Smart Money

Our regular summary of the capital markets. Check back each month for new updates.

Smart Money

April 30, 2019

Teeing Up The Offseason

Smart Money

One of the most popular summer pastimes for an NHL athlete is the sport of golf. Accordingly, we are often asked to provide guidance for players who are considering a private membership. From a financial perspective, it is impossible to justify the ongoing costs associated with a golf membership. However, professional athletes with otherwise disciplined cash flow habits, can afford th...

One of the most popular summer pastimes for an NHL athlete is the sport of golf. Accordingly, we are often asked to provide guidance for players who are considering a private membership. From a financial perspective, it is impossible to justify the ongoing costs associated with a golf membership. However, professional athletes with otherwise disciplined cash flow habits, can afford this type of indulgence. After all, everyone needs a hobby! It is important to engage in a healthy distraction after the stress and grind of an NHL season. Click the link below to learn more about the world of private golf.

Teeing Up The Offseason

April 23, 2019

Fund Flows Supporting Equity Market

Market Recap & Box Score

The equity rally stretched for another month as the MSCI World, TSX, and S&P 500 posted gains of 3.4%, 3.5% and 3.9%, respectively.  On a total return basis, the S&P 500 is now up 24.4% from its Christmas Eve low and 16.6% year-to-date.  Even more interesting, earnings season has only just begun and with an absence of positive signals from a macro perspective, these gains have...

The equity rally stretched for another month as the MSCI World, TSX, and S&P 500 posted gains of 3.4%, 3.5% and 3.9%, respectively.  On a total return basis, the S&P 500 is now up 24.4% from its Christmas Eve low and 16.6% year-to-date.  Even more interesting, earnings season has only just begun and with an absence of positive signals from a macro perspective, these gains have been driven purely through multiple expansion.  Despite calls for a stock market reversal from some of the smartest minds in finance; share repurchases, hedge fund short covering and retail fund flows have fueled the advance.  SentimenTrader tracks retail flows via the Dumb Money Confidence Index. The indicator has been climbing steadily and it recently reached its highest level in a decade.

Fundamentally, we cannot refute the ‘smart money’ call for a re-test of the December lows.  A slowdown in global GDP growth forecasts, potential margin compression and weakness in industrial production for export-driven countries (Germany and South Korea) support the bearish scenario.  However, fundamentals act more as a rudder rather than a motor in the short to medium-term.  Accordingly, fund flows remain the market’s engine, specifically corporate buybacks are fueling the machine.

What is driving the buybacks and potentially the market?  The embedded chart illustrates the growth of US corporate debt issuance since 1996.  Following the 2007 crisis, US debt issuance has been on a sustained upswing, while the growth of high yield debt over the same period has been even more pronounced.  Notably, corporate debt issuance diminished in 2011 and 2018.  The chart does not capture the drastic slowdown in corporate debt in late 2015, in anticipation of the Federal Reserves’ first rate increase in December. As a result, a backlog of mergers and acquisitions that had yet to be financed slid from $246bn at the end of September to more than $900bn.  Coincidently, these calendar years (2011, 2015 and 2018) were the three years since 2008 where the S&P 500 was either flat or down.

So, what is happening 2019?  At the recent March meeting, the Fed Committee announced their intention to halt any further rate hikes in 2019 and complete its balance sheet roll-off program by the end of September.  While many cite the Fed’s surrender to the stock market, it seems like credit market conditions were the impetus.  Mr. Powell did not hesitate to raise rates in Dec-18 following a 10% drop in equity markets in Oct-18.  However, when there was a 90% decline in credit issuance, the plan for hike rates and balance sheet runoff was quickly cancelled.  This pivot seemed to hit the mark as credit markets opened-up. Investment Grade issuance rose from $9.1Bn to $106.6Bn, month over month.  Similarly, high yield issuance leaped from $0.9Bn to $20.4Bn.  Equity markets followed suit; after the 9.18% collapse in Dec-18, the S&P500 has jumped 16.6% in 2019.

Which leads us to another piece of the puzzle, that being inflation and the underlying commodity prices that drive it.  April brought on a second consecutive 11.0% rise in the price of WTI oil to $65.50. The latest bump was in response to Trump’s call to end any waivers on countries importing Iranian oil. Not only does this escalate the current feud between the two countries but it essentially removes Iran’s 1.5MM barrels of oil per day from the market.  With oil continuing to trend higher, the potential short-term effect on inflation and on interest rate policy will be noteworthy.  An uptick in inflation could have a knock-on effect through the erosion of corporate margins.  Further, if it forces the Fed’s hand, or alters the markets’ expectations from the Fed, debt markets will come under pressure.  Within precious metals, both gold and silver took a breather in April, down 2.9% and 2.6%, respectively.

April 17, 2019

Yield Curve Signaling

First Quarter 2019 Newsletter

Markets Snap Back After Federal Reserve Pivot – While the fourth quarter of 2018 produced some of the worst data since the Great Depression, the first quarter of 2019 reversed that, posting its best start in nearly 20 years. Although the clouds around Brexit are still hanging over the global market, there is increasing optimism surrounding the US-China trade talks and a turnaround in ...

Markets Snap Back After Federal Reserve Pivot – While the fourth quarter of 2018 produced some of the worst data since the Great Depression, the first quarter of 2019 reversed that, posting its best start in nearly 20 years. Although the clouds around Brexit are still hanging over the global market, there is increasing optimism surrounding the US-China trade talks and a turnaround in the US Federal Reserve’s monetary policy stance. After stating interest rate hikes were on autopilot, Federal Reserve Chairman Powell reversed course with a rate hike pause and followed-up with news that quantitative tightening would come to an end by September. US equity markets continue to outpace global counterparts, although a higher dollar and wage cost increases will likely pressure corporate margins in the quarters to come.

US Treasury bond yields continued their descent, boosting returns to both high-quality and high-yield bonds. The all-important yield curve continued to invert during the quarter, with the 10-year Treasury bond yield falling below 3-month Treasuries.

Yield Curve Inverts Signaling Economic Slowdown – During the first quarter, 10-year Treasury yields fell below 3-month Treasury yields, inverting the yield curve. Curve inversions have preceded the past seven recessions.  However, on 10% of the occasions, an inversion does not lead to a recession. So, what does an inverted yield curve actually mean?

The main yield curve reflects government bond yields across a time series that is as short as one day and extends out to 30-years. Front-end, or overnight, rates are set by the Federal Reserve while all other rates are determined by the market. The importance of these “risk-free” rates cannot be understated as they determine the price of all other asset classes.

When the front-end interest rate rises faster than the market-setting long-term rates, it impacts markets and the economy in two ways. The first is the impact on asset prices and the second is the effects on lending. The first impact is more intuitive, as the reward for holding cash rises, long-duration asset prices decline due to funds flowing into cash. Long-duration assets include both bonds and real estate as well as stocks, in particular growth equities which are priced as the present value of future cash flows.

The second impact takes a bit more explaining. As the yield curve flattens, this causes a strain on lending as well as the broader economy. Banks for example borrow on the front-end and lend at the long-end, when the curve is inverted the spread becomes negative. Less lending is almost assured to slow the economy and because this is reflexive – the slowing economy will beget more restrictive lending.

Tightening credit/liquidity is often felt in the riskiest areas of the economy first. This could explain the current flood of initial public offerings (IPOs) that are coming to market. Companies like Levi Strass & Co., LYFT, UBER and Pintrest are possibly raising capital in public markets because private markets cannot keep pace with liquidity needs or have no further capacity for financings.

Since 1965, however, the time between inversion and recession has varied significantly, ranging between 8 and 33 months, with an average of 19. A top in the US market has typically preceded recessions by only an average of seven months. Most of the stock market damage is incurred prior to the recession. The average peak-to-recession lost is -14.6%.  Meanwhile, stock market performance during a recession is generally flat on average. Additionally, there have been two “head fakes” in which the curve steepened, and expansion continued.  The 10% anomaly is perhaps upon us.

For investors with short-term needs for cash, the timing for taking profits in long-term assets is suitable especially given higher yields in short duration securities.  For long-term investors, the yield curve inversion, should not be a signal to hastily dump stocks.  Opportunity is becoming more apparent in value-based equities because these rely less on higher residual values.

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