Q3 2019 Market Update

October 31, 2019

Q3 Highlights

  • Relatively flat quarter for stocks

  • Strong bond market returns on declining interest rates

  • Trade tensions continue but we have a “Phase 1” deal

  • Trade tensions likely have kept GDP restrained to a near 1.8% annual pace

  • Repo rates go crazy and create a FED conundrum

The third quarter continued this year’s steady climb, albeit at a slower pace. The Wilshire 5000 Stock Index added 0.73% while the Barclays Aggregate Bond Index added a very solid 2.36%. This moves stock returns over 18% for the year and the aggregate bond market over 8%. *(Source Folio Institutional Custodial Reporting)

Going forward we still expect a continued battle between interest rates, trade policy, and political sensitivities to shape near term results. Long term we believe companies and markets will adjust and continue to reward the patient investor with fantastic results.

“Phase 1” Trade Deal

The last few years have been a soap opera-like scene with regards to trade deals. From China to Mexico and pretty much everyone in between the saga has gone through many twists and turns. Regardless of your political affiliation, one thing always rings true…markets like certainty. The ability for a path…any path to be laid out will provide tremendous comfort to companies around the world and the market in general. Many companies have slowed plans related to international growth while tensions and plans get worked out. Even so, it is important to note that trade from the US to the world has been rising for many years. In the past twelve months, exports and imports of goods and services combined have been $5.65 trillion, versus $5.63 trillion in calendar 2018, $5.26 trillion in 2017, and $4.93 trillion in 2016. Even without deals, trade could be hitting a record high this year.

While we are not out of the woods by any stretch, it does appear we may be wrapping up some loose ends and getting the groundwork for some finalization. We have long contended some sort of temporary deal had to happen before the 2020 election cycle gets underway. It benefits both the current administration and China (among other countries) to have a “temporary” deal in place. It is almost certain that this deal will be re-examined after the election and we may find a repeat of trade turbulence again in 2021. However, it is important to remember that regardless of the short-term turbulence or who gets elected, the US economy has been extremely resilient and will continue to adjust to the deals placed in front of it. While these deals will alter structural frameworks and create adjustments for corporations, the economy as a whole can usually pivot in accordance and get back on track….as long as we have a track…a deal that we can follow. We are optimistic that positive discussions will continue throughout this year.

Slowing Economy – For Now or For the Future?

Numbers for the 3rd quarter GDP declined to a 1.90% annual growth rate. It continues to confirm a tug of war between a strong consumer base and lackluster business investments. While we remain in a healthy economy that is growing slow and steady, the concern around future trade and future regulations has caused many businesses to pause on spending. Much of the economy (roughly 68% of GDP) is fueled by consumer consumption, which has remained strong and is being fueled by record unemployment near 3.5%. As long as we see unemployment remain low we see the risk of a recession as somewhat muted due to strong consumption. However, the 15% drop in business spending on factories and offices continues to point toward economic restraints stemming from ongoing trade tensions. We are not sure how a “phase 1” trade deal and continued delay of the USMCA deal will affect the economy. I believe most companies will take with a grain of salt, continue to keep business investment lower than normal with an expectation for future trade turbulence post-election. It is unlikely that the current positive trade discussions will give companies enough finalization to feel confident building new factories or expanding in any direction (domestic or international). This uncertainty around trade is a restraint (likely temporary) to an otherwise healthy economy.

The China trade deal alone is likely not enough to push us into recession in and of itself; but when coupled with an inability to finalize the USMCA (United States, Mexico, Canada) deal, the economic headwinds could become very strong. It has been a year since the Executive branch agreed to the USMCA deal and yet we need the House of Representatives to originate and approve the deal to move forward. Consumer spending has supported and done the heavy lifting for our economy thus far but will need some help eventually. Business Investments make up roughly 19% of our economic activity and it would be nice to get added growth contribution from this segment to help offset our extreme reliance on consumption. These 2 variables combined makeup almost 90% of our economy and are extremely connected. Companies investing, building factories and offices create stability of jobs and increases consumption. If we see a prolonged business investment decline we will eventually see unemployment rise and consumption start to dip. In the short run, the accommodative Federal Reserve policy (low interest rates) and still healthy corporate profits can keep the economy in slow-growth mode at around 2%. In the long run, if we get real finalization on the trade deals we could see an acceleration back to 3% or more growth. However, if we do not get enough clarity for companies to feel confident and they decide to clamp down, we will likely continue between 0 and 2% growth for some time and potentially risk slipping into a recession. Our expectation is for a continued tug of war to take place, continued monitoring and action from FED to sustain as needed, clarity and deals slowly getting done with an ebb and flow of GDP growth around 2%. Rest assured we are monitoring very closely.

The FED, Crazy Repo Markets and a Conundrum

Behind the scenes of our banks is a little followed market called the Repo Market. The repo market is like plumbing for the U.S. financial system, making sure banks have enough cash to meet their short-term needs. A repo trade happens when a firm offers high-quality securities, like U.S. Treasury’s as collateral to finance trading and lending activities overnight. The borrowers the next day pay back those loans, with interest — essentially, they repo the bonds.

While very complicated in process, let me try to summarize it in a simple form.

  1. You give money to a bank

  2. Bank (dealer or works with dealer) trades money with the central bank (Federal Bank of NY)

  3. Banks hold “safe” Treasuries …Bonds so that they can make money on your money!

  4. Money markets, Hedge Funds will buy/borrow bonds from bank/dealers short term and give bank/dealers cash which helps banks get the cash they need…so you can make that large withdrawal

  5. Banks will buy/take back the bonds from Money Market Funds or Hedge Funds the next day or so and pay cashback with some interest

In this way, the bank makes money on your money. It can transition into cash at any point to get you your money back and safe money market funds can get a very certain interest return for buying (actually borrowing with a collateral payment agreement) the bonds very short term and giving back to banks.

This is the plumbing underneath ALL financial markets globally! This was the plumbing that sprung leaks and eventually exploded in 2008 that created the meltdown and this is the plumbing we keep an eye on to see if we should be worried about that doomsday scenario. This is the real risk of the financial system, NOT ups and downs in the stock market, politics or a recession.

We were a bit concerned in September when we saw the overnight repo rate spike. Rates at that time were supposed to stay within the FED interest rate range of 2-2.25%. Yet a shortage of liquidity (desire for funds to buy treasuries from banks) caused overnight lending rates to spike as high as 10% very briefly. This jump caused the FED to intervene in the repo markets for the first time since the great recession. Looking at our simple version above, not enough money market funds (most closed in 2008), hedge funds and investors were willing to buy treasuries from the banks at 2-2.5%. As a result, the FED stepped in and purchased the Treasuries to bring rates overnight back in line. Furthermore, the FED has had to remain active in buying up treasuries to keep the rate in line because there are simply not enough buyers of treasuries. This is happening as a result of many factors including regulatory needs for cash due to higher bank regulations and stress testing, large treasury auctions to finance massive government debt, inverted yield curve, currency carry trade and problems from negative rates overseas, lack of international treasury buyers since we have stronger exports (flipside of exporting more), among others. The bottom line: a lack of buyers for treasuries has sprung the first leak in our plumbing.

At this point, the FED is caught in a conundrum between desiring lower interest rates to compete and align with international rates while we negotiate trade AND a liquidity problem (not enough buyers to fund the lower rates). The only choice is to essentially reflate the balance sheet and embark on what should eventually be known as QE 4…quantitative easing 4. This means the FED needs to commit serious efforts and balloon the balance sheet for keeping the Fed Fund rate between the new range (expected to be announced this week) 1.50% – 1.75%. The yield curve wants to invert and is pointing to an inversion unless the FED continues to support with QE like purchasing. Again, we are keeping close tabs for what is happening and the possible risks/ opportunities being created.

What does this mean?

If the FED opens a QE like scenario and we get continued clarity and maybe finalization about trade deals, this market may very well melt its way upward to new highs. Lacking a trade deal, the government needs the FED to keep bailing it out until a deal is done or risk a slowing economy. We do not want to fight the FED, but they are being asked to do an abnormal amount of heavy lifting that is generally reserved for creating price stability during a recession and not healthy times.

Our best move is to remain patient, diversified relative to risk and plan to make some common-sense moves as opportunity presents itself. Going forward we are making active investment moves to bring down risk relative to our bond concerns while continuing to preach the importance of owning solid long-term stock companies (companies that can withstand any future downturns).

In the near term, we understand the battle between trade results, politics, business investment, corporate profits and FED actions will create a tug of war on the economy and Wall Street. Long term, solid companies and investments will adjust and overcome. While we believe there are real areas of concern that need to be addressed, we understand many variables will alter the end game results. We fully believe the US economy and markets continue to be the undisputed champion for long-term passive wealth accumulation. We are thrilled to be at high watermarks in most accounts and very blessed to be part of this economic engine and the fruits it has provided.

Evergreen Wealth remains committed to providing holistic investment solutions and financial planning. We remain honored to continue stewarding your assets and retirement journey.

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