For many, the concept of liquidity is a bit hard to grasp. In essence, liquidity, as it refers to financial markets, means, “the funds that are available to acquire something”. To a lesser extent, it also refers to the cost of money. If money is restricted as to what it can buy, then the cost of money is secondary to its availability. Most forecasting tools focus on the cost and not the availability of money.
Nowhere is this observation more stark than in the policies of the Federal Reserve of the past nine years. By making money both cheaper and more accessible, they have reflated the value of assets which were under pressure in 2008-2009 in the real estate collapse. Money has not been accessible to all. As one person observed, it is easier for a hedge fund manager to get a billion dollar loan to buy a company than it is for a couple to buy a house. Because so much of the liquidity went into the appreciation of financial assets, including stocks, the market has more than tripled in value since its 2009 bottom.
Some parts of the market went up more than others. Large technology companies such as Facebook, Amazon, Apple, Netflix, and Alphabet (née Google), which together are known as FAANG, have become an ever larger share of both market appreciation and market indexes. Index funds, whose popularity soared in this market upcycle, helped reinforce the appreciation of this group by funneling ever rising amounts of new cash to the purchase of their shares. The younger generation, seeing the value of their parent’s homes vaporize, vowed to rent and put money in the market through various computer programs. As bank deposits and other instruments of savings returned microscopic returns, more people were compelled to adopt this strategy of investing, not because they were comfortable with it, but because it was the only way to earn a decent return.
However, last fall Janet Yellen, the retiring Federal Reserve Chair, embarked on a program to reduce the amount of liquidity in the financial system. At its peak, the government had purchased some $4.4 trillion dollars in bonds to suppress interest rates and provide funds for the former bond owners. This policy reversed starting last fall, reducing the size of the government’s bond portfolio by $440 billion per year, to the purpose of eliminating it over ten years.
The effects have already been felt. Online banks are offering accounts yielding 1.5% and rising. Banks are raising rates, and raising lending standards to boot. Current interest rates are being suppressed by the remittance of foreign profits back to the US, aided by the lower corporate tax rate. After the first half of the year, the remittance effect will be spent, and interest rates are expected to rise further thereafter. Look for a two percent federal funds rate and a near three percent money market rate by year-end.
Underpinning the rise in interest rates will be the fall of the dollar. The dollar has already witnessed a year of decline, and that will only accelerate in 2018. Foreign investors, flummoxed by the positions taken by the US Government on everything from trade agreements to criticizing our closest allies in public, will likely continue to cut back on dollar-denominated debt in favor of stronger currencies like the Chinese Yuan. With a Federal deficit in 2019 estimated to be around $800 billion, climbing to $1 trillion by 2020, the US is not in a position to lose investors. Yet lose it shall.
The economy in 2018 will be on steroids. Many an investor has questioned the logic of passing a $150 billion per year tax cut when the economy is performing well, and has been for years. The answer has nothing to do with economics, and everything to politics. Trump campaigned on a promise to cut taxes for his base, and especially for his donors. This has exposed one of the ironies of politics. If a person were to try to buy someone’s vote, that is considered a crime. But if an entire political party does it, it is considered fiscal policy.
The result is a budget that moves ever further away from being balanced, and is more reliant on foreign investors to subsidize. This trend is not sustainable, and is expected to come to a head in 2020 or thereabouts.
The last time international investors lost confidence in the dollar was during the Carter administration. At one point, people so lacked faith in the willingness of Carter to take on inflation, that American tourists abroad could not convert their traveler’s cheques to the local currency. It took the appointment of Paul Volcker to head the Federal Reserve and restore trust in the value of the American dollar. Trust in a currency, once lost, is very difficult to regain. With China positioning the Yuan to be the successor reserve currency, the difficulty multiplies.
Domestic economic growth in 2018 will be good, but constrained by both the lack of immigrants to expand the labor force and slower exports as trade agreements are voided and the market for American goods is narrowed. Contrary to popular perception, little of the tax cut is going towards expanding the economy. One firm that paid each of its employees a $1,000 bonus upon the tax bill’s passage spent more on lobbyists than they did on bonuses.
Evidently the lobbying money was well spent. While it was true that other countries have had lower tax rates than the US, large domestic companies have a plethora of tax breaks from the Research & Experimentation Tax Credit from accelerated depreciation to various programs to assist the working poor, a term among developed nations that is unique to the United States. This uniqueness is due to the fact that our country’s minimum wage is not above the government’s own poverty line. Thus the funds provided to employees by the government become corporate welfare; conversely, businesses in other countries pay enough in wages and benefits to make such government support unnecessary. In theory, American companies should have received the lower tax rate in exchange for giving up their tax breaks and assistances. Instead, they got both.
While 2018 will be well, and perhaps better if Trump passes his $100 billion per year infrastructure spending bill, it would seem that it is past time for inflation to make its presence felt. Whether by design or not, government statistics on inflation remain subdued, per the government’s efforts to measure.
However, in 2018 there will be two trends that will be hard to miss. The first is the rally in commodity prices. Many of them started their ascent in 2017, as world demand caught up with world supply. The second is the fall of the dollar, once foreign reparations dry up, which will make imports (including commodities) more expensive.
Summing up, the tax cuts and falling dollar are a transfer of wealth from the government to the corporate and donor classes. There are not expected to be enough investment opportunities provided for the funds generated. A mature economy and a lack of population growth will ensure that firms will invest to become more efficient (i.e. generate fewer jobs) rather than become expansionary (i.e. generate more jobs to address additional demand). A falling dollar makes our exports more competitive, unless we are discriminated against for leaving trade treaties that have been in place for a while.
So what about stocks? This will be a year of cross currents, as rising interest rates force many investments to either perform or be cast aside.
Start with the FAANG stocks described above. Most are selling at price/earnings ratios that are several standard deviations from the overall market, which is itself richly valued. Expect several of these stocks to fall back to earth in 2018.
The poster child for this group is Amazon. This is a company that plays by the rules of Ayn Rand, who believed in the conquest of capitalism, but not of compassion for its victims. Amazon sells for over 300 times trailing earnings, 12 times more than the overall market, yet its stock progresses upwards on the implied promise of a near-monopoly in internet sales. As interest rates go up, expect to see more accountability, if not a rush for the exits. With very little effort, this stock could experience the fate of Tesla, which has not been around as long, but in terms of investment promises is cut from the same cloth.
The overall market has a trailing price/earnings ratio of around 26. According to work done by Steve Leuthold, when markets reach this level, the projected annual return for the next decade is 3.3 percent per year. The trick to navigating this market is to find investments in firms that have more reasonable valuations, but have the fundamentals that will give them room to run.
Among commodities, energy looks enticing. After the collapse in 2014, the oil and gas market seems to be tightening yet again. The better capitalized firms for stocks and master limited partnerships (MLPs), and bonds for the more speculative look good this year.
Are stocks too high? In some cases, yes. But the market is a big ocean full of stocks of different sizes and objectives. So long as you are looking for fundamental value, you should be able to sail past the more overvalued sectors.
Warren M. Barnett, CFA
January 8, 2018