Markets are supposed to discount the future, but the latest rout in stocks seems to reflect the risks that were already present and clear to just about anybody.
Take the plunge in Facebook’s (ticker: FB) shares over privacy concerns. The utterance of social media in the same sentence as privacy seemed to be the definition of an oxymoron to the teenager of the house, who rolled his eyes at the notion (or was it the suggestion that “oxymoron” would be a useful word for the SATs?). For those born before the admonition of a dot-com era mogul that “there’s no privacy, get over it,” Facebook’s failure to protect the data from its members led to the evaporation of some $75 billion in its shareholders’ net worth on the week.
The biggest culprit was the escalation of trade tensions as President Donald Trump announced tariffs on about $60 billion of products from China, which helped to erase some $1.8 trillion from the value of U.S. equities, according to Wilshire Associates. That made the week the worst for stocks since the week ended Jan. 8, 2016, as the Dow ended at its low for 2018 and the major averages lost about 6%, on average.
The step-up of trade conflicts would seem to be the absolutely least surprising aspect of the Trump administration. What’s lost in the noise, according to Christopher Wood of CLSA, “is that Trump seems totally focused on actually trying to implement the policy agenda he campaigned on and is also having some success in doing so.” He succeeded in getting his tax cut, while regulations are being reined in substantially, even if he hasn’t ended Obamacare, Wood adds.
While Trump has changed views over the decades on political parties and social issues such as abortion, he’s been steadfast in blasting the U.S. trade deficit.
The particulars of the tariffs on Chinese goods Trump announced last week remain to be set, affecting an unspecified list of imports to be published in 15 days, after which there will be a 30-day comment period. In other words, a lifetime in the current news cycle, which resembles a fidget spinner. As the previous tariffs on steel and aluminum show, there were waivers carved out for allies such as Canada, Mexico, the European Union, and others, so the final shape of the China tariffs may change substantially by the time they’re implemented.
As for their potential economic impact, JPMorgan economists Michael Feroli and Daniel Silver doubt that the China tariffs will do much to boost aggregate demand in the U.S. economy. Computers and other electronic goods, the biggest imports from China, may simply be deflected to other Asian producers. Meanwhile, U.S. exports of transportation equipment and agricultural goods show those sectors’ vulnerability. Friday, China hit back with $3 billion of potential tariffs on imports of U.S., including fruit and pork products.
The JPMorgan economists estimate the hit to output from this tit-for-tat wouldn’t be enough to adjust their growth forecasts. “A knock-on effect through reduced business confidence, or a further escalation in trade tensions, would add more significant downside risk to our U.S. outlook,” they add.
The trade restrictions could hit companies harder than they would hurt gross domestic product, however. Classic textbook analysis looks primarily at commerce between two nations, such as the exchange of wool from England for wine from Spain. By specializing, each country takes advantage of their comparative advantage and both come out ahead with trade.
That 19th century model doesn’t come close to describing today’s economy, with its intricate supply chains that stretch across borders. Even a moderate rise in protectionism could disrupt these lengthy and complicated supply chains and thus the global economy, writes Dario Perkins, managing director for global macro at TS Lombard.
“Consider, for example, an auto manufacturer that makes engines in Japan, ships them to Canada (where the cars undergo further assembly), before sending the cars to be finished in Mexico. Or the iPhone, ‘officially’ made in China but which includes components from Korea, Taiwan, Japan, and even the U.S.,” he writes.
The days of finished goods being shipped from one country to another are long gone, supplanted by components crossing borders in intricate networks. “It is clear that any attempt to make cross-border trade more difficult would be highly disruptive,” he contends.
It’s also clear that less confrontational tacks to deal with China’s appropriation of intellectual property haven’t worked. Thus, the conflict between the world’s two largest economies seems inevitable. Add to that the fact that the U.S. is the world’s largest debtor and China is its largest creditor. The decline in stock prices should be anything but surprising in that context.
Markets make the news, rather than the other way around, according to the old traders’ line. So, with all eyes riveted to a few solons at the Federal Reserve and their decision to raise the interest-rate target by 25 basis points (one-quarter percentage point), to a new range of 1.5%-1.75%, private borrowers are facing significantly higher costs on loans that are based on the London interbank offered rate, or Libor. That’s even been noticed beyond the money markets.
“From Riyadh to Sydney, short-term funding markets worldwide are starting to feel the effects of soaring U.S. dollar Libor rates,” writes Ian Winer, head of equities at Wedbush Securities. Unlike the causes of the financial crisis in 2008 or the European sovereign debt crisis in 2010, technical factors may be behind the jump in Libor, but it’s still costing borrowers, such as corporations with $2 trillion-plus in loans linked to Libor, or U.S. households with mortgages whose adjustable rates are pegged to that set by big banks in the City of London.
Three-month Libor, the main benchmark, was set Friday at 2.285%, up from 2.2% a week earlier and 1.69% at the end of 2017, according to Peter Boockvar, chief investment officer at Bleakley Advisory Group. That was the No. 1 negative news last week, topping even the Trump tariffs, according to his summation of the week’s market events, as Libor’s spread over overnight rates has widened sharply.
These rising borrowing costs could spell trouble for increasingly debt-reliant corporations, writes Michael Arone, chief investment strategist for the State Street Global Advisors U.S. Intermediary Business Group. Debt of nonfinancial companies has soared to 45% of GDP, the highest total since the financial crisis, which could pose challenges. Higher financing costs could hurt some business models and would diminish the cash available for dividends and share repurchases, he adds.
Policy changes explain a lot of Libor’s rise. The U.S. government’s debt ceiling has been suspended until 2019, so the Treasury has been borrowing heavily to rebuild its cash balance. That balance had been run down as Washington bumped up against the debt ceiling and had to resort to tricks to keep operating.
At the same time, the Fed is reducing its securities holdings, mainly by letting maturing Treasuries roll off, which means Uncle Sam has to sell more paper to the public. Most of that increased borrowing has come at the short end of the market, which has felt the effect of climbing yields in that maturity range. At the same time, repatriation of cash that U.S. corporations have stashed overseas—and have earmarked to be disbursed to shareholders or for capex—has reduced the supply of dollars available to lend. Share buybacks are on pace for a record year, as our colleague Vito Racanelli details on Barrons.com, That’s good for stocks, but results in a higher Libor rate.
These technical factors aside, Libor could be signaling trouble, if its relationship with other rates doesn’t revert to more normal levels. George Goncalves, Nomura’s head of rates strategy, suggests “there may be something more ominous at work.”
In that regard, writes Paul Shea, strategic economist at Miller Tabak + Co., the rise in credit costs shouldn’t be written off entirely as just benign technical effects from increased Treasury issuance or the Fed’s balance-sheet reduction. Investors’ risk aversion has increased since January, based on academic measures, but has remained near historic lows, he adds in an email.
For nonacademic types, the question is what to do. BCA Research suggests that dollar-based investors can buy low-yielding foreign bonds, but reap higher yields from hedging the currency back into dollars. For instance, a dollar-based investor can garner a 3.3% yield on a 10-year German Bund (which yields just 0.53% in euros) after hedging. This isn’t something readily done by individual investors, but institutional bond managers have that option.
For those playing at home, bank-loan funds may be the best bet. A recent Focus on Funds column noted the risk of the most popular such exchange-traded fund, the PowerShares Senior Loan Portfolio (BKLN), notably the credit risk in its loans and the limited liquidity of the loan market.
As noted here previously, closed-end funds that invest in bank loans don’t have to deal with the liquidity issue because they never have to redeem shares, which trade on an exchange. In addition, their market prices remain significantly below their net-asset values, affording investors some margin of safety, plus the potential for capital gains if those discounts narrow.
Among the CEFs with the deepest discounts, the Eaton Vance Senior Income Trust (EVF) and the Eaton Vance Floating-Rate Income Plus funds (EFF) have raised their monthly dividends in the past two months, bringing their yields to the 5.6%-5.7% range, while trading at discounts over 9%. The Apollo Senior Floating Rate fund (AFT) yields 7%, and trades at an 8% discount. So, while worries increase about rising Libor, these are ways investors can take advantage of the disturbing trend.
