Abusing The Privilege

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by: Mark J. Grant

"Every market has the right to be ugly, but some markets abuse the privilege." - The Wizard

Let's say you bought equities in early October. From that point, until now, utilizing the DJIA, you would be down 14.8%. Nothing pretty there. If we track the S&P 500 then you are down 15.7%. Even uglier!

Let's say you were in Corporate bonds and you plunged in the first part of February. You have watched the spread to Treasuries widen by 41.8%. The high-yield market has held in fairly well, only widening about 3.6%, and it has certainly outperformed the IG Corporates and the equity markets.

Having said that though, the amount of BAA3 Corporates, utilizing Moody's, is now equivalent to 57% of the high-yield market, which is the highest percentage ever. Chairman Powell, and the Fed's scramble to keep raising rates, could move these lower investment grade credits right into junk territory with the cost of borrowing pushing them over the cliff. If that weren't enough, more than one half of BBB-rated Corporates now have more leverage than those in the BB space and this could become a very serious problem dictated by the Fed's higher borrowing costs and a boatload of downgrades could be forthcoming.

One point of serious concern now is the dreaded "Inversion." The three-year Treasury and the five-year Treasury are now slightly inverted with the one-year Treasury Bill yielding a scant 4 basis points less in yield than the two year at yesterday's close. The two-year to 30-year Treasury spread is only 38bps as we continue to flatten like a pancake.

As we deal with all of this, I note that Brexit is becoming more and more of a problem that could seriously distort the markets. If Britain exits without a deal, on March 29, 2019, then we get to the infamous "cliff-edge" scenario in which EU law abruptly ceases to apply in the United Kingdom. Done and done would be correct.

A major issue for the markets, at that point, becomes the British banks. There's a huge question about their exposure to the major EU banks that, in my opinion, is going to put counterparty risk in the center of the table for the British and EU banks, but also, I note, for the major American banks that have a whole raft of interlocking obligations with both. I would be taking a hard look at your exposure to the British banks and the main EU banks and ponder just what to do while there's still time. If we do get to a hard Brexit, it will be far too late.

The European Union has warned that most banking, insurance and other financial firms in Britain would be cut off from the EU if there's no divorce deal. This leads you further afield. You better check your exposure to the insurance companies and other financial institutions such as money managers, in both Britain and the EU, and mull over the effects.

My biggest concern, for the markets, however, are American ones. The first is the Fed and whether they will recognize the error of their ways, and the second are the Democrats gaining control of the House. The Fed categorically stated, using data, that the U.S. economy was slowing down. Then they raised interest rates and said they were going to keep doing so. At the same time, they said that their reduction of their balance sheet was on "auto-pilot" and you wonder just what these people are thinking.

The Fed keeps saying that they are "data dependent" which is a very misleading comment. Sure, the data is there but it's the "interpretation" of the data, by the governors, that's what is really at issue. They are using a methodology of a return to a non-existent "normalcy" that is leading them, and the American economy, and hence, the markets, in the totally wrong direction. Some have stated, aloud to me, that they wonder if the Fed does not have a political motivation to cause a downturn so that President Trump will not be re-elected. I certainly hope that's not the case. In any event, their policies make me fearful and my fear was only enlarged by the Fed's recent decisions.

Next, I'm concerned that the Democrats, when they gain control of the House, will spend most of their time trying to investigate everything in sight and possibly try to impeach the president. I think the investigations will be very market unfriendly and any impeachment actions a disaster for both the bond and equity markets.

Now let me be very clear. This is not a political statement. This is a market warning. Frankly, I have been disgusted with the behavior of many people on both sides of the aisle. The rancor, the lack of civility, the rejection of politeness is just appalling. Having said all of that, if the Democrats spend all of their time investigating instead of legislating then I think that many market participants will become even more fearful of a breakdown of governance in the United States and back away from equities first and then fixed-income, if things get out of hand.

I suggest cash flow investments now as opposed to playing for appreciation. Anything with monthly payments not only compounds interest but allows you to adjust to the uncertainties that are now squarely in front of our noses. Having a regular stream of incoming cash allows you to "adjust" and that ability will be a huge advantage, in my opinion, in the upcoming months.

Caution is advised.

I proclaim my warning!

"Forewarned is Forearmed." - Benjamin Franklin