• "Kee" Points with Jim Kee, Ph.D.


    • Trade Overshadows Antitrust
    • The Federal Reserve
    • Stage Three
    • European Central Bank
    • Addendum


    Trade Overshadows Antitrust

    As I write this, markets are selling off because the trade war is back on. Specifically, President Trump announced Friday that tariffs (25%) on Chinese imports ($50bb) were slated for July 6, and China promised retaliatory tariffs. It has escalated from there. But what got my attention was U.S. District Court Judge Richard Leon’s ruling that AT&T could buy Time Warner with no conditions attached (CNBC). There is not a lot of research on the impact of these types of decisions on the overall stock market, but the research that is available (e.g. George Bittlingmayer’s work at the University of Kansas) suggests that it is long-term bullish (good) for stocks.

     

    The Federal Reserve

    The Federal Reserve raised rates (the benchmark federal funds rate) last week for the 2ndtime this year, with one or two more hikes expected by years’ end. The current rate is 2%, with the Fed targeting 2.5% this year, 3% in 2019, and 3.5% by 2020. The Fed had cut the federal funds rate effectively to zero in 2008, where it remained for 7 years, and then it started raising rates in 2015. That whole situation was unprecedented, which is part of what makes this episode unique from prior episodes. Another part is the fact that, with prior rate hikes, the Fed had been determined to keep inflation under control by raising rates when measures of growth and inflation indicators were getting too strong, or too far from normal. But under the current regime, the Fed wants to “normalize” rates from abnormally low levels, in effect saying “unless inflation numbers are too low, or unless growth number are too low,” we’re going to continue with rate hikes, i.e. rate normalization. That’s what’s different this time around. I’m sure you have all heard enough about the Fed lately, so I’ve put the rest of my thoughts in an addendum below.


    Stage Three

    Right now we are in kind of a third stage of Federal Reserve policy with respect to the financial crisis. The first stage was the extraordinary asset purchases made by the Fed, which came to be known as quantitative easing. Remember all of the fearmongering that this was going to lead to high inflation? Didn’t happen. The second stage was the tapering (2013) and then ending (2014) of these asset purchases or QE. Remember the fearmongering of market panics and economic decline that was going to follow the end of QE? Didn’t happen. Now we’re in the third stage of bringing interest rates back up to a more normal range, and reducing the Fed’s balance sheet. Expect more fearmongering, but so far so good.


    European Central Bank

    As for Europe, last Thursday the European Central Bank decided not to raise rates (the “deposit rate”) while laying out plans to wind down its bond-buying (i.e. QE) program by the end of the year. That represents a “soft” versus “hard” taper, whereby the ECB would stop abruptly in September. This was all largely as expected, and I think Mario Draghi’s tenure as head of ECB is aptly summed-up by the Wall Street Journalsubtitle, “Europe’s central bank chief did his best to give political space for reform.” I think the ECB has had some great success in managing the various crisis of the past few years (e.g. debt problems, Brexit, etc.). But there is also something to University of Chicago economist Luigi Zingales’s discussion of Italy, and I think it applies to other countries in the EU as well:


    “In many ways, the last few years have been the best possible world for Italy because interest rates were incredibly low, the euro was relatively cheap vis-à-vis the dollar, and oil prices were quite low…if you have to pick the best variables for Italy’s economy, those are the three variables. With this magic combination, we achieved 1.5% GDP growth.”


    To me, that expresses well the ongoing need for tax/regulatory reform – just less bureaucracy – not only in Italy but other parts of Europe. However, at 2.1%, Europe’s expected 2018 growth rate (IMF) is still above its longer-term averages, which are in the 1%-2% range depending upon the period.


    Addendum: Some Economics of Inflation

    Does growth cause inflation? Does the economy “overheat”? I don’t think so. In fact, for a given quantity of money, more output should lead to each dollar buying more goods and services, which is disinflationary. But under modern, fractional reserve banking systems, it gets a little more complicated. Whether growth leads to inflation or not depends upon (1) whether or not the banking system holds excess reserves, which are reserves in excess of required amounts (it does), and (2) whether those excess reserves get loaned out too quickly. The Federal Reserve has more control over excess reserves than it used to because, since 2008, it has had the authority to pay interest on those reserves. This is called Interest on Excess Reserves, or IOER. That allows – orshould allow – the Fed to hold those reserves in place if desired, thus controlling inflation. So growth can be inflationary, but need not be [note: increased banking regulations have also curtailed bank lending].


    And what is inflation? It is a rise in allprices, or a decline in the purchasing power of a currency. That’s distinct from a relative price change, or the rise of the price of some specificgood or service relative to another. Confusion occurs when people attach the word inflation to what is really a relative price movement. An example would be the term “wage inflation,” or “housing inflation.” That results in great economy of speech, as people very quickly understand what you mean, i.e. that wages are rising or house prices are rising. But that economy of speech comes at the cost of lost economic understanding, because the distinction between inflation (rise in all prices) versus a relative price movement(rise in some prices) has been lost. And that usually leads to the “cost-push fallacy,” or the notion that a relative price change (e.g. wages) can lead to overall inflation. But think about - If people spend more on wages, or houses, or both (driving up their prices), they have less to spend on other items (driving down their prices). You can only spend more on everything if there is a greater quantity of money to spend! And that all comes back to, or depends upon, how much excess reserves the banking system has, and how much of those excess reserves are being loaned out.


  • "Kee" Points with Jim Kee, Ph.D.


    • Trade
    • The Federal Reserve
    • Asset Classes
    • Sector Rotation


    Every so often I prepare some notes for press interviews and distribute them to Kee Points readers. The notes below will sound familiar to many of you, but sometimes a good summary of what’s been talked about is helpful.



    Trade

    Wealth is created by production and exchange (trade), and of this exchange is fundamental. Wealth can be created by exchange alone as goods (and people and resources) move from lower-valued uses to higher-valued uses. Not so with production; with production, firms, plants, and workers that make sense in a global economy become redundant (not needed) in a local economy. That’s why markets are pretty sensitive to potential trade wars and to nuances in various summits like the G7 meeting of industrialized countries that wrapped up on Saturday in Quebec. The G7 includes the US, Canada, France, Germany, Italy, Japan, and the United Kingdom. The European Union participates but is not technically part of the G7. Russia was in – it was the “G8” – but was suspended over its annexation of Crimea in 2014 (Some G7 members, including President Trump, desire Russia back in). Even today’s summit in Singapore (this morning Singapore time, Monday evening US time) between President Trump and North Korea’s leader Kim Jong Un can be broadly interpreted as important because its emphasis on weapons reduction would ultimately reduce global tensions that impact trade. Ultimately, markets are looking to whether trade agreements are being negotiated to better “level” trade policies between countries by (1) reducing restrictions in countries where they are high (good), or (2) raising restrictions where they are low (bad). So, you can have “bullish” leveling or renegotiating or “bearish” leveling or renegotiating. My sense is that there will be a little of both, but in the end more bullish than bearish developments. I know that sounds optimistic, but I think there is more recognition of mutual interdependence among countries now than there has been in the past.



    The Federal Reserve

    The Federal Reserve Open Market Committee (FOMC) meets this week (June 12-13) and the Fed is widely expected to raise the target range for the federal funds rate again, which currently stands at 1.75%. That will be the second hike this year, with one or two more expected by the end of the year. When discussing the Fed (which can be emotional), it helps to recognize that the extraordinary asset purchases (coming to be termed “quantitative easing”) that began in 2008 never led to the hyperinflation predicted by many. Also, the end of quantitative easing, which began in 2013 (“tapering” asset purchases) and ended in 2014, never led to the economic/market collapse predicted by many. Key things to keep in mind are that, historically, the economy speeds up while rates are rising, and the maximum negative impact of rate hikes on the economy occurs 12-16 months after the last rate hike. That would mean no Fed-induced recession this year or next. Also, rising short-term rates could flatten the yield curve, since global forces like the “global liquidity glut” (global cash looking for yield) and lower interest rates abroad could limit how high US rates can go. I think this means that the slope of the yield curve is currently less useful for forecasting in the current environment. Quality spreads (difference in yields between low and high-quality bonds) are probably more worth watching, as low-quality bond default rates tend to rise in downturns, so they sell-off, - i.e. their price goes down and their yield goes up. That means a big widening of spreads would be a prerequisite to an economic downturn, and right now spreads are historically low. As a final caveat, the Fed cut rates to zero following the 2008 recession and kept them there for 7 years, which has no historical precedent. That makes judgement at least as important as empirical analysis (number crunching) in the current environment. Consensus estimates are for 10-year US Treasury yields to be north of 3.5% by 2019 (year-end), 1.4% for the Euro area, 2.15% for the UK, and .13% for Japan (Alliance Bernstein).



    Asset Classes

    There has been a lot of talk lately about small-cap stock indices hitting their all-time highs, while large-caps (e.g. S&P 500) peaked in January and are since below their all-time highs. Some of this is just small-caps bouncing back from stretches of considerable underperformance (e.g. first half of 2017), while some of it is no-doubt driven by trade angst as small-caps (S&P 600) generate about 5% of sales from overseas, versus about 30% for large-caps (S&P 500) according to Credit Suisse. Small caps look a little more expensive than large caps at this point. However, the valuation gap of small cap stocks to large cap stocks is not as wide as the gap between value stocks and growth stocks. That differential ishistorically high, and it is not because value stocks are particularly cheap, but rather growth stocks are historically expensive (Credit Suisse HOLT). That makes me a little more leery of growth stocks than if it were otherwise (i.e. if value stocks being really cheap accounted for the differential). You can’t use valuation metrics to time asset class “rotations,” but historically these large valuation differentials between growth and value tend to get closed by growth stocks materially underperforming value stocks. This tendency for value and growth (and small and large-caps) to take turns, and the inability to time the switch, manifests itself in research showing that in the long-run you are better off owning both rather than trying to get in and out of each asset class. Owning both also leads to less overall portfolio volatility.



    Note on Sector Rotation 

    Can you make money by looking at how asset classes performed during prior periods, of say, Federal Reserve rate hikes? I used to think so, but after 20 years I’m pretty skeptical. Every new rate hike regime makes historical patterns look weaker and weaker. If you talk to anybody who has attempted to build sector or industry “rotation” models they will tell you the same. Part of this is the fact that there just isn’t a lot of historical sector data, so a lot of observed “patterns” might not be legitimate. Each episode is also somewhat unique, with sectors or industries at different stages of valuation or capital spending (for example) in each episode. And perhaps, most importantly, markets learn. Every Wall Street and global research firm in the world runs the same drill going into a series of Fed rate hikes by looking at how different asset classes and sectors behaved during prior hikes. Any real patterns would be and have been (in my opinion) exploited such that betting on different asset classes based upon prior patterns is probably not a great idea. I’ve made that bet with former research colleagues and won during prior rate hike regimes, and given a little, time I’ll report the results for the current rate-hike regime (i.e. "would I have made money by buying assets that did well based upon past rate hike regimes?").


    I’d like to also mention that this week’s Barron’s Magazine featured our CEO & Chief Investment Officer, Jeanie Wyatt, CFA, as she was named to the national Top 100 Women Advisors* list. Jeanie was also the highest ranked from Texas. Congratulations, Jeanie!


    *The ranking reflects the volume of assets overseen by the advisors and their team, revenues generated for the firms and the quality of the advisors' practices. The scoring system assigns a top score of 100 and rates the rest by comparing them with the top ranked advisor.


  • "Kee" Points with Jim Kee, Ph.D.


    • Global Summary
    • Trader’s Gotta Trade
    • Markets Reflect Risks
    • Interest Rates


    Global Summary

    Looking broadly at things, global economic growth continues apace, with the US in particular appearing to strengthen, while Europe and Japan have hit a bit of a soft patch. China’s recent PMI (Purchasing Managers Index) numbers were surprisingly strong, but underneath the economy there, it appears they are hitting a soft patch as well. Global stock market returns appear to be reflecting all of this, with US indices positive year-to-date, while global indices (Europe, Japan, China) are negative.


    Trader’s Gotta Trade

    “Fish gotta swim, bird’s gotta fly, trader’s gotta trade”. That was how Ben Stein recently described the hoopla surrounding the sell-off last week over Italy concerns, describing it as a “wild overreaction” and calling US exposure to Italy (and Spain) essentially trivial. What Stein was getting at was the fact that the press needs a daily story or headline, while an investor’s main job is to figure out what to ignore and what not to ignore. Acting on the daily news turns many investors into mere traders, and I know of no evidence that concludes anything other than the fact that long-term disappointment tends to follow such a short-term focus.



    Markets Reflect Risks

    Almost daily you will hear global investors talking about this or that market being cheap, without any suggestion that markets tend to look cheap, on whatever metric, because they have higher risks. For example, Europe has a lot of political churning going on, and it would be odd if that weren’t reflected in market valuations (i.e., “Europe’s cheap”). That’s even more true of emerging markets, stock markets which had a strong bounce last year but are back in negative territory this year. It is always worthwhile, by the way, to recognize that emerging markets are far from homogeneous. They are made up of countries that are a mix of developed and developing, with that mix often going back and forth from year-to-year. They also have very different drivers, with some essentially driven by global commodity prices, others more contingent upon global growth, and others being driven by country-specific political change.



    Interest Rates

    As for global interest rates, here too we see more a reflection of reality than any sort of obvious “play.” Borrowing from a summary provided by our Director of Fixed Income, Josh Hudson, CFA, US rates are basically higher across the yield curve (i.e. across maturities) while rates in the rest of the world are relatively flat. That reflects, I think, the global growth characteristics summarized above, along with a more accommodating stance by global central banks relative to the US Federal Reserve. The European Central Bank continues “QE” or asset purchases there, which helps keep rates low and benefits European borrowers. Higher country-specific rates in Europe, like Italy’s, reflect higher risks. I would add that global financial stress indices have moved up a bit in 2018, but only towards normal or average levels from what were below average levels a year ago. In this they reflect the return of volatility seen in stocks, which I view more as normalization. Looking at these stress indices broadly, like those constructed by the Kansas City and St. Louis Federal Reserve Banks, one sees almost no sense of elevated global financial risks. And these indices contain just about every type of warning signal that economists look at.


  • "Kee" Points with Jim Kee, Ph.D.

    We usually suspend Kee Points during holiday weeks like this, but I did have a few notes to share on Italy:


    If you followed the business press over the weekend, you know that the Italian President  (Sergio Mattarella) blocked the formation of a new government, which would consist of two populist parties. One party is the northern pro-business, pro-tax cut interests known as the Lega, or League. The other is the southern Five Star Movement, which is more pro-welfare payments/higher pensions. Given Italy’s quirky or “arcane” (Asian Times) political system, Mattarella’s actions could prompt another election in the fall, if not sooner.


    As I mentioned in a previous Kee Points, advocating for tax cuts (League) and welfare spending (Five Star) is pretty hard to do without increasing budget deficits, and therein lies Italy’s problem. At 130% of GDP, Italy’s debt in absolute terms is the largest in the Eurozone. With borrowing restricted from the last debt crisis, the only way for Italy to spend more and tax less without borrowing would be to print money for the additional spending. But Italy cannot do that because it is part of the euro currency area. That is what is leading to rumors of Italy leaving the euro, or issuing a kind of government “scrip” to pay its debts, sort of a parallel currency that would not sit well with the EU.


    Italy’s situation reminds me of Greece’s a few years back, when it was thought that Greece would leave the euro and issue their own devalued currency to pay its debts. Most economists felt that this would be a disaster for Greece and lead to capital flight and economic collapse, and I feel the same about Italy today. As the Financial Times put it today, “Any decision to leave the euro would send Italian banks insolvent, as they are big holders of Italian government bonds.” I think the Italian people know this – the Times calls it a “self-impoverishing decision” – and I think cooler heads will prevail.


    Having said that, 2-year interest rates in Italy have surged from -0.35% at the beginning of May to 2.5%. With government debt larger than GDP, this would add about 4% of GDP in additional interest costs to service existing debt (Asian Times). So, Italy has to do something, and it needs access to lower borrowing costs while it negotiates some spending/budget reform. But the real point I want to make in this note is that the Italian debt crisis does not pose a threat to the global financial system like the mortgage derivatives did in 2008. Foreign holdings of Italian debt have actually fallen from $900 million in 2010 to $700 million today (Asian Times). That’s million, not billion or trillion.


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