(R)aging Bull
The first three months for Inlet Private Wealth® are now in the books and what a quarter it has been! We are incredibly grateful to our clients and the professional community for their support which has contributed to our assets under management growing to nearly a quarter of a billion dollars and a robust pipeline of more to come. The S&P 500’s 7.4% advance and the work performed for our clients contributed meaningfully to the growth of their portfolios during the quarter. The current bull market is now the longest on record since its bottom in March 2009. However, as this aging bull enters the fourth quarter, trade war saber rattling, the rising U.S. Dollar, tightening monetary policy, a flattening yield curve, growing inflationary pressures and widening cracks in emerging markets have caused most global equity markets and the total returns for fixed income to loiter in the red.
Verbal pugilist President Trump did not pull any punches in hitting China with new tariffs on $200 billion worth of Chinese goods. About half of all Chinese imports into the U.S. now attract levies. These tariffs start at 10% and are scheduled to rise to 25% in January. Trade is a relatively small component of GDP in the U.S. and our economy has a significant growth buffer from last year’s fiscal stimulus. However, the complexity of modern supply chains typically stretches across multiple borders and any disruption could impair the global economy.
As the Federal Reserve jabs short-term rates upward, the yield curve in the U.S. has flattened significantly, causing the difference between the yield of the two and ten-year treasury bonds to duck below 25 basis points. Historically, a flattening yield curve implies that lower economic growth lies ahead. It is also concerning because an inverted yield curve, when short-term rates rise above long-term rates, has historically preceded a recession by 6 to 24 months. According to the Fed, every recession during the past 60 years has been preceded by an inverted yield curve, the sole exception being one false positive in the mid-1960’s. Outside of the U.S., the yield curve has inverted with the average yield in JP Morgan’s global government bond index below the average yields on bonds maturing in 1 to 3 years. The yield curve in Japan is negative; perversely, this is occurring while Japan’s ratio of debt to GDP is among the highest in the world and the U.S. is offering nearly 100 basis points more to borrow for the next four weeks than Japan offers for the next 40 years.
The headline rate for the Consumer Price Index in August was 2.7%, noticeably above the Fed’s targeted inflation rate of 2.0% and making additional rate increases by the Fed all but certain. Unemployment at 3.8% is near a 50-year low and is now causing some upward pressure on wages. Venezuela, one of the world’s largest oil producers, is on the proverbial financial ropes and the upcoming economic sanctions on Iran could cause the global market to lose 1+ million barrels of oil a day. As a result, oil prices have brawled their way upward more than 65% over the past year.
While 25% of the world’s economy still has negative interest rates, tightening monetary policy in the U.S. resulting from the Fed increasing interest rates and the unwinding of its balance sheet have contributed to the U.S. having an interest rate premium over other countries that is at multi-year highs. As a result, global savings are coming to the U.S. displacing other sovereign borrowers. In particular, the economies of emerging markets with large current account deficits have taken a dive.
A current account or trade deficit results from a country importing more than it exports. As a result, the country is required to either fund this deficit from its foreign reserves or by borrowing from other countries. Turkey has one of the largest current account deficits of any emerging market country and has financed it by borrowing in foreign currencies. According to Strategas, Turkey’s private sector also has about $375 billion of private sector debt, an amount representing approximately 44% of Turkey’s annual economic output. Turkish businesses owe significantly more dollars and euros to their domestic banks than they do to foreign investors and its central bank does not have enough in foreign reserves to cover its banks’ liabilities. As a result, there has been high inflation and a 45% decline in the Turkish Lira relative to the U.S. Dollar making Turkey’s U.S. Dollar denominated debt significantly more expensive. Turkey finds itself in the position of needing to finance $100 billion U.S. Dollars a year without access to private capital markets in an environment with rising oil prices and a strong U.S. Dollar. Argentina is fighting against similar issues and recently raised interest rates by 60% to counterpunch an inflationary hit and a run on its currency. China’s debt levels are high at approximately 300% of GDP and its equity market has been knocked-down 25% from its high, bear market territory. South Africa is in recession. According to BCA, the exposure of Spanish banks to the most vulnerable emerging markets totals nearly 120% of their banking system’s capital and reserves…French banks have large exposure to Spain and…German banks to France. We are not suggesting that investors throw in the towel, but these interconnections make the possibility of contagion a growing concern.
Most ring-side economic pundits weighed into 2018 with expectations of synchronized growth globally. However, the factors mentioned above have instead contributed to a desynchronization in global growth and highlighted the ability of Wall Street seers to make the forecasting efforts of fortune tellers seem respectable. Regardless, animal spirits remain strong with consumer confidence near 18-year highs, corporate profits are up nearly 25% year-over-year and global deal-making year-to-date has reached $3.2 trillion, an all-time high. While equity markets seem to be generally on the expensive side, individually many companies are selling at attractive valuations. To paraphrase Raging Bull Jake LaMotta, the current environment seems to be “giving a stage where active investment managers can rage.”
Ted, Vicki, and Terry
