2nd Quarter 2019

Why worry about something that isn’t going to happen? – KGB Chairman Charkov

Equity markets continued to rally during the second quarter, bringing the S&P 500’s year-to-date return to 18.5%. Technology and growth stocks continued to dominate with the 21.5% return of the Russell 1000 Value Index beating the 16.2% return of the corresponding Russell 1000 Value Index. Foreign stocks gained, but lagged the US. The MSCI EAFE Index of developed markets returned 14.0% and the MSCI Emerging Markets Index gained 10.6%. The Alerian MLP Index returned 16.9% and remains on track to deliver its first calendar year of aggregate distribution growth since 2014. The bond market sent mixed signals. The inverted yield curve and Fed Fund Futures rates indicate the market expects future rate cuts, typically a sign of an impending recession. However, credit spreads for high yield (‘junk’) bonds remain well below their December peak and far from recessionary levels.

HBO’s phenomenal series Chernobyl brought up some great lessons on how human-caused disasters happen. The show reveals that the Soviet government knew about a potentially lethal flaw in the RBMK reactors that were used across the USSR but kept this knowledge a secret from the plant operators. The flaw was that under a particular and unlikely set of conditions, a catastrophic meltdown would occur if operators attempted to shut down the reactor. The Soviet Union built approximately 15 of these reactors in the 1970s, and they operated without incident until the 1986 Chernobyl disaster, when an error in a planned maintenance routine triggered this flaw and the meltdown ensued. The show also illustrated how individuals in the Soviet government operated based on their own narrow career interests with few giving much thought to the general welfare of their fellow citizens. Ten years into a bull market and economic expansion, one wonders about what potentially lethal flaws await the right combination of circumstance and bad luck to wreak havoc.

An inverted yield curve – defined as the yield of three-month Treasury bills exceeding ten-year Treasury bonds – preceded every recession since 1961. Investors accept lower yields on longer-term bonds than what they could earn from holding a cash equivalent only if they believe future interest rates will decline. This typically occurs only in a recession. As a recession signal, an inverted yield curve possesses a perfect record – no recessions occurred without a prior curve inversion and a recession followed every curve inversion since 1960. However, although this encompasses a nearly 60-year period, only seven inversions and recessions occurred, which makes a small sample size. Furthermore, the length of time between an inversion and following recession ranged from four months in 1973, to 38 months when the curve inverted in 1966. Prior to the 2008 Financial Crisis, the yield curve inverted in February 2006, and nearly two years of strong market and economic performance followed before the recession and bear market began in 2008.

A naïve market timing strategy of owning the S&P 500 but going to cash when the yield curve inverts and remaining in cash until the end of the following recession would have outperformed a buy & hold strategy by 130 basis points per year since 1962. However, this ‘strategy’ would face serious problems if one actually tried to implement it. First, one would need to know when a recession ends in real time. The 2008-2009 recession ended in June 2009, but the NBER did not declare this until September 2010, over a year and a 27% gain in the S&P 500 later. Secondly, the outperformance of this strategy comes almost entirely from the past two recessions and bear markets. Prior to 2000, this market timing strategy was barely above the S&P 500 and had significantly underperformed for long stretches. Ultimately, there is no reason to believe that attempting to use an inverted yield curve to time the market would have a better probability than a coin toss of adding value.

Given their shared communist past, the Chernobyl analogy perhaps applies best to China. As the HBO series illustrated, the basis of a single party state is lying. Bureaucrats lie both to their superiors and to the people below them. China’s banking system currently has approximately $35 trillion in assets, 300% of the size of the country’s GDP and far larger than the banking systems of either US or Europe. The bureaucrats of the Chinese Communist Party control the allocation of most of the capital in this system. For this reason, China analyst Michael Pettis has termed Chinese GDP as an ‘input’ rather than an actual measurement of economic performance. The Chinese government simply directs the capital necessary to accomplish the desired rate of growth.

He writes:
“In any economic system, GDP is supposed to be a measure of output, and in most countries that is exactly what it measures, however messily. The economy does what it does, in other words, and at the end of a given time period, statisticians measure the things economists agree to include in the relevant calculations, and they express the change over time as the scale of GDP growth for that period. This is not what happens in China, where GDP is actually an input determined annually as the country’s GDP growth target. The growth target of a given time period is decided well ahead of time, and to achieve it, various entities, including local governments, engage in the requisite amount of activity, usually funded by debt. As long as China has debt capacity, and as long as it can postpone the writing down of nonproductive assets, Beijing can achieve any growth target it desires.”1

With unlimited credit, bankruptcy becomes impossible and economic growth becomes a simple function of capital employed. However, new debt continues to deliver diminishing rates of growth, and anecdotal evidence suggests the Chinese economy is much weaker than what the official 6.2% rate would suggest. What pitfalls lurk within this complex and opaque financial system as the returns from new borrowing continue to diminish?

Risks abound in the US debt markets. As we discussed in last quarter’s commentary, the International Monetary Fund (IMF) identified corporate debt levels as the most significant risk in its April 2019 Global Financial Stability Report. The combination of BBB-rated corporate bonds now comprising 50% of the investment grade market and the growth of the levered loan market with continued deterioration of creditor protection in loan terms, creates a hazard should the economy fall into a recession. The more restrictive banking regulations that followed the 2008 Financial Crisis resulted in dramatic changes to the mechanics of fixed income markets. Rather than trading on a centralized exchange like stocks, bonds trade through a network of dealers with buyers and sellers comparing multiple bids before deciding with whom to transact. Prior to 2008, banks provided the majority of liquidity in bond markets, using their balance sheets to hold inventory and making a small spread on purchases and sales. With the post-financial crisis regulations, banks no longer fill this role, and liquidity instead comes from less well-capitalized market makers unable to absorb the risk of holding bonds in inventory, particularly in a time of financial panic. Furthermore, US bond ETFs, which held an insignificant amount of assets prior to the Financial Crisis, have grown to $672 billion as of January 2019. This remains a small percentage of the overall fixed income market, but currently ETFs own about 4% of high yield bonds. The ETFs create a potential liquidity mismatch, as the requirements for ETF liquidity exceed the liquidity of the underlying bonds owned by the instruments.

While the historical default rates of investment grade municipal bonds are a fraction of comparably rated corporate bonds, the explosion of unfunded pension liabilities in many states poses significant risk. Ted Dabrowski and John Klingner of Wirepoints.org, point out that underfunded pensions saddle each Chicago household with about $145K of debt2. Trying to shift this burden to
wealthy households would put every family earning $200K or more on the hook for $2 million. Unlike the growth experienced by other major US cities, Chicago’s population actually declined over the past decade, from 2.9 million in 2009 to 2.7 million today. Despite this decline, public employee pension benefits have grown at about an 8% annual rate. Chicago debt trades one level above junk, and it is difficult to see how this situation will become stable without either a bankruptcy or federal bailout. Fortunately, the municipal bond market contains thousands of issuers and investors can construct diversified portfolios that avoid these problem areas.

Like the hidden flaw in Chernobyl’s RBMK reactor, the conditions where one of these structural flaws could create a significant market disruption could happen next quarter, or ten years from now. Such is the nature of risk. For investors the only solution remains knowing what you own and why you own it. Well-capitalized, quality businesses that create value for their customers, employees and shareholders will always remain the core of a diversified investment portfolio. These companies can be found around the world and it makes sense for investors to remain geographically diversified. While the valuation of these businesses currently implies lower future returns than investors experienced over the past decade and greater volatility of both share prices and operating results is likely, attempting to predict and time entry and exit points remains a fool’s game.

1 https://carnegieendowment.org/chinafinancialmarkets/78138
2 https://wirepoints.org/wealthy-chicago-households-on-the-hook-for-up-to-2-million-in-debt-each-under-progressive-approach-to-pension-crisis

Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer

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