Updates on the Fed and Repo Market Activities: January was a relatively busy month for the Fed. In the final week of the month, the Fed’s FOMC voted to leave its target range for interest rates unchanged following the series of cuts it made last year. During his post meeting press conference, Chairman Powell delivered remarks that were seemingly well received by the markets regarding the Fed’s outlook on policy for the coming months. Their view is essentially that things seem to be fine and they are monitoring the impact of the rate cuts before making any further changes. Behind all of this relative calm, the Fed plowed well over $100 billion into repo markets during January to provide liquidity and stability for yet another month. Also notable during the month were market expectations for further cuts (the market implied probability of two cuts for this year rose from around 40% to around 85%).
Our Takeaways: The outsized uptick in market implied probability for further cuts is the big "story" if you can call it that relative to the Fed and will likely remain noteworthy if the probability remains near this level for a prolonged period. The idea that the market is in some sense asking for further rate cuts on top of what has already been done is a little concerning. Whether the Fed will do anything about it is another issue entirely, but if probabilities remain elevated it creates a heightened downside risk that the market has its expectations let down. If the overwhelming expectation (as it seems it currently is) that we should expect two cuts this year and we receive one or none, that could be viewed by the markets as a big letdown. Otherwise, the continued repo activity certainly remains a growing concern. In what is being deemed “Not QE” as a joke about the Fed’s repeated insistence that their repo market operations are not a form of quantitative easing, the Fed is certainly providing support for the markets that looks very similar to that seen from quantitative easing. Relying so heavily on this tool in the “good times” may not work out so well when things aren’t so good.
Hold the Freight: With December’s numbers coming in negative once again, the decline in shipments solidified its worst year in a decade. There have been little to no positive indicators for increased activity since towards the beginning of 2018 with just about all sub-sectors (i.e. railcar, air, etc.) and measures (i.e. volume, expenditure, etc.) falling. Historically declining shipment metrics has been a negative macroeconomic sign, but many analysts have pointed to the series of trade related disputes globally - mostly led by the United States - as being the signal largest contributing factor. This very well could be the case which makes using, or interpreting, this metric much more difficult.
Our Takeaways: This is something we touched on in a letter a few months ago, but shipping volumes are getting crushed with no rebound in site. As stated above, this historically does not bode well for the economy. Although, as we pointed out in the previous note, the U.S. economy has made a significant shift towards service-based work, so a focus on shipments is not necessarily as an effective metric as it may have once been. However, it is hard to say that by any stretch of the imagination that declining shipping volumes is a good thing for the economy. It will be interesting to see what, if any, changes the U.S. and China’s “Phase 1” agreement will have.
U.S. 2019 Fourth Quarter and Full Year GDP: The good news is that the U.S. economy managed to squeeze out an over 2% growth rate for last year with GDP coming in at 2.3%. However, things slowed down slightly in the fourth quarter with GDP only posting a 2.1% annualized rate. A more detailed look at the component factors showed that consumer spending remained a strong factor with net exports serving as the other large positive factor, while business investment and inventories continued to be a drag for GDP in the fourth quarter.
Our Takeaways: The turnaround in exports was definitely a huge help. Without this component we would not have seen above 2.0% growth. Consumer spending ticked down again though, which is not a great sign for a 4th quarter number in this category. We will continue to monitor this because further deterioration (devoid of other factors stepping up) could cause us to see sub-1% growth. And the trade component was simply due to a huge drop in imports - not an increase in exports - which is not necessarily a positive thing. This exposes one of the flaws in the logic behind how we calculate GDP.
Is the Market Bullish or Bearish on Money Losing Companies: The title of this section might seem like an odd question, but it is one many market commentators are having a difficult time answering right now. In the bullish camp, many analysts point to companies like Tesla (NASDAQ: TSLA) which, despite two consecutive quarterly profits now, has been losing money hand over fist. More generally, these analysts may point to the strength in IPO new issuance as a sign that money losing private companies aren’t afraid to subject themselves to the public markets. In the bearish camp, analysts point to examples such as General Electric (NYSE: GE), the 100+ year old industrial conglomerate who has seen its stock price get hammered as it has tried to navigate the costly (and yet to be profitable) restructuring of many of its core business units. Or they point out that, while recent IPOs have seen some strength, it has not been an enjoyable experience for companies once going public, citing examples like Uber (NYSE: UBER) and Blue Apron (NYSE: APRN).
Our Takeaways: There are certainly a couple very noteworthy factors at play here. One factor is the big, sexy company losing money is ok as long as it has a cool growth story. Basically, if Elon does it then all the cool kids on Wall Street must be doing it too. There is at least some semblance of logic behind this. It is, at the very least, easy to see how a company like Tesla might be a paradigm shift for an entire industry - and not a small one at that. If they were ultimately able to capture a large share of the new way humans would get from point A to point B on a daily basis, then that would be unquestionably very valuable. On the other hand, an old guard company like GE seemingly possessing all of the same possibility (who would categorically disagree that a huge technical/industrial conglomerate would be capable of producing paradigm shifting technology?), but without the same sex appeal so it is not a function of size alone. The second factor is small companies are getting their lunches eaten. Over the last several years there has been a noticeable crowding out occurring in terms of profitability, and probably more importantly, recruiting. Incentives, such as benefits - healthcare in particular - have become so expensive that the price of poker has become too high for any firms to play below a certain size. This leaves the hiring advantage to the bigger players as the player firms have to get more creative or settle for lower quality talent. This is a snowballing effect with no end in sight at this point. The perpetuation of the lack of competitiveness, or at the very least the perception that markets are less competitive, is what (maybe in part) has led to a growing din of antitrust whispering from Capitol Hill.
Fallen Angel Risk in the Next Downturn: Bank of America recently released a report examining what kinds of shake ups we could expect in the investment grade bond market during the next down turn. Their team found, in their estimation, limited downside risk of “Fallen Angels” which in this context refers to companies who have their credit ratings lowered to below investment grade. This is an important factor for companies because many investors in “investment grade” (i.e. companies with credit ratings considered to be good, or at the very least, acceptable) either cannot or will not invest in companies, or more specifically their bonds, if they are rated below in a category generally referred to as “high yield” or “junk.” Currently, about 50% of all investment grade bonds are in the BBB category which is just one step away from high yield status. This proportionality is a record that was reached last year, but strikingly only 0.3% of bonds were downgraded from BBB to high yield status. The BoA team explained this occurrence with the following statement, “this is a testament to the resilience of large BBBs that are both willing and able to defend their IG ratings.” However, the opinion of the Bank of America team is far from consensus on Wall Street. Several other firms have expressed opposing opinions to the effect that Fallen Angel risk is actually rather large - especially in a recession scenario. This topic has even received attention from the New York Fed and IMF which have both categorized the risk of downgrades in corporate credit markets as being noteworthy for the stability of financial markets.
Our Takeaways: The opinion put forth by the BoA team, specifically the point that companies will fight for their investment grade status seems a bit ridiculous. The idea that companies will fight for, or “defend,” their investment grade rating is a little odd. Shouldn't they be fighting for more than that as it is? A company’s primary goal (at least in the classic economics since - not this new age version that has begun to float around that suggests companies should focus on other factors besides profits) is to maximize shareholder profits, so to suggest that only once the going gets tough that these already recognized to be suboptimal performers will step up and deliver doesn't make a whole lot of sense. In addition, one of the key underpinnings of a recession is it is an exogenous weakening of economic forces - by definition something that is out of the control of these companies. Now, it may be true these companies will "fight" to keep their rating, but only insofar as they are fighting with the rating agencies - similar to what was seen with mortgage bond issuers through ‘07-’08. The ratings agency model as a whole still has a lot of credibility that needs to be gained back since the GFC. The opinion that this is in fact a risk seems to strike a truer chord against the backdrop of the data. One interesting point worth highlighting again is the proportion of BBB investment grade debt relative to the full universe of IG, and then the amount of that which was downgraded last year (0.3%). Now, it is entirely possible that there is a suitable reason that explains why so much of the investment grade market is rated BBB such as how the rating models force rank the universe of bonds into certain proportion sizes buckets (i.e. there can only be 5% A, 10% AA or AAA, etc.). However, we know this is not the case because bonds are rated on an individual basis. The low downgrade percentage is slightly more understandable on its face. Last year was relatively good for business, certainly not significantly bad, so the idea that not many businesses would have experienced the kinds of challenges or setbacks that would warrant a downward rating to their credit risk is somewhat reasonable. Still, it is only possible to suspend disbelief on this idea for so long because, and despite a high number of downgrades from other IG categories, the proportion drops off noticeably once you get to a point where a downgrade represents a structural change to the investment quality of the underlying company's bonds.
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