Fourth Quarter 2019 Forecast and Opinion

In September, Trump tariffs were imposed on $112 billion more of Chinese imports. Trump now threatens to increase this to $550 billion. As a result, the World Trade Organization has now slashed its forecast for 2019 trade growth to 1.2% from 2.6%. The Chinese, Indian, Japanese, and U.S. economies are slowing. The European economy is slowing dramatically, and is now seen growing at zero in 2019. Germany is slowing because as Chinese companies export less to the U.S., they purchase less German machinery. This, plus the uncertainty of Brexit, has German companies nervous about investing.

In the U.S., the ISM manufacturing index, an important indicator for the health of the economy, contracted in September to its lowest level since June 2009. Meanwhile, the non-manufacturing index fell to a three-year low.

Aside from global slow down worries stemming from the trade war, the Federal Reserve has now begun draining its balance sheet of the bonds that it has been purchasing for 11 years to keep yields low and to stimulate the economy. At its peak, the Feds’ balance sheet was 25% of the annual economic output of the U.S. Now, the Fed would like to shrink that number to around 17%. That means removing liquidity from the economy, the opposite of stimulus. While the fed drains cash from our economy, the U.S. treasury is issuing more bonds to finance the additional debt the U.S. took on with its $2.5 trillion tax cut. These two factors provoked a cash squeeze in September which was compared to a “plumbing problem” in the nation’s financial system. “Repo” rates, or the rate at which banks lend cash to each other overnight, approached 10%, causing turmoil and concern about the U.S. banking system. The lack of cash liquidity was exacerbated by corporate tax payments which fell due that same day. While soothing language ensued from the central bank, investors were spooked, as the last time this happens was in 2008 after the Lehman Brothers collapse.

The U.S. dollar continues to rise, because the U.S. is one of the few countries that carries a positive interest rate on its bonds. There is now $15 trillion of debt around the globe offering negative bond yields. Naturally, foreign investors will continue to buy U.S. bonds because they offer a positive return. This pushes the value of the U.S. dollar up, which then in turn leads to weaker American exports.

If and when the U.S. enters its next recession, corporate debt will likely become a source of trouble. American companies have gorged themselves on cheap money for a decade, and have become over leveraged. 53% of all American corporate debt is now rated BBB, which is one notch above “junk”. We are one negative credit event away from half of our corporate debt becoming undesirable. But there are numerous other risks in the “big picture“ which are present in today’s investment landscape:

• Wealth inequality, caused by artificially low interest rates, has given rise to political populism worldwide, which is socially, economically, and politically unstable.

• Last year’s tax cuts in the U.S. have driven the U.S. deficit into dangerous territory, beyond 100% of debt to GDP. Showed interest rates rise, the amount we pay to service this debt could be crippling.

• Tariffs, while popular, don’t work, and are detrimental to all counterparties.

• Regardless of one’s political views, Wall Street has not begun building in the risk of an Elizabeth Warren presidency. If elected, she will have an immediate negative impact on the healthcare and financial sectors, and she would probably attempt to roll back the 2018 tax cuts which drove last year’s rally.

• A no deal Brexit, which is now looking likely, will tip the UK economy into recession. But it will also have unforeseen consequences globally. The European Central Bank estimates that Europe will suffer between 10-30% of what the UK suffers. That could tip the Europe zone economy into recession, which would impact the entire world economy.

• As mentioned above, there is now nearly $15 trillion of negative yielding sovereign debt in Europe and Japan, triple the amount from one year ago. It is not impossible for the U.S. begins to see negative interest rates either, which is not a healthy sign. If the Fed cuts rates all the way back down to zero and restarts quantitative easing, negative yields on U.S. Treasuries could become a reality. Over our entire financial history, it has never been experienced before. If and when it arrives, it could bring instability to the U.S. financial system for several reasons:

A) If banks have to pay interest to hold reserves and lend money, it jeopardizes their solvency and threatens credit growth and economic growth. The fractional reserve banking system is based upon positive interest rates.

B) Savers are punished by negative nominal interest rates, paying indirectly for the spending profligacy of governments. Imagine a saver who feels he or she needs $1 million to retire. In the past, he might save $700K and those savings would grow toward that target. With negative nominal interest rates, the saver might have to put away $1.3 million in order to have $1 million at retirement. While this may be an extreme example, it is included to illustrate a point, that negative interest rates are a threat to savings. Inflation, if present, only compounds the problem.

C) The time value of money, one of the primary pillars of our entire economic system, is disturbed with negative interest rates. Negative nominal rates are symptomatic of stagnating asset values and turn our ideas of the time value of money topsy-turvy.

D) Pension funds, insurance companies, retirement funds will undergo extreme pressures, as they depend upon positive interest rates.

E) The stock repo (repurchase agreement) market is based on positive interest rates. Repos are used to lend stocks to short sellers, which in turn, provides liquidity to the stock market. If investors don’t realize a return for lending their stocks out to short sellers, they simply won’t. Stock market liquidity will then begin to dry up.

Negative interest rates are poorly understood by even the most sophisticated economists, and there are probably many other consequences to them. Again, they are without historical precedent.

One beneficiary of negative interest rates is gold. Historically, there have always been some objections to holding gold because it has no yield. In a world of negative interest rates, this objection is removed and reversed in favor of an asset class that will hold its value. In 2019, the rise of gold seems to be correlating to the absolute amount of negative yielding sovereign debt. The lower bond yields and interest rates go worldwide, the more gold will benefit. If we dare to imagine bond yields going negative in the U.S., investor unease would likely boost gold considerably. U.S. bonds will also continue to benefit as their prices rise when yields fall.

At the time of this writing, the White House has sent a letter to congressional Democrats declining to participate in the impeachment inquiry. This will reinforce the Chinese government’s trade position, which smells “blood in the water” and may now stall on any tariff negotiations. We are left with a real chance of an impeachment moving forward, no deal on tariffs with China, a hard Brexit soon, and a slowing global economy.

Reasons to remain optimistic would include the fact that the Federal Reserve Bank still has the flexibility to cut rates if the economy weakens, and that foreign investors may continue to favor U.S. assets.

Our portfolio strategy is a continuation of exercising caution over the coming quarters.

The Dow rose 15.39%% during the first three quarters of this year, while the S&P 500 was up 18.7%

Grant Rogers

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