so as a store of value or a speculative instrument with the market for the physical commodity being relatively robust. This is not the case with palladium where a market solely interested in betting on and exchanging the value of the commodity for investment purposes exists. Overall, there are several exceptionally interesting outcomes that could come from the extreme dependence on this very precious metal. The most obvious is a question as to what will happen to the prices of other precious metals, such as platinum and nickel, that must be mined in order to mine palladium. If their increasing supply cannot be absorbed by the global market, then one would expect to see forced price decreases due to oversupply. Another question would be what effects could more specific/efficient mining technology have on the output of palladium and the cost of output. Similar to what we have seen in the oil markets with the U.S. adoption of hydraulic fracturing technology which has lowered cost of U.S. production, increased U.S. output, increased global supply, and (at least for the time being) lowered global prices.


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