The extra day in the Labor Day weekend allows us time to think about the above thought equation. The factors listed are more important than the reaction to short-term yields being higher than long-term yields. There will ultimately be the inevitable recession of unknown date. Since the beginning of recorded financial history there have been periodic recessions to wipe out excessive risk-taking. Currently, I see a limited amount of excessive risk assumption, mostly in unsound credit extensions and trading leverage. While these are important, they are probably insufficient to generate a broad economic recession. Nevertheless, the factors listed are significant enough to cause a disruption of some magnitude and length.
The investment markets, particularly in the US, have produced returns at a higher rate than the growth of the underlying economy. One of the lessons from both human and animal history is that too much success leads to failure through over-supply. Sir Isaac Newton viewed the laws of physics as the tools of the Watchmaker in the sky. Thus, the laws of gravity were immutable and it is also probably true regarding the returns on invested capital.
Compared to the US return on capital at its last peak in 2006, the current reading is lower, even though the size of the capital base is much larger. This suggests the law of large numbers is at work, making it difficult to sustain high rates when the base rises. Publicly-traded companies recognize this, and don't want to have an extra-large pile of cash on hand, making them the target of a raid. Their three-fold approach to this dilemma is to raise their cash dividend by at least the perceived rate of inflation (creating a quasi "growth bond"), make acquisitions for cash (often overseas), and buy back stock.
Those who sold their shares back to the company received cash, which should have been reinvested into equities to maintain their stock/bond ratio. The size of buybacks in 2019 appear to be smaller than those in 2018, making the chore of reinvesting more difficult. The enthusiasm for seemingly attractive stocks is less this year, resulting in cash building up in both institutional and individual investors portfolios. Because the cash build-up was reinvested in short-term paper while awaiting better (lower) prices, it increased the willingness to pay higher yields.
Less Equity Opportunities
The number of publicly traded stocks in the US has been falling for many years, resulting in about half the number of companies surviving. New enterprises are staying private longer, due to investments from private equity groups. Foreign companies have also been active buyers of both publicly traded and private companies. Private equity managers have raised considerable amounts which need to be invested each year, further reducing opportunities and generally raising prices. This alone can make a market more vulnerable to a shock.
Investors may believe that they are well-diversified, but they are probably not as diversified as they believe. Mutual funds are a good representation of how investors manage their money. With the smaller number of opportunities available, we are seeing the leading positions in the largest fund categories, like S&P 500 Funds, Global Funds and International Funds being dominated by the same large tech companies. Each of these funds has a few to over half its ten largest stock holdings represented in the twelve largest tech-oriented firms. If one includes the largest users or suppliers, the tech exposure probably represents the single largest driver of the funds' performance.
The speeches and political commentary in numerous countries, including the US, is frightening some investors away from their long-term responsibilities. Many of these investors have seen confiscatory taxes, capital controls (exporting capital) and limiting profitability in their lifetimes. The US looks more favorable to some than their home country, so cash is flowing into the US dollar. Some or most of this cash is going into short-term instruments, which is pushing up short rates.
Within the US, the presidential primary season has been a scene where each potential candidate seems to be trying to be more left-oriented than the others. For those with capital and long-term responsibilities there does not appear to be a single large safe home for investment, leading to an increase in international investing. Traditionally, one invests outside of one's home country for opportunities not found within it, but some of today's international investors are seeking safety or at least a different set of circumstances or projected time frames.
Thus, one can see a heavily US-oriented portfolio being hedged with some Asian/Chinese positions. The hope being that the hedged elements do relatively badly, meaning that the US holdings on balance do well. This reminds me of a quote from John F. Kennedy in the latest Marathon Global Investment Review: "Change is the law of life. And those who look only to the past or present are sure to miss the future."
How the global population feels towards "things" and people is one of the key change agents in the demand for products, services, and investments. An interesting article in The Wall Street Journal (WSJ) this week indicated that young people in China and I believe in Japan are taking on debt for products and services, mirroring the behavior of those in the US and other western countries. In both Chinese and Japanese societies saving was a paramount goal to provide for future healthcare and retirement.
This generation seems to spend their pay entirely on purchases and the repayment of consumer debts. They are setting up permanent households later and having fewer children, leading to an expansion in the number of financial intermediaries, rather than providers of mortgages and long-term investments. These changes are modifying the slope and nature of the yield curve, favoring short-term borrowing funded by longer-term capital.
One of the areas of specific interest is the use and ownership of autos and related vehicles. With the building of mega-cities that have reasonable public transportation supplemented by ride-sharing, there is a smaller need for private autos and the financing to support them. All of these changes shorten the time horizon of an increasing portion of the population, not only changing the structure of the yield curve, but the political attitudes concerning what is important. Increasingly, societies are sacrificing the future for the present, ignoring JFK's admonishment mentioned above. Bear in mind, he was the first young president of the US.
Interest Rate Inversion?
In my mind there is no doubt that we will have a recession during the next five years. In the post-mortem examination of the predictive elements, some may claim that notice was given when short rates were for some period higher than long rates. Because of the changing conditions for money I would note the inversion, but not place too much faith on in its predictive skills
- Prune the portfolio of those holdings currently trading at a loss, whose prospects are not exciting.
- Reduce all levels of debt.
- Slowly start a recovery portfolio that is quite different than the present one.
- Consider some exposure to value investing, but separate value into mispriced stocks and bonds vs. deep value plays. The latter will be selling at discounts of 25% or more from current value, with control in weak or feeble hands.
- Look to the more distant future. One place to look is this week's Bloomberg Businessweek entitled "The Elements." The magazine suggests some unexpected winners and losers from the commercialization of the lesser known chemical elements, but patience will likely be required.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.