Ugly!

The fourth quarter was an ugly one in the capital markets, although some of the losses have been erased so far in 2019. Compared to the market averages, we had a very good year but even with our safe-haven assets, we experienced weakness in some of our positions in December.

A number of pundits are comparing the current environment to 2007/2008 but I don’t agree. Having been one of the few analysts to correctly forecast the 2008 financial crisis, I can tell you that it doesn’t happen when a bunch of hedge funds are expecting it. The reason is that it’s extremely easy to lose money when betting against the markets, more so when the government is increasingly intervening in the markets. It’s not a coincidence that many hedge funds performed poorly in 2018 despite many expecting weakness in stocks.

In addition, there is one dramatic difference between 2008 and today and that is preparation. The US government and Federal Reserve Board were caught by surprise in 2008 but they are fully prepared today.

Starting on December 27th, the government was able to marshal its resources to stop the sell-off in the capital markets. Treasury Secretary Steven Mnuchin announced that he would convene a meeting of the Working Group on Financial Markets better known as the Plunge Protection Team. The result has been a 10% bounce in the S&P500 from that day. Until this bounce, the market was down 20% from late September highs.

We’re presently at the 50% retracement level and a lot of people are holding their breath to see if the markets can hold these levels. After recapturing 50% of the 4th quarter decline, I suspect the better option is to lighten up and wait for opportunities that are likely to be available later this year.

2019

I think it’s clear by now that the great bull market we’ve experienced since 2009 is over but unlike 2008, I don’t expect us to experience a dramatic sell-off that threatens the financial system. Instead, I expect the Federal Reserve to reverse their current policy of raising interest rates and start cutting those rates by the end of the year.

Fed Chairman Jay Powell hinted as much on January 4th. His dovish comments, combined with a very good December jobs report, were enough to drive the stock market dramatically higher. But soothing words can only take you so far and at some point, he’s going to get tested by the equity markets and he’ll be forced to slash rates. I’d like to be able to take advantage of such an opportunity so it may require holding some cash for a few months rather than equities.

Fortunately, December’s trial run gave us an excellent sign that our preferred safe asset, the 2 year US Treasury Note, is apt to make money during any difficulty. The move from 2.95% to 2.40% was an excellent opportunity to make a nice return at a time when equities fell 20%.

Besides being a great place to hide during a downturn in equities, the move from 2.95% to 2.40% tells us that the market is starting to anticipate a decline in interest rates later this year. The interesting part is that the yield on this ultra-safe asset moved below the Fed’s short term interest rate which is pegged at 2.50%. The reason is that investors who hold garbage like junk bonds and levered loans – bonds that are extremely difficult to sell in a downturn – rush to buy US Treasury Notes as a hedge against these garbage bonds. US Treasury Notes can make a lot of money in a short period of time when things get difficult such as in the 4th quarter of 2018!

In short, I believe that good returns are possible for the year.

Federal Reserve

With all of the dislocation involved with the fourth quarter meltdown, a legitimate question is why doesn’t the Fed just cut interest rates again? Why do they need to keep raising them or threatening to raise them?

The answer we get from the Fed is that they are worried about inflation. In particular, they are worried about wage inflation because so many new jobs have been created in this “great economy”. Unfortunately, most of the new jobs are low wage jobs so a little wage inflation wouldn’t be a bad thing. According to the Social Security Administration, 48% of all American jobs pay less than $30,000.

Besides, the employment participation rate is still at an extraordinarily low rate and higher wages would bring more people back into the labor market.

But I don’t believe the Fed is being completely honest with us. No, I believe that the real reason is that they are trying to protect the US dollar as the sole reserve currency along with the attendant benefits this position brings such as almost unlimited borrowing power. Since Barack Obama took office in the midst of the financial crisis, our federal debt has exploded from $11 trillion to almost $20 trillion when he left office. And since Donald Trump took office, federal debt has ballooned to almost $22 trillion.

The rest of the world is watching our complete lack of fiscal discipline and they’re starting to wonder whether they want to hold US dollars to pay for the things they purchase in trade. The Federal Reserve appears to be trying to move interest rates higher to offer foreigners a higher return for their investments in dollars so they don’t look to trade in potential competitors such as Chinese yuan, Japanese yen, or European euros.

But paradoxically, the Fed is creating the opposite effect – their interest rate policies are weakening the global economy because higher US interest rates rob the world of investment capital. The less global trade is transacted, the fewer dollars are needed to fund that trade. In effect, the Fed is starving the world of investment capital. It’s why we are likely to experience a global recession starting in 2019.

China

As I’ve said in previous newsletters, I have an alternate theory. I believe the Fed is trying to destroy the Chinese economy so nobody will want to hold Chinese yuan. I believe the Fed is trying to force the Chinese to devalue the yuan in dramatic fashion and that’s precisely what appears to be happening.

Notice the chart below where the green line shows China’s trade surplus and the red line shows how China is moving from being a creditor nation to a debtor nation where they need external capital to operate their economy. China is attempting to be like the US only the yuan is not a widely traded reserve currency that requires global central banks to own it.

China is now dependent on foreign capital which is predominantly valued in US dollars and the Fed effectively sets the price of foreign capital in the Eurodollar market. As I wrote in the last newsletter, the Eurodollar market is basically US dollars that are held outside the US banking system. When the Federal Reserve raises interest rates, the price of money basically rises all around the world.

Given that China’s economy continues to be dependent on capital investment for growth, the Fed is effectively squeezing the Chinese economy to death. And since the Chinese economy has been the primary growth engine for the global economy since the year 2000, the rest of the world is suffering along with China. The chart below is the 3 months LIBOR rate, or London Interbank Offered Rate. It’s the base rate for Eurodollar loans.

Once the Chinese economy succumbs to higher interest rates, they will no longer be a threat to supplant the US dollar as the primary currency for conducting trade. This is what I believe is the real reason why the Fed is keeping interest rates high and why they don’t want to cut rates until the US economy starts to weaken dramatically.

US Economy

Hopefully you can see why the Federal Reserve wouldn’t want to advertise their intentions of hurting the Chinese economy. It’s a form of economic warfare.

Higher interest rates bring a weaker economy as surely as night follows day. It’s even worse when the economy is completely inundated with debt. Notice the two charts below that show consumer debt and corporate debt – we’ve already seen a chart of US government debt. With all of these trillions of dollars in new debt, much of which is floating rate, what is likely to happen to the quality of this debt? How will consumers and corporations service this debt?

In the US, short term interest rates have risen from 0.25% to 2.50% today. The negative impact has been somewhat obscured by fiscal stimulus such as the Trump Tax Plan but fiscal changes are not enough to keep our economy elevated in the face of higher interest rates. The prudent thing to do is to expect a weaker domestic economy as the year progresses.

The GeoVest Approach

By having a clear understanding of what and why things are happening, we are better able to plan for future changes in the economy and in the markets. The picture is getting clearer by the day and that picture is pointing to a sharp decline in Chinese economic activity. The result is likely to be a decline in commodity prices and a further weakening of global trade.

But pain in one sector of the economy creates opportunities in other sectors, particularly economic sectors that are not dependent on Chinese trade. Electric utilities, food producers, government contractors and a number of other sectors made money for investors in 2018.

2018 saw an ugly end to the year in the capital markets. 2019 will bring change and we expect to take advantage of that change to safely grow our client’s portfolios. Thank you for investing with GeoVest Advisors. It’s our continued pleasure to serve you.

Philip M. Byrne, CFA
Chief Investment Officer